If you’ve seen a cost-benefit study reported or talked about in passing, you’ve probably heard a phrase that sounds like some sort of variation of “for every dollar you put in, you get $X out.” In cost-benefit, this is what we call a “benefit-cost ratio.”
Why do we use benefit-cost ratios? Well, they are intuitive. If you get more dollars out than you put in, sounds like a good deal, no? So benefit-cost ratios help us communicate a core insight from cost-benefit analysis.
Another use for benefit-cost ratios is in trying to figure out how to allocate a limited budget. If a government has limited funds and cannot increase its revenue, benefit/cost ratios are a great way to compare programs.
For instance, if a state government is doling out money for tackling substance abuse problems and a local government is trying to figure out how to spend it, local policymakers can turn to the Washington State Institute for Public Policy’s benefit-cost tables for substance abuse and order the programs from highest benefit-cost ratio to lowest. They can then eliminate low-yield programs and use a mixture of higher-yield programs, or if funds are very limited, just choose one of the programs has a higher benefit-cost ratio.
So if benefit-cost ratios have so much value, why do cost-benefit analysis textbooks and professors emphasize a different way of communicating cost-benefit results—"net benefits”—so much?
First, let’s establish what net benefits are. While a benefit-cost ratio is calculated by dividing benefits by costs, net benefits are calculated by subtracting costs from benefits.
Benefits / Costs = Benefit-Cost Ratio
Benefits - Costs = Net Benefits
So let’s say, for instance, that a county government was entertaining a proposal to implement a pre-k program that would generate $4 million in social benefits and $1 million in social costs. In this instance,
Benefits / Costs = $4 million / $1 million = 4 benefit-cost ratio
Benefits - Costs = $4 million - $1 million = $3 million of net benefits.
So what do people like about net benefits? Well, what matters is when net benefits diverge from benefit-cost ratios.
Let’s use an example here. Say a state legislative leader is trying to make a big impact in the world of education. She finds that a state universal early childhood education program would yield a little over $3 in benefits for every dollar invested and would help students enrolled to the tune of about $15,000 per student enrolled. Conversely, she finds that Second Step, a program for aggressive children, yields over $5 in benefits for every $1 invested but likely will impact a lot less children and will have a lower per-child impact as well at just about $500 in benefits per child.
If the legislator wants to raise a small amount of money, Second Step might be a better program. If the legislator is willing to raise the large up-front costs for universal pre-k, the net benefits will justify that revenue, even if it is more expensive to generate those dollars.
Ultimately, both measures are beneficial. Benefit-cost ratios are easier to explain, but they also don’t paint the whole picture. Cost-benefit studies would do well to include both of these results so policymakers can utilize a more full understanding of the policy when making a decision about what to fund.