A Primer on Benefit-Cost
Analysis
Presented to:
The Reclaimed Water Technical Committee
June 2, 2006
By
Bruce 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
Costs and Benefits of Project X
Costs
Benefits
Private Costs and Benefits
Private Interests
Costs
Benefits
Public Costs and Benefits
Public Interest
Private Interests
Costs
Benefits
The Reverse Case
Public Interest
Private Interests
Benefits
Costs
Example
• Getting to work
More Useful Concepts
Scarcity
Choice
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
Improved Efficiency
(Most Bang for the Buck)
Scarce
community
resources
Valuable
community
services
Community
well-being
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
Year
0
1
5
10
20
30
40
50
Tot
Present Value
@ 0%
@ 3%
@ 5%
@ 7%
$1,000
$1,000 $1,000 $1,000
$1,000
$971
$952
$935
$1,000
$863
$784
$713
$1,000
$744
$614
$508
$1,000
$554
$377
$258
$1,000
$412
$231
$131
$1,000
$307
$142
$67
$1,000
$228
$87
$34
$50,000 $26,502 $19,169 $14,767
Present Value Formula
(for those so inclined)
FV
PV =
t
(1+r)
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
$0
$0
$780
$680
$858
$748
$100
$110
$276
$277
$50
$50
$225
$225
$1
$225
$2
$0
$4,739
$674
$238
$706
$228
TOTAL BENEFITS
Financial
Social
Environmental
$60,000
$53,040
$0
$6,960
$0
TOTAL COSTS
Capital
O&M
Social
Environmental
Risk
$40,000
$27,800
$1,600
$3,000
$7,380
$220
$300
$300
PV of BENEFITS
PV of COSTS
$24,166
$33,171
$0
$300
NPV (3%)
NPV (5%)
NPV (7%)
-$1,374
-$9,005
-$13,784
$25,000
$22,000
$5,225
$5,000
$3,000
$0
$23,810
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