Cost-Benefit Analysis

Imagine a city that is considering the development of a new major park. It’s common for policymakers to use a cost-benefit analysis to weigh the pros and cons of such a decision. The city’s goal would be to tally up all the costs of this decision and subtract that amount from the total projected benefits of their decision. If the city found that the projected benefits of constructing the park outweigh the costs, the policymakers would likely argue that the decision is a good one to make. 

Let’s unpack the steps of performing a cost-benefit analysis and how this would apply to the example of the park development. 

1. Establish a Framework for Your Analysis

First, decision-makers need to identify the main goals of the initiative. This includes defining the scope and time frame of the analysis, the stakeholders involved, and the criteria for success. They must also decide which metric will be used to measure and compare the costs and benefits. To accurately compare the two, both should be measured in the same “common currency.” Although this doesn’t necessarily require setting a dollar amount for each cost or benefit, it’s common practice to assign monetary values whenever possible. 

In the case of the park, the city officials would need to identify the city’s main goals with this initiative. What would they need to accomplish to consider the park a success? They would need to identify (and agree on) their scope, timeline, and metrics for success (and failure!).

2. Identify Your Costs and Benefits

The next step would be to compile an explicit list of all the expected costs and benefits. This list is central to making a decision as it defines the variables being compared. There are several types of costs and benefits that can be considered, some more obvious than others.

Let’s begin with costs:¹

• Direct Costs: These are the costs that first come to mind, as they’re directly related to the end goal and are easily quantified. In terms of the park example, these would be the costs of acquiring the land to be used for the park, the construction costs (e.g., landscaping, infrastructure, pathways), and the ongoing maintenance of the park (e.g., staffing, equipment, utilities).
• Indirect costs: These are fixed or variable expenses that, while not directly related to the end goal, are still relevant to the final product or project. Indirect costs in the construction of the park might include traffic congestion during construction, the opportunity cost of using the land for other purposes, and increased demand for public services (e.g., security and sanitation).
• Intangible costs: Intangible costs are very difficult to measure but still crucial to consider, and include costs relevant in the present day and in the future. In the case of building a park, this could be things like noise and disruption during construction or possible displacement of current residents and businesses.
• Competitive costs: These are costs that affect an entity’s ability to compete in the marketplace or factors that may cause other entities to lose market share. Competitive costs associated with developing a new park might include the potential loss of commercial development opportunities (e.g., retail or housing projects).

Once all of the costs are defined, the corresponding types of potential benefits should be considered. In the example of a park…¹

• Direct benefits might include improved public health through the new recreational space and increased property values in surrounding areas. 
• Indirect benefits would include enhanced tourism and local business revenue (if the park is a nice one!), increased social cohesion through the introduction of additional community gathering space, as well as long-term savings from environmental sustainability, reduced flood risk, and improved air quality. 
• There are also many intangible benefits, including the beauty of nature, the joy of playgrounds and field spaces, and improved public health and quality of life. 
• Lastly, the competitive benefits would be the increased attractiveness of the city for future residents and businesses and an advantage over nearby cities with fewer green spaces.

Making sure that each cost and benefit list is as comprehensive as possible is crucial to ensure the calculation is accurate. If just a few minor benefits are overlooked, the calculation could tip toward avoiding a potentially beneficial choice.   

3. Assign a Dollar Amount or Value to Each Cost and Benefit

The next part is notoriously difficult: quantifying the value of each cost and benefit identified. For our park example, giving a dollar amount to something like “fresh air,” “beauty of the autumn leaves,” or “the sound of children playing” feels like almost an impossible task to complete. Indirect and intangible costs and benefits cannot be objectively quantified and thus will always be the center of debate. But, that doesn't mean we shouldn’t try. There are now countless software, social platforms, and tools available to help us assign values to some of these less obvious factors. Although we may never reach a perfect calculation, an attempt at a rough estimate can be more helpful than simply giving up on any potential change that involves intangible costs (spoiler alert: that’s almost everything in life). 

To conduct these imperfect analyses, someone might use a technique like shadow pricing to estimate the value of intangible goods, or attempt to calculate an individual's willingness to pay (WTP) for a specific good. Whatever method is used to quantify the costs and benefits, especially for non-monetary goods, the process should be transparent. This helps keep decision-makers accountable for their choices and consistent across evaluations. 

4. Tally the Total Value of Benefits and Costs and Compare

Once every cost and benefit has a dollar amount next to it (even if it’s just an estimate), the decision-makers can properly tally up each list and compare the two. If total benefits outnumber total costs, then they should move forward with the proposal. If the costs outweigh the benefits, perhaps there are alternatives to the proposal they haven’t considered. In the case of the park, perhaps some of the same goals could be achieved with a reduction in the costs. There might be the option to plant more trees along the road, install swing sets in preexisting greenspaces, change the proposed location of the park, or some other potential option that could help city planners meet some of their original goals. 

There is also the question of what value we give to future consequences. Traditional cost-benefit analysis attempts to put all costs and benefits on an even temporal level and a discount rate is chosen, which is then used to compute all relevant future costs and benefits in present-value terms. Most commonly, the discount rate used for present-value calculations is an interest rate taken from financial markets.² In reality, we often fail to give adequate value to future potential impacts. In the case of the park, the immediate monetary costs of installing a playground are conspicuous, but the health and happiness of future generations of children may be less apparent. If there are pollution concerns regarding the construction of the park, how might these compare to the potential health benefits to people for decades to come, stemming from cleaner air and increased access to nature?

By conducting cost-benefit analyses, decision-makers can parse out not only whether or not they should move forward with certain projects, but they can also predict a policy change’s ROI, identify any major expected barriers, and jumpstart conversations about potential roadblocks or ethical considerations. Although the basic principles and framework are most often applied in business and policy situations, they can be applied to virtually any decision-making process. In fact, cost-benefit analyses have been used in everything from planning electric vehicle charging infrastructure (which you can read about in our “case study” section) to proposals for telemedicine implementation in rural areas.