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ENGINEERING ECONOMY
SESSION IX
Benefit Cost Analysis and
Public Sector Economics
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.1 Learning Objectives
9.1 Public Sector Analysis
9.2 Benefit Cost Analysis
9.3 Alternative Selection
Using the
B/C
Ratio
Approach
9.4 Multiple Alternatives
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.1 Public Sector Projects
Public Sector:
Ownership by citizens- the public
Public Sector Projects:
Provide needed services to the public
and no profit
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.1 Types of Projects
Hospitals
Parks and recreation facilities
Highways, dams, bridges
Courts, schools, prisons
Public housing
Many other types
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.1 Characteristics Compared
Characteristic
Public Sector
Private Sector
Size of
Investment
Larger
Some Large;
medium to
small
Life Estimates
Quite Long:
30-50 years
Shorter:
2-25 years
Annual Cash
No Profit: costs Revenues
Flow Estimates and benefits
profit cost
estimates
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.1 Attributes
Public Sector Projects do not have
profits per se
Projects can have certain undesirable
consequences associated
Thus, can be controversial in nature
Draw media attention debated on pros
and cons
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.1 Estimating for Public Projects: Costs
Basic elements for public projects:
Costs
Construction, operations,
maintenance less est. salvage values
Initial costs fairly well know
Future O&M are less known and must
be estimated
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.1 Estimating: Benefits
BENEFITS to the public (users) must be
estimated in terms of periodic dollar values
Very difficult to do
Benefits = the advantages to the public
stated in $$
Owners generally the public
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.1 Estimating: Disbenefits
Disbenefits
Expected undesirable (negative)
consequences to the owners (public)
Assuming the project is undertaken
May be indirect economic
disadvantages to the public
Very hard to estimate and convert to $
amounts
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.1 General Principle
For public projects we find:
It is very difficult to estimate and reach
agreement on the economic impacts of
benefits and disbenefits for public sector
projects.
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.1 Funding Sources Compared
Characteristic
Public Sector
Funding
Taxes, fees,
bonds, pvt.
funds
Interest Rate
Tends to be
lower
Private Sector
Sale of new
stock, bonds,
loans, ret.
earnings
Higher: At
market cost
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9.1 Funding Public Projects
Generally low interest charges
Public entities do not pay taxes
Project investments basically backed by
public agencies
Cost-sharing arrangements often exist
Less perceived risk with public projects
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.1 Determination of an Interest Rate
Determined differently than in the private
sector
Called the social discount rate
For Federal Projects a current working
rate (2001) is 10% per year
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.1 Additional Comparisons
Characteristic
Selection
criteria
Public Sector
Multiple or
many
Environment of Political arena
the evaluation
(debated,
pressure groups)
Private Sector
Rate of return
or present
value
Primarily
economic
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9.1 Selection Process
Not as clean as in the private sector
Involves interest and pressure groups
Often draws media attention
Involves many different viewpoints
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9.1 Evaluation Process
The viewpoint finally adopted will:
Determine the estimates of..
Costs
Benefits
Disbenefits
Thus, the viewpoint must be established
before the economic evaluation
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.1 See Example 9.1
This is a common problem
Define the viewpoints
A given viewpoint will drive the analysis
Multiple views = multiple results!
Nature of the beast
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9.2 B/C Analysis Single Project
Historical Point
B/C analysis philosophy was instituted
and promoted by the Flood Control Act of
1936
Introduced to promote a sense of
objectivity in an analysis
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9.2 B/C Formulations
Assignable life, N - years
Estimate costs ($)
Estimate benefits in ($)
Estimate disbenefits in ($)
Assign an interest rate i (%/year)
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9.2 B/C Formulations
Then convert all amounts to either a
Present Worth PW(i%)
Annual Worth AW(i%)
Then calculate a B/C ratio in one of
three ways..
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.2 B/C Ratios: 3 Formats
Three acceptable formats are:
PW (benefits )
B/C
PW (cos ts )
AW (benefits)
AW (cos ts)
FW (benefits )
FW (cos ts)
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.2 Notes Regarding Signs
By convention:
Revenues are assigned (+) signs
Costs are assigned (+) signs
Salvage values are subtracted from
costs
Disbenefits are treated more than one
way
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.2 Handling Disbenefits
1. Disbenefit values are subtracted from
benefits
2. Disbenefit values are added to costs
3. Either approach will result in a consistent
analysis but be consistent throughout
an analysis
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.2 Decision Rule
IF B/C ratio (=>) 1.00
Conditionally accept the alternative
IF B/C ratio (<) 1.00, conditionally reject
the alternative
IF B/C ratio close to 1.00, then
intangible factors may sway the decision to
accept or reject
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.2 Conventional B/C Ratio
The conventional B/C Ratio is:
Benefits - disbenefits B D
B/C
Costs
C
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9.2 Modified B/C Ratio
Modified B/C subtracts the maintenance
and operations costs in the numerator
B / Cmodified
Benefits - disbenefits-M&O costs
Costs
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9. 2 Convention vs. Modified?
It makes no difference which approach is
used
However, the ratio values will differ
(magnitude)
But, the same absolute (accept/reject)
decision will be the same
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9. 2 Benefit-Cost Difference
B-C difference is not a ratio
B-C difference is:
(Benefits Costs) (as a PW or AW)
The B represents the Net Benefit
Benefits Disbenefits
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9. 2 See Example 9-2
Applies all three approaches to the same
problem situation
B/C = 0.51 (reject)
Mod B/C = 0.39 (reject)
(B-C) = $-1.24 million (< 0reject)
Result: Same decision with varying
magnitudes of the ratio
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9.2 Example 9.3
Given two alternatives
Bypass construction
Upgrade construction
Note: Unequal lives ..use AW
i is set to 8%
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9.2 Example 9.3 Continued
Conventional B/C Bypass = 1.17
Conventional B/C Upgrade = 1.13
Both B/C ratios are > 0
Both proposal are economically justified
at 8%
Which one would you select?
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.2 Uncertain Discount Rate (??)
What if the value of i is uncertain?
Apply a spreadsheet analysis and play
what-if
What if federal funds are available for the
upgrade and a 4% rate is applied to that
option?
Changing discount rates can impact the
ratio for that alternative!
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.3 Alternative Selection Using
Incremental Analysis: 2 Alternatives
This approach is similar to the material in
Chapter 8
Requires a proper ordering of the
alternatives
Order alternatives on the basis of Total
Costs
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.3 Rank on Total Costs Rules
1. Determine total equivalent costs for both
alternatives;
2. Order by total costs: Smaller first then
larger
Calculate the incremental cost for the
larger alternative = (C) be the
denominator in the B/C ratio
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.3 (B/C) Approach
3. For both alternatives determine:
Total equivalent benefits and
disbenefits
Calculate the (B) for the larger cost
alternative or (B-D) if disbenefits are
involved
4. Calculate the { (B-D)/C } ratio
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.3 (B/C) Approach
5. If (B/C) (=>) 1.00, go with the highercost alternative
else,
Go with lower-cost alternative!
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.3 Important Point
If you are using a PW to determine
equivalency, then you must have an equallife model or lowest-common multiple of
lives.
Or, apply the annual worth on a typical
cycle for the alternatives and the
repeatability assumption applies.
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.4 Incremental B/C for Multiple Projects
Select from three or more mutually
exclusive alternatives
Same approach as that in Chapter 8,
Section 8.6
Remember, the Do Nothing alternative
always exists and should be evaluated as
an alternative.
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.4 Steps for Multiple Incremental
Analysis
1. Using either PW or AW, determine the
total equivalent cost for all options. If
unequal lives, apply AW
2. Create the rankings based upon lowest
to highest total cost of the alternatives
3. Determine the total equivalent net
benefits for each alternative
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9.4 Steps Continued
4. The lowest-cost option is the first
Defender and the next-higher cost
alternative is the first Challenger.
Compute the B/C ratio on the increment
If B/C < 0, eliminate the Challenger, else
eliminate the Defender.
Current winner becomes new Defender
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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9.4 Multiple Alternatives.
5. Compare the new Defender to the nexthigher-cost Challenger and repeat the
analysis.
6. Continue through the alternative until
there are no more Challengers.
7. The last champion is the winner.
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9.4 Example 9.5
4 Alternatives { 1,2,3, and 4}
Ranked on total cost as shown
Analysis Summary:
(2 -1) B/C = 2.24 Go with {2}
(3-2) B/C =0.62Reject 3, stay with
{2}
(4-2) B/C = 1.83 Go with 4, final
winner
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Chapter Summary
B/C is primarily a public-sector analysis
technique
Uses PW or AW with a social cost of
capital interest rate (specified before the
analysis is conducted)
B/C ratio greater than 1 indicates
economic desirability
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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Chapter Summary
Very difficult to estimate $ values for
benefits and disbenefits
Results may depend upon viewpoints that
define costs and benefits
Applied within the political arena
Current interest rates vary from 6% to
10%, but are hard to justify
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End of Chapter 9 Lecture Set
Blank & Tarquin: 5th Edition. Ch. 9 Authored by: Dr. Don Smith, Texas A&M University.
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