PPA 502 – Program Evaluation Lecture 7 – Benefit-cost Analysis in Program Evaluation

Benefit-cost and Cost-effectiveness Analysis Benefit-cost analysis is an applied branch of economics that attempts to assess service programs by determining whether the total societal welfare has increased (in aggregate more people have been made better off) because of the project or program. Steps. Determine the benefits of a proposed or existing program and place a dollar value on those benefits. Calculate the total costs of the program. Compare the benefits and costs.

Benefit-cost and Cost-effectiveness Analysis Simple steps pose real challenge, especially estimating intangible benefits. Procedure still useful in uncovering assumptions and estimating value of intangibles.

Benefit-cost and Cost-effectiveness Analysis The major costing alternative to benefit-cost analysis. Relates the cost of a given alternative to specific measures of program objectives. For example, dollar per life saved on various highway safety programs. Often the first step in a benefit-cost analysis. Especially useful if analyst cannot quantify benefits, but has fairly specific program objectives. Key problem: situation where there are multiple benefits. Results often very subjective. 2nd key problem: does not produce a bottom line number.

Benefit-cost and Cost-effectiveness Analysis A private sector analogy. Benefit-cost analysis similar to financial analysis in private sector. Should the firm have done the project at all, i.e., Is the project producing a satisfactory rate of return? Public version: is the program a success, i.e., Has it improved social welfare? What other options are there for the use of the firm’s resources? Public version: should the program be continued when weighed against alternative uses for the government’s funds.

Benefit-cost and Cost-effectiveness Analysis A private sector analogy. Benefits and costs do not occur simultaneously in either private or public sector. R&D costs, marketing, capital investment, training. Government not priced, thus benefits are more broadly defined. Alternative uses of resources (opportunity costs).

Benefit-cost and Cost-effectiveness Analysis Benefit-cost illustration. Costs Year R & D Capital O & M Total Benefits 1 $1500 $2000 $0 $3500 2 500 2000 4500 3500 3 2500 5500 4 3000 5000 6500 5 8500 Totals $10000 $11000 $23000 $24000 Benefit-Costs Present Value, Benefits-Costs (10%) ($3500) (1000) (909) 1000 826 1500 1127 2049 $1000 ($407) Net Present Value @ 10% ($407) Net Present Value @ 5% 219

Benefit-cost and Cost-effectiveness Analysis Formula for net present value. Formula sensitive to choice of rate of return. Could also use return on investment. Discount rate that would make the present value zero.

Benefit-cost and Cost-effectiveness Analysis Continuing or not continuing the project. Costs Year R & D Capital O & M Total Benefits 6 $500 $400 $4500 $5400 $9000 7 400 5000 5400 8500 8 6000 6400 9 7500 7900 8000 10 8400 Totals $2000 $31000 $33500 $41500 Benefit-Costs Present Value, Benefits-Costs (10%) $3600 3600 3100 2818 2100 1736 100 75 (900) (615) $8000 $7614 Net Present Value @ 10% $7614 Net Present Value @ 5% $7803

Benefit-cost and Cost-effectiveness Analysis Total versus marginal benefits and costs. When considering the overall profitability of a project, an agency will consider the total costs involved in getting the project started through its operation’s cycle. But at any point in time, when an agency is continuing or discontinuing a project or program, it only considers the marginal costs or benefits. Definitions. Marginal cost: incremental cost of producing one more unit of output. Marginal benefit: incremental benefit of that one unit of output. Public sector usually does not do it on the basis of a single unit, but what are the benefits being generated now versus the costs now?

Benefit-cost and Cost-effectiveness Analysis Public-private sector differences and similarities. Similarities – alternative uses for funds, one-time costs, recurring costs, land, labor, capital. Differences. Distributional considerations. Spillovers.

Framework for Analysis Benefit Indicator Measure Dollar value Assumptions Real Direct Tangible Intangible Indirect Cost Transfers

Framework for Analysis Real benefits and costs versus transfers. Real: net gains and losses to society. Transfers: merely alter the distribution of resources in society.

Framework for Analysis Direct and indirect benefits and costs. Direct costs and benefits are closely related to the primary objectives of the project. Direct costs – personnel, facilities, equipment, material, project administration. Indirect costs and benefits are byproducts, multipliers, spillovers, or investment effects. Indirect costs are unintended costs that result from government action. Indirect benefits might include benefits of space exploration.

Framework for Analysis Tangible and intangible benefits and costs. Tangible benefits and costs can be converted readily into dollar figures. Intangible benefits and costs are those things that cannot be directly assigned an explicit price. Determining the geographic scope of analysis. Spillover effects may determine true geographic jurisdiction.

Framework for Analysis (Agricultural Dam Example) Real Benefits Nature of Benefit/Cost Direct Tangible Increased farm output New supply of water Intangible Maintaining family farms Indirect Reduced soil erosion Preservation of rural society Real Costs Construction material, labor, operations and maintenance, direct program supervision by agency Loss of recreational value of land or river Administrative overhead of government Diversion of water and its effects Increased salinity Loss of wilderness area Transfers Relative improvement of profit for farm implement industry General taxpayers may be subsidizing farmers.

Measuring Benefits Evaluation problem difficult for government because of multiple benefits and intangibles.

Measuring Benefits Sources of data. Existing records and statistics kept by agency. Feedback from clients. Ratings by trained observers. Experience of other governments or private or nonprofit corporations. Special data gathering. Whenever possible analyst should use market value or willingness to pay.

Measuring Benefits Valuing benefits. Cost savings. Time saved. Lives saved. Increased productivity or wages. Recreational benefits. Land values. Alternatives to market prices.

Measuring Costs Cost categories. One-time, fixed, or up-front costs. Ongoing investment costs. Recurring costs. Compliance costs. Mitigation measures.

Measuring Costs Valuing indirect costs. Flat overhead figure. Does the project actually costs increased administrative burden? Costs to the private sector. Valuing the use of capital. Valuing the damage effects of government programs. Other cost issues. Sunk costs. Interest costs.

Analysis of Benefits and Costs Framework. Retrospective. Snapshot. Prospective.

Analysis of Benefits and Costs Importance of using present value. Choice of an appropriate discount rate. Private sector rate. Low social discount rate. Long-term treasury bill rates. Adjustment for inflation.

Analysis of Benefits and Costs Presenting the results. Net present value (B-C). Benefit cost ratio (B/C). Return on investment (discount rate to reduce present value to zero). Appropriate perspective. Costs and benefits vary across stakeholders. May conduct analyses from several perspectives.

Analysis of Benefits and Costs Sensitivity analysis. Use spreadsheet analysis to vary the assumptions. Intangibles. Relate intangibles to dollar results: if there are net costs, do the intangible benefits overcome the deficit? Particular problems. Equity concerns (weighting of values). Multiple causation and co-production problems.