Cost Benefit Analysis

Cost benefit analysis is very similar to net benefit analysis in that it uses the same function to calculate the costs and benefits associated with a given health policy. The only difference between cost benefit and net benefit analysis is that cost benefit analysis uses monetary values. This function is as follows, the net benefits of X equal the benefits of X minus the costs of X.

NB(X) = B(X) – C(X)

NB(X) = the expected net benefits
X = the individual decision or choice being made
B = the expected benefits of the choice
C = the expected costs resulting from the choice

A simple illustration of cost benefit analysis can be seen in the decision whether to get Lasik eye surgery or not. The joy of being able to see without glasses or contacts and the benefit of not having to spend money on corrective vision eye wear are compared to the amount of money it may cost to have the surgery performed, the risk of the surgery not going well, and the amount of time spent in the surgery room that could have been spent doing something else possibly more productive are all weighed against eachother. This illustration shows the use of cost benefit analysis, weighing the costs and benefits and then making a decision depending on which one has a greater value than the other. In this case more costs are listed than benefits, so the argument may be made not to get the surgery done. On the other hand, a greater value may be placed on each of the benefits outweighing the costs, therefore the surgery should be performed.

An extension of personal cost benefit analysis decisions is the application of this type of analysis towards maximizing the total social utility of a population by determining the mix of goods and services that should be produced in the economy. Determining which goods and services should be produced based on the benefits gained compared to the costs incurred is another practical application of cost benefit analysis which is used to determine the total net social benefit of each possible good or service.

TNSB (Q) = TSB (Q) – TSC (Q)

TNSB = Total net social benefits of producing a particular amount of some good or service
Q = Amount of good or service
TSB = Total social benefit in consumption
TSC = Total social cost of production

Total net social benefit is an important means to allocating resources. It can be used to allocate resources to different industries across the entire economy as well as to different fields within each particular industry. For example, if the total net social benefits of say the healthcare industry are greater than the total net social benefits of the automobile industry, more of the economic resources of the nation should be allocated to healthcare than automobile production. Furthermore within the healthcare industry itself, if the total net social benefit of dialysis machinery is greater than that of
MRI machinery, then more resources should be devoted dialysis machinery.

Present Value
Present value in cost benefit analysis is associated with benefits. Benefits are worth less in the future than what they are worth today, therefore when calcualting cost benefit analysis, the benefits need to be stated in terms of what they are worth today, or present value. The equation for this is, present value equals a fixed sum of money divided by one plus the interest rate. This process is also known as discounting. In other words, in order for cost benefit analysis to be effective time value of money must be taken into account.
PV = FV / (1+r)^t

Effect of Interest Rates
Interest rates play a significant part in finding the present value of a benefit, or discounting. The higher the interest rate the less a benefit is worth in the present. The reverse is also true, the lower and interest rate the more a benefit is worth in the present. When choosing an interest rate to use in the present value function, be sure to use a number that is relevant when thinking of society's future consumption of goods and services. Usually the interest rate used is between three and five percent. The treasury bill rate is also used.

Surrogate Measures
Surrogate measures are based on the characteristics of what a cost or benefit may incur. They are especially helpful when it is tough to tell the actual monetary value of the cost or benefit. For example, the costs of a tornado going through a town are taken into account with surrogate measures. The amount of monetary damage done to buildings, cars, and the landscape are all surrogate measures of the tornado. Medical illnesses may be first taken into account by surrogate measures. Surrogate measures of the flu (or symptoms) doctors take into account before diagnosing may be fever, chills, vomitting, headaches, and so on.

Measuring Costs and Benefits
Costs and benefits can be difficult to measure due to not all costs or benefits being tangible. When practicing cost benefit analysis all the costs and benefits must be taken into account and given a value, whether they are tangible or not. Cost identification for purposes of cost benefit analysis should include the total costs associated with a particular decision. The total costs are made up of both direct costs as well as indirect costs. A person considering whether or not to have a particular medical procedure can apply the concepts of direct and indirect costs to their own personal cost benefit analysis scenario. Direct costs for the recipient of a medical procedure (disregarding the presense of insurance) include such things as the cost of the physician, hospital charges, and the cost of the medical supplies used during the procedure which will most likely be factored into one of these other costs. Direct costs that aren't exactly medical in nature include the cost of transportation to the hospital as well as the cost of any changes to diet and lifestyle required directly following the surgery. The indirect costs associated with having the surgery include the opportunity cost of the the patient or physician's time as well as the opportunity cost of the patient's recovery time. It is important to consider all costs, direct and indirect when determining the total cost associated with a particular decision. Over or understatement of costs can lead to inaccurate cost benefit analysis which may result in missed opportunities and bad decisions.

Sample Questions

1. Cost Benefit Analysis considers:
A) the monetary values of all costs and benefits
B) only the tangible costs and benefits
C) the future value of the costs and benefits
D) all of the above
ans: A

2. Cost benefit analysis should only consider the future value of the costs and benefits, true or false?
ans: False, in order for cost benefit to be accurate, it must consider the present values of the costs and benefits

3. Discounting is:
A) the role that interest rates take in determining present value
B) the role that interest rates take in determinig future value
C) not relevant when using cost benefit analysis
D) the characteristic of what a benefit or cost may incur
ans: A

4. If Cindy is considering getting the lasik eye surgery performed that was discussed earlier, which of the following facts is the most logical reason for her to choose to go through with the surgery?
A) the benefits Cindy perceives she will get from the surgery are less than the cost of the surgery
B) the insurance company only covers one physician due to price agreements that have been made
C) the total costs of the surgery are less than the benefits Cindy will receive
D) the cost of the time Cindy will miss during a crucial week at work are more than the benefits she will receive by not having to wear her contacts or glasses anymore
ans: C ; the entire basis of cost benefit analysis is that a decision is desirable and should be taken if the total costs are less than the benefits, stated differently if the total benefits are greater than the total costs

5. If the benefits of having the lasik eye surgery will be $5,000 five years down the road, what is the Present Value of those benefits given an interest rate of 4%?
A)$ 4,008
B)$ 4,110
C)$ 4,808
D)$ 5,110
ans: B The calculation is 5,000 / (1 + .04)^5 which equals $ 4,109.64. Rounded to the nearest dollar the answer would be $4,110.

6. When determining the costs of undergoing a cosmetic surgery for a problem that is not life threatening, which of the following costs should not be included?
A) the cost of wages lost due to unpaid time away from work
B) the cost of alternative uses of the surgery and recovery time
C) the cost of the uninsured procedure which includes surgeon's and hospital fees
D) all of the above costs should be considered when determining costs of a surgery
ans: D All of the listed costs should be considered because they are either a direct cost (cost of the actual surgery) or indirect cost (lost wages and opportunity cost of time.) Cost benefit analysis considers the total cost which includes both direct and indirect costs.

References:
Santerre, R., & Neun, S. (2007). Health economics.Mason: Thomson South-Western.
Saltzman, J (2007, March, 11). Surrogate Measures. Kenexa Blog, Retrieved April 24, 2007, from http://blog.kenexa.com/blogdetails.aspx?u=11&b=125