Demand Forecasting

.
 . Definition.
․ An estimate of future demand.

․ A forecast can be determined by mathematical means using

from
historical, it can be created subjectively by using estimates
both
informal sources, or it can represent a combinationof
techniques.

-2-
Need

• To reduce uncertainty.
• To anticipate inventory and capacity demands.
• To project costs of operations.
• To improve competitiveness
• To improve productivity by decreasing costs
• To improve delivery and
• To be responsive to customer needs.
Methods of Forecasting

Qualitative Techniques.

• Based on expert or informed opinion

• Information is intuitive and based on subjective judgment.
• Techniques include collecting information from customer groups,
experts, think tanks, research groups, etc.
Time Series Analysis

• ․ It is based on the idea that data relating to past demand can

be used to predict future demand. Past data may include trend,
seasonal, or cyclical influences
Market Research
• Market research is used mostly for looking new product ideas, like
and dislikes about existing products, competitiveness of the
existing products etc.

Panel Consensus
• Based on the idea that two heads are better than
• A panel of people from a variety of positions develop forecast
• Panel forecasts are developed through open meetings with free
exchange of idea from all levels of management and individuals.
Delphi Method

• The Delphi method hides the identity of the persons participating

in the forecasting. Every person has the same weight.
• A moderater produces a questionnaire and hand out it to
participants. Their answers are summed up and given back to the
whole group along with a new set of questions.
Quantitative Methods: Regression Analysis

It is a method of fitting an equation to

a data set.
Simple regression involves
one independent variable and
one dependent variable.
Least squares is the most common method of regression.
Quantitative Methods : Moving Average
• An arithmetic average of of the most recent observations.
• As each new observation is added, the old observation is discarded.
• The value ofn (the number of periods used to calculate average)
reflects responsiveness versus firmness.
Moving Average Method
Weighted Moving Average

• Simple moving average gives equal weight to each component, a

weighted moving average allows any weights to be placed on each
element, provided, the sum of all weights is equal to one
Exponential Smoothing.

• A forecasting techniques in which past observations are geometrically

discounted according to their age. The heaviest weight is assigned to the
most recent data.

• The techniques makes use of a smoothing constant to apply the difference

between the most recent forecast and the critical sales data.
Ft =α A t – 1 +( 1 - α) F t - 1
where
Ft = New forecast.
A t -1 = Latest demand.
F t -1 = Previous forecast.
α = Smoothing factor. (0 ≤α ≤ 1)
What is the break-even point? What is a break-even analysis?

Break-even point usually means the business volume that balances total costs with total gains. At
break-even volume, in other words, total cash inflows equal total cash outflows. At Break-Even, in other
words, net cash flow equals zero.

Business people calculate break-even to answer questions like these:

 How many product units must we sell to Break-Even?
 At what unit sales volume do we earn a profit?

Break-even analysis

Break-even analysis attempts to find break-even volume by analyzing relationships between fixed and
variable costs on the one hand, and business volume, pricing, and net cash flow on the other.
Understanding how these factors impact each other is crucial in budgeting, production planning, and profit
forecasting, and break-even analysis, is central to this understanding.
In the simple Break-Even analysis, the Break-Even Point is the quantity (unit volume) that balances total costs with total gains for a net
cash flow of 0.

The essential components of simple break-even analysis include:

 Cash inflows (or revenues).
 Fixed costs.
 Variable costs.

Cash Inflows

The simple analysis assumes that each unit brings the same cash inflow. For sellers, cash inflow per unit
is the same as the selling price per unit.

Fixed Costs

Fixed costs remain constant regardless of unit volume. For example, if the floor space expenses,
manager's salaries, and janitorial services do not change with unit volume, the total for these items is the
fixed cost.

Variable Costs

These costs vary in direct proportion to quantity sold or unit volume. Variable costs for selling goods, for
instance, might include the "direct cost" the seller pays to acquire each unit. As a result, the total variable
cost cost per unit multiplied by the unit volume.
 Within each call volume range (e.g., 201-300), operator cost is fixed.
 Across all ranges (0 - 300), operator cost is semi-variable.

Break-Even Point as Unit Volume

In business, the break-even point usually means the unit volume that balances total costs with total
gains. For the analyst, Break-Even is the quantity Q for which cash outflows equal cash inflows, exactly.
At the break-even quantity, therefore, net cash flow equals zero.

Break-Even Point as a Time Span

Note that business people also refer to a similar but different concept, the break-even point in time,
or payback period. Payback period is the time necessary for investment returns to cover investment
costs. Payback analysis does not consider units, but instead the timing of cash inflows and outflows. For
more on the break-even point in time, see Payback period.

Break-even points for Business Startup

Business people starting a new business need especially to understand both kinds of break-even points
(break-even time and break-even unit volume). They must understand both because startups typically
lose money for a while before becoming profitable. There is a limit, however, to the time owners can
tolerate losses. Before launching a new business, therefore, they have a keen interest in knowing the
break-even business volume. The new firm turns profitable only when business volume exceeds "break-
even volume." A decision to launch the business may depend on the owners' view of the time and
expense required to reach that volume.

Breakeven analysis is performed to determine the value of a variable of a project that makes

two elements equal, e.g. sales volume that will equate revenues and costs.

Single Project

The analysis is based on the relationship:

Profit = revenue – total cost

= R – TC

At breakeven, there is no profit or loss, hence,

revenue = total cost

or, R = TC

Note: It is to be noted that +ve sign is used for both the revenue and the costs. If we are to use

–ve sign for costs and +ve sign for revenue, then the above relationships become:

Profit = R + TC and R + TC = 0 at breakeven.

With revenue and costs given in terms of a decision variable, the solution yields the

breakeven quantity for the decision variable.

Costs, which may be linear or non-linear, usually include two components:

Fixed costs (FC) – Includes costs such as buildings, insurance, fixed overhead, equipment

capital recovery, etc. These costs are essentially constant for all values of the decision
variable.

Variable costs (VC) – Includes costs such as direct labour, materials, contractors, marketing,

advertisement, etc. These costs change linearly or non-linearly with the decision variable, e.g.

production level, workforce size, etc. For the analysis to be followed here, the variation will

generally be assumed to be linear.

Then, total cost, TC = FC + VC

Revenue also changes with the decision variable. Again, for the analysis, the variation will

generally be assumed to be linear.

The following diagram illustrates the basics of the breakeven analysis.

Revenue, R

Revenue Total Cost, TC

or

Cost VC

FC

QBE, Breakeven quantity

Production, Q units/year

It can be seen that we have profit if the production level is above the breakeven quantity and

loss if it is below.
Examples:

1. The fixed costs at Company X are $1 million annually. The main product has revenue of

$8.90 per unit and $4.50 variable cost. (a) Determine the breakeven quantity per year, and (b)

Annual profit if 200000 units are sold.

Let QBE be the breakeven quantity.

8.9QBE = 1,000,000 + 4.5QBE

QBE = 1,000,000/(8.90-4.50) = 227,272 units

(b) Profit = R – TC

= 8.90Q – 1,000,000 - 4.5Q

At 200,000 units: Profit = 8.90(200,000) – 1,000,000 - 4.50(200,000)

= $-120,000 (loss)

2. A product currently sells for $12 per unit. The variable costs are $4 per unit, and 10,000

units are sold annually and a profit of $30,000 is realized per year. A new design will increase

the variable costs by %20 and Fixed Costs by %10 but sales will increase to 12,000 units per

year. (a) At what selling price do we break even, and (b) If the selling price is to be kept same

($12/unit) what will the annual profit be?

Profit = revenue – costs

30000 = 10000(12) – [10000(4) + FC] FC = fixed costs

FC = 50000

(a) New variable cost = $4(1.2) = $4.8 per unit.

New fixed costs = 50000(1.1) = $55000

Let x = breakeven selling price per unit, then

12000x = 55000 + 12000(4.8)

or, x = $9.38/unit

(b) Profit = 12000(12) – 12000(4.8) - 55000

= $31400

3. A defense contractor has been able to summarize its total annual fixed costs as $100,000

and the total variable cost per unit of production as $33. (a) If only 5000 units is all that is

expected to sell to the government this year what should the per unit selling price be to make

a %25 profit this year? (b) If foreign sales of 3000 units per year is to be added to the 5000

units government contract above and a %25 profit is acceptable for this contractor again,

what could be the new selling price per unit?

a) Total costs = 100000 + 5000(33)

= 265000

% profit = 100(revenue – cost)/cost

Therefore, 25 = 100(revenue – 265000)/265000

or, revenue = 265000(1.25) = 331250

Selling price = 331250/5000

= $66.25 / unit.

b) Total cost = 100000 + 8000(33) = 364000

Revenue for 25% profit = 364000(1.25) = 455000

New selling price = 455000/8000

= $56.875 per unit.

Calculate the sales required to earn a profit of Rs. 4,50,000 for the following data.

Fixed Expenses = Rs. 90,000

Variable Cost per unit:

Direct Material = Rs. 5

Direct Labour = Rs. 2

Direct Overheads = 100% of Direct Labour

Selling Price per unit = Rs. 12.

Ballancee Sheeet
The bala ance sheet reports a coompany's asssets, liabilitiies, and stoc
ckholders' eequity as of a moment
in time. ((The other three financial statemennts report am mounts for a period
p me such as a year,
of tim
quarter, month, etc..) The balan nce sheet is also known as the statement of finanncial position and it
reflects the accountiing equation:
Ass
sets = Liabiliities + Stock
kholders' Equity.

Bankerss will look att the balanc

ce sheet to d
determine th
he amount of
o a companny's working g capital,
which iss the amou unt of curren nt assets m
minus the amount of current liabiliities. They will also
review tthe assets and
a the liabiilities and co
ompare thesse amounts to the amoount of stockkholders'
equity.

Balance Sheet Claassification

ns

Typically, companie
es issue a cllassified bala
ance sheet. This means that the am
mounts are
presenteed according to the follo
owing classiifications:

Descrip
ptions of th
he balance sheet
s classiifications
The follo
owing are brief descriptions of the cclassification
ns usually fo
ound on a coompany's ba
alance
sheet.

Currentt assets
Generally, current assets
a includde cash andd other assets that are expected
e to tturn to cash within
one yeaar of the date e of the balaance sheet. Examples of o current assets are cassh and cash
equivaleents, short-teerm investm ments, accou unts receivable, inventory and prepaaid expense es.
Investm
ments
This cla
assification iss the first of the noncurrrent or long--term assets s. Included aare long-termm
investm
ments in othe er companies s, the cash ssurrender va alue of life in
nsurance, boond sinking funds,
real esta
ate held for sale, and ca ash that is re
estricted for construction n of plant annd equipmen nt.
Propertyy, plant and equipment
This cattegory of noncurrent ass sets include
es the cost of
o land, buildings, machinnery, equipm ment,
furniture, fixtures, and vehicles used in the operations of a business. Except for land, these
assets will be depreciated over their useful lives.
Intangible assets
Intangible assets include goodwill, trademarks, patents, copyrights and other non-physical assets
that were acquired at a cost. The amount reported is their cost to acquire minus any amortization
or write-down due to impairment. Valuable trademarks and logos that were developed by a
company through years of advertising are not reported because they were not purchased from
another person or company.
Other assets
This category often includes costs that have been paid but are being expensed over a period
greater than one year. Examples include bond issue costs and certain deferred income taxes.
Current liabilities
Current liabilities are obligations of a company that are payable within one year of the date of the
balance sheet (and will require the use of a current asset or will be replaced with another current
liability).
Current liabilities include loans payable that will be due within one year of the balance sheet
date, the current portion of long-term debt, accounts payable, income taxes payable and
liabilities for accrued expenses.

Noncurrent liabilities
These are also referred to as long-term liabilities. In other words, these obligations will not be
due within one year of the balance sheet date. Examples include portions of automobile loans,
portions of mortgage loans, bonds payable, and deferred income taxes.
Stockholders' equity
This section of the balance sheet consists of the following major sections:
 Paid-in capital (the amounts paid by investors when the original shares of a corporation were
issued)
 Retained earnings (the earnings of the corporation since it began minus the amounts that were
distributed in the form of dividends to the stockholders)
 Treasury stock (a subtraction that represents the amount paid to repurchase the corporation's own
stock)

Income Statement
The income statement is also known as the statement of operations, the profit and loss statement,
or P&L. It presents a company's revenues, expenses, gains, losses and net income for a
specified period of time such as a year, quarter, month, 13 weeks, etc.

Income Statement Formats

There are two formats for presenting a company's income statement:

Multiple-step Single-step
Multiple-step income statement
Note that in the following multi-step income statement, there are three subtractions:
1. The first subtraction results in the subtotal gross profit.
2. The second subtraction results in the subtotal operating income.
 3. The third subbtraction prov
vides the botttom line net in
ncome.

Single-sttep income statement

s
In the siingle-step fo
ormat, the in
ncome statemment will ha ave only one subtractionn—all of the
expense es (both ope erating and non-operatin
n ng) are subttracted from all of the reevenues (botth
operatinng and non-o operating). In this forma
at, there is no subtotal fo
or gross prof
ofit or operating
income.. The bottom m line, net income, resullts from a sinngle subtrac
ction (a singlle step) as shown
s
here:

Types off Ratios

Liquidityy ratios • Efficiency ratios • Solvency ratios

liquidityy ratios

Liquidityy ratios meassure your company’s abi lity to cover its expensess. The two mmost common n
liquidityy ratios are th
he current ra
atio and the quick ratio. Both are bassed on balan ce sheet item
ms.

Current Ratio

The currrent ratio is a reflection of

o financial s trength. It iss the numberr of times a ccompany’s current
assets exxceed its currrent liabilitie
es, which is aan indication ency of the bbusiness. Here is the
n of the solve
formula to compute the current ratio: Curre nt Ratio = To otal current assets
a / Totaal current liab
bilities
he earlier balance sheet data
Using th d for the ffictional From m the Roots Up Companny, we can co ompute
the com
mpany’s curreent ratio

the adeq
quacy of a cuurrent ratio will
w depend oon the naturre of the business and th e character of the
current assets and current liabilities. There iss usually verry little uncerrtainty aboutt the amoun
nt of
hat are due, but
debts th b there can n be consideerable doubt about the quality of acccounts receivvable or
the cash value of inventory. That’s why a safety margin is needed. A current ratio can be improved
by increasing current assets or by decreasing current liabilities

Quick Ratio

The quick ratio is also called the “acid test” ratio. That’s because the quick ratio looks only at a
company’s most liquid assets and compares them to current liabilities. The quick ratio tests whether
a business can meet its obligations even if adverse conditions occur. Here is the formula for the
quick ratio: Quick Ratio = (Total Current Assets ‐ Total Inventory) / Total Current Liabilities Assets
considered to be “quick” assets include cash, stocks and bonds, and accounts receivable. In other
words, all of the current assets on the balance sheet except inventory.

Operating ratios

There are many types of ratios you can use to measure the efficiency of your company’s operations.
These “efficiency ratios” utilize data from both the Balance Sheet and the Profit & Loss Statement.
The eight ratios we will cover are: • Inventory Turnover Ratio • • Accounts Receivable Turnover
Ratio • Accounts Payable Turnover •Return on Assets

Inventory Turnover Ratio

The Inventory Turnover Ratio measures the number of times inventory “turned over” or was
converted to sales during a time period. It may also be called the Cost of Sales to Inventory Ratio. It
is a good indication of purchasing and production efficiency. In general, the higher the ratio, the
more frequently the inventory turned over. You might expect a company with a perishable
inventory, such as a grocery store, to have a very high Inventory Turnover Ratio. Conversely, a
furniture store might have a low Inventory Turnover Ratio. To calculate the ratio we use the formula:
Inventory Turnover Ratio = Cost of Goods Sold / Total Inventory

Accounts Receivable Turnover Ratio

The Accounts Receivable Turnover Ratio measures the number of time accounts receivable turned
over during a time period. A higher ratio indicates a shorter time between making a sale and
collecting the cash. The ratio is based on Net Sales and Net Accounts Receivable. Remember, Net
Sales equals Sales less any allowances for returns or discounts. Net Accounts Receivable equals
Accounts Receivable less any adjustments for bad debts. To calculate the ratio we use the formula:
Accounts Receivable Turnover Ratio = Net Sales / Net Accounts Receivable

Accounts Payable Turnover Ratio

The Accounts Payable Turnover Ratio measures the number of time Accounts Payable turned over
during a time period. Much like our previous turnover ratios, you want to understand how long your
Accounts Payable are on your books. This is important as Accounts Payable are a “source of cash.”
There is a balance between paying your suppliers within the terms they grant you and maximizing
the use of the cash in your business. To calculate the Accounts Payable Turnover Ratio we use the
formula: Accounts Payable Turnover Ratio = Cost of Goods Sold / Inventory

Return on Assets Ratio

The Return on Assets Ratio is the relationship between the profits of your company and your total
assets. It is a measure of how effectively you utilized your company’s assets to make a profit. It is a
common ratio used to compare how well you performed in relationship to your peers in your
industry. To calculate the Return on Assets Ratio use the formula: Return on Assets = Profit Before
Taxes / Total Assets

Solvency ratios

Solvency ratios measure the stability of a company and its ability to repay debt. These ratios are of
particular interest to bank loan officers. They should be of interest to you, too, since solvency ratios
give a strong indication of the financial health and viability of your business. We will look at the
following solvency ratios: • Debt‐to‐Worth Ratio • Working Capital • Net Sales to Working Capital •

Debt‐to‐Worth Ratio

The Debt‐to‐Worth Ratio (or Leverage Ratio) is a measure of how dependent a company is on debt
financing as compared to owner’s equity. It shows how much of a business is owned and how much
is owed. The Debt‐to‐Worth Ratio is computed as follows: Debt‐to‐Worth Ratio = Total Liabilities /
Net Worth

Working Capital

Working capital is a measure of cash flow and is not a real ratio. It represents the amount of capital
invested in resources that are subject to relatively rapid turnover (such as cash, accounts receivable
and inventories) less the amount provided by short‐term creditors. Working capital should always be
a positive number. Lenders use it to evaluate a company’s ability to weather hard times. Loan
agreements often specify that the borrower must maintain a specified level of working capital.
Working capital is computed as follows: Working Capital = Total Current Assets ‐ Total Current
Liabilities

Net Sales to Working Capital

The relationship between Net Sales and Working Capital is a measurement of the efficiency in the
way working capital is being used by the business. It shows how working capital is supporting sales.
It is computed as follows: Net Sales to Working Capital Ratio = Net Sales / Net Working Capital
Replacement Analysis
 The objective is to address the
question of whether a currently
owned asset should be kept in
service or immediately replaced.
 What to do with an existing asset?

• Keep it
• Abandon it (do not replace)
• Replace it, but keep it for backup purposes
• Augment the capacity of the asset
• Dispose of it, and replace it with another
 Three reasons to consider a
change.
• Physical impairment (deterioration)
• Altered requirements
• New and improved technology is now
available.
The second and third reasons are sometimes
referred to as different categories of obsolescence.
 Some important terms for
replacement analysis
• Economic life: the period of time (years) that
yields the minimum equivalent uniform annual
cost (EUAC) of owning and operating as asset.
• Ownership life: the period between acquisition and
disposal by a specific owner.
• Physical life: period between original acquisition
and final disposal over the entire life of an asset.
• Useful life: the time period an asset is kept in
productive service (primary or backup).
Replacement: past estimation errors

• Any study today is about the future—past

estimation “errors” related to the defender
are irrelevant.
• The only exception to the above is if there
are income tax implications forthcoming
that were not foreseen.
• Only present and future cash flows are
considered in replacement studies.
• Past decisions are relevant only to the extent
that they resulted in the current situation.
• Sunk costs—used here as the difference
between an asset’s BV and MV at a
particular point in time—have no relevance
except to the extent they affect income
taxes.
Replacement: the outsider viewpoint
• The outsider viewpoint is the perspective taken by
an impartial third party to establish the fair MV of
the defender. Also called the opportunity cost
approach.
• The opportunity cost is the opportunity foregone
by deciding to keep an asset.
• If an upgrade of the defender is required to have a
competitive service level with the challenger, this
should be added to the present realizable MV.
 Replacement: economic lives of the
challenger and defender
• The economic life of the challenger minimizes the
EUAC.
• The economic life of the defender is often one
year, so a proper analysis may be between
different-lived alternatives.
• The defender may be kept longer than it’s
apparent economic life as long as it’s marginal
cost is less than the minimum EUAC of the
challenger over it’s economic life.
 Replacement: income taxes

• Replacement often results in gains or losses

from the sale of depreciable property.
• Studies must be made on an after-tax basis
for an accurate economic analysis since this
can have a considerable effect on the
resulting decision.
 Example
Acme owns a CNC machine that it is considering
replacing. Its current market value is $25,000, but it can
be productively used for four more years at which time
its market value will be zero. Operating and maintenance
expenses are $50,000 per year
Acme can purchase a new CNC machine, with the same
functionality as the current machine, for $90,000. In four
years the market value of the new machine is estimated to
be $45,000. Annual operating and maintenance costs will
be $35,000 per year.
Should the old CNC machine be replaced using a before-
tax MARR of 15% and a study period of four years?
 Example solution
Defender

Challenger

PW of the challenger is greater than PW of the defender

(but it is close).
 Proper analysis requires knowing the
economic life (minimum EUAC) of the
alternatives.
• The EUAC of a new asset can be computed
if the capital investment, annual expenses,
and year-by-year market values are known
or can be estimated.
• The difficulties in estimating these values
are encountered in most engineering
economy studies, and can be overcome in
most cases.
 Finding the EUAC of the challenger
requires finding the total marginal cost
of the challenger, for each year. The
minimum such value identifies the
economic life.
This equation represents the present worth, through year k,
of total costs. (Although the sign is positive, it is a cost.
Eq. 9-1.)
 Total marginal cost formula
The total marginal cost is the equivalent worth, at the
end of year k, of the increase in PW of total cost from
year k-1 to year k.

This can be simplified to (eq. 9-2)

 Finding the economic life of the new
CNC machine.
Year 1 Year 2 Year 3 Year 4
O&M costs $35,000 $35,000 $35,000 $35,000
Market value $75,000 $60,000 $50,000 $45,000

Marginal costs:
Year 1 Year 2 Year 3 Year 4
O&M $35,000 $35,000 $35,000 $35,000
Depreciation $15,000 $15,000 $10,000 $5,000
Int. on capital $13,500 $11,250 $9,000 $7,500
TC $63,500 $61,250 $54,000 $47,500
 Pause and solve
In a replacement analysis for an industrial saw, the following
data are known about the challenger. Initial investment is
$18,000. Annual maintenance costs begin at the end of year
three, with a cost at that time of $1,000, with $1,000 at the
end of year four, increasing by $8,600 each year thereafter.
The salvage value is $0 at all times. Using a MARR of 6%
per year, what is the economic life of the challenger?
 The economic life of the defender
• If a major overhaul is needed, the life
yielding the minimum EUAC is likely the
time to the next major overhaul.
• If the MV is zero (and will be so later), and
operating expenses are expected to increase,
the economic life will the one year.
• The defender should be kept as long as its
marginal cost is less than the minimum
EUAC of the best challenger.
 Finding the economic life of the
defender CNC machine.
Year 1 Year 2 Year 3 Year 4
O&M costs $50,000 $50,000 $50,000 $50,000
Market value $15,000 $10,000 $5,000 $0

Year 1 Year 2 Year 3 Year 4

O&M $50,000 $50,000 $50,000 $50,000
Depreciation $10,000 $5,000 $5,000 $5,000
Int. on capital $3,750 $2,250 $1,500 $750
TC $63,750 $57,250 $56,500 $55,750
 Replacement cautions.
• In general, if a defender is kept beyond where the TC
exceeds the minimum EUAC for the challenger, the
replacement becomes more urgent.
• Rapidly changing technology, bringing about significant
improvement in performance, can lead to postponing
replacement decisions.
• When the defender and challenger have different useful
lives, often the analysis is really to determine if now is the
time to replace the defender.
• Repeatability or cotermination can be used where
appropriate.
 Abandonment is retirement without
replacement.
• For projects having positive net cash flows
(following an initial investment) and a finite
period of required service.
• Should the project be undertaken? If so, and given
market (abandonment) values for each year, what
is the best year to abandon the project? What is its
economic life?
• These are similar to determining the economic life
of an asset, but where benefits instead of costs
dominate.
• Abandon the year PW is a maximum.
 Abandonment example
A machine lathe has a current market value of
$60,000 and can be kept in service for 4 more
years. With an MARR of 12%/year, when
should it be abandoned? The following data are
projected for future years.

Year 1 Year 2 Year 3 Year 4

Net receipts $50,000 $40,000 $15,000 $10,000
Market value $35,000 $20,000 $15,000 $5,000
 Abandonment solution
Keep for one year

Keep for two years

Keep for three years (BEST!) Keep for four years

 CHAPTER 9

Benefit/Cost
Analysis and
Public Sector
Economics

L E A R N I N G O U T C O M E S

Purpose: Understand public sector projects and select the best alternative on the basis of incremental benefit /cost analysis.

SECTION TOPIC LEARNING OUTCOME

9.1 Public sector • Explain some of the fundamental differences

between private and public sector projects.
9.2 B/C for single project • Calculate the benefit/cost ratio and use it to
evaluate a single project.
9.3 Incremental B/C • Select the better of two alternatives using the
incremental B/C ratio method.
9.4 More than two alternatives • Based on the incremental B/C ratios, select the
best of multiple alternatives.
9.5 Service projects and CEA • Explain service sector projects and use cost-
effectiveness analysis (CEA) to evaluate projects.
9.6 Ethical considerations • Explain the major aspects of public project
activities, and describe how ethical compromise
may enter public sector project analysis.

bla76302_ch09_228-264.indd 228 13/01/11 9:39 AM

 T
he evaluation methods of previous chapters are usually applied to alternatives
in the private sector, that is, for-profit and not-for-profit corporations and busi-
nesses. This chapter introduces public sector and service sector alternatives and
their economic consideration. In the case of public projects, the owners and users (benefi-
ciaries) are the citizens and residents of a government unit—city, county, state, province,
or nation. Government units provide the mechanisms to raise capital and operating funds.
Public-private partnerships have become increasingly common, especially for large infra-
structure projects such as major highways, power generation plants, water resource devel-
opments, and the like.
The benefit/cost (B/C) ratio introduces objectivity into the economic analysis of public sec-
tor evaluation, thus reducing the effects of politics and special interests. The different for-
mats of B/C analysis, and associated disbenefits of an alternative, are discussed here. The B/C
analysis can use equivalency computations based on PW, AW, or FW values. Performed cor-
rectly, the benefit/cost method will always select the same alternative as PW, AW, and ROR
analyses.
This chapter also introduces service sector projects and discusses how their economic eval-
uation is different from that for other projects. Finally, there is a discussion on professional
ethics and ethical dilemmas in the public sector.

PE
Water Treatment Facility #3 Case: Allen The stated criteria used to make deci-
Water Utilities has planned for the last sions for WTF3 and the transmission
25 years to construct a new drinking mains were economics, environment,
water treatment facility that will supply community impact, and constructability.
the rapidly growing north and north- There are major long-term benefits for
west areas of the city. An expectation of the new facility. These are some men-
over 100,000 new residents in the next tioned by city engineers:
several years and 500,000 by 2040
• It will meet projected water needs
prompted the development of the plant
of the city for the next 50 years.
starting in 2012. The supply is from a
large surface lake currently used to pro- • The new treatment plant is at a
vide water to all of Allen and the sur- higher elevation than the current
rounding communities. The project is two plants, allowing gravity flow to
termed WTF3, and its initial capital in- replenish reservoirs, thereby using
vestment is $540 million for the treat- little or no electric pumping.
ment plant and two large steel-pipe • There will be an increase in the
transmission mains (84- and 48-inch) diversity and reliability of supply as
that will be installed via tunneling ap- other plants age.
proximately 100 to 120 feet under sub- • It will provide a water quality that
urban areas of the city to reach current is more consistent due to the loca-
reservoirs. tion of the raw water intakes.
Tunneling was selected after geotech-
• The facility uses water supplies
nical borings indicated that open trench-
already purchased; therefore, there
ing was not supportable by the soil and
is no need to negotiate additional
based upon a large public outcry against
allowances.
trenching in the living areas along the
selected transmission routes. Besides the The disbenefits are mostly short-term
treatment plant construction on the 95- during the construction of WTF3 and
acre site, there must be at least three transmission mains. Some of these are
large vertical shafts (25 to 50 feet in di- mentioned by citizen groups and one re-
ameter) bored along each transmission tired city engineer:
main to gain underground access for • There will be disruption of habi-
equipment and debris removal during tat for some endangered species
the tunneling operations. of birds, lizards, and trees not

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 230 Chapter 9 Benefit/Cost Analysis and Public Sector Economics

found in any other parts of the • The need for the facility has not
country. been proved, as the water will be
• Large amounts of dust and smoke sold to developers outside the city
will enter the atmosphere in a limits, not provided to residences
residential area during the 3½ years within Allen.
of construction, tunneling, and • Newly generated revenues will be
transmission main completion. used to pay off the capital funding
• Noise pollution and traffic conges- bonds approved for the plant’s con-
tion will result during an estimated struction.
26,000 truck trips to remove debris Last year, the city engineers did a ben-
from the plant site and tunnel efit/cost analysis for this massive public
shafts, in addition to the problems sector project; none of the results were
from regular construction traffic. publicized. Public and elected official in-
• Natural landscape in plant and tun- tervention has now caused some of the
nel shaft sites will be destroyed. conclusions using the criteria mentioned
• Safety will be compromised for chil- above to be questioned by the general
dren in a school where large trucks manager of Allen Water Utilities.
will pass about every 5 minutes for This case is used in the following topics
approximately 12 hours per day, of this chapter:
6 days per week for 2½ years. Public sector projects (Section 9.1)
• There may be delays in fire and Incremental B/C analysis, two alterna-
ambulance services in emergencies, tives (Section 9.3)
since many neighborhood streets are Incremental B/C analysis, more than
country-road width and offer only two alternatives (Section 9.4)
single ingress/egress streets for neigh-
borhoods along the indicated routes.

9.1 Public Sector Projects

Virtually all the examples and problems of previous chapters have involved the private sector,
where products, systems, and services are developed and offered by corporations and businesses
for use by individual customers and clients, the government, or other companies. (Notable excep-
tions are the long-life alternatives discussed in Chapters 5 (PW) and 6 (AW) where capitalized
cost analysis was applied.) Now we will explore projects that concentrate on government units
and the citizens they serve. These are called public sector projects.
A public sector project is 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. Areas such as public health, criminal justice, safety, transportation,
welfare, and utilities are publically owned and require economic evaluation.

Upon reflection, it is surprising how much of what we use on a daily or as-needed basis is
publicly owned and financed to serve us—the citizenry. These are some public sector
examples:
Hospitals and clinics Economic development projects
Parks and recreation Convention centers
Utilities: water, electricity, gas, Sports arenas
sewer, sanitation Transportation: highways, bridges,
Schools: primary, secondary, community waterways
colleges, universities

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 9.1 Public Sector Projects 231

Police and fire protection Public housing

Courts and prisons Emergency relief
Food stamp and rent relief programs Codes and standards
Job training

There are significant differences in the characteristics of private and public sector alternatives.
They are summarized here.

Characteristic Public sector Private sector

Size of investment Large Some large; more medium to small

Often alternatives developed to serve public needs require large initial investments, possibly
distributed over several years. Modern highways, public transportation systems, universities,
airports, and flood control systems are examples.

Characteristic Public sector Private sector

Life estimates Longer (30–50 years) Shorter (2–25 years)

The long lives of public projects often prompt the use of the capitalized cost method, where
infinity is used for n and annual costs are calculated as A  P(i). As n gets larger, especially
over 30 years, the differences in calculated A values become small. For example, at i  7%,
there will be a very small difference in 30 and 50 years, because (A/P,7%,30)  0.08059 and
(A/P,7%,50)  0.07246.

Characteristic Public sector Private sector

Annual cash flow No profit; costs, benefits, and Revenues contribute to
estimates disbenefits are estimated profits; costs are estimated

Public sector projects (also called publicly owned) do not have profits; they do have costs that are
paid by the appropriate government unit; and they benefit the citizenry. Public sector projects
often have undesirable consequences, as interpreted by some sectors of the public. It is these
consequences that can cause public controversy about the projects. The economic analysis should
consider these consequences in monetary terms to the degree estimable. (Often in private sector
analysis, undesirable consequences are not considered, or they may be directly addressed as
costs.) To perform a benefit/cost economic analysis of public alternatives, the costs (initial and
annual), the benefits, and the disbenefits, if considered, must be estimated as accurately as
possible in monetary units.

Costs—estimated expenditures to the government entity for construction, operation, and mainte-
nance of the project, less any expected salvage value.
Benefits—advantages to be experienced by the owners, the public.
Disbenefits—expected undesirable or negative consequences to the owners if the alternative is
implemented. Disbenefits may be indirect economic disadvantages of the alternative.

It is difficult to estimate and agree upon the economic impact of benefits and disbenefits for a
public sector alternative. For example, assume a short bypass around a congested area in town is
recommended. How much will it benefit a driver in dollars per driving minute to be able to by-
pass five traffic lights while averaging 35 miles per hour, as compared to currently driving
through the lights averaging 20 miles per hour and stopping at an average of two lights for an
average of 45 seconds each? The bases and standards for benefits estimation are always difficult
to establish and verify. Relative to revenue cash flow estimates in the private sector, benefit esti-
mates are much harder to make, and vary more widely around uncertain averages. (The inability
to make economic estimates for benefits may be overcome by using the evaluation technique
discussed in Section 9.5.) And the disbenefits that accrue from an alternative are even harder to
estimate. In fact, the disbenefit itself may not be known at the time the evaluation is performed.

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 232 Chapter 9 Benefit/Cost Analysis and Public Sector Economics

Characteristic Public sector Private sector

Funding Taxes, fees, bonds, Stocks, bonds, loans,
private funds individual owners

The capital used to finance public sector projects is commonly acquired from taxes, bonds,
and fees. Taxes are collected from those who are the owners—the citizens (e.g., federal gasoline
taxes for highways are paid by all gasoline users, and health care costs are covered by insurance
premiums). This is also the case for fees, such as toll road fees for drivers. Bonds are often issued:
U.S. Treasury bonds, municipal bond issues, and special-purpose bonds, such as utility district
bonds. Private lenders can provide up-front financing. Also, private donors may provide funding
for museums, memorials, parks, and garden areas through gifts.

Characteristic Public sector Private sector

Interest rate Lower Higher, based on cost of capital

Because many of the financing methods for public sector projects are classified as low-interest,
the interest rate is virtually always lower than for private sector alternatives. Government
agencies are exempt from taxes levied by higher-level units. For example, municipal projects
do not have to pay state taxes. (Private corporations and individual citizens do pay taxes.)
Many loans are very low-interest, and grants with no repayment requirement from federal
programs may share project costs. This results in interest rates in the 4% to 8% range. It is
common that a government agency will direct that all projects be evaluated at a specific rate.
As a matter of standardization, directives to use a specific interest rate are beneficial because
different government agencies are able to obtain varying types of funding at different rates.
This can result in projects of the same type being rejected in one state or city but accepted in
another. Standardized rates tend to increase the consistency of economic decisions and to re-
duce gamesmanship.
The determination of the interest rate for public sector evaluation is as important as the deter-
mination of the MARR for a private sector analysis. The public sector interest rate is identified
as i; however, it is referred to by other names to distinguish it from the private sector rate. The
most common terms are discount rate and social discount rate.

Characteristic Public sector Private sector

Alternative selection Multiple criteria Primarily based on rate
criteria of return

Multiple categories of users, economic as well as noneconomic interests, and special-interest

political and citizen groups make the selection of one alternative over another much more diffi-
cult in public sector economics. Seldom is it possible to select an alternative on the sole basis of
a criterion such as PW or ROR. It is important to describe and itemize the criteria and selection
method prior to the analysis. This helps determine the perspective or viewpoint when the evalu-
ation is performed. Viewpoint is discussed below.

Characteristic Public sector Private sector

Environment of the evaluation Politically inclined Primarily economic

There are often public meetings and debates associated with public sector projects to accommo-
date the various interests of citizens (owners). Elected officials commonly assist with the selec-
tion, especially when pressure is brought to bear by voters, developers, environmentalists, and
others. The selection process is not as “clean” as in private sector evaluation.
The viewpoint of the public sector analysis must be determined before cost, benefit, and dis-
benefit estimates are made and before the evaluation is formulated and performed. There are
several viewpoints for any situation, and the different perspectives may alter how a cash flow
estimate is classified.

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 9.1 Public Sector Projects 233

Some example perspectives are the citizen; the city tax base; number of students in the school dis-
trict; creation and retention of jobs; economic development potential; a particular industry interest
(agriculture, banking, electronics manufacturing); even the reelection of a public officeholder (often
termed pork projects). In general, the viewpoint of the analysis should be as broadly defined as those
who will bear the costs of the project and reap its benefits. Once established, the viewpoint assists in
categorizing the costs, benefits, and disbenefits of each alternative, as illustrated in Example 9.1.

EXAMPLE 9.1 Water Treatment Facility #3 Case PE

The situation with the location and construction of the new WTF3 and associated transmission
mains described in the chapter’s introduction has reached a serious level because of recent
questions posed by some city council members and citizen groups. Before going public to the
city council with the analysis performed last year, the director of Allen Water Utilities has
asked an engineering management consultant to review it and determine if it was an acceptable
analysis and correct economic decision, then and now. The lead consultant, Joel Whiterson,
took engineering economy as a part of his B.S. education and has previously worked on
economic studies in the government sector, but never as the lead person.
Within the first hour of checking background notes, Joel found several initial estimates
(shown below) from last year for expected consequences if WTF3 were built. He realized that
no viewpoint of the study was defined, and, in fact, the estimates were never classified as costs,
benefits, or disbenefits. He did determine that disbenefits were considered at some point in the
analysis, though the estimates for them are very sketchy.
Joel defined two viewpoints: a citizen of Allen and the Allen Water Utilities budget. He
wants to identify each of the estimates as a cost, benefit, or disbenefit from each viewpoint.
Please help with this classification.
Economic Dimension Monetary Estimate
1. Cost of water: 10% annual increase to Allen Average of $29.7 million (years 1–5, steady
households thereafter)
2. Bonds: Annual debt service at 3% per year on $16.2 million (years 1–19); $516.2 million (year 20)
$540 million
3. Use of land: Payment to Parks and Recreation $300,000 (years 1–4)
for shaft sites and construction areas
4. Property values: Loss in value, sales price, $4 million (years 1–5)
and property taxes
5. Water sales: Increases in sales to surrounding $5 million (year 4) plus 5% per year (years 5–20)
communities
6. M&O: Annual maintenance and operations $300,000 plus 4% per year increase (years 1–20)
costs
7. Peak load purchases: Savings in purchases of $500,000 (years 5–20)
treated water from secondary sources

Solution
The perspective of each viewpoint is identified and estimates are classified. (How this classifi-
cation is done will vary depending upon who does the analysis. This solution offers only one
logical answer.)
Viewpoint 1: Citizen of the city of Allen. Goal: Maximize the quality of life and wellness of
citizens with family and neighborhood as prime concerns.
Costs: 1, 2, 4, 6 Benefits: 5, 7 Disbenefits: 3
Viewpoint 2: Allen Water Utilities budget. Goal: Ensure the budget is balanced and of suf-
ficient size to fund rapidly growing city service demands.
Costs: 2, 3, 6 Benefits: 1, 5, 7 Disbenefits: 4
Citizens view costs in a different light than a city budget employee does. For example, the loss
of property values (item 4) is considered a real cost to a citizen, but is an unfortunate disbenefit

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 234 Chapter 9 Benefit/Cost Analysis and Public Sector Economics

from the city budget perspective. Similarly, the Allen Water Utilities budget interprets estimate
3 (payment for use of land to Parks and Recreation) as a real cost; but a citizen might interpret
this as merely a movement of funds between two municipal budgets—therefore, it is a disben-
efit, not a real cost.

Comment
The inclusion of disbenefits can easily change the economic decision. However, agreement on
the disbenefits and their monetary estimates is difficult (to impossible) to develop, often result-
ing in the exclusion of any disbenefits from the economic analysis. Unfortunately, this usually
transfers the consideration of disbenefits to the noneconomic (i.e., political) realm of public
project decision making.

Most of the large public sector projects are developed through public-private partnerships
(PPPs). A partnership is advantageous in part because of the greater efficiency of the private sec-
tor and in part because of the sizable cost to design, construct, and operate such projects. Full
funding by the government unit may not be possible using traditional means—fees, taxes, and
bonds. Some examples of the projects are as follows:

Project Some Purposes of the Project

Mass transportation Reduce transit time; reduce congestion; improve environment; decrease road
accidents
Bridges and tunnels Speed traffic flows; reduce congestion; improve safety
Ports and harbors Increase cargo capacity; support industrial development; increase tourism
Airports Increase capacity; improve passenger safety; support development
Water resources Desalination for drinking water; meet irrigation and industrial needs; improve
wastewater treatment

In these joint ventures, the public sector (government) is responsible for the funding and service
to the citizenry, and the private sector partner (corporation) is responsible for varying aspects of
the projects as detailed below. The government unit cannot make a profit, but the corporation(s)
involved can realize a reasonable profit; in fact, the profit margin is usually written into the con-
tract that governs the design, construction, and operation of the project.
Traditional methods of contracting were fixed-price (historically called lump-sum) and cost
reimbursable (also called cost-plus). In these formats, a government unit took responsibility for
funding and possibly some of the design elements, and later all operation activities, while the
contractor did not share in the risks involved—liability, natural disasters, funding shortfalls, etc.
More recently, the PPP has become the arrangement of choice for most large public projects.
Commonly these are called design-build contracts, under which contractors take on more and
more of the functions from design to operation. Details are explained in publications such as
Design-Build Contracting Handbook (Cushman and Loulakis). The most reliance is placed upon
a contractor or contractors with a DBOMF contract, as described below.

The Design-Build-Operate-Maintain-Finance (DBOMF) contract is considered a turnkey ap-

proach to a project. It requires the contractor(s) to perform all the DBOMF activities with col-
laboration and approval of the owner (the government unit). The activity of financing is the
management of cash flow to support project implementation by a contracting firm. Although a
contractor may assist in some instances, the funding (obtaining the capital funds) remains the
government’s responsibility through bonding, commercial loans, taxation, grants, and gifts.

When the financing activity is not managed by a contractor, the contract is a DBOM; it is also
common to develop a design-build contract. In virtually all cases, some forms of design-build
arrangements for public projects are made because they offer several advantages to the govern-
ment and citizens served:
• Cost and time savings in the design, build, and operate phases
• Earlier and more reliable (less variable) cost estimates

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 9.2 Benefit/Cost Analysis of a Single Project 235

• Reduced administrative responsibilities for the owner

• Better efficiency of resource allocation of private enterprise
• Environmental, liability, and safety issues addressed by the private sector, where there usually
is greater expertise
Many of the projects in international settings and in developing countries utilize the public-
private partnership. There are, of course, disadvantages to this arrangement. One risk is that the
amount of funding committed to the project may not cover the actual build cost because it is
considerably higher than estimated. Another risk is that a reasonable profit may not be realized
by the private corporation due to low usage of the facility during the operate phase. To prevent
such problems, the original contract may provide for special subsidies and loans guaranteed by
the government unit. The subsidy may cover costs plus (contractually agreed-to) profit if usage
is lower than a specified level. The level used may be the breakeven point with the agreed-to
profit margin considered.

9.2 Benefit/Cost Analysis of a Single Project

The benefit/cost ratio is relied upon as a fundamental analysis method for public sector projects.
The B/C analysis was developed to introduce greater objectivity into public sector economics,
and as one response to the U.S. Congress approving the Flood Control Act of 1936. There are
several variations of the B/C ratio; however, the fundamental approach is the same. All cost and
benefit estimates must be converted to a common equivalent monetary unit (PW, AW, or FW) at
the discount rate (interest rate). The B/C ratio is then calculated using one of these relations:

PW of benefits  ———————
B/C  ——————— AW of benefits  ———————
FW of benefits [9.1]
PW of costs AW of costs FW of costs

Present worth and annual worth equivalencies are preferred to future worth values. The sign
convention for B/C analysis is positive signs; costs are preceded by a  sign. Salvage values
and additional revenues to the government, when they are estimated, are subtracted from costs in
the denominator. Disbenefits are considered in different ways depending upon the model used.
Most commonly, disbenefits are subtracted from benefits and placed in the numerator. The
different formats are discussed below.

The decision guideline is simple:

If B/C  1.0, accept the project as economically justified for the estimates and discount rate
applied. Project evaluation
If B/C  1.0, the project is not economically acceptable.

If the B/C value is exactly or very near 1.0, noneconomic factors will help make the decision.
The conventional B/C ratio, probably the most widely used, is calculated as follows:

benefits  disbenefits  ———

B/C  —————————— BD [9.2]
costs C

In Equation [9.2] disbenefits are subtracted from benefits, not added to costs. The B/C value
could change considerably if disbenefits are regarded as costs. For example, if the numbers
10, 8, and 5 are used to represent the PW of benefits, disbenefits, and costs, respectively, the
correct procedure results in B/C  (10  8)兾5  0.40. The incorrect placement of disbenefits
in the denominator results in B/C  10兾(8  5)  0.77, which is approximately twice the cor-
rect B/C value of 0.40. Clearly, then, the method by which disbenefits are handled affects the
magnitude of the B/C ratio. However, regardless of whether disbenefits are (correctly) sub-
tracted from the numerator or (incorrectly) added to costs in the denominator, a B/C ratio of
less than 1.0 by the first method will always yield a B/C ratio less than 1.0 by the second
method, and vice versa.
The modified B/C ratio includes all the estimates associated with the project, once operational.
Maintenance and operation (M&O) costs are placed in the numerator and treated in a manner

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 236 Chapter 9 Benefit/Cost Analysis and Public Sector Economics

similar to disbenefits. The denominator includes only the initial investment. Once all amounts are
expressed in PW, AW, or FW terms, the modified B/C ratio is calculated as

benefits  disbenefits  M&O costs

Modified B/C  ———————————————— [9.3]
initial investment

Salvage value is usually included in the denominator as a negative cost. The modified B/C ratio
will obviously yield a different value than the conventional B/C method. However, as with dis-
benefits, the modified procedure can change the magnitude of the ratio but not the decision to
accept or reject the project.
The benefit and cost difference measure of worth, which does not involve a ratio, is based on
the difference between the PW, AW, or FW of benefits and costs, that is, B − C. If (B − C)  0,
the project is acceptable. This method has the advantage of eliminating the discrepancies noted
above when disbenefits are regarded as costs, because B represents net benefits. Thus, for the
numbers 10, 8, and 5, the same result is obtained regardless of how disbenefits are treated.
Subtracting disbenefits from benefits: B  C  (10  8)  5  3
Adding disbenefits to costs: B  C  10  (8  5)  3
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. It is possible for one alternative
with larger costs to generate lower benefits than other alternatives, thus making it unnecessary to
further consider the larger-cost alternative.
By the very nature of benefits and especially disbenefits, monetary estimates are difficult to
make and will vary over a wide range. The extensive use of sensitivity analysis on the more
questionable parameters helps determine how sensitive the economic decision is to estimate
variation. This approach assists in determining the economic and public acceptance risk asso-
ciated with a defined project. Also, the use of sensitivity analysis can alleviate some of the pub-
lic’s concerns commonly expressed that people (managers, engineers, consultants, contractors,
and elected officials) designing (and promoting) the public project are narrowly receptive to dif-
ferent approaches to serving the public’s interest.

EXAMPLE 9.2
In the past, the Afram Foundation has awarded many grants to improve the living and medical
conditions of people in war-torn and poverty-stricken countries throughout the world. In a
proposal for the foundation’s board of directors to construct a new hospital and medical clinic
complex in a deprived central African country, the project manager has developed some esti-
mates. These are developed, so she states, in a manner that does not have a major negative
effect on prime agricultural land or living areas for citizens.

Award amount: $20 million (end of) first year, decreasing by $5 million per year for 3
additional years; local government will fund during the first year only
Annual costs: $2 million per year for 10 years, as proposed
Benefits: Reduction of $8 million per year in health-related expenses for citizens
Disbenefits: $0.1 to $0.6 million per year for removal of arable land and commercial
districts

Use the conventional and modified B/C methods to determine if this grant proposal is eco-
nomically justified over a 10-year study period. The foundation’s discount rate is 6% per year.

Solution
Initially, determine the AW for each parameter over 10 years. In $1 million units,

Award: 20 − 5(A/G,6%,4)  $12.864 per year

Annual costs: $2 per year
Benefits: $8 per year
Disbenefits: Use $0.6 for the first analysis

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 9.2 Benefit/Cost Analysis of a Single Project 237

The conventional B/C analysis applies Equation [9.2].

8.0  0.6  0.50
B/C  ——————
12.864  2.0
The modified B/C analysis uses Equation [9.3].
8.0  0.6  2.0  0.42
Modified B/C  ———————
12.864
The proposal is not justified economically since both measures are less than 1.0. If the low
disbenefits estimate of $0.1 million per year is used, the measures increase slightly, but not
enough to justify the proposal.

It is possible to develop a direct formula connection between the B/C of a public sector and
B/C of a private sector project that is a revenue alternative; that is, both revenues and costs are
estimated. Further, we can identify a direct correspondence between the modified B/C relation in
Equation [9.3] and the PW method we have used repeatedly. (The following development also
applies to AW or FW values.) Let’s neglect the initial investment in year 0 for a moment, and
concentrate on the cash flows of the project for year 1 through its expected life. For the private
sector, the PW for project cash flows is
PW of project  PW of revenue  PW of costs
Since private sector revenues are approximately the same as public sector benefits minus disben-
efits (B  D), the modified B/C relation in Equation [9.3] may be written as
PW of (B  D)  PW of C
Modified B/C  ————————————
PW of initial investment
This relation can be slightly rewritten to form the profitability index (PI), which can be used to
evaluate revenue projects in the public or private sector. For years t  1, 2, . . . , n,

PW of NCFt
PI  ——————————— [9.4]
PW of initial investment

Note that the denominator includes only first cost (initial investment) items, while the numerator
has only cash flows that result from the project for years 1 through its life. The PI measure of
worth provides a sense of getting the most for the investment dollar (euro, yen, etc.). That is, the
result is in PW units per PW of money invested at the beginning. This is a “bang for the buck”
measure. When used solely for a private sector project, the disbenefits are usually omitted,
whereas they should be estimated and included in the modified B/C version of this measure for a
public project.
The evaluation guideline for a single project using the PI is the same as for the conventional
B/C or modified B/C.

If PI  1.0, the project is economically acceptable at the discount rate.

If PI  1.0, the project is not economically acceptable at the discount rate. Project evaluation

Remember, the computations for PI and modified B/C are essentially the same, except the PI is
usually applied without disbenefits estimated. The PI has another name: the present worth index
(PWI). It is often used to rank and assist in the selection of independent projects when the capital
budget is limited. This application is discussed in Chapter 12, Section 12.5.

EXAMPLE 9.3
The Georgia Transportation Directorate is considering a public-private partnership with Young
Construction as the prime contractor using a DBOMF contract for a new 22.51-mile toll road on
the outskirts of Atlanta’s suburban area. The design includes three 4-mile-long commercial/
retail corridors on both sides of the toll road. Highway construction is expected to require

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 238 Chapter 9 Benefit/Cost Analysis and Public Sector Economics

5 years at an average cost of $3.91 million per mile. The discount rate is 4% per year, and the
study period is 30 years. Evaluate the economics of the proposal using (a) the modified B/C
analysis from the State of Georgia perspective and (b) the profitability index from the Young
corporate viewpoint in which disbenefits are not included.
Initial investment: $88 million distributed over 5 years; $4 million now and in year 5 and
$20 million in each of years 1 through 4.
Annual M&O cost: $1 million per year, plus an additional $3 million each fifth year, includ-
ing year 30.
Annual revenue/benefits: Include tolls and retail/commercial growth; start at $2 million in
year 1, increasing by a constant $0.5 million annually through year 10, and then increasing by
a constant $1 million per year through year 20 and remaining constant thereafter.
Estimable disbenefits: Include loss of business income, taxes, and property value in sur-
rounding areas; start at $10 million in year 1, decrease by $0.5 million per year through year
21, and remain at zero thereafter.

Solution
The PW values in year 0 for all estimates must be developed initially usually by hand, calcula-
tor, or spreadsheet computations. If the 30 years of estimates are entered into a spreadsheet and
NPV functions at 4% are applied, the results in $1 million units are obtained. All values are
positive because of the sign convention for B/C and PI measures.
PW of investment  $71.89 PW of benefits  $167.41
PW of costs  $26.87 PW of disbenefits  $80.12
(a) From the public project perspective, the State will apply Equation [9.3].
167.41  80.12  26.87  0.84
Modified B/C  ——————————
71.89
The toll road proposal is not economically acceptable, since B/C  1.0.
(b) From the private corporation viewpoint, Young Construction will apply Equation [9.4].
167.41  26.87  1.95
PI  ———————
71.89
The proposal is clearly justified without the disbenefits, since PI > 1.0. The private project
perspective predicts that every investment dollar will return an equivalent of $1.95 over
30 years at a 4% per year discount rate.

Comment
The obvious question that arises concerns the correct measure to use. When PI is used in the pri-
vate project setting, there is no problem, since disbenefits are virtually never considered in the
economic analysis. The public project setting will commonly use some form of the B/C ratio with
the disbenefit considered. When a public-private partnership is initiated, there should be some
agreement beforehand that establishes the economic measure acceptable for analysis and decision
making throughout the project. Then the numerical dilemma presented above should not occur.

9.3 Alternative Selection Using Incremental

B/C Analysis
The technique to compare two mutually exclusive alternatives using benefit/cost analysis is virtu-
ally the same as that for incremental ROR in Chapter 8. The incremental (conventional) B/C ratio,
which is identified as B/C, is determined using PW, AW, or FW calculations. The higher-cost
alternative is justified if B/C is equal to or larger than 1.0. The selection rule is as follows:

If B/C  1.0, choose the higher-cost alternative, because its extra cost is economically justified.
ME alternative If B/C  1.0, choose the lower-cost alternative.
selection

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 9.3 Alternative Selection Using Incremental B/C Analysis 239

To perform a correct incremental B/C analysis, it is required that each alternative be compared
only with another alternative for which the incremental cost is already justified. This same rule
was used for incremental ROR analysis.
There are two dimensions of an incremental B/C analysis that differ from the incremental
ROR method in Chapter 8. We already know the first, all costs have a positive sign in the B/C
ratio. The second, and significantly more important, concerns the ordering of alternatives prior to
incremental analysis.
Alternatives are ordered by increasing equivalent total costs, that is, PW or AW of all cost
estimates that will be utilized in the denominator of the B/C ratio. When not done correctly, the
incremental B/C analysis may reject a justified higher-cost alternative.
If two alternatives, A and B, have equal initial investments and lives, but B has a larger equivalent
annual cost, then B must be incrementally justified against A. (This is illustrated in Example 9.4
below.) If this convention is not correctly followed, it is possible to get a negative cost value in
the denominator, which can incorrectly make B/C  1 and reject a higher-cost alternative that is
actually justified.
Follow these steps to correctly perform a conventional B/C ratio analysis of two alternatives.
Equivalent values can be expressed in PW, AW, or FW terms.
1. Determine the equivalent total costs for both alternatives.
2. Order the alternatives by equivalent total cost: first smaller, then larger. Calculate the in-
cremental cost (C) for the larger-cost alternative. This is the denominator in B/C.
3. Calculate the equivalent total benefits and any disbenefits estimated for both alternatives.
Calculate the incremental benefits (B) for the larger-cost alternative. This is (B  D) if
disbenefits are considered.
4. Calculate the B/C ratio using Equation [9.2], (B  D)/C.
5. Use the selection guideline to select the higher-cost alternative if B/C  1.0.
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 alternative 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 alter-
native is usually the current condition.

EXAMPLE 9.4
The city of Garden Ridge, Florida, has received designs for a new patient room wing to the
municipal hospital from two architectural consultants. One of the two designs must be ac-
cepted in order to announce it for construction bids. The costs and benefits are the same in most
categories, but the city financial manager decided that the estimates below should be consid-
ered to determine which design to recommend at the city council meeting next week and to
present to the citizenry in preparation for an upcoming bond referendum next month.

Design A Design B
Construction cost, $ 10,000,000 15,000,000
Building maintenance cost, $/year 35,000 55,000
Patient usage copay, $/year 450,000 200,000

The patient usage copay is an estimate of the amount paid by patients over the insurance coverage
generally allowed for a hospital room. The discount rate is 5%, and the life of the building is
estimated at 30 years.
(a) Use incremental B/C analysis to select design A or B.
(b) Once the two designs were publicized, the privately owned hospital in the directly adjacent
city of Forest Glen lodged a complaint that design A will reduce its own municipal hospi-
tal’s income by an estimated $500,000 per year because some of the day-surgery features
of design A duplicate its services. Subsequently, the Garden Ridge merchants’ association
argued that design B could reduce its annual revenue by an estimated $400,000, because it

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 240 Chapter 9 Benefit/Cost Analysis and Public Sector Economics

will eliminate an entire parking lot used by their patrons for short-term parking. The city
financial manager stated that these concerns would be entered into the evaluation as dis-
benefits of the respective designs. Redo the B/C analysis to determine if the economic deci-
sion is still the same as when disbenefits were not considered.

Solution
(a) Since most of the cash flows are already annualized, the incremental B/C ratio will use
AW values. No disbenefit estimates are considered. Follow the steps of the procedure
above:
1. The AW of costs is the sum of construction and maintenance costs.
AWA  10,000,000(A/P,5%,30)  35,000  $685,500
AWB  15,000,000(A/P,5%,30)  55,000  $1,030,750
2. Design B has the larger AW of costs, so it is the alternative to be incrementally justi-
fied. The incremental cost is
C  AWB  AWA  $345,250 per year
3. The AW of benefits is derived from the patient usage copays, since these are conse-
quences to the public. The benefits for the B/C analysis are not the estimates them-
selves, but the difference if design B is selected. The lower usage copay is a positive
benefit for design B.
B  usageA  usageB  $450,000  $200,000  $250,000 per year
4. The incremental B/C ratio is calculated by Equation [9.2].
$250,000
B兾C  ————  0.72
$345,250
5. The B/C ratio is less than 1.0, indicating that the extra costs associated with design B
are not justified. Therefore, design A is selected for the construction bid.
(b) The revenue loss estimates are considered disbenefits. Since the disbenefits of design B are
$100,000 less than those of A, this positive difference is added to the $250,000 benefits of
B to give it a total benefit of $350,000. Now
$350,000
B兾C  ————  1.01
$345,250
Design B is slightly favored. In this case the inclusion of disbenefits has reversed the previ-
ous economic decision. This has probably made the situation more difficult politically.
New disbenefits will surely be claimed in the near future by other special-interest groups.

Like other methods, incremental B/C analysis requires equal-service comparison of alterna-
tives. Usually, the expected useful life of a public project is long (25 or 30 or more years), so
alternatives generally have equal lives. However, when alternatives do have unequal lives, the
use of PW or AW to determine the equivalent costs and benefits requires that the LCM of lives be
used to calculate B/C. As with ROR analysis of two alternatives, this is an excellent opportunity
to use the AW equivalency of estimated (not incremental) costs and benefits, if the implied as-
sumption that the project could be repeated is reasonable. Therefore, use AW-based analysis of
actual costs and benefits for B/C ratios when different-life alternatives are compared.

EXAMPLE 9.5 Water Treatment Facility #3 Case PE

As our case unfolds, the consultant, Joel Whiterson, has pieced together some of the B/C
analysis estimates for the 84-inch Jolleyville transmission main study completed last year. The
two options for constructing this main were open trench (OT) for the entire 6.8-mile distance
or a combination of trenching and bore tunneling (TT) for a shorter route of 6.3 miles. One of
the two options had to be selected to transport approximately 300 million gallons per day (gpd)
of treated water from the new WTF3 to an existing aboveground reservoir.

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 9.3 Alternative Selection Using Incremental B/C Analysis 241

The general manager of Allen Water Utilities has stated publicly several times that the
trench-tunnel combination option was selected over the open-trench alternative based on anal-
ysis of both quantitative and nonquantitative data. He stated the equivalent annual costs in an
internal e-mail some months ago, based on the expected construction periods of 24 and
36 months, respectively, as equivalent to
AWOT  $1.20 million per year
AWTT  $2.37 million per year
This analysis indicated that the open-trench option was economically better, at that time. The
planning horizon for the transmission mains is 50 years; this is a reasonable study period, Joel
concluded. Use the estimates below that Joel has unearthed to perform a correct incremental
B/C analysis and comment on the results. The interest (discount) rate is 3% per year, com-
pounded annually, and 1 mile is 5280 feet.

Open trench (OT) Trench-tunnel (TT)

Distance, miles 6.8 6.3
First cost, $ per foot 700 Trench for 2.0 miles: 700
Tunnel for 4.3 miles: 2100
Time to complete, months 24 36
Construction support costs, $ per month 250,000 175,000
Ancillary expenses, $ per month:
Environmental 150,000 20,000
Safety 140,000 60,000
Community interface 20,000 5,000

Solution
One of the alternatives must be selected, and the construction lives are unequal. Since it is not
reasonable to assume that this construction project will be repeated many cycles in the future,
it is incorrect to conduct an AW analysis over the respective completion periods of 24 and
36 months, or the LCM of these time periods. However, the study period of 50 years is a rea-
sonable evaluation time frame, since the mains are considered permanent installations. We can
assume that the construction first costs are a present worth value in year 0, but the equivalent
PW and 50-year AW of other monthly costs must be determined.
PWOT  PW of construction  PW of construction support costs
 700(6.8)(5280)  250,000(12)(P兾A,3%,2)
 $30,873,300
AWOT  30,873,300(A兾P,3%,50)
 $1.20 million per year
PWTT  [700(2.0)  2100(4.3)](5280)  175,000(12)(P兾A,3%,3)
 $61,010,460
AWTT  61,010,460(A兾P,3%,50)
 $2.37 million per year
The trench-tunnel (TT) alternative has a larger equivalent cost; it must be justified against the
OT alternative. The incremental cost is
C  AWTT  AWOT  2.37 − 1.20  $1.17 million per year
The difference between ancillary expenses defines the incremental benefit for TT.
PWOT-anc  310,000(12)(P兾A,3%,2)
 $7,118,220
AWOT-anc  7,118,220(A兾P,3%,50)
 $276,685 per year

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 242 Chapter 9 Benefit/Cost Analysis and Public Sector Economics

PWTT-anc  85,000(12)(P兾A,3%,3)
 $2,885,172
AWTT-anc  2,885,172(A兾P,3%,50)
 $112,147 per year
B  AWOT-anc  AWTT-anc  276,685  112,147  $164,538 per year ($0.16 million)
Calculate the incremental B/C ratio.
B/C  0.16/1.17  0.14
Since B/C  1.0, the trench-tunnel option is not economically justified. Joel can now con-
clude that the general manager’s earlier comment that the TT option was selected based on
quantitative and nonquantitative data must have had heavy dependence on nonquantitative
information not yet discovered.

9.4 Incremental B/C Analysis of Multiple, Mutually

Exclusive Alternatives
The procedure necessary to select one from three or more mutually exclusive alternatives using
incremental B/C analysis is essentially the same as that of Section 9.3. The procedure also paral-
lels that for incremental ROR analysis in Section 8.6. The selection guideline is as follows:
Choose the largest-cost alternative that is justified with an incremental B/C  1.0 when this se-
lected alternative has been compared with another justified alternative.
There are two types of benefit estimates—estimation of direct benefits, and implied benefits
based on usage cost estimates. The previous two examples (9.4 and 9.5) are good illustrations of
the second type of implied benefit estimation. When direct benefits are estimated, the B/C ratio
for each alternative may be calculated first as an initial screening mechanism to eliminate unac-
ceptable alternatives. At least one alternative must have B/C  1.0 to perform the incremental
B/C analysis. If all alternatives are unacceptable, the DN alternative is the choice. (This is the
same approach as that of step 2 for “revenue alternatives only” in the ROR procedure of Section
8.6. However, the term revenue alternative is not applicable to public sector projects.)
As in the previous section when comparing two alternatives, selection from multiple alterna-
tives by incremental B/C ratio utilizes equivalent total costs to initially order alternatives from
smallest to largest. Pairwise comparison is then undertaken. Also, remember that all costs are
considered positive in B/C calculations. The terms defender and challenger alternative are used
in this procedure, as in a ROR-based analysis. The procedure for incremental B/C analysis of
multiple alternatives is as follows:
1. Determine the equivalent total cost for all alternatives. Use AW, PW, or FW equivalencies.
2. Order the alternatives by equivalent total cost, smallest first.
3. Determine the equivalent total benefits (and any disbenefits estimated) for each alternative.
4. Direct benefits estimation only: Calculate the B/C for the first ordered alternative. If B/C
 1.0, eliminate 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 by spreadsheet, deter-
mine the B/C for all alternatives initially and retain only acceptable ones.)
5. Calculate incremental costs (C) and benefits (B) using the relations
C  challenger cost  defender cost
B  challenger benefits  defender benefits
If relative usage costs are estimated for each alternative, rather than direct benefits, B may
be found using the relation
B  defender usage costs  challenger usage costs [9.5]

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 9.4 Incremental B/C Analysis of Multiple, Mutually Exclusive Alternatives 243

6. Calculate the B/C for the first challenger compared to the defender.
B/C  B兾C [9.6]
If B/C  1.0 in Equation [9.6], the challenger becomes the defender and the previous de-
fender 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 one.
In all the steps above, incremental disbenefits may be considered by replacing B with (B  D).

EXAMPLE 9.6
Schlitterbahn Waterparks of Texas, a very popular water and entertainment park headquar-
tered in New Braunfels, has been asked by four different cities outside of Texas to con-
sider building a park in their area. All the offers include some version of the following
incentives:
• Immediate cash incentive (year 0)
• A 10% of first-year incentive as a direct property tax reduction for 8 years
• Sales tax rebate sharing plan for 8 years
• Reduced entrance (usage) fees for area residents for 8 years
Table 9–1 (top section) summarizes the estimates for each proposal, including the present
worth of the initial construction cost and anticipated annual revenue. The annual M&O costs
are expected to be the same for all locations. Use incremental B/C analysis at 7% per year and
an 8-year study period to advise the board of directors if they should consider any of the offers
to be economically attractive.

Solution
The viewpoint is that of Schlitterbahn, and the benefits are direct estimates. Develop the AW
equivalents over 8 years, and use the procedure detailed above. The results are presented in
Table 9–1.
1. AW of total costs and an example for city 1 are determined in $1 million units.
AW of costs  first cost(A兾P,7%,8)  entrance fee reduction to residents
 38.5(0.16747)  0.5
 $6.948 ($6,948,000 per year)
2. The four alternatives are correctly ordered by increasing equivalent total cost in
Table 9–1.
TABLE 9–1 Incremental B/C Analysis of Water Park Proposals, Example 9.6
City 1 City 2 City 3 City 4
First cost, $ million 38.5 40.1 45.9 60.3
Entrance fee costs, $/year 500,000 450,000 425,000 250,000
Annual revenue, $ million/year 7.0 6.2 10.0 10.4
Initial cash incentive, $ 250,000 350,000 500,000 800,000
Property tax reduction, $/year 25,000 35,000 50,000 80,000
Sales tax sharing, $/year 310,000 320,000 320,000 340,000
AW of total costs, $ million/year 6.948 7.166 8.112 10.348
AW of total benefits, $ million/year 7.377 6.614 10.454 10.954
Overall B/C 1.06 0.92 1.29 1.06
Alternatives compared 1-to-DN B/C  1.0 3-to-1 4-to-3
Incremental costs C, $/year 6.948 1.164 2.236
Incremental benefits B, $/year 7.377 3.077 0.50
B/C 1.06 2.64 0.22
Increment justified? Yes Eliminated Yes No
City selected 1 3 3

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 244 Chapter 9 Benefit/Cost Analysis and Public Sector Economics

3. AW of total benefits and an example for city 1 are also determined in $1 million units.
AW of benefits  revenue  initial incentive(A兾P,7%,8)
 property tax reduction  sales tax sharing
 7.0  0.25(0.16747)  0.025  0.31
 $7.377 ($7,377,000 per year)
4. Since benefits are directly estimated (and no disbenefits are included), determine the over-
all B/C for each alternative using Equation [9.1]. In the case of city 1,
B兾C1  7.377兾6.948  1.06
City 2 is eliminated with B/C2  0.92; the rest are initially acceptable.
5. The C and B values are the actual estimates for the 1-to-DN comparison.
6. The overall B/C is the same as B/C  1.06, using Equation [9.6]. City 1 is economically
justified and becomes the defender.
7. Repeat steps 5 and 6. Since city 2 is eliminated, the 3-to-1 comparison results in
C  8.112  6.948  1.164
B  10.454  7.377  3.077
B兾C  3.077兾1.164  2.64
City 3 is well justified and becomes the defender against city 4. From Table 9–1, B/C  0.22
for the 4-to-3 comparison. City 4 falls out easily, and city 3 is the one to recommend to the
board. Note that the DN alternative could have been selected had no proposal met the B/C or
B/C requirements.

When two or more independent projects are evaluated using B/C analysis and there is no
budget limitation, no incremental comparison is necessary. The only comparison is between
Independent project each project separately with the do-nothing alternative. The project B/C values are calculated,
selection and those with B/C  1.0 are accepted.

This is the same procedure as that used to select from independent projects using the ROR method
(Chapter 8). When a budget limitation is imposed, the capital budgeting procedure discussed in
Chapter 12 must be applied.
When the lives of mutually exclusive alternatives are so long that they can be considered
infinite, the capitalized cost is used to calculate the equivalent PW or AW values for costs
and benefits. Equation [5.3], A  P(i), is used to determine the equivalent AW values in the
incremental B/C analysis. Example 9.7 illustrates this using the progressive example and a
spreadsheet.

EXAMPLE 9.7 Water Treatment Facility #3 Case PE

Land for Water Treatment Facility #3 was initially purchased in the year 2010 for $19.3 mil-
lion; however, when it was publicized, influential people around Allen spoke strongly against
the location. We will call this location 1. Some of the plant design had already been completed
when the general manager announced that this site was not the best choice anyway, and that it
would be sold and a different, better site (location 2) would be purchased for $28.5 million.
This was well over the budget amount of $22.0 million previously set for land acquisition. As
it turns out, there was a third site (location 3) available for $35.0 million that was never seri-
ously considered.
In his review and after much resistance from Allen Water Utilities staff, the consultant, Joel,
received a copy of the estimated costs and benefits for the three plant location options. The
revenues, savings, and sale of bulk water rights to other communities are estimated as incre-
ments from a base amount for all three locations. Using the assumption of a very long life for
the WTF3 facility and the established discount rate of 3% per year, determine what Joel dis-
covered when he did the B/C analysis. Was the general manager correct in concluding that
location 2 was the best, all said and done?

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 9.4 Incremental B/C Analysis of Multiple, Mutually Exclusive Alternatives 245

Location 1 Location 2 Location 3

Land cost, $ million 19.3 28.5 35.0
Facility first cost, $ million 460.0 446.0 446.0
Benefits, $ per year:
Pumping cost savings 5 3 0
Sales to area communities 12 10 8
Added revenue from Allen 6 6 6
Total benefits, $ per year 23 19 14

Solution
A spreadsheet can be very useful when performing an incremental B/C analysis of three or
more alternatives. Figure 9–1a presents the analysis with the preliminary input of AW values
for costs using the relation A  P(i) and annual benefits. Figure 9–1b details all the functions
used in the analysis. Logical IF statements indicate alternative elimination and selection deci-
sions. In $1 million units,
Location 1: AW of costs  A of land cost  A of facility first cost
 (19.3  460.0)(0.03)
 $14.379 per year
AW of benefits  $23
Location 2: AW of costs  $14.235 AW of benefits  $19
Location 3: AW of costs  $14.430 AW of benefits  $14
Though the AW of cost values are close to one another, the increasing order is locations 2, 1,
and 3 to determine B/C values. The benefits are direct estimates; therefore, the overall B/C
ratios indicate that location 3 (row 5; B/C3  0.97) is not economically justified at the outset.
It is eliminated, and one of the remaining locations must be selected. Location 2 is justified
against the DN alternative (B/C2  1.33); the only remaining comparison is 1-to-2 as detailed
in column C of Figure 9–1. Location 1 is a clear winner with B/C  27.78.
In conclusion, Joel has learned that location 1 is indeed the best and that, from the economic
perspective, the general manager was incorrect in stating that location 2 was better. However,
given the original evaluation criteria listed in the introduction—economics, environment, com-
munity impact, and constructability—location 2 is likely a good compromise selection.

(a)

(b)

Figure 9–1
Incremental B/C analysis for WTF3 case: (a) numerical results and (b) functions developed for the analysis.

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Basic Aspects of Depreciation
• An important component in computing income
taxes.
• For tax purposes:

Depreciation is the systematic allocation of the cost of an

asset spread over its depreciable life.

1
Depreciation
Definition - A decrease in value.
• In an economic context
• Market value
• Value to the owner
• In an accounting context a systematic allocation of
the cost of an asset over its depreciable life.
Depreciable life is related to
• Physical Depreciation
• Functional Depreciation
• Technological Depreciation
• Sudden failure
• Depletion
2
Depreciation and Expenses
• Expenses - subtracted from business revenues as
they occur (time frame < one year).
• Labor
• Utilities
• Materials
• Insurance, etc.
• Depreciation - subtracted from business expenses
over time as the asset is used up (applies to assets
with > 1 year useful life).
• Machinery
• Installation costs

3
Depreciation Methods
• Straight line
• Sum-of-years digits
• Declining balance

Terminology
• Cost Basis
• Adjusted Cost Basis
• Book Value

4
Example
• Consider the following example:
• Cost basis of an asset (B) = $900
• Useful life in years (N) = 5
• Salvage value (S) = $70

• Note:
• Cost basis includes installation and other “one-time”
costs associated with making the asset ready for use
• Salvage value (if used) is estimated or based on
accounting practices and procedures

5
Straight Line Depreciation

6
Straight Line Depreciation

7
 Accelerated Depreciation
• The rest of the methods discussed are called
“Accelerated Depreciation” methods.
• These methods deduct larger depreciation expenses in
the early years and less at the end.
• The large early deductions result in tax savings that are
realized sooner.
• A basic principle of the time value of money:
“Money now is better than money later”

8
Sum-of-Years-Digits (SOYD)

9
SOYD Calculations

10
SOYD

11
Double Declining Balance (DDB)

12
DDB Calculations

13
DDB

14
Inflation
Inflation may be defined as ‘a sustained upward trend in the general
level of prices’ and not the price of only one or two goods. It is also
defined as ‘a persistent and appreciable rise in the general level or
average of prices’. In other words, inflation is a state of rising prices,
but not high prices.

It is not high prices but rising price level that constitute inflation. It
constitutes, thus, an overall increase in price level. It can, thus, be
viewed as the devaluing of the worth of money. In other words,
inflation reduces the purchasing power of money. A unit of money
now buys less. Inflation can also be seen as a recurring phenomenon.

While measuring inflation, we take into account a large number of

goods and services used by the people of a country and then calculate
average increase in the prices of those goods and services over a period
of time. A small rise in prices or a sudden rise in prices is not inflation
since they may reflect the short term workings of the market.

It is to be pointed out here that inflation is a state of disequilibrium

when there occurs a sustained rise in price level. It is inflation if the
prices of most goods go up. Such rate of increases in prices may be
both slow and rapid. However, it is difficult to detect whether there is
an upward trend in prices and whether this trend is sustained. That is
why inflation is difficult to define in an unambiguous sense.

As inflation is a state of rising prices, deflation may be defined as a

state of falling prices but not fall in prices. Deflation is, thus, the
opposite of inflation, i.e., a rise in the value of money or purchasing
power of money. Disinflation is a slowing down of the rate of inflation.

Types of Inflation:
As the nature of inflation is not uniform in an economy for all the
time, it is wise to distinguish between different types of inflation.
Demand-pull inflation:
An increase in aggregate demand over the available output leads to a
rise in the price level. Such inflation is called demand-pull inflation
(DPI). Classical economists attribute this rise in aggregate demand to
money supply. If the supply of money in an economy exceeds the
available goods and services, DPI appears. It has been described as a
situation of “too much money chasing too few goods.”

DPI can be explained in terms of Fig. 4.2, where we measure output on

the horizontal axis and price level on the vertical axis. In Range 1, total
spending is too short of full employment output, Y F. There is little or
no rise in the price level. As demand now rises, output will rise. The
economy enters Range 2, where output approaches towards full
employment situation. Note that in this region price level begins to
rise. Ultimately, the economy reaches full employment situation, i.e.,
Range 3, where output does not rise but price level is pulled upward.
This is demand-pull inflation. The essence of this type of inflation is
that “too much spending chasing too few goods.”
Cost-push inflation:
Inflation in an economy may arise from the overall increase in the cost
of production. This type of inflation is known as cost-push inflation
(henceforth CPI). Cost of production may rise due to an increase in the
prices of raw materials, wages, etc. Often trade unions are blamed for
wage rise since wage rate is not completely market-determinded.
Higher wage means high cost of production. Prices of commodities are
thereby increased.

A wage-price spiral comes into operation. But, at the same time, firms
are to be blamed also for the price rise since they simply raise prices to
expand their profit margins. Thus, we have two important variants of
CPI wage-push inflation and profit-push inflation.

Causes of Inflation:
Inflation is mainly caused by excess demand/ or decline in aggregate
supply or output. Former leads to a rightward shift of the aggregate
demand curve while the latter causes aggregate supply curve to shift
leftward. Former is called demand-pull inflation (DPI), and the latter
is called cost-push inflation (CPI). Before describing the factors, that
lead to a rise in aggregate demand and a decline in aggregate supply,
we like to explain “demand-pull” and “cost-push” theories of inflation.

(i) Demand-Pull Inflation Theory:

There are two theoretical approaches to the DPI—one is classical and
other is the Keynesian.

According to classical economists or monetarists, inflation is caused

by an increase in money supply which leads to a rightward shift in
negative sloping aggregate demand curve. Given a situation of full
employment, classicists maintained that a change in money supply
brings about an equiproportionate change in price level.

That is why monetarists argue that inflation is always and everywhere

a monetary phenomenon. Keynesians do not find any link between
money supply and price level causing an upward shift in aggregate
demand.
According to Keynesians, aggregate demand may rise due to a rise in
consumer demand or investment demand or government expenditure
or net exports or the combination of these four components of
aggreate demand. Given full employment, such increase in aggregate
demand leads to an upward pressure in prices. Such a situation is
called DPI. This can be explained graphically.

Just like the price of a commodity, the level of prices is determined by

the interaction of aggregate demand and aggregate supply. In Fig. 4.3,
aggregate demand curve is negative sloping while aggregate supply
curve before the full employment stage is positive sloping and
becomes vertical after the full employment stage is reached. AD 1 is the
initial aggregate demand curve that intersects the aggregate supply
curve AS at point E1.
The price level, thus, determined is OP1. As aggregate demand curve
shifts to AD2, price level rises to OP2. Thus, an increase in aggregate
demand at the full employment stage leads to an increase in price level
only, rather than the level of output. However, how much price level
will rise following an increase in aggregate demand depends on the
slope of the AS curve.
(ii) Causes of Demand-Pull Inflation:
DPI originates in the monetary sector. Monetarists’ argument that
“only money matters” is based on the assumption that at or near full
employment excessive money supply will increase aggregate demand
and will, thus, cause inflation.
An increase in nominal money supply shifts aggregate demand curve
rightward. This enables people to hold excess cash balances. Spending
of excess cash balances by them causes price level to rise. Price level
will continue to rise until aggregate demand equals aggregate supply.

Keynesians argue that inflation originates in the non-monetary sector

or the real sector. In brief, increase in aggregate demand i.e., increase
in (C + I + G + X – M) causes price level to rise. However, aggregate
demand may rise following an increase in money supply generated by
the printing of additional money (classical argument) which drives
prices upward. Thus, money plays a vital role. That is why Milton
Friedman argues that inflation is always and everywhere a monetary
phenomenon.
There are other reasons that may push aggregate demand and, hence,
price level upwards. For instance, growth of population stimulates
aggregate demand. Higher export earnings increase the purchasing
power of the exporting countries. Additional purchasing power means
additional aggregate demand. Purchasing power and, hence, aggregate
demand may also go up if government repays public debt.

Again, there is a tendency on the part of the holders of black money to

spend more on conspicuous consumption goods. Such tendency fuels
inflationary fire. Thus, DPI is caused by a variety of factors.

(iii) Cost-Push Inflation Theory:

In addition to aggregate demand, aggregate supply also generates
inflationary process. As inflation is caused by a leftward shift of the
aggregate supply, we call it CPI. CPI is usually associated with non-
monetary factors. CPI arises due to the increase in cost of production.
Cost of production may rise due to a rise in cost of raw materials or
increase in wages.

However, wage increase may lead to an increase in productivity of

workers. If this happens, then the AS curve will shift to the right- ward
not leftward—direction. We assume here that productivity does not
change in spite of an increase in wages.
Such increases in costs are passed on to consumers by firms by raising
the prices of the products. Rising wages lead to rising costs. Rising
costs lead to rising prices. And, rising prices again prompt trade
unions to demand higher wages. Thus, an inflationary wage-price
spiral starts. This causes aggregate supply curve to shift leftward.

This can be demonstrated graphically where AS1 is the initial aggregate

supply curve. Below the full employment stage this AS curve is positive
sloping and at full employment stage it becomes perfectly inelastic.
Intersection point (E1) of AD1 and AS1 curves determine the price level
(OP1). Now there is a leftward shift of aggregate supply curve to AS 2.
With no change in aggregate demand, this causes price level to rise to
OP2 and output to fall to OY2. With the reduction in output,
employment in the economy declines or unemployment rises. Further
shift in AS curve to AS3 results in a higher price level (OP3) and a lower
volume of aggregate output (OY3). Thus, CPI may arise even below the
full employment (YF) stage.
(iv) Causes of Cost-Push Inflation:
It is the cost factors that pull the prices upward. One of the important
causes of price rise is the rise in price of raw materials. For instance,
by an administrative order the government may hike the price of
petrol or diesel or freight rate. Firms buy these inputs now at a higher
price. This leads to an upward pressure on cost of production.

Not only this, CPI is often imported from outside the economy.
Increase in the price of petrol by OPEC compels the government to
increase the price of petrol and diesel. These two important raw
materials are needed by every sector, especially the transport sector.
As a result, transport costs go up resulting in higher general price
level.

Again, CPI may be induced by wage-push inflation or profit-push

inflation. Trade unions demand higher money wages as a compen-
sation against inflationary price rise. If increase in money wages
exceed labour productivity, aggregate supply will shift upward and
leftward. Firms often exercise power by pushing prices up
independently of consumer demand to expand their profit margins.

Finally, production setbacks may result in decreases in output. Natural

disaster, gradual exhaustion of natural resources, work stoppages,
electric power cuts, etc., may cause aggregate output to decline.
Inefficiency, corruption, mismanagement of the economy may also be
the other reasons. Thus, inflation is caused by the interplay of various
factors. A particular factor cannot be held responsible for any
inflationary price rise.

4. Effects of Inflation:
People’s desires are inconsistent. When they act as buyers they want
prices of goods and services to remain stable but as sellers they expect
the prices of goods and services should go up. Such a happy outcome
may arise for some individuals; “but, when this happens, others will be
getting the worst of both worlds.”

When price level goes up, there is both a gainer and a loser. To
evaluate the consequence of inflation, one must identify the nature of
inflation which may be anticipated and unanticipated. If inflation is
anticipated, people can adjust with the new situation and costs of
inflation to the society will be smaller.

In reality, people cannot predict accurately future events or people

often make mistakes in predicting the course of inflation. In other
words, inflation may be unanticipated when people fail to adjust
completely. This creates various problems.

One can study the effects of unanticipated inflation under

two broad headings:
(a) Effect on distribution of income and wealth; and

(b) Effect on economic growth.

(a) Effects of Inflation on Distribution of Income and

Wealth:
During inflation, usually people experience rise in incomes. But some
people gain during inflation at the expense of others. Some individuals
gain because their money incomes rise more rapidly than the prices
and some lose because prices rise more rapidly than their incomes
during inflation. Thus, it redistributes income and wealth.

Though no conclusive evidence can be cited, it can be

asserted that following categories of people are affected by
inflation differently:
(i) Creditors and debtors:
Borrowers gain and lenders lose during inflation because debts are
fixed in rupee terms. When debts are repaid their real value declines
by the price level increase and, hence, creditors lose. An individual
may be interested in buying a house by taking loan of Rs. 7 lakh from
an institution for 7 years.

The borrower now welcomes inflation since he will have to pay less in
real terms than when it was borrowed. Lender, in the process, loses
since the rate of interest payable remains unaltered as per agreement.
Because of inflation, the borrower is given ‘dear’ rupees, but pays back
‘cheap’ rupees. However, if in an inflation-ridden economy creditors
chronically loose, it is wise not to advance loans or to shut down
business.

Never does it happen. Rather, the loan-giving institution makes

adequate safeguard against the erosion of real value. Above all, banks
do not pay any interest on current account but charges interest on
loans.

(ii) Bond and debenture-holders:

In an economy, there are some people who live on interest income—
they suffer most. Bondholders earn fixed interest income: These
people suffer a reduction in real income when prices rise. In other
words, the value of one’s savings decline if the interest rate falls short
of inflation rate. Similarly, beneficiaries from life insurance
programmes are also hit badly by inflation since real value of savings
deteriorate.

(iii) Investors:
People who put their money in shares during inflation are expected to
gain since the possibility of earning of business profit brightens.
Higher profit induces owners of firm to distribute profit among inves-
tors or shareholders.

(iv) Salaried people and wage-earners:

Anyone earning a fixed income is damaged by inflation. Sometimes,
unionised worker succeeds in raising wage rates of white-collar
workers as a compensation against price rise. But wage rate changes
with a long time lag. In other words, wage rate increases always lag
behind price increases. Naturally, inflation results in a reduction in
real purchasing power of fixed income-earners.

On the other hand, people earning flexible incomes may gain during
inflation. The nominal incomes of such people outstrip the general
price rise. As a result, real incomes of this income group increase.

(v) Profit-earners, speculators and black marketers:

It is argued that profit-earners gain from inflation. Profit tends to rise
during inflation. Seeing inflation, businessmen raise the prices of their
products. This results in a bigger profit. Profit margin, however, may
not be high when the rate of inflation climbs to a high level.

However, speculators dealing in business in essential commodities

usually stand to gain by inflation. Black marketers are also benefited
by inflation.

Thus, there occurs a redistribution of income and wealth. It is said

that rich becomes richer and poor becomes poorer during inflation.
However, no such hard and fast generalisation can be made. It is clear
that someone wins and someone loses during inflation.

These effects of inflation may persist if inflation is unanticipated.

However, the redistributive burdens of inflation on income and wealth
are most likely to be minimal if inflation is anticipated by the people.
With anticipated inflation, people can build up their strategies to cope
with inflation.

If the annual rate of inflation in an economy is anticipated correctly

people will try to protect them against losses resulting from inflation.
Workers will demand 10 p.c. wage increase if inflation is expected to
rise by 10 p.c.

Similarly, a percentage of inflation premium will be demanded by

creditors from debtors. Business firms will also fix prices of their
products in accordance with the anticipated price rise. Now if the en-
tire society “learn to live with inflation”, the redistributive effect of
inflation will be minimal.

However, it is difficult to anticipate properly every episode of inflation.

Further, even if it is anticipated it cannot be perfect. In addition,
adjustment with the new expected inflationary conditions may not be
possible for all categories of people. Thus, adverse redistributive
effects are likely to occur.
Finally, anticipated inflation may also be costly to the society. If
people’s expectation regarding future price rise become stronger they
will hold less liquid money. Mere holding of cash balances during
inflation is unwise since its real value declines. That is why people use
their money balances in buying real estate, gold, jewellery, etc. Such
investment is referred to as unproductive investment. Thus, during
inflation of anticipated variety, there occurs a diversion of resources
from priority to non-priority or unproductive sectors.

(b) Effect on Production and Economic Growth:

Inflation may or may not result in higher output. Below the full
employment stage, inflation has a favourable effect on production. In
general, profit is a rising function of the price level. An inflationary
situation gives an incentive to businessmen to raise prices of their
products so as to earn higher volume of profit. Rising price and rising
profit encourage firms to make larger investments.

As a result, the multiplier effect of investment will come into operation

resulting in a higher national output. However, such a favourable
effect of inflation will be temporary if wages and production costs rise
very rapidly.

Further, inflationary situation may be associated with the fall in

output, particularly if inflation is of the cost-push variety. Thus, there
is no strict relationship between prices and output. An increase in
aggregate demand will increase both prices and output, but a supply
shock will raise prices and lower output.

Inflation may also lower down further production levels. It is

commonly assumed that if inflationary tendencies nurtured by experi-
enced inflation persist in future, people will now save less and
consume more. Rising saving propensities will result in lower further
outputs.

One may also argue that inflation creates an air of uncertainty in the
minds of business community, particularly when the rate of inflation
fluctuates. In the midst of rising inflationary trend, firms cannot
accurately estimate their costs and revenues. That is, in a situation of
unanticipated inflation, a great deal of risk element exists.

It is because of uncertainty of expected inflation, investors become

reluctant to invest in their business and to make long-term
commitments. Under the circumstance, business firms may be
deterred in investing. This will adversely affect the growth
performance of the economy.

However, slight dose of inflation is necessary for economic growth.

Mild inflation has an encouraging effect on national output. But it is
difficult to make the price rise of a creeping variety. High rate of
inflation acts as a disincentive to long run economic growth. The way
the hyperinflation affects economic growth is summed up here. We
know that hyper-inflation discourages savings.

A fall in savings means a lower rate of capital formation. A low rate of

capital formation hinders economic growth. Further, during excessive
price rise, there occurs an increase in unproductive investment in real
estate, gold, etc. Above all, speculative businesses flourish during
inflation resulting in artificial scarcities and, hence, further rise in
prices.

Again, following hyperinflation, export earnings decline resulting in a

wide imbalances in the balance of payment account. Often galloping
inflation results in a ‘flight’ of capital to foreign countries since people
lose confidence and faith over the monetary arrangements of the
country, thereby resulting in a scarcity of resources. Finally, real value
of tax revenue also declines under the impact of hyperinflation.
Government then experiences a shortfall in investible resources.

Thus economists and policymakers are unanimous regarding the

dangers of high price rise. But the consequence of hyperinflation are
disastrous. In the past, some of the world economies (e.g., Germany
after the First World War (1914-1918), Latin American countries in the
1980s) had been greatly ravaged by hyperinflation.