Benefit-Cost Analysis Decision Criteria: Reconciling Conflicting Advice

Abstract

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. Show more