Learning Lab Denmark - INCUBEus

Cost-benefit Analysis

Cost-benefit analysis (CBA) is a method of reaching economic decisions by comparing the costs of doing something with its benefits. Cost-benefit analysis rests on the assumption that all costs and benefits can be measured in money and that an act should not be undertaken unless its' benefits outweigh its' costs.

In order to determine this, one tabulates the money values of benefits and costs in two parallel columns while a third column contains the cost-benefit ratio. The preferable solution is the one with the smallest cost-benefit ratio.

Applied to decisions with inherent risks, cost-benefit analysis is a way to measure the preferability of one risk exposure scenario over another. One scenario investigated is "do nothing", which then serves as a baseline for the evaluation.

As sensible as this approach sounds, cost-benefit analysis has severe limitations. With careful selection of the applied assumptions used CBA can be made to support, or oppose, almost anything. This is particularly so when the decision involves some cost or benefit for which there is no market price or which, because of an 'externality', is not fully reflected in the market price.

Typical examples would be a project to build a hydroelectric dam in an area of outstanding natural beauty or a law to require factories to limit emissions of gases that may cause ill-health.

In the case of uncertain (stocastic) outcomes, as it is common in risk systems, the resulting utility functions (a utility function is a mathematical representation of how good and useful a given technology is thought to be) can become irregular, producing conflicting results. Also, aggregate utility functions are not always obtainable, when individuals have varying levels of risk aversion. Furthermore, feed-back effects and probabilistic cause-effect chains can make balancing between several events meaningless. For this reason, many economists, as well as policy analysts, believe that cost-benefit analysis is an inappropriate tool for rationalising decisions about acceptable risks (Jaeger et.al. 2001).

Even worse, organisations often use CBA and other decision analysis tools, not to establish quantitative estimates of risk, but to rationalise management decisions already made. Bluntly put, the formal analysis of risk is used as an afterthought, legitimising political or economical considerations. A prominent example of this is the Ford Pinto case (card #C1); only after the production decisions had been made, Ford made a cost-benefit analysis to support the highly problematic location of the gas tank on the Ford Pinto (Kinghorn 1984).

Examples of using cost-benefit analysis
Calculating Employee Turnover Costs:

From the National Center for Environmental Decision-making Research

Further reading
Whipple, C. (1987). De Minimis Risk. New York: Plenum Press.

Adam Wolfoson, (2001). "The costs and benefits of cost-benefit analysis", The public interest, vol. 145, pp. 93-100.

Jaeger, C.C., Renn, O., Rosa, E.A., Webler, T. (2001). Risk, Uncertainty, and Rational Action, Earthscan Publications Ltd., London and Sterling, VA.

Kinghorn, S. (1984). Corporate Harm: A Structural Analysis of the Criminogenic Elements of the Corporation. Ann Arbor, University of Michigan Press.

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Nine Technologies

A. Air Transport
B. Buildings
C. Land Transport
D. Marine Transport
E. Bridges and Dams
F. Oil Tankers
G. Chemical Industry
H. Medical Industry
I. Nuclear Industry

Nine Theories

Quantitative Risk Assessment
Decision Analysis
Cost-benefit Analysis
Normal Accident Theory
High Reliability Organisations
Risk communication
Arena Theory
Cultural Theory

Five Categories

Hazard (0-1000)
Range (km2)
Fear Factor (0-10)
Media Effect (0-100)