The Cost-Benefit Analysis (CBA) aims to identify and quantify the positive (benefits) and negative (costs) consequences of a decision and then express them in a common unit: the monetary unit.
The Cost-Benefit Analysis (CBA) aims to identify and quantify the positive (benefits) and negative (costs) consequences of a decision and then express them in a common unit: the monetary unit. It is therefore a decision-making tool in the same way as the multivoting, the AHP…
The advantage of the method is that it provides a logical framework for identifying costs and benefits as well as beneficiaries and losers.
Note that this tool is widely used by American and English policies. Less by the French … For this reason, most uses and examples that you will find will be related to political issues (road construction …). For a Lean 6 Sigma approach, this method can be used to define the overall deployment plan. It will then allow us to prioritize the pilot plant and select the projects of scale.
1 – Define the stakeholders
At first, we will define our scope of study by performing a stakeholder analysis. We will identify all the people or groups of people impacted directly or indirectly by the project.
2 – Specify the different scenarios or projects
Then, to limit the risks, we will define the different scenarios for each of the possible solutions. For each of the alternatives, we will define a scenario to describe the situation with or without the project.
3 – List the consequences and choose their indicators
To make a relevant comparison, we will define a number of quantitative indicators common to all scenarios. These indicators represent the positive or negative impacts that the scenarios may have.
Note that if our indicator is difficult to measure, we will choose a “proxy” : a variable close to the one for which we are looking for the data, but for which the measurement is simple or available.
These indicators are as numerous as the type of projects that may exist. We can have productivity gains, reduction of incidents…
4 – Predict the “indirect ” consequences of the project
Then, we will predict the impacts of the project once it is in place. The exercise is interesting to anticipate problems and opportunities.
For example, regulations may be in place to produce safer vehicles that will lead to risky driving behaviors..
5 – Monetize the consequences
Once the indicators have been identified, they must be translated into “cost” currency. Two cases will come to us :
- The impacts relate to a market : they are the direct impacts of our project and therefore easily measurable, what we also call the Hard Dollar.
- The so-called “Out of Market” impacts: these are the impacts for which there is no direct price, so-called Soft Dollar. For example, projects on improving air quality have so-called “off-market impacts. There is no price directly, so most of us are ready to pay for it. This is called ” Consent to pay”. Several methods can be used to identify this’ price ».
The willingness to pay
The willingness to pay measures what an individual would be willing to give to benefit from a good (or the benefits of a project). This is a monetary measure of the variation in an individual’s well-being that would be required to accept a project…
Equivalently, we can evaluate the consent to receive, what the individual would like to obtain in compensation for the reduction of a good or a service.
This concept is represented most often via a graph that reads as follows: I have 6 people willing to pay the P6 Price, but only one to pay the P1 price. At the price P *, we therefore have the quantity Q *, the area in light gray of this rectangle representing the “consumer spending “. The rest being “consumer surplus ».
This notion was introduced by Jules Dupuit (1804 – 1866). Engineer, he worked on the economic problems related to the construction of public infrastructures. One of his responsibilities concerned the French road system and consisted in making choices among all the requests for new bridges and roads to be built. In 1844, he published “Measuring the Utility of Public Works”, a pioneering contribution to the theory of utility. He proposes in this book to focus more on the utility of public works (benefits derived by their users) than on their cost in terms of tolls, emphasizing that the well-being felt by the consumer exceeds the price paid (some individuals would be to pay more than the amount of the toll to cross the bridge or use a canal). It is this difference between the willingness to pay and the actual price that was later called the “consumer surplus”. These notions of value subjectivity and marginal utility were then developed by economists in the so-called “marginalist” approach. ».
Hedonic price method
This method makes it possible to isolate and monetize the different characteristics that define the same product. We will identify the total price of a product or project and identify the causes to identify the variation. From there, using aregression analysis or a hypothesis test, we will define the « price » of each parameters.
For example, suppose we want to determine the monetary value of the view that residents of a residential area enjoy. If sales prices of dwellings in this neighborhood and other neighborhoods are collected, and all the characteristics that influence these prices, a relationship can be described and estimated that isolates the value of each characteristic, particularly individuals are willing to pay to benefit from the view in question.
Joint analysis method
Another more sophisticated method is joint analysis. Derived from marketing, this method makes it possible to measure the relative weight of different attributes of a good or service in the eyes of potential beneficiaries, the price being one of the attributes to be evaluated. This consists of breaking down the property to be assessed into attributes (plant distance, air quality, etc.) and then defining “quality” levels for each of these. attributes (distance of 1, 2, 10 kilometers, poor, average or good air quality). Scenarios offering different combinations of these attributes are then offered to individuals, with associated cost. By analyzing the choices of individuals, we deduce their tradeoffs between different attributes and the monetary value associated with each level of quality.
This method avoids certain bias attributable to contingent valuation, since it is easier for people to make a qualitative choice between several alternatives than to give a gross monetary value. It requires more complex statistical processing.
6 – Update future costs and benefits
In most projects for which you will use this method, its impacts will be long-term. For this reason, the decision should be based on costs and benefits that will be updated. We will then use the principle of Net Present Value.
7 – Analyze the robustness of the results
The analysis of the robustness of our results will consist of identifying the probability of our profits. Thus, depending on the probability distribution of our input parameters and knowing their impact on Net Present Value, we will calculate the distribution of this one via an analysis of Monte-Carlo.
This calculation will be performed for all scenarios.
8 – Make a recommendation for a decision
Depending on the robustness analysis, several tracks will enable us to deduce our recommendation. We thus find :
- If our project has high operational risks, we will favor the one with the lowest variability and therefore the lowest statistical risk.
- We have budget, so we will favor the one with the biggest gain.