COST BENEFIT ANALYSIS- PUBLIC SECTOR INVESTMENTS

Lucky Yona

Major Concern in Private Investment In private investment the project appraisal

is the investor. Two major issues of Concern

Private Costs Private Benefits

The investor is not interested with social costs

and benefits

Major Concern in Public Investment

In public sector the focus would be broader to incorporate all who will be affected in terms of costs and benefits. In this case the investor must be concerned not only with

their private costs and benefits but all costs and benefits of all parties that will be impacted by the investment and its consequences. ( Consider all Stakeholders)

The benefits and costs to be considered Economic Costs and Benefits- Often Quantifiable Social Costs and Benefits- Often non quantifiable

Consider a Donor Funded Project

How should public expenditure or donor-led programs be appraised?

Formal economic analyses (based on net present values) tend to be inadequate for such analyses as the anticipated objectives are often broader than pure market concerns .

Consider a Donor Funded Project

In such cases of projects, donors may have expressed additional objectives such as local capacity-building, employment generation, as well as encouraging advocacy on disability issues.

How do we quantify these additional goals to assess the economic viability of the donor investment?

Standard Approach

The standard approach used in such analyses are developed from social cost-benefit analysis (Thirlwall, 2003).

Social cost-benefit analysis is often viewed as the public expenditure equivalent of net-present value methods used in evaluating private investments.

In general, any project appraisal must distinguish between three components: financial, economic, and

social appraisal.

Three Types of Appraisal

In general, any project appraisal must distinguish between three components:

financial, economic, social appraisal.

Financial appraisal examines the financial flows generated by the project itself, and the direct costs of the project measured at market prices.

Three Types of Appraisal

Economic appraisal adjusts costs and benefits to take account of costs and benefits to the economy at large, including the indirect effects of the project that are not captured by the price mechanism.

Three Types of Appraisal

Social appraisal examines the distributional consequences of project choices, both inter temporal concerns (i.e. effects over a period of time, today versus the future); and also intra temporal concerns (e.g. concerns between groups in society at a specific point in time).

Cost Benefit Analysis

Cost-benefit analysis (CBA) is a framework for evaluating the social costs and benefits of an investment project.  

This involves identifying, measuring and comparing the private costs and negative externalities of a scheme with its private benefits and positive externalities, using money as a measure of value.

STEPS IN CBA

Step 1: identify all costs and benefits using the principle of opportunity cost

Step 2: measure the benefits and costs using money as a unit of account

STEPS IN CBA

Step 3: consider the likelihood of the cost or benefit occurring (i.e. sensitivity analysis)

Step 4: take account of the timing of the cost and benefit (i.e. discounting). A £1,000 benefit now is worth more than £1,000 benefit in 10 years time

Step 1-Indentify all costs and benefits

A firm deciding on an investment project will only take account of its own private costs and benefits e.g. total cost and total revenue. Firms ignore externalities.

CBA will take account of both private and external costs and benefits.

Consider a project to build a bridge over a river: Private Costs e.g. construction costs, operating costs and

maintenance costs External Costs i.e. costs incurred by non users (a)

monetary e.g. loss of profits to competitors e.g. to ferry owner and (b) non monetary e.g. noise, loss of countryside, inconvenience

Step 1-Indentify all costs and benefits

Private benefits  (a) direct the amount consumers are prepared to pay e.g. the tolls paid (b) indirect i.e. consumer surplus

External benefits i.e. benefits to non users e.g. consumer surplus of users; time savings for travelers and fewer accidents

Step -2- Measure the Benefits and Costs Height can be measured using feet and inches.

Benefits and costs can be valued using money. Private costs and benefits relatively easy to measure in monetary terms

Total costs and total revenue. Private costs Build the bridge: £5,000, 000 to operate

it £200,000 a year, to repair and maintain £ 50,000  qPrivate benefits 1,000,000 users each paying £1

each = £1,000,000 a year

Step -2- Measure the Benefits and Costs Externalities are more difficult to measure:

Noise or loss of countryside. What value do people place on these? By how much do those who suffer need to be compensated Ask them using a questionnaire! If 50,000 affected people value the annual loss of countryside at £5 then cost = £250,000

Time savings. What value do we place on work time saved or leisure time saved? Is the time saved worth the same to everyone? If 100,000 hours re saved and valued at £4 per hour, benefit = £400,000

Fewer accidents. Economists value human life using money! One life = £750,000. If the bridge saves on life a year, annual benefit is £750,000

Step 3- Likelihood of the cost or Benefit If there is a 50% chance that a life will be

saved then the benefit is£750,000 x 0.5 = £325,000

Step 4- Timing of the cost and Benefits The major costs of the project occurs straight

away. The benefits occur over the life of the project. The bridge may cost £5m to build but consumers benefit by £1m a year.

If the expected life of the bridge is 25 years then how do we value now £1m of benefit in 25 years time? 

Economists discount the future benefit to identify the present value.

Step 5- Is a project worth undertaking? Yes if discounted benefits outweigh

discounted costs. If the government has to choose between

competing projects then the ones with the highest positive net present value should be undertaken.

SOCIAL DISCOUNT RATE OF RETURN Defined as the best return taken from all

alternative investment opportunities that had to be given up in favor of the current one

Question No 1

Consider the following two independent project proposals

1. A municipality is considering the establishment of an industrial Estate on the environment of a main township.

The environment currently are predominantly farm land.

Required

Draw up a list of what you may consider to be that of key stakeholders , for each show their social costs and Benefits.

Question No 2

Select a Public Investment Project in your Country and discuss how international Financial Institutions would evaluate the Project. What critical factors they will consider before funding the project?

Question No 3

2. An underground rapid transport system is being considered for a Nairobi Capital city. Who are likely to be the key stakeholders? What are the respective costs and Benefits? Discuss.

Question No 4

2. The Ministry of Transport is considering starting an Underground or a surface Railway system in Dar-es-salaam to eliminate fleet road congestions. The Funding of the project is yet identified but there are donors who are interested to fund the project. The Ministry has approached you to be one of the project team members. The terms of reference given to the project team are given below Enumerate the Project Objectives and Goals;

identify all possible project activities that are likely to take place during the implementation of the project.

Draw up a list of what you may consider to be that of key stakeholders in this project and what are likely to be the benefits and costs to the stake holders?

Prepare a budget based on the activities you have identified above including the assumptions that you take into consideration in preparation of the budget.

Advice the ministry going about sourcing the Funds for the Budget you has prepared.