Life Cycle costing, Financial and Economic Analysis, and Benefit cost Ratio Analysis

Introduction to Life cycle costing

When there is no need for estimating the revenue stream for a proposed project, we can consider only the cost streams of the project. In that case, it is common to convert this life cycle cost (LCC) into an equivalent annual cost for purposes of comparison. The industry has used the LCC to help determine which project will cost less over the life of a project. As 80% of the total life cycle cost of a system occurs after the system has entered into service, the finest long term system acquisition and support judgments are based on a full understanding of the total cost of obtaining, operating and supporting the system. Life cycle cost analysis (LCCA) enables the analyst to make certain that the selection of an alternative is not based solely on the lowest initial costs, but also takes into consideration of all the future costs over the project’s usable life. Some of the peculiar features of LCCA are as follows:

1. LCCA is used appropriately only to select from among design alternatives that would yield the same level of performance or profits to the project’s users during normal operations.
2. LCCA is a way to predict the most cost effective solution but does not guarantee a particular result, but allows the plant designer or manager to make a reasonable comparison among alternative solutions within the limits of the available data.
3. To make the fair comparison, the plant manager or designer might need to consider the measure used. For example, the same process output size should be considered and if the two projects being examined cannot give the same output volume, it may be suitable to express the figures in cost per unit of output which requires a calculation of annual equivalent dollars generated. This calculation is based on the annual output.

In many cases, we need to compare a set of different design alternatives, each of which would produce the same number of units (constant revenues) but would require different amounts of investment and operating cost (because of different degrees of mechanization).

Introduction to Financial and Economic Analysis:

Economic evaluation can be used to inform decision making and can provide information to assist in answering the following questions:

1. What services do we provide (or improve), when and at which level?
2. How do we provide such services?
3. Where do we provide the services?
4. What are the costs associated with providing or improving the services?

Economic analysis is used for two main purposes. The first is a scientific understanding of how allocations of goods and services are actually determined. This is a positive analysis, analogous to the study of electromagnetism or molecular biology and comprises only the attempt to understand the world around us. Economic analysis suggests the way distinct changes in laws and other government interferences in markets will affect people. Such analyses combine positive analysis forecasting the effects of changes in rules with value judgments and are known as normative analysis. For example, a gasoline tax invested in building highways harms gasoline buyers but helps drivers.

The three methods of economic evaluation are as follows:

1. Cost – Effective Analysis: It is a specific type of economic analysis in which all costs are associated with a single, common effect. It is used to compare different resource allocation option in like terms. CEA is a comparison tool; it will not always indicate a clear choice but it will evaluate options quantitatively and objectively on the basis of a defined model. This analysis includes Direct Cost, Indirect costs, and intangibles.
2. Cost – Utility Analysis: It is similar to CEA in which there is defined outcome and the cost to reach that outcome is measure in money.
3. Cost – Benefit Analysis: It is performed when information is required as to which interventions will result in overall resource savings. In CBA, the benefit is measured as the associated economic benefit of an intervention; hence both costs and benefits are expressed in money and the CBA may ignore many intangibles but important benefits that are tough to measure in monetary terms.

Public sector Economic Analysis (Benefit Cost Ratio Method)

Benefit Cost Analysis is a judgment making the tool that is used to systematically develop useful information about the necessary and unnecessary effects of public projects. In a sense, we may see in the public sector as profitability study in the private sector. In other words, it attempts to determine whether the social benefits of a planned public activity be greater than the social costs. Usually, public investment decisions comprise a great deal of expenditure and their benefits are likely to occur over an extended period of time.

Framework of Benefit-cost Analysis:

In performing benefit-cost analysis, we express users as the public and sponsors as the government. The general framework for benefit-cost analysis are stated as follows:

1. Identify all users’ benefits expected to arise from the project
2. Compute these benefits in rupees term as much as possible so that diverse benefits may be compared against one another and against the costs of achieving them
3. Find sponsors’ costs
4. Compute these costs’ in rupee terms as much as possible to allow comparisons
5. Find the equivalent benefits and costs during the base period, use an interest rate appropriate for the project
6. Do accept the project if the equivalent users’ benefits exceed the equivalent sponsors’ costs.

Benefit-cost analysis can be used to choose among such alternatives. If the projects are on the same scale with respect to cost, it is merely a question of choosing the project for which the benefits exceed the costs by the greater amount. The steps just outlined are for a single (or independent) project evaluation. As in this case of the internal rate of return criterion, in comparing mutually exclusive alternatives, an incremental benefit cost ratio must be used.

To begin the benefit-cost analysis, we identify all project’s benefits and disbenefits to the users.

Users’ Benefits (B) = Benefits – Disbenefits

Benefit-cost Ratios:

An alternative way of expressing the worthiness of a public project is to compare the sponsors’ costs (C) with the user’s benefits (B) by taking the ratio B/C.

For a given benefit-cost profile, let B and C be the present value of benefits and costs defined respectively by

Where, b_n­ = Benefit at the end of period n, b_n ≥ 0

c_n = Expense at the end of period n, c_n ≥ 0

A_n = b_n – c_n

N = project life

i = Sponsor’s interest rate (discount rate)

The sponsors’ costs (C) consist of the equivalent capital expenditure (I) and the equivalent annual operating costs (C’) accrued in each successive period.

The B/C ratio is defined as

If we are to accept the project, BC(i) must be greater than unity.

An alternative measure called the net B/C ratio, B’C(i) considers only the initial capital expenses as a cash outlay and annual net benefits are used.

The net B/C ratio also should be greater than one to accept the project. The magnitude of BC(i) will generally be different than that for B’C(i) but the magnitudes are irrelevant for making decisions.

NOTE: We must express the values of B, C’ and I in the present worth equivalents. Alternatively, we can compute these values in terms of annual equivalents and use them in computing the B/C ratio. The resulting B/C ration is not affected.

Comparison of Mutually Exclusive Project:

We must see the incremental investment analysis approach in comparing the mutually exclusive alternatives based on the B/C ratio.

Steps for incremental analysis based on B/C:

1. If there are more than one alternatives, eliminate any alternatives with a B/C ratios less than unity.
2. Arrange the remaining alternatives in ascending order of the denominator (I + C’). Thus, the alternative with the smallest denominator should be the first (j) and the alternative with the second smallest denominator should be second (k) and so forth.
3. Calculate the incremental differences for each term (B, I and C’) for the paired alternative (j, k) in the list:

4. Compute the BC(i) on incremental investment by evaluating

If BC(i)_{k – j} > 1, select the alternative ‘k’. Otherwise select the alternative ‘j’.

5. Compare the alternative selected with the next one on the list by computing the incremental B/C ratio. Continue the process until you reach the bottom of the list. The alternative selected during the final pairing is the best one.

BIBLIOGRAPHY:

Chan S.Park, Contemporary Engineering Economics, Prentice Hall, Inc.
E. Paul De Garmo, William G.Sullivan and James A. Bonta delli, Engineering
Economy, MC Milan Publishing Company.
James L. Riggs, David D. Bedworth and Sabah U. Randhawa,Engineering
Economics, Tata MCGraw Hill Education Private Limited.