Cost-Benefit Analysis

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Definition of a Cost-Benefit Analysis:

Cost-benefit analysis is a systematic approach used to evaluate the economic pros and cons of different projects, decisions, or policies by comparing the total expected costs of an action to the total expected benefits.

Detailed Explanation:

Have you ever listed the costs and benefits when making a difficult personal decision? If so, you completed a very basic cost-benefit analysis. Businesses and governments use a more sophisticated cost-benefit analysis when comparing options. Let’s use the example of deciding whether a recent high school graduate should attend college. A cost-benefit analysis considers the timing of costs and benefits, so it is important to include the timing of the expenses and benefits.

Step 1: List the current and future monetary costs. 

These would include:

• Tuition
• Books and supplies
• Room and board
• Student loan payments
• Opportunity cost – What would the student’s income be if he took a job shortly after graduating high school?

Step 2 - List the current and future intangible costs.

These might include.

• Family and social considerations of living away from home.

Step 3: List the current and future monetary benefits.

These would include.

• Future earnings potential.
• Financial aid or scholarships

Step 4: List the current and future intangible benefits. 

These would include. 

• Greater job stability
• More career opportunities
• Personal growth
• The student’s interest in the chosen field. Is this something she has aspired to her entire life, or is it a job that holds little interest? 

Step 5: Assign a monetary value to each cost and benefit, including the intangible costs and benefits. 

• This is straightforward for direct costs and benefits such as tuition, scholarship, room and board, travel, and income.  
• It is challenging to place a monetary value on intangible costs and benefits, such as the value of staying home or personal growth gained from the college experience.  

Step 6: Calculate the Net Present Value.

Net present values recognize the time value of money by weighing money spent or received today more heavily than future cash flows. A discount rate, or the minimum acceptable return on investment, is assumed. If the net present value of attending college is positive, then the best decision is to attend college. The option with the highest net present value should be chosen when comparing more than one option.

Step 7: Reliability of Outcome. 

Cost-benefit analysis usually requires many assumptions. How reliable are the assumptions? For example, is the chosen field vulnerable to economic downturns, which would influence income. 

Conclusion

Businesses and governments use cost-benefit analysis because it provides a structured framework for making decisions. It forces the decisionmaker to place a value on intangible benefits and costs. However, making assumptions and placing a value on intangible benefits and costs can be challenging and very subjective, leading to wrong decisions. Still, cost-benefit analysis is a useful tool for analyzing and making sound economic decisions.

Dig Deeper With These Free Lessons:

Opportunity Cost – The Cost of Every Decision
Production Possibilities Frontier
Fundamental Economic Assumptions
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