6.3 Benefit-Cost Analysis
A benefit-cost analysis (BCA) (or cost-benefit analysis) is a decision making tool that attempts to balance the components of a project in order to maximize its net benefits and/or minimize its costs. In this analysis, we try to quantify the costs of project factors that do not truly have monetary costs; for example, loss of life is often assigned a monetary value. These values are then incorporated into the analysis along with other financial costs. Using BCA, decision makers try to either maximize benefits for a set cost, minimize costs for a set level of benefit, or find the most beneficial compromise when both costs and benefits are variable. For any project to be worthwhile, the benefits must exceed the costs.
6.3.1 Service Projects vs. Revenue Projects
When evaluating various projects, it is important to draw a distinction between revenue projects and service projects. A revenue project is one that will generate both costs and revenues over its project life. When choosing between multiple revenue projects, you should select the alternative with the highest NPV. Nearly every example we have discussed so far in this text fits the definition of a revenue project.
A service project is one that will generate costs, but not revenues, over its project life, or whose revenues are constant regardless of the project alternative chosen. When choosing between multiple service projects, you should select the alternative that performs the service at the lowest cost. For example, a city contracts a company for residential garbage collection. Since the program generates no revenue for the city, when contracting a company to run the collection program, it should choose the business that will run the program at the lowest cost, or do it themselves.
6.3.2 Economic Sectors
Importantly, the concept of a service project should not be confused with concepts of services or the service sector. As a significant distinction, all types of economic activity are sometimes divided into three sectors: the primary sector, the manufacturing sector, and the service sector. The primary sector involves producing raw materials, and covers activities like mining, fishing, and agriculture. The manufacturing sector involves (as you might have guessed) manufacturing products from those raw materials. Finally, the service sector supplies services to consumers, where a service is anything intangible with economic value.
While the service sector might seem the most abstract of the three economic sectors, it is an enormous part of the economy for any developed country. Even in Canada, which has significant and well-developed natural resources, the service sector accounts for over 70% of the nation’s GDP (Statistics Canada, 2017). The service sector includes a wide-range of industries including retail, transportation, insurance, real estate, health care, and education.
In Chapter 1 we covered how a manufacturing business might set costs for its products. By und