EVALUATION OF PUBLIC EXPENDITURE

PROGRAMMES: COST-BENEFIT ANALYSIS (CBA)

Introduction
Cost benefit analysis (CBA) is a principle basis of appraising public projects. It is the
most appropriate method for appraising projects from national point of view. CBA
involves enumeration, comparison and evaluation of benefits and cost. It implies
weighing of returns against the costs involved in a project. CBA therefore purports to
describe and quantify the social advantages and disadvantages of a policy or public
project in terms of a common monetary unit. The objective function is expressed as:
Net Social Benefits (NSB) = Benefits – costs: where the benefits and costs are
measured in terms of shadow or accounting prices of inputs and outputs.
After identifying all the benefits and costs involved in a public project, there is need
to give a monetary value for each.

Project / Programme Evaluation Criteria

1.Net Present Value Criteria
Discounting the cash flows means translating future benefits streams into present
values. It is important because future benefits are less valuable than the present ones.
Net Present Value (NPV) is equal to the sum of the present value of all the cash flows
associated with a project.
Example:
Suppose there are two projects whose cash flows are as follows:

Project Year
0 1 2 3
A +1000 +500 +600 0
B +2361.60 +1000 1000 1000

With a discount rate of 10%

1000(1.00) +500(0.909) + 600(.826) + 0(.751)
= 1000 + 454.5 + 495.60 + 0
= $1950

PVB = 2361.6(1.00) + 1000 (.909) + 1000 (.826) +1000 (.751)

= 2361.60 + 909 + 826 + 751
= $4847.60
Example 2
Consider the following example .
Discount rate is 15%

Cash flow
Year Machin X Machin Y Discoun factor P.V for P.Vfor
e e t 1 Machine X Machine
(15%);  r) t
(20,000)
( Y (20,000)
1

0 (20,000) (20,000) 1.00 (20,000) (20,000)

1 10,000 12,000 .870 8,700 10,440
2 8,000 10,000 .756 6,048 7,560
3 7,000 8,000 .658 4,606 5,264
4 5,000 5,000 .572 2,860 2,860
5 5,000 5,000 .491 2,455 2,4 55
NPV 4,669 8,579

Machine Y is chosen because it has the highest net present

value
*Decision Criteria (Rule)
 NPV > 0 (+ ve) – the project is viable – accept. A positive NPV implies that
the project earns an excess return
 NPV < 0 (- ve) – the project is not viable – reject
Advantages of NPV Criteria
(i) It recognizes time value of money.
(ii) Considers all cash flows over the entire life of the project.
(iii) Ease to compare/rank projects.
(iv) The NPV of various projects can be added. This ensures that a poor project
(with a negative NPV) will not be accepted just because it is combined
with a good project (with positive NPV) since NPV (A + B) = NPV (A) +
NPV (B)

Disadvantages of the NPV Criteria

(i)NPV depends on the rate of discount chosen and tends to favour large projects,
which are capital intensive.
(ii)Given a discount rate, it favours projects whose returns (benefits) accrue in the
early life.
(iii)It may not give satisfactory results when the project compared involve different
amounts of investment.
(iv)Ranking of projects on NPV is influenced by the discount rate.
(v)NPV is an absolute measure and does not appeal to businessmen who think in
terms of rate of return.

2)Benefit Cost Ratio (BCR)

Benefits refer to increase in utility or production as a result of consumption of
outputs from a project. They are usually the reason for the investment.

Project Costs refer to the value of resources used in constructing, maintaining and operating
the project. Therefore relates to costs of labour, capital, intermediate goods, etc, including
allowance for induced adverse effects.

There are two ways of looking at the Benefit Cost Ratio:

(i)Benefit cost ratio (BCR) = PVB

I
OR

(ii)Net Benefit Cost Ratio (NBCR) = NPV = PVB-I = BCR - 1

I I

Where; BCR = Benefit Cost Ratio

PVB = Present Value of Benefits
I = Initial investment
NBCR=Net Benefit Cost Ratio
NPV=Net Present value

Example
If cash flows for a project are as follows

Year 0 1 2 3 4
Benefits (100000) 25000 40000 40000 50000

With a discount rate of 12%

Solution
Year cashflows Dis@12% PV
0 (100,000) 1.0000 (100,000)
1 25,000 ` 0.8929 22,322.5
2 40,000 0.7972 31,888
3 40,000 0.7118 28,472
4 50,000 0.6355 31,775

(i)BCR=PVB/I =114,457/100,000=1.145
(ii) NBCR = BCR – 1 = 1.145 - 1 = 0.145
Or NPV/I=14,457/100,000= 0.145
 Decision Rules
BCR > 1 Accept NBCR > 0 Accept
BCR = 1 Indifferent NBCR = 0
Indifferent
BCR < 1 Reject NBCR < 0 Reject

Strengths of CMA
-Provides a framework for structuring information and considering trade-offs.
-Helps make strategic choices about program priorities.
-Helps weed out the least desirable alternatives
-Can identify areas in which uncertainty is greatest and further research is desirable.
-Can increase explicitness in decisions and thereby elevate the level of public debate
and the usefulness of public participation.
-Enhances consistency among decisions.
-Can help assess the cumulative effects of regulations on groups, industries future
generations, geographical areas, etc.
-Can improve the credibility of government by showing how decisions are made and
that they are rational.
-Since the criterion measures NPV per shilling of outlay, it can discriminate better
between large and small investments hence preferred to NPV criterion.

Limitations
a.Difficulties in cost assessment: Cost estimates are made on the basis of the choice
of techniques, locations and prices of factor services used. But market prices,
particularly those of factors of production form an imperfect guide to resource
allocation in under- developed economies, because there exist fundamental
disequilibria which are reflected in the existence of massive underemployment at
present level of wages, the deficiency of funds at prevailing interest rates and the
shortage of foreign exchange at current rates of exchange.
b.Difficulties in Benefit Assessment, due to the element of uncertainty in a new
project as to the correct estimation of future prices, demand and supply of its
products, and difficulty in assessing external economies.
c.Arbitrary Discount Rate – the assumed social rate of discount for any project is
likely to be arbitrary. This might not make it possible to effectively calculate net
present value of benefits.
d.Neglects joint Benefit and costs arising from a project. It is difficult to evaluate and
calculate such benefits separately.
e.Ignores opportunity costs
f.Adjustment for Risk and Uncertainty problem also arises. This is done in three ways:-
 At the time of calculating the length of project life
 the discount rate and
 by making due allowance in benefit and costs
g.The problem of externalities. Side effects of a project are difficult to calculate in
this analysis. There may be technological and pecuniary spillovers (externalities) of a
river valley project such as the effects of flood control measures or a storage dam on
the productivity of land at other places in the vicinity. It is difficult to calculate such
external effects.
-Under unconstrained conditions, it will accept and reject the same projects as the NPV
-When the capital budget is limited in the current period, it may rank projects
correctly in the order of decreasingly efficient use of capital. However, its use is not
recommended because it provides no means for aggregating, several smaller projects
into a package that can be compared with a large project.
-When cash outflows occur beyond the current period, the BCR criterion is
unsuitable as a selection criterion.