Cost and Benefit
Cost and Benefit
A cost benefit analysis is done to determine how well, or how poorly, a planned action will turn out. Although a cost benefit analysis can be used for almost anything, it is most commonly done on financial questions. Since the cost benefit analysis relies on the addition of positive factors and the subtraction of negative ones to determine a net result, it is also known as running the numbers. A cost benefit analysis finds, quantifies, and adds all the positive factors. These are the benefits. Then it identifies, quantifies, and subtracts all the negatives, the costs.
The difference between the two indicates whether the planned action is advisable. The real trick to doing a cost benefit analysis well is making sure you include all the costs and all the benefits and properly quantify them. Should we hire an additional sales person or assign overtime? Is it a good idea to purchase the new stamping machine? Will we be better off putting our free cash flow into securities rather than investing in additional capital equipment? Each of these questions can be answered by doing a proper cost benefit analysis.
Jules Dupuit, a French engineer, first introduced the concept of Cost-Benefit Analysis in the 1930s. It became popular in the 1950s as a simple way of weighing up project costs and benefits, to determine whether to go ahead with a project. As its name suggests, Cost-Benefit Analysis involves adding up the benefits of a course of action, and then comparing these with the costs associated with it. The results of a cost-benefit analysis are often expressed as a payback period – this is the time it takes for benefits to repay costs. Many people who use Cost-Benefit Analysis look for payback in less than a specific period – for example, three years. You can use Cost-Benefit Analysis in a wide variety of situations. For example, when you are: .Deciding whether to hire new team members.
.Evaluating a new project or change initiative.
.Determining the feasibility of a capital purchase.
However, bear in mind that Cost-Benefit Analysis is best for making quick and simple financial decisions. More robust approaches are commonly used for more complex, business-critical or high cost decisions. http://www.mindtools.com/pages/article/newTED_08.htm
BCA attempts to capture all benefits and costs accruing to society from a project or course of action, regardless of which particular party realizes the benefits or costs, or the form these benefits and costs take. Used properly, BCA reveals the economically efficient investment alternative, i.e., the one that maximizes the net benefits to the public from an allocation of resources. BCA is not the same thing as financial analysis. Financial analysis is concerned with how to fund a project over its lifespan and measures the adequacy of current and future funds and revenues to cover the cost of building, operating, and maintaining the project. While financial analysis is an important part of project management, the economic merit of the project as measured by BCA is generally not affected by how the project is financed.
Useful Applications of Benefit-Cost Analysis
Benefit-cost analysis (BCA) considers the changes in benefits and costs that would be caused by a potential improvement to the status quo facility. In highway decision-making, BCA may be used to help determine the following: * Whether or not a project should be undertaken at all (i.e., whether the project’s life-cycle benefits will exceed its costs). * When a project should be undertaken. BCA may reveal that the project does not pass economic muster now, but would be worth pursuing 10 years from now due to projected regional traffic growth.
If so, it would be prudent to take steps now to preserve the future project’s right-of-way. Which among many competing alternatives and projects should be funded given a limited budget. BCA can be used to select from among design alternatives that yield different benefits (e.g., reconstruct a roadway with additional lanes versus no additional lanes); unrelated highway projects (a widened road versus an interchange on another road); and unrelated transportation projects in different transportation modes.
The Benefit-Cost Analysis Process
In BCA, the analyst applies a discount rate to the benefits and costs incurred in each year of the project’s life cycle. This exercise yields one or more alternative measures of a project’s economic merit. The BCA process begins with the establishment of objectives for an improvement to a highway facility, such as reducing traffic congestion or improving safety. A clear statement of the objective(s) is essential to reduce the number of alternatives considered. The next step is to identify constraints (policy, legal, natural, or other) on potential agency options and specify assumptions about the future, such as expected regional traffic growth and vehicle mixes over the projected lifespan of the improvement. Having identified objectives and assumptions, the analyst (or analytical team) then develops a full set of reasonable improvement alternatives to meet the objectives.
This process begins with the development of a “do minimal” option, known as the base case. The base case represents the continued operation of the current facility under good management practices but without major investments. Under these “do minimal” conditions, the condition and performance of the base case would be expected to decline over time. Reasonable improvement alternatives to the base case can include a range of options, from major rehabilitation of the existing facility to full-depth reconstruction to replacement by a higher volume facility. Such alternatives will often involve construction, but alternatives that improve highway operations (such as the use of intelligent transportation systems) or manage travel demand (such as incentives for off-peak travel) are suitable for consideration.
Major Steps in the Benefit-Cost Analysis Process
1. Establish objectives
2. Identify constraints and specify assumptions
3. Define base case and identify alternatives
4. Set analysis period
5. Define level of effort for screening alternatives
6. Analyze traffic effects
7. Estimate benefits and costs relative to base case
8. Evaluate risk
9. Compare net benefits and rank alternatives
10. Make recommendations
The Public Spending Code D. Standard Analytical Procedures Guide to economic appraisal: Carrying out a cost benefit analysis http://publicspendingcode.per.gov.ie/wp-content/uploads/2012/08/D03-Guide-to-economic-appraisal-CBA-16-July.pdf
University/College: University of California
Type of paper: Thesis/Dissertation Chapter
Date: 23 December 2016
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