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Part I
Introduction and problem formulation
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1 Introduction
Military cost–benefit analysis: theory and practice
Francois Melese, Anke Richter, and Binyam Solomon
1.1 Background
Military cost–benefit analysis (CBA) offers a vital tool to help guide governments through both stable and turbulent times. As countries struggle with the dual challenges of an uncertain defense environment and cloudy fiscal prospects, CBA offers a unique opportunity to transform defense forces into more efficient and effective twenty-first-century organizations.
Defense reforms typically involve politically charged debates over investments (in projects, programs, or policies) as well as contentious divestment decisions—from base realignment and closure (BRAC) to outsourcing and asset sales. A powerful contribution of CBA is to inform such complex and contentious decisions—carefully structuring the problem and capturing relevant costs and benefits of alternative courses of action. Lifting the veil on military CBA, this edited volume reveals several systematic quantitative approaches to assess defense investments (or divestments), combined with a selection of real-world applications.
The frameworks and methods discussed in the following chapters should appeal to anyone interested or actively involved in understanding and applying CBA to improve national security. These valuable approaches also have broader government-wide applications, especially in cases where it is difficult to monetize the benefits of a public project, program, or policy.
Unprecedented government spending to counter the global financial crisis has placed enormous pressure on public budgets. Combined with alarming demographics, many countries struggle to fulfill past promises to underwrite health care expenditures, social security payments, government pensions, and unemployment programs. As debt burdens grow to finance current operations, the risk of escalating interest payments threatens to crowd out vital future public spending. As the single largest discretionary item in many national budgets,1 military expenditures make a tempting target. Especially vulnerable are military and civilian compensation (pay and benefits) and the purchase and operation of equipment, facilities, services, and supplies.
Anticipating future spending cuts, this book explores both conventional and unconventional approaches to contemporary defense decisions—from critical investments in facilities, equipment, and materiel to careful vendor selection to build, operate, and maintain those investments. Recognizing the value of systematic quantitative analysis, senior US Army leadership has “directed that any decisions involving Army resources be supported by a CBA.”2
Faced with severe budget cuts and an uncertain threat environment, defense officials around the world confront urgent decisions on whether to approve specific projects (e.g. infrastructure—military housing; training, and maintenance facilities) or programs (e.g. weapon systems—unmanned aerial vehicles (UAVs), armored personnel carriers (APCs), cyber defense). Military CBA offers a valuable set of analytical tools to increase the transparency, efficiency, and effectiveness of critical defense decisions.
A synthesis of economics, management science, statistics, and decision theory, military CBA is currently used in a wide range of defense applications in countries around the world: i) to shape national security strategy, ii) to set acquisition policy, and iii) to inform critical investments in people, equipment, infrastructure, services, and supplies. This edited volume offers a selection of carefully designed CBA approaches, and real-world applications, intended to help public officials identify affordable defense capabilities that effectively counter security risks in fiscally constrained environments.
1.2 A brief history of cost–benefit analysis
The French engineer Jules Dupuit (Dupuit 1844) is widely credited with an early concept of CBA called “economic accounting.” The British economist Alfred Marshall (Marshall 1920) later developed formal concepts that contributed to the analytical foundations of CBA.3 In a pioneering survey, Prest and Turvey indicate that as early as 1902 the US River and Harbor Act required the Army Corps of Engineers to report on the desirability of any project, taking into account both the cost and the amount of “commerce benefited” (Prest and Turvey 1965). Widespread application of CBA in the United States is generally attributed to the 1936 Federal Navigation (Flood Control) Act. This required the Army Corps of Engineers to carry out projects to improve waterways when “the benefits to whomsoever they may accrue are in excess of the estimated costs” (Prest and Turvey 1965).
At the heart of CBA is the economists’ concept of “allocative efficiency,” in which resources are deployed to their highest valued use to maximize social welfare. A related and intuitively appealing definition called “Pareto efficiency” underpins CBA. An allocation is Pareto-efficient if no alternative allocation can make at least one person better off without making someone else worse off (Pareto 1909).
The link between allocations that yield maximum net benefits in CBA and Pareto efficiency is straightforward: If a public policy, program, or project has positive net benefits, then it is possible to find a set of transfers (side payments) that make at least one person better off without making anyone else worse off. Unfortunately, transfers necessary to achieve Pareto efficiency are difficult to implement in practice. Therefore, out of practical necessity, CBA relies on a related decision rule called the Kaldor–Hicks criterion (Kaldor 1939; Hicks 1940). This decision rule states that a public policy, program, or project should be adopted, if and only if gainers could potentially fully compensate losers, and still be better off.4
Application of this decision rule is relatively straightforward:5 Adopt all projects that have positive net benefits.6 An important caveat is that the Kaldor–Hicks criterion only applies when costs and benefits can be monetized. Given the prevalence of non-monetary benefits in national defense, this poses a serious challenge for the security sector.
The growing interest in CBA after WWII is often attributed to rapid developments in operations research and systems analysis—techniques that helped win the war by combining economics, statistics, and decision theory. Following the allied victory, Project RAND (launched in 1946 by the Army Air Corps) received government funding to maintain scientific expertise developed in WWII and to conduct independent and objective research in national security.
A key contribution of RAND’s research was “systems analysis” pioneered by Ed Paxson and advanced by Charles Hitch who in 1948 founded RAND’s Economics Division. Whereas operations research had a more immediate, wartime focus (e.g. finding the best short-run solution to a military mission, given a restricted set of equipment, etc.), systems analysis was more future-oriented, focused on finding the optimal mix of doctrine, forces and equipment necessary to accomplish a military goal at the lowest possible cost (or alternatively, for a given budget, to find the optimal mix that maximizes defense capabilities).
Working at RAND in the immediate post-war era, Hitch teamed up with another economist, Roland McKean, to publish a pioneering text entitled The Economics of Defense in the Nuclear Age (Hitch and McKean 1960). The authors emphasized two main ways in which military CBA can be applied: i) to guide defense policy (i.e. the allocation of resources between major missions or military goals) and ii) to guide defense investments (i.e. choices between alternative projects or programs to achieve a given mission or goal). A significant challenge in applying CBA to defense decisions is the complex and often controversial task of measuring “benefits.”
At the highest national strategic level, “benefits” of a specific defense policy7 might be measured in terms of its impact on long-term economic growth, peace, and prosperity—all key contributors to social welfare. For example, suppose resource costs to achieve specific military goals are viewed as insurance payments against hazardous states of the world. Suppose further that defense policy decisions that achieve specific military goals reduce risk premiums associated with domestic and foreign direct investment (FDI). Empirical evidence suggests that FDI boosts economic growth and in turn contributes to peace and prosperity.8 In this example, high-level defense decisions could ideally be made with the aim of increasing social welfare by encouraging investment, boosting GDP, and thereby generating a virtuous cycle of peace and prosperity.
In reality, this high-level effort to capture monetary benefits of defense policy as growth in GDP is rarely explored.9 Instead, it typically gives way to a more familiar perspective that makes up the bulk of chapters in this edited volume—where non-monetary “measures of effectiveness” (MoEs) of a policy, project or program substitute for monetary benefits.
Denied the opportunity to conduct controlled experiments or full-scale independent field tests to evaluate alternative policies, projects or programs, military officials and analysts are forced to resort to “proxy” variables. These include criteria and characteristics that reflect multiple objectives and that describe essential features of the alternatives being analyzed.10 When benefits cannot be monetized, the terms “systems analysis” or “cost-effectiveness analysis” (CEA) are often used to describe military CBA.11
A related literature, alternately called multi-criteria decision-making (MCDM) or multi-objective decision-making (MODM), rapidly evolved after WWII to address the challenge of measuring non-monetary benefits of defense investments. The reader is encouraged to explore this literature for details on competing benefit measurement strategies, some of which are discussed in this volume. These measures have been in continuous development since the adoption of systems analysis by the US Department of Defense in the early 1960s.12
Following his election as President in 1960, John F. Kennedy appointed Robert McNamara Secretary of Defense. McNamara subsequently hired Charles Hitch as Comptroller to implement the Planning, Programming, and Budgeting System (PPBS) that Hitch had earlier helped develop at RAND. An output-oriented budgeting framework, PPBS relies heavily on systems analysis, or military CBA, to build a defense budget.
Prior to Hitch’s tenure in the Office of Secretary of Defense, US defense budgets were largely based on the services’ (Army, Navy, Air Force) proposals for annual incremental increases in inputs or “appropriation” categories (military personnel, procurement, operations and maintenance, military construction, etc.), often with little or no clear connection to defense outputs, joint missions, or national security goals. Having successfully employed a variant of PPBS called “program budgeting” as CEO of Ford Motor Company, McNamara recognized the value of building a defense budget that focuses on outputs (benefits) as well as costs.
The major innovation of PPBS is “programming,” which bridges the gap between long-term military planning goals and short-term civilian budget realities. Designed as a constrained optimization underpinned by systems analysis, the “programming” phase was intended to produce a cost-effective mix of forces to maximize national security subject to funding constraints.13
Under certain conditions, the optimal allocation of a budget across various inputs (e.g. defense resources) that contribute to a common goal (i.e. increasing national security) requires the marginal contribution of each input towards that goal, for a given incremental cost, to be the same for any input. Since this decision rule is independent of the units in which the goal is measured, in principle it provides a valid test for allocative efficiency, satisfies the condition for Pareto optimality, and guarantees the most effective use of a defense budget.14
To implement PPBS, Hitch hired a RAND colleague, Dr Alain Enthoven, as Deputy Comptroller for Systems Analysis. In 1965, the impact of military CBA was reinforced when Dr Robert Anthony ...
