411. Benefit-Cost Analysis decision criteria

The question of whether to use Benefit: Cost Ratio or Net Present Value or Internal Rate of Return is “a world of confusion,” because textbooks and guidelines on Benefit-Cost Analysis often give incorrect advice about it. We’ve now published our advice on how to get it right.

I previously wrote several Pannell Discussions about this (PDs 322, 323 & 324) and there is also a video of a seminar I gave on this topic, here.

Our initial attempts to publish it failed, because of the way we had written it up as a criticism of existing textbooks and guidelines. We changed the approach to make it more constructive and submitted it to Applied Economics Teaching Resources, where it has now been published.

Here is the abstract of the published paper:

Net present value (NPV), benefit: cost ratio (BCR), and internal rate of return (IRR) are fundamental concepts of benefit-cost analysis (BCA), providing helpful criteria for decision making about investments. However, textbooks on BCA are remarkably inconsistent in the advice they provide about which of these decision criteria should be used, potentially creating confusion among teachers and students. We present an existing conceptual framework that clarifies which of the three criteria should be used in particular decision contexts, depending on whether the projects in question are independent or mutually exclusive, and on whether the projects are resourced from a fixed pool of funds. The framework reveals that some of the advice provided by particular textbooks is incorrect, and some is correct only in certain decision contexts. Some books dismiss the use of BCR in general, but we show that it is the preferred criterion in certain cases and clarify how it should be calculated. The argument that BCRs can be manipulated by moving costs between the denominator and the numerator is fallacious. Recognizing that these decision criteria should not be applied mechanistically, we argue that the framework presented has the potential to improve decision making in many cases.

Further reading

Pannell, D.J., Nguyen, H.T.M., Chu, H.L., Kompas, T. and Rogers, A.A. (2024). Benefit-Cost Analysis decision criteria: Reconciling conflicting advice, Applied Economics Teaching Resources 6(1). Full paper here