Cost-Benefit Analysis

Cost-benefit analysis (CBA) is a rational choice framework for identifying the best or most profitable option a decision maker can undertake. The decision maker may be a principal (i.e., an individual) or an agent (i.e., management or government) acting for others. The basic logic of CBA is that, for any specific course of action to be adopted, the total expected benefits should exceed the total expected costs to the principal or principals. If expected costs exceed expected benefits, the decision maker should not undertake the proposed action. If expected benefits and expected costs are equal, the principal or principals should be indifferent between the proposed action and the status quo. CBA is in the tradition of consequentialism and teleology. The logic of CBA, applicable with or without money values or other numbers, is to identify and evaluate all the consequences, positive (i.e., for) and negative (i.e., against), of a proposed course of action. The largest net positive change is superior to any alternative, consistently evaluated (qualitatively or quantitatively).

CBA justifies a specific decision computation methodology. In economic theory, reasonably competitive markets ought to lead to these superior outcomes. And these outcomes would be consistent with Pareto efficiency. CBA is a qualitative or quantitative substitute for market exchanges. CBA is, thus, used in circumstances in which markets are less than reasonably competitive, due typically to market failures or intangible considerations. An individual or management might need to weigh effects on reputation of some course of action. CBA is applicable to public goods (such as government investment projects) and setting of governmental regulatory standards. In the Flood Control Act of 1936, the U.S. Congress required for the first time the identification and quantification in dollars of all flood control project benefits and costs. Government CBA should maximize gross national product through the most efficient allocation of scarce resources. Government CBA is not, however, a theory of public finance. It is narrowly a public expenditure evaluation approach undertaken without considering the financing alternatives. Some business decisions such as investments in information systems or R&D and many nonprofit entity decisions are not necessarily resolved by discounted cash flow (DCF) estimates.

In a narrowly “economic” CBA, the proposed course of action is the allocation of scarce resources to one competing use rather than to the next best alternative use. The statement “there is no free lunch” expresses this underlying opportunity cost notion. The decision computation methodology estimates a money value equivalent for all the positives and negatives, which can then be summed to a net money gain [Page 523]or loss. This single decision criterion requires a consistent cardinal measurement of all consequences.

A broader “social” CBA decision context reflects incompleteness of cardinal measures (whether money or numbers) and also typically multiple decision criteria. Social CBA compares “apples” and “oranges” (i.e., “incommensurables”). In real decision situations, some benefits and costs may be tangible and measurable in money, while others may be intangible and not measurable in any system of cardinal units. The intangible considerations could arguably outweigh the tangible considerations. These intangible considerations might be ecological sustainability or values grounded in nonconsequentialist ethical perspectives. Social CBA is effectively multiple criteria assessment (MCA). If all relevant criteria concur, then the incommensurable decision problem is solved. Otherwise, the competing criteria must be weighted or prioritized against one another in some manner. The “triple bottom line” and corporate social performance (CSP) measurement are instances of MCA.

...