cost effectiveness analysis. cost-effectiveness analysis - 1 cost effectiveness analysis, slide...

Cost Effectiveness Analysis

Cost-effectiveness Analysis - 1

Cost Effectiveness Analysis, Slide 2 Copyright © 2004, Jim Schwab, University of Texas at Austin

What-if analysis is a useful tool in doing economic evaluations of proposed projects. Decision makers want to make the best use of available resources to accomplish their agency's goals and mission. Two tools for evaluating the economic aspects of prospective projects are cost-benefit analysis and cost-effectiveness analysis.

Cost-benefit analysis attempts to obtain the largest benefits for the dollars invested in a program. A proposed project is considered to be a reasonable investment if it's cost-benefit ratio is greater than 1, i.e. the benefits obtained by a project exceed its cost. If the decision maker has multiple opportunities that exceed the available investment, the projects would be rank ordered by the size of their cost benefit ratio.

Costs and benefits can be both tangible and intangible. Tangible costs are easier to take into account because they are generally associated with a dollar figure, i.e. it costs so many dollars to build this building (cost) and the rents that will be paid monthly are equal to this many dollars (benefits). In particular benefits are often intangible and difficult to assign an economic value to, e.g. the quality of life, the self-esteem of an individual, etc. The problem of assigning a monetary value to benefits has led many to drop benefits from the equation and examine the problem in terms of costs only.



Cost effectiveness analysis is conducted when there are multiple strategies for accomplishing a goal, and all of the alternatives would be equally effective at accomplishing the objective. Saying that all alternatives are equally effective at accomplishing the goal implies that they have the same benefits, so comparisons based on benefit calculations are not relevant to the decision The criteria for choosing one alternative over the others is an issue of determining which alternative makes the most effective use of resources, usually translated as costs the least.

There are two issues in cost-effectiveness tests: which costs should be included and how do we equate costs when they occur in different time periods (the time value of money problem). The costs to include should be all start up costs and the annual costs for operations and maintenance. Often we consider projects over their life span, i.e. the 5, 10, or more years that the program will be in effect, The trade-offs that we are considering in the cost effectiveness analysis often revolve around the question of whether we should spend more in the beginning and less in annual operating costs, or spend less in the beginning of the project and absorb higher operating costs in the future.



Including annual costs for operations requires us to make the costs in the future equivalent to costs in the present time, so that we not comparing inflated dollar amounts at different time periods in the future. The mathematical process of making future costs equivalent to today’s dollars is called finding the net present value of a future series of payments or investments. As we shall see, Excel reduces this complex set of calculations to a few manageable entries on a worksheet that it can solve with a single function.

We know that we can simply put our money in a savings account, let it accrue interest, and spend the larger amount at some time in the future. In investing money in savings, one question we can ask is how many dollars will we have in the future. Another question we can ask is: if we know how many dollars we want to spend in the future, how much would be have to put in savings now to let it grow to that future amount?



When we decide to do a project that spans many years in the future, we are committing to a series or stream of future payments. Net present value calculations tell us how many of today’s dollars we are committing to meet those future obligations. The total cost of a project is the sum of the initial expenditures, start-up costs, plus the total amount of future obligations expressed in today’s dollars.

When we think about putting money into savings, a critical factor is what interest rate will we obtain on our money. Similarly, when we convert future dollars back to today’s dollars, a critical value in Net Present Value calculations is what rate of interest or growth on our money is assumed. When we are computing the present value of future costs, we refer to the interest rate as the discount rate, because the amount of future dollars will be reduced or discounted when evaluated in today’s dollars.

Cost-effectiveness solutions are heavily impacted by the selection of the discount rate that is used in the calculations. Since we cannot be certain what rate of inflation or interest will be applicable in the future, what-if analysis lets us test the impact of selecting different discount rates on our proposed solution.

First Sample Problem


This problem is taken from Quantitative Methods for Public Decision Making by Christopher K. McKenna, page 140-142.

A community is considering installing a supplementary pumping station to maintain adequate water pressure at time of peak demand. Two alternatives have been presented; the effectiveness of the two alternative stations are assumed to be equivalent, and so the decision is essentially a cost comparison. Alternative A has a purchase and installation cost of $120,000 and estimated annual maintenance costs of $10,000. Alternative B has an initial cost of $190,000 with annual estimated maintenance costs of $4,000. Either station is expected to be operational for 20 years. Using a discount rate of 8%, which alternative should be chosen?

Set up the Cost Summary worksheet


In a new workbook, rename the first worksheet Cost Summary.


First, type the row and column heading as shown on the worksheet.


Second, enter the purchase and installation costs for both alternatives.

Second, enter the purchase and installation costs for both alternatives.

Third, enter the discount rate in cell F2. Putting the discount rate in a cell will make it easier later on to test alternatives.

Third, enter the discount rate in cell F2. Putting the discount rate in a cell will make it easier later on to test alternatives.

Set up the Future Expenses worksheet - 1


First, rename Sheet2 to Future Expenses.


Second, type the column headings on the worksheet as shown.


Third, enter a series of numbers from 1 to 20 to represent the years in the first column.

Third, enter a series of numbers from 1 to 20 to represent the years in the first column.

Fourth, in the second and third columns, enter the annual maintenance costs for each alternative for all 20 years.

In this example, the costs that we will pay each year are the same; in a real problem they might not all be the same.

Fourth, in the second and third columns, enter the annual maintenance costs for each alternative for all 20 years.

In this example, the costs that we will pay each year are the same; in a real problem they might not all be the same.

Use NPV to calculate value of future annual costs


First, select the cell in which we Excel to return the present value of the savings, cell B3 on the Cost Summary worksheet.

First, select the cell in which we Excel to return the present value of the savings, cell B3 on the Cost Summary worksheet.

Second, select the Function command from the Insert menu.


Locate the NPV function


We will search for the NPV function. First, type NPV in the Search for text box, and click on the Go button.


The NPV function name will appear in the Select a function list box. Click on the OK button access the dialog box where the function arguments are entered.


The arguments to the NPV function


The first argument to the NPV function is the discount rate, which we put in cell F2.


The second argument to the NPV function is the cells containing the future maintenance expenses for alternative A, 'Future Expenses'!B2:B21.

Remember to enter the quote marks around the name of the worksheet Future Expenses because it contains a space.

The second argument to the NPV function is the cells containing the future maintenance expenses for alternative A, 'Future Expenses'!B2:B21.


With the arguments entered, click on the OK button.


The annual costs for Alternative A


The NPV function returns the present value of the annual maintenance costs for Alternative A, $98,181.47.

The NPV function returns the present value of the annual maintenance costs for Alternative A, $98,181.47.

The annual costs for Alternative B


Repeat the same steps to use the NPV function to compute the present value of future maintenance costs for Alternative B, $39,273.59.

Repeat the same steps to use the NPV function to compute the present value of future maintenance costs for Alternative B, $39,273.59.

The project costs for Alternative A


The total project costs for Alternative A will be the sum of the Purchase Costs in cell B2 plus the Annual Costs in cell B3.

The total project costs for Alternative A will be the sum of the Purchase Costs in cell B2 plus the Annual Costs in cell B3.

Select cell B4 and type in the formula =B2+B3.


The project costs for Alternative B


The total project costs for Alternative B will be the sum of the Purchase Costs in cell C2 plus the Annual Costs in cell C3.

The total project costs for Alternative B will be the sum of the Purchase Costs in cell C2 plus the Annual Costs in cell C3.

Select cell C4 and type in the formula =C2+C3.


The cost-effectiveness solution


Based on our calculations, Alternative A is a more attractive proposal using the cost-effectiveness criterion.

The information used in the problem was based on reasonable assumptions and estimates. We can use what-if analysis to test the impact of using different estimates.

Based on our calculations, Alternative A is a more attractive proposal using the cost-effectiveness criterion.

The information used in the problem was based on reasonable assumptions and estimates. We can use what-if analysis to test the impact of using different estimates.

What if the correct discount rate is 7%


The discount rate is estimated (forecast) based on historical rates that are not guaranteed to be accurate. We will test whether or not our decision would change if the discount rate were lower than 8%.

The discount rate is estimated (forecast) based on historical rates that are not guaranteed to be accurate. We will test whether or not our decision would change if the discount rate were lower than 8%.

First, we substitute 7% in cell F2 for the discount rate.


Using a 7% discount rate, the total project costs for Alternative A are still less than the costs of Alternative B, so we would not alter our decision.




Next, we substitute 6% in cell F2 for the discount rate.








The total project costs for Alternative B are now less than the costs of Alternative A, so at a 5% discount rate we would change our decision.

The course of action we would now take would depend on whether we believe the correct discount rate for the future will be less than 6% or above 6%. We may be prepared to make a decision, or we may feel that additional research is required to confirm one position or the other.

The total project costs for Alternative B are now less than the costs of Alternative A, so at a 5% discount rate we would change our decision.

The course of action we would now take would depend on whether we believe the correct discount rate for the future will be less than 6% or above 6%. We may be prepared to make a decision, or we may feel that additional research is required to confirm one position or the other.

A third alternative


While the community decision makers are embroiled in assessing the alternatives, a third alternative is identified. The third alternative (C) requires an initial cost of $140,000 for purchase and installation of a sealed pumping station that is guaranteed maintenance-free for 10 years. At that time, however, the pumping station would have to be replaced at the same cost as the original. Is alternative C preferable to either A or B?

Add Alternative C to the Cost Summary worksheet


First, on the Cost Summary worksheet, type the heading for Alternative C in cell D1.

First, on the Cost Summary worksheet, type the heading for Alternative C in cell D1.

Second, enter the purchase price for Alternative C, $140,000, in cell D2.

Second, enter the purchase price for Alternative C, $140,000, in cell D2.

Third, change the discount rate in cell F2 back to the original 8%.

Third, change the discount rate in cell F2 back to the original 8%.

Add Alternative C the Future Expenses worksheet


First, type the column heading for Alternative C in cell D1 of the Future Expenses worksheet.

First, type the column heading for Alternative C in cell D1 of the Future Expenses worksheet.

Second, there are no yearly maintenance expenses, but there is a replacement cost after 10 years, or at the beginning of year 11.

We enter all zeros for annual costs except for the replacement cost of $140,000 in cell D12.

Second, there are no yearly maintenance expenses, but there is a replacement cost after 10 years, or at the beginning of year 11.

We enter all zeros for annual costs except for the replacement cost of $140,000 in cell D12.

The NPV function for Alternative C


Select cell D3 on the Cost Summary worksheet and insert the NPV function again.

Select cell D3 on the Cost Summary worksheet and insert the NPV function again.



The second argument to the NPV function is the cells containing the future maintenance expenses for alternative A, 'Future Expenses'!D2:D21.


The second argument to the NPV function is the cells containing the future maintenance expenses for alternative A, 'Future Expenses'!D2:D21.




The project costs for Alternative C


The total project costs for Alternative C will be the sum of the Purchase Costs in cell D2 plus the Annual Costs in cell D3.

The total project costs for Alternative C will be the sum of the Purchase Costs in cell D2 plus the Annual Costs in cell D3.

Select cell D4 and type in the formula =D2+D3.

Select cell D4 and type in the formula =D2+D3.

Alternative C has a lower total cost than A and B, making it the most attractive option from a cost-effectiveness perspective.

Alternative C has a lower total cost than A and B, making it the most attractive option from a cost-effectiveness perspective.

Second Sample Problem


This problem is taken from Quantitative Methods for Public Decision Making by Christopher K. McKenna, page 162.

A municipality wishes to build a city hall and a police station on the same site. City council asks you to evaluate two plans for construction.

The first plan calls of the building of the city hall now and the building of the police station at the end of 8 years. Each structure will cost $500,000. The second plan involves construction of one building now, at a cost of $700,000, to serve both purposes. Both plans are considered to be equally effective after the eighth year.

The buildings are assumed to have a usable life of 50 years from the present day. Maintenance costs are estimated to be $6,000 per year for the first 8 years and $40,000 per year after that for the first plan; for the second plan they are estimated at $60,000 per year for the period.

Determine which is the preferred alternative, first based on a 4 percent discount rate, and then based on an 8 percent discount rate.

Set up the Cost Summary worksheet






Second, enter the purchase cost for both alternatives. Enter $500,000 in cell B2 and $700,000 in cell C2.

Second, enter the purchase cost for both alternatives. Enter $500,000 in cell B2 and $700,000 in cell C2.

Third, enter the discount rate of 4% in cell F2. Putting the discount rate in a cell will make it easier later on to test alternatives.

Third, enter the discount rate of 4% in cell F2. Putting the discount rate in a cell will make it easier later on to test alternatives.







Third, enter a series of numbers from 1 to 50 to represent the years in the first column, beginning in cell A2.

Third, enter a series of numbers from 1 to 50 to represent the years in the first column, beginning in cell A2.



For the first alternative, the maintenance costs are $6,000 for the first eight years. Plus in year 8, we will build the police station at a cost of $500,000.

For the first alternative, the maintenance costs are $6,000 for the first eight years. Plus in year 8, we will build the police station at a cost of $500,000.

First, enter $6,000 in cells B2 through B8 to specify maintenance costs for the first seven years.

First, enter $6,000 in cells B2 through B8 to specify maintenance costs for the first seven years.

Second, enter $506,000 in cell B9 to include the maintenance cost on city hall and the cost of the police station in year 8.

Second, enter $506,000 in cell B9 to include the maintenance cost on city hall and the cost of the police station in year 8.

Third, enter $40,000 in cells B10 through B51 to represent the maintenance costs on the two buildings from year 9 through year 50.

Third, enter $40,000 in cells B10 through B51 to represent the maintenance costs on the two buildings from year 9 through year 50.



For the first alternative, the maintenance costs are $60,000 per year for all 50 years.

For the first alternative, the maintenance costs are $60,000 per year for all 50 years.

Enter $60,000 in cells C2 through C51.

Enter $60,000 in cells C2 through C51.

Use NPV function to calculate value of future annual costs


First, select the cell in which we Excel to return the present value of the future expenses for the first alternative, cell B3 on the Cost Summary worksheet.

First, select the cell in which we Excel to return the present value of the future expenses for the first alternative, cell B3 on the Cost Summary worksheet.



Locate the NPV function






The arguments to the NPV function




The second argument to the NPV function is the cells containing the future annual costs for the first alternative, 'Future Expenses'!B2:B51.


The second argument to the NPV function is the cells containing the future annual costs for the first alternative, 'Future Expenses'!B2:B51.




The annual costs for the first alternative


The NPV function returns the present value of the annual expenses for the first alternative, $995,719.16.

The NPV function returns the present value of the annual expenses for the first alternative, $995,719.16.

The annual costs for the second alternative


Repeat the same steps to use the NPV function to compute the present value of future maintenance costs for second alternative, $1,288,931.08.

Repeat the same steps to use the NPV function to compute the present value of future maintenance costs for second alternative, $1,288,931.08.

The project costs for the first alternative


The total project costs for the first alternative will be the sum of the Purchase Costs in cell B2 plus the Annual Costs in cell B3.

The total project costs for the first alternative will be the sum of the Purchase Costs in cell B2 plus the Annual Costs in cell B3.



The project costs for the second alternative


The total project costs for the second alternative will be the sum of the Purchase Costs in cell C2 plus the Annual Costs in cell C3.

The total project costs for the second alternative will be the sum of the Purchase Costs in cell C2 plus the Annual Costs in cell C3.



The cost-effectiveness solution


Based on our calculations, the first alternative is a more attractive proposal using the cost-effectiveness criterion.

Based on our calculations, the first alternative is a more attractive proposal using the cost-effectiveness criterion.

What-if the correct discount rate is 8%


The problem also calls for us to test the solution with an 8% discount rate.

The problem also calls for us to test the solution with an 8% discount rate.



Using an 8% discount rate, the total project costs for the first alternative are still less than the costs of the second alternative, though the difference is not as great as it was using a 4% discount rate. We would not alter our decision.

Using an 8% discount rate, the total project costs for the first alternative are still less than the costs of the second alternative, though the difference is not as great as it was using a 4% discount rate. We would not alter our decision.

cost effectiveness analysis. cost-effectiveness analysis - 1 cost effectiveness analysis, slide...

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