BES 125 ENGINEERING ECONOMICS

LESSON 9: BENEFIT/COST ANALYSIS

and Public Sector Economics
Prof.Jessica Maria Paz S. Casimiro, CE, EnP,DiSDS

Homework No. 6 is included inside.

Introduction
The benefit/cost analysis is used primarily to evaluate alternatives in the
public sector. When one is comparing mutually exclusive alternatives,
the incremental B/C ratio must be greater than or equal to 1.0 for the
incremental equivalent total cost to be economically justified. The PW, AW,
or FW of the initial costs and estimated benefits can be used to perform an
incremental B/C analysis.
For independent projects, no incremental B/C analysis is necessary. All
projects with B/C ≥ 1.0 are selected provided there is no budget
limitation.
Cost effectiveness analysis combines cost estimates and non-monetary
effectiveness measure to evaluate independent or mutually exclusive
projects using procedures that are similar to ROR and B/C Analysis.
Some potential ethical challenges in the public sector for engineers, elected
officials and government consultants are presented.
 Objectives
1. To explain the fundamental differences between private and
public sector projects.
2. Calculate the benefit/cost ratio and use it to evaluate a single
project.
3. Select the better of two or more alternatives using the
incremental B/C ratio method.
4. Use cost-effectiveness analysis to evaluate (CEA) to evaluate
projects.
5. Present ethical challenges in the public sector for engineers.
 Private sector vs. public sector
 private sector project – a product, syste, or services are
offered by corporations and businesses for use by individual
customers and clients, the government or other companies.
 Some investments are large, but more medium to small
 life estimates range from 2-25 years
 revenues contribute to profits; costs are estimated
 funding may come from stocks, bonds, loans or from individual
owners
 higher interest rate based on cost of capital
 alternative selection criteria is primarily based on Rate of
Return (ROR)
 Evaluation is primarily based on the economic environment
 the disbenefits are commonly ignored
Public Sector
 public sector project – a product, service, or system used,
financed, and owned by the citizens of any government level. The
primary purpose is to provide service to the citizenry for the
public good at no profit.
 investments are large
 longer life estimates of 30-50+ years
 no profit; costs, benefits and disbenefits are estimated
 Funding is derived from taxes, fees, bonds, or private funds
 lower interest rate that private sector projects
 uses multiple criteria in the selection of alternative
 the evaluation environment is often politically inclined
 project delivery is through Public Private partnership (PPP)
Read page 234-234)
 Benefit/cost analysis of a single project
𝐵 𝑃𝑊 𝑜𝑓 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝐴𝑊 𝑜𝑓 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 𝐹𝑊 𝑜𝑓 𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠
𝐶
= 𝑃𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠
= 𝐴𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠
= 𝐴𝑊 𝑜𝑓 𝑐𝑜𝑠𝑡𝑠

Conventional B/C:
𝒃𝒆𝒏𝒆𝒇𝒊𝒕𝒔 −𝒅𝒊𝒔𝒃𝒆𝒏𝒆𝒇𝒊𝒕𝒔
B/C=
𝒄𝒐𝒔𝒕𝒔

The decision guide:

If 𝐵/𝐶 ≥ 1.0, accept the project as economically justified for the
estimate and discount rate applied;
If B/C < 1.0, the project is not economically acceptable.

Profitability Index, PI (for private sector alternative)

𝑃𝑊 𝑜𝑓 𝑁𝐶𝐹
𝑃𝐼 =
𝑃𝑊 𝑜𝑓 𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
 Modified B/C ratio
𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑑𝑖𝑠𝑏𝑒𝑛𝑒𝑓𝑖𝑡𝑠 − 𝑀&𝑂
𝐵/𝐶 =
𝑖𝑛𝑖𝑡𝑖𝑎𝑙 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡

 All amounts are expressed in PW or AW or FW.

 A modified B/C can change the magnitude of the ratio but
not the decision outcome.
 Before calculating the B/C ratio by any formula, check
whether the alternative with the larger AW or PW of costs
also yields a larger AW or PW of benefits.
Incremental B/C
(please read pages 238-252)

Selection guideline:
∆𝐵
If 𝐶 ≥ 1.0, choose the higher-cost alternative, because its extra cost is
economically justified.
∆𝐵
If < 1.0, choose the lower-cost alternative.
𝐶

 When the B/C ratio is determined for the lower-cost alternative, it is a

comparison with the do-nothing (DN) alternative.
 If B/C <1.0, then DN should be selected and compared to the second
alternative.
 If neither alternatives has an acceptable B/C value and one of the alternatives
does not have to be selected, the DN alternative must be selected. In public
sector analysis, the DN alternative is usually the current condition.
 incremental B/C requires equal-service comparison of alternatives.
Steps for Incremental B/C:
1. Determine the total costs for both alternative (PW, AW, or
FW).
2. Order the alternatives by equivalent total cost: first smaller,
then larger. Calculate the incremental cost (ΔC) for the larger-
cost alternative. This is the denominator in ΔB/C.
3. Calculate the equivalent total benefits and any disbenefits
estimated for both alternatives. Calculate the incremental
benefits (ΔB) for the larger cost alternative. This is Δ(B-D) if
disbenefits are considered.
4. Calculate the ΔB/C ratio.
5. Use the selection guide decide the outcome.
 Example 1: B/C Analysis
From the following estimates, determine the feasibility for a project
that has a 20-year life. Use an interest rate of 8% per year.
Consequences to the People Consequences to the Government
Annual Benefits $ 90,000 per year First Cost $ 750,000
Annual Disbenefits $ 10,000 per year Annual cost $ 50,000 per year
Annual savings $30,000 per year

Using the AW analytical tool, we calculate the AW equivalent of the First

Cost as: AW=750,000(A/P,8%,20)
AW=750,000(0.10185)
AW=76,388 per year
B 90,000 − 10,000
= = 0.83
C 50,000 + 76,388 − 30,000

The project is not economically feasible since B/C <1.0.

 Example 2: Two-alternative comparison

9.36. A project to control flooding from rare, but sometimes heavy

rainfalls in the arid southwest will have the cash flows shown below.
Determine which project should be selected on the basis of a B/C
analysis at i=8% per year and a 20-year study period.
Sanitary Sewers Open Channels
First cost, $ 26 million 53 million
M&O cost, $ per year 400,000 30,000
Homeowner cleanup costs, $ per year 60,000 0

Interpretation:
The Open Channel alternative is the design to be justified. The AW
equivalent of all costs will be utilized. Benefits will consist of the
savings generated due to the selection of the Open Channel design. This
is a form of implied benefits based on usage cost estimates.
Calculation:
The Open Channel design has the higher-cost alternative, it
must be incrementally justified against the sanitary sewers
design:
AWOC = 53,000,000(A/P,8%,20) = 5,398,050
AWSS = 26,000,000(A/P,8%,20) = 2,648,100
∆𝐶 = 5,398,050 − 2,648,100 = 2,749,950
Benefit: annual savings generated due to Open Channel design
∆𝐵 460,000−30,000
= = 0.16 < 1.0
𝐶 2,749,950

Decision: Select Sanitary Sewers.

 Example 3: Unequal Life Alternatives:
Two mutually exclusive alternative public-works projects are under
consideration and cash flows are shown below. If the MARR is 9% per year,
which, if either, of this projects should be selected? The effect of inflation is
negligible.
Project I Project II
Capital investment, $ $750,000 $625,000
Annual M&O, $ per year 120,000 110,000
Annual Benefit 245,000 230,000
Useful life of project 35 25

Solution:
The AW method is appropriate for unequal life comparison. The higher-
cost alternative which is Project I will be compared to Project II. The
incremental B/C will determine whether the additional cost is justified.
AWI =750,000(A/P, 9%,35)+120,000 = 190,977
AWII = 625,000(A/P,9%,25)+110,000= 173,629
 Project I Project II
Capital investment, $ $750,000 $625,000
Annual M&O, $ per year 120,000 110,000
Annual Benefit 245,000 230,000
Useful life of project 35 25

Interpretation:
The AW method is appropriate for unequal life comparison. The higher-cost
alternative which is Project I will be compared to Project II. The incremental B/C
will determine whether the additional cost is justified. One project must be
selected.
Calculation:
AWI =750,000(A/P, 9%,35)+120,000 = 190,977
AWII = 625,000(A/P,9%,25)+110,000= 173,629
∆𝐵 245,000 − 230,000 15,000
= = = 0.86 < 1.0
𝐶 190,977 − 173,629 17,348
Decision:
The lower-cost alternative Project II should be selected.
Alternate solution: B/C analysis
Project I Project II
Capital investment, $ $750,000 $625,000
Annual M&O, $ per year 120,000 110,000
Annual Benefit 245,000 230,000
Useful life of project 35 25

Analysis:
Calculation:
Both projects have B/C ratios greater than 1
Project I
245,000
and are therefore economically justified
B/C = 190,977 = 1.28 since B/C for both are greater than 1 but
Project II Project II has higher B/C.
230,000 However, the additional cost of Project I is
B/C=173,629 = 1.32
not economically justified.
Decision:
Select Project II.
 Incremental B/C: Multiple alternatives
Steps:
1. Determine the equivalent total cost for all alternatives: Use PW, AW or FW
equivalencies.
2. Order the alternatives - smallest to largest.
3. Determine the total benefits ( and any disbenefits estimated) for each alternative.
4. Direct benefits estimation only: Calculate B/C for the first ordered alternative. If B/C
< 1.0, eliminated it. By comparing each alternative to DN in order, we eliminate all
that have B/C < 1.0. The lowest-cost alternative with B/C ≥ 1.0 becomes the
defender and the next higher cost alternative is the challenger in the next step. (For
analysis in the spreadsheet, determine the B/C for all alternatives and retain only
acceptable ones.
5. Calculate incremental cost (∆𝐶) and benefits ∆𝐵 using the relations:
(∆𝐶) = challenger cost – defender cost
∆𝐵 = challenger benefits – defender benefits
6. Calculate the ∆𝐵/𝐶 for the first challenger compared to the defender. If ∆𝐵/𝐶 ≥
1.0, the challenger becomes the defender and the previous defender is eliminated.
Conversely, if ∆𝐵/𝐶 <1.0, remove the challenger and the defender remains against
the next challenger.
7. Repeat Steps 5 and 6 until only one alternative remains. It is the selected on.
Incremental B/C (∆𝐵/𝐶)
 There are two types of benefits- direct benefits, and implied
benefits based on usage cost estimates.
 If alternatives are unacceptable, the DN alternative is the choice.
 All costs are considered positive in B/C calculations.
 The terms defender and challenger alternative are used in this
procedure, as in ROR analysis.
 If relative usage cost are estimated for each alternative, rather
than direct benefits, ∆𝐵 may be found using the relation:

∆𝑩 = 𝒅𝒆𝒇𝒆𝒏𝒅𝒆𝒓 𝒖𝒔𝒂𝒈𝒆 𝒄𝒐𝒔𝒕 − 𝒄𝒉𝒂𝒍𝒍𝒆𝒏𝒈𝒆𝒓 𝒖𝒔𝒂𝒈𝒆 𝒄𝒐𝒔𝒕

(See previous Example 2 (9.36))

 Example 4: ∆𝐵/𝐶
9.40/256:
Determine which one should be undertaken is they are (a)
independent and (b) mutually exclusive.
Alternative A B C D E F
PW of 80 50 72 43 89 81
capital, $
PW of 70 55 76 52 85 84
Benefits, $

Step 1: Calculate B/C and eliminate <1.0

B/C 0.875 1.10 1.06 1.21 0.96 1.04

(a) If alternatives are independent, D,B,C,F are selected.

Step 2: Order the remaining alternatives from smallest total
cost to highest: D, B, C, F.
Alternative D B C F
PW of capital, $ 43 50 72 81
PW of Benefits, $ 52 55 76 84

Step 3: Calculate incremental costs (∆𝐶) and benefits (∆𝐵):

∆𝐵 55−52 3
Defender D, Challenger B : = = = 0.4 < 1.0 eliminate B, retain D
𝐶 50−43 7

∆𝐵 76−52 24
Defender D, Challenger C: = = = 0.83 < 1.0 eliminate C, retain D
𝐶 72−43 29

∆𝐵 84−52 32
Defender D, Challenger F: = = = 0.84 < 1.0 eliminate F, retain D
𝐶 81−43 38

(b)Mutually exclusive: only one alternative is selected

Decision : Select D
Cost Effectiveness Analysis (CEA)
An evaluation method that combines monetary cost estimates
with nonmonetary benefit estimates is cost-effectiveness
analysis. Cost Effectiveness ratio (CER) is used to rank
projects and select the best of independent projects or mutually
exclusive alternatives:
𝑒𝑞𝑢𝑖𝑣𝑎𝑙𝑒𝑛𝑡 𝑡𝑜𝑡𝑎𝑙 𝑐𝑜𝑠𝑡𝑠 𝐶
CER = 𝑡𝑜𝑡𝑎𝑙 𝑜𝑓 𝑒𝑓𝑓𝑒𝑐𝑡𝑖𝑣𝑒𝑛𝑒𝑠𝑠 𝑚𝑒𝑎𝑠𝑢𝑟𝑒 = 𝐸

 Like ROR and B/C analyses, the CEA requires the ordering (ranking) of
alternatives prior to selection and the use of incremental analysis for
mutually exclusive alternative selection.
Steps for Cost-effectiveness analysis
(CEA)
1. Determine the equivalent total costs C and effectiveness
measure E, and calculate CER measure for each project.
2. Order projects from the smallest to the largest CER value.
3. Determine the cumulative cost for each project and
compare with the budget limit b.
4. The selection criterion is to fund all projects such that b is
not exceeded.
Example 5. Cost-effectiveness analysis

9.48/257
The cost in $/year and effectiveness measure in items salvaged
per year for four mutually exclusive service sector alternatives
have been collected as shown. (a) Calculate the CER for each
alternative. (b) Use the CER to identify the best alternative.
Step 1 Step 2
Cost C, Salvaged
Alternative CER Rank
$/year Items/year , E
W 355 20 17.75 3rd
X 208 17 12.23 2nd
Y 660 41 16.09 Highest
Z 102 7 14.57 Lowest
Step 3
Ethical Challenges in the Public
Sector
The results of the B/C or CEA analysis are routinely depended upon by
public officials and staff members to assist in making public planning
decisions.
Three of the foundation elements upon which engineers should use their
recommendations to decision-makers.
1. Impartiality
2. Consideration for wide range of circumstances.
3. Use of realistic assumptions.

This implies that engineers in public service avoid:

1. Self-serving, often greedy individuals and clients with goals of
excessive profits and future contract awards;
2. Using a politically favorable perspective
3. Narrowly-defined assumptions that serve special interest groups and
subcommittees
Areas with Ethical Challenges for
Engineers (read explanation in page 250)

1. Policy planning – development of strategy

2. Public planning – development of projects

Circumstances that pose ethical dilemma:

1. Use of technology
2. Scope of study
3. Negative community impact
Homework No. 6
Reference: Blank and Tarquin, 2015, pages 252-259
9.28
9.39
9.41
9.42
9.47
9.50

Note: You are expected to come up with a UNIQUE solution to the above problems. This
can only be done if you work independently. Compare your answer with those in the
Solution Manual. If you copied from the manual, your solution will not be unique, of
course!