Is. Department

Commerce

itional Bureau

Standards

A11103 07E111

Marshall, Ha'SdV£30721 11

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NBS Special Publication 558

Efficient Allocation

of Research Funds:

Economic Evaluation

Methods with Case

Studies in Building

Technology
NATIONAL BUREAU OF STANDARDS

The National Bureau of Standards' was established by an act ot Congress on March 3, 1901. The Bureau's overall goal is to strengthen and advance the Nation's science and technology

and facilitate their effective application for public benefit. To this end, the Bureau conducts

research and provides: (1) a basis for the Nation's physical measurement system, (2) scientific and technological services for industry and government, (3) a technical basis for equity in trade, and (4) technical services to promote public safety. The Bureau's technical work is per- formed by the National Measurement Laboratory, the National Engineering Laboratory, and

the Institute for Computer Sciences and Technology.

THE NATIONAL MEASUREMENT LABORATORY provides the national system of

physical and chemical and materials measurement; coordinates the system with measurement

systems of other nations and furnishes essential services leading to accurate and uniform

•physical and chemical measurement throughout the Nation's scientific community, industry,

and commerce; conducts materials research leading to improved methods of measurement,

standards, and data on the properties of materials needed by industry, commerce, educational

institutions, and Government; provides advisory and research services to other Government

agencies; develops, produces, and distributes Standard Reference Materials; and provides

calibration services. The Laboratory consists of the following centers:

Absolute Physical Quantities' — Radiation Research — Thermodynamics and

Molecular Science — Analytical Chemistry — Materials Science. THE NATIONAL ENGINEERING LABORATORY provides technology and technical ser- vices to the public and private sectors to address national needs and to solve national problems; conducts research in engineering and applied science in support of these efforts; builds and maintains competence in the necessary disciplines required to carry out this research and technical service; develops engineering data and measurement capabilities;

provides engineering measurement traceability services; develops test methods and proposes

engineering standards and code changes; develops and proposes new engineering practices;

and develops and improves mechanisms to transfer results of its research to the ultimate user. The Laboratory consists of the following centers:

Applied Mathematics — Electronics and Electrical Engineering' — Mechanical

Engineering and Process Technology' — Building Technology — Fire Research —

Consumer Product Technology — Field Methods.

THE INSTITUTE FOR COMPUTER SCIENCES AND TECHNOLOGY conducts

research and provides scientific and technical services to aid Federal agencies in the selection, acquisition, application, and use of computer technology to improve effectiveness and

economy in Government operations in accordance with Public Law 89-306 (40 U.S.C. 759), relevant Executive Orders, and other directives; carries out this mission by managing the Federal Information Processing Standards Program, developing Federal ADP standards

guidelines, and managing Federal participation in ADP voluntary standardization activities; provides scientific and technological advisory services and assistance to Federal agencies; and

provides the technical foundation for computer-related policies of the Federal Government. The Institute consists of the following centers:

Programming Science and Technology — Computer Systems Engineering.

'Headquarters and Laboratories at Gaithersburg, MD, unless otherwise noted; mailing address Washington, DC 20234. 'Some divisions within the center are located at Boulder, CO 80303.
^

FF'5 ? iQpn

NBS Special Publication 558 nob (-i ce -(tur<^

Efficient Allocation ^^y*

of Research Funds:

Economic Evaluation ^^^^ Methods with Case

Studies in Building

Technology

Harold E. Marshall

Rosalie T. Ruegg

Center for Building Technology

National Engineering Laboratory

National Bureau of Standards

Washington, D.C. 20234

U.S. DEPARTMENT OF COMMERCE

Luther H. Hodges, Jr., Under Secretary

Jordan J. Baruch, Assistant Secretary for Science and Technology

National Bureau of Standards

Ernest Ambler, Director December 1 979
Library of Congress Card Number: 79-60021

National Bureau of Standards Special Publication 558

Nat. Bur. Stand. (U.S.), Spec. Publ. 558, 56 pages (Dec. 1979)

CODEN: XNBSAV

U.S. GOVERNMENT PRINTING OFFICE WASHINGTON: 1979

For sale by the Superintendent of Documents, U.S. Government Printing Office, Washington, D.C. 20402

Stocl< No. 003-003-02132-6 Price $2.50

(Add 25 percent additional for other than U.S. mailing)
PREFACE

This study was conducted by the Applied Economics

Group in the Center for Building Technology (CBT)

at the National Bureau of Standards. The purpose was

to demonstrate how economic evaluation techniques can be applied to the evaluation of benefits and costs of research leading immediately to new technologies.

The intended audience for the resulting report is the National Bureau of Standards as well as other govern- ment and private applied research groups that are concerned with determining efficient allocations of

their research budgets.

The case studies of this paper are adapted from an

earlier, unpublished report entitled "Impact of CBT

Activities on the Building Community," submitted on March 31, 1975, to Dr. Richard Roberts, Director, National Bureau of Standards, and prepared by the

authors, et al. This project was interdisciplinary in that research personnel from disciplines other than economics

helped the authors in the formulation of the two case

studies. Special thanks are due to Edwin Mansfield of

the Department of Economics at the University of

Pennsylvania, to Stephen Weber and Bob Chapman of

the Applied Economics Group of CBT, and to Kenneth Gordon of the NBS Planning Office, who

reviewed the economics aspects of the paper; to Carl Muehlhouse of the Center for Consumer Product

Technology, who provided a policy review; to Robert

Wyly, from the Service Systems Program of CBT,

who provided data and information about reduced-size

venting; and to Robert Mathey, from the Building

Composites Program of CBT, who provided

assistance and data on roofing shingles. Appreciation

is also extended to the many persons within the National Bureau of Standards and persons outside in the plumbing and roofing industries who contributed

data and reviewed the manuscript.
ABSTRACT

Public and private administrators of research programs are concerned with maximizing the payoffs

from their research investments; that is, with

allocating their limited budgets most efficiently.

Benefit-cost, rate-of-return, payback, and other evaluation methodologies are examined for their usefulness

in helping administrators to decide whether to accept

or reject research projects leading directly to applications; to plan the scale of these research projects; and

to identify priorities among alternative research invest- ments, all of which may be profitable. Data needs for applying these evaluation methodologies are outlined. The net-benefits and rate-of-return methodologies are

applied to two case studies involving research in the Center for Building Technology (CBT) of the National Bureau of Standards. The first deals with a heavier asphalt shingle for roofing, and the second

deals with reduced-size venting in plumbing. The case

studies show high payoffs in these two areas of re- search, both for society as a whole and for CBT's contribution in undertaking the research. Recommendations from the study are that research funds be allocated on the basis of anticipated payoffs

determined through these evaluation techniques, and

that benefit and cost data for evaluating new technologies be collected.

Key words: Benefit-cost analysis, building technology;

economic impacts; economics; efficiency; payback;

plumbing; roofing; shingles; venting.

iv
CONTENTS

Page

PREFACE iii ABSTRACT iv LIST OF FIGURES vi LIST OF TABLES vi EXECUTIVE SUMMARY vii

1. INTRODUCTION 1

1.1 BACKGROUND 1 1.2 PURPOSE 2

1.3 SCOPE AND APPROACH 3

2. METHODS OF EVALUATION 5

2.1 TECHNOLOGICAL CHANGE AND IMPACTS 5

2.1.1 Definitions and Perspective 5

2.1.2 Data Needs 8

2.1.2.1 Benefit and Cost Measures 8

2.1.2.2 Time and Rate of Discount 10

2.2 SURVEY OF EVALUATION METHODS 11

2.2.1 Benefit Cost 11

2.2.2 Internal Rate of Return 14

2.2.3 Payback 16

2.2.4 Summary of Methods 18

3. CASE STUDY: 235 SHINGLES 19

3.1 BACKGROUND 19

3.2 APPROACH 20

3.3 GROSS BENEFITS OF 235 SHINGLES 21

3.4 BENEFITS OF CBT ACTIVITIES 24

3.5 SENSITIVITY ANALYSIS 25

3.6 INTERNAL RATE OF RETURN ON 235 SHINGLES 29

4. CASE STUDY: REDUCED-SIZE VENTING 31

4.1 BACKGROUND 31

4.2 APPROACH 32

4.3. COST SAVINGS 33

5. SUMMARY AND SUGGESTIONS FOR FURTHER RESEARCH 45

5.1 SUMMARY 45

5.2 SUGGESTIONS FOR FURTHER RESEARCH 46

REFERENCES 47

V
Figures

Page

Fig. 1.1 R&D Funding Trends, 1967-1977 2

Fig. 2.1 Technological Change 6

Fig. 2.2 Probability of Adoption as Function of Saturation and Profits 7

Fig. 2.3 Probability of Adoption as Function of Saturation and Size of

Investment /. 7

Fig. 2.4 Diffusion Over Time 7

Fig. 2.5 Consumers' Surplus 9

Fig. 2.6 Consumers' Surplus Measure of Benefits 10

Fig. 2.7 Maximum Net Benefits from R&D in Relation to Total Benefits and

Costs 12

Fig. 2.8 Efficient Scale of R&D as Determined by Marginal Benfits and Costs 12

Fig. 3.1 Consumers' Surplus Measure of Benefits for 235 Shingles 21

Fig. 4. 1 Basic Design Features for One-Story, Stack-Vented System, C3 34

Fig. 4.2 Basic Design Features for One-Story, Wet-Vented System, C2 35

Fig. 4.3 Basic Design Features for One-Story, Individually-Vented System, CI 36

Fig. 4.4 Basic Design Features for Two-Story, Wet-Vented System, C2 37

Fig. 4.5 Basic Design Features for Two-Story, Individually-Vented System, CI 38

Fig. 4.6 Estimated Percentage Use of the Three Different Types of Venting

System Designs in New Houses by Region 42

Tables

Page

Table 2.1 Comparison of Rankings by Net Benefits and Benefit-Cost Ratios 14 Table 2.2 Illustration of a Shortcoming of Simple Payback 17 Table 3.1 Calculation of Annual Cost Savings (ACS) to Consumers

from Substituting a Unit of 235 Shingles for a Unit of 210 Shingles 22 Table 3.2 Present Value Savings to Consumers from 235 Shingles 23 Table 3.3 Present Value Savings to Consumers from 235 Shingles

without CBT Involvement 24

Table 3.4 Present Value Savings to Consumers from 235 Shingles

Due to CBT Involvement 25 Table 3.5 Calculation of Net Benefits 26 Table 3.6 Sensitivity Analysis: Lower Bound Estimate of

Present Value Benefits from 235 Shingles 27 Table 3.7 Sensitivity Analysis: Lower Bound Estimate of Present Value ' Benefits from 235 Shingles without CBT Involvement 28 ) Table 3.8 Calculation of the Internal Rate of Return on the i Consumer's Investment in 235 Shingles 29 f Table 3.9 Calculation of the Internal Rate of Return on CBT's f Investment in 235 Shingle Research 30 Table 4. 1 Estimated Savings from RSV Per Plumbing System in One-Story

Residences 39

f Table 4.2 Estimated Savings from RSV Per Plumbing System in Two-Story \ Residences 39 I Table 4.3 Plastic Pipe Costs by Size 39 f Table 4.4 Plastic Fitting Costs by Size 40 ^ Table 4.5 Estimated Annual Number of New Privately Owned, Single-Family t Houses and Plumbing Systems 41 Table 4.6 Estimated Yearly Percentages of New Single-Family ' Houses with RSV, by Region 43

| Table 4.7 Estimated Potential Cost Savings from Use of RSV, 1975 to 1985 43 j J

i'
EXECUTIVE SUMMARY

The research and development (R&D) community is a major industry in terms of the resources that it controls. Research managers and planners, in both the public and private sectors, need guidelines for evaluating R&D alternatives so that they can maximize the payoffs from their R&D activities, given

limited resources. A quantitative approach is particularly useful when R&D results directly in a marketable application.

The purposes of this report are (1) to provide research

administrators with an examination of alternative methods for evaluating future, existing, and past re- search projects related to direct applications and (2) to provide a description of the data needs for evaluating

the impacts of the ensuing technological change.

The National Bureau of Standards (NBS), a scientific research agency of the U.S. Department of Commerce, has attempted to improve its resource allo- cation process by requiring all major operating units

to do a "microstudy" of their research impacts on society. This report is an outgrowth of the microstudy for the Center for Building Technology (CBT) of NBS. It

is developed in a general framework, however, so that

it can be used by any government agency allocating

applied research funds, and in many cases, by universities and research firms as well. Following the introduction, section 2 provides

definitions of terms relating to the measurement of

impacts from technological change. The different perspectives of research groups, as indicated by their different objective functions and different measures of

program benefits and costs, are discussed. Three

selected methods of project evaluation—benefit-cost

analysis, the internal rate of return, and payback—are evaluated for their use in comparing alternative R&D

investments. Research projects in building technology are examined

as case studies in sections 3 and 4 from the standpoint

of their payoffs to society and NBS. A case study of a heavier asphalt shingle for roofing (235 shingles)

shows that the net benefits to society of the new

shingle totaled approximately $4.0 billion during the period 1962 through 1974, in terms of present value

savings from increased shingle life. A substantial part of these net benefits, $1.7 billion, are estimated to be at- tributable to CBT's efforts in helping to develop the

shingle. The internal rate of return to society from its total investment in the new shingle is estimated to be

33%; the internal rate of return on CBT's investment

is estimated to be 70%.

Sensitivity analysis shows the net benefits of research

in 235 shingles to be high over a broad range of values

for the variables that most influence the level of

impact; namely, the time lag between initial research and introduction of the new technology, rates of diffu- sion, and the interest rate used to convert past and

future values to a common time basis. The second case study measures economic impacts of

research investments in reduced-size venting (RSV), a type of sanitary drainage vent system that utilizes smaller vent pipes than those currently permitted by

plumbing codes. Over the period from 1975 through

1985, the net benefits (i.e., net dollar savings in venting

costs) to society from introducing RSV are estimated

to be about $106 million.

Suggestions for further research are made in section 5. Analysis of past and ongoing innovations is needed to help predict rates of diffusion of new technologies.

Without reliable predictions of diffusion rates, benefits accruing in the future cannot be estimated. A second

area of research need is the development of a system

of recordkeeping on past and current projects so that

benefits and costs of R&D can be identified, quantified, and related to specific activities. A third area of research need is the computation and comparison of private and social payoffs on specific projects

to see where government support of R&D is warranted. A fourth need is the determination of gov- ernment cost-sharing (i.e., grant) formulas for supporting R&D in those private sector projects

where payoffs to society at large far exceed payoffs to private firms making the research investment. A final research need, and one that would be particularly

useful to a large research concern that funds many

low-budget projects, is the development, review, and

assessment of simplified approaches for use in deter- mining the relative economic efficiency of alternative research projects, and the extension of these to fit specific kinds of projects. An approach that is simpler,

cheaper, and more quickly applied than the benefit- cost and internal-rate-of-return approaches described

here, but generally reliable, would be helpful as an

initial screening device for selecting among alternative research projects.

vii
Facing page:

This scientist is working on analytical techniques fc

determining various constituents in blood sera.
1 i. ii-^ ii*.<iiiiuCTION

1.1 BACKGROUND

The research and development (R&D) industry is a major industry in terms of the total resources that it controls. Expenditures in the United States for R&D,

based on National Science Foundation statistics, have

risen in current dollars from $23.8 billion in 1967 to

I $40.8 billion in 1977. Applied research accounted for

! $9.0 billion and basic research for $5.2 billion out of

I the 1977 total of $40.8 billion. Figure 1.1, based on

j those same statistics, shows that total R&D spending

increased over twice as fast in the most recent 5-year

period (1972-1977) as in the previous 5 years (1967-

1972). Federal R&D spending, comprising more than

half of the total, rose 56% over the 10-year period

whereas nonfederal spending rose 110%. Expenditures

for R&D are estimated to have represented 2.2% of

the Gross National Product for 1977. In the United

States, an estimated 542,000 R&D scientists and engi- neers were employed in 1976. Approximately onethird of all scientists and engineers historically have

been employed in R&D work.'

' National Science Foundation, National Patterns of R&D

Resources: Funds and Manpower in the United States, 1953-

1977. NSF 77-310 (Washington, D.C.: U.S. Government

Printing Office), pp. 1-2.

1
0 I I I 1967 1972 1977|Est,| Figure 1.1 R&Dfunding trends, 1967-1977

(Expenditures are in current dollars).

Government and private organizations that fund and

conduct research have a responsibility to taxpayers

and stockholders respectively to allocate their limited resources efficiently. The National Bureau of

Standards (NBS), a scientific research agency of the U.S. Department of Commerce, has attempted to improve its resource allocation process by requiring

all major operating units to do a "microstudy" of their research impacts on society. The microstudy report

prepared for the Center for Building Technology

(CBT) was the starting point for this study. The

impact evaluation methodologies developed and

applied in this paper to case examples from CBT are provided as models that government agencies, universities, and research firms might follow in allocating re- search funds where impacts of applied research are expected in the near future. Since decisions regarding the allocation of funds to R&D have traditionally been made with little or no

formal analysis, one might ask why there is a need for evaluating impacts of applied research. The following

description of R&D management problems answers

this question at least in part. The R&D professional has essentially been

interested in only technical performance. Cost and

time have been considered as unnatural constraints

in the scientific environment. But they cannot be

ignored because they are scarce and vital resources.

Skillful management of these and all other productive resources in research and development is necessary in order to maximize accomplishment and

meet the challenge of a changing technology. As

R&D projects have become larger and more

complex, scientific activities have come to transcend

the responsibility or interest of a single individual or even organization. Information and communication

are tremendously important because duplication of

effort is wasteful and omission can be disastrous. Research and development do not easily lend themselves to evaluation. . . . Projects are generally authorized on the basis of time, cost, and

performance estimates of the scientists involved.

There are frequent miscalculations, which make it difficult for management to draw sound technical evaluations of the problems involved. When

program objectives are not achieved, this can cause

strained feelings and disillusionment. Management

must often base decisions on subjective factors rather than on accurate quantitative information. How can the creative accomplishment be evaluated and measured? What meaningful criteria can be

established in the commercially directed R&D organization? How can R&D effectiveness be deter- mined in organizations such as the government and

military and universities, where there is no material incentive system?

R&D can be a tremendous intangible benefit or a staggering liability, but present tools are inadequate

to weigh either conclusively. Applying reliable

criteria for measuring and evaluating R&D effec- tiveness would be an important step in managing the R&D process.^

The need for quantitative descriptions of research impacts also becomes apparent in budget requests. When contractions in government spending and

shrinking profit margins in business result in budget

squeezing, research is often the activity to be dropped.

A formal and objective approach to ascertaining re- search impacts is needed to assure the efficient alloca- tion of limited resources among competing research demands.

1.2 PURPOSE

This report has two major purposes. First, it provides

research administrators (e.g., in CBT and NBS) with an examination of several quantitative methods for evaluating existing and past research projects both

from the standpoint of widespread social impacts and

from the standpoint of the impacts on their particular

institution. This review of methods, with case applications, demonstrates one approach to analyzing re- search projects in an effort to promote more efficient allocations of limited research funds. The implementation of impact evaluation techniques described in this paper, where applicable, will enable CBT and NBS to give better service to the building community and to the nation's economy in general.

The second purpose of this report is to provide a description of the data needs for evaluating the impacts

of new technologies that result from an agency's or

firm's applied research programs. Data requirements must be defined for predicting ex ante the impacts of emergent technologies, as well as for measuring ex

post the results of past research.

^ Daniel D. Roman, Research and Development Management:

The Economics and Administration of Technology (New York: Appleton-Century Crofts, 1968), p. 26.

2
1.3 SCOPE AND APPROACH

This report takes a long-run view of research planning

and evaluation to encompass the entire period of time over which research leads to a new technology which

diffuses through society. The focus is on specific benefits and costs of developing new technologies, with

little attention being given to institutional considerations and other constraining factors. This does not imply that these are unimportant, but simply that they

are assumed to be considered in the initial screening of

research alternatives. Examples of such constraining

factors which research managers are likely to find important are the compatibility of research projects

with the organization's charter or mission statement, the ability to meet funding requirements within budget

constraints, and the ability to gather the required staff and equipment to perform specific research tasks. No attention is given in this paper to the step-by-step process by which research in the CBT (or other) labo- ratory makes its way (i.e., diffuses) as a new technolo- gy through codes, standards, or other processes to the

ultimate user. The estimation of rates of diffusion for the many routes through which new technologies

travel is a major research task in itself. The report has four sections in addition to the introductory section. Section 2 begins with definitions of terms and a discussion of the different perspectives or objective functions of research groups developing

and applying new technologies. The need for measures

of benefits and costs arising from the introduction of new technologies is described, as well as the importance of discounting costs and benefits to an

equivalent time basis for purpose of comparison.

Section 2.2 provides a survey or overview of three

selected methods or techniques for evaluating and

comparing alternative R&D investments. Two case studies of building technologies are developed in sections 3 and 4. The first, described in section 3, provides estimates of the net savings impact

from a past research effort in the development of an improved asphalt shingle for sloped roofing. The life- cycle costs of the improved shingle are compared

against the life-cycle costs of the traditional shingle it displaced. Net savings and the internal rate of return

are computed for the actual quantity of the improved

shingle that was installed during the period from 1962

to 1974. Furthermore, that part of dollar savings that appears attributable specifically to CBT's research

activities is estimated. The second case study, described in section 4, deals with reduced-size venting (RSV), a type of venting for sanitary drainage systems that utilizes smaller vent

pipes than those currently permitted by plumbing

codes. This case study shows the estimated net dollar savings in venting costs over the period from 1975

through 1985 if RSV were incorporated into building

codes and implemented in construction of singlefamily residences. Assumptions about material life, the appropriate dis- count rate, the rate of diffusion of new technologies in the building community, and the impact of CBT's

activities on that diffusion rate are necessary for carrying out the case studies. The bases for these as- sumptions are described in sections 3 and 4. To

provide the reader with as broad a perspective as

possible, sensitivity tables of cost savings are presented

in the shingle case study for several values of the fac- tors to which cost savings appear sensitive and for which the selection of values is controversial.

Section 5 concludes the paper with a summary and

suggestions for further research.

3
Facing page: Economic evaluation methods are needed to '^^^ocaie

funds most efficiently among competing research projects.

4
2. METHODS OF EVALUATION

2.1 TECHNOLOGICAL CHANGE AND

IMPACTS

Before reviewing alternative methodologies for evaluating impacts of technological change, it is useful

to define carefully some concepts relating to technolo- gy so that a common perspective will be shared by

authors and readers. It is also useful to consider the

definitions and measures of benefits and costs, since they may be defined and measured differently by

decision makers, depending upon whether their organization is public, private, or non-profit.

2.1.1 Definitions and Perspective

The measurement of economic impacts of R&D to improve the allocation of research funds is the subject

of this paper. Impact can be defined as the influence or effect that introduction of a new technology has on

the economy. Consider the following examples: new

technology may affect an individual in terms of a new

job and higher income, a community through a higher

tax base, and a nation through a higher GNP and

employment rate. Social impact is used here to denote

the total net effect on the nation at large. The term is used synonymously with social economic impact.

although the former term is sometimes construed in a broader context to incorporate more effects than are

5
usually covered under the term "economic." Social impact, as used here, covers a variety of influences or

effects, the benefit and cost consequences of which

can be quantified in some manner.

In section 1 we described the need for measuring

impacts in terms of allocating resources most effi- ciently and defending budgets. These activities require research managers to identify the objective functions

for their organizations and to plan the products which

will be produced and the resources which will be

allocated to their production. Objective functions describe what objectives or goals a given organization

is trying to optimize. Associated with objectives are

constraints, both in terms of resources and in terms of

institutional limitations or requirements. For example,

a Federal agency doing research on the prevention of

a communicable disease might have as its objective function the minimization of time taken to develop an

effective immunization, subject to the constraints of a

fixed annual and long-term budget, a fixed number of

research staff and existing facilities. On the other hand,

a private business firm's research department might

have very different objective functions and constraints. A drug firm, for example, might seek to develop a vaccine that is most likely to result in the

greatest profit to the firm, taking into account re- source constraints. A research project is undertaken

because it contributes to achievement of an organization's objective function. Research can be considered in two forms. Basic re- search is for the purpose of increasing scientific knowledge, whereas applied research is concerned with a

practical application of basic research findings. The de- velopment part of R&D puts the research findings into

practice, and may include the design of and

experimentation with particular products. There is a continuum of activity beginning with basic research and ending with the development of a product. Just where along that continuum applied research begins

and is then replaced by development is not clear, although the sequence of research and then develop- ment is generally accepted.^ A sharp demarcation

among research, applied research, and development is, in any case, not crucial to this study. The significant

point for using the evaluation techniques discussed here is that resource allocations apply to that type of R&D which leads in a direct way to a tangible

product whose impact can be measured.

Technology has been defined as "society's pool of knowledge regarding the industrial arts."* It includes

For a more complete description of these terms, see Daniel D. Roman, Research and Development Management, pp. 4-5, and Edwin Mansfield, Research and Innovation in the Modern

Corporation (New York: W. W. Norton & Co., 1971), pp. 1-3.

"* Mansfield, Research and Innovation, p. 2.

knowledge concerning physical and social phenomena.

Research and development contribute to this "pool of knowledge." The state of technology at any given

time controls what can be produced with existing re- sources. Associated with any given technology is a pro- duction function that shows the maximum rate of

output that can be obtained for given inputs. Any

advances in technology that result in the capability of producing a new product or of making a given

product in a new way is called technological change,

which results in a change in the production function.

Invention and innovation are also closely connected to technological change. Invention has been defined as "a

prescription for a new product or process that was not obvious to one skilled in the relevant art at the time

the idea was generated."' Innovation is the application of an invention, the result of which is a new good,

service, or process. A new technology is not implemented until an innovator takes the risk of production.

Diffusion is the spread of an innovation throughout the economy. An estimate of the rate of diffusion is usually needed to measure the impacts of R&D.

Some of these concepts can be made clearer with a graphical illustration. Figure 2.1 shows two functions

(labeled T, and Tj) that represent the same level of

output (could be a measure of service, performance, or

physical output) provided by two different technologies. These functions describe graphically the different combinations of capital and labor required to produce

the same level of output with technologies T, and T2.

Units of Capital

0 Units of Labor

Figure 2. 1 Technological change.

Mbid., p. 11.

6
Since the level of output is equal for Tj and Tj, we see

that the technology embodied in T, is a more efficient technology than that in T2. That is, the combination of

capital and labor resources necessary to produce the given level of output is smaller for T, than T2. A

change in technology which results in less capital and

labor required to produce a given output could be

represented by a shift in functions from T2 to Tj.^ The

case studies in section 3 examine two building technol- ogies to see whether, in fact, production functions have changed as a result of research, such that the same or greater performance or outputs can be

produced with a less costly combination of resources. Graphical analyses can also be used to describe the

influence of various factors on the extent of diffusion of an innovation among potential users. Figures 2.2 and 2.3 show the relationship between the probability of adoption of an innovation and several characteristics of that innovation. In figure 2.2, for example. A]

and A2, which designate two different innovations,

show a direct relationship between the probability of

adoption and the proportion of firms already using the innovation (degree of saturation). Figure 2.2 also shows that the probability of adoption is higher at every level of saturation for A2 than for A,, because

A2 is a more profitable innovation. Figure 2.3 shows a higher probability of adoption of an innovation

requiring a smaller investment (Bj) than one requiring

a larger investment (Bj), other things being equal.^

On a priori grounds, these are the relationships that one would expect. Because risks of introducing a new

technology generally diminish as market saturation grows, one would expect increased adoption as experience and information increase. Likewise, the more profitable the investment in a new technology

appears to be, the greater the compensation for antici- pated risks of undertaking that investment. Finally, it seems reasonable to expect firms to be more reluctant

to commit large amounts (particularly when they have

difficulty raising large capital amounts) than small amounts to undertaking new technologies.* Based on

these and other factors relevant to a particular innovation, the diffusion process could vary considerably.

' Figure 2. 1 by construction indicates that the more efficient technology requires less capital and labor to produce the same output. Other examples of more efficient technologies

might result in less of just one input and the same quantity of

another, or, even more of a lower-priced input accompanied

by less of a higher-priced input to achieve the same output at lower cost.

' For a more complete discussion of these diffusion graphs,

see Edwin Mansfield, Microeconomics: Theory and Applications

(New York: W. W. Norton & Co., 1975), pp. 480-485.

' See Edwin Mansfield, Industrial Research and Technological

Innovation: An Econometric Analysis (New York: W. W.

Norton & Co., 1968), pp. 136-154, for a deterministic econometric model that confirms these diffusion

relationships.

Probability

of Adoption

Proportion of Firms Using the Innovation

Figure 2.2 Probability ofadoption as function of

saturation and profits.

Probability

of Adoption

Proportion of Firms Using the Innovation Figure 2.3 Probability of adoption as function of

saturation and size of investment.

Percent of 100

Major Firms Using the Innovation

60

40

20

y / 1 ' 1 1 1 1 dl/ //

1 t 1 1 fsC DL = Diesel Locomotive / /CR / CR = Car Retarder / / / /

1 / SC = y 1

Shuttle Car

1 1 1920 1930 1940 1950 1960

Year

Figure 2.4 Diffusion over time.

Mansfield has charted the percentage of major firms adopting an innovation for 12 products in four U.S.

industries—iron and steel, bituminous coal, brewing,

and railroads. Figure 2.4 illustrates how diffusion patterns vary among innovations by tracing the percentage of acceptance of major firms of three of

the 12 products Mansfield investigated.^ He reached

two general conclusions. First, diffusion of a new tech- nique is slow. It took one-third of the 12 new tech- niques 20 years or more to be adopted by the major

'ibid., p. 134.
firms in that industry, and only one-fourth of the tech- niques made it in 10 years or less. Second, the rate of

diffusion varied widely among techniques. The

average time required for half of the firms to introduce the innovation was 7.8 years, but their range

varied from 0.9 to 15.'° The estimation of the rate of diffusion of a new tech- nology is a critical step in evaluating the future impacts of current or proposed research. The need for information on diffusion will be discussed further in section 2.1.2.2.

2.1.2 Data Needs

Specific elements of information are needed to evaluate alternative research opportunities. Here we discuss the general data requirements for evaluation, before surveying in section 2.2 the selected methodologies.

2.1.2.1 Benefit and Cost Measures

Social benefits (sometimes called national benefits) of a given research project can be defined as the increase

in monetary and nonmonetary values of goods and

services to the nation (all of society) which results from having that project as compared with not having

the project. Thus social benefits include all types of

positive features, for all project beneficiaries, no

matter how widespread throughout the nation. Note

that the savings of resources as a result of technological change may also be considered a benefit under this definition. That is, when resources are saved due to achieving the same output or performance with a new

technology, more goods or services can be produced

with a given budget. (See the discussion relating to fig. 2.1.) The increased value resulting from the new tech- nology can be approximated by the resource or cost savings which are available for the production of

additional goods and services. Local benefits, on the other hand, are defined as the

increase in monetary and nonmonetary values of goods and services to a group smaller than the nation (however that group is defined) which results from

having a project as compared to not having it. These

benefits may accrue, for example, to an individual, a

private firm, or to a local government unit. A similar distinction can be made between social and

local costs. Social costs are the total increase in monetary and nonmonetary burdens resulting from

having a project as compared to not having it. Local

costs are those same types of burdens, but only those

that accrue to the individual, firm, or group from

whose perspective we are examining the project.

The relationship of benefits and costs determines how

desirable a project is for the nation or for the

ibid., pp. 133-136.

institution which undertakes the R&D project. From

the standpoint of the organization conducting a

project, benefits and costs must be considered in terms of their relevancy to the organization's objective

function, and the economic efficiency of that project

will depend on its cost and contribution to the organization's objective function.

Innovations in building technology are used in this report as case examples for illustrating potential benefits and costs. There are several kinds of benefits that may result from introducing new building technologies. One type of potential benefit is safer buildings. Greater safety results when new information (which

may be embodied in the updating of standards and

codes) brings about modifications in materials or build- ing processes which reduce their hazardous characteristics. Safer buildings result in reduced injuries and/or

sickness. Consequent benefits accrue to building users or tenants through reduced injuries and lower medical

bills and less time lost from work. Similar benefits might accrue to workers involved in the construction phase of the building. Benefits from better health and

safety in buildings might also accrue to building

' producers and building operators in the form of fewer

liability claims, cheaper insurance, and less property

loss. A second type of benefit that might arise from an improved building technology is the increased productivity of occupants that carry out the functions of their job in a building and of construction workers who

build the structure. A new lighting system in an office building might enhance productivity as measured by

fewer labor hours required for tasks requiring

intensive reading. A new labor-saving technique might

increase worker productivity in the construction of

the building.

A third type of benefit from advancement of building

technology is more cost-effective buildings. With new

technology, a specified level of building performance

might be attained with a new, cheaper material, for example. Or better performance, in terms of increased

reliability and durability, might be attained with a new

process that costs no more than the currently used

process. Increased performance per dollar spent means

greater economic efficiency, which can result in decreased costs of production or operation for any one

of the participants in the construction process or some

combination of them. Thus the developer, contractor, owner/operator, and building user are potential

beneficiaries.

Note that the second and third catagories of benefits

listed above may be described as reductions in costs of

delivering a given product or service, and that these items might be listed either as benefits or as negative

costs. In the computation of net benefits, it makes no

8
difference whether a cost savings is deducted from

costs or added to benefits, although in the computation of benefit-cost ratios, it does make a difference. (The appropriate classification of cost savings will be

discussed in sec. 2.2.)

In addition to efficiency effects of new technologies, the research community is also interested in redistribution effects. That is, in addition to knowing

whether benefits are greater than costs for a research and development project, it is important to know how

those benefits and costs are distributed. This

redistribution of income issue is of interest to manufacturers of building materials, for example, in that the

introduction of new technology products may affect

their business profits. Incomes could be redistributed from one set of manufacturers to another, from manufacturers to consumers, from manufacturers to

installers, or in many other ways. Income

redistribution issues are identified here because they

are important in considering new technologies. They

are outside the scope of this report, however, and are

therefore not discussed further. The measurement of benefits and costs is usually made

in dollar terms. By nature most costs are expressible in dollars, such as the costs of research and development,

of new equipment required for producing new

products, and of developing a new market. However,

not all benefits are easily measured in dollar terms. Where an objective of a firm is growth or power, for example, it is difficult to measure the dollar value of

meeting that objective through research and develop- ment. The value of lives saved from technological in- novations in buildings is also difficult to measure in dollar terms. Establishing values for such difficult-to- measure benefits is one of the greatest challenges in de- termining the economic impact of technological

change. Where such objectives as power and safety

exist side-by-side with the more conventional objective

for the firm of maximizing profits and for the govern- ment of minimizing costs of reaching certain perfor- mance levels, the tradeoffs of benefits and costs for every research plan should at least be identified or

described in words if not measured quantitatively.

Project planners will have a more complete

perspective of research benefits and costs if both

monetary and nonmonetary items are displayed. '

Economists are making progress in the measurement

of benefits from technological change. Zvi Griliches' 1958 landmark article on the social returns of hybrid corn provided an approach to measuring the benefits

" For a description of one method that can be used to evaluate alternative projects given multiobjectives with incommensurable outputs, see Harold E. Marshall, "Cost

Sharing and Multiobjectives in Water Resource Development," Water Resources Research, Vol. 9, February

1973, pp. 2-4.

of new technologies in agriculture. '^ Edwin Mansfield

has applied a similar approach in exploring social and

private rates of return from industrial innovations.'^ A

brief overview of their conceptual approaches to measuring benefits is given here to acquaint the reader with what has been done to measure successfully the

benefits from technological change.''*

Both researchers rely to some extent on measures of consumers' surplus in determining benefits from tech- nological innovations. "Consumers' surplus" is an eco- nomic term defined as that amount which a consumer would have been willing to pay for a good or service beyond what he is required to pay by the market. Figure 2.5 shows the economist's conventional

demand-supply model for determining the price and

quantity of a given good or service. The cross-hatched

triangle represents the amount of consumers' surplus;

i.e., the difference between the willingness-to-pay in aggregate for all units up to Qe (the area under the demand curve) and the costs of OQe units (the rectangle with area Pe-Qe).

Supply

Demand

0 Qe Q

Quantity/Time

Figure 2.5 Consumers' surplus.

A simple model which follows the Griliches and

Mansfield method for measuring benefits from a new

industrial technology is shown in figure 2.6. The

introduction of the new technology is assumed to shift the supply from S) to Sj as a result of lower production costs to the producers using the new technology.'"'' The price (P) of the product in whose

manufacture the technology is used will decrease from

Zvi Griliches, "Research Costs and Social Returns: Hybrid Corn and Related Innovations," The Journal of Political Economy, LXVI (February-December, 1958), pp. 419-431. Edwin Mansfield, "An Exploratory Study of Social and

Private Rates of Return from Industrial Innovations," a paper

presented at the meetings of the Eastern Economic

Association on October 26, 1974. For a step-by-step description of Griliches' and Mansfield's methods, see their papers cited above. " For purpose of illustration, supply is assumed to be

perfectly elastic; that is, the supply function is perfectly flat or horizontal.

9
P, to P2, and the quantity demanded will increase from Q] to Q2. The measure of benefits from

introducing the new technology is the increase in con- sumers' surplus that results from the decreased price;

i.e., the dollar value of P2RTP1 (shown as the dotted

area in fig. 2.6). Mansfield extends his measure of benefits to incorporate the profit that is earned by the innovator of a new technology. If we designate the profit to the innovator per unit of industry output using the innovation as r (the difference between P2 and P2-r in fig. 2.6), we can depict the profit earned on the innovation

as the cross-hatched rectangle equal to r-Q2 (i.e., the area bounded by P2-r, K, R, and P2). Thus, according

J L 0 Ql Q2 Q

Quantity of Output

of Industry Using

Innovation Figure 2.6 Consumers' surplus measure of benefits.

to Mansfield, the total benefits resulting from the introduction of an industrial innovation would be

measured by the value of the area bounded by P2-r, K, R, T, P,. If the innovator of a government R&D

project is unable to collect profits from, for instance,

patent rights, the area P2RTP, alone might be an

appropriate measure of benefits from a new govern- ment-induced technology. This measure would

underestimate social benefits to the extent that private

users of the new technology might reap greater profits

after than before the innovation.

Benefits derived from cost savings in new building

technologies are closely related to the consumers'

surplus measure. That is, as supply shifts from S| to S2

in figure 2.6, the area PjRZP, represents what would

be saved by consumers in the purchase of Q2 units if they were bought at Pj rather than Pj. This value is close to that of consumers' surplus (it exceeds the con- sumers' surplus measure of benefits by the amount

TRZ), and could in fact be identical to it if quantity

demanded were constant in that range of prices. The

less responsive is quantity demanded to price change

(i.e., the more inelastic is demand), the smaller will be

the area TRZ. In the case studies of sections 3 and 4, we take this approach in calculating the expected

benefits from cost savings from new technologies in roofing and plumbing.

2.1.2.2 Time and Rate of Discount

In order to measure benefits and costs correctly, re- search administrators need additional elements of infor- mation. Much of this information is related to the flow

in time of benefits and costs. The rate of diffusion of new technology (see sec. 2.1.1), for example, must be

known in order to predict the time flow of benefits. For an ex post evaluation (e.g., shingles in sec. 3), documenting the rate of diffusion is not a great

problem, but for an ex ante evaluation (e.g., RSV in sec. 4), predicting the rate at which a new technology

will be adopted is one of the most difficult tasks. Considerations in predicting the diffusion rate include

the examination of any constraints, such as consumer

attitudes, labor union demands, or patent restrictions that would affect a technology's implementation. For

a change in building technology, for example, one of

the most important factors to consider is the set of

building codes and standards. Predicting the diffusion

rate requires a careful analysis of all of the institutions which affect the adoption of a new technology.

Time is also important in selecting the period

(sometimes called time horizon or life cycle) over which a research project's benefits and costs are to be

measured. The stream of benefits from research, even more so than for most other investments, generally comes in the distant future. The analyst who is evaluating alternative research projects must select time horizons that are consistent with the objective

function of the firm or agency and that will allow

valid comparisons with other investments. Furthermore, the analyst must be aware of possible obsolesence of any given technology so that future

benefits are not estimated beyond the innovation's competitive life span.

Another time-related factor that must be established

for accurate evaluations of research projects is the rate of discount. Cost savings, increased revenues, and re- search and development expenses occur at different points in time. Because dollars received or spent at dif- ferent times are not equal in value, it is necessary to convert the streams of benefits and costs to a common

time basis. This process is called discounting. For

example, $1,000 invested at 8% will return $1,080 at the end of 1 year. Thus $1,080 received 1 year from now would be equivalent to $1,000 held today, because that $1,000 could be invested today to return $1,080 in a year. Benefit-cost analysis is sensitive to the discount rate that is selected for converting costs and

benefits that are dispersed over time to time equivalent

figures. Thus analysts must be careful to select the appropriate rate and make their reasons for choosing

10
that rate known. The procedure and formulas for dis- counting can be found in most engineering economics

textbooks.'^

2.2 SURVEY OF EVALUATION METHODS

To allocate limited resources efficiently among alternative research projects, R&D managers need a method

for measuring and comparing benefits and costs associ- ated with those projects. Three such methods—benefit-cost, internal rate-of-return, and payback analysis

are described in this section. The intent of this survey is to familiarize the reader with these three appfbaches and their advantages and

disadvantages in different applications. These three were selected because they are used widely; they are

logically straightforward and relatively easy for a re- search manager to understand; and they are

theoretically and practically sound when applied

properly.''

The selected methods have many features in common.

For example, each requires estimates of benefits and

costs, assumptions about diffusion rates of new technologies, and assumptions about time horizons. Furthermore, they all can be used to measure the eco- nomic performance of an investment made either by a government agency, university research group, or by

a private firm.'* There are, however, important differences among the

three methods. Benefit-cost analysis, for example,

provides an evaluation measure in terms of dollars and/or ratios; the internal rate-of-return method, in terms of a percentage rate of return; and the payback

method, in terms of time. The benefit-cost and internal

rate-of-return methods measure benefits and costs over

the entire life of a project; the payback method

" For descriptions of discounting, see Gerald W. Smith,

Engineering Economy: Analysis of Capital Expenditures, 2nd

ed. (Ames, Iowa: The Iowa State University Press, 1973), and Eugene L. Grant and W. Grant Ireson, Principles of

Engineering Economy, 5th ed. (New York: The Ronald Press

Co., 1970). "There are other approaches to evaluating alternative investments, but this survey is limited to the selected three. For descriptions of these three methodologies and others, see

Ajit K. Dasgupta and D. W. Pearce, Cost-Benefit Analysis: Theory and Practice (New York: Harper and Row, 1972), pp. 159-173; and Rosalie Ruegg et al., Life-Cycle Costing: A Guide

for Selecting Energy Conservation Projects for Public Buildings, NBS BSS113 (Washington, D.C., National Bureau of

Standards, 1978). " In applying these methods to evaluate investments of

private, profitmaking organizations, the effect of taxes should be taken into account. Because of its focus on the evaluation of government projects, this report does not treat income tax

effects. For a description of income tax considerations, see Gerald W. Smith, Engineering Economy, pp. 191-267.

generally includes less than life-time benefits and costs. Each of the three methods is described in sections

2.2.1 through 2.2.3. Case illustrations in building tech- nology of two of the three techniques will be

presented in sections 3 and 4.

2.2.1 BeneHt Cost"

Benefit-cost^° analysis is a general term used to describe two economic evaluation measures: (1) net

benefits and (2) benefit-cost ratios. The net benefits measure is useful for determining the efficient scale or

level of investment in any given project, and for choosing among mutually exclusive projects. The benefit-cost ratio is useful for choosing among projects that are not mutually exclusive. Both measures are useful

for determining whether to accept or reject a given

project.

Graphical analyses can be used to demonstrate how

the most efficient^' scale or level of resources to be

allocated to a new technology project is found by an

analysis of net benefits. Figures 2.7 and 2.8 illustrate that net benefits, the difference between total benefits and total costs, are maximized at Re, that level of

R&D where marginal benefits equal marginal costs.

" The benefit-cost explanation presented here is designed to give the decision maker a general understanding of how this technique of evaluating R&D can be applied. For more

thorough treatments of benefit-cost analysis, see the

following: Dasgupta and Pearce, Cost-Benefit Analysis: Theory

and Practice; Otto Eckstein, Water-Resource Development: The Economics of Project Evaluation (Cambridge, Massachusetts: Harvard University Press, 1965); Stephen A. Marglin,

"Objectives of Water-Resource Development: A General

Statement," Chapter 2, Design of Water Resource Systems, by

Arthur Maass et al. (Cambridge, Massachusetts: Harvard

University Press, 1962), pp. 17-87; E. J. Mishan, Cost-Benefit

Analysis: An Introduction (New York: Praeger, 1971).

Benefit and cost figures discussed here are assumed to be in present value terms. That is, some rate of discount has been

applied to all benefits and costs over the life cycle of the

project to put them on a time equivalent basis, as discussed in section 2.1.2.2.

^' Efficiency as used in this study can refer to the welfare of a government agency, academic research institution, firm, or

society as a whole, depending on assumptions regarding

whose objective function or set of benefits and costs is being

evaluated. An increase in efficiency results if an additional investment in R&D results in benefits that exceed the marginal investment. A decrease in efficiency results if an

additional investment in R&D generates benefits less than the amount of the marginal investment. (Cost effective is often used synonymously with efficient in this context.) The following assumptions are made in the benefit-cost model shown above: the total benefit and cost functions are continuous and increasing functions of the level of R&D; the

first and second order derivatives of both functions exist for the range of levels of R&D under discussion; and the total benefits function increases at a decreasing rate and the total cost function increases at an increasing rate.

11
$

Benefits and

Costs

Total . Benefits /

1 / 1

1 Total i

1 Costs 1 Maximum ' ^ Net Benefits ! ^^^^^''^

Z— 1 I 0 Ru Re Ro Rc

Level of R&D

Figure 2.7 Maximum net benefits from R&D in relation to total benefits and costs.

Marginal

Benefits and Costs Marginal

Benefits

Marginal

Costs

Ru Re Ro Rc

Level of R&D

Figure 2.8 Efficient scale of R&D as determined by marginal benefits and costs.

12
Undertaking more R&D than Re, the maximum level, would be an overallocation.^^ This can be seen by

inspection of figure 2.7, where net benefits at Ro are

less than net benefits at Re, and by inspection of figure

2.8, where marginal costs exceed marginal benefits beyond Re. The net benefits foregone by this overallo- cation at Ro can be measured by the cross-hatched

area to the right of Re in figure 2.8.^" Undertaking less R&D for a given project than Re, say Ru, results in an

underallocation of resources. Again by inspection of

figure 2.7, we see that net benefits at Ru are less than

at Re, and by inspection of figure 2.8 we see that marginal benefits exceed marginal costs at every level of

R&D between Ru and Re. The potential net benefits forgone by this underallocation at Ru is indicated by

the cross-hatched area to the left of Re in figure 2.8.^' The R&D manager might properly point out that the outputs of R&D are not very predictable, and that to estimate the marginal benefits and costs associated with different levels of R&D in order to arrive at the most efficient level for a given technology might be

difficult. This analysis can be useful, however, even where estimates of benefits and costs are rough. Note

in figure 2.7 that net benefits are positive for the amount of R&D indicated from zero to Rc; that is, the

benefits are greater than the costs of R&D. Thus in general terms, an analyst would consider a project effi- cient or cost effective at levels of Ru and Ro as well

as Re, because benefits exceed costs. In absence of

complete information, the decision to accept or reject a given project might rest simply on whether or not

benefits exceed costs, even while recognizing that the

project may not be at its most efficient scale. This is the approach taken in sections 3 and 4 where the net

benefits from introducing a heavy shingle and from

developing reduced-size venting are computed to see if they are positive.

In comparing projects against one another on the basis of the maximum benefits for a given budget expenditure, a project which is overallocated or

underallocated in itself might still be more efficient than an alternative project. However, we stress that the most efficient scale of or level of resource alloca- tion to R&D is at Re for any given project, and that more or less R&D production represents wasted re- sources.^* Another problem for which the net benefits measure is useful is in choosing the most efficient project(s) from

a set of mutually exclusive alternatives.^^ Selecting one

project means rejecting the other(s). An example

would be the choice between research on two

innovative approaches to a new production process when only one approach can be followed due to budget, personnel, project interdependence, facility, or

other constraints. The objective is to choose the

project that will yield the greatest net benefits while

meeting funding and other constraints. Dasgupta and Pearce classify the choice of time for un- dertaking a single project, i.e., whether to begin the

project now or to delay it, as a special case of mutual

exclusion. They advocate the maximization of net benefits as the appropriate criterion for this case also.^* Choice of project scale may also be regarded as a case of mutual exclusion, in that choosing one size precludes choosing alternative project sizes for the same purpose.

" It is assumed throughout this paper that, for any given level of research and development, costs are being minimized, that

is, each level of R&D is being provided with the least-cost combination of resources. The complete discounting formula for measuring the

present value (P.V.) of net benefits of investments in R&D

for a given scale of R is the following:

N rB,(R)-C,(R) "1 P.V. of net B(R) = 2 , t=lL (1+i)' J

where

B, = benefits in year t,

t = years 1 through N,

C, = costs in year t, and

i = discount rate.

^' For a theoretical discussion and application of benefit-cost

analysis to a building technology problem, see Robert E. Chapman and Peter F. Colweil, Economics of Protection Against Progressive Collapse, National Bureau of Standards

Report, NBSIR 74-542, September, 1974.

" An assumption that is implicit in our designation of Re as the most efficient scale is that the cutoff benefit-cost ratio at the margin is 1.0; i.e., that the highest benefit yield available

at the margin is just equal to the cost of investment. However, in the case where a very limited budget has to be

allocated among a large number of high payoff opportunities,

this common assumption may not be appropriate. If carrying one or more projects to the scale where their marginal

benefit-cost ratio is 1.0 means foregoing other projects whose

marginal benefit-cost ratio is greater than 1 .0, then the

collection of projects should be scaled so that benefits produced are the same for the marginal dollar of expenditure on each project. In this case, the maximum efficient scale of each of the projects would be less than Re in figures 2.7 and

2.8. For a thorough discussion of cutoff benefit-cost ratios and how they alter efficient scale and project choice decisions, see Marglin, "Objectives of Water Resource Development: A

General Statement," pp. 164-177. " Note that, when alternative projects are examined with

these criteria, the assumption is made that the individual project scales have been previously determined. " Dasgupta and Pearce, Cost-Benefit Analysis: Theory and

Practice, pp. 160-163.

13
Another choice that decision makers must make is among a set of project alternatives that are not mutually exclusive. Choosing one project does not preclude selection of the other projects. Although the objective continues to be the maximization of net benefits for the available budget, ranking and choosing

projects with the net benefits measure will not

necessarily result in the maximization of net benefits

for a given R&D budget. The benefit-cost ratio method is recommended for this type of problem.

Table 2. 1 shows that the net benefits and benefit-cost

ratio criteria may indicate different choices, and that basing the choice on the latter measure will result in maximum net benefits.

Table 2.1 COMPARISON OF RANKINGS BY NET

BENEFITS AND BENEFIT-COST

RATIOS

$1,000

Benefits Costs

Project (B) (C) B-C B/C

1 300 200 100 1.50 2 200 120 80 1.67

3 140 80 60 1.75

If we assume a budget of $400,000 or larger, all projects would be selected if higher returns were not

available from alternative investment opportunities. But assuming the budget is limited, say at $200,000, not all projects can be developed. Applying the net

benefits criterion (i.e., taking the projects with the highest net benefits value) would result in the selection of Project 1 with net benefits of $100,000. On the other hand, if we pick projects on the basis of the benefit-cost ratio, we would take first Project 3 and then

Project 2, but not Project 1, and net benefits for the same $200,000 cost would rise to $140,000. Thus, it is clear from table 2. 1 that, for projects that are not mutually exclusive, the net benefits criterion cannot be

relied upon to yield the maximum net benefits under a budget constraint. In this case a gain of $40,000

($60,000 +$80,000-$ 100,000) could be realized by

selecting projects on the basis of the benefit-cost ratio rather than on the basis of the net benefits rule.^'

^' Note that using benefit-cost ratios instead of a net-benefits measure to rank mutually exclusive projects may result in losses in net benefits. For example, a project costing

$160,000, with benefits of $200,000, results in net benefits of

$40,000. This project would be preferred on economic

grounds to a project costing $90,000 with benefits of $120,000 and net benefits of 530,000. However, if the benefit-cost ratio were used as the selection criterion, the second (and less efficient) project with benefit-cost ratio of 1.33 would be chosen over the first (more efficient) project with a benefit- cost ratio of 1.25.

2.2.2 Internal Rate of Return

The internal rate of return is that compound interest rate which will discount net benefits of an investment

to zero; i.e., that rate at which discounted total costs and total benefits are equal. In contrast to the net benefits method of evaluation, which calculates the net

dollar value of an investment based on a given

minimum rate of return (i.e., a specified discount rate), this method finds the rate of return which makes the

net dollar value of the investment equal to zero.

The rate of return is usually calculated by a process of

trial and error, whereby net benefits from an invest- ment are calculated for various discount rates until the

rate at which net benefits are reduced to zero is discovered. ^° As a very simple example, consider the

calculation of the internal rate of return on a project

which is to research, develop, and bring to a state of

marketability a new technology in artificial lighting.

Assume the new technology will reduce the energy re- quirement per lumen/m^ of lighting delivered to 20%

below the energy requirement of the existing

counterpart lighting system, and that the investment

costs for R&D are $1,000,000 to be expended in the current year. Assume further that once developed, the purchase and installation cost of the new system will be the same as for the existing system, that the total energy savings will amount to $300,000 a year, and

that it is expected that the new technology will likely

become obsolete after 10 years.^'

The objective is to find that rate of return (i) which

will equate discounted benefits and costs as shown in equation 2. 1

:

B,

(l + i)"-!

id+i)"*

(2.1)

Substituting our problem values of $1,000,000 for C,

$300,000 for B„ and 10 for N, we find the value for i which will solve the equation.

^° For a more thorough treatment of the internal rate-of- return evaluation method, see, for example, Dasgupta and

Pearce, Cost-Benefit Analysis: Theory and Practice, pp. 164-

168; Grant and Ireson, Principles ofEngineering Economy, pp. 109-134.

^' In order to focus on the concept of internal rate of return, we neglect in the above example the complicating factors which may enter into an analysis, such as fuel price

escalation, differences in purchase prices and lives of new

and old technologies, the process of diffusion of the innovation throughout the economy, and, for a private research firm, tax considerations.

14
The bracketed term in equation 2.1 is called the uniform present value factor. By visual inspection of

tables of discount factors,^^ we find that the factor that solves equation 2.1 is 3.333. We then look in a table of

uniform present value factors to find the interest rate for which the factor is equal to, or approximately

equal to, 3.333. If we are working without the benefit of a comprehensive set of discount tables, the i for which the uniform present value factor is exactly

equal to 3.333 may not appear in the tables. We can, however, closely approximate it by calculating the net present value for those rates included in the factor

tables which appear to bound the correct i and

interpolate between the two rates. In this case, for

instance, if our tables of discount factors were

available for interest rates in increments of 5%, we

would select 25% (for which the uniform present value factor is 3.571) and 30% (for which the uniform

present value factor is 3.092) as trial i's. Applying the uniform present worth factor for 25% results in net present value benefits equal to $71,300 (i.e., $300,000

(3.571)-$1,000,000=$71,300). Applying the factor for 30% results in net present value benefits equal to - $72,400 (i.e., $300,000 (3.092)-$ 1,000,000 =-$72,400).

For i=25%, net present value benefits are positive; for i=30%, net present value benefits are negative. Thus,

for some discount rate between 25% and 30%, total present value benefits are equated to total present value costs. By interpolation,

$1,07 1,300-$ 1,000,000

i= .25 + .05 $l,071,300-$927,600

$71,300 = .25 + .05 $143,700

= .275, or expressed as a percentage, 27.5%.

To decide whether or not to undertake this invest- ment, the expected rate of return of 27.5% is compared with the research organization's minimum

acceptable rate of return. If it were a project being

" Tables of discount factors are tabular solutions to the discounting formulas which are used to move values in time

so that they may be compared on an equivalent basis. (See

sec. 2.1.2.2.) The factors are computed for a range of

discount rates and time, and are included as a statistical appendix in most engineering economics textbooks. (See for example. Grant and Ireson, Principles of Engineering

Economy, pp. 594-627.)

considered by a Federal laboratory, for example, the appropriate rate for comparison generally would be

10%."

The calculation of the rate of return can be quite

cumbersome when a number of cost benefit items are included in the equation. However, a computer

program can be used to facilitate the calculations as was done in the case studies in sections 3 and 4.

In section 2.2. 1 four kinds of investment decisions were discussed for which the decision maker may

need a method of evaluation—determining the effi- cient size of investment for a given project, choosing

among mutually exclusive projects, choosing among

projects that are not mutually exclusive, and determining whether to accept or reject a given project. Let us consider the internal rate-of-return method as a

criterion for addressing these problems, noting that in general a higher rate of return, or yield, is more

desirable than a lower rate. With respect to the sizing problem, the internal rate- of-return method can be used to size projects effi- ciently, although there may be more room for confusion in its use than in the use of the net benefits

criterion. To determine the most efficient size of a given project, the internal rate of return would be cal- culated for increments of investment in the project.

The project would be expanded up to the point that the rate of return on the incremental investment is just

equal to the investor's minimum acceptable rate of

return.^* Confusion, which may result in inefficient sizing, may

arise because the rate of return on the total investment

for a larger-sized version of a project may be less than

that on a smaller-sized version of the same project,

causing the smaller to appear to be more efficient. However, as long as the rate of return on the

difference between the larger and smaller versions exceeds the minimum acceptable rate, the larger version is the more efficient choice.^'

" Executive Office of the President, Office of Management

and Budget, Circular A-94, "Discount Rates to be used in Evaluating Time Distributed Costs and Benefits," March 27, 1972.

This assumes that the internal rate of return is a continuous and decreasing function of the level of R&D investment. "The same kind of problem exists with use of the benefit- cost ratio criterion to size projects, in that the more efficient sized project may have a lower ratio on the total investment

than the less efficient sized project. This reflects the fact that the incremental ratio usually declines as the investment is expanded, the most efficient scale when there is no budget

constraint being that for which the incremental ratio has declined to 1.0. It follows that the ratio on the overall investment declines as the investment is expanded toward the most efficient level. To avoid this problem, the net benefits measure is recommended for sizing projects.

15
The same problem may arise in using the internal rate- of-retum criterion to select among other mutually ex- clusive projects.^* That is, if applied to total costs and

total benefits, rather than incremental costs and incre- mental benefits, it may result in the choice of a project

with a higher internal rate of return, but with lower

net benefits than the alternative projects. The net benefits criterion therefore is preferred to the internal rate- of-return method for this kind of decision. For use in selecting among alternative, non-mutually

exclusive projects, when the available R&D budget is limited, the rate-of-retum criterion is comparable in effect to the benefit-cost ratio, both of which would

generally^' result in a valid ranking and both of which

are recommended over the net benefits method. Alter- native investments with rates of return larger than the minimum acceptable rate are ranked in order of their comparative rates, with the higher yielding projects

preferred. For determining whether to accept or reject a given project, the calculated rate of return is compared with the investor's minimum acceptable rate of return to determine if the project's rate of return is higher.

The major criticism of the internal rate-of-return method is that it is subject to a possible problem in computation. Namely, there may be either no rate-of- return solution or multiple solutions under certain

38 Circumstances.

2.2.3 Payback

A popular measure of an investment's desirability is its payback period, known variously as the payout,

payoff, recovery, or break-even period. This is the measure of the number of years (or other unit of time)

required for the invested capital to be offset by the

resulting yearly net benefits.^' ^ Recall that it is assumed that the mutually exclusive

situation is restricted to the selection of one project from

alternative potential substitute projects and does not take into account the possibility of other projects which might

compete with the group of mutually exclusive projects. " The validity of rankings is qualified because of the

possibility of computational problems with the internal rate- of-return as described in the last paragraph of this section, and because of the benefit-cost ratio may vary depending on

whether certain effects are treated as a benefit (numerator of

the ratio) or as a negative cost (denominator of the ratio).

Multiple solutions may result because the internal rate-of- return is in essence the solution to a polynomial equation,

which if of degree n, will have n roots, i.e., n solution rates. An example of a type of investment which gives rise to multiple solutions is one characterized by a net benefits stream which is first negative, then positive, and finally negative again.

^' For an in-depth treatment of the payback criterion, see Grant and Ireson, Engineering Economy: Analysis of Capital

Expenditures, pp. 347, 528-529; Educational Facilities Laboratories, The Economy ofEnergy Conservation in Educational Facilities (New York: EFL, Inc., 1973), pp. 67-68.

Although the payback measure may provide useful in- formation for evaluating an investment, it has shortcomings as a general criterion of economic effi- ciency, both from the standpoint of sizing a project

and of choosing among alternative projects. The

shortcomings stem from two sources: (1) problems in the method of calculation which is popularly used,

and (2) conceptual limitations of the measure.

The popular method of calculating payback is to relate the average yearly net inflow of cash to the first cost of the investment, on a before-tax basis and neglecting

the opportunity cost of capital (and often, other items of costs). This "short-cut" version of payback is called "simple" payback method, and it may be expressed as follows:

First Cost Payback Period = . (2.2)

(in years) Average Yeariy Benefits Minus Average Yearly Costs

Using this approach, for example, the payback period

for an investment of $1,000,000 in R&D for an improved fire detection system, which is expected to save 200 users $500 per year each in net operating

costs, would be calculated as follows:

$1,000,000

Payback Period = = 10 years. 200 X $500

But the payback period when calculated in this manner is the number of years required for the net

before-tax cash flow from a project to equal zero, when the opportunity cost of capital is 0%. For any

positive opportunity cost, this method of calculation does not correctly indicate the period of time before

costs will be recovered. For example, if an

opportunity cost of money of 10% were taken into account, the investment to develop the improved fire detection system would never recover the investment. A second problem in using a simple payback measure

is that the method fails to distinguish between projects

with benefit and cost streams which vary over time. For example, let us examine projects A and B

described in table 2.2. Both require a first cost of

520,000, but the benefit streams for A and B differ. Although they cost the same and yield the same in undiscounted terms (i.e., their simple payback period

is the same), B has a higher present value of net benefits ($1,525, evaluated with a 10% discount rate) than A ($698, evaluated with a 10% discount rate) because

of its larger return in the first year.

16
Table 2.2 ILLUSTRATION OF A SHORTCOMING OF SIMPLE PAYBACK

Projects First Cost

($)

Year 1

Benefits

($)

Year 2 Year 3

Payback

in YearsPresent Value Net Benefit^

($) A

B

20,000

20,000

5,000

15,000

15,000

5,000

5,000

5,000

2.4

2.4

698

1,525

^The present value of net benefits is calculated by finding the total present value of benefits discounted at a 10%

discount rate and subtracting first costs from the total.

The shortcomings that result from failure to discount

costs can be overcome simply by using a more comprehensive calculation method, called "discounted"

payback. This method finds the number of years, R,

for which the following equality holds:

C= 2

R Bj-Pj

(2.3)

j = l(l+i)j

where

C

R

= initial investment cost, = benefits in year j, = costs in year j, = break-even number of years, and = discount rate. Where yearly net benefits are uneven, an iterative process can be used to determine the solution. If, on

the other hand, yearly net benefits (M) are expected to be about uniform, the following formula can be used

to facilitate the calculation:

-log 1-

iC^

M;

R

log(l+i)

(2.4)

The conceptual limitations of the payback measure

persist, however, regardless of the method of computation. The chief problem is that the measure does not

include costs and benefits beyond the payback year, and, therefore, does not measure the efficiency of an in- vestment over its life. It is often argued that payback

does provide an adequate measure of efficiency, in that the analyst can compare the payback period with

the expected life of the investment to determine how

far beyond the payback time the investment will continue to yield net benefits, and to some extent this

is true. However, the subjective element of this

procedure often makes it inadequate for comparing the

relative efficiency of alternative investments with

differing hves and/or differing flows of net benefits. Thus, the other evaluation methods—net benefits, benefit-cost ratio, or internal rate of return—are preferred

to the payback method for most economic evaluations of R&D investments.'" Despite its limitations, the payback method is useful

for evaluating investments under two situations: (1) A

rapid payback may be a prime criterion for judging an

investment when financial resources are available to the investor for only a short period of time before repayment is required, as would be the case with the

speculative investor. (2) Where the expected life of the

assests is highly uncertain, determination of the break- even life, i.e., payback period, is helpful in assessing the likelihood of achieving a successful investment. The first situation appears more relevant to private

firms than to government agencies. The second may

be relevant to both. Provided there are no major costs occurring after the time of payback, the discounted payback measure can be used as a rough indicator of cost effectiveness. The

measure is not, however, reliable for choosing the most efficient projects from a set of alternatives,

although it may provide critical information for project selection when investment funds must be

repaid or asset life is very uncertain. The payback measure seems to be given undue

emphasis by both government agencies and private

firms, with decision makers preferring very short payback periods. Although giving preference to projects with relatively short paybacks may provide some guarantee of breaking even, it may also lead to a succession of less efficient, short-lived projects.

Myron Gordon has demonstrated that the internal rate of

return is the reciprocal of the payback period when an

investment earns the same amount indefinitely, and for shorter project lives, that the difference is negligible over a wide range of lives. See Myron J. Gordon, "The Payoff

Period and the Rate of Profit," The Journal ofBusiness, XXVIII (October, 1955), p. 254.

17
2.2.4 Summary of Methods

In section 2.2 we have examined three selected methods—benefit-analysis cost (including both net benefits and benefit-cost measures), internal rate of return, and payback analysis. Each of these methods can be

applied by a government, university, or firm to evaluate the economic feasibility of R&D investments from

the particular viewpoint of that institution. A decision maker might employ these methods to determine if a

specific R&D investment is economic to undertake,

what level of resources should be allocated to that R&D project (i.e., what scale of investment should be

made), and what set of R&D projects should be

undertaken from multiple investment opportunities

given budget and other constraints. Each of the methods described generally can be used

to decide whether to accept or reject a given project. For other types of investment decisions, however,

there are often advantages to using a particular

method. The efficient sizing of a specific R&D project

and the selection of a project from mutually exclusive

alternatives, for example, are decisions best deter- mined by the net benefits method. The choice of

projects from among project alternatives that are not mutually exclusive, on the other hand, is guided best by use of either the benefit/cost ratio or the internal rate-of-retum method when there is a budget constraint. When the required time for recovering invest- ment funds is critical and/or the life of major project

assets is uncertain, the discounted payback method can

provide a valuable supplementary measure for both

sizing projects and choosing among alternative

projects. Measurements of benefits and costs are required for all of the methods. Collecting sufficiently complete and

accurate historical data, along with predicting

sufficiently complete and accurate future values, are

crucial elements in the application of any of the methods.

A problem common to all of the evaluation measures

is the uncertainty surrounding benefit and cost predictions. Although the formulas for the various methods

are conceptually correct and generally easy to use, there is considerable uncertainty regarding the values

substituted into the formulas. One approach frequently

employed is sensitivity analysis, wherein different values of key parameters (such as discount rates, product life, process, and costs) are substituted into the formulas to determine economic payoffs under dif- ferent conditions. A second approach is to employ

mathematical techniques to predict expected values of

benefits and costs. If some historical data base exists for constructing a probability distribution, more

confidence generally can be placed in these expected

values than in single point estimates.

The following case studies in sections 3 and 4 demonstrate not only how to use some of the methods

outlined above, but illustrate pragmatic approaches to measuring benefits and costs as well. Both case studies are evaluations of actual research projects which were

carried on in the Center for Building Technology

(CBT). The first project measures the benefits and

costs of developing an improved asphalt shingle for sloped roofing; the second measures the benefits and

costs of introducing an innovative sanitary drainage

venting system called reduced-size venting, which can

be substituted for conventional venting systems in houses. Two case illustrations are given to demonstrate how

to measure impacts under different conditions. The

shingles case study describes a building innovation

that was voluntarily implemented, took place in the

past, and that had some historical data available for

analysis. The reduced-size venting case, on the other hand, describes a new building technology that is just

being introduced, whose benefits will be accruing in the future, and for which there are no real data for

analysis. Measures of both kinds of impacts—those

that have accrued in the past and those expected to accrue in the future—are needed to improve resource

allocations for R&D.

These particular two cases were selected for study

because data were available regarding their research

costs and because their benefits were thought to be

measurable. The purpose here was to illustrate the techniques and not to make any claims about the "goodness" or "badness" of research investments. No

inference can be drawn that all research by the Center

for Building Technology has the kind of payoffs described for these two case examples. On the other hand, no claim is made that these two cases are typical or atypical. They serve simply to illustrate the application of the techniques described earlier.

Facing page:

This house has a sloped roof with shingles of the type evaluated in this section.

18
3. CASE STUDY: 235 SHINGLES

3.1 BACKGROUND

Over 80% of the sloped roofs in the United States are covered with asphalt shingles, and expenditures for these shingles amount to many millions of dollars

yearly. Prior to 1962 the type of shingle in predominant use weighed approximately 210 lbs/100

ft^ (95.3 kg/9.3 m^) when in place on the roof;

Special thanks are due Robert Mathey, from the Building

Composites Program of CBT, who provided assistance and

data on roofing shingles.

consequently this type of shingle is usually referred to

as the 210 shingle. The relatively light weight of the 210 shingle contributed to a type of failure called "clawing," which resulted from moisture absorption

by the reinforcing organic felt. Clawing led to the need for frequent replacement. The expected life of

210 shingles was approximately 10 years. However, in hot climates their life was sometimes less than 9 years, and it was common for the shingles to fail due to clawing after only 2 to 4 years of exposure. The poor

durability was a serious and costly problem not only

for homeowners and businesses across the nation, but

also for the armed services which use asphalt shingles

extensively at military bases.

19
In face of the premature failure and attendant costs and inconvenience, the Tri Services (a joint organization of the U.S. Army, Navy, and Air Force) asked CBT to investigate ways of solving the problem. In response, CBT carried out field investigations on

Federal installations to identify the reasons for the premature failure of 210 shingles; led the development

of specifications for a heavier, more durable asphalt

shingle; and conducted outdoor exposure studies to validate the new specifications. In addition, CBT staff coordinated work among the various interested parties

and promoted the early acceptance of the standards on

a voluntary basis. As a result of its studies, CBT recommended that shingle felts be better saturated so that they contain more asphalt and that the coating on the back of the

shingle be significantly increased. Tests showed that greater saturation of the felt and a thicker asphalt

coating would provide more protection from moisture

penetration into the organic reinforcing felt.

These recommendations were subsequently adopted

by the roofing industry. The result was a heavier

shingle, weighing approximately 235 lbs/100 ft^ (106.6

kg/9.3 m^) in place,"*^ and generally referred to as the 235 shingle. By about 1962, the 235 shingle began substantially to displace sales of the 210 shingle. The

heavier shingle is not prone to the problem of

moisture penetration into the felts, nor the resultant clawing during the expected service life. Consequently, the 235 shingle generally lasts at least

1 5 years in hot climates and 20 or more years in cooler

climates; that is, 5 or more years longer than the 210

shingles. With its longer life, it reduces the frequency

and costs of replacement. Approximately 98% of the

shingles now used are of the 235 type or heavier types. Even without CBT's contribution, it is likely that

similar improvements would have eventually been

made, and that by now most shingles would be of the improved type. However, CBT's research contributed

to the development and acceptance of the voluntary

industry shingle standard. In the opinion of roofing

experts both in and outside of NBS, the availability

and extensive use of 235 shingles would have been

delayed from 2 to 5 years had it not been for CBT's

participation in, and coordination of, the development

of 235 shingles.*'

*^ Minimum weight as given in ASTM Standard D225-65

(reappraised 1970) is 228 lbs/100 ft^ (103.4 kg/9.3 m^). American Society for Testing and Materials, Annual Book of ASTM Standards. Part 15, Philadelphia, 1974.

*^ According to Harold Whittemore, Managing Director of

the Asphalt Roofing Manufacturers Association, CBT's

leadership was "absolutely necessary and most essential" in promoting the 235 shingle, and sped up the adoption of 235

shingles by at least "several years."

The price of the various types of similar asphalt

roofing shingles generally varies proportionately to

their weight. This price relationship reflects the fact that similar type shingles undergo essentially the same

production processes, but heavier shingles consume more materials. Thus, the 235 shingle costs more than

the 210 shingle. The price per sales square"** of 235

shingles is about $15 for materials and $20 for labor

for the initial installation.*' The price per sales square of 210 shingles is about $13.40 for materials (i.e., (210/235)X$15 = $13.40) and $20 for labor for the

initial installation (i.e., the same as for the 235

shingles).**

3.2 APPROACH

In this case study, benefit-cost and internal rate-of- return methodologies are used first to measure the

social payoff of substituting 235 shingles for 210

shingles, and secondly, to evaluate the efficiency of CBT's investment in the development and implementation of 235 shingles. The evaluations are aimed only at determining the presence or absence of net benefits and positive returns, and does not attempt to deter- mine the optimal investment size, nor to compare the payoffs from these projects with the expected returns on other potential uses of society's or CBT's funds. As was explained above, the 235 shingle costs more to purchase than the 210 shingle; however, the 235

shingle gives greater service life than the 210 shingle.

Both types of shingles give essentially the same perfor- mance up until their required replacement. Since it is not obvious which shingle actually costs more per unit of time over its life, the first step in the evaluation is to measure and compare the life-cycle costs of the two

types of shingles to determine if, and in what amount,

the 235 shingle results in cost savings to the owner of

a building on which it is applied. Total cumulative cost savings attributable to the 235

shingle will be taken as a measure of the gross benefits

to society. This approach is consistent with the graphical model of consumers' surplus illustrated in

** A sales square—the customary unit by which shingles are sold—is the quantity of shingles needed to cover 100 ft^ (9.3 m^) of roofing surface. "The $15 and $20 figures were the approximate costs (ignoring regional differences) of 235 shingles in 1974.

** At the time of the second replacement of shingles, it is generally necessary to remove the old shingles before

installing the new. Thus the labor cost for the second

replacement is usually greater than $20 per sales square. With

its need to be replaced more often, the 210 shingle would

require more "second replacements" and, hence, a higher average labor cost per installation than would the 235

shingle. This difference is not taken into account in this cost

evaluation. Thus the cost savings estimated here will be

biased downward from the true values.

20
figure 2.6 and slightly altered in figure 3.1. The objective of the shingles case study is to measure the dollar value of P2RZP1. This is thought to be a fairly accurate measure of social benefits for the following

reasons. First, no innovator profits are included

because the government cannot reap such profits.

Thus, the area below S2 labeled profits in figure 2.6 is not shown in figure 3.1. Second, consumers' surplus

(P2RTP1) resulting from the new technology is thought to be close in dollar value to P2RZP1. This is due to the fact that the quantity demanded of shingles

is expected to remain about the same whether they are 235 or 210 shingles. That is, the total market for shingles during the study period is expected to vary

little with the substitution of the heavier shingle.

Price

Q

Quantity of Output of industry Using tiie Innovation

Figure 3.1 Consumers' surplus measure of benefits for 235 shingles.

This is illustrated by the relatively inelastic (almost

straight up and down) demand function in figure 3.1. As the area RZT shrinks, the PjRZP, measure becomes a closer approximation to consumers' surplus,

PjRTP,. Finally, the price difference (P1-P2) between

the 235 and 210 shingles is assumed to be the

difference in life-cycle costs between the two shingles.

Thus multiplying the life-cycle cost differences between the two shingles times the quantity sold would yield PjRZP, as the esfimate of social net benefits from the 235 shingles innovation. Total cumulative

net benefits of the shingle will be found by subtracting

from its gross benefits the total costs of implementing

the new shingle. These costs consist of research, devel- opment, and dissemination-of-information costs incurred by CBT as well as by other groups with

which CBT coordinated its research efforts. The

gross benefits to society from CBT participation will be considered as the difference in total gross benefits estimated with and without CBT participation. Net benefits of CBT will be derived by subtracting

CBT costs from gross benefits of CBT participation. In addition, internal rates of return on investment will be calculated, both for society's extra expenditures for purchasing 235 rather than 210 shingles, and for CBT's research investment costs. Measurement of the impacts of the 235 shingle are based on the period from 1962, when extensive use began, to 1974. Any benefits or costs occurring after 1974 are not taken into account. All costs and benefits are brought forward in time to 1974 dollars.

3.3 GROSS BENEFITS OF 235 SHINGLES

The first step ;n the evaluation is to compare life-cycle costs of the two types of shingles in order to identify

any cost savings (benefits) to consumers of one over

the other. Ultimately the objective of the evaluation is to determine if the additional $1.60 which consumers

must pay in order to obtain a sales square of shingles

with 5 more years of life is a worthwhile investment."** By computing life-cycle costs in terms of the annual

costs of a unit of each type of shingle and then comparing them, the annual per unit savings of a 235 over a 210 shingle can be derived. The measure of

annual savings per unit of shingle is necessary to calculate the value of the expected stream of savings

which will accrue to consumers over the 13-year

period from the quantity of shingles sold in each of the

13 years. These 13 streams of annual savings are dis- counted to present value and summed in order to obtain a measure of total present value savings from

substituting 235 for 210 shingles over the period 1962 through 1974. Table 3.1 shows in three parts the computation of annual cost savings from 235 shingles. Part I of table

3. 1 shows the calculation of the annual cost of one

sales square of 235 shingles. This calculation is based on the assumptions of a combined purchase and instal- lation cost of $35 per sales square, a 15-year life, continuous replacement of the roof (see footnote a, table 3.1 for a discussion of this assumption), and a

Other groups that carried out research on and development

of the 235 shingle were the Underwriters Laboratories, the ASTM Committee D8, and the Asphalt Roofing Industry Bureau (now known as the Asphalt Roofing Manufacturers

Association) and its member companies. •^The analysis assumes that the prices of other goods are unaffected by the introduction of 235 shingles, and the gross

benefits are assumed to be the shingle cost savings accruing

exclusively to shingle consumers.

21
Table 3.1 CALCULATION OF ANNUAL COST SAVINGS (ACS) TO

CONSUMERS FROM SUBSTITUTING A UNIT OF 235

SHINGLES FOR A UNIT OF 210 SHINGLES

I. Calculation of Uniform Annual Cost Per Sales Square of 235 Shingles

(AC235), Assuming 15-Year life, Continuous Roof Replacement, and a 10%

Discount Rate:"

AC235 = (L235 + M235) (UCR,i = .10,N=15 yrs.) = ($20 + $15) (.1315) = $4.603/SQ

II. Calculation of Uniform Annual Cost Per Sales Square of 210 Shingles

(AC210). Assuming a 10-Year life. Continuous Roof Replacements, and a 10% Discount Rate:"

AC210 =(L2,o + M2,o) (UCR,i = .10,N=10yrs.) = ($20 + $13.40) (.1628) = $5.438/SQ

III. Calculation of Uniform Annual Cost Savings Per Sales Square (ACS235) of

Substituting 235 Shingles for 210 Shingles, where ACS235=AC2io-AC235.

ACS235 = $5.438/SQ - $4.603/SQ = $.835/SQ

' The formula to calculate the annual cost of one sales square of type k shingles, assuming

continuous roof replacements, is

i (1 + \^ AC, = (L, + M,) ,

where

L|( = labor cost of installing one sales square of type k shingles in 1974 dollars, = materials cost of one sales square of type k shingles, in 1974 dollars,

i = real discount rate, N = life of type k shingles, in years, and

i(l -f i)*^

(1 -I- i)N _ I ~ uniform capital recovery formula.

Note: Rather than continuous replacement, roofing will actually be replaced only as long as the building lasts. If shingle life does not divide building life evenly, i.e., if all of the shingle value is not consumed by the end of use of a building, the annual cost of the shingles will be

sensitive to the assumption of continuous replacement versus limited replacement. Annual

costs will differ because the salvage value of shingles at the end of building life is generally zero regardless of the "otherwise" remaining life of the shingles. But if shingle life does

divide building life evenly, as, for example, in the case of a 30-year building life and 10- and

1 5-year shingle lives, the annual cost results will be the same regardless of whether

continuous replacement or a limited number of years is assumed. Annual costs are here based on continuous replacement, because the choice of building life is somewhat arbitrary and may bias the costs of one shingle type relative to the other, depending on which shingle type the assumed building life corresponds to more closely. For example, a building life of 40 years would favor the 210 shingles, since the fourth installation would be exactly consumed and no life would be lost. On the other hand, building life of 45 years would

favor the 235 shingle, since three shingle installations would exactly match building life.

22
Table 3.2 PRESENT VALUE SAVINGS TO CONSUMERS FROM 235 SHINGLES

235 as Quantity of . Present value of

% of total total Quantity of Annual cost Annual cost annual cost Year shingles* shingles'" 235 shingles'^ savings/SQ'' savings/batch* Factors*^ savings^

($) ($) ($)

(1) (2) (3) (4) (5) (6) (7) (8)

1962 50 3o,oOo,003 18,303,001 0.833 I j,Zoj,UUj Z4.JZ i /4, /jy,4UU

jO,U/ T 1 AAA lAf^ U.OJJ 11

fio,U / J,UZ7 mo Z V.JO flfiA AAA \Ar\ 1964 80 40,162,409 32,129,927 0.835 26,828,489 18.53 497,131,910 1965 95 39,748,439 37,808,517 0.835 31,570,111 15.94 503,227,550 1966 95 36,830,053 34,988,550 0.835 29,215,439 13.58 396,745,670 1967 96 42,037,640 40,356,134 0.835 33,697,371 11.44 385,497,910 1968 97 43,306,669 42,007,468 0.835 35,076,235 9.487 332,768,280 1969 97 46,208,524 44,822,268 0.835 37,426,593 7.716 288,783,560 1970 98 45,488,916 44,579,137 0.835 37,223,579 6.105 227,249,950

1971 98 54,588,430 53,496,661 0.835 44,669,711 4.641 207,312,120 1972 98 58,518,259 57,347,893 0.835 47,885,490 3.310 158,500,970 1973 98 63,419,600 62,151,208 0.835 51,896,258 2.100 108,982,140 1974 98 65,956,384 64,637,256 0.835 53,972,108 1.000 53,972,108

Total present value savings = $3,921,355,708''

° Estimated on basis of information provided by the roofing industry.

Total quantity of shingles having a base of dry felt or other organic binder produced in each year. In absence of sales data, it

is assumed that the quantity produced is equal to the quantity purchased. The unit of measure is the "sales square" (SQ); i.e., a

quantity of shingles sufficient to cover 100 ft^ (9.3m^) of roof area.

" Col. 4=Col. 2xCol. 3. Quantity is stated in number of units of squares sold.

^ Annual cost savings per sales square as derived in table 3.1.

'Col. 6=Col. 4xCol. 5. This is the annual cost savings attributable to each year's production (i.e., batch) of 235 shingles. 'Uniform compound amount (UCA) factors computed from the uniform compound amount formula, (1 +i)'^-l, for a discount

rate of 10%. This formula can be used to convert an annual stream of past values to the present.

8Col. 8=Col. 6xCol. 7.

* No rounding of intermediate results was performed in this and subsequent tables to avoid unnecessary rounding errors. 10% real rate of discount—the rate recommended by

OMB for evaluating government investments.*' The

resulting annual cost of 235 shingles is shown to be

$4,603 per sales square.

Part II of table 3.1 shows the calculation of the annual

cost per sales square of 210 shingles, based on a combined purchase and installation cost of $33.40 per

sales square, a 10-year life, continuous roof replacement, and a 10% discount rate. The annual cost of 210

shingles is shown to be $5,438 per sales square.

Part III of table 3.1 derives the annual cost savings

(benefits) per sales square of 235 shingles by

subtracting the annual cost per square of 235 shingles

from the cost of 210 shingles. Annual savings from

using 235 instead of 210 shingles are $.835 per sales square.

Executive Office of the President, Circular No. A-94.

The subsequent steps in the estimation of gross benefits from 235 shingles are shown in table 3.2. First, the

quantity of 235 shingles purchased each year from

1962 through 1974 (column 4) is estimated by multiplying the estimated percentages of total shingle production comprised of 235 shingles in each year (column 2) times the total number of shingles produced in each

year (column 3). (In absence of purchase data, the quantity of shingles produced is used as a proxy for the quantity purchased and applied to roofs.)

Next, the annual savings resulting from the 235

shingles purchased in each year (column 6) are calculated by multiplying annual savings per square (column 5) by the yearly quantity of 235 squares (column 4). For example, the 18.3 million squares of

235 shingles sold in 1962, yielding an annual savings of

$.835 each, result in total annual savings equivalent to $15.3 million (in 1974 dollars). This is the amount of

23
savings which accrue in each of the 1 3 years over the evaluation period 1962 through 1974, as a result of the

use of the 18.3 million squares of 235 shingles in place of the same quantity of 210 shingles. The 62.2 million squares sold in 1973, also yielding an aimual savings of

$.835 each, are estimated to save a total of $51.9

million annually. The $51.9 million in annual savings

from these shingles will accrue only during 1973 and

1974, the last 2 years of the evaluation period.

The final step is to convert each stream of annual

savings to a present value equivalent (column 8). This

is done by applying the uniform compound amount

factors (column 7) to the annual cost savings (column

6). The uniform compound amount factors—or the uniform compound amount formula, from which the

factors are derived—are appropriate for converting a stream of past annual values to the present, which is the case here. For example, the 18.3 million squares of

235 shingles sold in 1962 yield a total present value

savings of S374.7 million over the 13 years. By summing the present value savings associated with

each year's consumption of 235 shingles, we arrive at an estimate of total present value savings (gross benefits) for the 13-year period. It totals nearly $4 billion.

This large sum is not too surprising given that millions of squares of 235 shingles are sold each year, and that each square is expected to reduce roofing costs by

almost $1.00 annually.

3.4 BENEFITS OF CBT ACTIVITIES

To estimate the gross benefits from CBT research

activities, we compare the total present value savings

to the consumer over the 1 3-year evalua*^ion period,

with and without CBT involvement. To do this, present value savings from 235 shingles are reestimated, assuming CBT had not been involved. It is assumed that CBT's work with 235 shingles speeded up their application by 3 years. This assumption takes approximately the middle value of our best guess that CBT speeded up the development and use of 235

shingles by 2 to 5 years. Hence, to take into account

the lack of CBT influence, the level of production

(hence consumption) of 235 shingles is lagged by 3 years. Table 3.3 shows the derivation of total consumer savings from 235 shingles assuming no CBT involve- ment. Table 3.4 takes the difference between tables 3.2 and 3.3 and shows that the present value of additional

Table 3.3 PRESENT VALUE SAVINGS TO CONSUMERS FROM 235 SHINGLES

WITHOUT CBT INVOLVEMENT'

235 as % Annual

of total cost Present value

shingles, Quantity of Annual savings per of annual without 235, cost batch, UCA cost savings. Year CBT without CBT savings/SQ without CBT factors without CBT

($) ($) ($)

(1) (2) (3) (4) (5) (6) (7)

1962-1964 0 0 0 0

1965 50 19,899,219 0.835 16,615,847 15.94 264,856,640 1966 60 22,098,031 0.835 18,451,855 13.58 250,576,250 1967 80 33,630,112 0.835 28,081,143 11.44 321,248,240 1968 95 41,141,335 0.835 34,353,014 9.487 325,907,000 1969 95 43,898,097 0.835 36,654,910 7.716 282,829,280 1970 96 43,669,359 0.835 36,463,914 6.105 222,612,170

1971 97 52,950,777 0.835 44,213,898 4.S41 205,196,700 1972 97 56,762,711 0.835 47,396,863 3.310 156,883,600 1973 98 62,151,208 0.835 51,896,258 2.100 108,982,140 1974 98 64,637,256 0.835 53,972,108 1.000 53,972,108

Total present value savings, without CBT = $2,193,064,128

° Present value savings in this table are computed exactly as they were in table 3.2, with one exception. It

is assumed that without CBT involvement, the quantity of 235 shingles prior to 1965 would have been

negligible, and that beginning in 1965 the percentage of the market given each year to 235 shingles would

have paralleled that for the period 1962 to 1971 with CBT involvement.

24
Table 3.4 PRESENT VALUE SAVINGS TO CONSUMERS FROM

235 SHINGLES DUE TO CBT INVOLVEMENT

Present value savings from 235 shingles = S3, ')2 1,355,708

(minus)

Present value savings from 235 shingles

without CBT involvement = $2,193,064,128

(equals) Present value savings attributable to CBT

involvement $1,728,291,580

consumer savings due to CBT involvement are estima- ted to be about $1.7 billion. To calculate net benefits to society of 235 shingles, the estimated total present value costs of introducing 235

shingles are deducted from the estimated total consumer benefits of the shingles. To calculate net benefits of

CBT's activities, the present value costs of CBT's

activities are deducted from these estimated consumer

savings attributable to CBT activities. Most research on 235 shingles, by CBT and other organizations, occurred between 1958 and 1960. Expenditure on research by CBT amounted to between $15,000 and $20,000 during this period. Other

organizations are estimated to have spent between

$50,000 and $100,000 over the same period. (Although

other groups spent more than CBT, it may be recalled

that CBT played a key role, in that it led the develop- ment of the new standt^rds, coordinated work of the

different groups, and promoted acceptance of the

standards.)

Converting these amounts to equivalent 1974 dollars requires taking into account not oriy the time value of money by discounting, but also the effect of inflation.'" These two operations may be accomplished by first applying consumer price indices to the expenditures

incurred between 1958 and 1960, to express the expenditures in 1974 dollars, and then applying the single

compound amount discount factor to bring the values forward in time.'' Adjusted for inflation and expressed

in present value terms, the costs of research on 235

shingles amounts to a total of $853,610, of which

In converting the annual cost savings to present value

terms, as was done in table 3.2, it was not necessary to adjust

for inflation, because annual cost savings were stated in 1974

dollars at the outset. Here, however, risearch expenditures

are expressed in 1958-1960 dollars. " To simplify the calculations, it is assumed that all costs were incurred in 1959. To avoid possible understatement of

costs, the upper end of the estimated range of expenditures is used. Application of a consumer price index to convert the 1959 costs to 1974 dollars yields $34,060 in costs for CBT and

$170,300 in costs for other groups. Multiplying the single compound amount factor, 4.177, by each cost figure yields $142,267 and $711,343, respectively.

$142,267 is attributable to CBT, and $711,343 to other

organizations.

Table 3.5 derives estimated net benefits by subtracting

costs from gross benefits. The net benefits to consumers from 235 shingles are estimated at $3.9 billion, and

the additional net benefits to consumers as a result of

CBT involvement, at $1.7 billion."

3.5 SENSITIVITY ANALYSIS

Recognizing that the results of the evaluation may be

sensitive to the particular assumptions which have

been employed, we consider the effects of alternative assumptions regarding shingle life, the discount rate, and other key variables. Each assumption change is described in turn, and then the sensitivity of net benefits to the new value is illustrated in tables 3.6 and 3.7. The realization of any benefits—in total or attributable to CBT—from the shingle research hinges on a lower

life-cycle cost for the 235 shingles. Given that the

selling price is higher for 235 shingles than for 210

shingles, that no important maintenance and operation

costs are involved for either, and that performance

during their service lives is essentially the same, the as- sumption of a longer service life for 235 is crucial to the findings of positive net benefits and positive rates of return on the investment (sec. 3.6). Therefore, let us first examine the assumption regarding shingle life. The original estimates of benefits were based on a life advantage of 5 years for the 235 shingles. To find out how much advantage in service life is required to make the life-cycle costs of 235 shingles lower than 210 shingles, the break-even life of 235 shingles can be

determined, given the life of 210 shingles. By break- even life we mean that service life of 235 shingles for which life-cycle costs would be equivalent for the two

types of shingles. Based on a 10-year life for 210

shingles and a discount rate of 10%, the break-even

point was found to occur between 10 3/4 and 1

" Other impacts that might be of interest, such as employment effects and excess profits to some shingle

producers, are not treated in this analysis.

25
Table 3.5 CALCULATION OF NET BENEFTTS

A. 235 Net Benefits

Present value cost savings of 235 shingles = $3,291,355,708

(minus)

Present value costs of introducing 235 shingles = 853,610

(equals) Present value net benefits of 235 shingles = $3,920,502,098

B. CBT Net Benefits

Present value cost savings attributable to CBT = $1,728,291,580

involvement

(minus)

Present value costs of CBT activities = 142,267

(equals) Present value net benefits of CBT involvement = $1,728,149,313

years. This means that 235 shingles need last not even

a full year longer than 210 shingles in order to justify

their additional purchase price; furthermore, for any

additional life beyond this point they would yield benefits in the form of reduced life-cycle roofing costs. We

conclude that the probability of positive gross benefits from 235 shingles is quite high given the very small

life advantage required to make them cost-effective, and the fact that 235 shingles often last considerably more than 5 years longer than 210 shingles.

Nevertheless, for a more conservative evaluation, we

will reestimate present value benefits based on the as- sumption of only a 2-year life advantage of 235

shingles.

It does not appear necessary to test for sensitivity to the assumed volume of 235 shingles. Since 235

shingles have been in widespread use for a number of

years, there is some confidence in the general

magnitude of the estimates of quantities of 235

shingles. These estimates are based on actual reports

of the annual volumes of total shingle production, and on assessments of the shingle market composition

provided by experts in the roofing industry.

Given the uncertainty and controversy regarding the appropriate discount rate, it appears useful to re-evaluate benefits for an alternative discount rate. The estimation of net benefits is affected by the choice

of discount rates in two ways. First, the consumer's

preference between a higher priced shingle with a longer life and a lower priced shingle with a shorter

life depends upon the discount rate. As the discount

rate is increased, the consumer's net benefit per unit of

235 shingle diminishes because he or she becomes

increasingly sensitive to the higher first cost and finds the benefits of deferred shingle replacement relatively

less attractive. For a discount rate greater than the

internal rate of return (32.6% on 235 shingles as computed in sec. 3.6) the consumer will prefer the lower priced 210 shingle, other things equal.

Second, the choice of discount rates affects the conversion of past annual costs and annual benefits to present value equivalents. These amounts are compounded as they are brought forward; the larger the discount rate, the larger the present value of the

past savings, and vice versa. By raising the discount rate in the range from zero to around 32%, the result will be an increase in the

estimate of the present value of net benefits, because

the increasing effect of compounding past annual

savings will more than offset the decreasing of annual

cost savings per square. Since the chief concern in this section is not to overestimate net benefits, we reevaluate gross benefits for a very low discount rate of 2%.

The least certain of the assumptions is the length of

the lag in acceptance of 235 shingles without CBT in- volvement, although there is substantial evidence that CBT speeded the adoption of 235 shingles by at least several years. Again, to provide a conservative lower

bound estimate of net benefits, we recalculate benefits assuming that CBT's effect was to speed adoption of 235 shingles by only 1 year instead of the originally

assumed 3 years.

26
Table 3.6 SENSITIVITY ANALYSIS: LOWER BOUND ESTIMATE OF PRESENT VALUE BENEFITS FROM

235 SHINGLES'

235 as Quantity of Present value of

% of total total Quantity of Annual cost Annual cost annual cost Year shingles" shingles" 235" savings/SQ*^ savings/batch'' Factors^ savifigs*^

($) ($) ($)

(1) (2) (3) (4) (5) (6) (7) (8)

1962 50 36,606,003 18,303,001 0.406 7,431,018 14.68 109,087,080 1963 60 36,077,904 21,646,742 0.406 8,788,577 13.41 117,860,490 1964 80 40,162,409 32,129,927 0.406 13,044,750 12.17 158,757,650 1965 95 39,748,439 37,808,517 0.406 15,350,257 10.95 168,082,500 1966 95 36,830,053 34,988,550 0.406 14,205,351 9.755 138,569,770 1967 96 42,037,640 40,356,134 0.406 16,384,590 8.583 140,629,020 1968 97 43,306,669 42,007,468 0.406 17,055,032 7.434 126,786,870 1969 97 46,208,524 44,822,268 0.406 18,197,840 6.308 114,792,980 1970 98 45,488,916 44,579,137 0.406 18,099,129 5.204 94,187,196

1971 98 54,588,430 53,496,661 0.406 21,719,644 4.122 89,528,372 1972 98 58,518,259 57,347,893 0.406 23,283,244 3.060 71,245,980 1973 98 63,419,600 62,151,208 0.406 25,233,390 2.020 50,970,660 1974 98 65,956,384 64,637,256 0.406 26,242,725 1.000 26,242,725

(est.) Total present value savings = $1,406,741,293

"Estimates are based on the new assumptions of a 2% discount rate, a 12-year life for 235 and a lO-year life for 210. These data are identical to those used in the original estimates (table 3.2).

" AC235 = $35 (the cost of purchasing and installing a sales square of 235 shingles) X .0946 (the uniform capital recovery factor for 12 years and 2%) =$3.311; AC2io =$33.40 (the cost of purchasing and installing a sales square of 210 shingles) X . 1 1 1 3 (the uniform capital recovery factor for 10 years and 2%) =$3.717; ACS235 =$3.717-$3.111=$0.406.

"Col. 6=Col. 4xCol. 5. "Uniform compound amount factors for a discount rate of 2% and the number of years indicated by Column 1.

•^Col. 8 = Col. 6xCol. 7.

Tables 3.6 and 3.7 show re-estimated gross benefits based on the conservative set of assumptions outlined above: a 2-year life advantage for 235 shingles (12 years for 235 compared with 10 years for 210), a 2%

discount rate, and a 1-year lag in the widespread use of

235 without CBT. (Other assumptions as to the

quantity of 235 shingles and the labor and materials

costs for both types of shingles are held constant.)

Table 3.6 shows the new estimates of gross benefits from 235 shingles per se, and table 3.7, the estimates of

what gross benefits would have been without CBT in- volvement. Under the new assumptions, present value

gross benefits of shingles are reduced from $3.9 billion (table 3.5) to $1.4 billion, and present value gross benefits of CBT activities from $1.7 billion (table 3.5) to about $200 million-(i.e., $1,407 million-$ 1,208 million). Despite this substantial decrease in estimated gross benefits, they remain impressive in amount.

From these results of the sensitivity analysis, together

with the original estimates, we conclude that 235

shingles have had a tremendous impact on roofing

costs, resulting in net savings of several billion dollars since their introduction in the early 1960's. We further conclude that CBT activities which promoted the de- velopment and use of 235 shingles were directly

responsible for millions of dollars of the savings which

resulted from lower roofing costs.

27
Table 3.7 SENSITIVITY ANALYSIS: LOWER BOUND ESTIMATE OF PRESENT VALUE

BENEFITS FROM 235 SHINGLES WITHOUT CBT INVOLVEMENT'

235 as % Annual

of total cost Present value

shingles, Quantity of Annual savings per of annual without 235, cost batch. UCA cost savings, Year CBT'' without CBT savings/SQ without CBT factors without CBT

(1) (2) (3) (4) (5) (6) (7)

1962 0 0 0.406 0 0

1963 50 18,038,952 0.406 7,323,815 13.41 98,214,840 1964 60 24,097,445 0.406 9,783,563 12.17 119,071,280 1965 80 31,798,751 0.406 12,910,292 10.95 141,364,500 1966 95 34,988,550 0.406 14,205,351 9.755 138,569,770 1967 95 39,935,758 0.406 16,213,917 8.583 139,164,760 1968 96 41,574,402 0.406 16,879,207 1A34 125,478,480 1969 97 44,822,268 0.406 18,197,840 6.308 114,792,980 1970 97 44,124,248 0.406 17,914,444 5.204 93,224,456

1971 98 53,496,661 0.406 21,719,644 4.122 89,529,840 1972 98 57,347,893 0.406 23,283,244 3.060 71,245,980 1973 98 62,151,208 0.406 25,233,390 2.020 50,970,660 1974 98 64,637,256 0.406 26,242,725 1.000 26,242,725

Total present value savings, without CBT = $1,207,870,271

" Estimates are based on the new assumptions of a 2% discount rate, a 12-year life for 235 and a 10-year life for 210, and a lag of 1 year without CBT.

Based on a lag of 1 year.

28
3.6 INTERNAL RATE OF RETURN ON

235 SHINGLES

Another measure of an investment's desirability,

shown in section 2.2.2, is the internal rate of return. It

is that compound rate of interest which equates the flow of costs of a project with the flow of benefits. The higher the rate, the larger the net beneficial yield

from the investment.

To evaluate with this method the social impact from

the improvement in shingles, we calculate the rate of

return on the additional investment of $1.60 per sales square of 235 shingles that is paid by the consumer to obtain the additional 5 years of shingle life.'^ Using a process of trial and error, as shown in table 3.8, the

rate of return is found to be between 30% and 35%,

and by interpolation, it is narrowed to 32.6%.

" In the preceding net-benefits evaluation of the value of the

shingle investment to society, the total present value of

research costs was deducted from the total present value of consumer cost savings to find net benefits to society. In

contrast, the rate of return method, as used in table 3.8, evaluates the value of the investment to society solely in terms of a consumer's direct cost savings on one unit of 235

shingle. This discrepancy arises from a simplification in the

calculation which, in any case, does not significantly affect the outcome. The rate of return is the same regardless of whether it is calculated on the basis of one unit of shingle or

Compared with other investment opportunities

typically open to the consumer, a return of 32.6%

appears quite high.

To evaluate CBT's investment in research by the rate- of-return method, we need to find the compound rate of interest which equates CBT's research costs with

the benefits from that research, where benefits are measured as the additional savings accruing to consumers due to the earlier availability of improved shingles

as a result of CBT research. As shown in table 3.9, the

rate of return on CBT's investment is a substantial 70%.

Note that these returns are calculated on one invest- ment—in this case one with a very favorable return. The return on the investment budget for a large R&D

program with many projects could be expected to fall below these rates, since some projects are likely to fail completely and lower the average project return.

on the basis of the millions that were sold during the period

in question. Including total research costs or excluding total research costs from the calculation in this example has a

negligible effect on the outcome (the rate is reduced from the 32.6% derived in table 3.8 to 32.2% by including research

costs) because the effect of the research costs is swamped by

the consumer impact per se. In other evaluations, however,

the research costs could be a significant factor and therefore should be included in the determination of the internal rate of

return.

Table 3.8 CALCULATION OF THE INTERNAL RATE OF RETURN ON THE

CONSUMER'S INVESTMENT IN 235 SHINGLES

Order of steps Description of steps

1 Where benefits and costs are defined in terms of the

differences in prices and lives of 235 and 210 shingles, we set net benefits equal to zero and solve for i, the

internal rate of return on the investment: $33.40 (UCR,i,10 years)''-$35.00 (UCR,i,15 years)=0.

2 Using a trial and error procedure, we calculate net

present value benefits for i = 30%:

$33.40 (.3235)-$35.00 (.3060) = $10.805-$10.710=$.095.

3 Finding positive net benefits for i = 30%, we next make

the same calculation for i = 35%:

$33.40 (.3683)-$35.00 (.3539)=$12.301-$12.387= -$.086. 4 Finding negative net benefits for i = 35%, we know that the

i for which net benefits are zero is bracketed by i = 30%

and i = 35%.

5 By interpolation we now solve for i on the consumer's

investment in 235 shingles: 095

' =

.095 + 086 ( 03) (100) = 32.6%.

° (UCR,i,n) is the notation for the uniform capital recovery discount factor, evaluated for a compound interest rate of i, over n years.

29
Table 3.9 CALCULATION OF THE INTERNAL RATE OF RETURN ON

CBT'S INVESTMENT IN 235 SHINGLE RESEARCH

PROBLEM: We wish to find that compound rate of interest, designated i, which

equates net benefits of GET research to zero; i.e., the value of i in the following

equation:

N

(1 + iy -

1

c(i + iy = 0,

where

B(j) = Annual consumer savings attributable to CBT from the batch of shingles

consumed in year j, which, for the evaluation period 1962 (j = 1) to 1974 (j=N), are as follows:^

1962 $15,283,005 1969 $771,683

1963 18,075,029 1970 759,665 1964 26,828,489 1971 455,813

1965 14,954,264 1972 488,627 1966 10,763,584 1973 0

1967 5,616,228 1974 0

1968 723,221

N 13 years, the number of years during which consumers

(1 + iV-l

(1 + i)^

SOLUTION"

1

purchased and consumed shingles; this is the benefits evaluation period.

= $34,060, CBT's estimated research expenditure adjusted

for price inflation, but not stated in present value equivalent.

= 15 years, the number of years which have elapsed

between CBT's research and the end of the period of

evaluation.

= the uniform capital recovery discount formula used here

to find the value in 1974 of annual savings which begin in the past and continue for j years, where j ranges from 1 to

1 3 and the annual savings are B(j).

= the single compound amount discount formula used here

to find the value in 1974 of a single expenditure, C, made y

years ago.

= that discount rate for which present value benefits of the investment are just offset by present value costs, i.e., the

internal rate of return on the investment.

= .697 X 100 = 69.7%, which can be rounded to 70%.

^ Annual savings attributable to CBT per batch of shingles are calculated as the difference between estimated actual savings and estimated savings if widespread use had been delayed

3 years; i.e., column 6, table 3.2 minus column 5, table 3.3. Note that these annual savings per batch are based on a savings per square of $.835, an amount which reflects an assumed opportunity cost of capital (i.e., discount rate) for consumers of 10%. Use of a lower rate of discount would have increased the value to the consumer of the additional 5 years of life, and would, therefore, have raised the estimated consumer savings per square and per batch. Correspondingly, CBT's investment would have shown a higher rate of return than that shown in the above analysis. Conversely, use of a higher discount rate for consumers would have caused them to realize less savings from the 235 shingle with its higher first cost, and would have resulted in a lower rate of return to CBT research than that reported in the above analysis. Because of the complexity of the above equation, i was solved by a computer rather than manually as was done in table 3.6. 30

Facing page:

This scientist is preparing to take measurements of the pneumatic pressure in a

reduced-size vent.
4. CASE STUDY: REDUCED-SIZE

VENTING^^

4.1 BACKGROUND

Venting is required for sanitary drain-waste-vent (DWV) systems in buildings to maintain the trap seals of plumbing fixtures. The venting provides protection

by maintaining adequate water seals in the traps and

Most of this section, with the exception of the discussion of

payoffs on CBT's research in reduced-size venting, is taken from "Cost Savings from Reduced-Size Venting," an article

in Plumbing Engineer {Jii\y-A.{ig\ist, 1977, p. 35, and

September-October, 1977, p. 45) by Harold E. Marshall,

thereby blocking the entry of sewer gases, suds,

sewage and vermin into the buildings.

Traditional plumbing codes require that venting meet

certain prescriptive standards. In the early 1960's, the National Association of Homebuilders (NAHB)

proposed a laboratory investigation of Reduced-SizeVenting (RSV), an innovative type of venting which

utilizes dry vent pipes substantially smaller in size than

those permitted by existing plumbing codes. The

Rosalie T. Ruegg, and Robert S. Wyly. An earlier version

also appeared in an unpublished CBT report entitled "Impact

of CBT Activities on the Building Community," submitted on March 31, 1975 to Dr. Richard Roberts, Director, National Bureau of Standards.

31
purpose of the investigation was to test the hypothesis

that RSV would be a viable approach to venting. The

hypothesis was based on two pieces of information.

First, traditional criteria for sizing vent systems were

derived from data obtained under hydraulic test conditions that were more severe than what would be

expected in service, particularly for one and two-story

residential buildings. Preliminary analysis indicated

that air requirements in the vents of the DWV systems

of these buildings are substantially less than that assumed in the prescriptive requirements of the codes. Second, traditional criteria were based on the assumption that a substantial diameter reduction in vent pipes

occurred in service from the accumulation of

corrosion products. But with new pipe materials such

as thermoplastics and some of the corrosion resistant metals, this assumption became invalid.

Studies by the NAHB, the National Bureau of

Standards (NBS), and the Stevens Institute have since shown that RSV can meet the implied essential require- ments for performance imposed on conventional vent

systems in one and two-story houses by the

prescriptive requirements of the traditional codes.

The purpose of this case study is to illustrate how to measure net benefits of a new technology by

examining the potential cost savings from substituting

RSV for conventional venting. Cost savings are expected from reduced materials costs, from reduced

labor installation costs, and from reduced overhead

and profit charges. No sacrifice in terms of higher

maintenance costs, reduced performance, or reduced

durability is expected for properly designed and

installed systems. Savings from introducing RSV are estimated for single new dweUing units and for groups

of new dwelling units nationwide over the next decade. In addition to illustrating how the benefits of

research can be measured, the analysis provides useful information to the research community which is concerned about the returns on its investment in plumbing research. This analysis of potential savings is also of interest to builders and contractors, both of whom are eager to cut costs and thereby be more

competitive, and to homebuyers, who wish to reduce

their costs for a home.^^

" We recognize that, in this early stage of the development of RSV, exact predictions of cost savings cannot be made.

Estimates of costs for the different plumbing system designs and some of the other information needed to make precise estimates of cost savings are without detailed empirical

verification. However, the estimates of savings developed in

this analysis give a reasonably accurate, preliminary view of

the economic viability of RSV, in that a conceptually logical model is used to evaluate cost savings, and the underlying

assumptions are based on a sampling of expert industry

opinion that appears realistic.

4.2 APPROACH

In this case study, a benefit-cost methodology is used

to measure the social payoff of substituting plastic

RSV for plastic conventional venting. As was the case with the 235 shingles, the evaluation is aimed only at determining the presence or absence of net benefits, and does not attempt to determine the optimal invest- ment size. Furthermore, this case study, unlike the 235

shingles study, focuses on social payoffs exclusively

and does not treat payoffs to CBT's investments. Cost savings per dwelling unit are estimated here in 1975 dollars as the difference in the costs of plastic

RSV as compared with plastic conventional venting

for particular kinds of dwelling units in specific

regions of the country. The consumers' surplus

model illustrated in figure 3.1 is the theoretical basis of

the cost comparison.

We will conclude that RSV is the more economically

efficient technology for venting on a hfe-cycle cost

basis if the following conditions obtain: (1) The costs of RSV must be less than those of the conventional

venting system called for by the plumbing code. (2) The performance of RSV must satisfy the minimum

performance requirements implied by the traditional code for venting. (3) The durability and maintainabili- ty of RSV must be equal to that of conventional

systems.

The life-cycle cost savings per dwelling unit from

using RSV instead of conventional venting is calculat- ed for plumbing systems in one-story and two-story

residences using thermoplastic piping materials. It is assumed that the plumbing system in each new house

contains two baths, one kitchen, and one laundry room. (Specifically, the system contains two bath tubs, two toilets, and two wash basins; a laundry tub; a washing machine; a kitchen sink; a dishwasher; a foodwaste grinder; water supply, drainage, and vent (DWV) piping; building sanitary drain; and building

sanitary sewer.)

Savings from using RSV are influenced by the kind of

pipe material used, as well as by the particular venting | design that is required by the code in force. This is ' because pipe materials vary in cost and because j venting designs vary in the amount of dry vent piping | they require. Furthermore, some codes require larger

sizes of vent piping in some applications than do other [ codes, resulting in potentially larger pipe size ; reductions and therefore greater cost savings. The cost

j savings that are anticipated from substituting RSV for j conventional venting therefore increase directly with

the price of the conventional pipe, the number of units j of dry vent piping required, and the size reductions made possible by substituting RSV.

'"Costs are expressed in 1975 dollars because that is the year ii in which this economic analysis was undertaken.

j

32
Note that plastic pipe and fittings are assumed in this study for both RSV and conventional venting, rather than copper tube and fittings. Basing the costs on

plastic piping results in a lower bound estimate of potential cost savings because the savings are smaller when plastic RSV is substituted for plastic conventional venting than when plastic RSV is substituted for copper conventional venting, other things equal.

The basic configuration of DWV systems utilizing

RSV does not differ from standard DWV systems.

However, the diameters of the dry vent pipes are

smaller than the standard sizes—usually from one to four commercial pipe sizes smaller. (Dry vents are pipes through which only air passes; wet vents, in addition to allowing air to pass, serve intermittently as

drains.) The analysis is based on the following three basic types of venting system designs: (1) a fully

individually vented system, referred to here as CI; (2) a wet vented system, referred to as C2; and (3) a stack vented system, referred to as C3. Figures 4.1 through

4.5 show schematically the details of these designs,

starting with the simplest, C3, and ending with the most complicated, CI, for one and two-story houses.'^

4.3 COST SAVINGS

Tables 4.1 and 4.2 show the estimated materials, labor, and overhead and profit savings from introducing

RSV in one and two-story houses with each type of

venting design. The estimated savings from using

plastic RSV in place of plastic conventional venting in a one-story home with venting design of type CI, for example, are $95 in total, comprised of $19 (20%) in materials, $56 (59%) in labor, and $20 (21%) in overhead and profit. Tables 4. 1 and 4.2 show that the

cost savings per plumbing system from using RSV are

greatest when it is applied in two-story homes with

venting systems of type CI. This Is to be expected

because C 1 is the most elaborate venting system and

thereby provides the largest potential for RSV savings on a per dwelling unit basis. The cost savings from

RSV are least when applied in one-story residences with venting designs of type C3, the least elaborate of

the systems. The savings from using RSV range from

$125 to $46.

To estimate the savings per system from RSV as shown in tables 4.1 and 4.2, the costs of RSV were

subtracted from the corresponding costs of conventional venting systems for each design. To calculate the

total costs of installing RSV and conventional venting

"The designs are not drawn precisely to scale. The purpose

is to illustrate approximate differences in the designs and the measurements of pipe sizes, pipe lengths, and number and size of fittings used in calculating savings from substituting RSV.

systems, the following cost formula was developed,

based on the NAPHCC Labor Calculator:^^

C = (P + F + L) Fo Fp, (4.1)

where

C = Total installed costs of a venting system,

P = Cost of pipe materials,

F = Cost of fitting materials,

L = Cost of labor, Fq = Contractor's overhead factor (e.g., if overhead charge =15%, then Fo=1.15), and

Fp = Contractor's profit factor (e.g., if profit= 10%,

the Fp=1.10).

The values for P and F were calculated on the basis of

the measurements shown in the schematics in figures

4.1 through 4.5 and on materials list prices.

Specifically, the lengths and sizes for RSV pipe and

the number and sizes of fittings were based upon the schematics and on NBS recommended design

criteria.^' The system configurations, as well as the

sizes and numbers of units for conventional pipe and

fittings, were based on the rquirements of

hypothetical, average local plumbing codes patterned

after the 1975 Basic Plumbing Code, 1975 Standard

Plumbing Code, and 1976 Uniform Plumbing Code.

Unit Costs of pipe and fitting materials, shown in tables 4.3 and 4.4 respectively, were obtained from

plumbing materials and equipment suppliers in the Washington, D.C. area. These national list prices

reflect a 30% reduction in retail prices to account for a realistic contractor discount. Multiplying the number

of units times their respective unit prices yields the

materials costs for RSV and conventional venting for each of the venting designs for one and two-story

residences. The values for labor costs, L, were derived by using

the "pipe and fittings.' method of the NAPHCC Labor

Calculator. Two factors regarding labor savings

should be elaborated. First, a national hourly labor

rate of $20 was chosen as average. This figure appears

large relative to the plumber's wage, but considering

that it incorporates supervisory and backup costs not included in overhead, it appears reasonable. Second,

although the proportions of total savings attributed to labor (44% to 61%) in tables 4.1 and 4.2 may appear

National Association of Plumbing-Heating-Cooling

Contractors, NAPHCC Labor Calculator, NAPHCC,

Washington, D.C. (1971 with 1975 revisions).

"Orloski, M. J. and Robert S. Wyly, Hydraulic Performance of a Full-Scale Townhouse Drain-Waste-Vent System with Reduced-Size Vents. National Bureau of Standards Report, BSS60, 1975.

33
ROOF

CEILING

FLOOR

3/T/4

7"

5'-0"

I

r-O"

T

VTR

I |— 3/1%

_l

I

5'-6"

3'-6"wc I?.

.VTR

-I

I

I J

WC

T7i

LEGEND:

DRAIN OR "WET" VENT

STANDARD SIZE DRY VENT

REDUCED-SIZE DRY VENT

MEANS DRY VENT REDUCTION IN SIZE FROM 3" TO 11/4"

ir-6'

VTR VTR

|-l'/2/'/2 ^V/l/Vl

^AT LEAST 6" ABOVE

FLOOD LEVEL

cw

VTR VENT THROUGH ROOF

L LAVATORY

V/C WATER CLOSET

B BATH

S SINK

CW CLOTHES WASHER

Figure 4. 1 Basic design features for one-story, stack-vented system, C3.

34
ROOF

CEILING

FLOOR

T5'-0'

r-0"

, VTR

-\-

3/1 '/4

I

-I 2-0'

] 5'-6" 1/2/ '^2//2'/2

t .^ ^1 T-0

4 3-6' 3/1/4 I wc

lUlL

VTR

<r^2/i'/4

2/1/4

1/2/ '/2 "T-r

L/lL

LEGEND:

VTR

n'-6"

/2/'/2

. VTR

I

I Jr^1/2//2

-I

I ^AT LEAST 6" ABOVE

FLOOD LEVEL

CW

DRAIN OR "WET " VENT

STANDARD SIZE DRY VENT

REDUCED-SIZE DRY VENT

MEANS DRY VENT REDUCTION IN SIZE FROM 3" TO VA"

VTR VENT THROUGH ROOF

L LAVATORY

WC WATER CLOSET

B BATH

S SINK

CW CLOTHES V/ASHER

Figure 4.2 Basic design features for one-story, wet-vented system, C2.

35
CEILING

T

5--0-

5'-6'

3'-6' 3/VA

FLOOR

^ WC

ir-6"

3/1 '/4

LEGEND:

DRAIN OR "WET" VENT

STANDARD SIZE DRY VENT

REDUCED-SIZE DRY VENT

MEANS DRY VENT REDUCTION IN SIZE FROM 3" TO VAl'/2/'/2

I

I

-I

I ^AT LEAST 6" ABOVE

FLOOD LEVEL

cw

VTR VENT THROUGH ROOF

L LAVATORY

WC WATER CLOSET

B BATH

S SINK

CW CLOTHES WASHER

Figure 4.3 Basic design features for one-story, individually vented system, CI.

36
t

I VTR

ROOF r-0" I

i VTR I VTR

.1

,

CEILING

5' .0" 3/1/2

5'-0"

2nd FLOOR

1st FLOOR

c

_AT LEAST 6"

5'-6" ABOVE ^ \ i

FLOOD LEVEL

t 3-6"

LEGEND:

3/T/4

DRAIN OR ' WET" VENT VTR VENT THROUGH ROOF

STANDARD SIZE DRY VENT L LAVATORY

REDUCED-SIZE DRY VENT WC WATER CLOSET

MEANS DRY VENT REDUCTION IN SIZE B BATH

FROM 3" TO VA" S SINK

CW CLOTHES WASHER

Figure 4.4 Basic design features for two-story, wet-vented system, C2.

37
VTR VTR

ROOF r-O"

5'-0" CEILIN G i

4-3/1/2

I

9'.0" [2/1/4 2/%

l'/2//2 5'-6"

3/l'/2-~-^

2nd floor! J \ jj

^1

1st FLOOR

r-O"

t

3-6"

V.0-\ 2'-0' /4^p_,-^.

2'-0'

L

5'-6'

I'-O'

AT LEAST 6" -ABOVE

FLOOD LEVEL

VTR

1/2/72

T 3'-6"

1/2/ /2

LEGEND:

3/1%

DRAIN OR "WET" VENT VTR VENT THROUGH ROOF

STANDARD SIZE DRY VENT L LAVATORY

REDUCED-SIZE DRY VENT WC WATER CLOSET

MEANS DRY VENT REDUCTION IN SIZE B BATH

FROM 3" TO 1/4" S SINK

CW CLOTHES WASHER

Figure 4.5 Basic design features for two-story, individually-vented system, CI.

38
Table 4.1 ESTIMATED SAVINGS FROM RSV PER

PLUMBING SYSTEM IN ONE-STORY RESIDENCES

Dollar savings

(percentage distribution)

System Overhead

design Materials Labor & profit Total

CI 18.65 56.26 19.85 94.76

(20) (59) (21) (100)

C2 17.28 44.34 16.33 77.95

(22) (57) (21) (100)

C3 16.01 20.22 9.60 45.83

(35) (44) (21) (100)

Table 4.2 ESTIMATED SAVINGS FROM RSV PER

PLUMBING SYSTEM IN TWO-STORY

RESIDENCES

Dollar savings

(percentage distribution)

System Overhead

design Materials Labor & profit Total

CI 22.73 76.14 26.20 125.07

(18) (61) (21) (100)

C2 21.79 34.34 14.87 71.00

(31) (48) (21) (100)

C3 N.A.« N.A. N.A. N.A.

" N.A. means not applicable for purposes of this analysis.

Table 4.3 PLASTIC PIPE COSTS BY SIZE'

Size in inches 3 2 11/2 11/4 1 3/4 1/2 Dollar costs per foot 1.36 0.66 0.48 0.41 0.38 0.26 0.20

"Cost estimates are based on 1976 list prices of a leading brand of thermoplastic

(ABS and PVC) pipe, reduced by 30% for a realistic contractor discount. Costs are

for Schedule 40 DWV pipe in sizes 3, 2, 1 1/2, and 1 1/4 inches, and for Schedule 40

water pipe in sizes 1, 3/4, and 1/2 inches.

39
Table 4.4 PLASTIC FITTING COSTS BY SIZE

Dollar costs

Size Reducing Reducing

in inches Coupling Tee Cross 90° Ell 45° Ell Tee Bushing

3 .74 2.59 4.53 N.A.^ N.A. N.A. N.A.

2 .38 .92 2.77 .58 .55 N.A. N.A.

1 1/2 .25 .68 1.86 .47 .37 N.A. N.A.

1 1/4 .25 .60 1.55 .42 .41 N.A. N.A.

1 .35 .70 N.A. .54 .70 N.A. N.A.

3/4 .21 .36 N.A. .30 .62 N.A. N.A.

1/2 .15 .29 N.A. .24 .37 N.A. N.A. 3X2 N.A. N.A. N.A. N.A. N.A. 2.00 .78 3X1 1/2 N.A. N.A. N.A. N.A. N.A. 1.85 1.02 2X1 1/2 N.A. N.A. N.A. N.A. N.A. .80 .26 2X1 1/4 N.A. N.A. N.A. N.A. N.A. N.A. .54

1 1/2x1 1/4 N.A. N.A. N.A. N.A. N.A. .96 .30

1 1/2x3/4 N.A. N.A. N.A. N.A. N.A. 1.21 .56

1 1/2x1/2 N.A. N.A. N.A. N.A. N.A. N.A. .56

1 1/4x3/4 N.A. N.A. N.A. N.A. N.A. .95 .52

1 1/4x1/2 N.A. N.A. N.A. N.A. N.A. .95 .52 3/4x1/2 N.A. N.A. N.A. N.A. N.A. .36 .20

^ N.A. means not applicable for purposes of this exercise.

Thus far the potential cost savings have been

j examined for specific venting designs in a single house

of one or two stories. To determine the potential total j impact of RSV on plumbing, it would be necessary to ! look at the aggregated cost savings over time for all i types of buildings that might use RSV.

For the aggregate analysis undertaken here, the I estimates of cost savings are limited to an 1 1-year I period from 1975 through 1985. The 11-year period was used because reasonably dependable projections of housing starts were available. The aggregate analy-

| sis is confined to privately-owned, one-family houses

constructed during this 11 -year period. The savings

from the possible use of RSV in multi-family [ residences and commercial buildings, as well as in new • plumbing units retrofitted in existing housing, are not j: included. j, The first step in calculating aggregate RSV savings is to estimate the number of plumbing systems in which '

\ RSV will be used. It is assumed that each new house

(one-story or two-story) will contain a plumbing

system as defined earlier. The estimated number of new privately owned, single-family homes to be

constructed yearly, which is assumed to indicate the number of new plumbing systems installed yearly, is

high, they are consistent with the labor calculation approach outlined in the NAPHCC Labor Calculator. As RSV becomes more widespread, however, it should be recognized that the process for determining

contractor bid prices may change to reflect a smaller

labor savings component for RSV.

Based on interviews with contractors, the values Fo=

1.15 and Fp= 1.10 were used for the calculations of overhead and profit. These figures may vary in practice, depending on the type and size of the project

as well as on the size of the firm and the business procedures of the plumbing contractor. The findings in tables 4. 1 and 4.2 are generally

consistent with results of another study^ which estima- ted RSV savings for one and two-story houses with

venting system designs similar to CI and C2. However, estimated cost savings in the other study

included a wider range of values ($24 to $151) than

did this analysis ($71 to $125).

Dickerson, Donald F., "Procedures for Estimating

Economic Benefits and Materials Savings for Plumbing

Drainage Systems with Reduced Size Venting," Report by

Dickerson/Gladstone/Associates under contract to National Bureau of Standards, 1975.

40
Table 4.5 ESTIMATED ANNUAL NUMBER OF NEW PRIVATELY-OWNED, SINGLEFAMILY HOUSES AND PLUMBING SYSTEMS

Number' of houses and plumbing systems constructed annually

Total U.S.A. Northeast South West

Year 1 story 2 story 1 story 2 story 1 story 2 story 1 story 2 story

1975-1980 750,400 369,600 201,600 190,400 380,800 112,000 168,000 67,200

1981-1985 917,900 452,100 246,600 232,900 465,800 137,000 205,500 82,200

shown in table 4.5 by region and number of stories. These estimates are based on Bureau of the Census

population forecasts,*' Bureau of Census Construction

Reports,^^ and U.S. Department of Agriculture housing

forecasts.*^ The estimated numbers of housing units and plumbing

systems are approximate projections of possible

housing demand (rather than actual construction),

under the assumption of continued economic growth,

moderate inflation, and no catastropic events such as war. Cyclical variations are assumed to be offsetting in the long run, and are ignored in the projections.

The breakdown of housing and plumbing systems by

region in table 4.5 is necessary because certain venting

designs tend to be used more in some regions than

others, depending upon the codes in effect. It is, therefore, necessary to evaluate the relative incidence

of codes in order to estimate cost savings.

Local jurisdictions generally adopt one of the widely

recognized model plumbing codes which have been

developed by various associations of plumbing and

building officials, or pattern the local code after one of

the models. The lAMPO Uniform Plumbing Code, one of the model codes, is usually interpreted to require venting systems of type CI in most installa- tions. The BOCA Basic Plumbing Code and the SBCC Standard Plumbing Code, two other popular

model codes, are similar to one another in terms of

their venting requirements, both allowing all three types of venting for specified types of construction.^

U.S. Bureau of Census, Projection of Population Growtfi. " U.S. Bureau of Census, Construction Report, Series C25,

July, 1974. " Marcin, Thomas C, The Effects ofDeclining Population Growth on the Demandfor Housing, U.S. Department of

Agriculture, General Technical Report NC-11, 1974. lAPMO stands for International Association of Plumbing

and Mechanical Officials; BOCA stands for Building Officials and Code Administrators International; and SBCC stands for Southern Building Code Congress International.

The Uniform Plumbing Code is the predominant code

for the West. Thus most venting in the West is likely to be of design type CI. The Basic Plumbing Code is probably the predominant code fdr the Northeast, but

the Uniform Plumbing Code and the Standard

Plumbing Code are also used in a number of localities

in the Northeast. The Standard Plumbing Code seems

to be the predominant code for the Southeast. A

relatively higher proportion of venting installed in the Southeast is likely to be of the design type C3 and a smaller proportion of the types CI and C2 than in the Northeast, mainly because a greater percentage of

houses in the Southeast are of an architectural design

conducive to venting designs of type C3, the simplest

type.

Figure 4.6 divides the U.S. into three main regions

Western, Northeastern, and Southeastern—for the purpose of showing the approximate percentages of new homes which will have venting designs of each of

the types CI, C2, and C3. The estimated percentages

of new plumbing systems in each region that will have

each type of venting design are shown in the legend at the bottom of the map.

Given the estimates of new plumbing systems over

time (table 4.5), the incidence of the different types of

venting designs (fig. 4.6), and the RSV savings per

unit (tables 4. 1 and 4.2), we could easily calculate the yearly cost savings under the assumption that RSV is applied to all new private houses built from 1975 through 1985. However, it is unlikely that RSV will be this widely adopted in the beginning. It takes time

for a new technology to be accepted by the building

regulatory system as well as by builders, plumbers,

and home buyers. Thus to estimate the future savings

of RSV, it is necessary to predict the rate at which

RSV will be accepted by code authorities and applied

in venting systems, i.e., the "diffusion rate" of RSV.

To develop a proxy for the diffusion rate, we estimated the percentage of new, single-family houses each

year in which RSV appears likely to be installed.

41
C1 = 80%

C2= 10%

C3= 10%

CI = 20%

C2 = 20%

C3 = 60%

CI = 10%

C2= 10%

C3- 80%

Figure 4.6 Estimated percentage use of the three different types of venting system designs in new houses by region.

Table 4.6 shows these estimates by region. To derive them, the percentage of new houses in which RSV

will be used by 1985 was first forecasted in consultation with experts in the plumbing industry.

The percentages of new houses in which RSV will be

used in each year from 1975 through 1984 were then

estimated on the basis of the 1985 forecast and the following formula:

J

i=l

n

i = l

(4.2)

where

Fj = calculated percentage of new houses

constructed in year j with RSV venting,

Yj = years from 1975 through 1985 represented by

consecutive numbers from 1 to 11, and

Fn = predicted percentage of new houses to be

constructed in year n (i.e., 1985) utilizing RSV.

This formula was selected for estimating the percent- ages of new houses from 1975 through 1985 which

will utilize RSV because it appeared reasonably

descriptive of the pattern of acceptance of an improved plumbing technology (i.e., a pattern of growing acceptance over time, but at a decreasing

rate). To derive the expected aggregate cost savings from

RSV, the savings for each region and house type were

first computed separately, taking into consideration

42
$106.5 million, based on the use of RSV in an estima- ted 3.9 million single-family residences. The largest

single part of these savings is expected from use of

RSV in one-story houses in the South. The present value costs of research and field testing

leading up to the introduction of RSV were estimated

in both government and private sectors to total $900

thousand. Thus, the social net benefits of RSV are esti- mated to be about $105.6 million;

Realization of these potential cost savings depends on how fast code authorities accept RSV in the plumbing

codes and how fast builders, developers, contractors, plumbers, and housing buyers implement RSV technol- ogy once it is authorized by codes. Greater use of

RSV would be promoted by demonstrations that RSV

meets the performance requirements of venting and

that RSV will save money. It should be recognized,

however, that such factors as possible difficulties in obtaining the smaller-sized piping and the special

transition fittings, initial lack of installation experience, lack of familiarity with research findings on the adequacy of performance of RSV, inappropriate code

content to facilitate proper design and inspection, and

resistance to change by labor may retard RSV

acceptance and reduce the savings to be realized from

RSV over the next decade. However, time will likely

reduce many of these barriers to RSV, and one might

expect that the combined thrust of greater famiharity,

better documentation on field trials, and demonstrated

cost savings will establish RSV as a viable venting

technique applicable to any type of standard DWV

system.

Table 4.7 ESTIMATED POTENTIAL COST SAVINGS FROM USE OF

RSV, 1975 THROUGH 1985

Number of RSV

Region Type of house systems Present value savings

($1,000) ($1,000,000)

Northeast 1 -story 670 20.5

2-story 633 12.3 Total 1,303 32.8

South 1 -story 1,557 41.5

2-story 458 44

Total 2,015 45.9

West 1 -story 429 18.7 2-story 172 9.1 Total 601 27.8

All regions 1 -story 2,656 80.7

2-story 1,263 25.8 Total 3,919 106.5

Table 4.6 ESTIMATED YEARLY PERCENTAGES

OF NEW SINGLE-FAMILY HOUSES

WITH RSV, BY REGION

Year Northeast South West

1975 1 1 1 1976 3 4 2 1977 6 7 5 1978 10 12 8 1979 15 18 11 1980 21 25 16 1981 28 34 21 1982 35 44 27

1983 44 55 34

1984 54 67 42

1985 65 80 50

Source: Percentages for 1985 were forecasted with advice from experts in the plumbing industry. The percentages for 1975-1984 were derived with equation 4.2.

the cost savings from RSV for each of the three types

of venting designs, the percentages of houses likely to contain each type of venting design, and the expected

percentage of houses utilizing RSV. The savings

across all regions and house types were then summed.

Table 4.7 shows the estimated total cost savings by

region and for the U.S. as a whole if RSV were to be

used as assumed during the period 1975 through 1985. The projected estimate of aggregate present value

savings, discounted with an interest rate of 10%, is

43
Facing page:

This scientist is sweeping dissolved hydrocarbons from

water.
5. SUMMARY AND SUGGESTIONS FOR FURTHER

RESEARCH

5.1 SUMMARY

Expenditures in the United States for research and de- velopment (R&D) represent large sums of money, and

the R&D community is a major industry in terms of

the human and material resources that it controls.

The National Bureau of Standards (NBS), a scientific research agency of the U.S. Department of

Commerce, has attempted to improve its resource allo- cation process by requiring all major operating units to do "microstudies" of their research impacts on society. This report is an outgrowth of the microstudy

prepared by the Center for Building Technology

(CBT) of NBS, and it incorporates the two case

studies on building technology described in the microstudy. The report is presented in a general

framework so that it can be adopted for application by

any government agency allocating research funds, and

in some cases, by universities and private research

firms as well.

45
A formal resource allocation process for research is needed in both the public and private sectors. Research managers need guidelines for research planning so that they can maximize the payoffs from

their limited resources. Furthermore, quantitative descriptions of research impacts have become a basic re- quirement in many organizations for justifying budget

requests. The purposes of this report are (1) to provide research

administrators with an examination of alternative methods for evaluating future, existing, and past re- search projects, and (2) to provide a description of the data needs for evaluating the impacts of technological

changes that results from an agency's or firm's applied research programs.

Section 2 provided a definition of terms and a

discussion of the different perspectives or objective

functions of research groups that develop and apply new technologies. The measurement of benefits and

costs arising from the introduction of new technologies was described. Three selected methods of project evaluation—benefit-cost analysis, the internal rate-of- return, and the payback methods—were described and

compared in terms of their usefulness in selecting

among alternative R&D investments.

Sections 3 and 4 presented two case studies in building

technology. The first provided estimates of the net savings and internal rate of return from a past research

effort at CBT in the development of an improved

asphalt shingle (the 235 shingle) for sloped roofing.

The life-cycle costs of the improved shingle were compared against the life-cycle costs of the shingle it replaced (the 210 shingle). The net benefits (i.e., life- cycle cost savings) to society from having the 235

shingle were estimated to be approximately $4.0

billion in present value terms over the period 1962 through 1974. The part of the total net benefits that can be attributed to CBT were estimated to be about

$1.7 billion. The internal rate of return on society's in- vestment in 235 shingle research was estimated to be

about 33%. The rate of return to CBT for its invest- ment was estimated to be about 70%.

The second case study deals with the net benefits from

research investments in reduced-size venting (RSV), a type of sanitary drainage vent system that utilizes smaller vent pipes than those currently permitted by

plumbing codes. The net benefits (i.e., net dollar savings in venting costs) to society from introducing

RSV over the period from 1975 through 1985 were es- timated to be over $105 million.

5.2 SUGGESTIONS FOR FURTHER

RESEARCH

The background work for this report, particularly for the case studies, uncovered additional areas of re- search that might be of value to government agencies

and other institutions that are concerned with an effi- cient allocation of their research budgets.

One type of research needed is the analysis of past and

ongoing innovations to determine their rates of diffu- sion. Reliable predictions of net benefits or rates of

return on proposed research projects cannot be made

without some relatively sound basis for predicting

rates of diffusion. A second area of research involves the development

of a system of record keeping on completed and

ongoing pojects so that benefits of R&D can be

correlated with specific actions by the organization,

and can be measured in some quantitative manner,

preferably dollars. A third potential area for research is the computation

and comparison of private and social payoffs on

specific projects to see where government support of R&D is warranted. Projects with high social payoffs, but low private payoffs, are those for which govern- ment sponsored R&D might be appropriate.

A fourth topic of research is the determination of gov- ernment cost-sharing (i.e., grant) formulas for supporting R&D in the private sector in those areas where social payoffs are much higher than private

payoffs.

A fifth area of research, and one that would be

particularly useful to a large research concern that funds many low budget projects, is the review and

assessment of simplified approaches to use in determining the relative economic efficiency of alternative re- search projects, and the extension of these to fit specific kinds of projects. An approach that is simpler,

cheaper, and more quickly applied than the benefit- cost and internal-rate-of-return approaches described

here, but generally reliable, would be helpful as an

initial screening device for selecting among alternative research projects.

46
REFERENCES

i American Society for Testing and Materials. Annual Book of

I ASTM Standards. Part 15, Philadelphia, 1974. Brown, Murray. On the Theory and Measurement of

Technological Change (Cambridge: University Press, 1968). Chapman, Robert E. and Colwell, Peter F. Economics of

Protection Against Progressive Collapse, National Bureau of

Standards Report, NBSIR 74-542, September 1974.

1 Dasgupta, Ajit K. and Pearce, D. W. Cost-Benefit Analysis:

I Theory and Practice (New York: Harper and Row, 1972).

! Dickerson, Donald F. "Procedures for Estimating Economic

I Benefits and Materials Savings for Plumbing Drainage

! Systems with Reduced Size Venting." Report by

Dickerson/Gladstone/Associates under contract to National Bureau of Standards, 1975. Eckstein, Otto. Water-Resource Development: The Economics

of Project Evaluation (Cambridge, Massachusetts: Harvard

University Press, 1962).

' Educational Facilities Laboratories. The Economy of Energy

i Conservation in Educational Facilities (New York: EFL,

j Inc., 1972).

' Executive Office of the President, Office of Management and

j Budget. Circular No. A-94 (Revised), March 27, 1972. Grant, Eugene L. and Ireson, W. Grant. Principles of

Engineering Economy, 5th ed. (New York: The Ronald

Press Co., 1970). Griliches, Zvi. "Research Costs and Social Returns: Hybrid Corn and Related Innovations," The Journal ofPolitical Economy, LXVI (February-December 1958).

] Mansfield, Edwin. "An Exploratory Study of Social and

i Private Rates of Return for Industrial Innovations." A

\ paper presented at the Meetings of the Eastern Economic

Association (October 26, 1974). Mansfield, Edwin. Industrial Research and Technological

Innovation: An Econometric Analysis (New York: W. W.

Norton & Co., 1968). Mansfield, Edwin. Microeconomics: Theory and Application

(New York: W. W. Norton & Co., 1975).

Mansfield, Edwin. Research and Innovation in the Modern

Corporation (New York: W. W. Norton & Co., 1971). Marcin, Thomas C. The Effects ofDeclining Population Growth of the Demandfor Housing, U.S. Department of

Agriculture, General Technical Report NC-11, 1974. Marglin, Stephen A. "Objectives of Water Resource Development: A General Statement." Chapter 2, Design of

Water Resource System, Arthur Maass et al., (Cambridge,

Massachusetts: Harvard University Press, 1962). Marshall, Harold E. "Cost Sharing and Multiobjectives in Water Resource Development," Water Resources Research, Vol. 9, February 1973. Marshall, Harold E., Ruegg, Rosalie T., and Wyly, Robert S. "Cost Savings from Reduced Size Venting," Plumbing

Engineer, July/August and September/October, 1977. Mishan, E. J. Cost-Benefit Analysis: An Introduction (New

York: Praeger, 1971). National Association of Plumbing-Heating-Cooling

Contractors. NAPHCC Labor Calculator, NAPHCC,

Washington, D.C. (1971 with 1975 revisions). National Science Foundation. National Patterns of R&D

Resources: Funds and Manpower in the United States, 1953-

1977. NSF 77-310 (Washington, D.C: U.S. Government

Printing Office). Orloski, Mary J. and Wyly, Robert S. Hydraulic Performance ofa Full-Scale Townhouse Drain- Waste- Vent System with Reduced-Size Vents. National Bureau of Standards Report, BSS60, 1975. Roman, Daniel D. Research and Development Management:

The Economics and Administration of Technology (New

York: Appleton-Century Crofts, 1968). Smith, Gerald W. Engineering Economy: Analysis of Capital

Expenditures, 2nd ed. (Ames, Iowa: The Iowa State University Press, 1973). U.S. Bureau of Census. Construction Report, Series C25, Washington, D.C, July 1974. U.S. Bureau of Census. Projection of Population Growth.

47
NBS-114A (REV. 9-78)

U.S. DEPT. OF COMM. 2 BIBLIOGRAPHIC DATA

SHEET

1. PUBLICATION OR REPORT NO. NBS SP 5582,Gov't Accessicsi No,

4. TITLE AND SUBTITLE Efficient Allocation of Research Funds: Economic

Evaluation Methods with Case Studies in Building Technology

5. Publication Date December 1979

f. PerfOffiiing Organization tS»&

7, AUTHOR(S)

Harold E.

8. Performing Organ. Report No. Marshall and Rosalie T, Ruegg

9. PERFORMING ORGANIZATION NAME AND ADDRESS ICfM^^t/WofK ikft No.

NATIONAL BUREAU OF STANDARDS

DEPARTMENT OF COMMERCE

WASHINGTON, DC 20234

11. Contract/Grant No.

12. SPONSORING ORGANIZATION NAME AND COMPLETE ADDRESS rS(reo(, Ciiy, Sute. ZIP)

Same as no. 9

13. Type of Report & Period Covered Final

14. %)onsoring Agency Code

15. SUPPLEMENTARY NOTES Library of Congress Catalog Card Niomber: 79-600210

I I Document describes a computer program; SF-185, FIPS Software Summary, is attached.

16. ABSTRACT (A 200-word or leaa factual summary of most significant information. If document includes a significant bibliography or

literature survey, mention it here.) Public and private administrators of research programs are concerned with maximizing

the payoffs from their research investments; that is, with allocating their limited

budgets most efficiently. Benefit-cost, rate-of-return, payback, and other evaluation methodologies are examined for their usefulness in helping administrators to decide whether to accept or reject research projects leading directly to applications;

to plan the scale of these research projects; and to identify priorities among

alternative research investments, all of which may be profitable. Data needs for

applying these evaluation methodologies are outlined. The net-benefits and rate<^ofreturn methodologies are applied to two case studies involving research in the

Center for Building Technology (CBT) of the National Bureau of Standards, The first

deals with a heavier asphalt shingle for roofing, and the second deals with reducedsize venting in plumbing. The case studies show high payoffs in these two areas of

research, both for society as a whole and for CBT's contribution in undertaking the

research. Recommendations from the study are that research funds be allocated on the

basis of anticipated payoffs determined through these evaluation techniques, and that

benefit and cost data for evaluating new technologies be collected.

17. KEY WORDS (six to twelve entries; alphabetical order; capitalize only the first letter of the first key word unless a proper name;

separated by semicolons) Benefit-cost analysis, building technology; economic impacts; economics; efficiency;

payback; plumbing; roofing; shingles; venting.

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