Cost–benefit analysis is typically used by governments to evaluate the desirability of a

given intervention. It is heavily used in today's government. It is an analysis of the cost

effectiveness of different alternatives in order to see whether the benefits outweigh the
costs. The aim is to gauge the efficiency of the intervention relative to the status quo. The
costs and benefits of the impacts of an intervention are evaluated in terms of the public's
willingness to pay for them (benefits) or willingness to pay to avoid them (costs). Inputs
are typically measured in terms of opportunity costs - the value in their best alternative
use. The guiding principle is to list all parties affected by an intervention and place a
monetary value of the effect it has on their welfare as it would be valued by them.

The process involves monetary value of initial and ongoing expenses vs. expected return.
Constructing plausible measures of the costs and benefits of specific actions is often very
difficult. In practice, analysts try to estimate costs and benefits either by using survey
methods or by drawing inferences from market behavior. For example, a product
manager may compare manufacturing and marketing expenses with projected sales for a
proposed product and decide to produce it only if he expects the revenues to eventually
recoup the costs. Cost–benefit analysis attempts to put all relevant costs and benefits on a
common temporal footing. A discount rate is chosen, which is then used to compute all
relevant future costs and benefits in present-value terms. Most commonly, the discount
rate used for present-value calculations is an interest rate taken from financial markets
(R.H. Frank 2000). This can be very controversial; for example, a high discount rate
implies a very low value on the welfare of future generations, which may have a huge
impact on the desirability of interventions to help the environment. Empirical studies
suggest that in reality, people's discount rates do decline over time. Because cost–benefit
analysis aims to measure the public's true willingness to pay, this feature is typically built
into studies.

During cost–benefit analysis, monetary values may also be assigned to less tangible
effects such as the various risks that could contribute to partial or total project failure,
such as loss of reputation, market penetration, or long-term enterprise strategy
alignments. This is especially true when governments use the technique, for instance to
decide whether to introduce business regulation, build a new road, or offer a new drug
through the state healthcare system. In this case, a value must be put on human life or the
environment, often causing great controversy. For example, the cost–benefit principle
says that we should install a guardrail on a dangerous stretch of mountain road if the
dollar cost of doing so is less than the implicit dollar value of the injuries, deaths, and
property damage thus prevented (R.H. Frank 2000).

Cost–benefit calculations typically involve using time value of money formulas. This is
usually done by converting the future expected streams of costs and benefits into a
present value amount.

[edit] Application and history

Cost–benefit analysis is used mainly to assess the monetary value of very large private
and public sector projects. This is because such projects tend to include costs and benefits
that are less amenable to being expressed in financial or monetary terms (e.g.,
environmental damage), as well as those that can be expressed in monetary terms. Private
sector organizations tend to make much more use of other project appraisal techniques,
such as rate of return, where feasible.

The practice of cost–benefit analysis differs between countries and between sectors (e.g.,
transport, health) within countries. Some of the main differences include the types of
impacts that are included as costs and benefits within appraisals, the extent to which
impacts are expressed in monetary terms, and differences in the discount rate between
countries. Agencies across the world rely on a basic set of key cost–benefit indicators,
including the following:

• NPV (net present value)

• PVB (present value of benefits)
• PVC (present value of costs)
• BCR (benefit cost ratio = PVB / PVC)
• Net benefit (= PVB - PVC)
• NPV/k (where k is the level of funds available)

The concept of CBA dates back to an 1848 article by Dupuit and was formalized in
subsequent works by Alfred Marshall. The practical application of CBA was initiated in
the US by the Corps of Engineers, after the Federal Navigation Act of 1936 effectively
required cost–benefit analysis for proposed federal waterway infrastructure. [1] The Flood
Control Act of 1939 was instrumental in establishing CBA as federal policy. It specified
the standard that "the benefits to whomever they accrue [be] in excess of the estimated
costs.[2]

Subsequently, cost–benefit techniques were applied to the development of highway and

motorway investments in the US and UK in the 1950s and 1960s. An early and often-
quoted, more developed application of the technique was made to London Underground's
Victoria Line. Over the last 40 years, cost–benefit techniques have gradually developed
to the extent that substantial guidance now exists on how transport projects should be
appraised in many countries around the world.

In the UK, the New Approach to Appraisal (NATA) was introduced by the then
Department for Transport, Environment and the Regions. This brought together cost–
benefit results with those from detailed environmental impact assessments and presented
them in a balanced way. NATA was first applied to national road schemes in the 1998
Roads Review but subsequently rolled out to all modes of transport. It is now a
cornerstone of transport appraisal in the UK and is maintained and developed by the
Department for Transport.[10]

The EU's 'Developing Harmonised European Approaches for Transport Costing and
Project Assessment' (HEATCO) project, part of its Sixth Framework Programme, has
reviewed transport appraisal guidance across EU member states and found that
significant differences exist between countries. HEATCO's aim is to develop guidelines
to harmonise transport appraisal practice across the EU.[11][12] [3]

Transport Canada has also promoted the use of CBA for major transport investments
since the issuance of its Guidebook in 1994.[4]

More recent guidance has been provided by the United States Department of
Transportation and several state transportation departments, with discussion of available
software tools for application of CBA in transportation, including HERS, BCA.Net,
StatBenCost, CalBC, and TREDIS. Available guides are provided by the Federal
Highway Administration[5][6], Federal Aviation Administration[7], Minnesota Department
of Transportation,[8] and California Department of Transportation (Caltrans)[9].

In the early 1960s, CBA was also extended to assessment of the relative benefits and
costs of healthcare and education in works by Burton Weisbrod.[10][11] Later, the United
States Department of Health and Human Services issued its CBA Guidebook.[12]

[edit] Accuracy problems

The accuracy of the outcome of a cost–benefit analysis depends on how accurately costs
and benefits have been estimated. A peer-reviewed study [13] of the accuracy of cost
estimates in transportation infrastructure planning found that for rail projects actual costs
turned out to be on average 44.7 percent higher than estimated costs, and for roads 20.4
percent higher (Flyvbjerg, Holm, and Buhl, 2002). For benefits, another peer-reviewed
study [14] found that actual rail ridership was on average 51.4 percent lower than
estimated ridership; for roads it was found that for half of all projects estimated traffic
was wrong by more than 20 percent (Flyvbjerg, Holm, and Buhl, 2005). Comparative
studies indicate that similar inaccuracies apply to fields other than transportation. These
studies indicate that the outcomes of cost–benefit analyses should be treated with caution
because they may be highly inaccurate. In fact, inaccurate cost–benefit analyses may be
argued to be a substantial risk in planning, because inaccuracies of the size documented
are likely to lead to inefficient decisions, as defined by Pareto and Kaldor-Hicks
efficiency ([15] Flyvbjerg, Bruzelius, and Rothengatter, 2003).

These outcomes (almost always tending to underestimation unless significant new

approaches are overlooked) are to be expected because such estimates:

1. Rely heavily on past like projects (often differing markedly in function or size and
certainly in the skill levels of the team members)
2. Rely heavily on the project's members to identify (remember from their collective
past experiences) the significant cost drivers
3. Rely on very crude heuristics to estimate the money cost of the intangible
elements
4. Are unable to completely dispel the usually unconscious biases of the team
members (who often have a vested interest in a decision to go ahead) and the
natural psychological tendency to "think positive" (whatever that involves)
Another challenge to cost–benefit analysis comes from determining which costs should
be included in an analysis (the significant cost drivers). This is often controversial
because organizations or interest groups may think that some costs should be included or
excluded from a study.

In the case of the Ford Pinto (where, because of design flaws, the Pinto was liable to
burst into flames in a rear-impact collision), the Ford company's decision was not to issue
a recall. Ford's cost–benefit analysis had estimated that based on the number of cars in
use and the probable accident rate, deaths due to the design flaw would run about $49.5
million (the amount Ford would pay out of court to settle wrongful death lawsuits). This
was estimated to be less than the cost of issuing a recall ($137.5 million) [16]. In the
event, Ford overlooked (or considered insignificant) the costs of the negative publicity so
engendered, which turned out to be quite significant (because it led to the recall anyway
and to measurable losses in sales).

In the field of health economics, some analysts think cost–benefit analysis can be an
inadequate measure because willingness-to-pay methods of determining the value of
human life can be subject to bias according to income inequity. They support use of
variants such as cost-utility analysis and quality-adjusted life year to analyze the effects
of health policies.

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A cost benefit analysis is done to determine how well, or how poorly, a planned action will turn
out. Although a cost benefit analysis can be used for almost anything, it is most commonly
done on financial questions. Since the cost benefit analysis relies on the addition of positive
factors and the subtraction of negative ones to determine a net result, it is also known as
running the numbers.

Cost Benefit Analysis

A cost benefit analysis finds, quantifies, and adds all the positive factors. These are the
benefits. Then it identifies, quantifies, and subtracts all the negatives, the costs. The
difference between the two indicates whether the planned action is advisable. The real trick to
doing a cost benefit analysis well is making sure you include all the costs and all the benefits
and properly quantify them.

Should we hire an additional sales person or assign overtime? Is it a good idea to purchase the
new stamping machine? Will we be better off putting our free cash flow into securities rather
than investing in additional capital equipment? Each of these questions can be answered by
doing a proper cost benefit analysis.
Example Cost Benefit Analysis

As the Production Manager, you are proposing the purchase of a $1 Million stamping machine
to increase output. Before you can present the proposal to the Vice President, you know you
need some facts to support your suggestion, so you decide to run the numbers and do a cost
benefit analysis.

You itemize the benefits. With the new machine, you can produce 100 more units per hour.
The three workers currently doing the stamping by hand can be replaced. The units will be
higher quality because they will be more uniform. You are convinced these outweigh the costs.

There is a cost to purchase the machine and it will consume some electricity. Any other costs
would be insignificant.

You calculate the selling price of the 100 additional units per hour multiplied by the number of
production hours per month. Add to that two percent for the units that aren't rejected because
of the quality of the machine output. You also add the monthly salaries of the three workers.
That's a pretty good total benefit.

Then you calculate the monthly cost of the machine, by dividing the purchase price by 12
months per year and divide that by the 10 years the machine should last. The manufacturer's
specs tell you what the power consumption of the machine is and you can get power cost
numbers from accounting so you figure the cost of electricity to run the machine and add the
purchase cost to get a total cost figure.

You subtract your total cost figure from your total benefit value and your analysis shows a
healthy profit. All you have to do now is present it to the VP, right? Wrong. You've got the
right idea, but you left out a lot of detail.

Running The Numbers Means All The Numbers

Lets look at the benefits first. Don't use the selling price of the units to calculate the value.
Sales price includes many additional factors that will unnecessarily complicate your analysis if
you include them, not the least of which is profit margin. Instead, get the activity based value
of the units from accounting and use that. You remembered to add the value of the increased
quality by factoring in the average reject rate, but you may want to reduce that a little
because even the machine won't always be perfect. Finally, when calculating the value of
replacing three employees, in addition to their salaries, be sure to add their overhead costs,
the costs of their benefits, etc., which can run 75-100% of their salary. Accounting can give
you the exact number for the workers' "fully burdened" labor rates.

In addition to properly quantifying the benefits, make sure you included all of them. For
instance, you may be able to buy feed stock for the machine in large rolls instead of the
individual sheets needed when the work is done by hand. This should lower the cost of
material, another benefit.

As for the cost of the machine, in addition to it's purchase price and any taxes you will have to
pay on it, you must add the cost of interest on the money spent to purchase it. The company
may purchase it on credit and incur interest charges, or it may buy it outright. However, even
if it buys the machine outright, you will have to include interest charges equivalent to what the
company could have collected in interest if it had not spent the money.
Check with finance on the amortization period. Just because the machine may last 10 years,
doesn't mean the company will keep it on the books that long. It may amortize the purchase
over as little as 4 years if it is considered capital equipment. If the cost of the machine is not
enough to qualify as capital, the full cost will be expensed in one year. Adjust your monthly
purchase cost of the machine to reflect these issues. You have the electricity cost figured out
but there are some cost you missed too.

HTA 101: IV. COST ANALYSIS METHODS

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• Main Types of Cost Analysis

• Quandrants of Cost-Effectiveness
• Key Attributes of Cost Analyses
• Collecting Cost Data Alongside Clinical Studies

Studies of costs and related economic implications comprise a major group of methods
used in HTA. These studies can involve attributes of either or both of primary data
collection and integrative methods. That is, cost data can be collected as part of RCTs
and other clinical studies, as well as administrative databases used in health care
payment. Cost data from one or more such sources often are combined with data from
primary clinical studies, epidemiological studies, and other sources to conduct cost-
effectiveness analyses and other cost studies that involve weighing health and economic
impacts of health technology.
Interest in cost analyses has accompanied concerns about rising health care costs,
pressures on health care policymakers to allocate resources, and the need for health
product makers and other technology advocates to demonstrate the economic benefits of
their technologies. This interest is reflected in a considerable increase in the number of
reports of cost analyses in the literature and further refinement of methods.

Main Types of Cost Analysis

There is a variety of approaches to cost analysis, the suitability of any of which depends
upon the purpose of an assessment and the availability of data and other resources. It is
rarely possible or necessary to identify and quantify all costs and all benefits (or
outcomes), and the units used to quantify these may differ.
Main types of cost analysis include the following.

• Cost-of-illness analysis: a determination of the economic

impact of an illness or condition (typically on a given population,
region, or country) e.g., of smoking, arthritis or bedsores,
including associated treatment costs
• Cost-minimization analysis: a determination of the least
costly among alternative interventions that are assumed to
produce equivalent outcomes
 • Cost-effectiveness analysis (CEA): a comparison of costs in
monetary units with outcomes in quantitative non-monetary
units, e.g., reduced mortality or morbidity
• Cost-utility analysis (CUA): a form of cost-effectiveness
analysis that compares costs in monetary units with outcomes
in terms of their utility, usually to the patient, measured, e.g.,
in QALYs
• Cost-consequence analysis: a form of cost-effectiveness
analysis that presents costs and outcomes in discrete
categories, without aggregating or weighting them
• Cost-benefit analysis (CBA): compares costs and benefits,
both of which are quantified in common monetary units.

Box 18 contrasts the valuation of costs and outcomes among these alternative economic
analyses.
Box 18
Different Types of Economic Analysis

Valuation of Valuation of outcomes

costs
Cost of Illness $ vs. None
Cost Minimization $ vs. Assume same
Cost Effectiveness $ ÷ Natural units
Cost Utility $ ÷ Utiles (e.g., QALYs)
Cost Benefit $ ÷ or - $
Cost-minimization analysis, CEA and CUA necessarily involve comparisons of
alternative interventions. A technology cannot be simply cost effective, though it may be
cost effective compared to something else. Although CBA typically involves
comparisons of alternative technologies, this is not necessary.
Because it measures costs and outcomes in monetary (not disease-specific) terms, CBA
enables comparison of disparate technologies, e.g., coronary artery bypass graft surgery
and screening for breast cancer. A drawback of CBA is the difficulty of assigning
monetary values to all pertinent outcomes, including changes in the length or quality of
human life. CEA avoids this limitation by using more direct or natural units of outcomes
such as lives saved or strokes averted. As such, CEA can only compare technologies
whose outcomes are measured in the same units. In CUA, estimates of utility are assigned
to health outcomes, enabling comparisons of disparate technologies.
Two basic approaches for cost-benefit analysis (CBA) are ratio approach and the net
benefit approach. The ratio approach indicates the amount of benefits (or outcomes) that
can be realized per unit expenditure on a technology vs. a comparator. In the ratio
approach, a technology is cost beneficial vs. a comparator if the ratio of the change in
costs to the change in benefits is less than one. The net benefits approach indicates the
absolute amount of money saved or lost due to a use of a technology vs. a comparator. In
the net benefits formulation, a technology is cost-beneficial vs. a comparator if the net
change in benefits exceeds the net change in costs. The choice between a net benefits
approach or a benefit/cost approach for a CBA can affect findings. The approach selected
may depend upon such factors as whether costs must be limited to a certain level,
whether the intent is to maximize the absolute level of benefits, whether the intent is to
minimize the cost/benefit ratio regardless of the absolute level of costs, etc. Indeed, under
certain circumstances these two basic approaches may yield different preferences among
alternative technologies.
Box 19 shows basic formulas for determining CEA, CUA, and CBA.
Box 19
Basic Formulas for CEA, CUA, and CBA
Quadrants of Cost-Effectiveness
A basic approach to portraying a cost-effectiveness (or cost-utility) comparison of a new
intervention to a standard of care is to consider the cost and effectiveness of a new
intervention in the space of four fields as shown in Box 20, starting with the upper figure.
The level of costs and the level of effectiveness for the standard of care are indicated by
the "X" in the middle of the figure. A new intervention may have higher or lower costs,
and higher or lower effectiveness, such that its plot may fall into one of the four
quadrants surrounding the costs and effectiveness of the standard of care. If it is known
that the plot of the new intervention falls into either of two of the quadrants, i.e., where
the new intervention has higher costs and lower effectiveness (indicating that it should be
rejected), or it has lower costs and higher effectiveness (indicating that it should be
adopted), then no further analysis may be required. If it is known that the plot of the new
intervention falls into either of the other two quadrants, i.e., where the new intervention
has higher costs and higher effectiveness, or it has lower costs and lower effectiveness,
then further analysis weighing the marginal costs and effectiveness of the new
intervention compared to the standard of care may be required.
Within either of the two quadrants that entail weighing tradeoffs of costs and
effectiveness, it may be apparent that the marginal tradeoff of costs and outcomes is so
high or low as to suggest rejection or adoption. As shown in the lower figure of Box 20,
this arises when the new intervention yields only very low marginal gain in effectiveness
at a very high marginal cost (reject), or yields very high marginal improvements in
effectiveness at a very low marginal cost (adopt).

Key Attributes of Cost Analyses

The approaches to accounting for costs and outcomes in cost analyses can vary in a
number of important respects, some of which are addressed briefly below. These should
be carefully considered by assessors, as well as the policymakers who intend to make use
of assessment findings. Given the different ways in which costs and outcomes may be
determined, all studies should make clear their methodology in these respects (Byford
1998; Drummond 1997; Gold 1996).
Comparator. Any cost analysis of one intervention versus another must be specific
about the comparator. This may be standard of care (current best practice), minimum
practice, or no intervention. Some analyses that declare the superiority of a new
intervention may have used a comparator that is no longer in practice or is considered
sub-standard care or that is not appropriate for the patient population of interest.
Perspective. The perspective of a cost analysis refers to the standpoint at which costs and
outcomes (or consequences or benefits) are realized. For instance, the perspective of an
analysis may be that of society overall, a third-party payer, a physician, a hospital, or a
patient. Clearly, costs and outcomes are not realized in the same way from each of these
perspectives. Many analysts favor using the broad perspective of society and identifying
all costs and all outcomes accordingly. However, "society" as such may not be the
decisionmaker, and what is cost effective from that perspective may not be what is cost
effective from the standpoint of a ministry of health, third-party payer, hospital manager,
patient, or other decisionmaker. It is possible that this perspective may resemble that of a
national or regional government, if indeed that government experiences (or is responsible
for representing the perspectives of those that experience) all of the costs and outcomes
that are included in a societal perspective.
Box 20
Quadrants of Cost-Effectiveness
Direct Costs. Depending upon the perspective taken, cost analyses should identify two
types of direct costs. Direct costs represent the value of all goods, services, and other
resources consumed in providing health care or dealing with side effects or other current
and future consequences of health care. Two types of direct costs are direct health care
costs and direct non-health care costs.
Direct health care costs include costs of physician services, hospital services, drugs, etc.
involved in delivery of health care. Direct non-health care costs are incurred in
connection with health care, such as for care provided by family members and
transportation to and from the site of care. In quantifying direct health care costs, many
analyses use readily available hospital or physician charges (i.e., price lists) rather than
true costs, whose determination may require special analyses of resource consumption.
However, charges (as well as actual payments) tend to reflect provider cost shifting and
other factors that decrease the validity of using charges to represent the true costs of
providing care.
Indirect Costs. Analyses should account for indirect costs, sometimes known as
"productivity losses." These include the costs of lost work due to absenteeism or early
retirement, impaired productivity at work, and lost or impaired leisure activity. Indirect
costs also include the costs of premature mortality. Intangible costs of pain, suffering,
and grief are real, yet very difficult to measure and are often omitted from cost analyses.
Time Horizon. Interpretation of cost analyses must consider that the time horizon (or
time-frame) of a study is likely to affect the findings regarding the relative magnitudes of
costs and outcomes of a health care intervention. Costs and outcomes usually do not
accrue in steady streams over time. Comparisons of costs and outcomes after one year
may yield much different findings than comparisons made after 5, 10, or 25 years. The
meaningful time horizons for assessing the cost horizons of each of emergency
appendectomies, cholesterol-lowering in high-risk adults, and smoking cessation in
teenagers are likely to be quite different. For example, an analysis conducted for the
Medicare program in the US to determine cost and time tradeoffs of hemodialysis and
kidney transplantation showed that the annualized expenditure by the Medicare End-
Stage Renal Disease Program for a dialysis patient was $32,000. Although patients with
functioning transplanted kidneys required a first-year expenditure of $56,000, they cost
Medicare only an average of $6,400 in succeeding years. On average, estimated
cumulative dialysis and transplantation costs reach a break-even point in about three
years, after which transplantation provides a net financial gain compared to dialysis
(Rettig 1991).
Time horizons should be long enough to capture streams of health and economic
outcomes (including significant intended and unintended ones). These could encompass a
disease episode, patient life, or even multiple generations of life (such as for interventions
in women of child-bearing age or interventions that may cause heritable genetic changes).
Quantitative modeling approaches may be needed to estimate costs and outcomes that are
beyond those of available data. Of course, the higher the discount rate used in an analysis,
the less important are future outcomes and costs.
Average Costs vs. Marginal Costs. Assessments should make clear whether average
costs or marginal costs are being used in the analysis. Whereas average cost analysis
considers the total (or absolute) costs and outcomes of an intervention, marginal cost
analysis considers how outcomes change with changes in costs (e.g., relative to a
comparator), which may provide more information about how to use resources
efficiently. Marginal cost analysis may reveal that, beyond a certain level of spending, the
additional benefits are no longer worth the additional costs. For example, as shown in
Box 21, the average cost per desired outcome of an iterative screening test may appear to
be quite acceptable (e.g.,$2,451 per case of colorectal cancer detected assuming a total of
six tests per person), whereas marginal cost analysis demonstrates that the cost of adding
the last test (i.e., the additional cost of the sixth test per person) to detect another case of
cancer would be astronomical.
Box 21
Average Cost Analysis vs. Marginal Cost Analysis
The importance of determining marginal costs is apparent in the analysis by Neuhauser
and Lewicki of a proposed protocol of sequential stool guaiac testing for colon cancer.
Here, average cost figures obscure a steep rise in marginal costs of testing because the
high detection rate from the initial tests is averaged over subsequent tests that contribute
little to the detection rate. This type of analysis helps to demonstrate how it is possible to
spend steeply increasing health care resources for diminishing returns in health benefits.
Cancer screening and detection costs with sequential guaiac tests

No. No. of Additional Total cost ($) Additional Average Marginal cost
of cancers cancers of diagnosis ($) cost of cost ($) ($)
tests detected detected diagnosis per cancer per cancer
detected detected
1 65.9469 65.9469 77,511 77,511 1,175 1,175
2 71.4424 5.4956 107,690 30,179 1,507 5,492
3 71.9004 0.4580 130,199 22,509 1,810 49,150
4 71.9385 0.0382 148,116 17,917 2,059 469,534
5 71.9417 0.0032 163,141 15,024 2,268 4,724,695
6 71.9420 0.0003 176,331 13,190 2,451 47,107,214
This analysis assumed that there were 72 true cancer cases per 10,000 population. The
testing protocol provided six stool guaiac tests per person to detect colon cancer. If any
one of the six tests was positive, a barium-enema test was performed, which was assumed
to yield no falsepositive and no false-negative results. Other assumptions: the true-
positive cancer detection rate of any single guaiac test was 91.667%; the false-positive
rate of any single guaiac test was 36.508%; the cost of the first stool guaiac test was $4
and each subsequent guaiac test was $1; the cost of a barium-enema was $100. The
marginal cost per case detected depends on the population screened and the sensitivity of
the test used.
Source: Neuhauser 1975.
Discounting. Cost analyses should account for the effect of the passage of time on the
value of costs and outcomes. Costs and outcomes that occur in the future usually have
less present value than costs and outcomes realized today. Discounting reflects the time
preference for benefits earlier rather than later; it also reflects the opportunity costs of
capital, i.e., whatever returns on investment that could have been gained if resources had
been invested elsewhere. Thus, costs and outcomes should be discounted relative to their
present value (e.g., at a rate of five percent per year).
Discounting allows comparisons involving costs and benefits that flow differently over
time. It is less relevant for "pay as you go" benefits, such as if all costs and benefits are
realized together within one year. It is more relevant in instances where these do not
occur in parallel, such as when most costs are realized early and most benefits are
realized in later years. Discount rates used in cost analyses are typically based on interest
rates of government bonds or the market interest rates for the cost of capital whose
maturity is about the same as the duration of the effective time horizon of the health care
intervention of program being evaluated. Box 22 shows the basic formula for calculating
present values for a given discount rate, as well as how the present value of a cost or
benefit that is discounted at selected rates is affected over time.
Cost analyses should also correct for the effects of inflation (which is different from the
time preference accounted for by discounting), such as when costs or cost-effectiveness
for one year are compared to another year.
Sensitivity Analysis. Any estimate of costs, outcomes, and other variables used in a cost
analysis is subject to some uncertainty. Therefore, sensitivity analysis should be
performed to determine if plausible variations in the estimates of certain variables
thought to be subject to significant uncertainty affect the results of the cost analysis. A
sensitivity analysis may reveal, for example, that including indirect costs, or assuming the
use of generic as opposed to brand name drugs in a medical therapy, or using a plausible
higher discount rate in an analysis changes the cost-effectiveness of one intervention
compared to another.

Collecting Cost Data Alongside Clinical Studies

The validity of a cost-related study depends upon the sources of the data for costs and
outcomes. Increased attention is being given to collection of cost data in more rigorous,
prospective studies, particularly RCTs. The closer integration of economic and clinical
studies raises important methodological issues. In order to promote more rational
diffusion of new technologies, it would be desirable to generate reliable cost and
outcomes data during the early part of a technology's lifecycle, such as during RCTs
required prior to marketing approval. An RCT would be expected to yield the most
reliable data concerning efficacy of an intervention; however, the care given in an RCT
and the costs of providing it may be atypical compared to more general settings. For
example, RCTs may involve more extensive and frequent laboratory tests and other
patient monitoring, and may occur more often in academic medical centers whose costs
tend to be higher than in community health care institutions. Other aspects of trial design,
sample size, choice of outcome measures, identification and tabulation of costs, burden
on investigators of data collection and related matters affect the usefulness of clinical trial
data for meaningful economic studies (Briggs 2003; Drummond 1991; Graves 2002; Poe
1995). Also, the growth of multinational clinical trials of drugs and other technologies
raises challenges of estimating country-specific treatment effects and cost-effectiveness,
given differences in epidemiological factors, health care delivery models, resource use,
and other factors (Willke 1998).
Box 22
Discount Rate Calculation and Use in Determining Present
Value of Future Costs and Benefits
In practice, there is wide variation in economic study methodologies (Elixhauser 1998;
Nixon 2000). Although some variation is unavoidable, many differences in perspective,
accounting for direct and indirect costs, time frames, discounting and other aspects are
often arbitrary, result from lack of expertise, and may reflect biases on the part of
investigators or sponsors. This diminishes comparability and transferability of study
results as well as credibility of findings. National and international groups have
developed and revised voluntary standards for conducting and reporting economic studies
of health care technologies (Drummond 1996; Glennie 1999; Gold 1996; Taylor 2002). A
recent review of 25 guidelines from North America, Europe, and Australia found a
general trend toward harmonization in most methodological aspects, although there were
more differences in such dimensions as choice of economic perspective, resources, and
costs to be included in analysis (Hjelmgren 2001).

COST AND PRODUCTION

Instructional Goals: You will understand:

• The difference between opportunity costs and accounting costs.

• The importance of sensitivity analysis.
• How to derive long run cost curves from production functions by
minimizing long run costs using both marginal and incremental
analysis.
• How to derive short run cost curves from short run production
functions.
• How to perform a shut down analysis.
• How to use Break-even analysis as a rule of thumb.

And the relevance of these concepts to operational decision making.

These concepts will also have relevance to more complex questions of
marketing policy and strategy.

Opportunity costs vs. accounting costs

Costs are bad things endured or good things lost. Cost always means
cost to do something. You cannot have a cost without a cost objective.
Most of the confusion about costs reflects a failure to be clear about
cost objectives. Nevertheless, where economists and accountants are
concerned, there is a second and equally critical source of confusion
about costs: economists and accountants use the term "cost" to mean
different although related things.

Economists define cost in terms of opportunities that are sacrificed

when a choice is made. Hence, economic costs are simply benefits lost
(and, in some cases, benefits are merely costs avoided). Economic
costs are subjective -- seen from the perspective of a decision maker
not a detached observer -- and prospective. Moreover, economic cost
is a stock concept -- economic costs are incurred when decisions are
made. Economic cost estimates are used for making decisions about
pricing, output levels, buying or making, alternative marketing
tactics/strategies, product introductions and withdrawals, etc.

Accountants define cost in terms of resources consumed. Hence, from

an accountant’s standpoint, costs are objective -- seen from the
perspective of a detached observer -- and retrospective. Accountants
usually define costs as flows. Accounting costs reflect changes in
stocks (reductions in good things, increases in bad things) over a fixed
period of time. Accounting cost measures are used in the evaluation of
managerial performance (usually together with information on income)
and as a basis for economic cost estimation.
There are two kinds of mistakes you can make when you use
accounting costs to estimate economic costs: you can include cost
measures that should be ignored; or, you can ignore costs that should
be included. You should ignore costs that will not vary as a result of
your decision; you should include all costs that will vary as a result of
your decision.

Example of including costs that should be ignored: sunk costs.

The DOE developed a cyclotron to enrich uranium. It spent billions on

research and development, and almost had a fully operational machine
(a rare "success") but they never brought it on-line because Congress
required them to charge a high enough price for enriched uranium to
recover the cost of capital. If they brought it on-line, they would have
"priced themselves out of the market."

Examples of ignoring costs that should be considered: the

"hidden cost" problem.

opportunity costs of capital (like all costs, opportunity cost

depend on the question being asked)
opportunity cost of office space.

EXERCISES:----------------------------------------------------

Dan Connor, Artie Zimmer, and Bob Bruss each earn $25 per hour
(including vacations, social security, and other benefits) as automobile
mechanics at a car dealership. They are considering opening a shop
that specializes in fast-service oil changes. The projected annual cost
of the building and equipment is $60,000. On average, an oil change
requires $6 of materials (oil and oil filter). The average price of an oil
change is $20 in the shops that currently provide this service. Dan,
Artie, and Bob think that they could each perform as many as six oil
changes per hour and could charge at least $25 per oil change if they
could guarantee to return the customer's car in fifteen minutes or less.

What are the accounting and economic (or opportunity) cost

functions for this oil-changing business?
Opportunity costs are the costs of the foregone or next best
alternative.
One should consider opportunity costs, not accounting costs
when making decisions.

------------------------------------------------------------------------
You are trying to determine whether it makes sense to buy a house or
to continue renting for $1100. You start looking at houses but decide
that you will not purchase a house unless it is more profitable than
renting. What price house is equivalent to $1100 in rent? Make several
assumptions:

1. Assume that any transactions costs incurred in buying and selling

the house will exactly be offset by the capital gains on the house

2. Assume that you borrow the purchase price at 7.25%. Your

investments also earn 7.25%.

3. Assume that you do not pay any principle on the mortgage, only
interest.

HINT: the annual rent equivalent for a $350,000 house is $25375.

Now you think that you will make enough money to put yourself in a
33% tax bracket. Redo the calculation above, assuming a 33% tax
bracket, and explain in words how this affects your willingness to pay
for a house.

Suppose that you think there is a 75% chance that you will make
enough to put yourself in a 33% tax bracket, and a 25% chance that
you will stay in the 0% tax bracket. Compute the expected value of
monthly rent equivalent payment on a $250,000 house.

Note this is a version of what is known as sensitivity analysis. When

you are uncertain about the future, it is important to redo your
forecasts, computations, or spreadsheets, using a variety of scenarios:
a best case, middling, and worse case scenario.

Long run production functions and cost functions

Q = f(K, L). Quantity is a function of the inputs used to produce it: in

this example capital and labor. Quantity is measured as a rate of
production (flow) as are capital and labor, e.g. the amount of cars
washed per day is a function of the amount of labor and capital used
each day.

• The production function specifies a technically efficient use of

labor and capital necessary to produce output, i.e. no resources
are "wasted."
• The cost function specifies an economically efficient use of
resources, i.e. the firm chooses the least cost combination of
inputs, to produce a given output.
 • This yields the long run cost function: total costs (C) = g(Q),
which depends on the prices of inputs. This function can be a
pretty good proxy for the opportunity cost of delivering Q, at
least where we measure costs in units of present value: i.e., the
change in present value or owner’s equity caused by some
specified action (and where for purposes of measurement the
attendant increase in wealth is excluded from the computation of
equity).

The following long-run functional relationships traditionally obtain in the

single product case: Cost varies as a function of total production volume (V),
the rate of output (x), the date of first delivery (T), and the date of completion
of the full production run (m), where x(t) denotes the rate of output at moment
t. Moreover, as the total quantity of units produced increases, the cost of future
output tends to decline because production-knowledge increases as a result of
production experience (this proposition is known as the ‘learning’ or ‘progress’
curve"). That is: dC / dT | x = x0 , V = V0 , < 0. This relationship probably
holds for most products produced in large batches using traditional mass-
production methods. Moreover it is usually assumed that:

1. dC / dx(t) | T = T , V = V > 0
0 0

2. d C / dx(t) | T = T , V = V > 0
2 2
0 0

3. dC / dV | x = x , T = T > 0
0 0

4. d C / dV | x = x , T = T < 0
2 2
0 0

Many of these functional relationships have been attenuated by the rise of

computer assisted design and manufacturing technology and modern
information.

Long run cost minimization: marginal analysis

Here we will assume that the firm can choose any level of capital and
labor to produce output, Q. More capital leads to more output; less
capital to less output. More labor leads to more output; less labor to
less output. This is known as a variable proportions production
technology because labor can substitute for capital, and vice-versa, in
production.

• The marginal product of labor is the additional output from one

extra unit of labor.
• The marginal product of capital is the additional output from one
more unit of capital.
The cost minimization rule for producing a given quantity: choose labor
and capital such that (MP of labor)/(Price of labor) = (MP of capital)/
(price of capital).

Proof: dividing the marginal products of each input by the price of the
input tells you how much output you can produce for a dollar. If it costs
more to produce output using labor than it does using capital, then sell
labor and buy capital. This allows you to produce the same amount at
lower cost. Only when the costs of production using each input are the
same are no further cost savings possible.

• If (MP of labor)/(Price of labor) is greater than (MP of capital)/

(price of capital), sell capital, buy labor.
• If (MP of labor)/(Price of labor) is less than (MP of capital)/(price
of capital), sell labor, buy capital.

Long run cost minimization: incremental analysis

Incremental analysis considers large discrete changes in input mix,

whereas marginal analysis considers small continuous changes in input
mix.

Example: 1985: John Deere acquisition of Versatile. John Deere had an

old fashioned production line for making farm tractors. Very high fixed
costs, but low marginal costs. Versatile had a "garage" style production
facility with much lower fixed costs, but higher marginal costs.

• It is easy to see that if production is less than or equal to 6 units,

then Versatile has lower costs of production. If production is
larger than or equal to 7 units, John Deere has lower costs of
production.
 • The long run decision between these two production processes
would depend on how many units you thought you would sell. If
you anticipated selling 7 or more units, use the John Deere
production process, if you thought you would sell 6 or fewer
units, use the Versatile production process.

Sensitivity analysis

Suppose you were uncertain about how many units you anticipated
selling. Sensitivity analysis allows you to build in uncertainty to your
analysis by determining the costs of various scenarios.

Suppose you thought that your uncertainty was best described by a

trinomial random variable:

1. with p1 = .4, Q = 7
2. with p2 = .3, Q = 10
3. with p3 = .3, Q = 4; note that p3 = 1-p1-p2

What's the best technology to choose?

ANSWER: The expected output is 7 (.4*7+.3*4+.3*10 = 7), the

average cost of the expected output is not the same as the expected
average cost, because Versatile has a large advantage at small
outputs, while Deere has a small advantage at high outputs. The table
below shows how to compute expected average costs, which is the
usually right criterion to use for deciding which technology to adopt.

Short run production functions

A long run production function relates the output produced to the

inputs used, e.g. Q = f(capital, labor). In the short run, some inputs
cannot be varied, so the firm does not have as much flexibility as in
the long run. In this case, the short run production function is a
function of only the inputs that can be varied. Suppose that capital is
fixed in the short run. Then Y = g(labor)
The "usual" shape of the short run production function:

1. In the short run, output at first increases at an increasing rate with

increases in labor (increasing returns to labor)

2. Then output increases at a constant rate with increases in labor

(constant returns to labor).

3. Finally, output increases at a decreasing rate with increases in labor

(diminishing returns to labor).

Short run cost functions are larger than long run cost functions
because, in the short run, fixed inputs can not be varied. In the long
run, all inputs can be varied, and this greater flexibility allows you to
achieve lower costs, i.e. h(Q) is greater than or equal to g(Q).
A Numerical example

Assume, the following short run production function: Fixed costs =

$20/hour, Labor costs $5/hour * The marginal productivity of labor
increases, then is constant, and then decreases.

Suppose that the output sells for $1 per unit and that the firm can sell
all it wants at a price of $1 (infinite elasticity, or a perfectly competitive
firm). How much labor should the firm hire?

ANSWER: Keep hiring as long as the benefit of hiring another worker is

greater than the cost of another worker. The benefit equals the
marginal revenue of the worker (price times the marginal production),
Benefit = $1*(marginal production); The cost is the wage. Cost = $5.

 It is easy to see that profits are maximized with 11 laborers.

 • Can we derive the optimal production decision (how much labor
to produce) from the cost curves instead of the production
curves?

Yes: keep producing as long as the benefit of producing another unit

($1) exceeds the cost of producing another unit. Looking at the graph,
you can see that $1 intersects the marginal cost curve somewhere
between 10 and 11 laborers (between 75 and 84 units). To determine
whether to produce at 75 or 84, you must look at the spread sheet.

Shut down analysis

In the long run, stop producing if economic profits are negative.

In the short run, stop producing if revenue is less than total variable
cost. In the short run, you don't have to cover your fixed costs, but you
must make enough to cover your variable costs. If not, then you can
shut down. You will still have to pay your fixed costs, but at least you
can avoid paying your variable costs (which are greater than revenue).

Break-even analysis

Assumptions: constant price, constant average variable cost. (P-AVC) is

sometimes called "contribution margin" because it represents profit
per unit sold (ignoring fixed costs).

Set profits equal to zero to solve for how much output would be
required to "break even." Another way of asking the same question is
to ask how much quantity would be required to produce enough profit
to cover fixed costs. revenue-variable costs-fixed Costs = 0 P*Q-AVC*Q
-fixed Costs = 0 (P-AVC)*Q-fixed Costs = 0 Q = fixed Costs/(P-AVC)
Standard Costing and
Variance Analysis:
In this section of the website we study
management control and performance
measures. Quite often, these terms carry
with them negative connotations - we may
have a tendency to think of performance
measurement as something to be feared.
And indeed, performance measurements
can be used in very negative ways - to cast
blame and to punish. However, that is not
the way they should be used. Performance
measurement serves a vital function in
both personal life and in organizations.
Performance measurement can provide
feedback concerning what works and what
does not work, and it can help motivate
people to sustain their efforts.

In this section we see how various

measures are used to control operations
and to evaluate performance. Even though
we are starting with the lowest levels in the
organization, keep in mind that
performance measures should be derived
from the organization's overall strategy. For
example, a company like Sony that bases
its strategy on rapid introduction of
innovative consumer products should use
different performance measures than a
company like Federal Express where on-
time delivery, customer convenience, and
low cost are key competitive advantages.
Sony may want to keep close track of the
percentage of revenues from products
introduced within the last year; whereas
Federal Express may want to closely
monitor the percentage of packages
delivered on time. Later in this section
when we discuss the balance scorecard,
we will have more to say concerning the
role of strategy in the selection of
performance measures. But first we will
see how standard costs are used by
managers to help control costs.

Company in highly competitive industries

like Federal Express, Southwest airlines,
Dell Computer, Shell Oil, and Toyota must
be able to provide high quality goods and
services at low cost. If they do not, they will
perish. Stated in the starkest terms,
managers must obtain inputs such as raw
materials and electricity at the lowest
possible prices and must use them as
effectively as possible - while maintaining
or increasing the quality of the output. If
inputs are purchased at prices that are too
high or more inputs are used than is really
necessary, higher costs will result.

How do managers control the prices

that are paid for inputs and the
quantities that are used? They could
examine every transaction in detail, but this
obviously would be an inefficient use of
management time. For many companies,
the answer to this control problem lies at
least partially in standard costing
system.

Standard Costs - Management by

Exception:
A standard cost is the predetermined cost
of manufacturing a single unit or a number
of product units during a specific period in
the immediate future. It is the planned cost
of a product under current and/or
anticipated operating conditions. Click here
to read full article.

Setting Standard Costs - Ideal Versus

Practical Standards:
Setting price and quantity standards
requires the combined expertise of all
persons who have responsibility over input
prices and over effective use of inputs. In a
manufacturing firm, this might include
accountants, purchasing managers,
engineers, production supervisors, line
mangers, and production workers. Past
records of purchase prices and input usage
can help in setting standards. However, the
standards should be designed to
encourage efficient future operations, not a
repetition of past inefficient operations.
Click here to read full article.

Direct Materials
Standards and
Variance Analysis:
Direct Materials Price and Quantity
Standards:
Standard price per unit of direct materials
is the price that should be paid for a single
unit of materials, including allowances for
quality, quantity purchased, shipping,
receiving, and other such costs, net of any
discounts allowed. Click her to read full
article.

Direct Materials Price Variance:

Direct materials price variance is the
difference between the actual purchase
price and standard purchase price of
materials. Direct materials price variance is
calculated either at the time of purchase of
direct materials or at the time when the
direct materials are used. Click here to
read full article

Direct Materials Quantity Variance:

Direct materials quantity variance or Direct
materials usage variance measures the
difference between the quantity of
materials used in production and the
quantity that should have been used
according to the standard that has been
set. Although the variance is concerned
with the physical usage of materials, it is
generally stated in dollar terms to help
gauge its importance. Click here to read
full article.

Direct Labor Standards

and Variance
Analysis:
Direct Labor Rate and Efficiency
Standards:
Direct labor price and quantity standards
are usually expressed in terms of a labor
rate and labor hours. The standard rate per
hour for direct labor includes not only
wages earned but also fringe benefit and
other labor costs. Click here to read full
article

Direct Labor Rate | Price Variance:

Direct Labor price variance is also termed
as direct labor rate variance. This variance
measures any deviation from standard in
the average hourly rate paid to direct labor
workers. Click here to read full article.

Direct Labor Efficiency | Usage |

Quantity Variance:
The quantity variance for direct labor is
generally called direct labor efficiency
variance or direct labor usage variance.
Click here to read full article.

Manufacturing
Overhead Standards
and Variance
Analysis:
Manufacturing Overhead Standards:
Procedures for the establishing and using
standard factory overhead rates are similar
to the methods of dealing with the
estimated direct and indirect factory
overhead and its application to jobs and
products. Click here to read full article.

Factory Overhead Variances:

Jobs or processes are charged with cost

on the basis of standard hours allowed
multiplied by the standard factory over
head rate. The standard overhead rate or
predetermined overhead rate is discussed
in detail at our job order costing system
page. The standard hours allowed figure is
determined by multiplying the labor hours
required to produce one unit (the standard
labor hours per unit) times the actual
number of units produced during the
period. The units produced are the
equivalent units of production for the
departmental factory overhead cost being
analyzed. At the end of the month,
overhead actually incurred is compared
with the expenses charged into process
using the standard factory overhead rate.
The difference between these figures is
called the overall or net factory overhead
variance.

overall or net factory overhead variance

needs further analysis to reveal detailed
causes for the variance and to guide
management toward remedial action. This
analysis may be made by using (1) the two
variance method, (2) the three variance
method, or (3) the four variance method.

The two variance method: When an

overall or net factory overhead variance is
further analyzed by using two variance
approach, the following two variances are
calculated:

1. Controllable variance
2. Volume variance

The three variance method: When an

overall or net factory overhead variance is
further analyzed by using three variance
approach, the following three variances are
calculated:

1. Spending variance
2. Idle capacity variance
3. Efficiency variance

The four variance method: When an

overall or net factory overhead variance is
further analyzed by using four variance
approach, the following four variances are
calculated:

1. Spending variance
2. Variable efficiency variance
3. Fixed efficiency variance
4. Idle capacity variance

Mix and Yield Variance - Definition and

Explanation:
Basically, the establishment of standard
product cost requires the determination of
price and quantity standards. In many
industries, particularly of the process type,
materials mix and materials yield play
significant parts in the final product cost, in
cost reduction, and in profit improvement.
Click here to read full article

Calculation of Mix and

Yield Variances:
1. Materials Mix and Yield Variance
 2. Labor Yield Variance
3. Factory Overhead Yield variance

Variance Analysis and Management By

Exception:
Variance analysis and performance reports
are important elements of management by
exception. Simply put, management by
exception means that the manager's
attention should be directed toward those
parts of the organization where plans are
not working out for reason or another.

Managerial importance and usefulness

of variance analysis:
Costs of production are effected by internal
factors over which management has a
large degree of control. An important job of
executive management is to help the
members of various management levels
understand that all of them are part of the
management team. Click here to read full
article.

Advantages and Disadvantages of

Standard Costing System:
The use of standard costs is a key element
in a management by exception approach. If
costs remain within the standards,
Managers can focus on other issues. Click
here to read full article

Standard Costing Discussion Questions

and Answers:
Find answers of various important
questions about standard costing system.
Click here.

Standard Costing and Variance

Analysis Formulas:
A collection of variance formulas /
equations which can help you calculate
variances for direct materials, direct labor,
and factory overhead. Click here to read
full article

Standard Costing and Variance

Analysis Problems and Solution:
Find a collection of comprehensive
problems about standard costing and
variance analysis. We have also provided
the solution. Click here