Benefit Cost Analysis –
Another Decision Making Tool in the Tool Box
Benefit Cost Analysis – What are they, and where did they come from? Benefit Cost Analyses are widely used across many industries and sectors to determine if the benefits of a project outweigh the costs. The practice of cost benefit analysis is not new, in fact this idea of “relative utility” for a public project was first sited in an article published in 1848 by a French engineer and economist Jules Dupuit. In later years, Alfred Marshall went on to expand upon the idea with “Marshallian Surplus”, which mirrors the foundations of benefit cost analysis. It was first used in the United States under the Corps of Engineers in 1936 to determine if certain waterway infrastructure projects would be economically and socially advantageous.
Today, the process of a benefit cost analysis is used by businesses across many disciplines. In fact when you Google the definition for “benefit cost analysis” many definitions and sources are returned, everything from investments, insurance, public health, geography, politics, sport science and medicine to architecture dictionaries. Almost every industry completes cost benefits analyses either formally or informally in their decision making processes.
Why are they so important?
Benefit cost analysis is becoming more important and relevant in the current economic climate of decreasing municipal budgets and increasing competition for grants. Therefore, providing a clear and concise rationale for a project proposal is essential to obtaining federal and state grant money.
In all benefit cost analysis, the goal is to compare the calculated direct and indirect benefits against the total costs of a given project to make an evidence based decision. While is it often times difficult to quantify some social benefits, it is essential to consider both the tangible and intangible costs and benefits. A report published by the Office of Budget and Management (Circular A-94) offers guidance to completing benefit cost analysis for government agencies. The following is a summary of the recommendations for “Identifying and Measuring Benefits and Costs”:
Actual costs of a project such as supplies, labor and etcetera should be included;
Incremental benefits and costs should be included as a function of the net present value of those benefits and costs over time;
Costs should reflect the opportunity costs of any resource used. (If you cannot remember the definition of Opportunity Costs from Economy 101, it is: “the cost related to the next best choice available to someone who has picked between two mutually exclusive choices”.) In other words, it is the “real cost” in foregone output, or lost time, if the project was not completed;
Indirect impacts should be considered; for example, this could include be an increase in land values and thus tax revenue;
Infra-marginal benefits and costs is the actual benefit that society places on the project or program, and is a method of determining consumer demand for a program. For all goods and services an individual would place a value on its usefulness, trying to determine this value is difficult but should be done to quantify the social impact of a project.
Accuracy in a cost benefit analysis is essential to the quality and effectiveness of this tool. Therefore being able to identify all of the costs associated with a project and providing either historical or projected data for a project is important. On the other side, the benefits have some easily quantifiable factors such as increased productivity or increased capacity; however many are intangible, such as the infra-marginal benefits noted above that are difficult and complex to calculate.
After the two sides are calculated per the applications request, a ratio called the benefit cost ratio is calculated by dividing the present value of the benefits by the present value of the costs.
Benefit Cost Ratio = Present Value of Benefits/Present Value of Costs
If the ratio is greater than one then the benefits outweigh the cost in monetary terms and the project would be considered economically advantageous.
How do they differ from other decision making tools?
Economic impact analysis, feasibility studies, and Social Return on Investments (SROI) are other tools used by economic development organizations, communities and policy makers across the world to determine if a project will have positive economic or social benefits. However, they each differ from a benefit cost analysis as they do not compare an alternative analysis for not completing the project. Additionally, these tools use multiplier effects, consider market trends and in the case of the SROI only identify the direct benefits of a project or program rather than inclusive of all benefits that are realized. While these tools are certainly useful in determining if a project is worthwhile, a benefit cost analysis is a great tool to make a calculated decision based on the evidence presented and provides a clear comparison of the alternative.
Who is requiring Benefit Cost Analysis?
The Federal Emergency Management Agency (FEMA), as well as Tiger I and Tiger II grants (among others), require Benefit Cost Analysis. Below is a brief overview of the FEMA Mitigation Grant process and requirements.
FEMA recently started requiring Benefit Cost Analysis using FEMA provided software. The grant programs under FEMA currently requiring the Benefit Cost Analysis are as follows: Flood Mitigation Assistance, Hazard Mitigation Grant Program, Pre-Disaster Mitigation, Repetitive Flood Claims, Supplemental Mitigation Grants and Severe Repetitive Loss Program. For a mitigation project, costs must be estimated using a six step process that FEMA outlines which includes: Preconstruction or non-construction costs, estimates of construction costs, ancillary costs, annual maintenance costs and the determination of project timing and currency. Benefit calculations are then determined by considering the avoided losses, and the time value of money. If your community does not have the resources to complete this daunting task, professionals are always available to assist with grants and benefit cost analysis requirements.
The prevalence of benefit cost analysis is becoming more apparent, as state and federal agencies are requiring this analysis as part of grant applications at a greater rate. However, don’t be frightened this tool will help everyone make better decisions regarding public funds and project priority, which will benefit everyone.
Triad Associates is currently the League’s Grant Consulting Firm. Their firm, which is known for its expertise in community and economic development, including strategic planning, redevelopment, acquisition, relocation and funding, has brought diverse plans and projects to life by generating more than $580,000,000 for over 120 public, private and nonprofit clients throughout the Northeast region since 1978. Every member of the Triad team is personally committed and dedicated to the success of its clients and the projects that benefit communities.