Cost Benefit Analysis: Decision Making in the Public Sector
This article will focus on cost benefit analysis as a tool for decision making in the public sector. Cost benefit analysis, a tool for investment appraisal, is the federal government's main economic assessment tool to evaluate federal programs. The main types of cost analysis, the history of cost benefit analysis, and the methodology of cost benefit analysis will be described and analyzed. The federal government's official guidelines for cost benefit analysis of federal programs will be explained. The article will summarize the main uses for cost benefit analysis including physical investment projects, loan guarantees, clean air initiatives, and big science. The main criticisms made against cost benefit analysis will be addressed.
Keywords Cost-Benefit Analysis; Federal Government; Investment Appraisal; Decision Making; Public Sector
Business and Public Policy: Cost Benefit Analysis: Decision Making in the Public Sector
The public sector, including the economic and administrative enterprises of a local, regional, or national government, uses multiple analytical tools for fiscal, administrative, and policy decision making. Examples of public sector decision-making tools include manpower planning, the social demand approach, and cost-benefit analysis. Cost benefit analysis (CBA), a type of investment appraisal also referred to as benefit-cost analysis, is one of the most prominent and widely used analytical and quantitative tools for decision making in the public sector. The federal government recommends cost benefit analysis to its agencies as the main technique to use in a formal economic analysis of government programs or projects. Cost benefit analysis, as an analytical tool or methodological technique, is a practical tool for assessing the desirability of projects particularly in situations when it is important to take a long-term view. In this process, costs and benefits will be enumerated and evaluated (Hough, 1994).
Cost benefit analysis provides a systematic and formalized set of procedures for assessing whether to fund and implement a public policy or program. In instances where a choice must be made between public programs or policies, cost benefit analysis can be used to compare the programs and select the most promising one (Mustafa, 1994). Cost benefit analysis is the government's primary economic tool to assess and evaluate proposed resource allocation. The public sector is responsible for allocating public resources. Resource allocation influences economic development, quality of life, and opportunity for the public at large. The public sector works to make decisions about the allocation of resources in ways that promote and sustain economic productivity (Julnes, 2000). Cost benefit analysis is implemented in instances when a cost analysis will provide information that will help decision makers determine how resources will be allocated (Beyea, 1999). Cost benefit analysis is based on the idea that government should only undertake programs that promise favorable (usually monetary) return. It focuses on the economic efficiency aspects of governmental decision making (Mustafa, 1994).
Cost benefit analysis is used in all areas of public sector investment, including in nationalized industries, health expenditures, housing schemes, traffic networks, land-use and town planning problems, and regional development. Cost benefit analysis, though developed in the early twentieth century in United States to assess public sector environmental projects, is practiced throughout the industrialized and developing world. The United States has most notably used cost benefit analysis to assess reservoir projects and disease control. The United Kingdom has most notably used cost benefit analysis to assess the M1 motorway, the third London airport, London's Victoria Line underground, the Morecambe Bay Barrage project and the re-siting of London's Covent Garden market (Hough, 1994).
The following sections describe the main types of cost analysis, the history of cost benefit analysis, and the methodology of cost benefit analysis. These sections serve as the foundation for a later discussion on the main uses for cost benefit analysis. Issues related to the main criticisms made against cost benefit analysis will be introduced.
Types of Cost Analysis
The public sector uses multiple cost analysis tools to aid decision making. There are four main “types of cost analysis including cost-benefit analysis, cost-effectiveness analysis, cost-minimization analysis, and cost-utility analysis” (Beyea, 1999, p. 129).
- Cost-benefit analysis
- Cost-effectiveness analysis
- Cost-minimization analysis
- Cost-utility analysis
All four types of cost analysis used by the public sector for decision making, according to Beyea, share the same the same framework or guiding principles:
- Specify the analytic perspective that provided the framework for determining who pays the costs for and who benefits from a particular service or intervention.
- Define and specify the anticipated benefits and outcomes of a service or intervention.
- Identify all of the actual and potential costs using the specified analytic perspective to determine the costs.
- Account for how time may affect projected costs.
- Evaluate the results and consider alternative explanations for the conclusions.
- Calculate a cost-benefit or cost-effectiveness ratio as a summary Measure (Beyea, 1999, p. 130).
While there are four related types of cost analysis, described above, cost benefit analysis is the most popular and widely used analytical tool for economic decision making in the public sector.
History of Cost Benefit Analysis
Cost benefit analysis has been used by the United States' public sector, particularly in association with environmental projects, since the early 1900s. Cost benefit analysis was a formal part of the River and Harbor Act of 1902 (Hough, 1994). The development of cost benefit analysis, at the turn of the nineteenth century, was a way to gather objective measurements and information to use in public decision making (Julnes, 2000). In the 1950s, cost benefit analysis was used by the public sector to analyze large-scale environmental projects such as the development of large U.S. river valleys. The applications of the technique were extended to all areas of government operations and became a ubiquitous part of public sector decision-making practice in the second half of the twentieth century. Cost benefit analysis, which began in the United States, has been adopted by the United Kingdom and most other industrialized and developing countries (Hough, 1994).
In the late twentieth century, the U.S. government formalized its approach to cost benefit analysis for use by all of its agencies. In 1981, President Reagan enacted Executive Order No. 12291 which created the Office of Information and Regulatory Affairs (OIRA) and “required regulatory agencies to prepare impact analyses for any regulations that are likely to result in annual effects on the economy of $100 million or more.” Executive Order No. 12291 specifies that the “analyses must identify social costs and benefits and attempt to determine if the proposed regulation maximizes net benefits to society” (Mustafa, 1994). Section 3 of the Executive Order No. 12291, Regulatory Impact Analysis and Review, requires that all proposed rules be analyzed through cost benefit analysis and that “all final regulatory impact analysis shall contain the following information:
- A description of the potential benefits of the rule, including any beneficial effects that cannot be quantified in monetary terms, and the identification of those likely to receive the benefits.
- A description of the potential costs of the rule, including any adverse effects that cannot be quantified in monetary terms, and the identification of those likely to bear the costs.
- A determination of the potential net benefits of the rule, including an evaluation of effects that cannot be quantified in monetary terms.
- A description of alternative approaches that could substantially achieve the same regulatory goal at lower cost, together with an analysis of this potential benefit and costs and a brief explanation of the legal reasons why such alternatives, if proposed, could not be adopted” (Section 3(d)1-5).
The federal government's institutionalized and formalized the practice of cost benefit analysis, as the primary tool for economic decision making, continues today in the majority of federal agencies.
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