# Presentation: 551501

## Capital PIanning WorkshopBenefit-Cost AnalysisOctober 8, 2003Benjamin SimonOffice of Policy Analysis

## Why do benefit-cost analysis?

- To determine the net change (i.e., net benefit) in social welfare as a result of a policy change.
-  To determine if a given program or activity  is “worth it.”
-  Need to have strong, defensible form 300s.

## Structuring the analysis

- Analysis overkill is not helpful.
- Magnitude, level of detail, and resources invested in the analysis should be appropriate for the given activity being analyzed.
- Analysis required by form 300 is similar to a financial analysis for most (but not all) capital investments.

## Structuring the analysis

- Who is the client?  Analysis requires a perspective.
- What are the goals of the analysis?   Need to define the problem.
- What is the objective?  The answer to this lays out how the problem is to be treated as a practical matter.

## Structuring the analysis

- What are the alternatives and what are the consequences of the alternatives?                  Answering this involves choices of techniques for predicting consequences.
-  How are the effects to be valued?                  A technique must be chosen for valuing outcomes.

## Structuring the analysis

- How are certain are the outcomes? Outcomes are always uncertain and this should be addressed explicitly.
- What is the choice?  This step is for the analyst who recommends a choice to the decision maker.
- What is the decision?  This step is for the decision maker

## Structuring the analysis

- Identify the baseline
- Determine the period of analysis
- Identify alternatives
- Evaluate impacts quantitatively (if possible)
- Select a discount rate
- Sensitivity testing

## Defining the baseline

- Clearly state the question the analysis is to address.  The type of question may affect the baseline.
- Identify all assumptions made in specifying the baseline.
- Identify the nature and magnitude of the baseline conditions that are subject to uncertainty.

## Defining the baseline

- Use a consistent baseline throughout the analysis.
- Determine the appropriate level of effort for baseline specification.  Concentrate on those components of the baseline that are most important to the analysis.
- Clearly state the “starting point” of baseline and policy scenarios.

## Defining the baseline

- Let the duration of important effects of a policy dictate the structure of the analysis and baseline.
- Benefits and costs do not necessarily occur at the same time.  Forecasts of economic, demographic, and technological trends necessary for baseline specification must span the entire period of analysis.
- Identify – and quantify to the extent possible – risks associated with the baseline.

## Alternatives

- One alternative should be the status quo - “do nothing.”
- The status quo *DOES NOT* imply nothing changes over time.
- Alternatives should be evaluated relative to the defined baseline.

## Alternatives

- Benefits are evaluated relative to the baseline.
- Identify potentially affected benefit categories.
- Quantify the significant physical effects.
- Estimate the $ values associated with the effects.
- Evaluate sources of uncertainty.

## Discount Rate

- One discount rate used must be 7%.
- Also do the analysis with two other rates for sensitivity testing purposes – one higher rate and one lower rate.

## Decision Criteria

- How to decide if a project/program is “good?”
- Standard decision criteria are used to evaluate the extent to which the project results in economic efficiency improvements.

## Decision Criteria

- Net present value of benefits
- Benefit-cost ratio
- Internal rate of return
- Pay back period

## Payback Period

- Defined as the time required for a project’s total benefits to exceed its total costs.  At that point, the project can be said to have “paid back” its initial costs.
- Common application is in the analysis of energy conservation programs.

## Payback Period, Con’t

- Not a good guide for accepting or rejecting projects.  Is a payback period of 3 years acceptable?  100 years?
- Ignores cash flows that occur beyond the payback period.

## Payback Period, Con’t

- A project with a large cost in later years  (e.g., replacing or maintaining a machine) might be unacceptable from the NPV approach, but would be approved by the payback analysis since this charge would never be considered when the cash flows are summed chronologically.
-  Essentially favors short-term projects over long-term projects.

## Net Present Value

- Present value of benefits less present value of costs
- Select the project that yields the largest positive net benefits.
- This is not necessarily the same as the project with the largest B/C ratio.

## Evaluating Benefits

- Benefits are measured against the benefits that are currently being received under the baseline.
- Data is necessary to establish a starting point.
- Avoided costs.