Kathmandu University
Engineering Economy MGTS 301
Chapter-10
Benefit Cost Ratio
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The objective of Chapter 10 is to
demonstrate the use of the benefit-cost
ratio for the evaluation of public projects.
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Public Projects are unique in many ways.
• Frequently much larger than private ventures
• They may have multiple, varied purposes that sometimes conflict
• Often very long project lives
• Capital source is ultimately tax payers
• Decisions made are often politically influenced
• Benefits are often nonmonetary and are difficult to measure
• more...
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Applying the benefit-cost ratio method
• The consideration of the time value of money means this is really
a ratio of discounted benefits to discounted costs.
• Recommendations using the B-C ratio method will result in
identical recommendations to those methods previously
presented.
• B-C ratio is the ratio of the equivalent worth of benefits to the
equivalent worth of costs.
• The equivalent worth measures applied can be PW, FW, or AW,
but customarily, either PW or AW is used.
• The B-C ratio is also known as the saving-investment ratio (SIR)
by some governmental agencies.
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Two B-C ratios
Conventional B-C ratio with PW
Modified B-C ratio with PW
A project is acceptable when the B-C ratio is greater than or equal to one.
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B-C ratios for annual worth.
Conventional B-C ratio with AW
Modified B-C ratio with AW
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Pause and solve
Stillwater has initiated discussions on attracting rail service. A depot would need to be
constructed, which would require $500,000 in land and $5.2 million in construction
costs. Annual operating and maintenance costs for the facility would be $150,000, and
personnel costs would be an additional $120,000. Other assorted costs would be born
by the railroad and federal authorities. Annual benefits of the rail service are estimated
as listed below.
$1,300,000 Railroad annual payments
$200,000 Rail tax charged to passengers
$180,000 Convenience benefits to local residents
$120,000 Additional tourism dollars for Stillwater
Apply the B-C ratio method, with a MARR of 8% per year and 20 year study period, to
determine if the rail service should be established.
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Pause and solve
The city of Columbia is considering extending the runways of its municipal airport so
that commercial jets can use the facility. The land necessary for the runway extension is
currently a farmland that can be purchased for $350,000. Construction costs for the
runway extension are projected to be $600,000, and the additional annual maintenance
costs for the extension to be $22,500. If the runways are extended, a small terminal will
be constructed at a cost of $250,000. The annual operating and maintenance costs for
the terminal are estimated at $75,000. Finally, the projected increase in flights will
require the addition of two air traffic controllers at an annual cost of $100,000. Annual
benefits of the runway extension have been estimated as follows:
$325,000 Rental receipts from airlines leasing space at the facility
$65,000 Airport tax charged to passengers
$50,000 Convenience benefits for residents of Columbia
$50,000 Additional tourism dollars for Stillwater
Apply the B-C ratio method, with a MARR of 10% per year and 20 year study period, to
determine whether the runways at Columbia Municipal Airport should be extended.
Pause and solve
The construction cost of the bypass is $20 million, and $500,000 would be required
each year for annual maintenance. The annual benefits to the public have been
estimated to be $ 2 million. If the study period is 50 years and the state’s interest
rate is 8% per year, should the bypass be constructed? What impact does a social
interest rate of 4% per year have on the B-C ratio of the project?
At 8% interest rate per year, the conventional B-C ratio of the proposed Bypass is:
𝑩 − 𝑪 = 𝑨𝑾 𝑩𝒆𝒏𝒆𝒇𝒊𝒕𝒔 ] /𝑪𝑹 + 𝑨𝑾(𝑶&𝑴)
.
𝑩 − 𝑪 = 𝟐, 𝟎𝟎𝟎, 𝟎𝟎𝟎//𝟐𝟎, 𝟎𝟎𝟎, 𝟎𝟎𝟎 (A/P,4%,50)+$500,000
𝑩 − 𝑪 = 𝟐, 𝟎𝟎𝟎, 𝟎𝟎𝟎/𝟐𝟎, 𝟎𝟎𝟎, 𝟎𝟎𝟎*0.0466+$500,000
=1.4>1
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Dis-benefits in the B-C ratio
• Dis-benefits were defined as negative consequences to the
public resulting from the implementation of a public sector
project.
• The traditional approach for incorporating dis-benefits into a
B-C analysis is to reduce benefits by the amount of dis-
benefits (i.e. to subtract dis-benefits from benefits in the
numerator of the B-C ratio).
• Alternatively, the dis benefits could be treated as costs (i.e.
add dis-benefits to costs in the denominator.)
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Dis-benefits (D) can be included in the B-C ratio in either
the numerator or denominator, as shown with AW below.
or
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Pause and solve
Refer back to Question 1. In addition to the benefits and costs, suppose that there are dis-
benefits associated with the runway extension project. Specifically, the increased noise level
from commercial jet traffic will be a serious nuisance to homeowners living along the approach
path to Columbia Municipal Airport. The annual dis-benefit to citizens of Columbia caused by
this noise pollution is estimated to be $100,000. Given this additional information, reapply the
conventional B-C ratio, with equivalent annual worth, to determine whether this dis-benefit
affects your recommendation on the desirability of this project.
$325,000 Rental receipts from airlines leasing space at the facility
$65,000 Airport tax charged to passengers
$50,000 Convenience benefits for residents of Columbia
$50,000 Additional tourism dollars for Stillwater
Apply the B-C ratio method, with a MARR of 10% per year and 20 year study period, to
determine whether the runways at Columbia Municipal Airport should be extended.
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Added benefits vs. reduced cost
• As with the different types of ratios, the question arises if
classifying certain cash flows as either added benefits or reduced
costs.
• As before, while the numerical value of the ratio may change, there
is no impact on project acceptability regardless of how the cash
flows are handled.
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Let,
B = the equivalent annual worth of projects benefits,
C = the equivalent annual worth of projects costs,
X = the equivalent annual worth of a cash flow (either an added
benefit or a reduced a cost) not included in either B or C
𝐵+𝑋.
𝐼𝑓 𝑋 𝑖𝑠 𝑐𝑙𝑎𝑠𝑠𝑖𝑓𝑖𝑒𝑑 𝑎𝑠 𝑎𝑛 𝑎𝑑𝑑𝑒𝑑 𝑏𝑒𝑛𝑒𝑓𝑖𝑡, 𝑡ℎ𝑒𝑛 B − C =
𝐶
Alternatively,
𝐵.
𝐼𝑓 𝑋 𝑖𝑠 𝑐𝑙𝑎𝑠𝑠𝑖𝑓𝑖𝑒𝑑 𝑎𝑠 𝑎 𝑟𝑒𝑑𝑢𝑐𝑒𝑑 𝑐𝑜𝑠𝑡, 𝑡ℎ𝑒𝑛 B − C =
𝐶−𝑋
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Assuming that the project is acceptable, that is B − C ≥ 1.0,
B+X
≥ 1.0, 𝑤ℎ𝑖𝑐ℎ 𝑖𝑛𝑑𝑖𝑐𝑎𝑡𝑒𝑠 𝑡ℎ𝑎𝑡 𝐵 + 𝑋 ≥ 𝐶, 𝑎𝑛𝑑
𝐶
B
≥ 1.0, which indicates that B ≥ C − X,
𝐶−𝑋
which can be restated as B + X ≥ C.
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Pause and solve
A Project is being considered by the Tennessee Department of
Transportation to replace an aging bridge across the Cumberland River on
a state highway. The existing two lane bridge is expensive to maintain
and creates a traffic bottleneck because the state highway is four lanes
wide on either side of the bridge. The new bridge can be constructed at a
cost of $300,000, and estimated annual maintenance costs are $10,000.
The existing bridge has annual maintenance cost of $18,500. The annual
benefits of the new four-lane bridge to motorists, due to the removal of
the traffic bottleneck, has been estimated to be $25,000. Conduct the B-C
analysis, using MARR of 8% and a study period of 25 years, to determine
whether the new bridge should be constructed.
Solution
Treating the reduction in annual maintenance costs as a reduced cost:
B-C= BENEFIT/COST-(X)
B-C= $25,000/[$300,000 (A/P, 8%, 25)-(18,500-10,000)]
=$25,000/[$300,000*0.937-8,500
=1.275>1
Treating the reduction in annual maintenance costs as an increased benefits:
B-C= BENEFIT+(X)/COST
B-C= $25,000+(18,500-10,000)/[$300,000 (A/P, 8%, 25)
B-C= $33,500 /300,000*0.937
=1.192
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Selecting projects
• If projects are independent, all projects that have a B-C great than
or equal to one may be selected.
• For projects that are mutually exclusive, a B-C greater than one is
required, but selecting the project that maximizes the B-C ratio does
not guarantee that the best project is selected.
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Incremental B-C analysis for mutually exclusive projects.
• Incremental analysis must be used in the case of B-C and
mutually exclusive projects.
• Rank alternatives in order of increasing total equivalent worth of
costs.
• With “do nothing” as a baseline, begin with the lowest equivalent
cost alternative and determine the incremental B-C ratio (B/C),
selecting the alternative with the higher equivalent cost if the ratio
is greater than one.
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Which, if any, of the MEA projects below should be selected
using B-C analysis? Assume a 20 year study period and
MARR=10%.
A B C
Investment $125,000 $160,000 $180,000
Annual O&M 10,000 10,000 9,500
MV (20 yrs.) 40,000 50,000 50,000
Benefit/yr. 35,000 42,000 44,000
PW(10%)-costs 204,190 237,703 253,447
PW(10%)-benefits 297,975 357,570 374,597
B-C ratio 1.46 1.50 1.47
Each alternative is attractive.
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Incremental Analysis
(-A) (C-B)
Investment $35,000 $20,000
Annual O&M 0 -500
MV (20 yrs.) 10,000 0
Benefits/yr. 7,000 2,000
PW(10%)-costs 33,514 15,743
PW(10%)-benefits 59,595 17,027
B-C ratio 1.78 1.08
Conclusion B is better C is better
Choose alternative C.
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Three mutually exclusive alternative public-works projects are
currently under consideration. Their respective costs and benefits are
included in the table that follows. Each of the projects has a useful life
of 50 years, and MARR is 10% per year. Which, if any, of these
projects should be selected?
A B C
Capital Investment $8,500,000 $10,000,000 $12,000,000
Annual Operating & 750,000 725,000 700,000
Investment Costs
Market value 1,250,000 1,750,000 2,000,000
Annual Benefit 2,150,000 2,265,000 2,500,000
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Some Criticisms of B-C Analysis.
• B-C is often used as an “after-the-fact” justification tool.
• Distributional inequities (one group benefits, another pays the
cost) may not be accounted for.
• Qualitative information is often ignored.
• Bottom line: these are largely reflective of the inherent
difficulties in evaluating public projects rather than the B-C
method itself.
