HOW DO PROPERLY DO A COST BENEFIT ANALYSIS

In their recent bestseller Decisive, Chip Heath and Dan Heath are critical of a decision-making method that is tantamount to doing a cost/benefit analysis. Given how common cost/benefit analyses are used in business decisions, it would be remarkable if indeed such a method was, as Heath and Heath claim, “profoundly flawed”.

 

Heath and Heath trace the origin of this method to Benjamin Franklin. In 1772, in response to a colleague’s request for advice concerning a job opportunity, Franklin suggested that he “divide half a sheet of paper by a line into two columns, writing over the one Pro and over the other Con.”  If the pros outweigh cons, he should take the job.  If the cons outweigh the pros, he should not.

 

Heath and Heath offer several criticisms of this method, but primarily the problem is that by merely looking at the pros and cons of one action, one is narrowly framing the decision into a choice between doing X and not doing X. Obviously this is not a good way to do a cost/benefit analysis and Heath and Heath provide several examples of bad decisions that resulted from using this method. However, are Heath and Heath justified in their claim that the method is “profoundly flawed”?  The method they describe is, in fact, only a small step in a proper cost/benefit analysis.

 

The proper form of a cost/benefit analysis owes it origins to the Utilitarianism of Jeremy Bentham and John Stuart Mill.  According to (Act) Utilitarianism, an act is the right act for an agent to perform in some set of circumstances if and only if it is the best act available to the agent (or is at least as good as any alternative act available to the agent) in those circumstances. The best act available to an agent in a given set of circumstances is the act which, of all the alternatives available to the agent in those circumstances, would produce the greatest net sum total of utility.  In other words, one shouldn’t necessarily perform an act merely because it has a positive net utility.  One must consider the net utility of all available alternatives, and choose the act that has the highest net utility of those available alternatives.

 

Similarly, a proper cost/benefit analysis is not merely a consideration of whether one should do X by weighing the costs of doing X against the benefits of doing X and concluding that one should do X if the benefits outweigh the costs of doing X.  The first step in doing a cost/benefit analysis is the consideration of what all the available options are. One then evaluates the benefits and costs of each of those options and chooses the option that has the best net effect.

 

For example, suppose action X would have 5 units of benefit and only 3 units of cost.  Should company A do action X?  The answer is no, not necessarily since one hasn’t considered the net effects of any other options.  Perhaps an alternative option, action Y, has 6 units of benefit and only 3 units of cost.  Maybe there’s even a third option, option Z, which would produce 5 units of benefit but has only 1 unit of cost.  We can represent the options in the following chart:

 

Option     Action X     Action Y     Action Z

Benefit          5                 6                5

Cost              3                  3                1

Net                2                 3                4

 

As we can see, the correct decision is this case, is to perform action Z as it has the highest net benefit of all available options.  Deciding to perform Action X when Action Z is an alternative would be a bad decision.

 

How does one ensure that one is considering all the available options?  Our method is to do a cost/benefit argument analysis.  The first step in a cost/benefit argument analysis is to construct an argument of the following form:

 

  1. 1. The only available alternatives are A1, A2, …

  2. 2. The costs of A1, A2,… are C1, C2,…

  3. 3. The benefits of A1, A2,… are B1, B2,…

  4. 4. The overall value of C1-B1 is greater than the overall value of C2-B2, …

Therefore,

5. We should do A1

 

We then evaluate this argument.   Part of evaluating the argument involves evaluating the premises.  Are the premises reasonable to believe? Is it true that the only available alternatives are what you list them to be in premise 1? Notice that by performing a cost/benefit argument analysis you are forced in considering all the available alternatives.  What about the other premises?  Is it reasonable to believe that the costs associated with each option are what you claim they are in premise 2? Is it reasonable to believe that the benefits associated with each option are what you claim they are in premise 3?  

 

In summary, the benefits of a cost/benefit argument analysis are that it:

 

  • Forces you to look at all available alternatives;

  • Forces you to consider what the costs of each alternative is;

  • Forces you to consider what the benefits of each alternative is;

  • Ensures that you make the best decision!