Estimation of Project Costs and Benefits Ohn Myint ADFD/WB Project Preparation and Appraisal Workshop Abu Dhabi, April 2010
Overview • Project Objectives and Components • Project Costs • Project Benefits • Project Justification-Cost-Benefit Analysis, etc. • Linkages to lending and fiduciary issues 2
I. Project Objective (s) Define • PDO in relation to cost and benefit analysis • PDO defines why a project is needed • The project is a means to achieve the PDO • Cost/benefit analysis determines which among alternative projects have acceptable returns(and for whom) • Analysis also reviews with and without project cases • Quantification of activities in valuation for the project –COSTS • Quantification of achievements by the project-BENEFITS • Cost is anything that reduces an Objective, and Benefit is anything that contributes to an Objective
Project Components and Costs • Means for achieving the PDO are defined by activities to be undertaken in a project • Activities of a similar nature are grouped together in themes and the group of such activities are called a “component” • Each and every quantifiable activity is enumerated as an accounted cost • A non-quantifiable activity is enumerated as a lump sum cost
II. Project Costs Direct Cost Estimates, Unit Rate Analysis, Lump Sum Provision, Optimization • Direct cost estimates are prepared using Unit Rate Analysis and the quantity involved in a particular activity of a component. • Unit Rate Analysis is done by using the principle of output and outturn capacity of machines or labor. (Chart.1) • If unit rate analysis cannot be used, lump sum provision is used; lump sum is usually experience-based • The final project activity and the quantities adopted are usually derived from the “optimum” variant of design
Optimum Option (outcome) of a Project • The optimum option does not always mean maximized “returns” to investment • Farmers may choose a traditional variety of rice over HYV rice because of taste preference • For private businesses, firms or public corporations, a major objective is to maximize net income at less risk • For public projects, due to policy and social reasons, a transport corporation may run a bus service in a less populated area • The project should be the best mix of policy, social, environment and economics (National Planning Policy)
Project Period and Schedule • A detailed project cost estimate is prepared in this way for each component of the project. • The project cost estimates are then spread out over the entire project period, in what is called a “schedule” • The project period depends on an annual capacity of work force and investment (example of cost estimate and scheduling(chart 2) • Some typical cases of project costing estimates are shown in the next slide.
Concept of “before” and “after” and “with” and “without”(cases) chart 3
Types of Costs: Direct and Indirect, Transfer Payments, Debt Service • Most of the costs of a project are for goods or material, labor or services, land, taxes and duties. • Many of these costs are directly measurable, or called “direct costs”, at least at the time of feasibility study. • We assume no modifications or changes in the design or in the adopted data and assumptions (flow data, foundation etc.) • The base cost estimate also assumes that there would be no relative changes in domestic and international prices and no inflation during the investment project period.
Transfer Payments and Debt Service (Cont’d.) • The project costs may also directly or indirectly include duties and tariffs and also debt service (interests and principal payment). Taxes and tariffs are considered as transfer payments. • Transfer payments are important in financial analysis (for society), but not in economic analysis. • This is also true for debt service, which is not considered in economic analysis. • Both types of these indirect costs are considered as a transfer within the economy of the “country”.
Base Costs and Contingencies • A longer term project includes “operation and replacement costs” in the valuation of the project. • Contingencies: Due to the relatively long period of the project and conditions of base data used in design, it would be unrealistic to exclude provisions for possible adverse changes in physical conditions or prices that would alter the base cost estimate. • Base Cost only applies to the design of the project at appraisal; in reality all costs at the present time of consideration (inherently) include allowances for physical and price contingencies and are termed Total Costs.
Contingencies (Cont’d.) • The physical contingency is decided by the project designers who know the level of project details. • A price contingency includes two categories; • one for relative changes in price • the other for general inflation (domestically and foreign). • The physical contingency and relative price changes reduce the real extent of project activities and are therefore included in real costs.
Contingencies (Contd.) • However, inflation poses a different problem and is complex. • In project analysis, the most common method for dealing with inflation is to use constant prices, on the assumption that all prices will be affected equally by any rise in the general price level at different times. This allows valid comparisons among alternatives. • The price contingency for inflation would not be included in project evaluation and analysis other than in the financing plan of the project.
Cost-Benefit Compilation by Using Computer (Database) Programs • The project cost compilation, taking into account of the above-mentioned factors, is quite complex and systematically compiled in a database program called COSTAB (originally designed at the WB) • Complexity is exacerbated by the need to compile costs by procurement category and expenditures (for different users) • COSTAB is now available for public use at the Asian Development Bank (Chart 4www.adb.org/Projects/costab.asp and on the World Bank website www.worldbank.org/html/opr/costab/contents
Definition of COSTAB & FARMOD COSTAB is designed to prepare, organize and analyze project costs. It produces standardized tables that show the costs of each project component, as well as costs attributable to the specific categories of expenditure of which the project or components are composed. COSTAB estimates total costs with and without physical or price contingencies, computes the operation and maintenance costs of capital goods and estimates the foreign exchange components of costs. It also allows for conversion of costs from financial to economic terms and for changes in exchange rate assumptions. FARMOD: The data are then incorporated in the economic evaluation of the project using the computer programs & displays.
Feasibility Level Costing---- Examples • Some examples of feasibility level costing completed by the COSTAB program in a project are shown. (Handout 4) • Two sets of cost tables showing Financial Costs and Economic Costs of a project are shown below for visualization. (Uzbekistan-Ferghana Valley Water Resources Management Project) • Detailed component-wise costs as well as compiled total costs of the project can be obtained from: • Chart 5- FWRMP-Costables NEG.zip (Chart 5 , 10 files) • Chart 6- FWRMP-NegoEconomicCosts.zip (Chart 6 -5 files)
III. Project Benefits Benefits are “tangible” and “intangible.” • Tangible: include increased production (quantity), increases in quantifiable objectives, measurable expectations, quality improvements, time scale improvements, improvement in location, reduction in costs for production or transportation, losses avoided etc. • Secondary benefits – outside the project and taken into accountonly for economic analysis but not in financial analysis.
Tangible and Intangible Benefits (Cont’d.) • Intangible benefits: include employment opportunity, health, education, social benefits, some political benefits etc. Difficult for valuation and disputable due to surrounding factors. • Projects generating only or primarily intangible (nature) benefits are also modified to “least-cost analysis” type. • Projects of such kind call for special attention, team tries in the best way to indirectly quantify, even though valuation is impossible (i.e. public safety)
Time Scale Influence on Benefit Projections • Benefits usually occur in the later part or after the implementation period of project. The time value of money in this case accounts for benefits as in costs, (i.e. inflation) (ex. Chart 7 officially published) • In cases of traded commodities involved in projects, two types are considered • --domestically-traded and internationally-traded • If prices within a country are distorted, financial and economic prices are used for commodities (Chart 8-Fin.&Eco. -price determination of commodities)
Benefit Projections (Cont’d.) • Benefits are also optimized in different ways • Deriving optimum benefits also depends on market prices and the law of diminishing returns • Prices: Import parity prices are used for some internationally-traded commodities • Because of the time value of money, the earlier the tangible benefits are realized, the better is the case for the project.
Other Benefits, Sunk Costs, Foregone Values • Not all, but most benefits are time sensitive; some benefits of rare occurrence are based on the probability of incidence. • Other (inherent) benefits: Sunk costs are past costs that cannot be retrieved as a residual value from an earlier investment (not opportunity costs) and are not included in the analysis. • Rehabilitation projects are one example.
Other Benefits (Cont’d.) • Negative benefits include foregone values (land, swapping resources development). Foregone values are considered in the analysis. • Some examples are Farm Gate prices and Farm Budget Analysis (Chart 8 Ferghana Valley WRMP) • This type of analysis is essential for all non-homogeneous entities (i.e. diversified crops, tradable and non-tradable goods) that produce production for the project and account for its benefits.
IV- Project Justification – Cost-Benefit Analysis Some Terms and Definitions: Opportunity Cost (OC) of capital, labor, goods. The OC of capital is indicated by what banks are willing to pay in “interest” to increase the future value/worth based on the present reduced principal. The OC of labor also likewise depends on the economic value of labor in the prevailing market. As for goods, tradable and non-tradable goods were discussed earlier and their value is determined in “market prices.” (Time Value of Money Slide) Why Cost/Benefit Analysis? When cost and benefit streams have been worked out, there needs to be some way to evaluate projects that will last several years. The team must also be able to evaluate across projects which have different cost and benefit streams.
Some History of Benefit-Cost Analysis The idea of this economic accounting originated with Jules Dupuit, a French engineer whose 1848 article is still worth reading. Later, the British economist, Alfred Marshall, formulated some of the concepts that are at the foundation of BCA. But the practical development of BCA came as a result of the impetus provided by the Federal Navigation Act of 1936, USA. This Act required that the U.S. Corps of Engineers carry out projects for the improvement of the waterway system when the total benefits of a project to whomever they accrue,exceeded the costs of that project. Thus, the Corps of Engineers had to create systematic methods for measuring such benefits and costs. The engineers of the Corps did this without much, if any, assistance from the economics profession. It wasn't until about twenty years later in the 1950's that economists tried to provide a rigorous, consistent set of methods for measuring benefits and costs and deciding whether a project is worthwhile. Some technical issues of BCA have not been wholly resolved even now, but the fundamentals are well established.
Cost/Benefit Analysis (Cont’d) Both cost and benefit streams should be based on data that enables the team to evaluate projects of different sizes. Evaluation could be done without discounting in the case of short-lived economic projects. Discounting methods can be used for determining (i) Cost-Benefit Ratios; (ii) Internal Rates of Return and (iii) Net Present Value or Worth. This can be used for financial or economic analysis. Not all projects are decided by monetary return values alone See - Time/Money dependent or not
Time Value of Money As the folk wisdom of people throughout the ages has recognized, present values are better than the same values in the future; earlier returns to investments are better than later. Thus, undiscounted measures of project worth should include a time dimension in evaluation through the use of a discounting factor, which will reduce future benefits and costs to their Present Worth/Value-PV.
Discounting Factors and Some Definitions • Some discussion on interest rate and discounting factor determination are: Definitions of some important factors (Chart 9) and Discount Table (Chart 10) • The Internal Rate of Return (economic and financial analysis) is the rate at which the Net PW/V = 0 and Net PW/V = PV of Costs – PV of Benefits • Financial Analysis of Cost-Benefit (for whom and when used) • Economic Analysis of Cost-Benefit (for whom and when used) • The Net Present Worth/Value at the OC of capital is also a gauge (positive or negative) or measure for project justification.
Foreign Exchange Premium & Standard Conversion Factor • When people pay a premium on traded goods over what they pay for non-traded goods, the Foreign Exchange Premium (FEP) is necessary to know, as it is not properly reflected when the official exchange rate is used for converting to local currency value. • In economic analysis, all costs and benefits are valued on the basis of opportunity costs or willingness to pay (economists usually forecast) • More information on traded and non-traded commodities, Foreign Exchange Premium –FEP (Shadow Rate –Chart 11 determination) and Standard Conversion Factor
Standard Conversion Factor (Cont’d.) Conversion can be done by multiplying the Foreign Exchange Cost (FEC) by (1+FEP) to get a shadow exchange adjusted price; not optimal method. Alternatively, a non-traded item price can be reduced by “Standard Conversion Factor - SCF” which is the ratio of the official exchange (OER) to shadow exchange rate (SER) or by taking OER x (1+FEP) = SER or 1/(1+FEP) = SCF which is always less than 1. All financial prices for local currency components are multiplied by SCF to get to economic prices
Other Analysis Sensitivity Analysis: Determines the robustness of the project under uncertain future conditions for a long-term project Investment Effects and Balance of Payments: Determines the project impact on the Borrower’s budget (making use of the discounting table and POP) CostRecovery: Determines how much Borrower will pay ( making use of the discounting table to calculate how much to pay)
Indirect Justification of Projects • Least cost principle – Definitely beneficial investment but difficult to quantify the benefits • Alternative use principles • Other justification methods (social, environmental, including long term effects) • Cost-Benefit analysis in social projects already discussed (see also Chart 12).
V. Effects on Lending and Fiduciary Issues • In procurement (packaging, BOQ, pre- and post- reviews, thresholds) the unit rate is used in rate based contracts • Financial management relates to investment scheduling • Progress reporting and evaluation – relates to the possibility of achieving estimated benefits and then linking them to the PDO • Safeguard issues (social, environmental, others) address what happens across and within interventions using results of Benefit-Cost analysis. • PIP-POP is usually prepared by project implementation agencies (using base costs including physical contingencies) • The Project Appraisal Document (PAD) is prepared by lending agencies (includes forecast for financial contingencies)
Eight Principles of Cost-Benefit Analysis One of the problems of BCA is that the computation of many components of costs and benefits is intuitively obvious, but there are others for which intuition fails to suggest methods of measurement. The following eight basic principles can help as a guide to Cost Benefit Analysis (CBA). • There Must Be a Common Unit of Measurement and Time • CBA Valuations Should Represent Consumer or Producer Valuations As Revealed by Their Actual Behavior • Benefits Are Usually Measured by Market Choices • The Analysis of a Project Should Involve a With Versus Without Comparison • Some Measurements of Benefits Require the Valuation of Human Life • Cost Benefit Analysis Involves a Particular Study Area (Society or Country) • Double Counting of Benefits or Costs Must be Avoided • Decision Criteria for Projects (relate to PDO)