What is a Cost/Benefit Analysis?

Cost-benefit analysis refers to the method of estimating and measuring input and output based on monetary units. It is a plan made in advance. Under the conditions of a market economy, when any economic subject conducts economic activities, it is necessary to consider the gains and losses of specific economic behaviors in order to have a scientific estimate of the relationship between input and output.

Cost-benefit analysis

Three main methods of cost-benefit analysis

1.Net present value method (NPV)

2. Present value index method

3.Internal rate of return method

Each of these three methods has its own characteristics and has different applicability. In general, if the investment project is indivisible, the net present value method should be used; if the investment project is divisible, the present value index method should be used, and the project with the higher present value index is preferred; When it can be used for reinvestment, the IRR method can be used.

Cost-benefit analysis procedure steps

The cost-benefit analysis process includes the following four steps:

1.First clarify related costs and benefits

2. Then calculate these costs and benefits

3.Then compare the costs and benefits incurred during the life of the project

4. Finally select the project.

The cost-benefit analysis method mainly includes the following:

(1) Define and estimate expected costs and benefits from a social perspective rather than a central (federal) government perspective.

(2) In the calculation of cost-benefit, the cost should be defined by opportunity cost, and incremental costs and benefits should be used instead of sunk costs.

(3) In the calculation of net income, only the actual economic value is calculated, excluding transfer payments; transfer payments are considered only when the issue of distribution is discussed.

(4) In calculating costs and benefits, the concept of consumer surplus must be used; moreover, the willingness to pay must be estimated directly or indirectly.

(5) Market prices provide an inestimable starting point for the calculation of costs and benefits, but in the presence of market failures and price distortions, shadow prices have to be used.

(6) Whether a public project is acceptable or not is determined based on the NPV standard, in which the internal rate of return is calculated.

(7) When using the NPV standard, it is necessary to analyze not only the actual discount rate but also the sensitivity to various other discount rates.