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Cost-benefit & cost-effectiveness analysis
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in practice
Cost-benefit and cost-effectiveness analysis sum up all
of the costs and all of the benefits associated with an option using a
common metric, typically monetary units. This enables the calculation of
the net cost or benefit associated with an option. All options with a net
benefit are worth doing - the one with the greatest net benefit is the
most worth doing.
Cost-benefit analysis (CBA):
Cost-benefit analysis suggests that a monetary value
can be placed on all the costs and benefits of a strategy, including
tangible and intangible returns to other people and organisations in
addition to those immediately impacted.
Decisions are made by comparing the present value of
the costs with the present value of the benefits of the strategy.
Decisions are based on whether there is a net benefit or cost to the
strategy, i.e. total benefits less total costs.
Costs and benefits that occur in the future have less
weight attached to them in a cost-benefit analysis. To account for this,
it is necessary to discount, or reduce, the value of future costs or
benefits to place them on a par with costs and benefits incurred today.
The current recommendation is that public sector activity should generally
use a discount rate of 6%. This means that £1 in one year's time will be
worth 1 ÷ 1.06 now; £1 in two year's time will be worth 1 ÷ 1.062
and so on. The sum of the discounted benefits of an option minus the sum
of the discounted costs, all discounted to the same base date, is the net
present value of the option.
Cost-benefit analysis should normally be undertaken for
any strategy project which involves policy development, capital
expenditure, use of assets or setting of standards. Depending on the
nature of the issue, it will sometimes be very quick and easy. At other
times it will require full-blown economic analysis. There are no set rules
as to the level of detail required, but it should reflect the significance
of the options being assessed. CBA should typically take a broad view of
costs and benefits, including indirect and longer-term effects, reflecting
the interests of taxpayers and users of public services and those affected
in other ways by public sector activity.
Although in practice monetary valuation is often
difficult, it can be done and, despite difficulties, cost-benefit analysis
is an approach which is valuable if its limitations are understood. Its
major benefit is in forcing people to be explicit about the various
factors which should influence strategic choice.
Cost-effectiveness analysis (CEA)
Cost-effectiveness analysis is an alternative to
cost-benefit analysis. CEA is most useful when analysts face constraints
which prevent them from conducting CBA. The most common constraint is the
inability or unwillingness of analysts to monetise benefits.
CEA measures costs in a common monetary value (normally
£) and effectiveness in physical units. Because the two are
incommensurable, they cannot be added or subtracted to obtain a single
criterion measure. One can only compute the ratio of costs to
effectiveness in the following ways:
CE ratio = C1/E1
EC ratio = E1/C1
where: C1 = the cost of option 1 (in £);
and E1 = the effectiveness of option 1 (in physical units).
Equation 1. represents the cost per unit of
effectiveness (e.g. £/life saved). Projects can be rank ordered by CE
ratio from lowest to highest. The most cost-effective project has the
lowest CE ratio.
Equation 2. is the effectiveness per unit of cost (e.g.
lives saved/£). Projects should be ranked from highest to lowest EC
ratios.
The outputs to be ranked by cost-effectiveness analysis will often be
social or environmental in nature. For example, work in health economics
looking at the cost-effectiveness of different treatments, or work to
assess the net costs of different ways of reducing greenhouse gases. As
with CBA, the level of detail for the analysis will typically depend on
the specific issue being addressed, but should take a broad view of costs
and benefits to reflect public and taxpayer interests.
Process for carrying out a CBA/CEA
There are 5 core elements to carrying out a successful
CBA/CEA:
- define the objectives
- identify the options (including a base case)
- identify and, if possible, quantify and value the costs, benefits,
risks and uncertainties
- analyse the information
- present the results
Strengths & Weaknesses
CBA and related techniques are tools to be used in
decision-making - they provide a means of systematically and rigorously
balancing the costs and benefits of different options. They should be used
intelligently, making use of relevant knowledge and expertise. CBA can be
essential in setting out the costs and benefits associated with different
options, and in making a rigorous choice between them. But it is rarely
sufficient on its own, because other, typically more nebulous, factors
will also need to be taken into account. The option identified as
"best" from a CBA does not always need to be chosen - but any
departure from the "best" option needs to be very carefully
justified.
CBA is based on conventional welfare economics, which
provides a utilitarian account whereby value relies upon individual
self-interest. In practice, people express defined preferences for a much
wider set of public goals. Even though in theory this should be compatible
with traditional welfare economics, in practice analytical techniques such
as CBA rarely give proper recognition to these wider public preferences.
In carrying out a CBA, there are probably two main
pitfalls to avoid:
- The first and perhaps most serious is missing out some key
options, or some key costs and benefits. If this occurs, the
results of the analysis can be significantly skewed away from the
actual "best" option. The way to avoid this is to spend some
time making an exhaustive list of the options, and then all the
different costs and benefits that could arise - even if some are later
excluded.
- The second potential pitfall is relying too much on the data.
Information on costs, benefits and risks is rarely known with
certainty, especially when one looks to the future. This makes it
essential that sensitivity analysis is carried out, testing the
robustness of the CBA result to changes in some of the key numbers.
References
The
Treasury Green Book is the main source for information on CBA and
other appraisal techniques. This also contains a bibliography of other
material.
The Civil Service College runs courses on cost-benefit
analysis and related techniques. Details are available via the CMPS
website.
Cost-benefit & cost-effectiveness analysis
In Practice: SU Childcare Project
The objective of the study was to provide a value for
money analysis of Government investment in different types of childcare.
The choice was between higher cost "integrated" childcare
centres, providing a range of services to both children and parents, or
lower cost "non-integrated" centres that provided basic
childcare facilities.
In order to undertake a full cost-benefit analysis data
must be available which allows the full costs and benefits of the policy
to be converted into monetary units. This was not possible, owing to a
lack of detailed evidence in all areas of the policy, and so in the case
of the childcare review the team undertook a dual track approach:
- A partial cost-benefit analysis: to allow us to compare
integrated and non-integrated childcare for areas where detailed
evidence was available.
- A variant of cost-effectiveness analysis: to allow us to compare
childcare to other policy areas such as employment, education and crime,
where the evidence allowed us to quantify intermediate outputs from
policy (e.g. improved educational attainment aged 18) but not the final
outcomes of the policy (e.g. better overall life chances, higher skilled
workforce and higher economy wide productivity growth).
For both analyses there was a 'hard exercise' and a
'soft exercise'. The hard exercise identified, quantified and monetised
direct costs and benefits. The soft exercise identified and described
qualitatively non-monetisable impacts leading to option ranking.
There are always caveats involved in cost-benefit
analysis and many assumptions were necessary:
For example an important assumption had to be made
about the governments targeting of policies. A single childcare place will
provide a 'bundle' of outcomes from increased parental employment levels
to reduced future crime rates and improved educational attainment owing to
better child development. These outcomes cannot be separated and so must
be analysed together. However, in reality the provision of an additional
childcare place may not achieve additional outcomes in all of these areas.
A child may already be at very low risk from committing future crimes but
their parents may use a childcare place so that they can return to work.
In this case an additional employment benefit would be realised but no
additional benefit from reduced future crime rates. An ex ante value for
money analysis says nothing about whether the benefits of a future policy
will actually accrue to targeted populations. In this analysis we
calculated the full costs and benefits of the childcare place and then
assumed that government would have to target programmes sufficiently to
minimise loss from benefits that would have occurred anyway.
An Example Partial Cost-Benefit Analysis template is
shown below:
Note: For sensitivity reasons the figures below are illustrative and do
not represent numbers actually used in the Childcare Review
In this illustrative example the quantifiable
employment benefits are not sufficient to cover the total cost for either
integrated or non-integrated childcare. The gap between costs and benefits
for integrated childcare is £2.5m compared to £1m for non-integrated
childcare. Thus for the government to choose to promote integrated
childcare the 'soft exercise' would have to provide sufficiently strong
evidence that the reduced poverty and other child outcomes (Y + larger
effect) were greater than:
- The £2.5 million gap between the full costs and benefits of the
integrated places
- The £11,500 difference per child from reduced poverty and other
child outcomes given by non-integrated childcare (X + small effect)
> See a full explanation of the Childcare
value for money analysis
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