PPA 502 – Program

Evaluation

Lecture 7 – Benefit-cost Analysis in

Program Evaluation
Benefit-cost and Cost-
effectiveness Analysis
 Benefit-cost analysis is an applied branch of
economics that attempts to assess service
programs by determining whether the total societal
welfare has increased (in aggregate more people
have been made better off) because of the project
or program.
 Steps.
– Determine the benefits of a proposed or existing
program and place a dollar value on those benefits.
– Calculate the total costs of the program.
– Compare the benefits and costs.
Benefit-cost and Cost-
effectiveness Analysis
 Simple steps pose real challenge, especially
estimating intangible benefits.
 Procedure still useful in uncovering
assumptions and estimating value of
intangibles.
Benefit-cost and Cost-
effectiveness Analysis
 Cost-effectiveness analysis.
– The major costing alternative to benefit-cost analysis.
• Relates the cost of a given alternative to specific measures of
program objectives.
– For example, dollar per life saved on various highway
safety programs.
– Often the first step in a benefit-cost analysis.
– Especially useful if analyst cannot quantify benefits,
but has fairly specific program objectives.
– Key problem: situation where there are multiple
benefits. Results often very subjective.
– 2nd key problem: does not produce a bottom line
number.
Benefit-cost and Cost-
effectiveness Analysis
 A private sector analogy.
– Benefit-cost analysis similar to financial analysis in
private sector.
• Should the firm have done the project at all, i.e., Is the project
producing a satisfactory rate of return?
• Public version: is the program a success, i.e., Has it improved
social welfare?
• What other options are there for the use of the firm’s
resources?
• Public version: should the program be continued when
weighed against alternative uses for the government’s funds.
Benefit-cost and Cost-
effectiveness Analysis
 A private sector analogy.
– Benefits and costs do not occur simultaneously
in either private or public sector.
• R&D costs, marketing, capital investment, training.
• Government not priced, thus benefits are more
broadly defined.
– Alternative uses of resources (opportunity
costs).
Benefit-cost and Cost-
effectiveness Analysis
 Benefit-cost illustration.
Costs
Year R&D Capital O&M Total Benefits
1 $1500 $2000 $0 $3500 $0
2 500 2000 2000 4500 3500
3 2000 2500 4500 5500
4 2000 3000 5000 6500
5 2000 3500 5500 8500
Totals $2000 $10000 $11000 $23000 $24000

Year Benefit-Costs Present Value, Benefits-Costs (10%)

1 ($3500) ($3500)
2 (1000) (909)
3 1000 826
4 1500 1127
5 3000 2049
Totals $1000 ($407)
Net Present Value @ 10% ($407)
Net Present Value @ 5% 219
Benefit-cost and Cost-
effectiveness Analysis
 Formula for net present value.

B y2
 C y2
B y3
 C y3
B yx
 C yx
NPV  B y1  C y1    ... 
1 r (1  r ) 2
(1  r ) x1
 Formula sensitive to choice of rate of return.
 Could also use return on investment.
– Discount rate that would make the present value zero.
Benefit-cost and Cost-
effectiveness Analysis
 Continuing or not continuing the project.
Costs
Year R&D Capital O&M Total Benefits
6 $500 $400 $4500 $5400 $9000
7 400 5000 5400 8500
8 400 6000 6400 8500
9 400 7500 7900 8000
10 400 8000 8400 7500
Totals $500 $2000 $31000 $33500 $41500

Year Benefit-Costs Present Value, Benefits-Costs (10%)

6 $3600 3600
7 3100 2818
8 2100 1736
9 100 75
10 (900) (615)
Totals $8000 $7614
Net Present Value @ 10% $7614
Net Present Value @ 5% $7803
Benefit-cost and Cost-
effectiveness Analysis
 Total versus marginal benefits and costs.
– When considering the overall profitability of a project,
an agency will consider the total costs involved in
getting the project started through its operation’s cycle.
– But at any point in time, when an agency is continuing
or discontinuing a project or program, it only considers
the marginal costs or benefits.
– Definitions.
• Marginal cost: incremental cost of producing one more unit of
output.
• Marginal benefit: incremental benefit of that one unit of output.
– Public sector usually does not do it on the basis of a
single unit, but what are the benefits being generated
now versus the costs now?
Benefit-cost and Cost-
effectiveness Analysis
 Public-private sector differences and
similarities.
– Similarities – alternative uses for funds, one-
time costs, recurring costs, land, labor, capital.
– Differences.
• Distributional considerations.
• Spillovers.
Framework for Analysis
Benefit Indicator Measure Dollar value Assumptions
Real
Direct
Tangible
Intangible
Indirect
Tangible
Intangible

Cost Indicator Measure Dollar value Assumptions

Real
Direct
Tangible
Intangible
Indirect
Tangible
Intangible

Transfers
Framework for Analysis
 Real benefits and costs versus transfers.
– Real: net gains and losses to society.
– Transfers: merely alter the distribution of
resources in society.
Framework for Analysis
 Direct and indirect benefits and costs.
– Direct costs and benefits are closely related to
the primary objectives of the project.
• Direct costs – personnel, facilities, equipment,
material, project administration.
– Indirect costs and benefits are byproducts,
multipliers, spillovers, or investment effects.
• Indirect costs are unintended costs that result from
government action.
• Indirect benefits might include benefits of space
exploration.
Framework for Analysis
 Tangible and intangible benefits and costs.
– Tangible benefits and costs can be converted
readily into dollar figures.
– Intangible benefits and costs are those things
that cannot be directly assigned an explicit
price.
 Determining the geographic scope of
analysis.
– Spillover effects may determine true
geographic jurisdiction.
Framework for Analysis
(Agricultural Dam Example)
Real Benefits Nature of Benefit/Cost
Direct
Tangible Increased farm output
New supply of water

Intangible Maintaining family farms

Indirect
Tangible Reduced soil erosion

Intangible Preservation of rural society

Real Costs
Direct
Tangible Construction material, labor, operations and maintenance, direct program supervision by agency

Intangible Loss of recreational value of land or river

Indirect
Tangible Administrative overhead of government
Diversion of water and its effects
Increased salinity

Intangible Loss of wilderness area

Transfers Relative improvement of profit for farm implement industry

General taxpayers may be subsidizing farmers.
Measuring Benefits
 Evaluation problem difficult for government
because of multiple benefits and
intangibles.
Measuring Benefits
 Sources of data.
– Existing records and statistics kept by agency.
– Feedback from clients.
– Ratings by trained observers.
– Experience of other governments or private or
nonprofit corporations.
– Special data gathering.
 Whenever possible analyst should use
market value or willingness to pay.
Measuring Benefits
 Valuing benefits.
– Cost savings.
– Time saved.
– Lives saved.
– Increased productivity or wages.
– Recreational benefits.
– Land values.
– Alternatives to market prices.
Measuring Costs
 Cost categories.
– One-time, fixed, or up-front costs.
– Ongoing investment costs.
– Recurring costs.
– Compliance costs.
– Mitigation measures.
Measuring Costs
 Valuing indirect costs.
– Flat overhead figure.
• Does the project actually costs increased administrative
burden?
– Costs to the private sector.
– Valuing the use of capital.
– Valuing the damage effects of government programs.
– Other cost issues.
• Sunk costs.
• Interest costs.
Analysis of Benefits and Costs
 Framework.
– Retrospective.
– Snapshot.
– Prospective.
Analysis of Benefits and Costs
 Importance of using present value.
– Choice of an appropriate discount rate.
• Private sector rate.
• Low social discount rate.
• Long-term treasury bill rates.
– Adjustment for inflation.
Analysis of Benefits and Costs
 Presenting the results.
– Net present value (B-C).
– Benefit cost ratio (B/C).
– Return on investment (discount rate to reduce
present value to zero).
 Appropriate perspective.
– Costs and benefits vary across stakeholders.
– May conduct analyses from several
perspectives.
Analysis of Benefits and Costs
 Sensitivity analysis.
– Use spreadsheet analysis to vary the assumptions.
 Intangibles.
– Relate intangibles to dollar results: if there are net
costs, do the intangible benefits overcome the deficit?
 Particular problems.
– Equity concerns (weighting of values).
– Multiple causation and co-production problems.