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Cost Benefit Analysis Essay

Cost Benefit Analysis

In the economy of the world today, one must think of how he or she should be able to work anything out without using all of his or her resources. This paper will talk about how one will be able to increase yields without exhausting all of one’s resources.

When a person wants to improve his or her profit, he or she should limit his or her expenses at the same time he or she should also increase his or her revenue. But the problem is how should he or she decrease the expenses while at the same time increasing the revenue? That is what cost benefit analysis is made for. Cost benefit analysis is simply optimization. Meaning, one should maximize all the present value of the benefits while the cost should be less than that of the benefits subjected to some constraints. Further simplified, the cost benefit analysis is divided in to questions that can be answered depending on the interests that should be maximized. What costs and benefits should be included? How should one evaluate the costs and the benefits?

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What interest rate should be used in obtaining the present value of the costs and the benefits?

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What are the constraints that affect the costs and the benefits?

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Therefore, cost benefit analysis is very useful in dealing with optimization problems of everyone (Layard & Glaister, 1994).

Foundations of cost benefit analysis

            The cost benefit analysis has some limitations that should be considered. The main limitations of cost benefit analysis is said to be that whenever the reality is influenced by a project, it becomes flawed. In cost benefit analysis, the distance of a situation from the ideal is said to be the distortions, assuming Pareto efficiency is fulfilled. Such distortions that alter the ideal situation are brought about by market power, externalities, taxes etc. Such distortions measure is hard to determine because of practical reasons and difficulties of determining whether it is a removable or irremovable distortion. Removal distortions can be omitted by the use of shadow prices. On the other hand, irremovable distortions cannot use shadow prices alone and are very difficult to calculate (Acocella, 1998).

Measures of costs and benefits

            In order to conduct a cost benefit analysis, one must be able to quantify the costs and the benefits into monetary values. Measure of costs and benefits gives us an idea of how to convert or quantify such benefits and costs. Measurement of cost and benefits usually involves estimating, forecasting and costing (Shah, Nagpal & Brandon, 1997).

            Estimating is associated to the different types of costs and benefits that should be counted. The types of costs and benefits that should be counted involve real and pecuniary costs and benefits, tangibles and intangibles and the direct and indirect benefits (Stevens & Rabin, 2002).

            Forecasting involves great interpretative potential. Forecasting should not be bounded by politics. Forecasting is used to know the future based on the given data sets. Judgements that are involved in forecasting must know what to be considered good enough to be monitored to tell whether it is a novel or a trend (Stevens & Rabin, 2002).

            The last one is costing. Costing is one of the harder tasks of cost benefit analysis. A cost benefit analyst must be able to compute quantities to the costs and benefits stream. In order to come up with a good costing, one will face three difficulties in costing: estimating shadow prices, final prices and opportunity costs (Rabin, 1992).

Time discounting

            Discounting, particularly time discounting, is a process of determining the net present value. Inclination to the time assessment of money is known to be time discounting. For example, if we are to choose between two different values like money, we will choose the value of the money now because if we choose the value of the money in the future, we are uncertain of what its value would be. It may be higher, lower or equal to the value of the money right now (Stevens & Rabin, 2002).

Discount rates

            Discount rate is basically the interest that is applied in future values to adjust the risk and the uncertainty of time factor. If two discount rates are unequal, then the larger discount rate has a higher risk compared to the smaller discount rate (Nikbakht & Groppelli, 2000).

Decision Rules

            Certain rules must be followed in choosing a project so that the cost benefit analysis can be applied. One of t he general rules in choosing a project is that the discounted benefits should be greater than that of the discounted costs. The general rule is subdivided to different categories for the convenience of the decision-maker. The categories include: accept-reject, ranking and choosing between mutually exclusive projects. There are also alternate decision rules that can be used in order to make a good decision for the cost benefit analysis. This include: Benefit-cost ratio, internal rate of return and some other considerations (Pearce, Atkinson & Mourato, 2006).

            Accept-reject decision rule is the most basic of all the decision rules. In this rule, one must accept a project if it follows the general rule. If the project does not follow the general rule, then one should reject the project (Pearce, Atkinson & Mourato, 2006).

            Note that in the accept-reject decision rule, all projects that are acceptable are the ones that follow the general rule. What if the project follows the general rule but certain aspects like capital is insufficient? Then we can use the ranking decision rule in order to deal with that. Constraints are always available in different projects. In ranking decision rule, one must consider all the constraints that will affect the net present value before accepting the project (Pearce, Atkinson & Mourato, 2006).

Disadvantages of cost benefit analysis

            Cost benefit analysis in some ways have its own disadvantages. Those disadvantages may hinder in completing the cost benefit analysis. Some of the disadvantages of cost benefit analysis are it is difficult to measure social costs and benefits and then converting it to monetary fund, there can be an overstatement of the value of social benefits, it is very complex, it is inaccurate due to the use of money as yardstick for comparison, it is very infinite regarding values relating to human life itself, etc (Langston & Ding, 2001).

            In general, the cost benefit analysis is used by decision makers in good faith and for the purpose only as technical aid for them. Cost benefit analysis is very useful in an attempt to convince parties that the path of action is actually validated. Validated values are often concealed in the assumptions based on the calculations (Ashford, 1976).

References

Acocella, N. (1998). The Foundations of Economic Policy : Values and Techniques. (B. Jones trans.). Cambridge, UK ; New York, NY, USA: Cambridge University Press.

Ashford, N. (1976). Crisis in the Workplace : Occupational Disease and Injury : a Report to the Ford Foundation. Cambridge, Mass. MIT Press.

Langston, C. and Ding, G. (2001). Sustainable Practices in the Built Environment. Oxford [u.a.]: Butterworth-Heinemann.

Layard, R. and P. Glaister. (1994). Cost-benefit Analysis. Cambridge [England] ; New York, NY, USA: Cambridge University Press.

Nikbakht, A. and Groppelli, A. (2000). Finance. Hauppauge, N.Y. Barron’s.

Pearce, D. W., Atkinson, G. and Mourato, S. (2006). Cost-benefit Analysis and the Environment : Recent Developments. Paris: Organisation for Economic Co-operation and Development.

Rabin, J. (1992). Handbook of Public Budgeting. New York: M. Dekker.

Shah, J., Nagpal T. and Brandon, C. (1997). Urban Air Quality Management Strategy in Asia : Guidebook. Washington, DC: The World Bank.

Stevens, G and Rabin, J. (2002). Handbook of Fiscal Policy. New York [u.a.]: Dekker.

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