Basic Cost Benefit Analysis for Assessing Local Public Projects

Barry P. Keating, Maryann O. Keating

• Publisher: Business Expert Press
• Year: 2013
• ISBN:
  9781606496374
• Topic: Economics
• Subtopic: Public Finance
• Index: Economics

CBA is an attempt to fully account for all costs associated with a new proposal along with a detailed calculation of specific private and public benefits. Properly employed, CBA is simply a method for assessing a proposal prior to a collective decision by calculating net benefits relative to an alternative project or the default option of doing nothing.

CHAPTER 1

An Introduction to Cost Benefit Analysis

The very need to weigh benefits against costs-the essence of economicsis evaded by the irresponsible exercise of arrogance.

Thomas Sowell

Chapter 1 Preview

When you have completed reading this chapter you will:

• see this book as a practical guide for decision-makers charged either with performing or interpreting basic cost benefit analysis (CBA);

• be aware of project proposals for which CBA is and is not an appropriate decision tool;

• know why government project assessment requires different tools than private project assessment;

• realize that objective decision making is based on considering foregone options, minimizing costs, and using scarce resources to produce what residents need and desire;

• be able to explain why CBA is a useful tool for determining net benefits based on the difference between discounted benefits and discounted costs;

• refer to available statistics for your particular local government unit;

• know how to discount future costs and benefits using a spreadsheet;

• realize that collective decision-making, with respect to a specific government proposal, ultimately depends on the choice of the voting public.

Introduction

It is a truth universally acknowledged that any project proposed to local government is in want of a good justification. In too many instances, only well-meaning intentions suffice. It is odd that public projects, in contrast to private corporate investments, are often devoid of simple decision making rules. There is a way, however, for local officials/residents to rank and evaluate modest public proposals without commissioning costly feasibility studies. In modified form, cost benefit analysis methodology has a role in ruling out egregious, unrealistic proposals.

Suppose that you were one of nine Common Council Members of a mid-sized town. The main business at the next Council meeting is to read for the second time a Bill forwarded to the Council for consideration and approval by the Mayor and the Community and Economic Development Committee. The Bill represents a plan to be implemented by the City, the nonprofit Northside Neighborhood Association, and a private for-profit corporation working together to develop the housing stock in a strategic area of the City. The goal is to improve the quality of present owner-occupied properties, to renovate viable homes for resale and as rentals, and to demolish vacant and abandoned structures.

The proposal requests that $9 million be allocated to the program in equal installments over the next 5 years. The source of funds would be City tax revenue, the State foreclosure prevention program, and Federal government’s block grants for community development and neighborhood stabilization. A total of 100 properties would be affected by the program. The City would retain ownership of 50 vacant and abandoned properties until sold on behalf of the City prior to the program completion in 10 years. Another 50 dwellings would be rehabilitated. Increased property values are expected to generate additional property taxes to finance infrastructure and policing throughout the City.

As a hypothetical Council member you are undecided on voting to approve the Mayor and Development Committee’s proposed Bill. Distressed by the number of decaying properties in town, you, nevertheless, act in trust for a District outside the targeted area. A quick calculation ($9 million divided by 100 properties) suggests that per property cost of $90,000 exceeds the average price of homes throughout the City. You are not an expert in law, finance, or construction, and there are so many variables to consider. What technique would allow you to get a handle on voting rationally in the present and long-term best interests of the City? Cost benefit analysis is an option, worthy of serious consideration.

Cost benefit analysis (CBA) is an exercise leading decision-makers to list and quantify in monetary terms all costs and benefits associated with a proposal. Assessing costs and benefits is resisted, understandably. It is emotionally difficult to accept that certain benefits, particularly the value of human life, be evaluated and quantified. In addition, we are legitimately cautious about any analysis that can be easily skewed in favor of personal interests. Yet, accountability requires public officials, as well as agency administrators, to deal with the question, “What value do residents receive in return for projects subsidized with taxpayer funds?”

Corporations, in maximizing profits, rely on benefits per dollar to differentiate between projects. Unfortunately, such tools do not translate well into the government sector. In the case of public goods and services, those who benefit do not necessarily purchase them, and those who finance them do not necessarily consume them. Generally, in both the nonprofit and government sectors, users do not pay fees covering the full cost of providing the goods and services offered.

Cost benefit analysis is an appropriate tool for estimating a project’s net direct and indirect benefits received regardless of who pays the bill or who receives the benefits. In assessing public project proposals, CBA attempts explicitly to account for external (public) effects in addition to personal (private) costs and benefits. External effects refer to those costs and benefits affecting third parties in addition to primary providers and beneficiaries. For example, students, the primary beneficiaries of publicly funded college education, generally are charged only a portion of university expenses with the remaining amount financed by alumni funded endowments (for private universities) and state revenue (for public universities).

In this book, we reserve the term CBA to government financed projects, but elsewhere this method is referred to as “social cost benefit analysis”. We prefer the simple term “cost benefit analysis (CBA)” and use it both in reference to infrastructure-type projects such as highways as well as those dealing with social concerns such as housing, education, and health.

Federal agencies are required, but struggle with mandates, to provide a cost-benefit analysis for all proposals above a certain cost. If large Federal bureaucracies struggle with it, how can we argue here for CBA’s applicability in assessing modest local government projects? If CBA is such an appropriate tool, why is it so seldom applied? The answer to both questions is that CBA is based on economic theory that is sometimes difficult to understand and even more difficult to operationalize; undoubtedly it is easier to make decisions based on emotions and political expediency. In essence, we repeat, CBA is simply a standardized method to fully account for all costs associated with a new proposal along with a detailed calculation of specific private and public benefits. Properly employed, CBA determines whether or not a proposal should be considered and attempts to calculate net benefits relative to an alternative project or the default option of doing nothing.

Government guidelines are essential for CBA but, at this point, are still in the developmental stage. Excellent CBA guidelines are found in governmental handbooks and in reports that have been contracted out to corporate consultants. At present, these handbooks and reports (listed in the “Suggestions for Further Reading” section in this book) are good reference sources, but fail in providing a level of transferable standards accessible to those engaged in local government decision making.

We call attention to the gap between high church CBA, so to speak, and the need, on the other hand, for rudimentary CBA required by local officials to self-assess local projects. CBA is often out-sourced to professional consultants, raising costs and eliminating its use for all but mega-projects. We maintain that there is a role for making CBA accessible and understandable to those, appraising small scale public projects, who possess undergraduate levels of numerical and economic proficiency. Then, case studies, for similar projects in comparable communities, can be replicated and modified to gain CBA expertise.

As CBA techniques and additional data become available, the cost of performing CBA should fall. Statistical packages, spreadsheets, and data bases are more accessible to local officials and ordinary residents than at any previous time. The CBA method should be presented as one tool among others to effectively combine computational tools and available data to assess any proposed intervention involving tax revenue.

When CBA Is an Appropriate Tool

CBA provides helpful advice for decisions involving infrastructure in government buildings, roads, public housing, sewage, and water treatment as well as for programs dealing with public safety, education, health, leisure, welfare reform, employment, and child protection. CBA is also used in assessing regulatory impact. In other words, CBA is useful in considering the potential impact of any project that changes the prevailing use of a community’s scarce resources currently available to both the public and private sectors. The benefits and costs of any project impacts all members of the community for whom the decision-makers act in trust.

It is essential not to attribute to CBA functions exceeding its capability. CBA, particularly on a local level, is an inappropriate tool for analyzing income distributional goals, the incidence of various taxes, or in addressing questions associated with property or personal rights. It does not, for example, help in assigning the degree of entitlements to certain levels of health care or education.¹

The CBA Decision Rule

At all levels of complexity, CBA reduces to the simple diagram presented in Figure 1.1, An Overview of Cost Benefit Analysis. Figure 1.1 shows that the minimal acceptance criterion for any proposal is that the value of net benefits be greater than zero. Net benefits are equal to the present value of benefits minus the present value of costs.

Figure 1.1. An overview of Cost Benefit Analysis. Minimal acceptance criterion for any proposed intervention is that the present value of net benefits, equal to the present value of benefits minus the present value of costs, be greater than zero.

The framework for CBA is a straightforward calculation of net benefits expected from implementing a proposal. Each proposal has a specific time horizon and addresses the costs and benefits defined in terms of the constituency for which the decision maker has fiduciary responsibility. The base line in considering whether or not to accept a proposal is the default option of doing nothing. The concept of present value is presented in a tutorial in the Appendix. In subsequent Chapters, we proceed with the task of quantifying public and private costs and benefits. We begin here by examining the roots of CBA within economic theory.

CBA and Economic Efficiency

Because this book deals with the assessment of relatively small local projects, we can legitimately ignore the complexities of economic growth models and macroeconomic stabilization. On the other hand, an intuitive microeconomic understanding of opportunity costs and economic efficiency is essential for CBA. Ironically, there is no analytical distinction between benefits and costs. A benefit is a net gain that accrues either in a monetary form or in a well-being to any individual included in the relevant group. Opportunity costs are simply benefits foregone in some other activity by using resources required for the proposed project in some alternate way.² Consider the hypothetical City project, previously discussed, to rehabilitate, over 10 years, 100 properties at a cost of $9 million. This cost represents x number of miles of that will not be resurfaced or $9 million in private consumption forfeited throughout the country. CBA compares this $9 million cost, representing lost opportunities, with the monetary value of expected benefits resulting from the rehabilitated properties.

Rational local decision-making starts with assuming that there are mutual values/goals held in common by residents and a means to reconcile conflicts through voting and democratic processes.³ We take this legal framework for local government as given. CBA, then, is a means for ensuring that an area’s limited resources are not wasted or squandered. Consequently, economic efficiency lies at the crux of CBA, as indicated by the following three assumptions.

First, every accepted proposal has an opportunity cost, measured in units of local currency adjusted for inflation. Funds expended represent the value of a community’s scarce resources; the funds used to pay those building a new government financed park, for example, could be used to pay those building bridges or making athletic shoes or mobile devices. Those limited and valuable inputs, presently employed in producing various private and public goods, would be reallocated to any project being appraised.

Second, any good or service provided locally must consider cost effectiveness. Consider a worthy goal, such as the preservation of historic buildings. CBA along with a related methodology, cost effectiveness, can uncover excessively high marginal costs for restoring and preserving, for example, certain decrepit structures deemed to have historical value. Such proposals can then be rejected and alternatives considered on the grounds of cost-effectiveness with respect to the overall benefits to residents of preserving a community’s history. This does not preclude private individuals’, with a great appreciation for antiquities, expending enormous private resources on preservation.

Finally, CBA takes as a given that at this time and place there is an optimal limit to the production of any good, public or private, based on the public’s willingness to pay. A particular community, for example, may express a willingness (measured in terms of attendance or entrance fees) to publicly subsidize one or two historical structures in center city, but not eight or ten.

Aside from its own operational expenses, government spending may be classified as either allocative or distributive. Allocative activities involve shifting resources between the private and public sectors of the economy or within the pu...

Table of contents

• Cover
• Half Title
• Title Page
• Copyright
• Abstract
• Contents
• Chapter 1 An Introduction to Cost Benefit Analysis
• Chapter 2 Cost Benefit Analysis and Individual Preferences
• Chapter 3 Time Preference and the Discount Rate
• Chapter 4 Measuring Costs and Benefits
• Chapter 5 Shadow Pricing
• Chapter 6 Potential Pitfalls in Cost Benefit Analysis
• Chapter 7 Introducing Cost Benefit Analysis to the Non-Specialist
• Chapter 8 Cost Benefit Analysis of Proposed New Regulations
• Chapter 9 Case Study: Contracting Versus a Municipal Animal Control Shelter
• Chapter 10 Case Study: Cost Benefit Analysis for a Forty Acre Industrial Park Intended to Spawn Economic Development and Jobs
• Chapter 11 Case Study: Establishing a Recreational Program for the Disabled
• Appendix
• Notes
• References
• Index
• Ad Page
• Backcover