benefit cost analysis and public sector economics

Copyright © Professor Deok-Joo Lee(Kyunghee University, Korea), Permission required for reproduction or display.

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CHAPTER 9

Benefit Cost Analysis and Public Sector Economics


Engineering Economy (2016) 2

9.1 Public Sector Projects

• Public Sector:• Ownership – by citizens(the public)

• Public Sector Projects:• Provide needed services to the public with “no profit”



Types of Projects

• Hospitals• Parks and recreation facilities• Highways, dams, bridges• Courts, schools, prisons• Public housing• Many other types


Engineering Economics (KHU, 2015) 4

Characteristics – Compared

Characteristic Public Sector Private Sector

Size of Investment

Larger Some Large; medium to small

Life Estimates Quite Long: 30-50 years

Shorter:2-25 years

Annual Cash Flow Estimates

No Profit: costs and benefits

Revenues –profit cost estimates



Estimating for Public Projects: Costs

• Basic elements for public projects:• Costs

• Construction, operations, maintenance less any salvage values• Initial costs are fairly well known• Future O&M are less known and must be estimated



Estimating: Benefits

• BENEFITS to the public (users) must be estimated in terms of periodic dollar values• Very difficult to do• Benefits = the advantages to the public stated in $$• Owners – generally the public



Estimating: Disbenefits

• Disbenefits• Expected undesirable (negative) consequences to the owners (public)• Assuming the project is undertaken• May be indirect economic disadvantages to the public• Very hard to estimate and convert to $ amounts



General Principle

• For public projects we find:

It is very difficult to estimate and reach agreement on the economic impacts of

benefits and disbenefits for public sector projects.



Funding Sources – Compared

Characteristic Public Sector Private SectorFunding Taxes, fees,

bonds, private funds

Sale of new stock, bonds, loans

Interest Rate Tends to be lower

Higher: At market cost



Funding Public Projects

• Generally low interest charges• Public entities do not pay taxes• Project investments basically backed by public agencies• Cost-sharing arrangements often exist• Less perceived risk with public projects



Determination of an Interest Rate

• Determined differently than in the private sector• Called the social discount rate• For Governmental Projects(Korea), a current working rate (2013) is 5.5% per year



Additional Comparisons

Characteristic Public Sector Private Sector

Selection criteria

Multiple Rate of return or present value

Environment of the evaluation

Political arena(debated,

pressure groups)

Primarily economic



Selection Process

• Not as “clean” as in the private sector• Involves interest and pressure groups• Often draws media attention• Involves many different viewpoints



9.2 B/C Analysis – Single Project

• Historical Point•B/C analysis philosophy was instituted and promoted by the Flood Control Act of 1936•Introduced to promote a sense of objectivity in an analysis



B/C Formulations

• Assignable life, N - years• Estimate costs ($)• Estimate benefits in ($)• Estimate disbenefits in ($)• Assign an interest rate – i (%/year)



B/C Formulations

• Then convert all amounts to either a• Present Worth – PW(i%)• Annual Worth – AW(i%)• Then calculate a B/C ratio in one of three ways

( )/(cos )

PW benefitsB CPW ts

=( )(cos )

AW benefitsAW ts

=( )

(cos )FW benefitsFW ts

=



Notes Regarding Signs

• By convention:• Revenues are assigned (+) signs• Costs are assigned (+) signs• Salvage values are subtracted from costs• Disbenefit values are subtracted from benefits



Decision Rule

• IF B/C ratio (=>) 1.00• Economically accept the alternative

• IF B/C ratio (<) 1.00, economically reject the alternativev IF B/C ratio “close” to 1.00, then intangible factors may sway the decision to accept or reject



Conventional B/C Ratio

• The conventional B/C Ratio is:

- disbenefits/ Benefits B DB CCosts C

-= =



Modified B/C Ratio

• Costs will be mainly initial investment• Subtracts the maintenance and operations costs in the numerator

modifiedBenefits - disbenefits-M&O costs/

CostsB C =



Convention vs. Modified?

• It makes no difference which approach is used• However, the ratio values will differ (magnitude)• But, the absolute (accept/reject) decision will be the same



Example 9.2



Profitability index(PI)

• Private perspective• PI = PW of NCF / PW of initial investment

Decision Guidelines of PI Analysis

If PI ≥ 1.0, project is economicallyjustified at discount rate appliedIf PI < 1.0, project is not economicallyacceptable



Example 9.3

• PW of investment=$80.02• PW of benefits=$158.23• PW of costs=$26.8• PW of disbenefits=$80.12



9.3 & 9.4 Incremental B/C for Multiple Projects

• Select from three or more mutually exclusive alternatives• Same approach as that in Chapter 8, Section 8.6• Remember, the Do Nothing alternative always exists and should be evaluated as an alternative.



Steps for Multiple Incremental Analysis

1. Using either PW or AW, determine the total equivalent cost for all options. If unequal lives, apply AW

2. Create the rankings based upon lowest to highest total cost of the alternatives

3. Calculate B/C for each alternative and eliminate all with B/C < 1.0



Steps – Continued

4. The lowest-cost option is the first Defender and the next-higher cost alternative is the first Challenger.Compute the B/C ratio on the increment.If ∆ B/C < 1, eliminate the Challenger, else (∆ B/C > 1) eliminate the Defender.Current winner becomes new Defender



5. Compare the new Defender to the next-higher-cost Challenger and repeat the analysis.

6. Continue through the alternative until there are no more Challengers.

7. The last “champion” is the winner.

Steps – Continued


Engineering Economy (2016)

Example 9.4 Incremental B/C

One of the two designs must be selected using i = 5% and B/C ratioAlternative A B

Construction cost, $ 10M 15MM&O costs, $/year 35,000 55,000Usage copay, $/year 450,000 200,000Life, years 30 30

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Example 9.4

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Example 9.6

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• Social rate=7%, 8-year• AW of total cost = First cost(A/P,7%,8)+entrance fee

reduction



B/C Analysis of Independent Projects

v Independent projects comparison does not require incremental analysis

v Compare each alternative’s overall B/C with DN option

+ No budget limit: Accept all alternatives with B/C ≥ 1.0

+ Budget limit specified: capital budgeting problem; selection follows different procedure (discussed in chapter 12)

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Engineering Economics (KHU, 2015)

Service sector projects primarily involve intangibles, not physical facilities; examples include health care, security programs, credit card services, etc.

Cost-effectiveness analysis (CEA) combines monetary cost estimates with non-monetary benefit estimates to calculate the

Cost-effectiveness ratio (CER)

Equivalent total costs (C)Total effectiveness measure (E)CER =

9.5 Service sector project & Cost-Effectiveness Analysis

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CER Analysis for Independent Projects

Procedure is as follows:(1) Determine equivalent total cost C, total effectiveness measure E and CER(2) Order projects by smallest to largest CER(3) Determine cumulative cost of projects and compare to budget limit b(4) Fund all projects such that b is not exceeded

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Example 9.8

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CER = Program cost per person (C)/ Patents per graduate (E)



Example 9.8

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CER Analysis for M. E. Projects

• Order projects by smallest to largest E• Without budget limit, choose the alternative

with the highest effectiveness measure, E.• With budget limit, the concept of Dominance is

utilized

Dominance occurs when(∆C/E)challenger-defender < (C/E)defender

• When dominance exists, eliminate defender. Otherwise, both alternatives remain

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Selection Procedure(1) Order alternatives smallest to largest by effectiveness measure E(2) Calculate CER for first alternative (defender)(3) Calculate incremental cost (∆C), effectiveness (∆E), and incremental measure

∆C/E for challenger (next higher E measure)(4) If ∆C/Echallenger < C/Edefender , challenger becomes defender (dominance);

otherwise, no dominance is present and both alternatives are retained(5) Dominance present: Repeat steps (3) and (4) with new defender & challenger

Dominance not present: Current challenger becomes new defender against next challenger, but old defender remains viable

(6) Continue steps (3) through (5) until only 1 alternative remains or only non-dominated alternatives remain

(7) Apply budget limit or other criteria to determine which of remaining non-dominated alternatives can be funded

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Example

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The effectiveness measure (E) is wins per person. From the cost and effectiveness values shown, determine which alternative to select.

Cost (C) Effectiveness (E) CERProgram $/person wins/person $/win

A 2200 4 550B 1400 2 700C 6860 7 980



Example

Order programs according to increasing effectiveness measure E

Cost (C) Effectiveness (E) CERProgram $/person wins/person $/win

B 1,400 2 700A 2,200 4 550C 6,860 7 980

Solution:

C/EB = 1400/2 = 700A vs. B: ∆C/E = (2200 – 1400)/(4 – 2) = 400 Dominance; eliminate BC vs. A: ∆C/E = (6860 – 2200)/(7 – 4) = 1553 No dominance; retain C

Must use other criteria to select either A or C



Example 9.9

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5 vs. 4: ∆C/E = (5500 – 2500)/(2.9 – 2.1) = 3750 > 1190 No dominance; retain both2 vs. 5: ∆C/E = (4500 – 5500)/(3.1 – 2.9) = - 5000 < 1897 Dominance; eliminate 52 vs. 4: ∆C/E = (4500 – 2500)/(3.1 – 2.2) = 2000 >1190 No dominance; retain both

Must use other criteria to select either 2 or 4

benefit cost analysis and public sector economics

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