cost benefit analysis

Cost‐Benefit Analysis As Project Evaluation Tool

Paul Guthiga, ReSAKSS‐ECA

Workshop on Strengthening Capacity for Strategic Agricultural Policy and Investment Planning and Implementation in Africa

Safari Park Hotel, Nairobi on 25th‐ 26th April 2012

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An Overview of CBA…1

Decision‐making at…

• An individual; intuition, or some analysis

• For a private entity (say company)– Profit motive hence… full financial appraisal of theproject.

• For the Government; more difficult– Not just profitability but social cost and benefits oftheir choices.

– Other considerations; equity, environmental

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• CBA is a tool primarily used by governments in

making their social and economic decisions.

• It also considers activities that are not normally

priced by the market (externalities)

• Attempts to quantify and include in estimates of

cost and benefits not just to individual and private

entities but also to rest of community.

An Overview of CBA…2• Development interventions often involve huge costs

• These costs should be quantified and compared with thepotential or actual benefits

• Can be done through use of a CBA which could beconducted ex ante and/or ex post

• CBA is not done on a before‐and‐after basis but on a‘with’ and ‘without’ project basis (to avoid over/under‐estimation)

• Ultimate measure is the incremental net benefit of theproject


• Involves comparing costs and benefits from different

time periods

• Money values across time periods are not

immediately comparable; why?

• …because of inflation and returns in the market

• Hence the need to discount future costs and benefits

Theoretical foundations of CBA…1

• a) The preferences of individuals are to be taken asthe source of value.

• b) Preferences are measured by a willingness to pay(WTP) for a benefit and a willingness to acceptcompensation (WTA compensation) for a cost.

• c) Individuals’ preferences can be aggregated so thatsocial benefit = the sum of all individuals’ benefitsand social cost is the sum of all individuals’ costs.


• d) If beneficiaries from a change can‘hypothetically’ compensate the losers from achange, and have some net gains left over, thenthe basic test that benefits exceed costs is met.

• The theoretical concept (d) above is the Kaldor‐Hicks principle of potential compensation…

• …if the gainers from an action could compensatethe losers, the action is an improvementregardless of whether compensation is actuallypaid.


• Provided that compensation could occur then

no one is actually worse off…

• the Pareto‐criterion for improvement in

overall well‐being is met.

Limitations of CBA…1

• CBA fails to explicitly account for distribution of

benefits in the society (equity)

• Attempts to integrate distributive issues in CBA by

applying weighting factors to benefits or costs to

reflect the income of individual affected

• The theoretical arguments for these weights are

based on the declining marginal utility of income

Limitations of CBA…2

• Some CBA practitioners feel that inclusions of equity

goals fall outside the realm of economics

• But…possibility to track the distribution of costs and

benefits among the various segments of society.

Financial versus Economic CBA…1

• Financial CBA is carried out from the perspective of a private point of view

• Key question; does a project have a sufficiently high return on investment for a private entity to be worth implementing.

• A positive outcome of financial CBA means that a project is profitable to an investor.

• However, projects that may seem appealing to a private investor…may be unattractive to a country as a whole.

• Hence the need for an economic CBA.


• All benefits and costs to society, or all impacts on real national income, are taken into account in economic CBA

• An economic CBA will have to be conducted only when there are reasons to believe that the outcomes will differ from financial CBA.

• When does this occur;– This is the case when taxes are levied/subsidies granted,

– External effects exist and/or

– prices are distorted (do not reflect their real scarcity).


• To transform a financial CBA into an economic CBA three groups of adjustments have to be made: – Step 1: transfers (taxes, subsidies) are to be removed;

– Step 2: all positive and negative external effects have to be included;

– Step 3: market prices of goods and services have to be replaced by economic prices;


• Financial CBA may give artificially positive outcomes;when subsidies are more important than taxation.

• Subsidization; e.g. cheap fertilizer to farmers.• Makes farmers production costs to be lower thanthose of imported commodities, hence artificially highfinancial NPV/IRRs.

• Subsidies should be ignored in an economic analysis.• The economic IRR will, all other things assumed equal,be lower than the financial IRR.


• Low profitability resulting in financial CBA may becaused by excessive taxation

• Tax payments are part of a project's costs, andtherefore negatively affect the financialprofitability.

• For instance, if in the financial CBA of a firm theimport costs of US$ 0.5m for raw materials includea 25% import tariff..

• The corresponding cost to the nation in economicterms is just US$ 0.375m.

Financial versus Economic CBA…6• Prices play an essential role in CBA, because themethod requires that all effects are recorded inmonetary terms

• Financial CBA applies actual, domestic market prices;• Whether these are free‐market prices, or the resultof government intervention is of no importance toprivate decision‐makers.

• In economic CBA, that question is elementary.• Prices in economic CBA should give a comprehensivepicture of the value to society (a measure of theirscarcity).


• If market prices fail to do so, if they are distorted,and economic CBA prescribes that prices arereplaced by economic (or accounting or shadow)prices.

• These prices are not observed in reality, butcalculated on the basis of the concept of opportunitycosts.

STEPS OF CARRYING OUT CBA

Steps…1

1. Identifying the resources being reallocated in agiven project or activity as well as the gainers andthe losers in that process (set the boundary of theanalysis);

2. Identifying the economically relevant impacts of theproject/activity implementation.

3. Group them into positive impacts (benefits) andnegative impacts (costs).

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Typical costs and benefits….

Steps…2

4. The identified impacts are physically quantified and assigned a monetary value.

5. The decision criteria are applied once the net benefits are discounted.

The decision criteria include NPV; Internal Rate of Return (IRR) or Benefit‐Cost ratio (B‐C ratio)

Any course of action is judged acceptable if it confers a net benefit (present value of benefits outweighs the present value of costs)

Steps…3

6. Finally, sensitivity analysis is carried out to capture

the different possible scenarios.

How? By varying the discount rate, time frame or policy

scenarios.

Decision‐Criteria…1

• Net present value/worth

If NPV(W) >0; B/C>1 the project is worthwhile

Decision‐Criteria…2

Decision rule; largest IRR above cut‐off rate (many

projects can give multiple IRRs from the same data set

and cannot decide among many projects)

Critical issues in CBA

Discount rate…1• The concepts of discounting and choice of a discount rate are controversial in CBA

• Discounting & discount rate has implications for future benefits and costs

• Decisions on implementation of long term projects depend on the choice of discount rate.

• Implication of discounting;– Benefits and costs long in future are weighed less; higher the time bias.

Discount rate…2

• From an economic perspective, discount rate is therate at which society weighs future consumptionagainst present consumption, or..

• Rate by which it attaches a social time preference toconsumption by its members.

• From a financial perspective the discount rateis the prevailing interest rate..

• Which one would be higher and why?

Discount rate…3

• The process of discounting is defended by economists as reflecting the way people value things….– Positive rate of time preference (for both consumers and producers) and…

– Opportunity cost of capital (for producers) the future is treated as less important than the present.

• In practice the choice of the discount rate is the onus of the researcher guided by various considerations such as;– The discount rates applied for government agencies – The length of the project time considered – Opportunity cost of capital in the country/area

Time horizon

• An important consideration in CBA

• From private individual perspective…it is the most

relevant time horizon is the part of their lifetime that

they are likely to benefit from the project.

cost benefit analysis

Economy & Finance