Economic Analysis 1 Economic Analysis Analysis of Alternatives

Economic Analysis 1

Economic Analysis (Analysis of Alternatives) 2

Economic Analysis • “A systematic approach to the problem of choosing the best method of allocating scarce resources to a given objective” – Recognizes that there may be alternative ways of meeting an objective » Each alternative requires different resources and produces different results • Economic analysis examines and compares the benefits, costs, and uncertainties of each alternative • Objective: to determine the most cost effective means of meeting the objective 3

Elements of Economic Analysis • Definition of the Objective • Assumptions and Constraints • List of Alternatives • Analysis of Benefits • Analysis of Costs • Comparison of Alternatives • Sensitivity and Risk Analyses • Conclusions/Recommendations 4

Definition of the Objective • Should clearly define and quantify, to the maximum extent possible, the function to be accomplished • Must be as objective as possible – Should not assume a specific means of achieving the desired result – Must be worded to reflect a totally unbiased point of view 5

Assumptions and Constraints • Assumptions: Explicit statements used to describe the present and future environment upon which the economic analysis is based • Required Assumptions: (1) Economic life » the period of time over which benefits from an alternative are expected to accrue. Usually constrained by physical, mission or technological life (2) Period of Comparison (period of analysis) » begins when money is spent on the first alternative requiring expenditure of funds and ends when the alternative with the longest economic life ceases to produce benefits • There is one period of comparison for an economic analysis 6

Limits on Economic Life • Physical life – The estimated number of years that an asset can physically be used • Mission life – The estimated number of years over which the need for the asset is anticipated • Technological life – The estimated number of years a facility, piece of equipment, or automated information system will be used before it becomes obsolete due to changes in technology 7

Constraints • External factors that limit alternatives to problem solutions – Physical » a fixed amount of space – Time-Related » a fixed deadline – Financial » a limited amount of resources – Institutional » policy or regulation • Conditions that are beyond the control of the decision maker that limit the number of available alternatives 8

List of Alternatives • All reasonable ways of satisfying the objective should be documented and discussed • At a minimum, each of the following alternatives must be considered: – Status quo » the existing way of meeting the objective must be included even if it’s considered to be infeasible – Modification of existing assets » renovation, conversion, upgrade, expansion, or other forms of improvement of existing assets or services – Leasing or privatization – New acquisition • Alternatives dismissed as infeasible must be discussed, but need not be formally compared in the analysis 9

Analysis of Benefits • Benefits = outputs expected for the costs incurred – Synonymous with results, effectiveness, or performance • Should present the decision maker with an objective, orderly, comprehensive, and meaningful display of the benefits expected for each alternative 10

Analysis of Costs • Includes identification and evaluation of all anticipated expenditures associated with each alternative over its entire life cycle – Encompasses costs of research and development, investments in procurement & facilities, operating and support, and disposal – Magnitude and timing of expenditures are equally important 11

Comparison of Alternatives • Four conditions are possible: (1) Both benefits and costs are equal » A subjective choice may be made (2) Benefits are equal and costs are unequal » Recommend the least cost alternative (3) Benefits are unequal and costs are equal » Recommend the alternative with greater benefits (4) Both benefits and costs are unequal » The most common outcome and the most difficult to analyze 12

Comparison of Alternatives • Benefits and costs are unequal – Rank order the alternatives in terms of benefits and also in terms of costs » recommend an alternative based on the relative importance of benefits and costs – Compare cost benefit ratios » divide the quantifiable benefits by the uniform annual cost » provides a measure of efficiency of resource utilization 13

Sensitivity and Risk Analyses • Uncertainty is always present in economic decision making because of the assumptions required in conducting the analysis and estimating benefits and costs • It is important to analyze whether changes in assumptions, quantitative values, or priorities will affect the recommendation • A range of expected benefits and costs will provide more information of which to base a decision than the basic analysis alone 14

Benefits Analysis • Presents the decision maker with an objective, orderly, comprehensive, and meaningful display of the benefits expected for each alternative • Benefits: – “Outputs or measures of effectiveness or performance” – Should not be quantified in terms of dollars • Costs and benefits must be defined so that they are mutually exclusive – Cost savings or avoidances, which are reductions in the resources used, should be reflected in cost analysis » such savings should not be counted again as a benefit 15

Identification of Benefits (1) Develop a conceptual viewpoint – Inputs (Costs) Resources used; Effectiveness, Readiness, Throughput Outputs (Benefits) (2) Examine the project from various viewpoints – Benefits should relate to the mission need that has been identified, the combat capability that is lacking, the problem that needs to be solved – Benefits should be clearly defined and distinct and directly relate to mission success » cruising range vs. fuel capacity (3) Quantify benefits to the maximum extent possible – Numerical measures are preferred » descriptions such as high, average, or low may be the best available measures in some instances 16

Categories of Benefits • Production: # of items produced for each alternative • Productivity: # of items produced per hour of work, volume of output per hour of work, flight hours per month • Operating efficiency: the rate at which a system consumes resources (miles per gallon) • Reliability: MTBF, number of service calls per year • Accuracy: error rate (errors per time period, per 100 records, per 100 items produced) • Maintainability: difficulty of repair (average # of hours necessary for repairs, crew size necessary to maintain the system) 17

Categories of Benefits • Manageability: impact on organizational workload resulting from changes in supervision or inspection times associated with the new system Integratability: impact that integration of a new system will have on organizational workload and output • Availability: when will the system 1 st be available for use vs. when its use is required • Service Life: when does the system become obsolete? • Quality: will a better quality or service be obtained, can it be quantified? • Acceptability: will the new system interfere with operations within the organization, parallel organizations, or higher headquarters? 18

Categories of Benefits • Ecology: environmental impact, are current requirements met? • Economic: benefits including employment, impact on economically depressed areas, small business obligations Morale: opinion surveys to impact effects on employee morale • Safety: is the system secure, will more security precautions be needed? • Flexibility: how adaptable is the system to various modes of operation? 19

Decision Making With Multiple Attributes • Normally there will be more than one objective or attribute to achieve • Several techniques can be used for evaluating multiple objectives – Additive weighting and ranking – Additive weighting and scaling • Reduce complexity of the evaluation process by eliminating alternatives if possible – If an alternative fails to meet the requirement for even one benefit, it is an unacceptable alternative and can be eliminated from further consideration. – If an alternative is rated the best in every attribute being considered, that alternative dominates all others. No additional benefits analysis will be necessary. Can proceed directly to cost analysis. 20

Weighting Schemes • Weights can be assigned in any logical manner that reflects the priorities of the decision maker – A higher number will always represent better performance – Ties are allowed Ordinal Rankings – Benefits are arrayed from most to least important » if 5 benefits are being considered, the most important benefit would receive a weight of 5 Percentages – Each benefit is assigned a weight between 0 and 1 to reflect the benefit’s relative importance » weights, when summed, equal 1. 0 21

Weighting Schemes Scores – Benefits are assigned a weight (score) within some specified range to indicated its relative importance » Pick one benefit and arbitrarily assign its weight » Determine the other weights one at a time by estimating their relative importance compared to the “starting” benefit 22

Additive Weighting and Ranking • For each alternative, assign a weight based on how important the benefit is to the overall objective of the project. – A higher number indicates greater relative importance • For each benefit, multiply the weight by the rank to determine the weighted rank. • Add the weighted ranks for each alternative. – The alternative with the largest sum is the preferred alternative based on benefits. 23

Additive Weighting and Scaling • A refinement of Additive Weighting and Ranking to reflect quantitative data rather than just rankings • Inconsistencies in benefits requires a way of scaling raw data to attain comparable units of measurement – Data collected on different benefits will likely be in different units of measure » pounds, miles, pk – Some benefits may have verbal descriptions (high, average, low) rather than numerical descriptions – For some benefits a high number is good (pk), for others a low number is good (breakdowns per 100 hrs of operation) 24

An Example • Three contractors are competing to build observation helicopters for the Army and Marine Corps. The alternatives are named A, B, and C. The benefits under consideration include speed, range, survivability, reliability, and crew size. – Speed is maximum airspeed measured in knots per hour. – The survivability rating is based primarily on the helicopters armaments. – Reliability ratings area based on estimates of equipment readiness. – Crew size is expressed in number of crew members. • The decision maker has stated that survivability is the most important benefit. – Based on additional guidance from the decision maker, a percentage weighting scheme is devised. 25

Additive Weighting and Scaling 26

Additive Weighting and Scaling • Data for survivability and reliability is qualitative – Can be converted to quantitative data using the following scale 27

Additive Weighting and Scaling • Two data problems remain: – Units of measure are not compatible » miles, knots, people, and dimensionless scores for survivability and reliability – A small number is good with respect to crew size but bad for all other benefits » adding numbers scaled where low is good will distort the analysis • Normalization of the raw data is required 28

Data Normalization • One technique: linear proportional scaling – Raw values are transformed to scaled values between 0 and 1, with a high number always the best. If a high number is good: where Sij = the scaled value for benefit i and alternative j Xij = the raw value for benefit I and alternative j Xi max = the highest (best) raw value for benefit j If a low number is good: where Sij = the scaled value for benefit i and alternative j Xij = the raw value for benefit I and alternative j Xi min = the lowest (best) raw value for benefit j 29

Normalized Data 30

Alternative B is preferred, followed by Alternative A. Alternative C, which has the lowest score, is last. 31

Benchmarked Additive Weighting and Scaling • Additive Weighting and Scaling technique can be refined if standards have been established which the project must meet. – Alternatives are rated against project standards (minimum requirements/maximum limits) vice other alternatives. If a high number is good: where BSij = the benchmark-scaled value for benefit i and alternative j Xij = the raw value for benefit I and alternative j Xi required = the minimum required raw value for benefit j If a low number is good: where BSij = the benchmark- scaled value for benefit i and alternative j Xij = the raw value for benefit I and alternative j Xi limit = the maximum limit raw value for benefit j 32

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Cost Analysis • Begins with the life cycle cost estimate for each alternative – Encompasses R&D, investments in procurement & facilities, operating and support, and disposal » Analogy, industrial engineering, parametric • Sunk costs may be mentioned in the narrative but are not included in the cost analysis – Only costs influenced by the decision maker are included • Residual value: “the value of an asset at any given point in time” – Counted as an offset only if money is expected to change hands, representing a positive cash flow for the investment » Salvage Value: the expected value of an asset at the end of its useful life » Terminal Value: the estimated value of an asset at a point in time subsequent to its initial fielding 34

Special Considerations • Phase-out costs: “costs that must be incurred for parallel operations of the status quo while the development or modification is taking place” » must be added to the life cycle cost for the new system • When the magnitude and timing of a cost is identical for all alternatives, it can be considered a “wash cost” and excluded from the cost analysis – Such exclusions must be carefully documented to ensure that cost figures from the cost analysis are not taken out of context 35

Special Considerations • Inflation is an important consideration – Analyses normally done using constant (uninflated) dollars of a particular base year – Can also be done using current (inflated) dollars by applying compound inflation indices » Constant dollars are preferable to current dollars » Do not use then-year dollars 36

Special Considerations • The time value of money must also be considered – Time phasing of expenditures is important » when money must be paid out, it is preferable to pay it at some future date rather than now because of the opportunity to earn interest on money held – Costs should be allocated according to the fiscal year in which payment will be made – To compare the value of a dollar in the future to the value of a dollar held now, an adjustment to a common point in time must be made using a technique called discounting 37

Special Considerations • By discounting, present values of future cash streams can be calculated to facilitate valid comparisons – The discount rate is the interest rate used to determine the present value of a future cash stream » represents the opportunity cost of making the investment – The government’s cost of borrowing is the basis for discount rates used in conducting economic analysis within Do. D » discount rate used represents the average interest rate on Treasury securities of maturity similar to the expected project length 38

Discount Rates • If expenditures are assumed to occur at the end of the fiscal year, the following formula applies: • If expenditures are assumed to occur at mid-year, the following formula applies: Fn = the present value factor for year n, i = the discount rate, = the project year n 39

Inflation vs. Discounting • Inflation and time value of money are two different effects – Two different reasons why a dollar today is worth more than a dollar to be received in the future » Inflation causes a loss of purchasing power due to a general rise in prices » A dollar held today can be invested; interest earned makes it more valuable than a dollar received in the future • Effects of inflation are already removed when performing constant dollars analysis – Constant dollars must still be discounted to obtain their present value • Effects of inflation and discounting must be accounted for when performing current dollar analysis – Current dollars must be deflated and discounted to derive the present value of future cash flows 40

A Cost Analysis Example • Due to a shortage of office space, a decision must be made whether to lease office space off base (Alternative A) or buy temporary buildings (Alternative B). – Alternative A: Lease 10, 000 square feet of office space for $12. 00 per square foot per year for six years beginning 1 October 1997. Maintenance and utility costs will be paid by the owner. – Alternative B: Purchase five temporary buildings for $190, 000. Buildings can be delivered by 1 October 1997 for a cost of $7, 500. Maintenance and utilities are expected to total $18, 000 per year. The buildings have an economic life of seven years and can be disposed of in the eighth year for a net salvage value of $10, 000 41

TDPC = Total Discounted Project Cost 42

Salvage Value of Buildings must also be considered: Net Present Value of salvage dollars received in year eight = ($10, 000)(0. 8207) = $8, 207 Net TDPC = $306, 972 - $8, 207 = $298, 765 43

Uniform Annual Cost • Must also account for differences in economic life by computing a Uniform Annual Cost for each alternative – Uniform Annual Cost: a constant amount that, if paid annually throughout the economic life of an alternative, would yield a total discounted project cost (less discounted salvage value) equal to the actual present value cost of the alternative » UACs are directly comparable 44

A Practical Exercise in Economic Analysis • Dinwiddie Army Depot is contemplating the purchase of four new forklift trucks to move supplies and equipment in a maintenance yard. The new trucks will replace four worn out machines that are currently in service. The new vehicles must have a usable service life of at least seven years and can be electric, gasoline, or propane powered. FY 99 is the base year for the project. The vehicles are to be delivered the first week of October 2000 and used immediately. Three alternatives are being considered: – Zimco Roadrunner – High Lift Mfg. Co. , Mark III – Watley Motormule 45

Alternative A: Zimco Roadrunner • Description and Particulars: The Zimco Roadrunner is a propane powered vehicle having a lift capacity of 4, 000 lbs and a max speed of 12 mph. It is manufactured in the U. S. Special pallets are required to accommodate the extra wide blades of the fork, which are too wide to pick up existing pallets from the sides. A total of 300 pallets is required. There are currently 60 of this type pallet on hand. Due to current operational policies, only 160 pallets will be needed in FY 01. The remainder will be acquired in FY 02. The Roadrunner has a salvage value of $1, 400/vehicle and an economic life of 10 years. During the 5 th year, a $1, 600 overhaul is required for each vehicle. 46

Alternative B: Mark III • Description and Particulars: The Mark III is an electric powered vehicle having a lift capacity of 5, 000 lbs and a max speed of 12. 5 mph. It is manufactured in the U. S. and has an economic life of 9 years. It is a highly reliable vehicle and has a salvage value of $1, 450. A little development must be completed to determine the changes needed for operation of the Mark III. The cost of each vehicle includes the charging facilities and their estimated cost of installation. This vehicle must be overhauled in the 6 th year at a cost of $1, 400 per unit. 47

Alternative C: Watley Motormule • Description and Particulars: The Motormule is a gasoline powered vehicle having a lift capacity of 2, 500 lbs and a max speed of 7. 5 mph. It is manufactured in Great Britain. The Motormule, which is a highly reliable machine, has a salvage value of $1, 500. It does not require overhaul until the 8 th year of operation. A complete overhaul costs $1, 425 and can be completed in the United States. The low cost of this alternative plus its 12 -year economic life, makes it a very attractive choice. 48

Benefits Analysis 49