Intro to Cost-Benefit Analysis

By IDI Staff

In cases where resource decisions are to be made, it is important to emphasize that cost and benefits must be assessed simultaneously. Comparisons enhance the decision-maker's insight into what specific improvements to an enterprise will come from proposed resource investments. When we are talking informally about this principle, it is common to use general terms in phrases like "we need to compare the costs and benefits". That's fine for such general statements. But the terms "cost-benefit analysis" and "cost-effectiveness analysis" have specific technical meanings in certain communities, and one should take care to avoid those terms unless one specifically means to use them.

Cost-Benefit Analysis (or sometimes Benefit-Cost Analysis) is a technique popular in analyzing programs and regulations to determine if their net value is greater than their net cost. The technique requires an effort to monetize all potential benefits and commonly includes efforts to develop likelihood estimates for events that would cause death or harm to individuals from implementing or not implementing the proposal. The intent of Cost-Benefit Analysis is to develop a single measure (usually the Net Present Value (NPV) of the total benefits minus the total costs) that can be used for a decision on which programs and regulations to continue and which to change. In some cases, this measure (NPV, or alternatively a "Benefit-to-Cost Ratio") is further used to rank a number of alternatives, taking as a given that programs with larger Net Present Values are a better deal than those with smaller NPVs. A good reference for this work is Cost-Benefit , 2nd Edition, Boardman, Greenber, Vining, and Weimer, 2001. Certain companies may require that proposed regulations and investments undergo this sort of rigorous cost-benefit analysis before they are enacted or placed into future year budgets.

There are problems with using Cost-Benefit Analysis for certain industries, particularly in national security studies. First, it is difficult to monetize many of the key benefits with any confidence. Most of the benefits for national security programs are in the avoidance of negative consequences. When an analyst attempts to monetize those benefits (cost-avoidances), it is usually possible to justify almost any national security project in terms of NPV terms because the potential consequences of failing to predict a major attack on the homeland are very large of overwhelm most potential costs. Therefore the relative ranking of national security programs by NPV is more likely a function of the proper enumeration of negative consequences, and the choice of probability values for the negative consequences, than a real measure of the relative bang-for-the-buck.

The key thing to remember about Cost-Benefit Analysis is that it requires that the benefit be converted to monetary units for comparison. Results of such an analysis can be stated in terms of the size of the NPV of the investment, or a dimensionless ratio of benefits to cost.

Cost-Effectiveness Analysis is a different technique in which costs and benefits are compared by selecting one or more measures-of-effectiveness (MOEs), and comparing programs on the basis of the cost-normalized performance on that measure. Let's leave the national security industry, and use health care as an example. If the effectiveness measure is "number of patients covered", programs would be compared on the basis of "number of patients covered per unit cost." There is no need, or desire, in cost-effectiveness analysis to convert the benefits into monetary units.

Programs or proposals may be compared against several cost-normalized measures-of-effectiveness in one study, although that introduces the problem of developing an appropriate approach to integrating them for comparative ranking. Rarely is one alternative the most cost-effective on all the relevant measures. A disadvantage of cost-effectiveness analysis relative to cost-benefit analysis is that there is no common basis for comparison between cost-effectiveness studies (since MOEs are different).

When doing cost-effectiveness analysis, we need to challenge ourselves to use MOEs that reflect utility at the highest levels possible. We used the example of "number of patients covered," but a better measure would be "percentage of high risk patients covered" or "likelihood of high risk patients being covered."

When working on the question of "how much is enough" investments, a further refinement of cost-effectiveness analysis that may be useful is the concept of "marginal cost-effectiveness." If one is investing resources to increase the total number of a particular resource, it is always true that getting more investment will get more effectiveness. But there may be diminishing marginal returns at play, and therefore using a metric of "MOE per unit cost" allows you to graph potential increases and decrements in resources and see the impacts in ways that allow decision-makers to draw a line at investments that are judged not worth the additional expense. The marginal cost-effectiveness of the next level of investment is almost always less than the existing investment. Sometimes determining the knee in such a curve is the best answer we can give to "how much is enough?"