For example, supppose practitioners needed to evaluate a program that is intended to boost employment. To assess this program, they might calculate the cost incurred for each person returned to work. Likewise, suppose practitioners needed to evaluate a program that is intended to reduce the incidence of influenza. Again, they could calculate the cost associated with each person who did not contract this illness as a consequence of the initiative. This calculation of the cost per unit of outcome achieved is called a cost effectiveness analysis.
Typically, cost effectiveness analysis is conducted to identify which of several options is the best means to fulfill a particular goal. In contrast, cost benefit analysis is usually conducted to ascertain whether or not a specific program or initiative should even be implemented. For example, a novel program to improve the wellbeing of employees might be compared to the existing practices. A cost effectiveness anslysis might reveal the cost for decreases in the prevalence of depression might be $1000 per person. If this cost is deemed to be sufficiently low, the initiative is regarded as cost effective, although this judgment is arbitrary and does not imply the initiative saves money.
Usually, a cost effectiveness analysis is conducted to compare two or more initiatives with each other. One initiative is often more costly, but also more effective, than is another initiative. In these instances, practitioners need to decide whether the additional cost is warranted.
A cost effectiveness analysis focusses on marginal, not absolute, costs and benefits. That is, the marginal cost of the inexpensive initiative, sometimes called the incremental cost, is the difference between the cost of this program and the cost of no program at all. The marginal cost of the expensive initiative, however, is the difference between the costs of this program and the costs of the inexpensive program--not the costs of no program at all. Likewise, the marginal benefits of the inexpensive initiative is the difference between the benefits of this program and the benefits of no program at all. The marginal benefits of the expensive initiative is the difference between the benefits of this program and the benefits of the inexpensive program. The final calculation is the ratio of marginal costs to marginal benefits for each alternative.
Step 1. Identify the projects or initiatives you need to compare.
Calculations change when practitioners include or exclude a possible program from their analysis. That is, cost effectiveness analysis focusses on marginal costs and benefits--that is, costs and benefits when compared with the less expensive alternative. Sometimes, several different versions of some program might be possible. A program to reduce diabetes, for example, could be directed to individuals most at risk or a broader segment of the population. Calculations will depend on whether or not these alternatives are deemed as separate programs.
Step 2. Determine which individuals are assigned "standing".
Sometimes, practitioners cannot readily decide which individuals are assigned standing--which individuals are assumed to incur the costs and receive the benefits. For example, consider a program that is intended to reduce diabetes. In this instance, whether or not travelers, who are not citizens of this region, should be assigned standing is unclear.
This ambiguity can also apply to the costs. For example, suppose an organization will receive a grant only if it implements some program. In this instance, the grant is not a cost, and is potentially a benefit, of the program. In contrast, some the organization will receive the grant, regardless of whether or not it implements this program. In this instance, the grant is a cost--the funds could be used elsewhere if the program was discarded.
Step 3. Stipulate the costs and benefits.
Practitioners need to identify the costs and benefits. Several complications can arise when costs need to be catalogued. First, in addition to operating costs--such as salaries, supplies, communication, and distribution--practitioners need to consider support costs--such as depreciation of resoures, heating, lighting, rent, insurance, tax, and administration, particularly human resources, budgeting, accounting, and information technology. Operating costs relate to the payments to operate the program. Support costs relate to activities that facilitate the operation of this program.
Second, some costs are intangible and not readily translatable to money, such as leisure time. Economists sometimes measure these intangible costs, or benefits, as the money that individuals are willing to pay for such activities. Perhaps a survey, for example, could determine the average amount that individuals are willing to pay to increase the leisure time by one hour.
Third, some factors are not universally regarded as costs, such as social and environmental implications. Finally, opportunity costs need to be included--which is the next best economic activity that needs to be rejected as a consequence of this program.
Step 4. Estimate the discounting of costs.
Costs that can be payed in the future are considered less onerous. For example, suppose an organization owes a company $1000, but can pay in 5 years time. They are, presumably, able to invest this $1000 elsewhere. Depending on the interest rate, they could earn perhaps $200 in that five years. Accordingly, the net cost is really $800 not $1000.
Formulas have been formulated to estimate these discounts. For example, the estimated cost now, such as the $800 in this example, equals the actual cost in the future, such as $1000, divided by (1 + i) to the power of t. In this formula i is the interest rate and t is the number of years in the future.
Step 5. Sensitivity analysis.
Often, practitioners will conduct a sensitivity analysis. A sensitivity analysis shows the range of outcomes that emerge if various predictions are not entirely accurate. For example, the practitioner might compute the cost effectiveness of programs if the interest rates varied from 1% to 10%. Alternatively, the practitioner might compute the cost effectiveness of programs if the rate of utilization ranged from 50% to 100%. Usually, the practitioner will construct a table with the cost effectiveness associated with a broad range of possibilities on these variables.
Often, practitioners use some data from a limited sample to calculate the costs or benefits of some program. This sample is then used to predict costs and benefits in the future. Unfortunately, in many instances these data are not representative of future programs. That is, the program might have been modified, improved, or streamlined, for example.
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McDavid, J. C., & Hawthorn, L. R. L. (2006). Program evaluation and performance measurement: An introduction to practice. London: Sage.
Weinstein, M. C., Siegel, J. E., Gold, M. R., Kamlet, M. S., & Russell, L. B., (1996). Recommendations of the panel on cost-effectiveness in health and medicine. Journal of the American Medical Association, 276, 1253-1258.
Weinstein, M. C., & Stasson W. B. (1977). Foundations of cost-effectiveness analysis for health and medical practice. New England Journal of Medicine, 296, 716-721.
Last Update: 6/1/2016