Cost Analysis Essay

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Cost analysis refers to a specific methodology that can be used to analyze financial decisions. This methodology includes several distinct, but related tools that are useful for calculating costs, particularly of something that is being appraised, assessed, or evaluated. Cost analysis is used by decision makers in both the public and private sectors, and is useful for both for-profit and not-for-profit decision making. It is primarily discussed in the literature as a methodology for optimizing the use of resources in light of economic constraints and limited resources; however, this methodology should be employed to make decisions even if resources are not an issue.

Cost analysis methodologies became popular in the 19th century with the use of cost benefit analysis by the U.S. Corps of Engineers when it began to evaluate federal expenditures on navigation in 1902. Over the next 60 years, this methodology gathered momentum in the United States with the enactment of the Flood Control Act of 1936, use by the U.S. Department of Defense in the 1960s, and promotion by the Office of Management and Budget. In 1981 cost benefit analysis became an official appraisal tool of the U.S. federal government with the signing of Order 12291 by President Reagan.

The term cost analysis is often used interchangeably with terms such as cost benefit analysis, cost effectiveness analysis, cost utility analysis, and cost feasibility analysis. However, each of the aforementioned methodologies has unique characteristics that make each appropriate to specific applications. In cost benefit analysis, costs and benefits are both translated into monetary terms. This methodology can therefore facilitate comparison of alternatives with widely disparate objectives (e.g., health, education, national security) to determine which provides the highest ratio of benefits to costs in order to facilitate overall social analysis for public investment decisions. Cost effectiveness analysis is useful for comparing the costs of different programs that are designed to achieve the same or similar outcomes. It is an appropriate tool for cost appraisals when it is difficult to assess benefits in pecuniary terms, when controversy arises over the valuation of certain types of benefits (e.g., reduced mortality), or where the effort of calibrating benefits into monetary units is unjustifiably great. In cost effectiveness analysis, only costs are translated into monetary units—benefits are expressed in outcome units such as lives saved, percentage of alcoholics abstaining for one year, and so forth. In other words, efficiency is expressed in terms of the costs of achieving a given result.

Cost utility analysis assesses alternatives by comparing costs and utility (satisfaction derived by someone from some outcome) as perceived by users, to determine which option yields the highest level of utility for a given cost. Cost feasibility analysis compares the cost of an investment with the available budget to determine if the investment would be feasible. Other methodologies classified under cost analysis include: net present value, which measures wealth maximization; the internal rate of return, which measures the return on capital; and the payback period, which is the time required to recover the original investment.

Cost analysis methodologies can yield invaluable information for decision making—however, these methodologies can be quite complex and complicated. Cost analysis can be complicated by the following issues, among others: choice of discount rate, selection of the correct costs/benefits for the analysis, duplication/double counting of costs/benefits, measurement of intangible (e.g., reduced stress, cleaner environment) or controversial (e.g., value of lives saved) costs/ benefits, and valuation of nonmonetary costs/benefits, indirect costs/benefits, and opportunity costs.

Bibliography:

  1. Anthony E. Boardman, David H. Greenberg, Aidan R. Vining, and David L. Weimer, Cost-Benefit Analysis: Concepts and Practice 2nd ed. (Prentice Hall, 2001);
  2. Henry M. Levin and Patrick J. McEwan, Cost-Effectiveness Analysis 2nd ed. (Sage, 2001);
  3. Tevfik F. Nas, CostBenefit Analysis: Theory and Application (Sage, 1996).

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