Cost Benefit Analysis: Decision Making in the Public Sector

This article will focus on cost benefit analysis as a tool for decision making in the public sector. Cost benefit analysis, a tool for investment appraisal, is the federal government's main economic assessment tool to evaluate federal programs. The main types of cost analysis, the history of cost benefit analysis, and the methodology of cost benefit analysis will be described and analyzed. The federal government's official guidelines for cost benefit analysis of federal programs will be explained. The article will summarize the main uses for cost benefit analysis including physical investment projects, loan guarantees, clean air initiatives, and big science. The main criticisms made against cost benefit analysis will be addressed.

Keywords Cost-Benefit Analysis; Federal Government; Investment Appraisal; Decision Making; Public Sector

Business and Public Policy > Cost Benefit Analysis: Decision Making in the Public Sector

Overview

The public sector, including the economic and administrative enterprises of a local, regional, or national government, uses multiple analytical tools for fiscal, administrative, and policy decision making. Examples of public sector decision-making tools include manpower planning, the social demand approach, and cost-benefit analysis. Cost benefit analysis (CBA), a type of investment appraisal also referred to as benefit-cost analysis, is one of the most prominent and widely used analytical and quantitative tools for decision making in the public sector. The federal government recommends cost benefit analysis to its agencies as the main technique to use in a formal economic analysis of government programs or projects. Cost benefit analysis, as an analytical tool or methodological technique, is a practical tool for assessing the desirability of projects particularly in situations when it is important to take a long-term view. In this process, costs and benefits will be enumerated and evaluated (Hough, 1994).

Cost benefit analysis provides a systematic and formalized set of procedures for assessing whether to fund and implement a public policy or program. In instances where a choice must be made between public programs or policies, cost benefit analysis can be used to compare the programs and select the most promising one (Mustafa, 1994). Cost benefit analysis is the government's primary economic tool to assess and evaluate proposed resource allocation. The public sector is responsible for allocating public resources. Resource allocation influences economic development, quality of life, and opportunity for the public at large. The public sector works to make decisions about the allocation of resources in ways that promote and sustain economic productivity (Julnes, 2000). Cost benefit analysis is implemented in instances when a cost analysis will provide information that will help decision makers determine how resources will be allocated (Beyea, 1999). Cost benefit analysis is based on the idea that government should only undertake programs that promise favorable (usually monetary) return. It focuses on the economic efficiency aspects of governmental decision making (Mustafa, 1994).

Cost benefit analysis is used in all areas of public sector investment, including in nationalized industries, health expenditures, housing schemes, traffic networks, land-use and town planning problems, and regional development. Cost benefit analysis, though developed in the early twentieth century in United States to assess public sector environmental projects, is practiced throughout the industrialized and developing world. The United States has most notably used cost benefit analysis to assess reservoir projects and disease control. The United Kingdom has most notably used cost benefit analysis to assess the M1 motorway, the third London airport, London's Victoria Line underground, the Morecambe Bay Barrage project and the re-siting of London's Covent Garden market (Hough, 1994).

The following sections describe the main types of cost analysis, the history of cost benefit analysis, and the methodology of cost benefit analysis. These sections serve as the foundation for a later discussion on the main uses for cost benefit analysis. Issues related to the main criticisms made against cost benefit analysis will be introduced.

Types of Cost Analysis

The public sector uses multiple cost analysis tools to aid decision making. There are four main “types of cost analysis including cost-benefit analysis, cost-effectiveness analysis, cost-minimization analysis, and cost-utility analysis” (Beyea, 1999, p. 129).

• Cost-benefit analysis
• Cost-effectiveness analysis
• Cost-minimization analysis
• Cost-utility analysis

All four types of cost analysis used by the public sector for decision making, according to Beyea, share the same the same framework or guiding principles:

• Specify the analytic perspective that provided the framework for determining who pays the costs for and who benefits from a particular service or intervention.
• Define and specify the anticipated benefits and outcomes of a service or intervention.
• Identify all of the actual and potential costs using the specified analytic perspective to determine the costs.
• Account for how time may affect projected costs.
• Evaluate the results and consider alternative explanations for the conclusions.
• Calculate a cost-benefit or cost-effectiveness ratio as a summary Measure (Beyea, 1999, p. 130).

While there are four related types of cost analysis, described above, cost benefit analysis is the most popular and widely used analytical tool for economic decision making in the public sector.

History of Cost Benefit Analysis

Cost benefit analysis has been used by the United States' public sector, particularly in association with environmental projects, since the early 1900s. Cost benefit analysis was a formal part of the River and Harbor Act of 1902 (Hough, 1994). The development of cost benefit analysis, at the turn of the nineteenth century, was a way to gather objective measurements and information to use in public decision making (Julnes, 2000). In the 1950s, cost benefit analysis was used by the public sector to analyze large-scale environmental projects such as the development of large U.S. river valleys. The applications of the technique were extended to all areas of government operations and became a ubiquitous part of public sector decision-making practice in the second half of the twentieth century. Cost benefit analysis, which began in the United States, has been adopted by the United Kingdom and most other industrialized and developing countries (Hough, 1994).

In the late twentieth century, the U.S. government formalized its approach to cost benefit analysis for use by all of its agencies. In 1981, President Reagan enacted Executive Order No. 12291 which created the Office of Information and Regulatory Affairs (OIRA) and “required regulatory agencies to prepare impact analyses for any regulations that are likely to result in annual effects on the economy of $100 million or more.” Executive Order No. 12291 specifies that the “analyses must identify social costs and benefits and attempt to determine if the proposed regulation maximizes net benefits to society” (Mustafa, 1994). Section 3 of the Executive Order No. 12291, Regulatory Impact Analysis and Review, requires that all proposed rules be analyzed through cost benefit analysis and that “all final regulatory impact analysis shall contain the following information:

• A description of the potential benefits of the rule, including any beneficial effects that cannot be quantified in monetary terms, and the identification of those likely to receive the benefits.
• A description of the potential costs of the rule, including any adverse effects that cannot be quantified in monetary terms, and the identification of those likely to bear the costs.
• A determination of the potential net benefits of the rule, including an evaluation of effects that cannot be quantified in monetary terms.
• A description of alternative approaches that could substantially achieve the same regulatory goal at lower cost, together with an analysis of this potential benefit and costs and a brief explanation of the legal reasons why such alternatives, if proposed, could not be adopted” (Section 3(d)1-5).

The federal government's institutionalized and formalized the practice of cost benefit analysis, as the primary tool for economic decision making, continues today in the majority of federal agencies.

Methodology of Cost Benefit Analysis

Cost benefit analysis produces data about the cost and benefit of a program, practice, or investment. This data can be presented in three main ways to aid the evaluation stage of analysis:

First, data can be presented in a cost-benefit ratio. Second, data can be presented through a calculation of the present net value of the project. Third, data can be presented by calculating the internal rate of return of the investment. The third method, the internal rate of return or rate-of-return analysis, is the most common cost benefit analysis tool used to evaluate investments and make decisions.

Cost benefit analysis generally begins with a tabulation of all the costs and all the benefits of the proposed investment. Costs may include “direct and indirect costs for labor, programming, hiring, training, equipment and supplies, overhead, startup costs, adverse effects, loss of productivity, and morbidity” (Beyea, 1999). The tabulation or computation of costs and benefits is often a process characterized by debate and disagreement. Benefits, in particular, can be extremely difficult to tabulate due to the differing subjectivity, philosophy, and values of the people involved in the assessment process. In theory, cost benefit analysis leads the public sector to select all projects where the present value of benefits exceeds the present value of costs (Hough, 1994).

The federal Office of Management and Budget (OMB) issues guidelines (Circular No. A-94 Revised) to the heads of executive departments for conducting cost benefit analysis of federal programs. These guidelines, released in 1992, are intended by the federal government to promote efficient resource allocation through well-informed decision-making by the federal government. The guidelines provide general guidance for conducting benefit-cost and cost-effectiveness analyses. The guidelines are designed to serve as a checklist of whether a government agency has considered all the elements for sound benefit-cost and cost-effectiveness analyses.

The Office of Management and Budget's Guidelines for Benefit-Cost Analysis of Federal Programs includes four main elements of cost benefit analysis including policy rationale, explicit assumptions, evaluation of alternatives, and verification (Circular No. A-94 Revised, 1992):

• Policy rationale refers to the rationale for the government program being examined. Programs may be justified on efficiency grounds and they may also be justified where they improve the efficiency of the government's internal operations through cost-saving investments.
• Explicit assumptions about the underlying assumptions used to arrive at estimates of future benefits and costs should be clear. The required analysis should include a statement of the assumptions, the rationale behind them, and a review of their strengths and weaknesses.
• Evaluation of alternatives is a required step of federal cost benefit analysis and decision making. Analyses should consider alternative means of achieving program objectives by examining different program scales, different methods of provision, and different degrees of government involvement.
• Verification of investment outcome is a required part of cost benefit analysis. Federal agencies should have a plan for periodic, results-oriented evaluation of program effectiveness.

The federal guidelines for identifying and measuring benefits and costs include both intangible and tangible benefits and costs such incremental benefits and costs, interactive effects, international effects, and transfers.

• Incremental benefits and costs: Calculation of net present value should be based on incremental benefits and costs.
• Interactive effects: Possible interactions between the benefits and costs being analyzed and other government activities should be considered.
• International effects: Analyses should focus on benefits and costs accruing to the citizens of the United States in determining net present value.
• Transfer payments: Transfer payments should be excluded from the calculation of net present value as there are no real economic gains from a pure transfer payment. The benefits to those who receive a transfer are matched by the costs borne by those who pay for it (Circular No. A-94 Revised, 1992).

While the federal government has generalized and formalized guidelines for the federal use of cost benefit analysis, described above, multiple variables influence the applicability and effectiveness of cost benefit analysis. The following section describes the varying uses for cost benefit analysis for public sector decision making and the varying outcomes.

Application

Uses of Cost Benefit Analysis

While cost benefit analysis is used to varying degrees in nearly every area of public sector investment and decision making, including nationalized industries, health expenditures, housing schemes, traffic networks, land-use and town planning problems, and regional development, there are areas of public sector decision making where cost benefit analysis proves to be the most applicable and useful and areas where cost benefit analysis cannot be used effectively. The following examples, including physical investment projects, loan guarantees, clean air initiatives and big science, illustrate the strengths and limitations of cost benefit analysis when applied to real world scenarios (Gramlich, 2002).

• Environmental projects: Cost benefit analysis is used routinely for assessing public sector physical investment projects such as rivers, dams, and harbors. Cost benefit analysis for physical investment projects involves the weighing of initial capital costs against project benefits which often involve increased business activity. Complications of computing the cost benefit analysis of physical investment projects include the difficulties associated with tabulating the potential long-term environmental costs of projects.
• Loan guarantees: Cost benefit analysis is used routinely by public sector loan guarantee programs to assess loan risk. Public sector loan guarantee programs, authorized by Congress, provide guaranteed loans to industries, such as steel, oil and gas, and airlines, who may be facing economic challenges. The loan guarantee boards use cost benefit analysis to find appropriate loans and to estimate the effects of the guarantee. The loan guarantee boards make loan decisions based on benefit-cost outcomes. Cost benefit analysis by loan guarantee boards includes creating year-by-year models of repayment probabilities, calculations of the value of fees, collateral, and stock warrants.
• Clean air programs: Cost benefit analysis is used routinely by the Environmental Protection Agency (EPA) to assess the benefits and costs of their clean air programs. In particular, the Environmental Protection Agency uses cost benefit analysis to evaluate benefits and costs of the Clean Air Act. For example, the Environmental Protection Agency estimates that the direct costs of its own agency's measures to reduce air pollution from 1970-90 cost $689 billion and provided $29.3 trillion in benefits.
• Big science: Cost benefit analysis is used routinely by the public sector to assess and analyze big science projects such as the superconducting super collider. In the assessment of big science projects, costs can be calculated but benefits tend to remain hard to tabulate or calculate. Valuing benefits for big science projects is nearly impossible as outcomes and applications are generally unknowable at early stages of research.

These four cases illustrate how cost benefit analysis can be used in different ways to aid governmental decision making.

Issues

Challenges to Cost Benefit Analysis

There are numerous conceptual, computational, and analytical criticisms of cost benefit analysis including its apolitical nature, its level of effectiveness, its economic bias, and its methodological limitations:

• Apolitical: Cost benefit analysis, a formal approach to public policy decision making, is used as a means of avoiding politics in public sector decision making. The benefits and costs of a particular public policy program can be assessed, tabulated, and compared without weighing politics or requiring political evaluation (Gramlich, 2002). Cost benefit analysis, as it is generally practiced in the public sector, is designed to be politically neutral. This methodological goal creates problems and limitations. Namely, cost benefit analysis separates politics and policy making. Cost benefit analysis obscures the conflict of multiple interests and competing agendas. Cost benefit analysis is apolitical. Cost benefit analysis does not provide all the information needed for policymakers to make informed decisions (Mustafa, 1994).
• Level of effectiveness: Critics ask whether or not cost-benefit analysis has resulted in regulations with greater net benefits. There is little proof (no conclusive study) that compares the net benefit of federal regulations before Executive Order No. 12291 (i.e. President Ronald Reagan's executive order requiring cost-benefit analysis on some regulations) and the net benefit of federal regulations after Executive Order No. 12291. Since 1981, there have been near constant attempts to improve and strengthen cost benefit analysis including requirements in the private sector like the Unfunded Mandates Reform Act and the Congressional Review Act. This constant revision and updating signals to critics that cost benefit analysis does not work (Shapiro, 2006). Shapiro and Morrall (2012) did find that, though there seemed to be no significant correlation "between the information provided by the analysis and the net benefits," the least politically salient regulations yield the highest net benefits.
• Economic bias: Critics of the expanding scope of the American government argue for the need to make regulations more cost effective. These critics lobbied for greater regulatory oversight and assessment accountability. Executive Order No. 12291 created the Office of Information and Regulatory Affairs (OIRA) and the requirement that federal agencies use cost benefit analysis to evaluate investment in programs (Shapiro, 2006). This federal institutionalization of cost benefit analysis created an economic bias in policy evaluation and decision making in the public sector. Further questions arise when counted costs extend beyond national concerns, as in the case of carbon emissions originating at a source that derives a clear benefit to the possible detriment of the wider world's climate (Heyes, Morgan, & Rivers, 2013).
• Methodological limitations: Cost benefit analysis has methodological limitations particularly when applied to scientific fields. Gaps in scientific knowledge, in areas such as climate change or other types of extreme scientific uncertainty, make using benefit-cost analysis in real world decision making difficult (Gramlich, 2002). Some agencies combine cost benefit analysis with simultaneous approaches to arrive at a more three-dimensional model (Popovic, Vasic, Lazovic, & Grbovic, 2012).

Conclusion

In the final analysis, cost benefit analysis is one of several cost assessment techniques that tabulate and evaluate total costs and consequences of an investment or program in a systematic manner. Cost benefit analysis is a useful economic tool that reveals a monetary and quantitative view of an investment or policy decision. Cost benefit analysis tabulates costs and benefits in comparable units such as the monetary unit. As a result, cost benefit analysis is a useful strategy for comparing distinct variables by giving each a price in dollars.

The public sector is increasingly called upon to find policy solutions to public problems such as poverty, child abuse, smoking, crime, aging, and terrorism. Public problem solving requires multiple types of analytical tools. Cost benefit analysis is a fine tool for economic decision making in the public sector but it does not account for social values and social need. As a result of the complexity of public problems, the future of decision making in the public sector will likely evolve to include both cost benefit analysis and political and social feasibility approaches (Mustafa, 1994).

Terms & Concepts

Cost Benefit Analysis: A systematic and formalized set of procedures for assessing whether to fund and implement a policy or program.

Cost-Effectiveness: A comparison between the costs of two or more alternative means of achieving the same string of benefits or a specific objective.

Economic Analysis: The study of trends, phenomena, and information that are related to the economics of a venture.

Federal Government: A form of government in which a group of states recognizes the sovereignty and leadership of a central authority while retaining certain powers of government.

Net Present Value: The difference between the discounted present value of benefits and the discounted present value of costs.

Policy Rationale: The rationale for the government program being examined.

Public Problems: Undesirable conditions that impinge on a society.

Public Problem Solving: The approaches and strategies that citizens and their elected representatives undertake to solve or alleviate public problems.

Public Sector: The economic and administrative enterprises of a local, regional, or national government.

Transfer Payment: A payment of money or goods.

Values: Personally and culturally specific moral judgments.

Bibliography

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Circular No. A-94 Revised. (1992). The Office of Management and Budget. Retrieved May 20, 2007, from http://www.whitehouse.gov/omb/circulars/a094/a094.html#1

Executive Order 12291. (2007). The Federal Register. Retrieved May 20, 2007, from http://www.archives.gov/federal-register/codification/executive-order/12291.html

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Heyes, A., Morgan, D., & Rivers, N. (2013). The use of a social cost of carbon in Canadian cost-benefit analysis. Canadian Public Policy, 39S67-S79. Retrieved October 31, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=90080750&site=ehost-live

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Mustafa, H. (1994). Conflict of multiple interests in cost-benefit analysis. International Journal of Public Sector Management, 7(3/4), 16. Retrieved May 20, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=3920537&site=ehost-live

Persky, J. (2001). Cost-benefit analysis and the classical creed. Journal of Economic Perspectives, 15, 199-208. Retrieved May 20, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=5718453&site=ehost-live

Popovic, V.M., Vasic, B.M., Lazovic, T.M., & Grbovic, A.M. (2012). Application of new decision making model based on modified cost-benefit analysis &mash; a case study: Belgrade tramway transit. Asia-Pacific Journal of Operational Research, 29, -1. Retrieved October 31, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=84601758&site=ehost-live

Shapiro, S. (2006). Politics and regulatory policy analysis. Regulation, 29, 40-45. Retrieved May 20, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=21633718&site=ehost-live

Shapiro, S., & Morrall III, J.F. (2012). The triumph of regulatory politics: Benefit-cost analysis and political salience. Regulation & Governance, 6, 189-206. Retrieved October 31, 2013, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=76302906&site=ehost-live

Suggested Reading

Ackerman, F., & Heinzerling, L. (2002). Pricing the priceless: cost-benefit analysis of environmental protection. University of Pennsylvania Law Review, 150,1553. Retrieved May 20, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=6870039&site=ehost-live

Johnston, J. (2002). A game theoretic analysis of alternative institutions for regulatory cost-benefit analysis. University of Pennsylvania Law Review, 150, 1343. Retrieved May 20, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=6870004&site=ehost-live

McIntosh, E., Donaldson, C., & Ryan, M. (1999). Recent advances in the methods of cost-benefit analysis in healthcare: Matching the art to the science. PharmacoEconomics, 15, 357-367. Retrieved May 20, 2007, from EBSCO Online Database Business Source Complete. http://search.ebscohost.com/login.aspx?direct=true&db=bth&AN=9526703&site=ehost-live