Cost Benefit Analysis

Gopalakrishnan K 028 Manish Murthy 139

PGDM-Operations

Introduction

CBA estimates and totals up the equivalent money value of the benefits and costs to the community of projects to establish whether they are worthwhile

Federal Navigation Act of 1936

U.S. Corps of Engineers carry out projects for the improvement of the waterway system

Consistent set of methods for measuring benefits and costs and deciding whether a project is worthwhile

Principles of CBA

Computation of components of costs and benefits sometimes intuitive and sometimes not
So, common unit of measurement most convenient unit is money
All

benefits and costs of a project should be measured in terms of their equivalent money value

Benefits that are not directly expressed in terms of dollars but some money the recipients of the benefits would consider

E.g. Free monthly visit to a doctor

Principles of CBA
Benefits and costs of a project have to be expressed in terms of dollars of a particular time

Net benefit of the projects is just the sum of the present value of the benefits less the present value of the costs

Discounted present value of that benefit of the project

CBA Valuations

Should Represent Consumers or Producers Valuations As Revealed by Their Actual Behaviour

Should reflect preferences revealed by choices which have been made

E.g. Improvements in transporation

Choices involving tradeoffs between time and money

Challenging part of CBA is finding past choices which reveal the tradeoffs and equivalencies in preferences

CBA Valuations

Should Represent Consumers or Producers Valuations As Revealed by Their Actual Behaviour

Should reflect preferences revealed by choices which have been made

E.g. Improvements in transporation

Choices involving tradeoffs between time and money

Challenging part of CBA is finding past choices which reveal the tradeoffs and equivalencies in preferences

Market Choices
Consumers buy things which are at least as beneficial as the money they relinquish

For any consumer buying some of a commodity, the marginal benefit is equal to the market price

Relationship between the market price and the quantity consumed is called the demand schedule

Gross Benefits of an Increase in Consumption is an Area Under the Demand Curve

Market Choices

When the increase in consumption is small compared to the total consumption the gross benefit is adequately approximated, as is shown in a welfare analysis

CBA

Some Measurements of Benefits Require the Valuation of Human Life

Choices can be used to estimate the personal cost people place on increased risk and thus the value to them of reduced risk

The impact of a project is the difference between what the situation in the study area would be with and without the project
An

alternative to the project must be explicitly specified and considered in the evaluation of the project

CBA
The impacts of a project are defined for a particular study area, be it a city, region, state, nation or the world

Sometimes an impact of a project can be measured in two or more ways. E.g. : highway

Decision Criteria for Projects

Ratio

of benefits to costs greater than

1(PV)
Highest

net PV value (mutually exclusive projects) rate based on trial and error net PV = funds available ratio arbitrary operating costs net out from benifits

Discount

Benefit-Cost

Example Highway Project

Four-lane

highway 101 and the traffic to San Jose no median divider inordinate number of heads-on collision Blood Alley extension to San Jose is proposed as a new project

Highway

Time

Saving & Lowers risk

traffic

Increased

Analysis
TRIP DATA Rush Hours Passenger Trips (per hour) Trip Time (minutes) Value of Time ($/minute) Nonrush Hours Passenger Trips (per hour) Trip Time (minutes) Value of Time ($/minute) Traffic Fatalities (per year) No Extension, 101 Extension "Blood Alley" Only and "Blood Alley" 3,000 50 $0.10 4,000 30 $0.10

500 35 $0.08 12

555.55 25 $0.08 6

Monetary Benefits
Hourly
TYPE

Benefit

Trips Which Would Trips Generated Total Be Taken Anyway By the Project Rush Hour 6,000.00 1,000.00 7,000.00 Nonrush Hour 400 22.22 422.22

Yearly

Benefit 260 weekdays @ 6 rush hours/weekday 1560 Rush & 7200 nonrush Trips Which Trips Generated
Total Would Be By the Project Taken Anyway Rush Hour $9,360,000 $1,560,000 $10,020,000 Nonrush Hour $2,880,000 $160,000 $3,040,000 Total $12,240,000 $1,720,000 $13,960,000 TYPE

Total Value Benefits

Risk

Saving

Accept $400 increase for every increase in 1/1000th increase in risk of death Implicit valuation of life is $400,000
Total

Value of Benefits
TYPE OF BENEFIT Time Saving Reduced Risk Total Saving VALUE OF BENEFITS PER YEAR $13,960,000 $2,400,000 $16,360,000

Assumed

to be constant over 30 years

Costs
Cost

of Construction - $200m for 4 years Maintenance - $1m/year after construction Right-of-way - $100m Assumed to recover right-of-way cost at end of BENEFITS 30 years TIME RIGHT-OF CONSTRUCTION MAINTENANCE
(year) ($millions) 0 1-4 5-29 30 0 0 16.36 16.36 -WAY ($millions) 100 0 0 -100 COSTS ($millions) 0 50 0 0 ($millions) 0 0 1 1

Net Present Value

Interest Rate Real All

Rate on long term bonds is 8%

of Inflation is 6% rate of interest is 2%

benefits & costs discounted at 2% to time zero

Formula

Net Present Value

Benefits Costs Right-of-Way Construction Maintenance Total Costs Net Benefits PRESENT VALUE ($ millions) 304.11

44.79 190.39 18.59 253.77 50.35

Key Takeaways
Benefit/Cost At

ratio at 2% discount 1.2

3% discount, <~1

Right-of-way

may have increasing value with time discounted PV for alternate use may be more like $150m instead of $100m

Summary

Monetary representation of postive and negative impacts helps determining worthiness of the project Valuation based on consumer and product market choices Care to include all impacts including inflation Worthwhile project is one whose
Discounted value of benefits exceeds discounted value of costs Benefit/cost ratio greater than one Internal rate of return greater than cost of capital