(c) 2001 Contemporary Engineering Economics 1 Chapter 17 Economic Analysis in the Public Sector Framework of Benefit- Cost Analysis Valuation of Benefits and Costs Benefit-Cost Ratios Analysis of Public Projects Based on Cost-Effectiveness

(c) 2001 Contemporary Engineering Economics 2 Benefit-Cost Analysis Benefit-cost (BC) analysis is decision making tool commonly used to evaluate public projects. In the Benefits-cost analysis determining social benefits of a public activity is more important than costs. Examples of BC analyses: Public transportation systems, Environmental regulations on noise and pollution, Public safety programs, Education and training programs, Public health programs,..

(c) 2001 Contemporary Engineering Economics 3 Framework of Benefit-Cost Analysis 1) Identifying all the users’ benefits and sponsors’ costs of the project. 2) Identifying all the benefits (favorable outcome) and disbenefits (unfavorable outcome) of the project. 3) Identify sponsor’s cost. 4) Quantifying all benefits and disbenefits in dollars to allow comparisons. 5)Determine the equivalent benefits and costs at the base period and use an appropriate interest rate for the project. 6)Accept the project if the equivalent users’ benefits exceed the equivalent sponsors’ costs..

(c) 2001 Contemporary Engineering Economics 4 Benefit-Cost Ratios Alternative way to express the value of a public project is to compare the users’ benefits (B) to sponsors’ cost (C) by taking the ratio B/C. Define the benefit-cost (B/C) ratio, and explain the relationship between the conventional NPW criterion and the B/C ratio.

(c) 2001 Contemporary Engineering Economics 5 Benefit-Cost Ratio Criterion If this BC ratio exceeds 1, the project can be justified

(c) 2001 Contemporary Engineering Economics 6 Definition of Benefit-Cost Ratio b n =Benefit at the end of period n, c n =Expense at the end of period n, A n = b n – c n N = Project life i =Sponsor’s interest rate (discount rate)

(c) 2001 Contemporary Engineering Economics 7 Definition of Benefit-Cost Ratio continue…………….. The sponsor’s cost (C) consist of the capital expenditure (I) and the equivalent annual operating and maintenance costs (C’) accumulated in each successive period. Let’s assume series of initial investment required during the first K periods, while annual operating and maintenance costs accumulate in each period.

(c) 2001 Contemporary Engineering Economics 8 Equivalent capital investment at n = 0 Equivalent annual O&M costs at n = 0 Breakdown of the Sponsor’s Cost

(c) 2001 Contemporary Engineering Economics 9 Example 17.1 B-C Analysis

(c) 2001 Contemporary Engineering Economics 10

(c) 2001 Contemporary Engineering Economics 11 Relationship between B/C Ratio and NPW B > (I + C’) B – (I+ C’) > 0 PW(i) = B – C > 0

(c) 2001 Contemporary Engineering Economics 12 Incremental Analysis Based on B/C(i) To apply incremental analysis, we compute the incremental differences for each term (B,I, and C’) and take the B/C ratio based on these differences. To use the B/C(i) on incremental investment, we may proceed as follows; 1.Eliminate any alternatives with a B/C ratio less than 1. 2.Arrange the remaining alternatives in the increasing order of the denominator (I+C’). Thus, the alternative with the smallest denominator should be the first (j), the alternative with the second smallest (k), and so forth. 3.Compute the incremental differences for each term (B, I, and C’) for the paired alternatives (j, k) in the list.

(c) 2001 Contemporary Engineering Economics 13 Incremental Analysis Based on BC(i)

(c) 2001 Contemporary Engineering Economics 14 Example 17.2 Incremental Benefit-Cost Ratios A1A2A3 I$5,000$20,000$14,000 B12,00035,00021,000 C’C’4,0008,0001,000 PW(i)$3,000$7,000$6,000

(c) 2001 Contemporary Engineering Economics 15 Solution A1A2A3 BC(i) Ranking BaseA1A3A2 I +C’$9,000$15,000$28,000

(c) 2001 Contemporary Engineering Economics 16 Summary Benefit-cost analysis is commonly used to evaluate public projects: Difficulties involved in public project analysis include the following: 1)Identifying all the users who can benefit from the project. 2)Identifying all the benefits and disbenefits of the project. 3)Quantifying all benefits and disbenefits in dollars or some other unit of measure. 4)Selecting an appropriate interest rate at which to discount benefits and costs to a present value.

(c) 2001 Contemporary Engineering Economics 17 The B/C ratio is defined as: The decision rule is if BC(i) > 1, the project is acceptable. The net B/C ratio is defined as The net B/C ratio expresses the net benefit expected per dollar invested. The same decision rule applies as for the B/C ratio.