Benefit Cost Analysis

TOPIC 5
Learning Outcomes
▪ Explain difference in public vs private sector projects
▪ Calculate B/C ratio for one project
▪ Select better of two alternatives using B/C analysis
▪ Select best Multiple Alternatives using B/C analysis

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 Size: small, medium,
Size: large
large
Life: Shorter (2-20
Life: Longer (30-50+)
years)
Selection criteria: Selection criteria:
Multiple criteria primarily ROR
Annual CF: Not Annual CF: Profit-
profit-driven driven

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 Total

Initial investment

Profitable Index Analysis

𝑃𝑊 𝑜𝑓 𝑁𝐶𝐹
𝑃𝐼 =
𝑃𝑊 𝑜𝑓 𝐼𝑛𝑖𝑡𝑖𝑎𝑙 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
Decision Rule

PI ≥ 1.0 accept
PI < 1.0 reject 5
Example 1
A flood control project will have a first cost of $1.4 million with an annual maintenance cost
of $40,000 and a 10 year life. Reduced flood damage is expected to amount to $175,000
per year. Lost income to farmers is estimated to be $25,000 per year. At an interest rate of
6% per year, should the project be undertaken?

Express all values in AW terms and find B/C ratio

𝐵 = 175,000
𝐵 175,000 − 25,000
𝐷 = 25,000 = = 0.65 < 𝟏. 𝟎
𝐶 230,218
𝐴
𝐶 = 1,400,000 , 6%, 10 + 40,000 = 230,218 Since B/C < 1.0, the project is not justified.
𝑃

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Alternatives Selection using
Incremental B/C Analysis
Defender, Challenger and Do Nothing Alternatives

When selecting from 2 or more ME alternatives, there is a:

 Defender – in-place system or currently selected alternative
 Challenger – Alternative challenging the defender
 Do-nothing option – Status quo system
General approach for incremental B/C analysis of two ME alternatives:
 Lower total cost alternative is first compared to Do-nothing (DN)
 If B/C for the lower cost alternative is < 1.0, the DN option is compared to
∆B/C of the higher-cost alternative
 If both alternatives lose out to DN option, DN prevails, unless overriding
needs requires selection of one of the alternatives

© 2012 by McGraw-Hill All Rights Reserved 9-8

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Example 2
Compare two alternatives using I = 10% and B/C ratio.
Alternative X Y DN X Y

First cost, $ 320,000 540,000 AW of Costs 0 97,080 98,428

M&O, $/year 45,000 35,000 Alternative Compared X ─ DN Y ─ DN

Benefit, $/year 110,000 150,000 ∆C 97,080 98,428

Disbenefits, $/year 20,000 45,000 ∆(𝑩 − 𝑫) 110,000 − 20,000 150,000 − 45,000

∆𝑪 97080 98,428
Life, years 10 20 = 0.93 = 1.07
Incremental Justified? No Yes
Solution:
Alternative Selected DN Y
Calculate equivalent total cost
𝐴
𝐴𝑊 of Costs = 320,000 , 10%, 10 + 45,000 = $97,080
𝑃
𝐴
𝐴𝑊 of Costs = 540,000 , 10%, 20 + 35,000 = $98,428
𝑃

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 METHOD 1 X Y

AW of Costs 97,080 98,428

AW of Benefit 110,000 150,000

Example 2a AW of Disbenefit 20,000 45,000

Alternative Compared Y─X

Compare two alternatives using I = 10% and B/C ratio. ∆C 1348
One must be selected.
∆B 40000

∆D 25000
Alternative X Y
∆𝑩 − ∆𝑫 40,000 − 25,000
= 11.1
First cost, $ 320,000 540,000 ∆𝑪 1348
Incremental Justified? Yes
M&O, $/year 45,000 35,000
Alternative Selected Y
Benefit, $/year 110,000 150,000
METHOD 2 X Y
Disbenefits, $/year 20,000 45,000 AW of Costs 97,080 98,428

Life, years 10 20 AW of Benefit 110,000 150,000

AW of Disbenefit 20,000 45,000

Solution: AW of (Benefit – Disbenefit) 90,000 105,000

Calculate equivalent total cost Alternative Compared Y─X

𝐴 ∆C 1348
𝐴𝑊 of Costs = 320,000 , 10%, 10 + 45,000 = $97,080
𝑃 ∆(B – D) 15000

𝐴 ∆ 𝑩−𝑫 15,000
𝐴𝑊 of Costs = 540,000 , 10%, 20 + 35,000 = $98,428 = 11.1
𝑃 ∆𝑪 1348
Incremental Justified? Yes 11

Alternative Selected Y
Incremental B/C Analysis for
Multiple Alternatives
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B/C Analysis for Independent
Projects
 B/C Analysis of Independent Projects

 Independent projects comparison does NOT require incremental analysis

 Compare each alternative’s overall B/C with DN option

 If there is no budget limit: Accept all alternatives with B/C ≥ 1.0

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Example 4
The Army Corp wants to construct a dam on a flood-prone river. The estimated costs and
benefits are listed below. A 6% per year interest applies and the dam life is considered infinite
for analysis purposes. If the sites are considered independent projects, which sites are
acceptable?

Site Construction Cost Annual Benefits

$ $/year
A 6,000,000 350,000
B 8,000,000 420,000
C 3,000,000 125,000
D 10,000,000 400,000
E 5,000,000 350,000
F 11,000,000 700,000

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Solution:

AW of a permanent investment AW = P.i

A B C D E F

Construction Cost, $ 6000 8000 3000 10000 5000 11000

AW Costs, $/year 360 480 180 600 300 660

AW Benefits, $/year 350 420 125 400 350 700

𝐵
Site 0.97 0.88 0.69 0.67 1.17 1.06
𝐶
Site selected NO NO NO NO YES YES

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