What is cost-benefit analysis?
A cost is what you give up to do something. A benefit is what you gain from it. Cost-benefit analysis (CBA) puts all costs and all benefits on one scale, usually money, so they can be compared.
The rule is simple: net benefit = total benefits − total costs. If net benefit is above zero, the choice is worth doing. If you have two choices, pick the one with the bigger net benefit.
The steps of a cost-benefit analysis
- Name the choice and the other choices you could make.
- List costs: money paid now, running costs later, and damage to other people or nature.
- List benefits: money earned, money saved, time saved, health and safety.
- Give each item a money value. Time and health get a fair estimate.
- Bring future money to today. Rs 100 next year is worth a little less than Rs 100 today, so we reduce future amounts. This is called discounting.
- Compare with net benefit or with the benefit-cost ratio (benefits ÷ costs). A ratio above 1 is good.
- Decide, and check how the answer changes if numbers are a bit wrong.
Hidden costs and opportunity cost
A good analysis counts more than the price tag. Opportunity cost is the best other thing you give up. If a town uses land for a car park, it cannot use it for a school. External costs fall on people who did not choose, like noise or smoke from a factory. These should be counted too. Money already spent and cannot come back (a sunk cost) should not change today's decision.
Where governments and firms use it, and its limits
Governments use CBA for roads, metro lines, schools and clean-air rules. Firms use it for a new machine or shop. But CBA has limits: some things are hard to price (a clean river, a human life), costs and gains may fall on different groups of people, and the future is uncertain. So CBA helps a decision; it does not replace fairness and common sense.
Key formulas and definitions
- Net benefit = total benefits − total costs
- Benefit-cost ratio = total benefits ÷ total costs (above 1 means worth doing)
- Present value = future amount ÷ (1 + r)^t, where r is the discount rate and t is years
- Opportunity cost = value of the best choice you did not take
Worked examples
1. A bakery plans a new oven. Cost: Rs 60,000. Extra profit: Rs 80,000. Find the net benefit and the ratio.
Net benefit = 80,000 − 60,000 = Rs 20,000. Ratio = 80,000 ÷ 60,000 = 1.33. It is above 1, so buy the oven.
2. A village school bus costs Rs 5 lakh. The benefits (fuel saved, time, safety) are worth Rs 4 lakh. Should the village buy it by this test alone?
Net benefit = 4 − 5 = −1 lakh. The ratio is 0.8, below 1. By money alone, no. The village may still add things not yet counted, such as more girls staying in school, and test again.
3. You will get Rs 1,100 one year from now. The discount rate is 10%. What is it worth today?
Present value = 1,100 ÷ 1.10 = Rs 1,000.
4. Option A: net benefit Rs 30,000. Option B: net benefit Rs 45,000. Both cost the same. Which is better?
Choose B. It has the larger net benefit.
5. A factory earns Rs 90 lakh but its smoke causes health costs of Rs 1 crore to nearby people. Is it worth it for society?
Benefits Rs 90 lakh − costs Rs 100 lakh = −Rs 10 lakh. For society it is not worth it, even though the factory owner profits.
Common mistakes
- Counting only the price and forgetting hidden, outside or future costs.
- Adding future money without discounting it.
- Letting sunk costs change the decision: "I already paid, so I must continue".
- Thinking the biggest benefit wins. Compare benefits minus costs, not benefits alone.