Presentation 2-Cost Benefit Analysis final

Estimation of Project
Costs and Benefits
Ohn Myint
ADFD/WB Project Preparation and Appraisal Workshop Abu Dhabi, April 2010
Project Objectives and Components
Project Costs
Project Benefits
Project Justification-Cost-Benefit Analysis, etc.
Linkages to lending and fiduciary issues
I. Project Objective (s)
• PDO in relation to cost and benefit analysis
• PDO defines why a project is needed
• The project is a means to achieve the PDO
• Cost/benefit analysis determines which among alternative
projects have acceptable returns ( and for whom)
• Analysis also reviews with and without project cases
• Quantification of activities in valuation for the project –COSTS
• Quantification of achievements by the project-BENEFITS
• Cost is anything that reduces an Objective, and Benefit is
anything that contributes to an Objective
Project Components and Costs
• Means for achieving the PDO are defined by
activities to be undertaken in a project
• Activities of a similar nature are grouped
together in themes and the group of such
activities are called a “component”
• Each and every quantifiable activity is
enumerated as an accounted cost
• A non-quantifiable activity is enumerated as a
lump sum cost
II. Project Costs
Direct Cost Estimates, Unit Rate Analysis, Lump Sum
Provision, Optimization
• Direct cost estimates are prepared using Unit Rate
Analysis and the quantity involved in a particular activity
of a component.
• Unit Rate Analysis is done by using the principle of
output and outturn capacity of machines or labor.
• If unit rate analysis cannot be used, lump sum provision
is used; lump sum is usually experience-based
• The final project activity and the quantities adopted are
usually derived from the “optimum” variant of design
Optimum Option (outcome) of a Project
• The optimum option does not always mean maximized
“returns” to investment
• Farmers may choose a traditional variety of rice over
HYV rice because of taste preference
• For private businesses, firms or public corporations, a
major objective is to maximize net income at less risk
• For public projects, due to policy and social reasons, a
transport corporation may run a bus service in a less
populated area
• The project should be the best mix of policy, social,
environment and economics (National Planning Policy)
Project Period and Schedule
• A detailed project cost estimate is prepared in this way
for each component of the project.
• The project cost estimates are then spread out over
the entire project period, in what is called a “schedule”
• The project period depends on an annual capacity of
work force and investment (example of cost estimate
and scheduling (chart 2)
• Some typical cases of project costing estimates are
shown in the next slide.
Concept of “before” and “after” and
“with” and “without”
(cases) chart 3
Figure 1
net benefit
Figure 2 Case showing declining future without
Figure 3. Case showing declining benefits without
changed to enhanced benefits with project
Figure 4. No benefit without to enhanced but
steady out by time benefits with project
Figure 5. 0 benefit to enhanced steady out benefits with project
Types of Costs: Direct and Indirect,
Transfer Payments, Debt Service
• Most of the costs of a project are for goods or material,
labor or services, land, taxes and duties.
• Many of these costs are directly measurable, or called
“direct costs”, at least at the time of feasibility study.
• We assume no modifications or changes in the design or in the
adopted data and assumptions (flow data, foundation etc.)
• The base cost estimate also assumes that there would be
no relative changes in domestic and international prices
and no inflation during the investment project period.
Transfer Payments and Debt Service
• The project costs may also directly or indirectly include
duties and tariffs and also debt service (interests and
principal payment). Taxes and tariffs are considered
as transfer payments.
• Transfer payments are important in financial analysis
(for society), but not in economic analysis.
• This is also true for debt service, which is not
considered in economic analysis.
• Both types of these indirect costs are considered as a
transfer within the economy of the “country”.
Base Costs and Contingencies
• A longer term project includes “operation and
replacement costs” in the valuation of the project.
• Contingencies: Due to the relatively long period of
the project and conditions of base data used in design,
it would be unrealistic to exclude provisions for
possible adverse changes in physical conditions or
prices that would alter the base cost estimate.
• Base Cost only applies to the design of the project at
appraisal; in reality all costs at the present time of
consideration (inherently) include allowances for
physical and price contingencies and are termed
Total Costs.
Contingencies (Cont’d.)
• The physical contingency is decided by the
project designers who know the level of project
• A price contingency includes two categories;
– one for relative changes in price
– the other for general inflation (domestically and
• The physical contingency and relative price
changes reduce the real extent of project
activities and are therefore included in real
Contingencies (Contd.)
• However, inflation poses a different problem
and is complex.
• In project analysis, the most common method
for dealing with inflation is to use constant
prices, on the assumption that all prices will be
affected equally by any rise in the general price
level at different times. This allows valid
comparisons among alternatives.
• The price contingency for inflation would not be
included in project evaluation and analysis
other than in the financing plan of the project.
Cost-Benefit Compilation by Using
Computer (Database) Programs
• The project cost compilation, taking into account of the
above-mentioned factors, is quite complex and
systematically compiled in a database program called
COSTAB (originally designed at the WB)
• Complexity is exacerbated by the need to compile costs
by procurement category and expenditures (for different
• COSTAB is now available for public use at the Asian
Development Bank (Chart 4 and on the World
Bank website
Definition of COSTAB & FARMOD
COSTAB is designed to prepare, organize and analyze project
costs. It produces standardized tables that show the costs of
each project component, as well as costs attributable to the
specific categories of expenditure of which the project or
components are composed.
COSTAB estimates total costs with and without physical or price
contingencies, computes the operation and maintenance costs
of capital goods and estimates the foreign exchange
components of costs. It also allows for conversion of costs from
financial to economic terms and for changes in exchange rate
FARMOD: The data are then incorporated in the economic
evaluation of the project using the computer programs &
Feasibility Level Costing---- Examples
• Some examples of feasibility level costing completed by
the COSTAB program in a project are shown. (Handout
• Two sets of cost tables showing Financial Costs and
Economic Costs of a project are shown below for
visualization. (Uzbekistan-Ferghana Valley Water
Resources Management Project)
• Detailed component-wise costs as well as compiled total
costs of the project can be obtained from:
• Chart 5- FWRMP-Costables (Chart 5 , 10 files)
• Chart 6- (Chart 6 -5
III. Project Benefits
Benefits are “tangible” and “intangible.”
• Tangible: include increased production (quantity),
increases in quantifiable objectives, measurable
expectations, quality improvements, time scale
improvements, improvement in location, reduction in
costs for production or transportation, losses avoided
• Secondary benefits – outside the project and taken into
account only for economic analysis but not in financial
Tangible and Intangible Benefits (Cont’d.)
• Intangible benefits: include employment
opportunity, health, education, social benefits, some
political benefits etc. Difficult for valuation and
disputable due to surrounding factors.
• Projects generating only or primarily intangible
(nature) benefits are also modified to “least-cost
analysis” type.
• Projects of such kind call for special attention, team
tries in the best way to indirectly quantify, even
though valuation is impossible (i.e. public safety)
Time Scale Influence on Benefit Projections
• Benefits usually occur in the later part or after the
implementation period of project. The time value of
money in this case accounts for benefits as in costs,
(i.e. inflation) (ex. Chart 7 officially published)
• In cases of traded commodities involved in projects,
two types are considered
– --domestically-traded and internationally-traded
• If prices within a country are distorted, financial and
economic prices are used for commodities (Chart 8Fin.&Eco. -price determination of commodities)
Benefit Projections (Cont’d.)
• Benefits are also optimized in different ways
• Deriving optimum benefits also depends on
market prices and the law of diminishing
• Prices: Import parity prices are used for some
internationally-traded commodities
• Because of the time value of money, the earlier
the tangible benefits are realized, the better is
the case for the project.
Other Benefits, Sunk Costs, Foregone
• Not all, but most benefits are time sensitive;
some benefits of rare occurrence are based on
the probability of incidence.
• Other (inherent) benefits: Sunk costs are
past costs that cannot be retrieved as a
residual value from an earlier investment (not
opportunity costs) and are not included in the
• Rehabilitation projects are one example.
Other Benefits (Cont’d.)
• Negative benefits include foregone values (land,
swapping resources development). Foregone values
are considered in the analysis.
• Some examples are Farm Gate prices and Farm
Budget Analysis (Chart 8 Ferghana Valley WRMP)
• This type of analysis is essential for all nonhomogeneous entities (i.e. diversified crops,
tradable and non-tradable goods) that produce
production for the project and account for its
IV- Project Justification – Cost-Benefit Analysis
Some Terms and Definitions: Opportunity Cost (OC) of
capital, labor, goods. The OC of capital is indicated by
what banks are willing to pay in “interest” to increase the
future value/worth based on the present reduced principal.
The OC of labor also likewise depends on the economic
value of labor in the prevailing market. As for goods,
tradable and non-tradable goods were discussed earlier
and their value is determined in “market prices.” (Time
Value of Money Slide)
Why Cost/Benefit Analysis? When cost and benefit streams
have been worked out, there needs to be some way to
evaluate projects that will last several years. The team
must also be able to evaluate across projects which have
different cost and benefit streams.
Some History of Benefit-Cost Analysis
The idea of this economic accounting originated with Jules Dupuit, a French
engineer whose 1848 article is still worth reading. Later, the British
economist, Alfred Marshall, formulated some of the concepts that are at the
foundation of BCA.
But the practical development of BCA came as a result of the impetus provided
by the Federal Navigation Act of 1936, USA. This Act required that the U.S.
Corps of Engineers carry out projects for the improvement of the waterway
system when the total benefits of a project to whomever they accrue,
exceeded the costs of that project. Thus, the Corps of Engineers had to
create systematic methods for measuring such benefits and costs. The
engineers of the Corps did this without much, if any, assistance from the
economics profession.
It wasn't until about twenty years later in the 1950's that economists tried to
provide a rigorous, consistent set of methods for measuring benefits and
costs and deciding whether a project is worthwhile. Some technical issues
of BCA have not been wholly resolved even now, but the fundamentals are
well established.
Cost/Benefit Analysis (Cont’d)
Both cost and benefit streams should be based on data that
enables the team to evaluate projects of different sizes.
Evaluation could be done without discounting in the case of
short-lived economic projects.
Discounting methods can be used for determining (i) CostBenefit Ratios; (ii) Internal Rates of Return and (iii) Net
Present Value or Worth. This can be used for financial or
economic analysis.
Not all projects are decided by monetary return values alone
See - Time/Money dependent or not
Time Value of Money
As the folk wisdom of people
throughout the ages has recognized,
present values are better than the
same values in the future; earlier
returns to investments are better
than later. Thus, undiscounted
measures of project worth should
include a time dimension in
evaluation through the use of a
discounting factor, which will reduce
future benefits and costs to their
Present Worth/Value-PV.
Discounting Factors and Some
Some discussion on interest rate and discounting factor
determination are: Definitions of some important factors
(Chart 9) and Discount Table (Chart 10)
The Internal Rate of Return (economic and financial
analysis) is the rate at which the Net PW/V = 0 and Net
PW/V = PV of Costs – PV of Benefits
Financial Analysis of Cost-Benefit (for whom and when used)
Economic Analysis of Cost-Benefit (for whom and when used)
The Net Present Worth/Value at the OC of capital is
also a gauge (positive or negative) or measure for
project justification.
Foreign Exchange Premium &
Standard Conversion Factor
When people pay a premium on traded goods over
what they pay for non-traded goods, the Foreign
Exchange Premium (FEP) is necessary to know, as it is
not properly reflected when the official exchange rate is
used for converting to local currency value.
In economic analysis, all costs and benefits are valued
on the basis of opportunity costs or willingness to pay
(economists usually forecast)
More information on traded and non-traded
commodities, Foreign Exchange Premium –FEP
(Shadow Rate –Chart 11 determination) and Standard
Conversion Factor
Standard Conversion Factor (Cont’d.)
Conversion can be done by multiplying the Foreign
Exchange Cost (FEC) by (1+FEP) to get a shadow
exchange adjusted price; not optimal method.
Alternatively, a non-traded item price can be reduced
by “Standard Conversion Factor - SCF” which is the
ratio of the official exchange (OER) to shadow
exchange rate (SER) or by taking OER x (1+FEP) =
SER or 1/(1+FEP) = SCF which is always less
than 1.
All financial prices for local currency components are
multiplied by SCF to get to economic prices
Other Analysis
Sensitivity Analysis: Determines the robustness of
the project under uncertain future conditions for a
long-term project
Investment Effects and Balance of Payments:
Determines the project impact on the Borrower’s
budget (making use of the discounting table and
Cost Recovery: Determines how much Borrower will
pay ( making use of the discounting table to
calculate how much to pay)
Indirect Justification of Projects
1. Least cost principle – Definitely beneficial
investment but difficult to quantify the benefits
2. Alternative use principles
3. Other justification methods (social,
environmental, including long term effects)
4. Cost-Benefit analysis in social projects
already discussed (see also Chart 12).
V. Effects on Lending and Fiduciary Issues
• In procurement (packaging, BOQ, pre- and post- reviews,
thresholds) the unit rate is used in rate based contracts
• Financial management relates to investment scheduling
• Progress reporting and evaluation – relates to the possibility of
achieving estimated benefits and then linking them to the PDO
• Safeguard issues (social, environmental, others) address what
happens across and within interventions using results of BenefitCost analysis.
• PIP-POP is usually prepared by project implementation agencies
(using base costs including physical contingencies)
• The Project Appraisal Document (PAD) is prepared by lending
agencies (includes forecast for financial contingencies)
Eight Principles of Cost-Benefit Analysis
One of the problems of BCA is that the computation of many
components of costs and benefits is intuitively obvious, but there are
others for which intuition fails to suggest methods of measurement.
The following eight basic principles can help as a guide to Cost
Benefit Analysis (CBA).
 There Must Be a Common Unit of Measurement and Time
 CBA Valuations Should Represent Consumer or Producer Valuations
As Revealed by Their Actual Behavior
 Benefits Are Usually Measured by Market Choices
 The Analysis of a Project Should Involve a With Versus Without
 Some Measurements of Benefits Require the Valuation of Human Life
 Cost Benefit Analysis Involves a Particular Study Area (Society or
 Double Counting of Benefits or Costs Must be Avoided
 Decision Criteria for Projects (relate to PDO)

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