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| What is meant by cost benefit analysis? |
Defining Cost Benefit Analysis
Cost–benefit analysis (CBA), sometimes also called benefit–cost analysis, is a systematic approach to estimating the strengths and weaknesses of alternatives used to determine options which provide the best approach to achieving benefits while preserving savings (for example, in transactions, activities, and functional business requirements).
A CBA may be used to compare completed or potential courses of actions, or to estimate (or evaluate) the value against the cost of a decision, project, or policy. It is commonly used in commercial transactions, business or policy decisions (particularly public policy), and project investments. For example, the U.S. Securities and Exchange Commission has to conduct cost-benefit analysis before instituting regulations or de-regulations.
CBA has two main applications:
- To determine if an investment (or decision) is sound, ascertaining if – and by how much – its benefits outweigh its costs.
- To provide a basis for comparing investments (or decisions), comparing the total expected cost of each option with its total expected benefits.
CBA is related to cost-effectiveness analysis. Benefits and costs in CBA are expressed in monetary terms and are adjusted for the time value of money; all flows of benefits and costs over time are expressed on a common basis in terms of their net present value, regardless of whether they are incurred at different times. Other related techniques include cost–utility analysis, risk–benefit analysis, economic impact analysis, fiscal impact analysis, and social return on investment (SROI) analysis.
Cost–benefit analysis is often used by organizations to appraise the desirability of a given policy. It is an analysis of the expected balance of benefits and costs, including an account of any alternatives and the status quo. CBA helps predict whether the benefits of a policy outweigh its costs (and by how much), relative to other alternatives.
This allows the ranking of alternative policies in terms of a cost–benefit ratio. Generally, accurate cost–benefit analysis identifies choices which increase welfare from a utilitarian perspective. Assuming an accurate CBA, changing the status quo by implementing the alternative with the lowest cost–benefit ratio can improve Pareto efficiency.
Although CBA can offer an informed estimate of the best alternative, a perfect appraisal of all present and future costs and benefits is difficult; perfection, in economic efficiency and social welfare, is not guaranteed.
The value of a cost–benefit analysis depends on the accuracy of the individual cost and benefit estimates. Comparative studies indicate that such estimates are often flawed, preventing improvements in Pareto and Kaldor–Hicks efficiency. Interest groups may attempt to include (or exclude) significant costs in an analysis to influence its outcome.
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What is the purpose of cost benefit analysis?
A cost-benefit analysis (CBA) is the process used to measure the benefits of a decision or taking action minus the costs associated with taking that action. A CBA involves measurable financial metrics such as revenue earned or costs saved as a result of the decision to pursue a project.
The Disadvantages of a Cost Benefit Analysis:
- Potential Inaccuracies in Identifying and Quantifying Costs and Benefits
- Increased Subjectivity for Intangible Costs and Benefits
- Inaccurate Calculations of Present Value Resulting in Misleading Analyses
- A Cost Benefit Analysis Might Turn in to a Project Budget
A generic cost–benefit analysis has the following steps:
- Define the goals and objectives of the action.
- List alternative actions.
- List stakeholders.
- Select measurement(s) and measure all cost and benefit elements.
- Predict outcome of costs and benefits over the relevant time period.
- Convert all costs and benefits into a common currency.
- Apply discount rate.
- Calculate the net present value of actions under consideration.
- Perform sensitivity analysis.
- Adopt the recommended course of action.
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