When making a decision, especially in the public sector, it is imperative that officials understand the costs and benefits of their choice, whether it be establishing a new program or making changes to an existing program. Below, I provide a broad, standard process officials can follow when conducting a cost-benefit analysis. I did not go into a lot of detail for each step and if you would like to know more, please checkout this cost-benefit analysis guide.
- Set the framework for the analysis. Specify the program or policy change and the current status quo, or the state of the world before implementation compared to after.
- Decide whose costs benefits should be recognized. You need to determine the geographic scope of the analysis in order to limit the groups impacted by the policy.
- Identity and categorize costs and benefits. It is important to label costs and benefits as direct (intended costs/benefits)/indirect (unintended costs/benefits), tangible (easy to measure and quantify)/intangible (hard to identify and measure), and real (anything that contributes to the bottom line net-benefits)/transfer (money changing hands) in order to ensure that you understand the effects of each cost and benefit.
- Project costs and benefits over the life of the program. Assess how costs and benefits will change each year. It is important to do this even before you begin to place numbers on things.
- Monetize costs. Make sure to place all costs in the same unit.
- Monetize benefits. Make sure to place all benefits in the same unit.
- Discount costs and benefits to obtain present values. This means converting future costs and benefits into present value. This is also known as the social discount rate, or the rate at which society makes tradeoffs over time. Every agency tends to have a different discount rate. It generally ranges between 2-7%.
- Compute net present values. This is done by subtracting costs from benefits. The policy is considered efficient if a positive result is produced; however, it is important to think about the policy’s feasibility and social justice.
- Perform sensitivity analysis. This step allows you to check the accuracy of your estimates and assumptions. This is normally done by altering the social discount rate utilized, by increasing it and decreasing it. If you still get a positive number during this step, then the policy should be accepted. If you get a negative number during this step, then you should calculate where the balancing point is zero.
- Make a recommendation. Assess all results and account for other qualitative considerations.
What Do You Think?
Do you think performing a cost-benefit analysis is important when making government decisions?