Project Cost and

Benefits

Nalini Ranjan Kumar

CIFE, Mumbai
 Costs

 Any expenditure incurred during the

production of a good or service to get the
output into the hands of the customer
 The customer could be the public (the final
consumer) or another business
 Controlling costs is essential to business
success
 Identification of costs
Project costs: Value of the resources in
maintaining and operating the projects Ex.
Physical goods, land, labour, debt service,
taxes etc.
Primary costs or direct costs: cost incurred in
construction, maintenance, and execution of
the projects.
Indirect costs or secondary costs: Value of
goods and services incurred in providing
indirect benefits from the projects .Ex.
Houses, schools, hospitals, etc.
 Identification of costs
Real costs and nominal costs: costs at current
market prices are nominal costs, whereas if costs are
deflated by general price index are termed as real
costs.

Social cost: cost due to technological externalities

and technological spill over accrued to the society
due to the presence of projects i.e. pollution
problems, health hazards, salinity conditions etc.

Replacement costs: the cost for replacing the

assets/capital goods of lower life span than that of
project.
 Benefits of projects

 Benefit in projects are either by increased value of

production or from reduced costs.
 Increased production:
 Quality improvement
 Change in time of sale
 Change in location of sale
 Change in product form
 Improvement in packing etc.
 Benefits of projects

 Reduction in cost:
 Improvement in transport facility
 Reduction in post harvest losses
 Better marketing strategies of produce and
purchase of inputs
 Intangible costs and Benefits

 Intangible Benefits: Improved health

resulting from better diet, better income
distribution, and better regional balance,
etc.
 Intangible Costs: Loss of productive
environment or treasured scenic beauty,
increase in soil and water pollution,
increase in unemployment
 Secondary benefits and costs

 Value added by aquaculture in the region

 Value added is the payment to individuals
for labour, managements, the use of real
property and capital and risk taking. Such
payments are in the form of wages,
salaries, rent, interest, depreciation and
profit.
 Cost: Like increase in salinity/ acidity in soil
due to aquaculture which require use of
lime/gypsum for correcting the soil pH.
 Valuation of inputs and outputs

Marginal value product (MVP): It is the extra revenue that

comes from increasing the use of inputs by one unit.
MVP=MPP×Price
Opportunity cost: The opportunity cost of capital is the
expected return forgone by bypassing of other potential
investment activities for a given capital It is a rate of return
that investors could earn in financial markets.

The consideration of opportunity costs is one of the key
differences between the concepts of economic cost and
accounting cost. Assessing opportunity costs is
fundamental to assessing the true cost of any course of
action.
 Example A person who invests Rs.10,000 in a stocks
denies herself or himself the interest that could have
accrued by leaving the Rs10,000 in a bank account
instead. The opportunity cost of the decision to invest in
stock is the value of the interest.
 Mutually exclusive events: two events are said to be
mutually exclusive if they cannot occur at the same time
(i.e., they have no common outcomes). The best example
is tossing a coin, which can result in either heads or tails,
but not both. Both outcomes can't happen simultaneously.
 Shadow Price: The value used in economic analysis for a
cost or a benefit in a project when the market price is felt
to be a poor estimates of Economic value. Synonym to
accounting price.
Determining prices

1.Pricing of Farm produce

Point of first sale/Farm gate price
2.Pricing of Farm Inputs
Purchase price
Market price
3.Pricing of Intermediate Goods
 Financial Analysis

 Objectives
 Assessment of financial impact
 Judgment of efficient resources use
 Assessment of incentives
 Provision of sound financial plan
 Co-ordination of financial contribution
 Assessment of financial management
competence
 Economic Analysis

 Objectives :
 Economic efficiency: like water charges
for canal projects
 Income distribution
 Public saving
 Farm families incremental net benefit
 Increase Net income of firm/farm:
 Maximize the national income
 Maximise the national welfare
 Comparison of Economic and Financial
Analysis
1. In economic analysis taxes and subsidies are treated as
transfer payments. The new income generated by a project
includes any taxes the project can bear during production and
any sales taxes buyers are willing to pay when they purchase
the project's product.
1. In financial analysis such adjustments are normally
unnecessary; taxes are usually treated as a cost and
subsidies as a return.
2. In financial analysis market prices are normally used. These
take into account taxes and subsidies.
1. In economic analysis, however, some market prices may
be changed so that they more accurately reflect social or
economic values.These adjusted prices are called
"shadow" or "accounting" prices.
2. In both financial and economic analysis projected prices
are used, so both rely to a substantial extent on what are,
in effect, hypothetical prices.
Economic and Financial Analysis
3. In economic analysis, interest on capital is never
separated and deducted from the gross return because it
is part of the total return to the capital available to the
society as a whole and because it is that total return,
including interest, that economic analysis is designed to
estimate.
1.In financial analysis, interest paid to external suppliers
of money may be deducted to derive the benefit stream
available to the owners of capital. But interest imputed
or "paid" to the entity from whose point of view the
financial analysis is being done is not treated as a cost
because the interest is part of the total return to the
equity capital contributed by the entity.
2.The methodology of comparing costs and benefits is the
same for either an economic or a financial measurement
of project worth, but what is defined as a cost and what
is considered a benefit are different.
 Important Concepts

1) Benefit minus 2) Cost

- marginal benefit - marginal cost
- total benefit - total cost

=
3) Net benefits
- marginal net benefit
- total net benefit

!!! An efficient allocation maximizes !!!

Total Net Benefit
 Recent Developments
Total economic value = Use value + Intrinsic value

Use value = Actual use value + Option value + Quasi-

option value

Option value = Value in potential use by self + Value in

potential use by others + Value in potential use by
future individuals

Quasi-option value = Value of avoiding irreversibilities

in the light of expected future knowledge

Intrinsic value = Existence value

 Existence Value
Existence value is unrelated to any actual or
potential use
Existence value may be related to sympathy,
or stewardship; as such, existence values
do not fit into neo-classical economics
Existence value may also be related to
"spiritual consumption", and then it does fit
Existence value is not right-based, as rights
are absolute, and values relative
 Cost-Benefit Analysis (CBA)
by 'Cost-Benefit Analysis' we mean the social appraisal of
investment projects (to appraise investments that
correct for market failure).

CBA and Environment:

1) benefits in the form of the provision of goods and

services that have environmental impacts (e.g.,
damming a river in a wilderness area; i.e. negative
environmental effects)

2) projects with beneficial environmental impacts (sewage

treatment plant; i.e. positive environmental effects)
 CBA
CBA should be used for policies and projects, which unfold
over time and be assessed by calculating a Net Present
Value (NPV), or a Benefit-Cost Ratio (BCR).

4 informational inputs:

1. time horizon

2. benefit schedule

3. cost schedule

4. discount rate
 Present Value Concept
Time Value of Money Concept: = a rupee today is worth
more than a rupee tomorrow

why:
* uncertainty: the future is unknown, will you be around
to spend the rupee.
* inflation: erodes the buying power of a rupee
* utility gain from consumption today versus future
consumption,
* investment opportunities: invest today, earn interest,
and have more than a rupee to spend in the future.

Basic idea is to get the present value of some future

payment to be received at time t.
 Present Value Concept
Discounting: = process to obtain the present value of future
Euro amounts:
 1 
PV FV *   where
 1  r t 
 
PV = present value, FV = future value, r = discount rate, and t
is the number of periods into the future.

0 t
time

present value future value

Rupees

idea of discounting
 Present Value Concept
Nominal versus Real: = nominal refers to the Euro value in
current terms (not discounted), whereas real refers to
the dollar value discounted to some base Euro value
(discounted values).

Discount Rate: indicates how you value present

consumption (utility) versus future consumption (utility)

- the higher the discount rate the more you value

present consumption relative to future consumption

- the lower the discount rate the more you value future
consumption relative to present consumption.
 Cost-Benefit Analysis (CBA)
In any CBA, several stages must be conducted (Hanley and
Spash, 1993):

1) Definition of the Project

2) Identification of the Project Impacts
3) Which Impacts are Economically Relevant?
4) Physical Quantification of Relevant Impacts
5) Monetary Valuation of Relevant Effects
6) Discounting of Cost and Benefit Flows
7) Applying the Net Present Value Test
8) Sensitivity Analysis
 Cost-Benefit Analysis (CBA)
Private appraisal T
NRt NPV>
1) The net present value test NPV  0
1  r 
t
0

2) The internal rate of return test T

0 
NRt
IRR=0
1  x 
t
0

Social appraisal
1) Utility based appraisal
Problems: - no general agreed social welfare function
- interpersonal utility comparison are admissible
- utilities are not observable

2) Consumption based appraisal

T
NBt
NPV 
1  r 
t
0
 Cost-Benefit Analysis (CBA)
 NPV test is a potential compensation test => is concerned
with allocative efficiency (select projects that move the
economy toward an efficient allocation of its resources).

 The proper time horizon for the appraisal of a project is

the date at which its impacts cease, not the date at which
it ceases to serve the purpose for which it was intended.
e.g., for a nuclear fission plant the time horizon is not the
40 years to the time when it ceases to generate electricity
but the time over which it is necessary to devote
resources to storing the plant's waste products - 100s of
years.
 Choice of discount rate
The Present Values of 100 Euros arising from 25 to 200 years
ahead at discount rates from 2 -8 %
time horizon in years
discount rate 25 50 100 200
2 60.95 37.15 13.80 1.91
4 37.51 14.07 1.98 0.04
6 23.30 5.43 0.29 0.0009
8 14.60 2.13 0.05 0.00002

=> need for judgements

however, there is universal agreement among economists such that the

real rates should be taken not nominal rates in CBA.
 Environmental Cost-Benefit Analysis
T
NBt
NPV 
1  r 
t
0

T
Bt  Ct T
Bt T
Ct
NPV    
1  r  1  r  1  r 
t t t
0 0 0

Bd  Cd
where Bd/Cd is the discounted of benefit/cost stream over the
project lifetime. NPV ignores environmental impacts => NPV'.
NPV Bd  Cd  EC  NPV '  EC EC = environmental cost

NPV ' Bd  Cd  EC ECBA decision rule!!!

 Environmental Cost-Benefit Analysis
EC = UV + EV + OV +QOV
UV = Use Value and arises from the actual and/or planned use
of the service by an individual, for recreation for example;
EV = Existence Value and arises from knowledge that the
service exists and will continue to exist, independently of any
actual or prospective use by the individual;
OV = Option Value and relates to willingness to pay to
guarantee the availability of the service for future use by the
individual;
QOV = Quasi-Option Value and relates to willingness to pay to
avoid an irreversible commitment to development now, given
the expectation of future growth in knowledge relevant to the
implications of development.
 Direct Benefit Estimation
In private CBA it it usually relatively easy to perform because
prices are readily observed.

Often this is not the case (no price exist) or prices are socially
biased due to externality, public good, or market power
considerations.

This problem is particularly apparent for non-use values which

tend to be more intangible.

intangible = cannot be valued

if intangibles remain in our analysis, then NPV and BCR are

incomplete.

So, what can we do when prices and demand information is

absent or is clearly biased?
 Alternative Approaches
1. Contingent Valuation
- use surveys that ask
- widely applicable

2. Travel-Cost Method
- obtain a demand curve by examining how participation
varies with the cost of getting there.
- primarily useful for recreation benefits.

3. Property value and Wage differentials (hedonic prices)

- statistically investigate how these prices vary with
property of job conditions
- more limited application possibilities than for CV.
 Indirect (Secondary) Benefits
= Ripple effects due to economic linkages

We have all heard public projects and policies being touted for
their employment and income generating effects.

In a full employment economy, however, these inputs were

necessarily reallocated away from other productive uses.

!! Do not count secondary effects in a full employment

economy!!

also no transfer payments should be included, e.g,

unemployment payments
 Overall Appraisal of CBA
Cons:
- intangibles
- BC analysts and information sources are often biased
- distributional Issues occasionally objectionable
* weighs same period impacts equally
* weighs future impacts less

Pros:
- help prevent bad decisions which would otherwise be
undiscovered
- counters rent-seeking (which might normally be
successful in the political process).
 Analytical Styles other than CBA
Cost Effectiveness Analysis
- = try to achieve a non-economic target at least cost
- often practical when there is an intangible physical quantity in
need of enhancement; if it was tangible, we could just use CBA.

Impact Analysis
- usually employed in lieu of or as a complement to CBA because
either
* there are many intangible impacts of the policy/project
and they need to be described, or
* the impacts are tangible but not allowed into CBA (such
as secondary economic impacts)

Multi Criteria Analysis

 CBA Example
Someone has proposed a 4-period pollution control project
that will cost EUR 100.000 to construct in the initial
period. After that, the project will cost EUR 10.000 to
operate in each following period. After the construction
is completed, the benefits of this project will be EUR
40.000 in the first period, EUR 45.000 in the second, and
EUR 50.000 in the last period. The facility is expected to
be non-functional for any future periods. There are no
intangibles to be considered for this project.

Calculate Net Present Value (NPV), and Benefit-Cost Ration

(BCR) using a discount rate of 5%.
 CBA- Example
r = 5%
Bt Ct NBt
t Bt Ct NBt
1  r  1  r  1  r 
t t t

0 0 100 -100
1 40 10 30

2 45 10 35

3 50 10 40
totals

NPV = ???
BCR = ???