Cost/Benefit Analysis Cost/Benefit Analysis ReviewReview

Cost/Benefit Analysis Cost/Benefit Analysis ReviewReview• Cost/Benefit can done using NPW or EAW,

pick one! (choose whichever method is easiest for the problem statement)

• Criteria: Benefits – Disbenefits (to the public)

Costs (to the sponsor)• Benefits must outweigh costs, so if the B/C

ratio is: > 1 project is justified = 1 barely justified – political < 1 not justified

• Alternative viewpoints complicate the process!

• Terms: • Primary Benefits – easy to measure, change to

$$• Secondary Benefits – difficult to quantify

(political)• Disbenefits – paid by public users (tolls,

etc.)• Costs – 1st costs & salvage, O & M paid –

revenues collected by sponsor

Incremental Analysis with Incremental Analysis with B/CB/C

Incremental Analysis with Incremental Analysis with B/CB/C

• Incremental Analysis MUST be used when comparing! (Cost/Benefit Ratio is a relative measure)

• Caution: Must compare only feasible projects!

• Steps:• Order projects by increasing TOTAL costs

AND eliminate any infeasible projects

• Use first feasible project – becomes current best

• Compare with Doing Nothing if that is an option

• Do same “apples to apples” comparison for all

• Pairwise Comparison on Incremental Cash Flow

• If incremental B/C > 1, then higher cost is better

• If incremental B/C ≤ 1, then lower cost is better

Note: There is NO modified B/C analysis on exam!

Replacement ReviewReplacement ReviewReplacement ReviewReplacement Review

• Essentially, there are two aspects to replacement:

• What is the economic service life of the replacement alternatives (challengers)?

• What is the ownership life of the existing system (defender)?

• Criteria: Choose the lowest EAC method today

• Must take an outsider’s perspective when valuing the existing system

• Terms:• Physical Life• Ownership Life• Economic Service Life• Accounting Life

• Fair Market Value• Market Value• Trade-in Value• Book Value

Economic Service Life Economic Service Life ReviewReview

Economic Service Life Economic Service Life ReviewReview

• Economic Service Life (ESL) is the length of time that minimizes the equivalent annual cost for the system

• Relationship: Total EACTotal = EACownership + EACoperation

• EACownership:• 1st Costs(A/P, i, N) – Salvage(A/F, i, N)• Typically decrease with longer lifetime

(N)• EACoperation:

• Annualized Operating + Maintenance Costs

• Typically increase with longer lifetime (N)

• Steps:• Find EACTotal for each year of remaining life (N =

1, 2, …)

• Find the lowest cost lifetime (ESL) among EACtotal:

• Plan to use until end of ESL year• Plan to replace at the start of the next

year

The system with the lowest cost ESL is the best replacement Challenger!

Outsider’s Perspective Outsider’s Perspective ReviewReview

Outsider’s Perspective Outsider’s Perspective ReviewReview• The outsider would have to purchase the

existing system in order to use it – paying “Fair Market Value”

Priority Order: (& information sources)1. Market Value

• Independent Audit / Appraisal• Want/For Sale Ads in paper/trade

magazine• Selling/Asking price at auction

2. Trade-In Value• Must use if accepting lower challenger

price from vendor• Can shop around to different vendors• “Blue Book” price• Bank / Savings & Loan estimate

3. Book Value• Prefer Book depreciation to MACRS

value

Opportunity Cost Opportunity Cost ApproachApproach

Opportunity Cost Opportunity Cost ApproachApproach

The fair market value of the defender will be treated as a cost to retain the defender (this is the opportunity cost that is foregone by retaining the defender)

Fair Mkt. Value

01 2 3 n = Lifetime

Operating Cost

DEFENDER DIAGRAM:

Maintenance Cost

Salvage

Overhaul Cost

Overhaul Cost

Ownership Life ReviewOwnership Life ReviewOwnership Life ReviewOwnership Life Review

• Ownership Life is the length of time to keep the existing system that minimizes the equivalent annual cost for the ongoing performance of the function

• Decision is based on expected costs as known today

• No sunk costs (original price doesn’t matter)• Relevant costs only (common costs are just

clutter)• Steps:

• Use the Opportunity Cost approach (Fair Market Value appears as a cost on the Defender CFD)

• Find ESL of the best Challenger option

• Find each EACtotal up through the physical lifetime for the Defender:

• Find the Ownership Life of the Defender• Plan to replace with the Challenger at

the start of the next year: when the EACDefender > ESLChallenger