Question

Cost-benefit analysis provides a method for identifying the most efficient alternative. Consider its relationship to distributional values from a theoretical and practical perspective.

Answer 1

Cost-Benefit Analysis
A cost-benefit analysis is a process businesses use to analyze decisions. The business or analyst sums the benefits of a situation or action and then subtracts the costs associated with taking that action. Some consultants or analysts also build the model to put a dollar value on intangible items, such as the benefits and costs associated with living in a certain town
The Cost-Benefit Analysis Process
The first step in the process is to compile a comprehensive list of all the costs and benefits associated with the project or decision. Costs should include direct and indirect costs, intangible costs, opportunity costs, and the cost of potential risks. Benefits should include all direct and indirect revenues and intangible benefits, such as increased production from improved employee safety and morale, or increased sales from customer goodwill. The analyst should then apply a common unit of monetary measurement to all items on the list, taking special care not to underestimate costs or overestimate benefits. A conservative approach with a conscious effort to avoid any subjective tendencies when calculating estimates is best suited when assigning a value to both costs and benefits for a cost-benefit analysis.

The final step is to compare the results of the aggregate costs and benefits quantitatively to determine if the benefits outweigh the costs. If so, then the rational decision is to go forward with the project. If not, the business should review of the project to see if it can make adjustments to either increase benefits or decrease costs to make the project viable. Otherwise, the company may abandon the project.

A CBA application includes the following stages:

General description of the project:- This part includes an explanation on the environment under which each analysis is done such as the objectives, the assumptions, the project/decision life etc.

List of alternative scenarios:- In order to decide which is the best option in the CBA we have to consider the costs and the benefits for each of these options. This section lists the options considered during the analysis.

Identify Benefits and Costs:- In this part, the application lists the exact benefits and costs met in each of the alternative scenarios. The application divides these into two kinds: The ones that are relatively straightforward to be measured and the ones that are not very easy to be measured. Many factors must be considered during the process of estimating the costs associated with competing alternatives in a CBA.
All costs for the full system life cycle for each competing alternative must be included. The following factors must be addressed: Activities and Resources, Cost Categories, Personnel Costs, Direct and Indirect Costs (Overhead), Depreciation, and Annual Costs.
Benefits are the services, capabilities, and qualities of each alternative system, and can be viewed as the return from an investment. To estimate benefits, first identify the benefits for both the customers and the organization that provides the service(s) to the customers. Benefits to customers are improvements to the current IT services and/or the addition of new services. Some possible benefits for the servicing organization are productivity gains, staffing reductions, or improved organizational effectiveness. After the benefits are identified, the user has to establish performance measures for each benefit. The final step is to estimate the value of the benefits. If a benefit cannot reasonably be assigned a monetary value, it should be valued using a more subjective, qualitative rating system (which assigns relative numerical values for the competing alternatives). All benefits for the full system life cycle for each competing alternative must be included.

Schedule Benefits and Costs:- For each of the alternatives defined in step 2, the user now identifies the value of each benefit and cost for each year through the life cycle of the decision beginning from Year 0, which is the start of the decision life. After the costs and benefits for each year of the system life cycle have been estimated, convert them to a common unit of measurement to properly compare competing alternatives. That is accomplished by discounting future Euro values, which transforms future benefits and costs to their "present value." The present value (also referred to as the discounted value) of a future amount is calculated with the following formula:P = F (1/(1+I)n), where P = Present Value, F = Future Value, I = Interest Rate, and n = number of years.
Comparison of alternatives:- In this part the application compares the alternative solutions. The comparison is illustrated with tables and graphs so as to facilitate decision making. When the costs and benefits for each competing alternative have been discounted, compare and rank the discounted net value (discounted benefit minus discounted cost) of the competing alternatives. When the alternative with the lowest discounted cost provides the highest discounted benefits, it is clearly the best alternative.
Sensitivity Analysis:- In this part the application helps the user define how sensitive the results are to changes in the costs and benefits. This sensitivity involves costs and benefits whose definition is not straightforward or is not easy to be exactly defined. Sensitivity analysis tests the sensitivity and reliability of the results obtained from the cost-benefit analysis. Since the CBA is normally the key document in the investment review process, reviewers want assurance that the analysis is reliable. Sensitivity analysis identifies those input parameters that have the greatest influence on the outcome, repeats the analysis with different input parameter values, and evaluates the results to determine which, if any, input parameters are sensitive. If a relatively small change in the value of an input parameter changes the alternative selected, then the analysis is considered to be sensitive to that parameter. If the value of a parameter has to be doubled before there is a change in the selected alternative, the analysis is not considered to be sensitive to that parameter. The estimates for sensitive input parameters should be re-examined to ensure that they are as accurate as possible.