Before economists came along and formalised the concept, people had long tried to weigh up the costs and benefits of pursuing different choices. The American polymath Benjamin Franklin was one of the first to document this in a letter to a friend:

“When difficult cases occur, they are difficult chiefly because while we have them under consideration, all the reasons pro and con are not present to the mind at the same time. To get over this, my way is to divide half a sheet of paper by a line into two columns; writing over the one ‘Pro’, and the other ‘Con’.”

Franklin nailed the underpinnings of a modern cost-benefit analysis (CBA) where the benefits of the decision are weighed against the costs - with whichever side weighing the most winning. All of us make decisions like this every day. Whether they be choices about whether to take the car or public transport to work, or cook dinner or eat out we are weighing up benefits we may gain in time and enjoyment versus the additional expense.

What is a cost-benefit analysis?

In theory, undertaking a CBA seems as straightforward as Franklin suggests, you sum up the costs and benefits in separate columns and see which is better off. In reality it can be more complex. What if the benefits and costs are not immediately obvious? Or occur simultaneously? How do you take into account an intangible benefit that might occur five years down the road?

These are overcome by expressing benefits and costs in monetary terms and discounting them by the time value of money. This allows costs and benefits, which generally occur at different time periods, to be expressed in terms of their net present value. By monetising benefits a CBA allows decision makers to assess whether a policy intervention is a sound investment, as well providing the ability to compare it with competing policy options - developing a new car ferry might look like a good investment, but a new bridge might be an even better one.

In public policy, CBAs have been used to assess investment decisions relating to major capital projects like building a new motorway or an extension to an airport. In recent times developments in economic theory and practice in the past decade have meant that CBA has become not only an accessible tool, but a preferred method, of allocating scarce investment resources across worthy causes in social policy too.

How do you put a number on that?

In the context of social provision, a CBA is based on a rigorous evaluation of a programme’s actual impact on an outcome of interest - for example, reoffending among released prisoners. The results of an high quality evaluation (like a randomised-control trial) can be compared to a meta-analysis of a systematic review of the literature.

The impact that the program has on reoffending for example can be translated into the economic benefit that it generates for state, for the released prisoner and for society more widely by examining the relationship between lower reoffending rates and other outcomes that have a financial impact. In this case that might mean benefits to the state from reduced police, courts and corrections costs that are no longer incurred, benefits to society from reduced victimisation costs from lower crime and benefits to the individual from higher lifetime earnings as they are now employable.

Why is it better than other methods?

Whereas other economic techniques like cost-effective analysis or cost utility analysis - popular methods used in healthcare and pharmaceutical decision making - compare two or more interventions based on a common unit of measurement. The monetisation of benefits in CBA allows decision makers to compare the relative costs and benefits across a suite of interventions in different policy areas. This attribute allows governments to be able to determine, for example what proportion of resources should be spent on early intervention and prevention versus treatment‑based interventions.

In econospeak the difference between effectiveness and efficiency is akin to the difference between doing the right things and doing things right. To improve efficiency, you must first be doing something effective. By using money as a metric it is possible to compare the benefits across a range of activities. It also allow the benefits from interventions that flow across sectors to be included, bolstering the case for investment.

In the U.S., it has been demonstrated that the Nurse Family Partnership - which provides maternal and early childhood support to low income mothers - has positive health benefits for the mother as well as long term benefits educational, employment and criminal justice benefits for their child.   

How can it be used to prioritise social policy spending?

In Australia we are facing increased demand for services, particularly in the health and justice space. Facing a situation like this it would be prudent to try and seek to get a greater efficiency dividend from the current resources we currently expend. However when it comes to making spending decisions we are largely flying blind. While they are no doubt made with good intentions, they seldom rely on a rigorous assessment of their relative effectiveness or efficiency at delivering tangible results.

It need not be this way. The Washington State Institute for Public Policy has been supporting the Washington State Legislature by providing impartial advice on the impact of policy spending decisions for over 30 years. Legislators have used the results of the Institute’s rigorous modelling to justify what could be considered radical changes to justice policy which have saved money and improved outcomes.