Strategy Survival Guide

Strategy Survival Guide Version 2.1
Prime Minister’s Strategy Unit
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Strategy Skills > Appraising Options
Cost-benefit & cost-effectiveness analysis
> in practice
Cost-benefit and cost-effectiveness analysis sum up all of the costs and all of the benefits associated with an
option using a common metric, typically monetary units. This enables the calculation of the net cost or
benefit associated with an option. All options with a net benefit are worth doing - the one with the greatest
net benefit is the most worth doing.
Cost-benefit analysis (CBA):
Cost-benefit analysis suggests that a monetary value can be placed on all the costs and benefits of a
strategy, including tangible and intangible returns to other people and organisations in addition to those
immediately impacted.
Decisions are made by comparing the present value of the costs with the present value of the benefits of the
strategy. Decisions are based on whether there is a net benefit or cost to the strategy, i.e. total benefits less
total costs.
Costs and benefits that occur in the future have less weight attached to them in a cost-benefit analysis. To
account for this, it is necessary to discount, or reduce, the value of future costs or benefits to place them on
a par with costs and benefits incurred today. The current recommendation is that public sector activity should
generally use a discount rate of 6%. This means that £1 in one year's time will be worth 1 ÷ 1.06 now; £1 in
two year's time will be worth 1 ÷ 1.06 2 and so on. The sum of the discounted benefits of an option minus the
sum of the discounted costs, all discounted to the same base date, is the net present value of the option.
Cost-benefit analysis should normally be undertaken for any strategy project which involves policy
development, capital expenditure, use of assets or setting of standards. Depending on the nature of the
issue, it will sometimes be very quick and easy. At other times it will require full-blown economic analysis.
There are no set rules as to the level of detail required, but it should reflect the significance of the options
being assessed. CBA should typically take a broad view of costs and benefits, including indirect and longerterm
effects, reflecting the interests of taxpayers and users of public services and those affected in other
ways by public sector activity.
Although in practice monetary valuation is often difficult, it can be done and, despite difficulties, cost-benefit
analysis is an approach which is valuable if its limitations are understood. Its major benefit is in forcing
people to be explicit about the various factors which should influence strategic choice.
Cost-effectiveness analysis (CEA)
Cost-effectiveness analysis is an alternative to cost-benefit analysis. CEA is most useful when analysts face
constraints which prevent them from conducting CBA. The most common constraint is the inability or
unwillingness of analysts to monetise benefits.
CEA measures costs in a common monetary value (normally £) and effectiveness in physical units. Because
the two are incommensurable, they cannot be added or subtracted to obtain a single criterion measure. One
can only compute the ratio of costs to effectiveness in the following ways:
CE ratio = C 1 /E 1
EC ratio = E 1 /C 1
where: C 1 = the cost of option 1 (in £); and E 1 = the effectiveness of option 1 (in physical units).
Strategy Survival Guide – Strategy Skills
Page 174