When making a decision, especially in the public sector, it is imperative that officials understand the costs and benefits of their choice, whether it be establishing a new program or making changes to an existing program. Below, I provide a broad, standard process officials can follow when conducting a cost-benefit analysis. I did not go into a lot of detail for each step and if you would like to know more, please checkout this cost-benefit analysis guide.
- Set the framework for the analysis. Specify the program or policy change and the current status quo, or the state of the world before implementation compared to after.
- Decide whose costs benefits should be recognized. You need to determine the geographic scope of the analysis in order to limit the groups impacted by the policy.
- Identity and categorize costs and benefits. It is important to label costs and benefits as direct (intended costs/benefits)/indirect (unintended costs/benefits), tangible (easy to measure and quantify)/intangible (hard to identify and measure), and real (anything that contributes to the bottom line net-benefits)/transfer (money changing hands) in order to ensure that you understand the effects of each cost and benefit.
- Project costs and benefits over the life of the program. Assess how costs and benefits will change each year. It is important to do this even before you begin to place numbers on things.
- Monetize costs. Make sure to place all costs in the same unit.
- Monetize benefits. Make sure to place all benefits in the same unit.
- Discount costs and benefits to obtain present values. This means converting future costs and benefits into present value. This is also known as the social discount rate, or the rate at which society makes tradeoffs over time. Every agency tends to have a different discount rate. It generally ranges between 2-7%.
- Compute net present values. This is done by subtracting costs from benefits. The policy is considered efficient if a positive result is produced; however, it is important to think about the policy’s feasibility and social justice.
- Perform sensitivity analysis. This step allows you to check the accuracy of your estimates and assumptions. This is normally done by altering the social discount rate utilized, by increasing it and decreasing it. If you still get a positive number during this step, then the policy should be accepted. If you get a negative number during this step, then you should calculate where the balancing point is zero.
- Make a recommendation. Assess all results and account for other qualitative considerations.
What Do You Think?
Do you think performing a cost-benefit analysis is important when making government decisions?
When making a cost-benefit analysis in the public sector, personnel should be following the guidelines of Office of Management and Budget (OMB) Circular A-94, Guidelines and Discount Rates for Benefit-Cost Analysis of Federal Programs.
Another important tool is the Government Accountability Office (GAO) Cost Estimating and Assessment Guide, Best Practices for Developing and Managing Capital Program Costs (GAO-09-3SP, Mar 2, 2009).
These processes are further outlined there, and used for capital assets and budgetary decisions for cost effective analysis.
Having taught this topic for DoD for several years now, I think there are several steps that need to be highlighted a bit more. In government circles (especially DoD) the benefits are not always monetary. In fact, it is rare that DoD gets to do projects that have monetary benefits. Therefore government agencies need to consider more than just the net present value of projects. Even when there are monetary benefits, the calculations are not as straight forward as the academic rule books would have us believe. Many of the economic calculations were based on assumptions that economic benefits exceed or at least come close to the costs. When they don’t come close (which is most of the time), then the sensitivity analysis will give results that appear to support the decision when in reality it is a flawed formula.
I teach an 8 step process that is not a linear process. It works better that way. The two key elements in a CBA are: (1) know what issue you are trying to solve, (2) understand what your status quo is. A well described status quo gives insight into why you need to change. If the status quo is perfectly fine, then why are you doing a CBA?
After that, it is a fairly easy process to understanding where do you want to go (i.e., defining alternatives), deriving your costs and benefits (both monetary and non-monetary). The real skill is then in being able to take all of the issues and supporting documentation and come up with a way to show a rational way through all of it. For the real purpose of a CBA is to communicate the issues. The second goal is to come up with a decision.
hi Darell , will you be able to help me with the 8 step process that you teach ? and i do agree with the fact that benefits need to be only monetary so i ll would like to know your insight on this
I mean benefits need not to be only monetary .
some benefits are not monetary but you can try to come up with the money value of that benefit sothat all benefits have a one unit of measurement. this will help in computing present value and easy comparison between cost and benefits
[…] by S. Holquist […]
There are different types of cost analysis
Question:
What is the difference between a cost-effectiveness analysis, a cost-utility analysis, a cost-benefit analysis, and a cost-minimization analysis?
Answer:
All four types of analyses are just sub-types of decision analysis. A decision analysis is a technique to help make decisions under conditions of uncertainty.
A cost-effectiveness analysis is a type of decision analysis that generates results where cost is in the numerator, and a measure of effectiveness is in the denominator. The most typical measure of effectiveness is “life years.”
A cost-utility analysis also has cost in the numerator, but has a special measure of effectiveness called a “quality adjusted life year,” or “QALY,” in the denominator.
A cost-benefit analysis has cost in both the numerator and denominator. The cost in the denominator is based upon the “willingness to pay” for a cure.
Finally, a cost minimization analysis only generates costs – it does not have a denominator.
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