C9.4 CBA Limitations

 

While CBA continues to be a primary tool for economic evaluation, adequate use of the tool requires a clear understanding of its limitations and pitfalls. It is important to keep in mind that CBA should not be used to set the ends of policy, but it may be used to set the most cost effective means of implementing the predetermined policy.

 

Limitations of CBA include:

  • Difficulties in Cost-Assessment.
    • A cost benefit analysis requires that all costs and benefits be identified and appropriately quantified. Unfortunately, human error often results in common cost benefit analysis errors such as accidentally omitting certain costs and benefits due to the inability to forecast indirect causal relationships. Additionally, the ambiguity and uncertainty involved in quantifying and assigning a monetary value to intangible items leads to an inaccurate cost benefit analysis. These two tendencies lead to inaccurate analyses, which can lead to increased risk and inefficient decision-making.
    • There is a lot of subjectivity involved when identifying, quantifying, and estimating different costs and benefits. Since some costs and benefits are non-monetary in nature, such as increases in customer and employee satisfaction, they often require one to subjectively assign a monetary value for purposes of weighing the total costs compared to overall financial benefits of a particular endeavor. This estimation and forecasting is often based on past experiences and expectations, which can often be biased. These subjective measures further result in an inaccurate and misleading cost benefit analysis.
  • Difficulties in Benefit Assessment.
    • There is an element of uncertainty in a new project as to the correct estimation of future price, demand and supply of its product. Another difficulty of measuring the benefit is the assessment of external economies. It has been stated during studies on LCA that the figures submitted to governments almost always involve exaggerated optimism and double counting.
  • There can be issued with joint costs (and joint benefits).
  • The side effects of a project are difficult to calculate in this analysis.
    • There may be spill over’s from a project, such as the effects of flood control measures or a storage dam on the productivity of land at other places in the vicinity. It is difficult to calculate such external effects of a project.
  • Market Imperfections
    • CBA works best in a regime of perfectly competitive markets with a large number of sellers and buyers, none of whom are in a position to dominate the market; but this condition is hardly met in actual practice. There are monopolies and there are governments whose interventions distort the market further. Therefore market prices need to be adjusted before these can be used for CBA.
  • Quantification of Intangibles
    • Attempts made to measure items of value that are generally immeasurable remain approximations and cannot be a perfect representation of the true value. The use of value judgements and assumptions becomes unavoidable. Thus, the quantification of intangibles is particularly susceptible to manipulation.
  • Income Distribution
    • Economic analysis is practiced to determine economic efficiency. Efficiency is measured without regard to who would get the benefits and who would incur the costs. Questions related to distribution of income are not taken up for consideration.
  • Discount Rate and Intergenerational Equity
    • Traditional CBA tends to give little weight to costs that occur far in the future and overly emphasize short-term gain. This is because a high discount rate tends to give a lower value to benefits which accrue after longer periods. It does the same for the negative effects that may arise in the distant future. It is therefore important that inter-temporal equity issues form an integral part of each decision-making process.
  • The final use of the CBA.
    • There is the possibility that the evaluative mechanism turns in to a proposed budget. When a project manager puts together a cost benefit analysis and presents it to a leadership team, the leadership team might view the expected costs as actual rather than estimation, which may lead to misappropriating costs and setting unrealistic goals when approving and implementing a project budget. This can put a project manager in an unfavourable situation when they attempt to control costs in order to maintain the expected profit margin.

 

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