Cost benefit analysis

ReSAKSS-AfricaLead Workshop on Strengthening Capacity for Strategic Agricultural Policy and Investment Planning and Implementation in Africa Safari Park Hotel, Nairobi, June 25th‐ 26th 2012

1. Cost‐Benefit Analysis As Project Evaluation Tool
Paul Guthiga, ReSAKSS‐ECA
Workshop on Strengthening Capacity for Strategic Agricultural Policy 
and Investment Planning and Implementation in Africa 
Safari Park Hotel, Nairobi on 25
th
‐26
th
April 2012

2. ss4 2
An Overview of CBA…1
Decision‐makingat…
•Anindividual;intuition,orsomeanalysis
•Foraprivateentity(saycompany)
–Profit motive hence… full financial appraisal of the
project.
•FortheGovernment;moredifficult
–Not just profitability but social cost and benefits of
theirchoices.
–Otherconsiderations;equity,environmental

3. ss4 3
An Overview of CBA…4
•CBA is a tool primarily used by governments in
makingtheirsocialandeconomicdecisions.
•It also considers activities that are not normally
pricedbythemarket(externalities)
•Attempts to quantify and include in estimates of
costandbenefitsnotjusttoindividualandprivate
entitiesbutalsotorestofcommunity.

4. An Overview of CBA…2
•Developmentinterventionsofteninvolvehugecosts
•Thesecostsshouldbequantifiedandcomparedwiththe
potentialoractualbenefits
•Can be done through use of a CBA which could be
conductedexanteand/orexpost
•CBA is not done on a before‐and‐after basis but on a
‘with’and‘without’projectbasis(toavoidover/under‐
estimation)
•Ultimatemeasureistheincrementalnetbenefitofthe
project

5. An Overview of CBA…3
•Involvescomparingcostsandbenefitsfromdifferent
timeperiods
•Money values across time periods are not
immediatelycomparable;why?
•…becauseofinflationandreturnsinthemarket
•Hencetheneedtodiscountfuturecostsandbenefits

6. Theoretical foundations of CBA…1
•a)
Thepreferencesofindividualsaretobetakenas
thesourceofvalue.
•b)Preferencesaremeasuredbyawillingnesstopay
(WTP) for a benefit and a willingness to accept
compensation(WTAcompensation)foracost.
•c)Individuals’preferencescanbeaggregatedsothat
social benefit = the sum of all individuals’ benefits
andsocialcostisthesumofallindividuals’costs.

7. Theoretical foundations of CBA…2
•d
)If beneficiaries from a change can
‘hypothetically’ compensate the losers from a
change,andhavesomenetgainsleftover,then
thebasictestthatbenefitsexceedcostsismet.
•Thetheoreticalconcept(d)aboveistheKaldor‐
Hicksprincipleofpotentialcompensation…
•…ifthegainersfromanactioncouldcompensate
the losers, the action is an improvement
regardless of whether compensation is actually
paid.

8. Theoretical foundations of CBA…3
•Providedthatcompensationcouldoccurthen
nooneisactuallyworseoff…
•the Pareto‐criterion for improvement in
overallwell‐beingismet.

9. Limitations of CBA…1
•CBA fails to explicitly account for distribution of
benefitsinthesociety(equity)
•Attempts to integrate distributive issues in CBA by
applying weighting factors to benefits or costs to
reflecttheincomeofindividualaffected
•The theoretical arguments for these weights are
basedonthedecliningmarginalutilityofincome

10. Limitations of CBA…2
•SomeCBApractitionersfeelthatinclusionsofequity
goalsfalloutsidetherealmofeconomics
•But…possibilitytotrackthedistributionofcostsand
benefitsamongthevarioussegmentsofsociety.

11. Financial versus Economic CBA…1
•Financial CBA is carried out from the perspective of a 
private point of view
•Key question; does a project have a sufficiently high 
return on investment for a private entity to be worth 
implementing. 
•A positive outcome of financial CBA means that a 
project is profitable to an investor. 
•
However, projects that may seem appealing to a 
private investor…may be unattractive to a country as 
a whole. 
•Hence the need for an economic CBA.

12. Financial versus Economic CBA…2
•All benefits and costs to society, or all impacts on real 
national income, are taken into account in economic 
CBA
•An economic CBA will have to be conducted only 
when there are reasons to believe that the outcomes 
will differ from financial CBA.
•When does this occur;
–This is the case when taxes are levied/subsidies granted, 
–External effects exist and/or 
–prices are distorted (do not reflect their real scarcity). 

13. Financial versus Economic CBA…3
•To transform a financial CBA into  an  
economic  CBA three groups of adjustments 
have to be made:  
–Step 1:  transfers (taxes, subsidies) are to be 
removed;  
–Step 2: all positive and negative external effects 
have to be included; 
–Step 3: market prices of goods and services have 
to be replaced by economic prices;

14. Financial versus Economic CBA…4
•FinancialCBAmaygiveartificiallypositive outcomes;
whensubsidiesaremoreimportantthantaxation.
•Subsidization;e.g.cheapfertilizertofarmers.
•Makes farmers production costs to be lower than
thoseofimportedcommodities,henceartificiallyhigh
financialNPV/IRRs.
•Subsidiesshouldbeignoredinaneconomicanalysis.
•TheeconomicIRRwill,allotherthingsassumedequal,
belowerthanthefinancialIRR.

15. Financial versus Economic CBA…5
•LowprofitabilityresultinginfinancialCBAmaybe
causedbyexcessivetaxation
•Tax payments are part of a project's costs, and
therefore negatively affect the financial
profitability.
•For instance,if inthefinancialCBA ofa firm the
importcostsofUS$0.5mforrawmaterialsinclude
a25%importtariff..
•Thecorresponding costtothenationineconomic
termsisjustUS$0.375m.

16. Financial versus Economic CBA…6
•Prices play an essential role in CBA, because the
method requires that all effects are recorded in
monetaryterms
•FinancialCBAappliesactual,domesticmarketprices;
•Whether these are free‐market prices, or the result
of government intervention is of no importance to
privatedecision‐makers.
•IneconomicCBA,thatquestioniselementary.
•PricesineconomicCBAshouldgiveacomprehensive
picture of the value to society (a measure of their
scarcity).

17. Financial versus Economic CBA…7
•If market prices fail to do so, if they are distorted,
and economic CBA prescribes that prices are
replaced by economic (or accounting or shadow)
prices.
•These prices are not observed in reality, but
calculatedonthebasisoftheconceptofopportunity
costs.

18. STEPS OF CARRYING OUT CBA

19. Steps…1
1. Identifying the resources being reallocated in a
givenprojectoractivityas wellasthe gainers and
thelosersinthatprocess(settheboundaryofthe
analysis);
2. Identifyingtheeconomicallyrelevantimpactsofthe
project/activityimplementation.
3. Group them into positive impacts (benefits) and
negativeimpacts(costs).

20. ss4 20
Typical costs and benefits….

21. Steps…2
4. The identified impacts are physically 
quantified and assigned a monetary value. 
5. The decision criteria are applied once the net 
benefits are discounted. 
9The decision criteria include NPV; Internal Rate of Return 
(IRR) or Benefit‐Cost ratio (B‐C ratio)
9Any course of action is judged acceptable if it confers a 
net benefit (present value of benefits outweighs the 
present value of costs) 

22. Steps…3
6. Finally, sensitivity analysis is carried out to capture 
the different possible scenarios.
9How? By varying the discount rate, time frame or policy 
scenarios.

23. Decision‐Criteria…1
•Net present value/worth
If NPV(W) >0; B/C>1 the project is worthwhile

24. Decision‐Criteria…2
Decision rule; largest IRR above cut ‐off rate (many
projectscangivemultipleIRRsfromthesamedataset
andcannotdecideamongmanyprojects)

25. Critical issues in CBA

26. Discount rate…1
•The concepts of discounting and choice of a 
discount rate are controversial in CBA
•Discounting & discount rate has implications 
for future benefits and costs
•Decisions on implementation of long term 
projects depend on the choice of discount 
rate. 
•Implication of discounting;
–Benefits and costs long in future are weighed less; 
higher the time bias. 

27. Discount rate…2
•From an economic perspective, discount rate is the
rate at which society weighs future consumption
againstpresentconsumption,or..
•Ratebywhichitattachesasocialtimepreferenceto
consumptionbyitsmembers. •Fromafinancialperspectivethediscountrate
istheprevailinginterestrate..
•Whichonewouldbehigherandwhy?

28. Discount rate…3
•The process of discounting is defended by 
economists as reflecting the way people value 
things….
–Positive rate of time preference (for both consumers 
and producers) and…
–Opportunity cost of capital (for producers) the future 
is treated as less important than the present.  
•In practice the choice of the discount rate is the 
onus of the researcher guided by various 
considerations such as;
–The discount rates applied for government agencies 
–The length of the project time considered 
–Opportunity cost of capital in the country/area

29. Time horizon
•AnimportantconsiderationinCBA
•From private individual perspective…it is the most
relevanttimehorizonisthepartoftheirlifetimethat
theyarelikelytobenefitfromtheproject.