5.4 Tips and Traps
The following tips and traps are useful to consider before presenting the analysis to decision-makers:
Are all the costs and benefits included? It is very easy to forget something. It pays to explain the project to a reviewer who hasn’t been involved in the development of the proposal to see if they can think of anything. Costs should be taken into account even if they do not actually involve spending cash. In particular, the value of land, of existing buildings, and of all services provided by other government departments should normally be included: the only costs that can be ignored are those that have already been incurred and which are for items with no alternative use, or those common to all options. Residual values should be estimated and included, whatever the length of the analysis.
Have you miscounted the use of real economic resources as a benefit? For example, the costs of building a stadium (materials, labour etc) is not a benefit to the economy. Often the jobs created by such projects are just a transfer from elsewhere in the region or country.
Are all the costs and benefits realistically valued? Use the previous points to assess whether you have either overvalued the benefits or undervalued the costs. If you have had to rely on figures provided by those promoting the project, check them for the optimism bias. Seek evidence of benefits and costs from reputable sources.
If the NPV is very high, why hasn’t the proposal been implemented earlier? If the NPV is very large, a useful check is to ask why it hasn’t been done earlier. A large NPV suggests a very high return, and possibly higher than the existing programmes.
Are there any variables that really influence the results? Often there are one or two variables (prices, values, capital cost) that drive the whole project, usually the capital cost of the project and the level of benefits. As these costs/benefits can be hard to estimate, you can check the robustness of the analysis by undertaking a sensitivity analysis, which is simply a second analysis with a sensitive variable changed by ±10% or ±50% or whatever is a realistic and possible variation. If the benefits of a project are uncertain, a sensitivity analysis will show the impact on the NPV of (say) a 100% variation to the estimated benefits. If the NPV remains positive or negative (whichever is the case) despite the change in the assumption, you can be much more comfortable of the robustness of your result.
Have you considered too few options? Decisions where there are no realistic choices are rare. There is always the “do-nothing”/“status quo” option and there will usually be choices as to the size, scope, form, or timing of projects. It is important that options are not ruled out solely because of differences in technical performance without an examination of comparative costs.
Have you confused real and nominal values? All costs and benefits in an options analysis should be converted to a common money value by removing general inflation. Changes in the price of particular goods and services relative to the general price level should be taken into account. Common examples of relative price changes are changes in real wages and the real exchange rate.
Have you used an appropriate time horizon? Time horizons need to be set in relation to the economic lives of assets, residual values should be included in the analysis for any assets that have some value beyond the appraisal period.
What about uncertainty? Events seldom turn out as expected and this often needs to be taken into account. Sensitivity analysis is the preferred technique for allowing for risk and uncertainty. The analysis should also specify when changing circumstances require a re-analysis.
Have you quantified all relevant factors? Factors such as non-market outputs or important environmental effects should not be ignored, even if they cannot be valued. At least a description of important effects of this kind should always be included.
Have you discounted future costs and benefits? Costs and benefits occurring at different pointsin time are not equally valuable and should be discounted to a common base date.
Have you used average instead of marginal benefits and costs? Be aware of the bias introduced. The use of average instead of marginal costs could significantly distort the analysis.
Ensure you exclude interest payments on borrowed capital? Interest payments on borrowed capital, while being a financial outlay, have no significance as far as the economic costs of a project are concerned. The real resources used - labour, material and equipment, etc - are the same regardless of the source of financing.
Have you excluded depreciation? Depreciation is an accounting device that does not necessarily reflect real resource use. To include depreciation on top of lump sum capital costs is double-counting.
5.5 Concluding Comments
This primer has been written as an introduction to Cost Benefit Analysis for public sector policy and financial analysts with little previous financial or economic analysis experience. It is pitched at an introductory level. If more information is required, the reader is referred to other sources (see bibliography) or the relevant Treasury Vote team.
