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Cost Benefit Analysis Framework


Guidelines on Assessing Policy Options

Regulatory Impact Analysis Unit, Effective Markets Branch
[ Last Updated 23 April 2007 ]


Within this section …

6. These guidelines suggest using a cost benefit analysis framework because it is simple, systematic, and ensures that all of the relevant information is put before decision-makers.

What Is Cost Benefit Analysis?

7. Cost benefit analysis (CBA) means:

  • analysis of the status quo;
  • identifying the full range of feasible options;
  • identifying and understanding the impacts of each option (including the status quo);
  • assessing the magnitude of all options' impacts; and
  • comparing the options and identifying the best option (by weighing up the costs and benefits, often using a net benefit and/or benefit cost ratio criterion).

8. The cost benefit analysis framework is generic enough to be used in all policy areas. Cost benefit analysis does not necessarily mean calculating the dollar value of all impacts. Another common misconception is that cost benefit analysis applies primarily (or only) to economic proposals - this is incorrect: cost benefit analysis can and should be applied to all types of policy development. It is simple, systematic, and ensures that all of the relevant information is put before decision-makers; it is not area specific and you do not need a thorough understanding of economics to undertake a mainly textual/qualitative cost benefit analysis or quantify some impacts.

Cost Benefit Analysis Is Only One Input into the Decision Making Process

9. The decision as to which option is best does not stop once you have completed your cost benefit analysis. A comparison of options by a simple comparison of each option's costs and benefits implies that all impacts are valued equally. Sometimes this is not appropriate. In these cases you should focus on the policy objectives and whether certain impacts should have a greater or lesser weighting than others.1

10. The source of these objectives or weightings may come from an assessment of society's preferences,2 which may be estimated through careful consideration of submissions during consultation, polling and surveys, or looking at where political representatives stand on issues. Alternatively, your Minister may wish to include the Government's preferences, and leave Parliament to debate the appropriate weights to use. You need to be aware of and explicit about these weightings, whichever set of preferences is used.

Levels of Cost Benefit Analysis

11. There are different levels of CBA. The level you should use depends on how significant the proposal is. The main principle is that the level of analysis should be commensurate with the significance/magnitude of the proposal. How significant a proposal is depends on how large the impacts are and how controversial the proposal will be. For more guidance on the level of analysis you should undertake, see What Level of Analysis Is Required?.

12. Carrying out an appropriate level of analysis is important for ensuring that your policy development is robust, and is also relevant for ensuring compliance with the regulatory impact analysis (RIA) requirements (see RIA Guidelines).

Mainly Textual/Qualitative Cost Benefit Analysis

13. A mainly textual/quantitative CBA may be appropriate for less significant proposals. It is different from quantitative CBA in two ways:

  • Whereas quantitative CBA requires that all or most impacts are quantified in dollar terms, a textual CBA will describe all of the impacts, giving assessments of magnitude where these are available. It is a "weighing up" exercise - you state the relative size of impacts compared with other quantifiable or unquantifiable impacts.
  • Whereas in quantitative CBA you calculate the net benefit and/or benefit-cost ratio, in a textual CBA the preferred option is identified by comparing the relative size of impacts without necessarily making overall calculations.

Formal Quantitative Cost Benefit Analysis

14. When to undertake a quantitative cost benefit analysis. You should strive to undertake a quantitative CBA when the proposal is likely to be significant. For the most significant proposals, this will be required in order for your analysis to be adequate (as assessed against the RIA adequacy criteria). Formal quantitative cost benefit analysis can be expensive so for less significant proposals, a mainly textual analysis may be preferred.

15. What is formal quantitative cost benefit analysis? Formal quantitative cost benefit analysis means, in addition to identifying the full range of feasible options and all of the impacts of these options:

  • quantifying all impacts in dollar terms;
  • converting all costs and benefits to their present value (for more detail on calculating the net present value, see Appendix 3);
  • identifying the best option by:
    • identifying the option with the highest net benefit (benefits minus costs); and/or
    • identifying the option with the highest benefit-cost ratio (benefits divided by costs).3

16. What if I cannot quantify some impacts? For more guidance on how to quantify, see Assess the Magnitude of Each Impact of Each Option. You can still carry out a formal quantitative CBA even if you are unable to quantify some impacts. One way to factor in these impacts is to exclude them when you calculate the net benefit or benefit-cost ratio, then test how high the benefits or costs would have to be to influence your decision. For example, suppose you are using a net benefit criterion and for one of the options you are able to quantify all impacts apart from one of the benefits. If you find that this benefit would need to be worth at least $200,000 for the option to be preferred, you can still make a decision based on a quantitative CBA by estimating whether the benefit would be valued at $200,000 or more.

17. More guidance on formal quantitative CBA is available in Treasury's Cost Benefit Analysis Primer [link to Treasury website].

18. For more guidance on the level of analysis you should undertake, see What Level of Analysis Is Required?.

Alternatives to Cost Benefit Analysis

19. This document provides a brief description of two alternatives to cost benefit analysis, but the guidance in the rest of the document is only about cost benefit analysis, as this is the recommended approach.

Where There Are Multiple Objectives

20. Where multiple objectives are involved (for example, there are a number of criteria in addition to or instead of a cost benefit criterion), you should assess the options against all of the objectives. This is often referred to as "multi-criteria analysis". Note that multi-criteria analysis is different from setting policy objectives and then doing a cost-benefit analysis: multi-criteria analysis means focussing only on the objectives and largely ignoring other costs and benefits. If you are assessing options against multiple objectives, it may be useful to produce a table that indicates how well each option achieves each objective. While focussing on the objectives of the proposal (rather than the costs and benefits) is a useful exercise, you should always bear in mind all impacts of a proposal and the potential for unintended consequences. You should also note that multi-criteria analysis is a useful complement to cost benefit analysis.

Cost Effectiveness Criterion

21. Cost effective analysis can be used on those occasions when the Government specifies an objective below which it will not be willing to trade off other objectives. For example, in introducing competition to the Employers' Account of the ACC Scheme, it was agreed that claimant access to entitlements was not to be compromised by insurer insolvency. The appropriate mechanism for assessing options for achieving this objective then becomes cost effectiveness analysis. That is, the option expected to achieve the specified objective at least cost. Analysis of benefits, in this case, is not required. Cost effectiveness analysis should only be used where the different benefits associated with different options is not important - this is not likely to be often (cost benefit analysis is usually more appropriate).

22. Cost effectiveness analysis measures provide an index of the relative cost to society of various options for promoting a particular objective (usually expressed as cost per unit of benefit). Within the context of risk regulation, for example, the task of this approach is to ascertain which policies minimise the cost of reducing a given risk.

23. A critical difference between cost-effectiveness analysis and quantitative CBA is that, for the former, benefits need not be valued explicitly. The cost-effectiveness measure calculates the cost per unit of benefit but otherwise does not assign dollar values to outcomes. The data needs for cost-effectiveness tests will consequently be less. It should also be noted that cost effectiveness analysis does not easily deal with multiple objectives.

1

Risk weightings
When addressing a risk problem, you should consider, and be explicit about, what risk profile you are applying to the impacts, i.e. the level of risk aversion being used. A higher level of risk aversion means that costs from an adverse event occurring will be more important relative to the costs of mitigating the risk than with a lower level of risk aversion, so that more should be done to avoid the adverse event. Scenario analysis might be useful in some circumstances when considering the impact of different risk profiles (depending on the nature and significance of the option).
Equity weightings
Impacts are likely to be weighted for equity or distributional concerns. To do this, you need to make judgements about how much weight to give to impacts on different affected parties. This weighting is also important for how to value distributional impacts, for example an option may be favoured that has the same net benefit as another but distributes those benefits more equally (who is affected can be as important as the aggregate impact).

2 Whichever is most appropriate in the situation.

3 Note that for both of these tests, the benefits and costs need to be discounted.


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