Engineering Economics

Lecture 10

Er. Sushant Raj Giri

B.E. (Industrial Engineering), MBA
Lecturer
Department of Industrial Engineering

Contemporary Engineering 1
Economics 3rd Edition Chan S Park
 Chapter 17
Economic Analysis in the Public
Sector
• Framework of Benefit-
Cost Analysis
• Valuation of Benefits
and Costs
• Benefit-Cost Ratios
• Analysis of Public
Projects Based on
Cost-Effectiveness

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 Benefit-Cost Analysis
• Benefit-cost analysis is commonly used to
evaluate public projects.
• Benefits of a nonmonetary nature can be
quantified and factored into the analysis.
• A broad range of project users distinct from the
sponsor should be considered—benefits and
disbenefits to all these users can (and should) be
taken into account,

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 Framework of Benefit-Cost
Analysis
1) Identifying all the users and sponsors of the
project.
2) Identifying all the benefits and disbenefits of
the project.
3) Quantifying all benefits and disbenefits in
dollars or some other unit of measure.
4) Selecting an appropriate interest rate at which
to discount benefits and costs to a present
value.

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 Benefit-Cost Ratio Criterion

Equivalent Users' Net Benefits

Benefit - Cost Ratio =
Equivalent Sponsor' s Net Cost

If this BC ratio exceeds 1, the project can be justified

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Definition of Benefit-Cost Ratio
N
B = ∑ bn (1 + i ) − n
n=0
N
C = ∑ cn (1 + i ) − n
n=0

bn=Benefit at the end of period n, bn ≥ 0

cn=Expense at the end of period n, cn ≥ 0
An= bn – cn
N = Project life
i =Sponsor’s interest rate (discount rate)

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 K
I = ∑ cn (1 + i ) − n Equivalent capital investment
n=0
N
C' = ∑ c (1 + i)
n = K +1
n
−n Equivalent O&M costs

B B
BC(i ) = = , I + C' > 0
C I + C'

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Example 17.1 BC Analysis

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 B = $20( P / F, 10%, 2) + $30( P / F, 1%, 3)
+$30( P / F, 10%, 4) + $20( P / F, 10%, 5)
= $71.98

C = $10 + $10( P / F, 10%, 1) + $5( P / F, 10%, 2) + $5( P / F, 10%, 3)

+ $8( P / F, 10%, 4) + $8( P / F, 10%, 5)
= $37.41
I = $10 + $10( P / F, 10%, 1)
= $19.09
C’ = C – I
= $18.3
71.98
BC(10%) = = 1.92 > 1, Accept the project.
$19.09 + $18.32
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Relationship between B/C Ratio and NPW

B
>1
I + C'

B > (I + C’)

B – (I+ C’) > 0

PW(i) = B – C > 0

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Incremental Analysis Based on BC(i)

∆B = Bk − Bj
∆I = I k − I J
∆C' = C' k − C' j

∆B
BC (i ) k − j =
∆I + ∆C '

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Example 17.2 Incremental Benefit-Cost Ratios

A1 A2 A3

I $5,000 $20,000 $14,000

B 12,000 35,000 21,000

C’ 4,000 8,000 1,000

PW(i) $3,000 $7,000 $6,000

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 Solution
A1 A2 A3
BC(i) 1.33 1.25 1.40

Ranking Base A1 A3 A2
I +C’ $9,000 $15,000 $28,000

$21,000 − $12,000
BC(i ) 2 −1 =
($14,000 − $5,000) + ($1,000 − $4,000)
= 1.5 > 1, select A2.
$35,000 − $21,000
BC(i ) 2 −3 =
($20,000 − $14,000) + ($8,000 − $1,000)
= 1.08 > 1, select A2.
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 General Procedure for Cost-Effectiveness
Studies

• Step 1: Establish the goals to be achieved by the analysis.

• Step 2: Identify the imposed restrictions on achieving the
goals, such as budget or weight.
• Step 3: Identify all the feasible alternatives to achieve the
goals.
• Step 4: Identify the social interest rate to use in the analysis.
• Step 5: Determine the equivalent life-cycle cost of each
alternative, including research and development, testing,
capital investment, annual operating and maintenance costs,
and salvage value.

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• Step 6: Determine the basis for developing the cost-
effectiveness index. Two approaches may be used;
– (1) the fixed-cost approach and
– (2) the fixed-effectiveness approach.
– If the fixed-cost approach is used, determine the
amount of effectiveness obtained at a given cost.
– If the fixed-effectiveness approach is used, determine
the cost to obtain the predetermined level of
effectiveness.
• Step 7: Compute the cost-effectiveness ratio for each
alternative based on the selected criterion in Step 6.
• Step 8: Select the alternative with the maximum cost-
effective index.

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 Cost-Effectiveness Decision
Criterion
• Fixed Cost Approach • Fixed Effectiveness
Approach

Maximize Effectiveness Minimize Cost

Subject to: Subject to:

Budget Constraint Must meet the minimum

effectiveness

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Case Study - Selecting an Weapon
System

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 Weapon System Alternatives
Alternative Aj Advantage Disadvantage Probability
of Kill
A1: Inertial navigation Low cost, mature Accuracy, target 0.33
system technology. recognition
A2: Inertial navigation Moderate cost, nature Target recognition 0.70
system: Global technology
positioning system
A3: Imaging infrared Accurate, target High cost, bunkered 0.90
(I2R) recognition target detection
A4: Synthetic aperture Accurate, target High cost 0.99
radar recognition
A5: Laser Accurate, target High cost, technical 0.99
detection/ranging recognition maturity
A6: Millimeter wave Moderate cost, Target recognition 0.80
(MMW) accurate

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 Life-Cycle Costs for Weapon Development
Alternative
Expenditures in Million Dollars
Phase Year A1* A2 A3 A4 A5 A6
0 $15 $19 $50 $40 $75 $28
FSD 1 18 23 65 45 75 32
2 19 22 65 45 75 33
3 15 17 50 40 75 27
4 90 140 200 200 300 150
5 95 150 270 250 360 180
IOC 6 95 160 280 275 370 200
7 90 150 250 275 340 200
8 80 140 200 200 330 170
PW(10%) $315.92 $492.22 $884.27 $829.64 $1,227.23 $612.70

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 Cost-Effectiveness Index
Type Cost/Unit Probability Cost/Kill Kill/Cost
of Kill
A1 $31,592 0.33 $95,733 0.0000104

A2 49,220 0.70 70,314 0.0000142

A3 88,427 0.90 98,252 0.0000102

A4 82,964 0.90 83,802 0.0000119

A5 122,723 0.99 123,963 0.0000081

A6 61,370 0.80 76,713 0.0000130

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 $130,000 Unacceptable
region A5

120,000

110,000
Fixed cost
Cost/kill

100,000
A1 A3
90,000
Maximize
effectiveness A4
80,000
A6
A2
70,000
300 400 500 600 700 800 900 1000 1100 1200 1300
Present value of life cycle cost ($ million)
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 Summary
• Benefit-cost analysis is commonly used to evaluate
public projects:
• Difficulties involved in public project analysis include
the following:
1) Identifying all the users who can benefit from the
project.
2) Identifying all the benefits and disbenefits of the
project.
3) Quantifying all benefits and disbenefits in dollars or
some other unit of measure.
4) Selecting an appropriate interest rate at which to
discount benefits and costs to a present value.
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• The B/C ratio is defined as:

B B
BC (i ) = = , I + C' > 0
C I + C'

The decision rule is if BC(i) > 1, the project is acceptable.

• The net B/C ratio is defined as

B − C' B'
B / C (i ) = = ,I > 0
I I'
The net B/C ratio expresses the net benefit expected per
dollar invested. The same decision rule applies as for the
B/C ratio.
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• The cost-effectiveness method allows us to
compare projects on the basis of cost and
nonmonetary effectiveness measures.
• We may either maximize effectiveness for a given
cost criterion or minimize cost for a given
effectiveness criterion.

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End of Lecture 10
 Notice!!!

Internal Assessment
Date: September 1, 2015 11:00 AM

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 Examination Pattern
Phase I: Objective Round
10 Questions (1 marks for correct
answer, -0.2 for each incorrect one)
Phase II: Subjective Round
2 Short Questions (5 marks each)
1 Long Question (10 marks)

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 Scheme for Internal Evaluation

Assessment: 50%
Assignments: 50%
Total Internal Evaluation: 100%

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 Chance
Assignment
Chapter 8
(Page 383) 8.1, 8.4, 8.8, 8.12, 8.16, 8.21, 8.26, 8.32, 8.35
Chapter 9
(Page 436) 9.1, 9.5, 9.7, 9.10, 9.12, 9.16, 9.21, 9.25, 9.28

Submission Deadline:
September 1, 2015
(Tuesday)
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