Benefit/Cost Analysis

and
Public Sector Economics

Chapter 9
Learning Objectives

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Benefit/Cost Ratio
The benefit/cost ratio (B/C) is an economic analysis technique used
commonly, especially by governmental agencies. In its purest form, the
numerator B consists of economic consequences to the people
(benefits and disbenefits), while the denominator C consists of
consequences to the government (costs and savings).
The units in the calculation can be present worth, annual worth or
future worth dollars; they have to be the same in the numerator and
denominator.
A B/C ratio > 1 indicates that the project is economically attractive. If
disbenefits are involved, they are substracted from the benefits; if
government savings are involved, they are subtracted from the costs.

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 The benefit/cost (B/C) ratio was developed, in part, to introduce objectivity
into the economic analysis of public sector evaluation in an effort to reduce
the effects of politics and special interests.
However, there is always predictable disagreement among individuals and
groups about how the benefits of an alternative are defined and
economically valued.
The different formats of B/C analysis and associated disbenefits of an
alternative, are discussed in Chapter 9.
The B/C analysis can use equivalency computations based on PW, AW or
FW values.
Performed correctly, the benefit/cost method will always select the same
alternative as PW, AW, and ROR analyses.

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Public Sector Examples
Hospitals and clinics Schools: primary, secondary,
Transportation: highways, Community colleges, universities
bridges, waterways, airports Food stamp and rent relief
Parks and recreation programs
Utilities: water, electricity, gas, Job training
sewer, sanitation Economic development
Police and fire protection Public housing
Courts and prisons Convention centers
Sports arenas Codes and standards
Emergency relief

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Characteristics
There are significant differences in the characteristics of private and
public sector alternatives.
Characteristic Public Sector Private Sector

Size of Investment Larger Some Large; medium to

small

Life Estimates Longer: Shorter:

30 50 years 2-25 years
Annual Cash Flow No Profit: costs and Revenues profit cost
estimates benefits estimates

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Public Sector Projects
To perform an economic analysis of public alternatives, the costs (initial
and annual), the benefits, and the disbenefits must be estimated as
accurately as possible in monetary units.
Costs - estimated expenditures to the government entity for construction,
operation, and maintenance of the project, less any expected salvage
value.
Benefits - advantages experienced by the owners (the public).
Disbenefits - expected undesirable or negative consequences to the
owners if the alternative is implemented. Disbenefits may be indirect
economic disadvantages of the alternative.
The following is important to realize: It is difficult to estimate and agree
upon the economic impact of benefits and disbenefits for a public sector
alternative.

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Viewpoints
There are often public meetings and debates associated with public
sector projects to accommodate the various interests of citizens
(owners). Elected officials commonly assist with the selection,
especially when pressured by voters, developers and
environmentalists.
The selection process is not as clean as in private sector
evaluation.
The viewpoint of the public sector analysis must be determined
before cost, benefit and disbenefit estimates are made and before
the evaluation is formulated and performed.
There are several viewpoints for any situation, and the different
perspectives may alter how a cash flow estimate is classified.

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 The Capital Improvement Projects (CIP) Committee has
recommended a $5 million bond issue for the purchase of
greenbelt/floodplain land to preserve low-lying green areas and
wildlife habitat in a rapidly expanding city of 62,000. The proposal is
referred to as the Greenway Acquisition Initiative.
Developers immediately opposed the proposal due to the reduction
of available land for commercial development. The city engineer and
economic development director have made the following preliminary
estimates for some obvious areas, considering the Initiatives
consequences in maintenance, parks, commercial development,
and flooding over a projected 15-year planning horizon.
The inaccuracy of these estimates is made very clear in the report to
the City Council. The estimates are not yet classified as costs,
benefits or disbenefits.
If the Greenway Acquisition Initiative is implemented, the estimates
are as follows.
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Identify three different viewpoints for the economic analysis of
the proposal, and classify the estimates.

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Solution
There are many perspectives. The viewpoints and goals are identified and each
estimate is classified as a cost, benefit or disbenefit. (How the classification is
made will vary depending upon who does the analysis. This solution offers only
one answer.)
Viewpoint 1: Citizens
Goal: Maximize the quality and wellness of citizens with family and neighborhood
as prime concerns.
Costs: 1, 2, 3 - Benefits: 6, 7, 8 - Disbenefits: 4, 5

Viewpoint 2: City budget.

Goal: Ensure the budget is balanced and sufficient to fund rapidly growing city
services.
Costs: 1, 2, 3, 5 - Benefits: 6, 7, 8 - Disbenefits: 4

Viewpoint 3: Economic development.

Goal: Promote new commercial and industrial economic development for creation
and retention of jobs.
Costs: 1, 2, 3, 4, 5 - Benefits: 6, 7, 8 - Disbenefits: none
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B/C Analysis of a Single Project
All cost and benefit estimates must be converted to a
common equivalent monetary unit (PW, AW or FW)
at the discount rate (interest rate). The B/C ratio is
then calculated using one of these relations:

If B/C >1.0, accept the project as economically acceptable for the

estimates and discount rate applied.
If B/C < 1.0, the project is not economically acceptable.

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B/C ratio
Conventional most commonly used

The modified B/C ratio includes maintenance and operation (M&O) costs in
the numerator and treats them in a manner similar to disbenefits. The
denominator includes only the initial investment. Once all amounts are
expressed in PW, AW or FW terms, the modified B/C ratio is calculated as

It makes no difference which approach is used; the ratio values will differ.
But, the same absolute (accept/reject) decision will be the same

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Sign Conventions
Revenues are assigned (+) signs
Costs are assigned (+) signs
Salvage values are subtracted from costs
Disbenefit values are subtracted from benefits or
Disbenefit values are added to costs
Either approach will result in a consistent analysis but be
consistent through out an analysis

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 The Ford Foundation expects to award $15 million in grants to public high
schools to develop new ways to teach the fundamentals of engineering that
prepare students for university-level material. The grants will extend over a
10-year period and will create an estimated savings of $1.5 million per year
in faculty salaries and student-related expenses. The Foundation uses a
rate of return of 6% per year on all grant awards. This grant program will
share Foundation funding with ongoing activities, so an estimated $200,000
per year will be removed from other program funding. To make this program
successful, a $500,000 per year operating cost will be incurred from the
regular M&O budget.
Use the B/C method to determine if the grant program is economically
justified.

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The project is also not justified by the modified B/C method, as expected. For the (B - C) model,
B is the net benefit, and the annual M&O cost is included with costs.
B -C = (1,500,000 - 200,000) - (2,038,050 + 500,000) = - $1.24 million
Since (B - C) < 0, the program is not justified. 16
Benefit and Cost difference measure of worth
The benefit and cost difference measure of worth does not involve a ratio, and is
based on the difference between the PW, AW or FW of benefits and costs (B C).
If (B - C) > 0, the project is acceptable. This method has the advantage of
eliminating the discrepancies noted when disbenefits are regarded as costs,
because B represents net benefits. For the numbers 10, 8 and 8 the same result is
obtained regardless of how disbenefits are treated.
Subtracting disbenefits from benefits: B - C = (10 - 8) - 8 = -6
Adding disbenefits to costs: B - C = 10 - (8 + 8) = -6
If the numbers 10, 8 and 8 are used to represent the PW of benefits, disbenefits and
costs, respectively, the correct procedure results in B/C = (10 - 8)/8 = 0.25.
The incorrect placement of disbenefits in the denominator results in B/C =10/(8 + 8)
=0.625, more than twice the correct B/C value of 0.25.
Clearly, then, the method affects the magnitude of the B/C ratio.

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 Alternative Selection Using Incremental B/C Analysis
Follow these steps to correctly perform a conventional B/C ratio analysis of
two alternatives. Equivalent values can be expressed in PW, AW or FW terms.
1. Determine the total equivalent costs for both alternatives.
2. Order the alternatives by total equivalent cost; smaller first, then larger.
Calculate the incremental cost (C) for the larger-cost alternative. This is the
denominator in B/C.
3. Calculate the total equivalent benefits and any disbenefits estimated for
both alternatives. Calculate the incremental benefits ( B) for the larger cost
alternative. (This is (B - D) if disbenefits are considered.)
4. Calculate the incremental B/C ratio using Equation [9.2], (B - D)/C.
5. Use the selection guideline to select the higher-cost alternative if B/C >1.0.

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 A city in Florida has received designs for a new patient room wing to
the municipal hospital from two architectural consultants. One of the
two designs must be accepted to announce it for construction bids.
The costs and benefits are the same in most categories, but the city
financial manager decided that the three estimates should be
considered to determine which design to recommend at the city
council meeting next week and to present to the public in
preparation for an upcoming bond referendum next month.
The patient usage cost is an estimate of the amount paid by patients
over the insurance, the building is estimated at 30 years.

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 When the two designs were publicized, another hospital lodged a
complaint that design A will reduce its income by an estimated
$500,000 per year; some of the day-surgery features of design A
duplicate its services.
Subsequently, the merchants association argued that design B
could reduce its annual revenue by an estimated $400,000; it will
eliminate an entire parking lot used by their patrons for short-term
parking.
The city financial manager stated that these concerns would be
entered into the evaluation as disbenefits of the respective designs.

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 Use B/C ratio analysis to select design A or B. Most of the cash flows are already annualized, so
the incremental B/C ratio uses AW values. No disbenefit estimates are considered.

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 Redo the B/C analysis to determine if the economic decision is still
the same as when disbenefits were not considered.

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Incremental B/C Analysis of Multiple Alternatives
Choose the largest-cost alternative that is justified
with an incremental B/C > 1.0 when this selected
alternative has been compared with another justified
alternative.

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 The Economic Development Corporation (EDC) for the city of Bahia, California, and
Moderna County is operated as a not-for-profit corporation. It is seeking a developer
that will place a major water park in the city or county area. Financial incentives will
be awarded. In response to a request for proposal (RFP) to the major water park
developers in the country, four proposals have been received. Larger and more
intricate water rides and increased size of the park will attract more customers,
therefore, different levels of initial incentives are requested in the proposals. One of
these proposals will be accepted by the EDC and recommended to the Bahia City
Council and Moderna County Board of Trustees for approval.

Approved and in-place economic incentive guidelines allow entertainment industry

prospects to receive up to $500,000 cash as a first-year incentive award and 10% of
this amount each year for 8 years in property tax reduction. All the proposals meet
the requirements for these two incentives. Each proposal includes a provision that
residents of the city or county will benefit from reduced entrance (usage) fees when
using the park. This fee reduction will be in effect as long as the property tax
reduction incentive continues. The EDC has estimated the annual total entrance fees
with the reduction included for local residents. Also, EDC estimated the extra sales
tax revenue expected for the four park designs. These estimates and the costs for
the initial incentive and annual 10% tax reduction are summarized in Table 91.

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Perform an incremental B/C study to determine which park proposal is the best economically.

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 Solution
The discount rate used by the EDC is 7% per year.
Can the current incentive guidelines be used to accept the winning proposal?
The viewpoint taken for the economic analysis is that of a county resident.
The first-year cash incentives and annual tax reduction incentives are real costs to the
residents.
Benefits are derived from two components: the decreased entrance fee estimates and the
increased sales tax receipts. These will benefit each citizen indirectly through the increase
in money available to those who use the park and through the city and county budgets
where sales tax receipts are deposited. Since these benefits must be calculated indirectly
from these two components, the initial proposal B/C values cannot be calculated to initially
eliminate any proposals. A B/C analysis incrementally comparing two alternatives at a time
must be conducted.
Equivalent AW values are used for benefit and cost amounts per year. Since the benefits
must be derived indirectly from the entrance fee estimates and sales tax receipts, step 4 is
not used.
1. For each alternative, the capital recovery amount over 8 years is determined and added
to the annual property tax incentive cost.
For proposal #1,
AW of total costs = initial incentive (A/P, 7%, 8) + tax cost
= $250,000 (A/P, 7%, 8) + 25,000 = $66,867
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 2. The alternatives are ordered by the AW of total costs in Table 91.
3. The annual benefit of an alternative is the incremental benefit of the entrance fees and sales tax
amounts. These are calculated in step 5.
4. This step is not used.
5. Table 91 shows incremental costs calculated by Equation [9.4]. For the 2-to-1 comparison,
C = $93,614 - 66,867 = $26,747
Incremental benefits for an alternative are the sum of the resident entrance fees compared to those of
the next-lower-cost alternative, plus the increase in sales tax receipts over those of the next-lower-cost
alternative. The benefits are determined incrementally for each pair of alternatives. For example, when
proposal #2 is compared to proposal #1, the resident entrance fees decrease by $50,000 per year and
the sales tax receipts increase by $10,000. Then the total benefit is the sum of these, that is,
B = $60,000 per year.
6. For the 2-to-1 comparison, Equation [9.7] results in B/C = $60,000 / $26,747 = 2.24
Alternative #2 is incrementally justified. Alternative #1 is eliminated, and alternative #3 is now compared
to #2.
7. This process is repeated for the 3-to-2 comparison that has an incremental B/C of 0.62 because the
incremental benefits are substantially less than the increase in costs.
Therefore, proposal #3 is eliminated, and the 4-to-2 comparison results in
B/C = $220,000 / $120,360 = 1.83
Since B/C > 1.0, proposal #4 is retained and selected.
The recommendation for proposal #4 requires an initial incentive of $800,000 that exceeds the
$500,000 limit of the approved incentive limits. The EDC will have to request the City Council and
County Trustees to grant an exception to the guidelines. If the exception is not approved, proposal #2 is
accepted.

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Summary
The benefit/cost method is used primarily to evaluate projects and to select from
alternatives in the public sector. When comparing mutually exclusive alternatives, the
incremental B/C ratio must be greater than or equal to 1.0 for the incremental equivalent
total cost to be economically justified.
The PW, AW or FW of the initial costs and estimated benefits can be used to perform an
incremental B/C analysis.
If alternative lives are unequal, the AW values should be used, provided the assumption of
project repetition is not unreasonable.
For independent projects, no incremental B/C analysis is necessary. All projects with B/C >
1.0 are selected provided there is no budget limitation.
Public sector economics are substantially different from those of the private sector. For
public sector projects, the initial costs are usually large, the expected life is long (25, 35 or
more years), and the sources for capital are usually a combination of taxes levied on the
public, user fees, bond issues and private lenders. It is very difficult to make accurate
estimates of benefits for a public sector project. The interest rates, called the discount rates
in the public sector, are lower than those for corporate capital financing.

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