Would you pay one hundred dollars for a bar of chocolate? Absolutely not, since it’s not worth it. From the smallest everyday decisions to the biggest choices in life, you constantly make decisions by comparing what you give vs. what you get. When you have to choose from two or more alternatives, you choose the one that gives you more at a lesser cost. Whether you know it or not, you are constantly performing cost-benefit analyses.
What is cost-benefit analysis?
Cost-benefit analysis is a framework for calculating the costs and benefits of a project/purchase to establish if it is worthwhile. The costs and benefits are calculated according to the principles governing this analysis and are compared with each other to reach a conclusion. Basically, a project is accepted if its benefits exceed its costs.
When there is more than one project to consider, all the projects with more benefits than costs can be approved. However, more often than not, there are constraints with respect to money or other factors that force us to choose between various options.
In such a situation, the project offering the lowest cost-to-benefit ratio is selected. This means that the project with the lowest cost per dollar of benefit is the best option. The best possible project or the best combination of projects can therefore be chosen and scarce productive resources can be allocated efficiently. It goes without saying that we must never opt for a project that has negative benefits, i.e., where the costs exceed the benefits.
Let us first try to understand certain concepts that govern the calculation of costs and benefits.
Common unit of measurement
You cannot compare apples to oranges. All the aspects of the project—both positive and negative—must be expressed in a common unit in order to reach a conclusion. Money is the most convenient common unit, so all the benefits and costs are measured in their equivalent monetary values.
Imagine that you purchased a $15 ticket for a basketball game a few days in advance, but on the day of the game, it’s snowing and your favorite player that you dreamed of seeing is sick and won’t play. The game isn’t of much interest to you anymore. Do you still go to the game or stay home and lose the money that you spent?
Most people will still go to the game solely because they’ve already spent a lot of money on it. Why is this wrong? Going to the game won’t enable them to get the worth of the money they have already spent. It will simply inflict upon them the pain of sitting through a boring match instead!
The money that has already been spent is a sunk cost. Nothing you do afterwards will affect that cost; it cannot be recovered. Ignoring this principle can sometimes lead to another situation that we call the “extra cost trap”.
Imagine reaching the theatre to see your favorite play and realizing that you lost the ticket worth $20 that you had bought in advance. Would you buy another ticket or skip the play entirely? Most people would skip the play, since they would feel that the play is not worth twice the amount of the ticket. The sunk cost principle, however, suggests that you ignore the money already spent and decide whether the future benefits of watching the play is worth the future cost. Think of it this way: Would you still go to the play if you had simply lost $20 in cash instead of losing the ticket? The answer is probably yes, since you don’t link the amount lost to the value of the play.
Business organizations often have difficulty in abandoning the strategies they spent so much time and resources working on, even if those strategies aren’t the right choice for the company. A decision maker should only consider the costs and benefits that will be incurred from the time of the decision going forward. The decision must essentially be based on future cash flows and future expected benefits; sunk costs must be ignored.
Choosing one out of many options will mean not choosing others. When you take one opportunity, you forgo the other choices. Opportunity cost is said to be the cost of the opportunity lost. For example, choosing to go to college not only includes the cost of tuition and books, but also the cost of the forgone opportunity to earn. The value of the best forgone alternative is considered for calculating the opportunity cost.
People often fail to take into consideration opportunity costs when they are unstated. They will often do something themselves, such as mowing the lawn, in a bid to save the amount that they would have to pay if they had someone else perform the service for them. However, doing this seems illogical if they could utilize the same time to do something that would earn them more money than they would pay that helper. The opportunity cost of mowing the lawn by ourselves is that we cannot perform another, possibly high-yielding activity.
Present-Value of Future Dollar
Did you know that the value of one dollar five years down the line will be far less than the value of one dollar today? This difference in the value of money over time is not just caused by inflation. The dollar that you have today can be invested and will be worth much more in five years as it accumulates interest.
For this reason, in addition to expressing the costs and benefits in their equivalent monetary values, they must also be expressed as the money of a particular time. The time value of money is a very important aspect to consider, especially when costs and benefits accrue over a period of many years.
If the rate of interest is r, one dollar will grow to (1+r)t in t years. Conversely, you must invest (1+r)-t dollars today to get one dollar after t years. This is the discounted value (present value) of one dollar available t years in the future. For example, the present value of one dollar at the rate of 10% after one year is (1+0.1)-1 is 0.9090; after two years, that is (1+0.1)-2 =0.8264 and so on. To calculate this on a simple calculator, divide 1 by 1.1 (since the rate has been assumed to be 10%) and press the equal key as many times as the number of years you wish to calculate.
(The figures have been rounded off to four decimal places)
The monetary values of costs and benefits accruing at some time in the future must be placed into today’s values. Multiplying these amounts with the present value of one dollar in the future gives us the present values of those amounts. For example, since the present value of one dollar at the rate of 10% after two years is 0.8264 (as calculated above), the present value of $500,000 after two years at the same rate would be 500,000 x 0.8264, amounting to approximately $413,200.
This shows that, at the assumed rate of interest, receiving $500,000 dollars after two years is as good as receiving $413,200 today. This knowledge helps us make better decisions by facilitating the correct calculation of amounts to be received or paid over time.
Challenges in implementing Cost-Benefit Analysis
The main problem in implementing this type of analysis lies in identifying and quantifying the costs and benefits. Hidden or indirect costs might get neglected, leading to under-measurement of costs. Benefits, on the other hand, are often easy to identify, but difficult to measure, especially when they are non-monetary and qualitative in nature.
The valuation of some costs and benefits must be made on the basis of the actual behavior of people. This becomes very person-specific, as it involves preferences of people and a judgment of what they perceive the value of a non-monetary cost or benefit to be. For example, a person has the choice of parking close to a destination for a fee of 50 cents or parking farther away and spending 5 additional minutes walking. If he chooses to spend the money and save time, it reveals that the person values his time at more than 10 cents per minute. If he was indifferent between the two choices, it would mean that the person perceives the value of their time to be exactly 10 cents per minute.
In addition to this, costs and benefits are usually measured by market choices. The value of commodities increases or decreases based on the demand for that specific commodity.
Some situations demand measuring human life in terms of monetary value. Placing a dollar value on human life has been met with considerable antipathy among the general public. However, it is impossible to fund every project that promises to save human lives; as a result, some rational basis becomes necessary to decide which projects are approved and which ones are not.
To conclude, costs and benefits must be compared after they are properly identified and measured. It’s important to make use of the sunk cost and opportunity cost principles and discount the costs and benefits to their present values!
- San Jose State University
- University Of Michigan
- The University Of Arizona, Tucson, Arizona
- Harvard Business School
- Brigham Young University
- Worcester Polytechnic Institute (WPI)