A Primer on Benefit-Cost Analysis

Presented to:The Reclaimed Water Technical Committee

June 2, 2006

ByBruce Flory, Ph. D.

Seattle Public Utilities

A Little History of BCA• Idea of economic accounting – France, 1848

• “Foundational” concepts - Alfred Marshall

• Practical development - Federal Navigation Act of 1936

– Required the U.S. Corps of Engineers carry out projects for the improvement of the waterway system when the total benefits of a project, to whomsoever they accrue, exceed the costs of that project.

– The Corps developed methods without economists

History - continued• Economists get in the act – 1950s

– provide a rigorous, consistent set of methods

• BCA expands into new areas -1980s – all major new regulations

• Some technical issues of BCA still unresolved

• However, the fundamentals are well established.

General Definitions• Benefit-cost analysis is a way of identifying,

portraying and assessing the factors which need to be considered in making rational economic choices.

• BCA is a method of evaluating the relative merits of alternative public investment projects in order to achieve efficient allocation of resources.

• In principle, BCA entails adjusting conventional business profit-and-loss calculations to reflect social instead of private objectives, criteria, and constraints in evaluating investment projects.

Pearls from Tom Fox

• A benefit-cost analysis is a systematic evaluation of the advantages (benefits) and disadvantages (costs) of a set of investment alternatives.

• Typically, a base case is compared to one or more alternatives.

Another Pearl

• A full social cost accounting identifies and accounts for all the benefits and costs of a potential action, including economic, environmental and social costs and benefits, even those that do not have readily observable market values.

Some Useful Concepts

• Externalities

• Public Goods– Non-rival

– Non-excludable

– Non-rejectable

BenefitsCosts

Costs and Benefits of Project X

BenefitsCosts

Private Interests

Private Costs and Benefits

BenefitsCosts

Private Interests

Public Interest

Public Costs and Benefits

Benefits Costs

Private Interests

Public Interest

The Reverse Case

Example

• Getting to work

More Useful Concepts

ScarcityChoice

Opportunity Cost

Opportunity cost:What we forego when we make a choice

Inefficient Use of Resources

Scarce community resources

Valuable community services

Community well-being

Scarce community resources

Valuable community services

Community well-being

Improved Efficiency(Most Bang for the Buck)

And More Still

• Sunk Costs

• Common Unit of Measure• Present Value (Discounting the Future)

Ignore Sunk Costs

• Sunk costs are sunk, – they cannot be recovered

• Do not include them in BCA

• Do not use them to justify project

Common Metric

• Apples and Oranges– Capital costs ($)– Revenue ($)– Reduced traffic congestion (driver hours)– Reduced cancer risk (deaths per million) – Improved habitat for endangered species

(spotted owls per acre)

• Ideal: Quantify all in $ terms

Present $ vs. Future $

• Not all dollars are equal

• $1 a year from now < $1 now– Time preference– Risk– Opportunity cost of capital

• Discount future values to obtain…

Present Value

Present ValueYear @ 0% @ 3% @ 5% @ 7%

0 $1,000 $1,000 $1,000 $1,0001 $1,000 $971 $952 $9355 $1,000 $863 $784 $713

10 $1,000 $744 $614 $50820 $1,000 $554 $377 $25830 $1,000 $412 $231 $13140 $1,000 $307 $142 $6750 $1,000 $228 $87 $34

Tot $50,000 $26,502 $19,169 $14,767

Present Value Formula(for those so inclined)

PV =

FV(1+r)t

Putting It All Together

• Identify the problem to be solved

• Define Baseline

• Identify Alternatives

• Identify All Benefits and Costs for Each Alternative

Putting It All Together – cont.

• Quantify All Benefits and Costs in $

• Calculate Present Values

• Calculate Net Present Value

• Rank by NPV

Net Present Value for One Option TOTAL 2006 2007 2008 2009 2010

TOTAL BENEFITS $60,000 $0 $0 $0 $780 $858Financial $53,040 $680 $748Social $0Environmental $6,960 $100 $110

TOTAL COSTS $40,000 $300 $25,000 $5,225 $276 $277Capital $27,800 $300 $22,000 $5,000O&M $1,600 $50 $50Social $3,000 $3,000Environmental $7,380 $225 $225 $225Risk $220 $1 $2

PV of BENEFITS $24,166 $0 $0 $0 $674 $706PV of COSTS $33,171 $300 $23,810 $4,739 $238 $228

NPV (3%) -$1,374NPV (5%) -$9,005NPV (7%) -$13,784 OPTION A

Net Present Value (NPV) Table

Option A Option B Option C

PV of Benefits $24,166 $42,750 $215,025

PV of Cost $33,171 $15,575 $204,842

Net Present Value -$9,005 $27,175 $10,183

Problems with BCA

#1 Problem: Difficulty of quantifying all benefits and costs in $

• Non-Market Valuation Methods– Stated Preference

• Contingent Valuation• Conjoint Choice Analysis

– Revealed Preference• Hedonic Pricing• Travel Cost Method

– Benefits Transfer “Method”

So, What Do You Do?

• 80-20 Rule

• Sensitivity Analysis

• Cost Effectiveness Analysis

Cost Effectiveness (another pearl)

• The phrases cost effectiveness analysis and benefit-cost analysis are often confused.

• Cost effectiveness analysis involves specifying a set of benefits or level of service, then comparing the costs of various alternatives that can deliver those benefits.

• The alternative with the lowest life-cycle costs is the most cost effective.

Perspectives Analysis

• Who gains, who pays?

• BCA doesn’t answer this question– “Compensation Principle”

• Ideally, design financing scheme to:– charge those who benefit– compensate those who lose

Summary (+s)

• BCA useful tool to help public agencies

– Ask the right questions

– Make good investment decisions

– Avoid costly mistakes

– Get the most “Bang for the Buck”

Summary (–s)

• BCA is not the only tool– Necessary but not sufficient

– Measurement issues

– Susceptible to abuse

– Doesn’t do distribution