Cost Benefit Analysis Factors in Intangibles

Cost Benefits Analysis Considers Social and Environmental Costs

May 2, 2009 Gopinathan Thachappilly

Whereas businesses typically work with concrete measures like Return on Investment, governments typically go for social and environmental cost benefits analysis.

Even businesses, however, are being forced to consider intangible costs like environmental damage, loss of goodwill and other factors that significantly affect their results. A classic example of not doing such a cost benefit analysis is the case of the Ford Pinto.

The car had a serious design flaw and Ford decided not to recall it considering that the amount it would have to pay for human lives lost from the flaw would be less than the cost of recall. Negative publicity resulting from this action ultimately led to a later recall, and also to a loss of significant amounts of sales.

Costs and Benefits Analysis

Investment decisions are made on the expectation of specific benefits. For example, a government might construct a road in the expectation that it will stimulate economic activity and lead to greater employment opportunities for its citizens. Even improvement of existing roads can lead to speedier movement of people and goods, leading to economic benefits.

All these investments have costs associated with them. These costs might not just be monetary costs. The road-building project, for example, can lead to destruction of environment. Environment damage can lead to climate change and other consequences that in turn can lead to economic losses and lowered quality of life.

Costs Benefits Analysis (CBA) seeks to compare the costs and benefits and take decisions on the basis of the findings. The problem with CBA is that it is difficult to quantify all benefits and costs, especially the intangibles.

The Cost Benefit Ratio

All costs and benefits are expressed in terms of money. Where the money is received or paid on a future date, it is discounted using current interest rate to a "Present Value (PV)." We will thus have:

• PVB - Present value of benefits
• PVC - Present value of costs
• NPV - Net present value, i.e. PVB minus PVC
• BCR - Benefit/Cost ratio, i.e. PVB/PVC

Computing the ratio thus involves not only quantifying the benefits and costs but also estimating the timing of their occurrence. A cash flow statement is prepared showing the estimated cash outflows and inflows, along with their dates. The future flows are then reduced to their present values, using PV tables.

The Use of CBA

Governments pioneered the use of costs benefits analysis, using them for evaluating infrastructure projects such as road and rail building. It was then used to assess all government interventions as opposed to letting the status quo to continue. Monetary values were placed on the benefits to all parties affected by the intervention, and compared with the costs of the intervention, including intangible costs.

Studies have found that benefits tend to be overestimated and costs underestimated in typical cost benefit analyses. This happens not only because there is a tendency to support go-ahead with specific projects but also because the estimators work with their previous experience, which is based on past conditions.

Cost benefits analysis is an attempt to quantify the costs and benefits (including intangible and difficult-to-measure ones) of specific decisions. These intangibles typically include social and environmental costs and benefits. Despite all its problems, CBA is an exercise that has to be done to ensure that the best alternative decisions are chosen to the greatest extent possible.

The copyright of the article Cost Benefit Analysis Factors in Intangibles in Business Management is owned by Gopinathan Thachappilly. Permission to republish Cost Benefit Analysis Factors in Intangibles in print or online must be granted by the author in writing.

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