An Introduction To Cost Benefit Analysis

AN INTRODUCTION TO COST BENEFIT ANALYSIS
Background
Cost-Benefit Analysis (CBA) estimates and totals up the equivalent money value of the benefits and
costs to the community of projects to establish whether they are worthwhile. These projects may be
dams and highways or can be training programs and health care systems.
The idea of this economic accounting originated with Jules Dupuit, a French engineer whose 1848
article is still worth reading. The British economist, Alfred Marshall, formulated some of the formal
concepts that are at the foundation of CBA. But the practical development of CBA came as a result of
the impetus provided by the Federal Navigation Act of 1936. This act required that the U.S. Corps of
Engineers carry out projects for the improvement of the waterway system when the total benefits of a
project to whomsoever they accrue exceed the costs of that project. Thus, the Corps of Engineers had
create systematic methods for measuring such benefits and costs. The engineers of the Corps did this
without much, if any, assistance from the economics profession. It wasn't until about twenty years
later in the 1950's that economists tried to provide a rigorous, consistent set of methods for
measuring benefits and costs and deciding whether a project is worthwhile. Some technical issues of
CBA have not been wholly resolved even now but the fundamental presented in the following are well
established.
Principles of Cost Benefit Analysis
One of the problems of CBA is that the computation of many components of benefits and costs is
intuitively obvious but that there are others for which intuition fails to suggest methods of
measurement. Therefore some basic principles are needed as a guide.
There Must Be a Common Unit of Measurement
In order to reach a conclusion as to the desirability of a project all aspects of the project, positive and
negative, must be expressed in terms of a common unit; i.e., there must be a "bottom line." The most
convenient common unit is money. This means that all benefits and costs of a project should be
measured in terms of their equivalent money value. A program may provide benefits which are not
directly expressed in terms of dollars but there is some amount of money the recipients of the
benefits would consider just as good as the project's benefits. For example, a project may provide for
the elderly in an area a free monthly visit to a doctor. The value of that benefit to an elderly recipient
is the minimum amount of money that that recipient would take instead of the medical care. This
could be less than the market value of the medical care provided. It is assumed that more esoteric
benefits such as from preserving open space or historic sites have a finite equivalent money value to
the public.
Not only do the benefits and costs of a project have to be expressed in terms of equivalent money
value, but they have to be expressed in terms of dollars of a particular time. This is not just due to the
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differences in the value of dollars at different times because of inflation. A dollar available five years
from now is not as good as a dollar available now. This is because a dollar available now can be
invested and earn interest for five years and would be worth more than a dollar in five years. If the
interest rate is r then a dollar invested for t years will grow to be (1+r) t. Therefore the amount of
money that would have to be deposited now so that it would grow to be one dollar t years in the
future is (1+r)-t. This called the discounted value or present value of a dollar available t years in the
future.
When the dollar value of benefits at some time in the future is multiplied by the discounted value of
one dollar at that time in the future the result is discounted present value of that benefit of the
project. The same thing applies to costs. The net benefit of the projects is just the sum of the present
value of the benefits less the present value of the costs.
The choice of the appropriate interest rate to use for the discounting is a separate issue that will be
treated later in this paper.
CBA Valuations Should Represent Consumers or Producers Valuations As Revealed by Their Actual
Behavior
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. If people have a choice of parking close to their destination for a
fee of 50 cents or parking farther away and spending 5 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 10 cents per minute. If they were indifferent between the two choices they
would have revealed that the value of their time to them was exactly 10 cents per minute.
The most challenging part of CBA is finding past choices which reveal the tradeoffs and equivalencies
in preferences. For example, the valuation of the benefit of cleaner air could be established by finding
how much less people paid for housing in more polluted areas which otherwise was identical in
characteristics and location to housing in less polluted areas. Generally the value of cleaner air to
people as revealed by the hard market choices seems to be less than their rhetorical valuation of
clean air.
Benefits Are Usually Measured by Market Choices
When consumers make purchases at market prices they reveal that the things they buy are at least as
beneficial to them as the money they relinquish. Consumers will increase their consumption of any
commodity up to the point where the benefit of an additional unit (marginal benefit) is equal to the
marginal cost to them of that unit, the market price. Therefore for any consumer buying some of a
commodity, the marginal benefit is equal to the market price. The marginal benefit will decline with
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the amount consumed just as the market price has to decline to get consumers to consume a greater
quantity of the commodity. The relationship between the market price and the quantity consumed is
called the demand schedule. Thus the demand schedule provides the information about marginal
benefit that is needed to place a money value on an increase in consumption.
Gross Benefits of an Increase in Consumption is an Area Under the Demand Curve
The increase in benefits reulting from an increase in consumption is the sum of the marginal benefit
times each incremental increase in consumption. As the incremental increases considered are taken
as smaller and smaller the sum goes to the area under the marginal benefit curve. But the marginal
benefit curve is the same as the demand curve so the increase in benefits is the area under the
demand curve. As shown in Figure 1 the area is over the range from the lower limit of consumption
before the increase to consumption after the increase.
Figure 1
When the increase in consumption is small compared to the total consumption the gross benefit is
adequately approximated, as is shown in a welfare analysis, by the market value of the increased
consumption; i.e., market price times the increase in consumption.
Some Measurements of Benefits Require the Valuation of Human Life
It is sometimes necessary in CBA to evaluate the benefit of saving human lives. There is considerable
antipathy in the general public to the idea of placing a dollar value on human life. Economists
recognize that it is impossible to fund every project which promises to save a human life and that
some rational basis is needed to select which projects are approved and which are turned down. The
controversy is defused when it is recognized that the benefit of such projects is in reducing the risk of
death. There are many cases in which people voluntarily accept increased risks in return for higher
pay, such as in the oil fields or mining, or for time savings in higher speed in automobile travel. These
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choices can be used to estimate the personal cost people place on increased risk and thus the value to
them of reduced risk. This computation is equivalent to placing an economic value on the expected
number of lives saved.
The Analysis of a Project Should Involve a With Versus Without Comparison
The impact of a project is the difference between what the situation in the study area would be with
and without the project. This that when a project is being evaluated the analysis must estimate not
only what the situation would be with the project but also what it would be without the project. For
example, in determining the impact of a fixed guideway rapid transit system such as the Bay Area
Rapid Transit (BART) in the San Francisco Bay Area the number of rides that would have been taken
on an expansion of the bus system should be deducted from the rides provided by BART and likewise
the additional costs of such an expanded bus system would be deducted from the costs of BART. In
other words, the alternative to the project must be explicitly specified and considered in the
evaluation of the project. Note that the with-and-without comparison is not the same as a before-
and-after comparison.
Another example shows the importance of considering the impacts of a project and a with-and-
without comparison. Suppose an irrigation project proposes to increase cotton production in Arizona.
If the United States Department of Agriculture limits the cotton production in the U.S. by a system of
quotas then expanded cotton production in Arizona might be offset by a reduction in the cotton
production quota for Mississippi. Thus the impact of the project on cotton production in the U.S.
might be zero rather than being the amount of cotton produced by the project.
Cost Benefit Analysis Involves a Particular Study Area
The impacts of a project are defined for a particular study area, be it a city, region, state, nation or the
world. In the above example concerning cotton the impact of the project might be zero for the nation
but still be a positive amount for Arizona.
The nature of the study area is usually specified by the organization sponsoring the analysis. Many
effects of a project may "net out" over one study area but not over a smaller one. The specification of
the study area may be arbitrary but it may significantly affect the conclusions of the analysis.
Double Counting of Benefits or Costs Must be Avoided
Sometimes an impact of a project can be measured in two or more ways. For example, when an
improved highway reduces travel time and the risk of injury the value of property in areas served by
the highway will be enhanced. The increase in property values due to the project is a very good way,
at least in principle, to measure the benefits of a project. But if the increased property values are
included then it is unnecessary to include the value of the time and lives saved by the improvement in
the highway. The property value went up because of the benefits of the time saving and the reduced
risks. To include both the increase in property values and the time saving and risk reduction would
involve double counting.
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Decision Criteria for Projects
If the discounted present value of the benefits exceeds the discounted present value of the costs then
the project is worthwhile. This is equivalent to the condition that the net benefit must be positive.
Another equivalent condition is that the ratio of the present value of the benefits to the present value
of the costs must be greater than one.
If there are more than one mutually exclusive projects that have positive net present value then there
has to be further analysis. From the set of mutually exclusive projects the one that should be selected
is the one with the highest net present value.
If the funds required to carry out all of the projects with positive net present value are less than the
funds available this means the discount rate used in computing the present values is too low and does
not reflect the true cost of capital. The present values must be recomputed using a higher discount
rate. It may take some trial and error to find a discount rate such that the funds required for the
projects with a positive net present value is no more than the funds available. Sometimes as an
alternative to this procedure people try to select the best projects on the basis of some measure of
goodness such as the internal rate of return or the benefit/cost ratio. This is not valid for several
reasons.
The magnitude of the ratio of benefits to costs is to a degree arbritrary because some costs such as
operating costs may be deducted from benefits and thus not be included in the cost figure. This is
called netting out of operating costs. This netting out may be done for some projects and not for
others. This manipulation of the benefits and costs will not affect the net benefits but it may change
the benefit/cost ratio. However it will not raise the benefit cost ratio which is less than one to above
one. For more on this topic see Benefit/ cost Ratio Magnitude.
An Example
To illustrate how CBA might be applied to a project, let us consider a highway improvement such as
the extension of Highway 101 into San Jose. The local four-lane highway which carried the freeway
and commuter traffic into San Jose did not have a median divider and its inordinate number of fatal
head-on collisions led to the name "Blood Alley." The improvement of the highway would lead to
more capacity which produces time saving and lowers the risk. But inevitably there will be more traffic
than was carried by the old highway.
The following is a highly abbreviated analysis using hypothetical data.
TRIP DATA No Extension, 101 Extension
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"Blood Alley" Only and "Blood Alley"
Rush Hours
Passenger Trips
3,000 4,000
(per hour)
Trip Time
50 30
(minutes)
Value of Time
$0.10 $0.10
($/minute)
Nonrush Hours
Passenger Trips
500 555.55
(per hour)
Trip Time
35 25
(minutes)
Value of Time
$0.08 $0.08
($/minute)
Traffic Fatalities
12 6
(per year)
The data indicates that for rush-hour trips the time cost of a trip is $5 without the project and $3 with
it. It is assumed that the operating cost for a vehicle is unaffected by the project and is $4.
The project lowers the cost of a trip and the public responds by increasing the number of trips taken.
There is an increase in consumer surplus both for the trips which would have been taken without the
project and for the trips which are stimulated by the project.
For trips which would have been taken anyway the benefit of the project equals the value of the time
saved times the number of trips. For the rush-hour trip the project saves $2 and for the nonrush-hour
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trip it saves $0.80. For the trips generated by the project the benefit is equal to one half of the value
of the time saved times the increase in the number of trips.
The benefits per hour are:
Trips Which Would Trips Generated

TYPE Total
Be Taken Anyway By the Project
Rush Hour 6,000.00 1,000.00 7,000.00
Nonrush Hour 400.00 22.22 422.22
To convert the benefits to an annual basis one multiplies the hourly benefits of each type of trip times
the number of hours per year for that type of trip. There are 260 week days per year and at six rush
hours per weekday there are 1560 rush hours per year. This leaves 7200 nonrush hours per year. With
these figures the annual benefits are:
Trips Which
Trips Generated
TYPE Would Be Total
By the Project
Taken Anyway
Rush Hour $9,360,000 $1,560,000 $10,020,000
Nonrush Hour $2,880,000 $160,000 $3,040,000
Total $12,240,000 $1,720,000 $13,960,000
The value of the reduced fatalities may be computed in terms of the equivalent economic value
people place upon their lives when making choices concerning risk and money. If the labor market has
wages for occupations of different risks such that people accept an increase in the risk of death of
1/1,000 per year in return for an increase in income of $400 per year then a project that reduces the
risk of death in a year by 1/1000 gives a benefit to each person affected by it of $400 per year. The
implicit valuation of a life in this case is $400,000. Thus benefit of the reduced risk project is the
expected number of lives saved times the implicit value of a life. For the highway project this is
6x$400,000= $2,400,000 annually.
The annual benefits of the project are thus:
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VALUE OF BENEFITS
TYPE OF BENEFIT
PER YEAR
Time Saving $13,960,000
Reduced Risk $2,400,000
Let us assume that this level of benefits continues at a constant rate over a thirty-year lifetime of the
project.
The cost of the highway consists of the costs for its right-of-way, its construction and its maintenance.
The cost of the right-of-way is the cost of the land and any structures upon it which must be
purchased before the construction of the highway can begin. For purposes of this example the cost of
right-of-way is taken to be $100 million and it must be paid before any construction can begin. At
least part of the right-of- way cost for a highway can be recovered at the end of the lifetime of the
highway if it is not rebuilt. For the example it is assumed that all of the right-of-way cost is
recoverable at the end of the thirty-year lifetime of the project. The construction cost is $200 million
spread evenly over a four-year period. Maintenance cost is $1 million per year once the highway is
completed.
The schedule of benefits and costs for the project are as follows:
RIGHT-OF CONSTRUCTION
TIME BENEFITS MAINTENANCE
-WAY COSTS
(year) ($millions) ($millions)
($millions) ($millions)
0 0 100 0 0
1-4 0 0 50 0
5-29 16.36 0 0 1
30 16.36 -100 0 1
The benefits and costs are in constant value dollars; i.e., there was no price increase included in the
analysis. Therefore the discount rate used must be the real interest rate. If the interest rate on long
term bonds is 8 percent and the rate of inflation is 6 percent then the real rate of interest is 2 percent.
Present value of the streams of benefits and costs discounted at a 2 percent back to time zero are as
follows:
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PRESENT VALUE

($ millions)
Benefits 304.11
Costs
Right-of-Way 44.79
Construction 190.39
Maintenance 18.59
Total Costs 253.77

Net Benefits 50.35
*independent rounding
The positive net present value of $50.35 million and benefit/cost ratio of 1.2 indicate that the project
is worthwhile if the cost of capital is 2 percent. When a discount rate of 3 percent is the benefit/cost
ratio is slightly under 1.0. This means that the internal rate of return is just under 3 percent. When the
cost of capital is 3 percent the project is not worthwhile.
It should be noted that the market value of the right-of-way understates the opportunity cost of
having the land devoted to the highway. The land has a value of $100 million because of its income
after property taxes. The economy is paying more for its alternate use but some of the payment is
diverted for taxes. The discounted presented value of the payments for the alternate use might be
more like $150 million instead of $100 million. Another way of making this point is that one of the
costs of the highway is that the local governments lose the property tax on the land used.
Summary
By reducing the positive and negative impacts of a project to their equivalent money value Cost-
Benefit Analysis determines whether on balance the project is worthwhile. The equivalent money
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value are based upon information derived from consumer and producer market choices; i.e., the
demand and supply schedules for the goods and services affected by the project. Care must be take to
properly allow for such things as inflation. When all this has been considered a worthwhile project is
one for which the discounted value of the benefits exceeds the discounted value of the costs; i.e., the
net benefits are positive. This is equivalent to the benefit/cost ratio being greater than one and the
internal rate of return being greater than the cost of capital.
History of Cost-Benefit Analysis
CBA has its origins in the water development projects of the U.S. Army Corps of Engineers. The Corps
of Engineers had its orgins in the French engineers hired by George Washington in the American
Revolution. For years the only school of engineering in the United States was the Military Academy at
West Point, New York.
In 1879, Congress created the Mississippi River Commission to "prevent destructive floods." The
Commission included civilians but the president had to be an Army engineer and the Corps of
Engineers always had veto power over any decision by the Commission.
In 1936 Congress passed the Flood Control Act which contained the wording, "the Federal
Government should improve or participate in the improvement of navigable waters or their
tributaries, including watersheds thereof, for flood-control purposes if the benefits to whomsoever
they may accrue are in excess of the estimated costs." The phrase if the benefits to whomsoever they
may accrue are in excess of the estimated costs established cost-benefit analysis. Initially the Corps of
Engineers developed ad hoc methods for estimating benefits and costs. It wasn't until the 1950s that
academic economists discovered that the Corps had developed a system for the economic analysis of
public investments. Economists have influenced and improved the Corps' methods since then and
cost-benefit analysis has been adapted to most areas of public decision-making.
Cost Benefit Analysis
Cost-Benefit Analysis - 1
Cost Benefit Analysis, Slide 2
Copyright © 2004, Jim Schwab, University of Texas at Austin
In cost-benefit analysis, we compare the costs and benefits of one or more projects to determine
which are worthwhile, and which should be prioritized when there are multiple projects. The
computations are similar to those in cost effectiveness analysis; we simply are applying economic
evaluation techniques to two entities: costs and benefits.
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The minimum requirement for a project to be judged worthwhile is that its benefit-cost ratio be at
least 1.0. This means that the benefits equal or exceed the costs of the project.
When comparing multiple worthwhile projects, priority would be given to the project with the
highest benefit-cost ratio.
Cost-benefit analysis can be much more complex that we will present here. Real work problems
frequently have benefits to multiple groups, i.e. the recipients of the service and society at large. For
example, a person cured of substance abuse could show his or her wages as a personal benefit.
Society would also gain because this individual now pays taxes, does not steal to pay for the drug
habit, etc.
Cost-Benefit Analysis - 2
In many cases, benefits to one group may be costs to another group. For example, welfare reform
may save the government money, but reduce the income of merchants who own the stores where
welfare recipients shop.
Another complexity which we will not pursue is the probability or likelihood of the occurrence of
different events or outcomes. Future events and costs are based on the assumption of their likelihood
of occurrence. We can calculate scenarios with different probabilities for future events to see what
impact that would make for choosing among the available alternatives.
Example 1: East Stockton Urban Renewal Project - 1
This problem is similar to the problem in Quantitative Methods for Public Decision Making by
Christopher K. McKenna, page 157-159.
The objective and social benefits of urban renewal are (1) superior pattern of resource allocation,
(2) social benefits of the removal of blight, and (3) improved local financial position. Although there
may be a number of alternative uses for land being redeveloped, we are here considering the more
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aggregate alternatives, either urban renewal or no urban renewal in a particular section of the city.
This is the level of evaluation appropriate for cost-benefit analysis. The alternatives would then be
the particular urban renewal projects that should or should not be undertaken.
Among the constraints active on urban renewal is the legal requirement that a redevelopment
agency must provide former residents of an urban renewal area with decent, safe, and sanitary
housing that is conveniently located and within the means of the residents. Note that it is not
implicitly assumed that relocation results in housing facility improvement for the residents,
The costs include those for relocation, survey and planning, administration, public improvements,
demolition, and the value of improvements demolished. Benefits include those specifically associated
with the stated objectives as well as non-economic negative effects of relocation and possible land
value write-down. In urban renewal there are, of course, tangible and intangible benefits; in this
exercise, our goal is to determine what level of intangible benefits would decision makers have to
substantiate in order to justify the project from a cost-benefit perspective.
The East Stockton, California, Urban Renewal Project was officially approved by the federal
government in July 1959. The workbook, “UrbanRenewal.xls”, which can be downloaded from the
course download web page, displays the various costs associated with the renewal project and the
time at which they occurred. Most of the costs were actually incurred over an interval of time; in such
cases the center of the interval is used as the date of the cost.

The cost of the land is not included in the list of costs since land purchases were later resold. In
the East Stockton renewal project, the land was purchased for $669,129 over a period roughly
centered at June 30, 1960. After clearing and renewal, the land was subsequently sold for $1,200,000
over a period roughly centered at June 30, 1965. Employing a discount rate of 6 percent, the selling
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price was discounted to June 30, 1960, yielding a present value of $896,760; hence, the
redevelopment agency had a “profit” of $227,631 on the project area land. This amount is included in
the list of tangible benefits in the “UrbanRenewal” workbook.
Other tangible benefits were not quite so easily estimated. The increase in the property value in
the project area was the result of three factors: inflation, growth in real income and population, and
urban renewal. To isolate the increase due to urban renewal, a comparison was made between
increases in the project area and increases near the project area. The comparison led to an estimate
of $415,500 as the increase in the value of the neighborhood properties. Public improvements such as
schools and parts were estimated at a value equal to their cost.
Urban renewal is generally expected to reduce the cost of municipal services. The savings in the
cost of fire protection was estimated by noting that prior to urban renewal the per person
expenditure for East Stockton as was 2½ times what it was for the rest of the city. Assuming that after
renewal the residents of East Stockton would require only average protection, the reduced cost of fire
protection was estimated to be $42,000 annually. Capitalizing the annual amount of $42,000 at 6
percent yields $700,000 as the present value of future fire protection cost savings. The savings in
health protection and police protection costs were estimated similarly.
The questions we will answer in this exercise are: what level of intangible benefits need to be
identified in order for this project to satisfy the minimum cost benefit ratio of 1.0? Does a higher or
lower discount rate substantially change our answer?

Tangible costs/benefits of urban renewal project
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The tangible costs and benefits for the project have been entered in a workbook called
UrbanRenewal.xls which can be downloaded from a course web page. All of this information is given
in the chapter by McKenna. Note that the worksheet includes the Date of the expense because not all
expenses occurred at regular annual intervals. Excel has another worksheet function to support
calculations of net present value when the stream of payments occur in different time periods, the
XNPV function.
The discount rate
First, we enter the discount rate stated in the problem 6% in the cell D2 of the Cost-benefit analysis
worksheet.
Use XNPV function to calculate value of tangible costs
First, select the cell in which we Excel to return the present value of the tangible costs, cell B14 on the
Cost-benefit analysis worksheet.
Second, select the Function command from the Insert menu.
Unlike the ‘NPV’ function, the ‘XNPV’ function does not make the assumption that the series of costs
occurs at regular, annual intervals. XPNV permits us to associated dates with each cost item.
Locate the XNPV function
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We will search for the XNPV function. First, type XNPV in the Search for text box, and click on the Go
button.
The XNPV function name will appear in the Select a function list box. Click on the OK button access the
dialog box where the function arguments are entered.
Note: the XNPV function is part of the Analysis Toolpak that we used for Data Analysis. If Excel does
not find it, check to make sure the Analysis Toolpak Add-in has been installed.
The arguments to the XNPV function
The first argument to the XNPV function is the discount rate, which we put in cell D2.
The second argument to the XNPV function is the cells containing the tangible costs, B2:B12.
The third argument to the XNPV function is the cells containing the dates the tangible costs occurred,
C2:C12.
With the arguments entered, click on the OK button.
Net present value of tangible costs
Excel computes the net present value for the series of costs for this project.
The table of tangible benefits - 1
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The XPNV function discounts the stream of costs or benefits back to the first date in the series. For
costs, the entry for ‘Survey and planning’ was dated to occur at the start of the project. Since this
item was listed first, it could be used for the date (12-31-58) to which all other costs were discounted.
The table of tangible benefits - 2
The table of tangible benefits was copied from the McKenna text, except for the entry on row 18
which was added as a requirement of the XNPV function.
In the case of benefits, there was, quite naturally, no benefit to be realized at the start of the project.
To satisfy the Excel XPNV function, I added a dummy entry to the table, ‘Immediate benefits’ with a
value of $0 to be realized at the start of the project on 12-31-58. Since this entry was for zero dollars,
it will not affect our benefit calculations. The date entry in cell C18 meets the requirement of the
XNPV function for an initial date to which all other benefits are discounted.
Use XNPV to calculate value of tangible benefits
First, select the cell in which we Excel to return the present value of the tangible benefits cell B26 on
the Cost-benefit analysis worksheet.
Locate the XNPV function
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We will search for the XNPV function. First, type XNPV in the Search for text box, and click on the Go
button.
The XNPV function name will appear in the Select a function list box. Click on the OK button access the
Note: the XNPV function is part of the Analysis Toolpak that we used for Data Analysis. If Excel does
not find it, check to make sure the Analysis Toolpak Add-in has been installed.
The arguments to the XNPV function
The first argument to the XNPV function is the discount rate, which we put in cell D2.
The second argument to the XNPV function is the cells containing the tangible benefits, B18:B24.
The third argument to the XNPV function is the cells containing the dates the tangible benefits
occurred, C18:C24.
Net present value of tangible benefits
Excel computes the net present value for the series of benefits for this project.
Compute the required intangible benefits
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The problem statement wanted us to find the minimum level of intangible benefits that would be
necessary to meet the minimum benefit-cost ratio of 1.0.
The ‘Required intangible benefits’ are equal to the difference between tangible costs and tangible
benefits.
In cell B28, enter the formula for computing the difference between tangible costs in cell B14 and
tangible benefits in cell B26: =B14-B26.
In order to satisfy benefit-cost criteria, the project planners would have to identify and document
$1,062,932 in intangible benefits.
What if the discount rate were different
The problem statement also wanted us to determine whether or not a higher or lower discount rate
substantially changes our answer.
In order to see the results of the testing different discount rates, we split the screen at row 24 and
arrange the panes as shown.

Test a higher discount rate
Enter 7% in cell D2 to test the effect of a higher discount rate.
Excel has recalculated the required intangible benefits needed to be higher by about $15,000
($1,077,691-$1,062,932).
For this size of the urban renewal project, I would not consider this a substantial difference
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Test a lower discount rate
To test a lower discount rate, enter 5% in cell D2 to test the effect of a higher discount rate.
Excel has recalculated the required intangible benefits needed to be lower by about $16,000
($1,046,037-$1,062,932).
For this size of the urban renewal project, I would not consider this a substantial difference
We have answered all of the questions stated in the problem.
Example 2: A Highway Expansion Project
This example was adapted from a problem presented in Public Policy Analysis: Applied Research
Methods by Theodore H. Poister, pages 397-400.
This case pertains to a hypothetical highway project in which two alternative expansion levels
(expansion to a 4-lane highway and expansion to a 6-lane highway) are considered in comparison with
the alternative of retaining the existing roadway. In this application, the alternatives are compared
incrementally, so that the benefits and costs of expanding to a 4-lane highway are derived by
comparing it with the existing roadway, and the costs and benefits corresponding to the 6-lane
expansion are based on the incremental costs and benefits beyond the 4-lane highway expansion.
Sequentially, then, the analysis addresses the issue of whether it is justifiable to expand to a 4-lane
highway, as if so, whether it is further justified to expand to the 6-lane highway.
For this problem, we will present in detail how the benefits and costs are derived. The sheet,
column, and row labels have been entered into the workbook, HighwayProject.xls.
The benefit of travel time saved by the proposed highways
19
The average time spent per trip declines dramatically with the expansion to the 4-lane highway, and
then modestly as we move to the 6-lane highway expansion. Average driving time per trip on the
existing highway is estimated to be 30 minutes. If the highway is expanded to 4-lanes, the average
trip time drops to 18 minutes. If the highway is expanded to 6-lanes, the average trip time drops an
additional two minutes to 16 minutes.
Computing the time cost per trip
Setting the value of the driver’s time at $2.00 per hour, the time cost per trip is computed by dividing
the number of minutes in the average trip by 60 and then multiplying by $2.00.
In cell B3, enter the formula =B2/60*2. In cell C3, enter the formula =C2/60*2. In cell D3, enter the
formula =D2/60*2.
Total cost per trip
Other trip costs increase slightly at the first expansion level (from $1.75 to $1.90), because of higher
and less efficient operating speeds, and then decrease slightly at the second expansion level (from
$1.90 to $1.85) because of improved maneuverability in dispersed traffic. Enter $1.75 in cell B4, $1.90
in cell C4, and $1.85 in cell D4.
Total variable cost per trip is computed by adding ‘Time cost per trip’ and ‘Other costs per trip’. Enter
=B3+B4 in cell B5, =C3+C4 in cell C5, and =D3+D4 in cell D5.
Cost savings per trip
20
The cost savings per trip when expanding to the 4-lane highway is the difference between the total
variable costs for the existing highway ($2.75) and the 4-lane highway ($2.50) which equals $.25. Enter
the formula =B5-C5 in cell C6.
The cost savings per trip when expanding to the 6-lane highway is the difference between the total
variable costs for the 4-lane highway ($2.50) and the 6-lane highway ($2.38) which equals $.12. Enter
the formula =C5-D5 in cell D6.
Computing cost savings on current trips
First, we enter the same number of trips per year for each highway condition, 1 million trips per year
in cells B8, C8, and D8. It is likely that the number of trips would increase because of improved travel.
Estimating savings based on the existing number of trips is, therefore, a conservative estimate of the
probable savings.
Second, to compute the cost savings for all trips, we multiply the cost savings per trip on row 6 by the
number of trips per year on row 8. Enter =C6*C8 in cell C9 and =D6*D8 in cell D9.
Projected savings worksheet
First, copy the cost savings for each of the expansion projects from cells C9 through D9 on the ‘Cost-
benefit Analysis’ worksheet and Paste Special the Values into cells B2 through C2 on the ‘Projected
Savings’ worksheet.
Second, fill the annual savings down for a twenty-five year time period. For this problem, the present
value of the benefits stream is computed by assuming that the same amount of benefit will accrue for
each of 25 years into the future.
21
Highlight cells B2 through C26 and select the Fill > Down command from the Edit menu.
Compute NPV of savings for 4 lane expansion
First, select the cell in which we Excel to return the present value of the savings, cell C10 on the Cost-
benefit Analysis worksheet.
Locate the NPV function
We will search for the NPV function. First, type NPV in the Search for text box, and click on the Go
button.
The NPV function name will appear in the Select a function list box. Click on the OK button access the
The arguments to the NPV function
The first argument to the NPV function is the discount rate, which we will enter directly as 8%.
The second argument to the NPV function is the cells containing the projected savings for 4 lane
expansion, 'Projected Savings'!B2:B26.
22
Remember to enter the quote marks around the name of the worksheet Projected Savings because it
contains a space.
NPV for projected savings for 4 lane expansion
The NPV function returns the present value of the projected savings for 4 lane expansion,
$2,668,694.05.
Compute NPV of projected savings for 6 lane expansion
First, select the cell in which we Excel to return the present value of the savings, cell D10 on the Cost-
benefit Analysis worksheet.
button.
23

The second argument to the NPV function is the cells containing the projected savings for 6 lane
expansion, 'Projected Savings'!C2:C26.
Remember to enter the quote marks around the name of the worksheet Projected Savings because it
contains a space.
NPV for projected savings for 6 lane expansion
The NPV function returns the present value of the projected savings for 6 lane expansion,
$1,245,394.11.
The costs of the highway projects - 1
The expansion to a 4-lane highway will cost $2,000,000 in construction costs. Enter $2,000,000 in cell
C13.
Similarly, the expansion to 6 lanes will cost an additional $2,000,000. Enter $2,000,000 in cell D13.
24

The annual maintenance costs for both the existing highway and each of the alternatives is entered in
the worksheet.
Enter $20,000 in cell B14, $30,000 in cell C14, and $50,000 in cell D14.
The increase in maintenance costs are computed by subtracting the existing roadway maintenance
costs from the 4-lane expansion maintenance costs and subtracting the 4-lane expansion maintenance
costs from the 6-lane maintenance costs.
First, enter the formula =C14-B14 in cell C15 to compute the increase in maintenance costs associated
with the expansion to 4 lanes.
Second, enter the formula =D14-C14 in cell D15 to compute the increase in maintenance costs
associated with adding two additional lanes to the 4 lane highway.
Annual Maintenance worksheet
First, copy the increase in maintenance costs for each of the expansion projects from cells C15 through
D15 on the ‘Cost-benefit Analysis’ worksheet and Paste Special the Values into cells B2 through C2 on
the ‘Annual Maintenance’ worksheet.
25
Second, fill the annual maintenance cost increases down for a twenty-five year time period. For this
problem, the present value of the cost stream is computed by assuming that the same amount of
maintenance costs will be incurred for each of 25 years into the future.
Highlight cells B2 through C26 and select the Fill > Down command from the Edit menu.

Compute NPV of increased maintenance for 4 lane expansion
First, select the cell in which we Excel to return the present value of the increased maintenance, cell
C16 on the Cost-benefit Analysis worksheet.
button.
26
The second argument to the NPV function is the cells containing the increased maintenance for 4 lane
expansion, 'Projected Savings'!B2:B26.
Remember to enter the quote marks around the name of the worksheet Annual Maintenance because
it contains a space.
NPV for increased maintenance for 4 lane expansion
The NPV function returns the present value of the increased maintenance for 4 lane expansion,
$106,747.76.

Compute NPV of maintenance for 6 lane expansion
First, select the cell in which we Excel to return the present value of the increased maintenance, cell
D16 on the Cost-benefit Analysis worksheet.
button.
27
The second argument to the NPV function is the cells containing the increased maintenance for 6 lane
expansion, 'Projected Savings'!C2:C26.
Remember to enter the quote marks around the name of the worksheet Annual Maintenance because
it contains a space.
NPV for increased maintenance for 6 lane expansion
The NPV function returns the present value of the increased maintenance for 6 lane expansion,
$213,495.52.
Total project costs
The total project costs for the two expansion projects are the sum of the capital costs and the yearly
maintenance costs.
28
Sum total project costs for the 4 lane expansion by entering the formula =C13+C16 in cell C17. Sum
total project costs for the 6 lane expansion by entering the formula =D13+D16 in cell D17.

Compute benefit-cost ratio for the two expansion plans
First, compute the benefit-cost ratio for the 4-lane expansion by dividing the present value of savings
(C10) by total project costs (C17), displaying the result in cell C19.
Second, compute the benefit-cost ratio for the 6-lane expansion by dividing the present value of
savings (D10) by total project costs (D17), displaying the result in cell D18.
Results of the benefit-cost analysis
The benefit-cost ratio for the 4-lane expansion is over 1.0. Based on this analysis, the 4-lane
expansion is justified.
However, the benefit-cost ratio for the additional 2 lanes to complete a 6-lane expansion is less than
1.0. The additional 2 lanes to complete the 6-lane expansion is not justified, based on benefit-cost
analysis.
Example 3: Methadone Maintenance Treatment Program - 1
This problem is from Quantitative Methods for Public Decision Making by Christopher K. McKenna,
page 162-163.
29
Cost-benefit analysis has used the past 6 years' experience of a methadone maintenance
treatment program (MMTP) to see if it is worth continuing for the next six years. Here decision
makers are considering two basic alternatives, to continue the program or not. Although the effects
of the program are expected to last longer than the 6-year length of the program, only the benefits
during these years are considered. All projections are based on the assumption that future
experience will follow the patterns of the past.
The actual expenditures of the program include salaries for physicians, counselors, nurses, and
administrators, rent, supplies, and the cost of the methadone. The analysis includes a dropout rate; if
a patient drops out there no further costs or benefits for that patient. The total costs for the six years
can be found on the 'Costs of the MMTP' worksheet in the 'MMTP.xls' workbook.
Example 3: Methadone Maintenance Treatment Program - 2
In methadone treatment as in most social programs there are both tangible and intangible
benefits. Here the intangibles are not included in the calculations; however, the decision maker must
be aware of them when interpreting the results of the analysis. The benefits of MMTP include
decreases in private protection expenditures, the costs of injury to crime victims, the negative value
placed on fear of attack by an addict, criminal justice expenditures, expenditures on heroin by the
addict, expenditures for narcotic-related illnesses, and increases in legal earning. The last three are
tangible benefits and are summarized on the worksheet 'Benefits of the MMTP' worksheet in the
'MMTP.xls' workbook.
Your assignment is to determine the net present value of the MMTP, and to compute and interpret
its cost-benefit ratio.
HINT: since we conducting this analysis on an on-going program, any start-up costs have either
been absorbed or included in the first year of the new cycle for the program, 1978. Do not discount
1978 costs or benefit with the NPV function, but rather add the full amount of 1978 costs and benefits
to the discounted costs and benefits for the years 1979 to 1983, discounted back to 1978 using a 10%
discount rate.
Open the MMTP.xls workbook
30
The MMTP.xls workbook contains three worksheets: one containing the annual costs for the program,
one containing the annual benefits for the program, and one for computing the benefit-cost ratio.
Costs in the first year
The first-year costs are not discounted.
First, enter a label Costs, year 1 in cell B9.
Second, enter the first year costs, $2,220,000, in cell C9.
Costs in the years two through six
The total costs for years two through six are discounted to the first year using a 10% rate.
First, enter a label NPV, Costs, year 2-6 in cell B10.
Second, select cell C10 and insert the NPV function.
31
button.
The second argument to the NPV function is the cells containing the costs of the program in years 2
through 6, 'Costs of the MMTP'!D3:D7.
Remember to enter the quote marks around the name of the worksheet Costs of the MMTP because
it contains spaces.
NPV for projected savings for MMTP
The NPV function returns the present value of the costs for years 2 through 6, $5,247,308.
Total Project Cost
32
The total project cost is computed by summing the first year costs and the discounted costs for years
two through six.
First, enter the label Total Project Cost in cell B11.
Second, sum the costs by entering the formula =C9+C10 in cell C11. The total project cost is
$7,467,308.
Increased earnings benefit in the first year
Like the first-year costs, the first-year benefits are not discounted.
First, enter a label Year 1 in cell A9.
Second, enter a formula to point to the first year benefits =B2 in cell B9. By using a formula, we can
drag fill the other benefit columns.

Increased earnings benefit in years two through six
The total benefits for years two through six are discounted to the first year using the same 10% rate
we used for costs.
First, enter a label Yr 2-6 in cell A10.
Second, select cell B10 and insert the NPV function.
33
button.
The second argument to the NPV function is the cells containing the increased earnings, 'Benefits of
the MMTP'!B3:B7.
Remember to enter the quote marks around the name of the worksheet Benefits of the MMTP
because it contains a space.
NPV for increased earnings for MMTP
The NPV function returns the present value of the increased earnings for years 2 through 6,
$6,727,065.65.
Total Increased Earnings Benefit
34
The total for the increased earnings benefit is computed by summing the first year benefit and the
discounted benefits for years two through six.
First, enter the label Total in cell A11.
Second, sum the costs by entering the formula =B9+B10 in cell B11. The total project cost is
7,141,065.65.
Drag fill the other benefit columns
The benefits attributed to criminal justice savings and reduced heroin consumption are computed in
the same way as increased earnings. We can complete these calculations by drag filling the columns.
First, select cells B9 through D11.
Second, select the Fill > Right command from the Edit menu.
Total Project Benefits
The total benefits attributed to the project are computed by summing the total benefits from the
three tangible sources.
First, select cell B13 and enter the label Total project benefits.
Second, select cell C13 and enter the formula =B11+C11+D11.
The total project benefits are $ 39,352,844.66.
35

The Benefit-cost Ratio
To compute the benefit cost ratio for the MMTP project, we enter the total costs and total benefits on
the Benefit-cost Ratio worksheet.
First, in cell B1, enter a reference to the total project costs ='Costs of the MMTP'!C11.
Second, in cell B2, enter a reference to the total project benefits ='Benefits of the MMTP'!C13.
Third, compute the ratio by entering the formula =B2/B1 in cell B4.
The ratio of 5.27 indicates that the benefits clearly out weigh the costs. Using benefit-cost criteria, the
MMTP program should be continued.
36

An Introduction To Cost Benefit Analysis

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An Introduction To Cost Benefit Analysis

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AN INTRODUCTION TO COST BENEFIT ANALYSIS

Principles of Cost Benefit Analysis

There Must Be a Common Unit of Measurement

Benefits Are Usually Measured by Market Choices

Gross Benefits of an Increase in Consumption is an Area Under the Demand Curve

Some Measurements of Benefits Require the Valuation of Human Life

The Analysis of a Project Should Involve a With Versus Without Comparison

Cost Benefit Analysis Involves a Particular Study Area

Double Counting of Benefits or Costs Must be Avoided

The following is a highly abbreviated analysis using hypothetical data.

TRIP DATA No Extension, 101 Extension

The benefits per hour are:

Trips Which Would Trips Generated

Rush Hour 6,000.00 1,000.00 7,000.00

Nonrush Hour 400.00 22.22 422.22

Rush Hour $9,360,000 $1,560,000 $10,020,000

Nonrush Hour $2,880,000 $160,000 $3,040,000

Total $12,240,000 $1,720,000 $13,960,000

The annual benefits of the project are thus:

Time Saving $13,960,000

Reduced Risk $2,400,000

Total Costs 253.77

Net Benefits 50.35

History of Cost-Benefit Analysis

Cost Benefit Analysis

Cost Benefit Analysis, Slide 2

Copyright © 2004, Jim Schwab, University of Texas at Austin

Cost Benefit Analysis, Slide 3

Copyright © 2004, Jim Schwab, University of Texas at Austin

Example 1: East Stockton Urban Renewal Project - 1

Cost Benefit Analysis, Slide 4

Copyright © 2004, Jim Schwab, University of Texas at Austin

Example 1: East Stockton Urban Renewal Project - 2

Cost Benefit Analysis, Slide 5

Copyright © 2004, Jim Schwab, University of Texas at Austin

Example 1: East Stockton Urban Renewal Project - 3

Cost Benefit Analysis, Slide 6

Copyright © 2004, Jim Schwab, University of Texas at Austin

Example 1: East Stockton Urban Renewal Project - 4

Cost Benefit Analysis, Slide 7

Copyright © 2004, Jim Schwab, University of Texas at Austin

Tangible costs/benefits of urban renewal project

Cost Benefit Analysis, Slide 8

Copyright © 2004, Jim Schwab, University of Texas at Austin

The discount rate

Cost Benefit Analysis, Slide 9

Copyright © 2004, Jim Schwab, University of Texas at Austin

Use XNPV function to calculate value of tangible costs

Cost Benefit Analysis, Slide 10

Copyright © 2004, Jim Schwab, University of Texas at Austin

Second, select the Function command from the Insert menu.

Locate the XNPV function

Cost Benefit Analysis, Slide 11

Copyright © 2004, Jim Schwab, University of Texas at Austin

The arguments to the XNPV function

Cost Benefit Analysis, Slide 12

Copyright © 2004, Jim Schwab, University of Texas at Austin

With the arguments entered, click on the OK button.

Net present value of tangible costs

Cost Benefit Analysis, Slide 13

Copyright © 2004, Jim Schwab, University of Texas at Austin

The table of tangible benefits - 1