Management Consulting/MS- 42
3. What do you understand by Economic appraisal and social cost benefit analysis of a project? 4. What is project risk? Explain the various techniques used for measurement of project risk.
3.What do you understand by Economic appraisal and social cost benefit analysis of a project?
WHAT IS Economic appraisal of a project?
Analysis from the economic aspect assesses the desirability of an investment proposal in terms of its effect on the economy. The question to be addressed here is whether the investment proposal contributes to the developmental objective of the country and whether this contribution is likely to be large enough to justify the use of scarce resources such as capital, skilled labour, managerial talents etc., that would be needed to implement and operate the project. In economic analysis, input and output prices are adjusted to reflect true social or economic values. These adjusted prices are often termed as shadow or accounting prices. The taxes and duties are treated as transfer payments and are excluded from the capital and operating cost. The two main steps in economic analysis are: (a) the "pricing of project inputs and outputs" and (b) the "identification of project costs and benefits". These steps are discussed below:
(a) Pricing of Project Inputs and Outputs
In economic analysis, the valuation of inputs and outputs can be made keeping in view the following three rules:
i) Most of the inputs in economic analysis are valued at opportunity cost or on the principle of willingness to pay. Actually it is assumed that all inputs to the project are diverted away from alternative uses. Each input has generally value in alternative use. But this use may be sacrificed so that the input can be used by the project. This sacrifice is a cost to the nation; it is an opportunity foregone because of the project. Every input to the project is valued at this opportunity cost-the value of the input in its best alternative use;
ii) For some final goods and services, usually non-traded ones, the concept of opportunity cost is not applicable because it is consumption value that sets the economic value. This criterion is called "willingness to pay" or "value in use".
iii) The third rule of pricing inputs and outputs is that the analysis is done at present, i.e. constant prices. This is because current price analysis entails the prediction of inflation rate which is difficult and unreliable.
(b) Identifying Project Costs and Benefits
Proper identification of project costs and benefits is an important step. An improper identification of costs and benefits would lead to under - estimation of costs or over-estimation of benefits or vice versa. The identification of secondary costs and benefits is a difficult task. For example, most of the benefits from an expanded irrigation project may be offset by a fall in fish production and reduce income for thousands of fishermen. Increased benefits due to the construction of a new highway may be equally matched by a reduction in the income of the railways due to decrease in passengers/goods. An important technique which is followed for correct quantification of costs and benefits is "with and without project" comparison of costs and benefits. Project analysis tries to identify and value costs and benefits that arise with the proposed project and to compare them with the situation as it would be without the project. The difference is the incremental net benefits arising from the project investment. This approach is not the same as comparing the situation "before" and "after" the project. The "before" and "after" comparison fails to account for changes in production over the life of the project that would occur without the project and thus leads to an erroneous statement of benefits attributable to the project investment. A change in output can also occur without the project if production would actually fall in the absence of new investment. In some cases, an investment to avoid a loss might also lead to an increase in production so that the total benefits would arise partly from the loss avoided and partly from increased production. Here are some special items which must carefully be handled while identifying and quantifying costs and benefits for financial and economic analyses:
i) Direct Transfer Payments
Some entries in financial accounts really represent shifts in claims of goods and services from one entity in the society to another and do not reflect changes in the national income. The following four kinds of transfer payments are important which are not included in economic analysis:
(a) Taxes (Direct and Indirect)
When a farmer pays a tax, his net benefit is reduced but it does not reduce national income. It is a cost to the farmer and is not a cost from the stand-point of society as a whole. Thus, unlike financial analysis, in economic analysis, we would not treat the payment of taxes as a cost in project accounts. However, some taxes called user taxes are exempted from this rule. Governments often include payments for road improvements, water or power supply charges in property taxes and this element of property tax does represent a real cost to society. Highway and bridges tolls, if accurately set, also may be users taxes and represent real cost. But taxes on gasoline and petrol do not represent users taxes.
Subsidies are simply direct transfer payments, that flow in the opposite direction from taxes. If a farmer is able to purchase fertilizer at a subsidized price, that will reduce his costs and thereby increase his net benefit. But fertilizer used by the farmer is cost to the economy and in economic analysis must enter the full cost of fertilizer. Another form of subsidy is that which lowers the selling price of inputs below what otherwise would be their market price. Market price may be maintained at a level higher than it otherwise would be by, say, levying an import duty on competing imports or forbidding competing imports altogether. The difference between the higher controlled price, set by such measures, and lower price for competing imports, that would prevail without such measures, does represent such indirect subsidy.
(c) Credit Transactions
Credit transactions are the other major form of direct transfer payment. Loan to a farmer, for example, does not reduce the national income. It merely transfers the control over resources from the lender to borrower. Same is the case when the farmer repays the loan (interest + principal).
In determining the gross cost-stream for calculating discounted measures of project worth, we do not include interest as a cost both in economic and financial analysis. Expressing it in another way, we do not deduct interest from the benefit-stream on the capital supplied by the entity for which we are doing the analysis, because in effect the result of a discounted flow analysis is the allowance for the return to the entity capital (interest). If we compute net present worth, we are determining what would be left over after allowing for some specific rate of return to the entity's own capital, the interest. When we compute "IRR", this is return to the entity's own capital and, in a sense, is the interest which that capital earns. Thus, interest is not cost in deriving the cash flow for financial/economic analysis.
Project appraisal attempts to measure the profitability of all resources devoted to the project; it is not concerned with the way in which these resources are financed. Interest is the cost of time (waiting) and discount rate is also supposed to be a measure of the cost of waiting for future benefits. So interest is automatically allowed for in the discounting procedure. Since the principal of a loan is used to purchase building and equipment whose costs are already part of the cash flow, repayment of that principal would add a cost that had already been charged to the project. It may however be noted that interest on capital is to be shown in the overall cost of a project.
Depreciation is an accounting concept necessary when accounts are to be prepared for one year at a time (not prepared as a projection over the life of the project) and must include an allowance for the capital use during each year. Actually a part of the project's revenue is set aside in an account labelled "depreciation" to ensure that some revenues are retained to replace capital when it wears out. Thus, it is neither a cost nor a cash outflow. In fact, to include it as a cost would be double-counting. So in determining the gross cost-stream for calculating out discounted measures of project worth we do not include depreciation as a cost or, expressing it in an other way, in computing the incremental net benefits, we do not deduct from the gross benefits any allowance for depreciation because the incremental net benefit-stream already allows for the return of capital (depreciation) over the life of the project. When we discuss cash flow, it is an undifferentiated combination of:
(a) depreciation or amortization - return of capital
(b) returns paid for the use of capital, such as, dividends, profits, and the like-returns of capital.
We do not subtract depreciation as a cost. Yet the internal rate of
return is a measure of the earning capacity of a project - that is, the return to capital - while net present worth determines whether a project can earn more than some stated amount of return to capital. The easiest way to go about illustrating what happens to depreciation is to compute the benefit-cost ratio, the net present worth, and the internal rate of return of a hypothetical example in which we analyse a project which does not exactly lose money, but, on the other hand, does not make money either. In other words, its internal rate of return is zero, its net present worth at zero discount rate is zero, and its benefit-cost ratio at zero rate of interest is just exactly one. Can we get our money back? Yes, we can. We spent say Rs 1,200,000 over the five years of the project and by the end of the fifth year suppose we have received just exactly Rs 1,200,000 back. So we do not lose any of our capital and we recovered all of our other costs. Did we earn anything on this project? No both the internal rate of return and the net present worth of this project were simply zero, and the benefit-cost ratio had to be computed at zero rate of interest to have them come out to 1. Therefore, return of capital is realized (that is, depreciation is covered and fully accounted for) when the net present worth of the project at a zero discount rate is zero or greater, when the project earns an internal rate of return of zero or greater, and when the benefit-cost ratio or net benefit-investment ratio is 1 at a zero or greater rate of interest. We do not need to include depreciation separately as a "cost" in analyzing our project. It is automatically taken care of in the computational process. (There is another convenience -- we do not need to make any decision about what depreciation schedule to use, a notoriously difficult and arbitrary choice that is essentially an accounting, not an economic, problem.)
Of course, if the net present worth at zero discount rate is less than zero, if the internal rate of return is less than zero, or if the benefit-cost ratio or the net benefit-investment ratio at zero rate of interest is less than 1, then we not only would have earned nothing, but actually would not even have recovered all our costs.
iii) Sunk Cost
It is a cost incurred in the past that cannot be retrieved as a residual value from an earlier investment. A sunk cost is not an opportunity cost and thus is not included in the costs in the project analysis. The purpose of economic and financial analysis is to help determine which among the alternatives open to us provides the best use of resources. Our decision starts from today; what is past is past and cannot be changed. The argument that much has already been spent on a project and, therefore, the project must be continued is not a valid decision criterion. In a case where a project is midway toward completion and a decision regarding the fate of the project has to be taken, we have two options, ie (i) simply stop the project and (ii) draw it to an early conclusion and then to use the available future resource expenditures freed from the project for higher-yielding alternatives.
For evaluating past investment decisions, it is often desirable to do an economic and financial analysis of a completed project. Here, of course, the analyst would compare the expenditures with all returns over the past life of the project. But this kind of analysis is useful only for determining the yield of past projects in the hope that judgement about future projects may be better informed.
iv) Contingency Allowance
While preparing projects, it is assumed that there will be no exceptional conditions, say, in agriculture, a land-slide, floods and bad weather. It is also assumed that there will be no relative changes in domestic or international prices and no inflation during the investment period. It would clearly be unrealistic to base project cost estimates only on these assumptions of perfect knowledge and complete price stability. Sound project planning requires that provisions be made in advance for possible adverse changes in physical conditions or prices that would add to the baseline costs. Contingency allowance may be divided into physical and price contingency. Price contingency comprises two categories, that for relative changes in price and that for general inflation. The increase in the use of real goods and services represented by the physical contingency allowance is a real cost and will reduce the final goods & services available for other purposes, ie it will reduce the national income and hence is a cost to the society. Similarly, a rise in the relative cost of an item implies that its productivity elsewhere in the society has increased, ie its potential contribution to the national income has increased. In project analysis, the most common means of dealing with inflation is to work in constant prices on the assumption that all prices of inputs and outputs will be affected equally by any rise in the general price level. Hence, contingency allowance for physical and relative price changes is included in the financial and economic analysis but contingency allowance for inflation is not included in economic analysis.
Project analysis is undertaken in constant prices. It is assumed that the current price level will continue to apply and that inflation will affect most prices to the same extent so that prices retain their same general relations. By comparing the current estimates of costs and benefits with the constant prices, we can judge the effects of inflation on the project. It is quite possible to undertake project analysis in current prices. The problem in this approach is that it involves predicting inflation rates, and predicting inflation rates is one of the most difficult jobs because its accuracy may be seriously questioned. Furthermore, governments due to political reasons understate high inflation rates which may lead to the under-estimation of project costs.
vi) Changes in Relative Prices
A change in a relative price means a change in the market price structure that the producer pays either for inputs or for outputs. A change in relative price, then, is reflected directly in the project's financial accounts. A rise in the relative price of fertilizer reduces the incremental net benefits to the farmer. It is, thus, a cost in the farm account. A change in the relative price of an item implies a change in its marginal productivity, that is, a change in its marginal product value. In economic analysis, where maximizing national income is the objective a change in the relative price of an input implies a change in the amount that must be forgone by using the item in the project instead of elsewhere in the economy. Thus, changes in relative prices have a real effect on the project objective and must be reflected in the project accounts in the years when they accrue.
vii) Working Capital
Confusion sometimes arises about how to treat capital used for short-term purposes and revolving within a single year. This might be the case, for example, for production credit lent to farmers but recovered at the end of the growing season. Such capital is sometimes overlooked because it may not show up as a net expenditure in a year-by-year build-up of project costs and benefits. It is not, however, available for other purposes in the society and is properly considered a project cost. It should be entered as a cost in the cash flow build-up under the first year. It then becomes a part of salvage value at the end of the project.
viii) Replacement Costs
Many projects require investments which have different economic lives. A good example is found in the case of a sugarcane processing factory where the buildings and machinery may be expected to last twenty years but where boilers may have a life of only five years. In preparing the analysis, allowance must be made for the replacement costs of the boilers during the life of the project. It can be shown in the year of occurrence, ie when the boilers will be replaced.
ix) Residual/Salvage Value
Often at the end of a project, some residual (or salvage/terminal) value may reasonably be expected. It should not be confused with scrap value. It is the value of that part of a capital asset that has not been used up in the course of the project period. We would treat this value as a project benefit during the last year of the project life. This value is entered as a negative cost in the cost-stream against the year it will accrue. This value will not change the results significantly, unless the period of the analysis is short, or the value of the capital items is quite large in relation to the value of the benefit-stream.
SOCIAL Cost-benefit analysis is a term that refers both to:
1 helping to appraise, or assess, the case for a PROJECT or proposal, which itself is a process known as PROJECT APPRAISAL ; and
2 an informal approach to making economic decisions of any kind.
Under both definitions the process involves, whether explicitly or implicitly, weighing the total expected costs against the total expected benefits of one or more actions in order to choose the best or most profitable option. The formal process is often referred to as either CBA (Cost-Benefit Analysis) or BCA (Benefit-Cost Analysis).
Benefits and costs are often expressed in money terms, and are adjusted for the time value of money, so that all flows of benefits and flows of project costs over time (which tend to occur at different points in time) are expressed on a common basis in terms of their “present value.” Closely related, but slightly different, formal techniques include COST-EFFECTIVENESS analysis, ECONOMIC IMPACT ANALYSIS , fiscal impact analysis and SOCIAL RETURN IN INVESTMENT (SROI) analysis. The latter builds upon the logic of cost-benefit analysis, but differs in that it is explicitly designed to inform the practical decision-making of enterprise managers and investors focused on optimising their social and environmental impacts.
States have limited resources which they use for addressing public problems. In addition to public expense for buying goods and services or for social assistance, the State also has a great impact on businesses and population when adopting various rules governing their activities (regulation) or setting taxes. The adoption of legislation itself does not cost much but the regulations laid down in legislation often make a great impact on the whole economy.
In planning a public initiative it is always relevant to analyse whether or not a state intervention is necessary, which problems should be addressed first using the available limited resources, what methods of intervention implementation should be selected, and what is the envisaged impact of a public initiative (regulation, tax, assistance or public expenses) on society and its separate groups.
The cost-benefit analysis is a widely applied technique of economic analysis which allows the determination and evaluation of economic costs and benefits, both direct and indirect, of a certain public initiative. These costs and benefits are expressed in terms of money. This technique is suitable for evaluating the net benefit of an intervention and comparing different alternatives of the intervention with each other. The cost-benefit analysis is carried out when the envisaged consequences of an intervention for the implementing organisation cover much more than financial consequences alone. The aim of the cost-benefit analysis is determine whether or not an intervention is necessary and whether or not it will contribute to public welfare. Another advantage of the cost-benefit analysis lies in the fact that it provides a uniform methodological basis for the assessment of the impact of a decision in various aspects.
The main features of the cost-benefit analysis are the following:
cost-benefit analysis should be used for the evaluation and comparison of all (i.e. not only one) realistic alternative solutions/measures to the problem at issue;
the consequences of a public initiative – economic benefits and costs – are assessed regardless of which public group or institution derives or incurrs tehm;
it aims to estimate in monetary value all most important constituents of the initiative’s costs and benefit (not only those having clear market value);
cost-benefit assessment is based on the principles of (a) individuals’ willingness of pay for goods or services and (b) willingness to accept a compensation for negatives consequences. (For more information on these principles see chapter 2.4.3 of the Guide);
assessment takes into account the impact of the time factor on the value of cost and benefit flows.
The cost-benefit analysis is often used to assess investment projects2; however, it is a flexible technique which can be applied for the assessment of initiatives of another type – regulation, taxes, public sector reforms, etc. This technique may be employed both ex-ante (prior to initiative implementation) and ex-post (upon initiative implementation).
Despite a number of advantages provided by the technique of a cost-benefit analysis for public initiatives assessment, certain difficulties are encountered during its application which are important to know and evaluate prior to starting the analysis. Firstly, the fullness and reliability of data are of major relevance in the cost-benefit analysis. Quality and complete data are sometimes unavailable and a lot of effort and resources (time, financial) may be required for their collection. Secondly, it is often more easy to evaluate the costs rather than benefit of decision implementation. The evaluation of benefit is more difficult in the cases when certain goods are not sold on the market (e.g. human health, security, clean environment). In certain cases the reliability of an analysis is too much dependent on the selected assumptions.
Advantages of applying the cost-benefit analysis technique Difficulties of applying the cost-benefit analysis technique
A uniform methodological basis for the quantitative evaluation and comparison of the costs and benefit of different public initiative alternatives Full and reliable data are required
Evaluation of both positive and negative consequences is possible
Evaluation of initiative’s benefit for the whole society It is often more easy to evaluate the costs rather than benefit of decision implementation
Can be applied for the assessment of public initiatives of different nature alternatives
The carrying out of the cost-benefit analysis itself results in costs and therefore its benefit should be above the costs. (Furthermore, the cost-benefit analysis may be carried out at different levels of detail. In adopting a decision on the requirement to carry out the cost-benefit analysis of a particular public initiative and the level of its detail it is very important to observe the principle of proportionality, i.e. the level of detail of the analysis should depend on the importance, the envisaged impact extent and riskiness of a decision and data availability. In Lithuania it is recommended to apply the cost-benefit analysis for assessing the impact of the most important decisions and only if the required data or resources to collect them are available.
A full cost-benefit analysis is be carried out when most key elements of costs and benefit can be evaluated in terms of quantity and money and if a certain freedom of choice when formulating the goals and target results of an initiative (e.g. their modelling depending on alternative’s costs is possible) exists.
Where only part of the relevant costs and benefit are quantifiable a partial cost-benefit analysis is carried out (i.e. only part of important cost and benefit elements is evaluated). The outcome of analysis should be discussed taking into account the qualitative evaluation of other costs and benefit.
APPLICATION OF THE COST-BENEFIT ANALYSIS TECHNIQUE FOR PROPOSED DECISION IMPACT ASSESSMENT
An assessment of the envisaged impact of any initiative shall be carried out in several steps:
1. Description a public life problem;
2. Determination of the pursued goals, results and the target situation;
3. Identification of realistic alternative solutions to the problem;
4. Evaluation of alternatives and their comparison with each other;
5. Upon determining the optimum alternative, discussion of its further implementation.
Identification of a public policy problem Step 2
Determination of the public initiative goals Step 3
Identification of realistic alternative solutions to the problem Step 4
Analysis of alternatives Step 5
Evaluation of implementation of the selected alternative
What is the problem of public policy? What is its extent and relevance?
What results are pursued through initiative implement ation?
What are possible solutions to the problem?
To analyse alternative solutions to the problem: to evaluate the costs and benefit of implement
How will the selected alternative be implement ed? (responsib ility, action
Should the State address it? What will happen if no actions are taken by the State?
How will we know whether the State’s actions proved to be successful?
Include status quo as an alternative
ation of each alternative.The recommendation is to use the cost-benefit analysis for this evaluation, where possible
What indicators will be used to assess the success of implementation?
There are several assumptions on the basis of which the cost-benefit analysis is carried out:
a decision may have an impact on various economic sectors as they are interrelated (general equilibrium);
intangibles are included into analysis if they can be reliably evaluated;
all related costs/investments are assessed;
costs and benefit are evaluated from the perspective of the national economy (i.e. not the perspective of the Government or an individual institution);
generally, the period covered by the cost-benefit analysis depends on the useful life of fixed assets (e.g. if a new information system is introduced). However, it is impossible to establish such period for part of public policy decisions (e.g. for health policy instruments etc.). In such a case the recommended period of analysis is 20 years. A longer period is relating to great uncertainty; furthermore, in many cases cost and benefit flows lose their significance in the distant future due to discounting.8
Most frequent types of costs Type of costs Sustained by state institutions implementing a decision Sustained by decision’s target groups/society groups
Financial direct expenses from State and municipal budgets and other funds
Administrative expenses of state institutions
Human resources required for intervention implementation
Implementation expenses Policy implementation, monitoring, supervision expenses Expenses relating to the selection of the most acceptable manner of the observance of requirements
Compliance expenses Uniform implementation expenses – see above Direct expenses sustained by regulated or intervention-impacted entities seeking to comply with the established requirements. These costs include an administrative burden (for more
information about its assessment see chapter 188.8.131.52.).
Adjustment expenses Costs sustained because of the redistribution of resources which is encouraged by behavioural change predetermined by a policy instrument (production/consumption).