BY
ASIIMIRE DONAH
COST-BENEFIT ANALYSIS (PROFITABILITY INDEX)

Cost-Benefit Analysis (CBA)
CBA is one of the techniques used in project selection by
analyzing the project costs and benefits with a view of
determining whether or not the project is economically
or socially or environmentally feasible or viable. Cost-
benefit analysis is a technique that attempts to identify,
quantify and compare the costs and benefits of a
proposed project over a given time period in order to
determine its acceptability or rejection.

Cont’
In principal, a proposed project or investment activity is
said to be economically feasible or viable or acceptable
when the benefits out weigh the costs.
The following are the steps, which are used in cost-benefit
analysis (CBA) to determine whether a project or policy
is worthwhile or feasible.

Cont’
1. Set the project targets or objectives in relation to the
problem identified
2. Identify or propose a suitable project to address the
problem or to achieve a set of objectives
3. Identify and define the problem and its root causes to
be addressed
4. List some anticipated impacts or effects from the
proposed project on the environment, different groups
or segments of the society, on the economy and other
stakeholders

Cont’
5. Collect information or data related to the proposed
project using consultation, research, etc
6. Classify each effect/impact of the project as a benefit or a
cost to the society, economy, regulated agents,
environment and implementer of the project
7. Quantify the expected costs and benefits over the
intended period of the project

Cont’
8. Identify the future costs and benefits and estimate their
monetary values
9. Determine the life cycle of the project
10. Estimate when (time or year) the future benefits or costs
will occur and identify which discounting rate or
interest rate should be used in discounting the benefits
or costs

Cont’
11. Discount (D) the quantified costs and benefits as a
process of converting the future values (F) of the costs
and benefits into their present values (P). This can be
done using a discounting factor.

D=
 t
r

1
1
P=
  






t
r
F
1
1

Cont’
Where P=Present value of benefits or costs
F=Future value of benefits or costs
r=Discount rate
t= Number of years or time period within which a
benefit or a cost occurs

Cont’
12. When there are many projects being compared, make
relevant comparisons among all the projects by putting
each on a cost-benefit matrix or scale in order to select
one, which greatly outweigh the costs when using the
various decision criteria or methods.

Benefit-Cost Ratio (BCR or B/C)
 BCR criterion/method gives the ration of the present
value of benefits to the present value of costs. It is
calculated by getting present value of benefits (PVB)
divided by the initial investment (I). I.e
BCR=
I
PVB

Decision criterion based on BCR (B/C)
1. If B/C >1, the project is accepted since the value of
benefits outweigh the value of costs
2. If B/C <1, the project should be rejected since the
benefits are less than the costs
3. If the B/C =1, the situation is a marginal case or break-
even point situation. This implies that B = C or NPV=0
(B-C=0).In this case the decision maker is indifferent
or indecisive such that he may or not accept the
implementation of the project.

Cont’
 NB: If there are more alternative projects whose BCRs
are greater than 1, then, one with a higher benefit-cost
value should be selected for implementation, ceteris
paribus.

Example
Given initial investment of $100,000
Cost of capital (r), 12%
Stream of benefits are given below
Year cash inflow
1 25,000
2 40,000
3 40,000
4 50,000
Required: Calculate the BCR

Solution
Solution
Year Cash flows Discount factor
(
 t
r

1
1
(12%)
Present value (PV)
0 100,000 1 (100,000)
1 25,000 0.8928571 22321.43
2 40,000 0.7971939 31887.76
3 40,000 0.7117802 28471.21
4 50,000 0.6355181 31775.90
PVB= 114456.3

Cont’
BCR=
I
PVB
=
100000
3
.
114456
=1.14.

Cont’
 Since BCR is greater than 1, the project is feasible or
acceptable.
NB. You can also compute the Net Benefit Cost Ratio
(NBCR), which is the present value of benefits to the
initial investment, minus one (1). I.e.

Continue
NBCR = 1

I
PVB
Using the above example, NBCR=1.45-1=0.145
Since the NBCR is greater than 0,the project is acceptable as
being worthy.
NB: If NBCR is 0 (Zero), decision maker is indifferent.
If NBCR is less than zero, the project should be rejected.

Limitations of Benefit-Cost Analysis
1. It ignores the income distribution effects because it does
not consider the issue of actual distribution of gains and
losses of the project under consideration
2. It helps decision makers to choose between different
methods of achieving particular objectives but not to
choose between the different objectives

Cont’
3. Cost-benefit analysis ignores the problem of opportunity
cost that should be part of total cost of the project
4. The assumed discount rate (arbitrary discount rate) for
discounting the future costs and benefits to their
present values is difficult to determine, as it may be too
large or small.
5. It is calculated based on data and sometimes data may
not be available

BENEFIT-COST ANALYSIS FOR SOCIAL DEVELOPMENT PROJECTS
Allocation of Resources in the public sector
In the market, resources are allocated through the
interaction of demand and supply. Prices are the signals
which coordinate the wishes of consumers with the cost
of supplying goods.

Cont’
 But market signals may be either non-existent or
defective. This applies particularly to many of the goods
supplied by the government, such as roads, bridges,
airports, parks, education, health services, new urban
areas and housing. Such goods are provided free or at
less than cost.

The nature of CBA
 CBA is the technique which seeks to bring greater
objectivity into decision-making. It does this by
identifying all the relevant benefits and costs of a
particular scheme and quantifying them in money terms.
This allows all the benefits and costs to be aggregated, as
it were, in the form of a balance sheet upon which the
ultimate

Cont’
decision can be made. E.g. the benefits of a new motorway
would obviously include the time saved in travel, fuel
economies, reduced congestion in towns through which
motor traffic formerly passed, fewer road accidents and
the pleasure derived by the extra motorists who could
now make day trips. Against this, however, would have

Cont’
to set the cost of constructing the motorway, the
additional noise suffered by nearby residents, the
congestion on the feeder roads, the toll of animal life, etc.
There are some methods used to quantify some of the non-
marketed items although these methods are still not
accurate. These include:

Cont’
1. Revealed preference method. The valuation of benefits
and costs should reflect preferences revealed by choices
which have been made. For example, improvements in
transportation frequently involve saving time. The
question is how to measure the money value of that time
saved? The value should not be merely what
transportation planners think time should be worth or
even what people say their time is worth. The value of
time should be that which the public reveals their time is
worth through choices involving tradeoffs between time
and money.

Cont’
 If people have a choice of parking close to their destination
for a fee of 500 shillings or parking farther away and
spending 10 minutes more walking and they always choose
to spend the money and save the time and effort then they
have revealed that their time is more valuable to them than
50 shillings per minute. If they were indifferent between the
two choices they would have revealed that the value of their
time to them was exactly 50 shillings per minute.

Cont’
If all the listed benefits and costs are quantified through
this method, then benefit-cost ratio can be computed to
determine the worthiness of the project.
2. Contingent valuation method (CVM). It is basically used
to estimate economic values for all kinds of ecosystem
and environmental services. CVM involves directly
asking people in a survey, how much they would be
willing to pay for specific social or environmental
services.

Cont’
It is called “contingent” valuation because people are
asked to state their willingness to pay, contingent on a
specific hypothetical scenario.
The CVM is preferred to as a “stated preference” method
because it asks people to directly state their values,
rather than inferring values from the actual choices as
the “revealed preference” methods do.

Cont’
The fact that CVM is based on what people say they would
do, as opposed to what people are observed to do, is the
source of its greatest strengths and its weaknesses.
However, applying the CVM is generally a complicated,
lengthy, and expensive process. In order to collect useful
data and provide useful results, the CV survey must be
properly

Cont’
designed, pre-tested, and implemented. CV survey
questions must focus on specific social or environmental
services and specific context that is clearly defined and
understood by survey respondents. The result of CV
surveys are often highly sensitive to what people believe
they are being asked to value, as well as the context that
is described in the survey.

Cont’
Thus, it is essential for CV researchers to clearly define the
services and the context, and demonstrate that
respondents are actually stating their values for these
services when they answer the valuation questions.
Limitations of CVM
 There is considerable controversy over whether it
adequately measures peoples willingness to pay for social
services or environmental quality.

Cont’
 Information bias may arise whenever respondents are
forced to value attributes with which they have little or
no experience.
 Many people including jurist policy-makers, economists
and others, do not believe in the results of CVM.

Cont’
Therefore, in giving both theoretical and practical
valuation of social developmental projects a lot of
difficulties are always met.
 There is likely to be some form of income redistribution.
For the construction of the road for example those who
suffer from

Cont’
the noise of the traffic on the by-pass, lose; the motorists
and lorry drivers who save traveling time gain. Only if
the losers can be fully compensated by the gainers can be
satisfied that there has been no loss of satisfaction. But
can we identify all those who are adversely affected by
noise, and the extent of the noise on them? This difficulty
of identification occurs frequently.

Cont’
 Since there is no charge for the use of the road,it is not
possible to value the benefits to be received. Much as the
number of motorists to use the road are likely to be
estimated,it is not possible to value the journey each
makes, since some are traveling on business and others
on leisure. Similarly with the reduction in accidents; we
can estimate the saving to the hospital service, in police
time, etc, but it is hard to value the physical sufferings
that are avoided. The road may result in fewer deaths,

Cont’
but is not possible to put a price on saving of human life.
Similarly problems arise in valuing such intangibles as
noise, traffic congestion and the toll of animal life.It may
be possible to obtain a price by analogy, e.g. the fall in
the value of houses resulting from the noise, and the life-
span earning-power of people dying in accidents, but no
such calculation can be completely satisfactory.

Cont’
 Therefore while social factors can be identified, it is
almost difficult to to apply CBA and therefore
computing benefit cost ratio becomes difficult.
Revision questions
1. Government has a plan of providing either a school or a
health center in one of the remote areas of Uganda and
yet these projects are mutually exclusive, meaning that
by implementing one another one is foregone due
scarcity of resources.

Cont’
Using the cost benefit analysis, highlight the procedure that
should be taken to choose the project that worthy
undertaking.
2. Salama publishing co. wishes to invest in newer models of
printing machines. They are unsure whether to make the
U$ 15,000 investment on model A or B. Given that the
cost of capital is 12% p.a. Using benefit cost ratio,
determine which of the two models is worthwhile?

Cont’
Year 1 2 3 4
Model A 8000 6800 4000 3500
Model B 6000 6000 6000 6000