How does a cost benefit analysis work?
January 3, 2011 6:53 AM Subscribe
How does a cost benefit analysis work?
I'm having real trouble understanding the deeper uses of a cost benefit analysis e.g. why/when it's used and the advantages/disadvantages etc. Could someone steer me in the right direction please.
I'm having real trouble understanding the deeper uses of a cost benefit analysis e.g. why/when it's used and the advantages/disadvantages etc. Could someone steer me in the right direction please.
Is there a particular context you're interested in here? We might be able to help you more specifically.
posted by chesty_a_arthur at 7:06 AM on January 3, 2011
posted by chesty_a_arthur at 7:06 AM on January 3, 2011
Taken a step further with the movie analogy, you can go to the movies for $13, or you can wait a month and rent it for $3. Is the big screen, big sound, cushy seat, and seeing a movie when it comes out worth more than $10 to you? If yes, go to the movies, if no, rent it in a month.
posted by Grither at 7:08 AM on January 3, 2011 [2 favorites]
posted by Grither at 7:08 AM on January 3, 2011 [2 favorites]
Response by poster: I am currently doing a study on the Severn Barrage in the UK. The English government has done a cost benefit analysis on the barrage, so I'm trying to research how a cost benefit analysis works so I can address this within the report.
posted by sockpim at 7:13 AM on January 3, 2011
posted by sockpim at 7:13 AM on January 3, 2011
Wikipedia's entry on cost-benefit analysis has a lot of information about various government analyses, which may help your thinking.
posted by dfriedman at 7:15 AM on January 3, 2011
posted by dfriedman at 7:15 AM on January 3, 2011
Also this article by Tim Worstall in the Guardian seems interesting. (Though as an American I am wholly uninformed about the issue here, so take this with a grain of salt.)
posted by dfriedman at 7:20 AM on January 3, 2011
posted by dfriedman at 7:20 AM on January 3, 2011
In general, a cost benefit analysis is best understood within the context of a business or government entity doing something necessary. You can construct a series of cost benefit analyses (however you spell the plural there?) if comparing a range of alternatives, but strictly speaking, it's the COST of implementing an alternative vs. the BENEFITS of implementing it, measured in:
- revenues generated, if any.
- money saved (and this assumes that you had to spend the money regardless, i.e. if the jacket was $200 and it's $100 on sale, you canNOT say "hey, it's a wash - spend $100, save $100, we're breakin' even here!)
It does NOT include things like quality of life, how nice it would be to do, environmental impact (unless there is a price tag for not doing something, like a fine or clean up costs), etc.
Properly constructed, a cost-benefit analysis should lead to an ROI figure, at least in business - don't know that government accounting works like that.
Example, pulled out of my - ear:
Cost/benefit of buying another car:
Cost of new car:
$24,000 purchase
$1,000 taxes
$200 costs of shopping for it, etc.
Total $25,100
if financed: interest costs of loan, $2,000
$27,100 final total
$451.66 cost per month over 5 years (this is not necessarily the payment, but we're spreading it over the projected life of the car before we intend to dispose of it)
Benefit of buying new car:
Better gas mileage - at projected gas prices save $360 per year.
Car is under warranty, so routine maintenance ($500 per year) vs. average repairs of clunker for past 3 years ($3,500 per year) - net savings of $3,000 per year.
Car rentals, taxis, etc. we've paid average per year because car breaks down - $500 per year.
Projected value of car after 5 years if we sell it: $6,000
So if I've done my math right:
cost of buying car: $5,420 per year, assuming keep the car 5 years.
benefit of buying car: $5,060 per year.
Notice there are lots of assumptions, most notably - do you need a car at all? But assuming you do need a car, this is how THIS car you're looking at breaks down. And this is how businesses (should) do it, not based on emotional factors like "I hate the color of my current car" or even "I'm frustrated that it always breaks down when I need it."
posted by randomkeystrike at 7:48 AM on January 3, 2011
- revenues generated, if any.
- money saved (and this assumes that you had to spend the money regardless, i.e. if the jacket was $200 and it's $100 on sale, you canNOT say "hey, it's a wash - spend $100, save $100, we're breakin' even here!)
It does NOT include things like quality of life, how nice it would be to do, environmental impact (unless there is a price tag for not doing something, like a fine or clean up costs), etc.
Properly constructed, a cost-benefit analysis should lead to an ROI figure, at least in business - don't know that government accounting works like that.
Example, pulled out of my - ear:
Cost/benefit of buying another car:
Cost of new car:
$24,000 purchase
$1,000 taxes
$200 costs of shopping for it, etc.
Total $25,100
if financed: interest costs of loan, $2,000
$27,100 final total
$451.66 cost per month over 5 years (this is not necessarily the payment, but we're spreading it over the projected life of the car before we intend to dispose of it)
Benefit of buying new car:
Better gas mileage - at projected gas prices save $360 per year.
Car is under warranty, so routine maintenance ($500 per year) vs. average repairs of clunker for past 3 years ($3,500 per year) - net savings of $3,000 per year.
Car rentals, taxis, etc. we've paid average per year because car breaks down - $500 per year.
Projected value of car after 5 years if we sell it: $6,000
So if I've done my math right:
cost of buying car: $5,420 per year, assuming keep the car 5 years.
benefit of buying car: $5,060 per year.
Notice there are lots of assumptions, most notably - do you need a car at all? But assuming you do need a car, this is how THIS car you're looking at breaks down. And this is how businesses (should) do it, not based on emotional factors like "I hate the color of my current car" or even "I'm frustrated that it always breaks down when I need it."
posted by randomkeystrike at 7:48 AM on January 3, 2011
The tricky thing about cost benefit analysis is valuation. This is the most stark example of garbage in/garbage out I can think of (not in regards to Severn Barrage, but generally). The answer you get depends entirely on what is chosen as a representative value. Average taxpayer? Value of something at what date? What appraised value? Add to that the time value of money and answers can be radically different.
I use cost benefit analysis all the time, but I am aware of the values I am choosing. If you question an analysis, the place to start is what they base their premises on.
posted by readery at 7:48 AM on January 3, 2011 [1 favorite]
I use cost benefit analysis all the time, but I am aware of the values I am choosing. If you question an analysis, the place to start is what they base their premises on.
posted by readery at 7:48 AM on January 3, 2011 [1 favorite]
Think of it as a simulation. Or playing out the various options, to see which option gives you the greatest value.
A simple cost benefit analysis is one of the basics of market economics, the demand curve. You have a product that is in demand. You need to figure out what to price it at. Too low, and you will run out of them, and probably not make any profit. Too high and you will end up with some left over. So you run the numbers (cost benefit analysis) and figure out the price that will maximize your profits while minimizing your costs. In doing the analysis, you might find that your initial reaction to price them low and sell a bunch won't be the most profitable option. By doing the cost benefit analysis, you find that knocking the price up a bit reduces the number of things you sell, but increases the gross profit.
To add a layer of complexity, suppose you get a competitor. You sell your thing at $10, he sells his for $8. A price you really don't want to compete at. You have two options: make your product crappier to compete at the other guy's price, or improve your product to differentiate it from the competition. Suppose your current profit per year on this thing is $100,000. But this new competitor is going to cut into your sales and you won't make $50,000 next year. Lowering the quality and price reduces your profit to $80,000. Your other option is to add a handsome carrying case that adds differentiation to your product. This will cost you $5000 in materials, and maybe another $5000 in lost business. Your gross profit is now $90000. Or, you might add differentiation to your product by spending that same $10,000 on some advertising that sexes up your product. Instead of losing business, your revenue goes up without costs going up, and now your profit is back to $100,000.
Cost benefit analysis is playing out all the scenarios you can think of with the information you currently have, and figuring out which choice makes the most economic sense.
(Another (probably apocryphal) cost-benefit analysis example is the stories you hear about auto manufacturers or Home Depot figuring out whether it is cheaper to improve their safety at great cost, or just pay off when they injure people. This is a case where the cost-benefit analysis must include non financial aspects. Do they want to be known as the place where prices are low and death benefits are fair and paid quickly? Or as the place that sacrifices profit because safety is the right thing to do? Every management team will have different ideas of these intangibles.)
(A third is the Sam's Club versus Costco example. They both compete in the same marketplace. Sam's improves profits by paying their people low, and accepting that this might lower customer satisfaction. But they have the lowest prices, and a certain number of customers will suffer almost anything for that. Costco treats their employees well, and hopes this will translate into customer loyalty, despite not always being the lowest price. Each company solved the same problem a different way, and in this case, we can do a meta-analysis on the cost versus benefit of each option by looking at the relative performance of the two companies.)
posted by gjc at 7:54 AM on January 3, 2011
A simple cost benefit analysis is one of the basics of market economics, the demand curve. You have a product that is in demand. You need to figure out what to price it at. Too low, and you will run out of them, and probably not make any profit. Too high and you will end up with some left over. So you run the numbers (cost benefit analysis) and figure out the price that will maximize your profits while minimizing your costs. In doing the analysis, you might find that your initial reaction to price them low and sell a bunch won't be the most profitable option. By doing the cost benefit analysis, you find that knocking the price up a bit reduces the number of things you sell, but increases the gross profit.
To add a layer of complexity, suppose you get a competitor. You sell your thing at $10, he sells his for $8. A price you really don't want to compete at. You have two options: make your product crappier to compete at the other guy's price, or improve your product to differentiate it from the competition. Suppose your current profit per year on this thing is $100,000. But this new competitor is going to cut into your sales and you won't make $50,000 next year. Lowering the quality and price reduces your profit to $80,000. Your other option is to add a handsome carrying case that adds differentiation to your product. This will cost you $5000 in materials, and maybe another $5000 in lost business. Your gross profit is now $90000. Or, you might add differentiation to your product by spending that same $10,000 on some advertising that sexes up your product. Instead of losing business, your revenue goes up without costs going up, and now your profit is back to $100,000.
Cost benefit analysis is playing out all the scenarios you can think of with the information you currently have, and figuring out which choice makes the most economic sense.
(Another (probably apocryphal) cost-benefit analysis example is the stories you hear about auto manufacturers or Home Depot figuring out whether it is cheaper to improve their safety at great cost, or just pay off when they injure people. This is a case where the cost-benefit analysis must include non financial aspects. Do they want to be known as the place where prices are low and death benefits are fair and paid quickly? Or as the place that sacrifices profit because safety is the right thing to do? Every management team will have different ideas of these intangibles.)
(A third is the Sam's Club versus Costco example. They both compete in the same marketplace. Sam's improves profits by paying their people low, and accepting that this might lower customer satisfaction. But they have the lowest prices, and a certain number of customers will suffer almost anything for that. Costco treats their employees well, and hopes this will translate into customer loyalty, despite not always being the lowest price. Each company solved the same problem a different way, and in this case, we can do a meta-analysis on the cost versus benefit of each option by looking at the relative performance of the two companies.)
posted by gjc at 7:54 AM on January 3, 2011
In the case of governmental decisions, many times it is almost like actuarial science and demography. (And politics.) If you handwave the political and assume everyone is in favor of the concept, and the only argument is in cost, you get your economic prognosticators and have them figure out how much each option will add to the economy. So they figure out that doing the thing will add 1000 jobs and 10m pounds to the GDP every year. But it costs 500m- will those benefits last over 50 years? If so, then it makes sense. Those 1000 new jobs take 1000 people off the dole, and you are saving money. But then you talk to the actuaries and demographers- the area is full of people, and growing, and they are all fully employed. Adding 1000 jobs to that area will cause chaos. So then it doesn't make sense. Or the actuaries and demographers tell you that your regional population is aging and in 15 years, nobody is going to need the thing and it will end up being a boondoggle.
But to answer your unasked question, the best thing would be to try and find the results of their cost benefit analysis. Reading the results as they apply to something relevant to you will probably teach you more than what we can here.
posted by gjc at 8:12 AM on January 3, 2011
But to answer your unasked question, the best thing would be to try and find the results of their cost benefit analysis. Reading the results as they apply to something relevant to you will probably teach you more than what we can here.
posted by gjc at 8:12 AM on January 3, 2011
Response by poster: Thanks a lot for all your help, that'll keep me going for a while.
posted by sockpim at 2:53 PM on January 3, 2011
posted by sockpim at 2:53 PM on January 3, 2011
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If the benefit exceeds the cost, the cost/benefit analysis would suggest that the thing being considered be done.
To make it more concrete: assume that a movie ticket costs $13. Your cost is $13. Is the two hours of entertainment worth more than $13 to you? If it is, the benefit you derive from being entertained is worth more than the $13 it costs to be entertained. Therefore, a cost/benefit analysis would suggest that you buy the movie ticket.
Now, this is a form of economic reasoning, and most economic reasoning assumes a rationality on the part of the actors that is generally not present in the real world. So, people naturally question the utility of cost/benefit analyses.
posted by dfriedman at 7:04 AM on January 3, 2011