Chapter 9

Benefit/Cost
Analysis
Lecture slides to accompany

Engineering Economy
7th edition

Leland Blank
Anthony Tarquin

© 2012 by McGraw-Hill All Rights Reserved

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 LEARNING OUTCOMES

1. Explain difference in public vs. private sector projects

2. Calculate B/C ratio for single project
3. Select better of two alternatives using B/C method
4. Select best of multiple alternatives using B/C method
5. Use cost-effectiveness analysis (CEA) to evaluate
service sector projects
6. Describe how ethical compromises may enter public
sector projects

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 Differences: Public vs. Private Projects
Characteristic Public Private
Size of Investment Large Small, medium, large

Life Longer (30 – 50+ years) Shorter (2 – 25 years)

Annual CF No profit Profit-driven

Funding Taxes, fees, bonds, etc. Stocks, bonds, loans, etc.

Interest rate Lower Higher

Selection criteria Multiple criteria Primarily ROR

Environment of evaluation Politically inclined Economic

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 Types of Contracts
Contractors does not share project risk
 Fixed price - lump-sum payment
 Cost reimbursable - Cost plus, as negotiated
Contractor shares in project risk
 Public-private partnerships (PPP), such as:
 Design-build projects - Contractor responsible from
design stage to operations stage
 Design-build-operate-maintain-finance (DBOMF)
projects - Turnkey project with contractor managing
financing (manage cash flow); government obtains
funding for project

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 Cash Flow Classifications and B/C Relations
Must identify each cash flow as either benefit, disbenefit, or cost

Benefit (B) -- Advantages to the public

Disbenefit (D) -- Disadvantages to the public
Cost (C) -- Expenditures by the government
Note: Savings to government are subtracted from costs

Conventional B/C ratio = (B–D) / C

Modified B/C ratio = [(B–D) – C] / Initial Investment
Profitability Index = NCF / Initial Investment

Note 1: All terms must be expressed in same units, i.e., PW, AW, or FW
Note 2: Do not use minus sign ahead of costs
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 Decision Guidelines for B/C and PI
Benefit/cost analysis
If B/C ≥ 1.0, project is economically justified at
discount rate applied
If B/C < 1.0, project is not economically acceptable
Profitability index analysis of
revenue projects
If PI ≥ 1.0, project is economically justified at
discount rate applied
If PI < 1.0, project is not economically acceptable
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 B/C Analysis – Single Project

B-D
Conventional B/C ratio = If B/C ≥ 1.0,
C
accept project;
Modified B/C ratio = B – D – M&O otherwise, reject
C
Denominator is
PW of NCFt
PI = initial investment
PW of initial investment
If PI ≥ 1.0,
Note: Ignore sign –ve for calculation especially the
accept project; cost for B/C analysis
otherwise, reject © 2012 by McGraw-Hill All Rights Reserved
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 Example: B/C Analysis – Single Project
(C)
A flood control project will have a first cost of $1.4 million with an annual
maintenance cost of $40,000 and a 10 year life. Reduced flood damage is (B)
expected to amount to $175,000 per year. Lost income to farmers is estimated
to be $25,000 per year. At an interest rate of 6% per year, should the (D)
project be undertaken? (Hint: using B/C Analysis)

Solution: Express all values in AW terms and find B/C ratio

Steps: 1) Find
keyword B = $175,000
2)Since using per
year, means use Aw
D = $25,000
3) Find C,B,D C = 1,400,000(A/P,6%,10) + $40,000 = $230,218
(first cost should
involve (factor)+ B/C = (175,000 – 25,000)/230,218
M/O cost)
4) For single
= 0.65 < 1.0
project, B/C>1,
accept project, vice
Do not build project
versa reject 9-8 © 2012 by McGraw-Hill All Rights Reserved
Defender, Challenger and Do Nothing Alternatives

When selecting from two or more ME alternatives, there is a:

 Defender – in-place system or currently selected alternative (if ΔB/C<1)
 Challenger – Alternative challenging the defender (if ΔB/C>1)
 Do-nothing option – Status quo system

General approach for incremental B/C analysis of two ME alternatives:

 Lower total cost alternative is first compared to Do-nothing (DN)
 If B/C for the lower cost alternative is < 1.0, the DN option is compared to
∆B/C of the higher-cost alternative
 If both alternatives lose out to DN option, DN prevails, unless overriding
needs requires selection of one of the alternatives

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Alternative Selection Using Incremental B/C
Analysis – Two or More ME Alternatives

Procedure similar to ROR analysis for multiple alternatives

(1) Determine equivalent total cost for each alternative

(2) Order alternatives by increasing total cost
(3) Identify B and D for each alternative, if given, or go to step 5
(4) Calculate B/C for each alternative and eliminate all with B/C < 1.0
(5) Determine incremental costs and benefits for first two alternatives
(6) Calculate ∆B/C; if >1.0, higher cost alternative becomes defender
(7) Repeat steps 5 and 6 until only one alternative remains

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 1) Example: Incremental B/C Analysis
Compare two alternatives using i = 10% and B/C ratio (Y-X)
Alternative X Y
First cost, $ (C) factor 320,000 540,000
M&O costs, $/year (C) 45,000 35,000
Benefits, $/year (B) 110,000 150,000
Disbenefits, $/year (D) 20,000 45,000
Life, years (just use given year) 10 20

1Solution: First, calculate equivalent total cost, C (AW for X and Y) (ignore sign –ve for cost)
AW of costsX = 320,000(A/P,10%,10) + 45,000 = $97,080
AW of costsY = 540,000(A/P,10%,20) + 35,000 = $98,428
2Orderof analysis is X, then Y (lower have to compare to DN)
X vs. DN: (B-D)/C =(110,000 – 20,000) / 97,080 = 0.93 Eliminate X (challenger)
Y vs. DN: (150,000 – 45,000) / 98,428 = 1.07 Eliminate DN (challenger)

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 2) Example: ∆B/C Analysis; Selection Required
Must select one of two alternatives using i = 10% and ∆B/C ratio
Alternative X Y
First cost, $ 320,000 540,000
M&O costs, $/year 45,000 - 35,000
Benefits, $/year 110,000 - 150,000
Disbenefits, $/year 20,000 45,000
Life, years 10 20
Solution: Must select X or Y; DN not an option, compare Y to X
AW of costsX = $97,080 - AW of costsY = $98,428
Incremental values: ∆B = 150,000 – 110,000 = $40,000
(Y-X) ∆D = 45,000 – 20,000 = $25,000
∆C = 98,428 – 97,080 = $1,348
Y vs. X: (∆B - ∆D) / ∆C = (40,000 – 25,000) / 1,348 = 11.1 Eliminate X

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 (C)

(B)

CITY 1

Note:
Divide 1,000,000 (cause per million depends
on question) to be easier calculate cost or
value (let’s say 500,000/1,000,000= 0.5)

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Select City 3 (Challenger)
For ME
alternatives

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 B/C Analysis of Independent Projects

 Independent projects comparison does not require

incremental analysis
 *Compare each alternative’s overall B/C with DN
option

+ No budget limit: Accept all alternatives with B/C ≥ 1.0

+ Budget limit specified: capital budgeting problem; selection
follows different procedure (discussed in chapter 12)

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 Ethical Considerations
Engineers are routinely involved in two areas
where ethics may be compromised:
Public policy making – Development of strategy, e.g.,
water system management (supply/demand strategy;
ground vs. surface sources)
Public planning - Development of projects, e.g., water
operations (distribution, rates, sales to outlying areas)

Engineers must maintain integrity and impartiality and

always adhere to Code of Ethics
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Answer: B/C= 1.26

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Answer: Compare with DN
Proposal 1 vs DN, B/C =0.91, Proposal 2 vs
DN, B/C=1.95 so select proposal 2
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Summary of Important Points
B/C method used in public sector project evaluation

Can use PW, AW, or FW for incremental B/C analysis, but must
be consistent with units for B,C, and D estimates
For multiple mutually exclusive alternatives, compare two at a time
and eliminate alternatives until only one remains

For independent alternatives with no budget limit, compare each against

DN and select all alternatives that have B/C ≥ 1.0

CEA analysis for service sector projects combines cost and

nonmonetary measures

Ethical dilemmas are especially prevalent in public sector projects

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END OF CHAPTER 9

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