Example 8.

7
9
Engineering Economy
ME2045

Benefit Cost Analysis and Public Sector

Economics
Assoc. Prof. Dr. Le Ngoc Quynh Lam

39

Learning outcomes AIC

• Explain some of the fundamental differences between private and public • 10 mins
sector projects. • Review chapter 7 and chapter 8.
• Calculate the benefit/cost ratio and use it to evaluate a single project. • 15 mins
• Select the better of two alternatives using the incremental B/C ratio method. • Select and discuss a section (9.1 to 9.4).
• Summary what you have learnt.
• Based on the incremental B/C ratios, select the best of multiple alternatives.
• Present to your friends in from of class. (10 mins per section)
• Explain service sector projects and use costeffectiveness analysis (CEA) to
evaluate projects.
• Explain the major aspects of public project activities, and describe how
ethical compromise may enter public sector project analysis.

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9.1 Public Sector Projects 9.1 Public Sector Projects
• Public Sector:
• Ownership – by citizens- the public
• Public Sector Projects:
Examples:
• Provide needed services to the public and “no profit”
• Projects such as hospitals, parks and recreation facilities,
highways, dams, bridges, courts, schools, prisons, public
housing, etc.

4 5

9.1 Characteristics – Compared 9.1 Attributes

• Public Sector Projects do not have “profits”
Characteristic Public Sector Private Sector • Projects can have certain undesirable consequences
Size of Investment Larger Some Large; medium associated
to small
• Thus, can be controversial in nature
Life Estimates Quite Long: 30-50 Shorter:
• Draw media attention – debated on pros and cons
years 2-25 years
Annual Cash Flow No Profit: costs and Revenues – profit
Estimates benefits cost estimates

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 9.1 Estimating for Public Projects:
9.1 Estimating for Public Projects: Costs
Benefits
• Basic elements for public projects:
• BENEFITS to the public (users) must be estimated in terms of
• Costs periodic dollar values
• Construction, operations, maintenance less est. salvage • Very difficult to do
values
• Benefits = the advantages to the public stated in $$
• Initial costs fairly well know
• Owners – generally the public
• Future O&M are less known and must be estimated

8 9

9.1 Estimating for Public Projects:

Disbenefits
9.1 General Principle
• Disbenefits • For public projects we find:
• Expected undesirable (negative) consequences to the
owners (public)
It is very difficult to estimate and reach
• Assuming the project is undertaken agreement on the economic impacts of
• May be indirect economic disadvantages to the public benefits and disbenefits for public sector
projects.
• Very hard to estimate and convert to $ amounts

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9.1 Funding Sources – Compared 9.1 Funding Public Projects
• Generally low interest charges
• Public entities do not pay taxes
Characteristic Public Sector Private Sector
• Project investments basically backed by public agencies
Funding Taxes, fees, bonds, Sale of new stock,
private funds bonds, loans, ret.
• Cost-sharing arrangements often exist
earnings • Less perceived risk with public projects

Interest Rate Tends to be lower Higher: At market

cost

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9.1 Determination of an Interest Rate 9.1 Additional Comparisons

• Determined differently than in the private sector
• Called the social discount rate Characteristic Public Sector Private Sector
• For Federal Projects a current working rate (2001) is 10% per
year Selection criteria Multiple Rate of return or
present value

Environment of Political arena Primarily

the evaluation (debated, pressure economic
groups)

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 9.2 Benefit/Cost Analysis of a Single
9.1 Selection Process Project
• Not as “clean” as in the private sector • Assignable life, N - years
• Involves interest and pressure groups • Estimate costs ($)
• Often draws media attention • Estimate benefits in ($)
• Involves many different viewpoints • Estimate disbenefits in ($)
• The viewpoint finally adopted will determine the estimates of • Assign an interest rate – i (%/year)
costs, benefits, disbenefits • Then convert all amounts to either a
• Thus, the viewpoint must be established before the economic • Present Worth – PW(i%)
evaluation • Annual Worth – AW(i%)
• Calculate a B/C ratio
EXAMPLE 9.1 Water Treatment Facility

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9.2 B/C Ratios: 3 Formats 9.2 Notes Regarding Signs

• Three acceptable formats are: • By convention:
PW (benefits ) AW (benefits ) FW (benefits ) • Revenues are assigned (+) signs
B /C = = =
PW (cos ts) AW (cos ts ) FW (cos ts) • Costs are assigned (+) signs
• Salvage values are subtracted from costs
• Disbenefits are treated more than one way

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9.2 Handling Disbenefits 9.2 Conventional B/C Ratio
• Disbenefit values are subtracted from benefits • The conventional B/C Ratio is:
• Disbenefit values are added to costs
• Either approach will result in a consistent analysis – but be
consistent throughout an analysis
Benefits - disbenefits B − D
B /C = =
Costs C

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9.2 Modified B/C Ratio 9. 2 Convention vs. Modified?

• Modified B/C subtracts the maintenance and operations
costs in the numerator
• It makes no difference which approach is used
• However, the ratio values will differ (magnitude)
• But, the same absolute (accept/reject) decision will be the
Benefits - disbenefits-M&O costs same
B / Cmodified =
Costs

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9. 2 Benefit-Cost Difference EXAMPLE 9.2

• B-C difference is not a ratio

• B-C difference is:
• (Benefits – Costs) (as a PW or AW)
• The “B” represents the Net Benefit
• Benefits – Disbenefits

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EXAMPLE 9.2 EXAMPLE 9.2

• Initially, determine the AW for each parameter over 10 years. In • The conventional B/C analysis applies Equation [9.2]
$1 million units,
• Award: 20 − 5(A/G,6%,4) = $12.864 per year
• Annual costs: $2 per year
• Benefits: $8 per year • The modified B/C analysis uses Equation [9.3]
• Disbenefits: Use $0.6 for the first analysis

(B-C) and conclusion????

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9.2 Benefit/Cost Analysis of a Single
Project
9.2 Uncertain Discount Rate (??)
• Profitability index (PI) • What if the value of “i” is uncertain?
• PW of NCF = PW of revenues − PW of costs EXAMPLE
• Apply a spreadsheet analysis and play “what-if”
• 9.3
• What if federal funds are available for the upgrade and a 4%
rate is applied to that option?
• Changing discount rates can impact the ratio for that
alternative!

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9.3 Incremental B/C Analysis (Two

Alternatives)
9.3 Rank on Total Costs – Rules
• Determine total equivalent costs for both alternatives;
• This approach is similar to the material in Chapter 8 • Order by total costs: Smaller first then larger
• Requires a proper ordering of the alternatives • Calculate the incremental cost for the larger alternative = (
• Order alternatives on the basis of Total Costs C) – be the denominator in the B/C ratio

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9.3 (B/C) Approach 9.3 (B/C) Approach
5.If (B/C) (=>) 1.00, go with the higher- cost alternative
• 3. For both alternatives determine:
• else,
• Total equivalent benefits and disbenefits
• Go with lower-cost alternative!
• Calculate the (B) for the larger cost alternative or (B-D) if
disbenefits are involved
• 4. Calculate the { (B-D)/C } ratio

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9.3 Important Point 9.4 Incremental B/C for Multiple Projects

• If you are using a PW to determine equivalency, then you must • Select from three or more mutually exclusive alternatives
have an equal- life model or lowest-common multiple of lives. • Same approach as that in Chapter 8, Section 8.6
• Or, apply the annual worth on a typical cycle for the alternatives • Remember, the Do Nothing alternative always exists and
and the repeatability assumption applies. should be evaluated as an alternative.

EXAMPLE 9.4

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9.4 Steps for Multiple Incremental Analysis 9.4 Steps for Multiple Incremental Analysis
1. Using either PW or AW, determine the total equivalent cost for
all options. If unequal lives, apply AW
2. Create the rankings based upon lowest to highest total cost of 4. The lowest-cost option is the first Defender and the next-higher
the alternatives cost alternative is the first Challenger.
3. Determine the total equivalent net benefits for each alternative • Compute the B/C ratio on the increment
• If B/C < 1, eliminate the Challenger, else eliminate the Defender.
• Current winner becomes new Defender

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9.5 Service Sector Projects and Cost-

9.4 Steps for Multiple Incremental Analysis
Effectiveness Analysis

5. Compare the new Defender to the next- higher-cost

Challenger and repeat the analysis. • A service sector project is a process or system that provides
6. Continue through the alternative until there are no more services to individuals, businesses, or government units.
Challengers. The economic value is developed primarily by the intangibles
7. The last “champion” is the winner. of the process or system, not the physical entities (buildings,
machines, and equipment).
EXAMPLE 9.6 • Manufacturing and construction activities are commonly not
considered a service sector project, though they may support
the theme of the service provided.

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9.5 Service Sector Projects and Cost- 9.5 Service Sector Projects and Cost-
Effectiveness Analysis Effectiveness Analysis
• In service and public sector projects, as expected, it is the
benefits that are the more difficult to estimate.
• An evaluation method that combines monetary cost estimates
with non-monetary benefit estimates is cost-effectiveness
analysis (CEA).
• The CEA approach utilizes a costeffectiveness measure or
the cost-effectiveness ratio (CER) as a basis of ranking
projects and selecting the best of independent projects or
mutually exclusive alternatives. EXAMPLE 9.8

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9.6 Ethical Considerations in the Public

Sector
10
Engineering Economy
• Engineer are routinely involved in two areas where ethics may ME2045
be compromised:
• Pbulic policy making- Development of strategy e.g. Water
system management ( supply/ demand strategy, ground and
surface sources) Replacement and Retention Decisions
• Public planning: Development of projects e.g water operations
(Distribution, rates, sale to outlying areas) Assoc. Prof. Dr. Le Ngoc Quynh Lam

Engineers must maintain integrity and impacticalilty and always

adhese to Code of Ethics.

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Learning outcomes Introduction
Keep or Replace the Kiln Case:
• Perform a replacement/retention study between an in-place asset,
• B&T Enterprises manufactures and sells high melting-temperature ceramics and high performance metals to other corporations.
process, or system and one that could replace it • The products are sold to a wide range of industries from the nuclear and solar power industry to sports equipment
manufacturers of specialty golf and tennis gear, where kiln temperatures up to approximately 1700°C are needed.
• Explain the fundamental approach and terminology of replacement
• For years, B&T has owned and been very satisfied with Harper International pusher-plate tunnel kilns.
analysis. • Two are in use currently at plant locations on each coast of the country; one kiln is 10 years old, and the second was purchased
only 2 years ago and serves, primarily, the ceramics industry needs on the west coast. This newer kiln can reach temperatures
• Determine the economic service life (ESL) that minimizes the total AW for of 2800°C.
estimated costs and salvage value. • During the last two or three quarter maintenance visits, the Harper team leader and the head of B&T quality have discussed the
ceramic and metal industry needs for higher temperatures. In some cases the temperatures are as high as 3000°C for emerging
• Perform a replacement/retention study between a defender and the best nitride, boride, and carbide transition metals that form very high-melting temperature oxides. These may find use in hypersonic
vehicles, engines, plasma arc electrodes, cutting tools, and high temperature shielding.
challenger.
• A looming question on the mind of the senior management and financial officers of B&T revolves around the need to seriously
• Perform a replacement/retention study over a specified number of years. consider a new graphite hearth kiln,
• which can meet higher temperature and other needs of the current and projected customer base.
• Calculate the minimum trade-in (breakeven) value required to make the • This unit will have lower operating costs and significantly greater furnace efficiency in heat time, transit, and other crucial parameters.

challenger economically attractive • Since virtually all of this business is on the west coast, the graphite hearth kiln would replace the newer of the two kilns currently in use.

2 3

Introduction
• A common and important issue:
Introduction • Replacement or retention of an asset, process, or system.
• For identification, • Should it be replaced now or later?
• let PT identify the • When to replace it?
currently installed
pusher plate tunnel kiln
(defender)
• A replacement study is usually designed to first make the economic
• GH identify the decision to retain or replace now.
proposed new graphite
hearth kiln (challenger) • If the decision is to replace, the study is complete.
• Relevant estimates
follow in $ millions for
• If the decision is to retain, the cost estimates and decision can be revisited
monetary units. periodically to ensure that the decision to retain is still correct.

4 5
1. Basics of a replacement study 1. Basics of a replacement study
Possible sources of replacement study:
Terminology:
• Reduced performance
• Because of physical deterioration, the ability to perform at an expected level of reliability • Defender and challenger
(being available and performing correctly when needed) or productivity (performing at a • are the names for two mutually exclusive alternatives.
given level of quality and quantity) is not present.
• This usually results in increased costs of operation, higher scrap and rework costs, lost • The defender: the currently installed asset
sales, reduced quality, diminished safety, and larger maintenance expenses. • The challenger: the potential replacement.
• Altered requirements • A replacement study compares these two alternatives.
• New requirements of accuracy, speed, or other specifications cannot be met by the existing
equipment or system. • The challenger is the “best” challenger because it has been selected as the best one to
• Often the choice is between complete replacement or enhancement through retrofitting or possibly replace the defender.
augmentation. • Market value
• Obsolescence (lỗi thời)
• International competition and rapidly changing technology make currently used systems • The current value of the installed asset if it were sold or traded on the open market.
and assets perform acceptably but less productively than equipment coming available. • Also called trade-in value, this estimate is obtained from professional appraisers, resellers,
• The ever-decreasing development cycle time to bring new products to market is often the or liquidators familiar with the industry.
reason for premature replacement studies, that is, studies performed before the estimated
useful or economic life is reached.

6 7

1. Basics of a replacement study 1. Basics of a replacement study

Terminology:
Terminology: • Economic service life (ESL) for an alternative is the number of years at which the lowest AW of cost occurs.
• The equivalency calculations to determine ESL establish the life n for the best challenger and the lowest
• AW values cost life for the defender in a replacement study.
• are used as the primary economic measure of comparison between the defender • Defender first cost is the initial investment amount P used for the defender.
• The current market value (MV) is the correct estimate to use for P for the defender in a replacement
and challenger.
study.
• The term equivalent uniform annual cost (EUAC) may be used in lieu of AW • The estimated salvage value at the end of one year becomes the market value at the beginning of the
because often only costs are included in the evaluation; revenues generated by next year, provided the estimates remain correct as the years pass.
the defender or challenger are assumed to be equal. • It is incorrect to use the following as MV for the defender first cost:
• trade-in value that does not represent a fair market value, or the depreciated book value taken from
• Since EUAC calculations are exactly the same as for AW, we use the term AW. accounting records.
• All values will be negative when only costs are involved. • If the defender must be upgraded or augmented to make it equivalent to the challenger (in speed,
capacity, etc.), this cost is added to the MV to obtain the estimated defender first cost.
• Salvage or market value is an exception; it is a cash inflow and carries a plus sign.
• Challenger first cost is the amount of capital that must be recovered when replacing a defender with a
challenger.
• This amount is almost always equal to P, the first cost of the challenger.
8 9
1. Basics of a replacement study 1. Basics of a replacement study
Terminology: Terminology:
Two characteristics of replacement analysis: Sunk cost and Nonowner's viewpoints
• If an unrealistically high trade-in value is offered for the defender compared to its fair
• Sunk cost:
market value, the net cash flow required for the challenger is reduced, and this fact
• An amount of money that has been expended in the past and cannot be recovered now or in the
should be considered in the analysis.
future.
→The correct amount to recover and use in the economic analysis for the challenger is its • The replacement alternative for an asset, system, or process should not be burdened with this cost in
first cost minus the difference between the trade-in value (TIV) and market value (MV) any direct fashion; sunk costs should be handled in a realistic way using tax laws and write-off
of the defender. allowances.
• A sunk cost is the difference between an asset's book value (chapter 16) and its current market value.
P − (TIV − MV)
Ex: assume an asset costing $100,000 two years ago has a depreciated value of $80,000 on the
Ex: corporate books. It must be replaced prematurely due to rapidly advancing technology.
Assume an installed piece of equipment has a MV of $50,000; however, a TIV of $75,000 If the replacement alternative (challenger) has a first cost of $150,000, the $80,000 from the current
is offered provided a newer model (the challenger) is purchased for $300,000. asset is a sunk cost were the challenger purchased.
For the purposes of an economic analysis, it is incorrect to increase the challenger’s first cost to
→ The amount to recover is $275,000, if the challenger is acquired, based on the $230,000 or any number between this and $150,000.
difference of $25,000 between the TIV and MV estimates.

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1. Basics of a replacement study Summary

• The nonowner’s viewpoint: also called the outsider’s
viewpoint or consultant’s viewpoint, provides the greatest
objectivity in a replacement study.
• This viewpoint performs the analysis without bias; it means the analyst
owns neither the defender nor the challenger.
• Additionally, it assumes the services provided by the defender can be
purchased now by making an “initial investment” equal to the market
value of the defender.

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1. Basics of a replacement study Examples 11.1
• A replacement study is an application of the annual worth method
➔ the fundamental assumptions for a replacement study parallel
those of an AW analysis.
• If the planning horizon is unlimited, that is, a study period is not
specified, the assumptions are as follows:
1. The services provided are needed for the indefinite future.
2. The challenger is the best challenger available now and in the future to
replace the defender. When this challenger replaces the defender (now or
later), it can be repeated for succeeding life cycles.
3. Cost estimates for every life cycle of the defender and challenger will be
the same as in their first cycle.

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Examples 11.1 1.2 Economic Service Life

The economic service life (ESL) is the number of years n at

which the equivalent uniform annual worth (AW) of costs is the
minimum, considering the most current cost estimates over
Economic service life all possible years that the asset may provide
a needed service.

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1.2 Economic Service Life 1.2 Economic Service Life
• The ESL is also referred to as the economic life or minimum cost life. • The ESL is the n value for the smallest
• The ESL is determined by calculating the total AW of costs if the asset is in total AW of costs.
service 1 year, 2 years, 3 years, and so on, up to the last year the asset is
• The CR component of total AW
considered useful.
decreases, while the AOC component
• Total AW of costs is the sum of capital recovery (CR), which is the AW of the
increases:
initial investment and any salvage value, and the AW of the estimated annual
operating cost (AOC), • Decreasing cost of capital recovery.
• Increasing cost of AW of AOC.

Annual worth curves of cost elements that determine the economic

service life.
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1.2 Economic Service Life EXAMPLE 11.2

• The complete equation for total AW of costs over k years (k = 1, 2,
3, . . . ) is: A 3-year-old heavy-duty transport vehicle is being considered for early
replacement. Its current market value is $20,000. Estimated future market values
and annual operating costs for the next 5 years are given in Table 11–1, columns
2 and 3. What is the economic service life of this defender if the interest rate is
Where 10% per year? Solve by hand and by spreadsheet.

P = initial investment or current market value

Sk = salvage value or market value after k years
AOCj = annual operating cost for year j ( j = 1 to k)

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EXAMPLE 11.2 EXAMPLE 11.2

22 23

1.2 Economic Service Life 1.2 Economic Service Life

• When the expected life n is known and specified for the
Marginal costs (MC) are year-by-year estimates of the costs to own and operate an asset
challenger or defender, no ESL computations are necessary. for that year. Three components are added to determine the marginal cost:
• Cost of ownership (loss in market value is the best estimate of this cost)
• Determine the AW over n years, using the first cost or current • Forgone interest on the market value at the beginning of the year
market value, estimated salvage value after n years, and AOC • AOC for each year
The sum of the AW values of the first two of these components is the capital recovery
estimates. amount.

• This AW value is the correct one to use in the replacement study.

EXAMPLE 11.3 Keep or Replace the Kiln Case

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 11.4 Additional Considerations in a
11.3 Performing a Replacement Study Replacement Study

Three of additional aspects of a replacement study.

• Future-year replacement decisions at the time of the initial
replacement study
• Opportunity cost versus cash flow approaches to alternative
comparison
• Anticipation of improved future challengers

EXAMPLE 11.4 and EXAMPLE 11.5 26 27

11.5 Replacement Study over a Specified 11.5 Replacement Study over a Specified
Study Period Study Period
• The AW values for the challenger and for
the remaining life of the defender are not • Study period Capital recovery
based on the economic service life; the
When a study period shorter than the life of the challenger is defined,
AW is calculated over the study period
only. What happens to the alternatives the challenger’s capital recovery amount increases in order to
after the study period is not considered in recover the initial investment plus a return in this shortened time period.
the replacement analysis. Highly abbreviated study periods tend to disadvantage the challenger
• When the defender’s remaining life is because no consideration of time beyond the end of the study period is
shorter than the study period, the cost of made in calculating the challenger’s capital recovery amount.
providing the defender’s services from
the end of its expected remaining life to
the end of the study period must be
estimated as accurately as possible and
included in the replacement study
EXAMPLE 11.8

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11.6 Replacement Value
• If a realizable market value or trade-in of at least this amount Type Find/Given
Factor Notation
and Formula Relation
Sample Cash Flow
Diagram

canbe obtained, from an economic perspective the challenger Single

Amount
0
1 2 –1

should be selected immediately.

• This is a breakeven value between AWC and AWD; it is referred
0

1 2 –1

Uniform

to as the replacement value (RV). Set up the relation AWC =

Series

AW D with the market value for the defender identified as RV,

which is the unknown. The AWC is known, so RV can be Arithmetic
Gradient
0 1 2 3

determined.
2
( –1)

[ ( )]
Geometric

• If the actual market trade-in exceeds the breakeven

Gradient

replacement value, the challenger is the better alternative

and should replace the defender now.

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