COST BENEFIT ANALYSIS

Cost benefit analysis

COST BENEFIT ANALYSISOECS ENGINEERING WORKSHOPOBJECTIVESWhy Cost Benefits AnalysisCBA MethodologyCBA ExerciseCBA LimitationApplication in the Context of Disaster Risk Reduction

Why YOU, the Engineer?Those who generate solutions are most intimate with the details and best suited to analyze them financially.

To be heard, engineers must be able to speak financially:It is generally assumed that the engineering solution will work -- must justify financiallyEngineeringEngineers provide answers.Ability to solve problems or take advantage of opportunities through the application of science.Must meet certain criteria.Technical feasibility/efficiency: meet or exceed specifications.Economic feasibility/efficiency: meet budgets and return.

The Role of engineering Economic analysisEngineering economic analysis is most suitable for intermediate problems and economic aspects of complex problem, they have those qualities :1) the problem is important enough to justify our giving it serious thought and effort.2) careful analysis requires that we recognize the problem and all various consequences, and this is just too much to be done all at once.3)the problem has economic aspects important in reaching a decision. CBA Terms & ConceptsInterest and equivalencePresent Value AnalysisCash Flow AnalysisRate of ReturnDeprecationCost benefit analysisRisk, and uncertainlySensitivity analysis

Engineering EconomyEvery technical solution has financial consequences.Engineering economic analysis determines whether a proposed solution is financially viable.Will it pay?Is this the minimum cost solution?Will it generate an acceptable return?Engineering economic analysis is used to answer many different questions :Which engineering projects are worthwhile ? Which engineering project should give higher priority?How should the engineering project be design? involves the systematic evaluation of the economic merits of proposed solutions to engineering problems.

7Making an Economic DecisionThe steps:Problem or opportunity recognition and definitionGeneration of Solution AlternativesDevelopment of Feasible Solution Alternative Cash Flows and Information GatheringEvaluation of Solution AlternativesSelection and Implementation of Best AlternativePost-implementation Analysis and Evaluation

Decisions in DesignThe design process is generally embedded in the second step of the decision-making process.Designs = Solution Alternatives

Design decisions are generally discipline specific.

But the economics surrounding design decisions are for all engineersinvolves the systematic evaluation of the economic merits of proposed solutions to engineering problems.9Engineering Economic Decision Analysis DifficultyInvestments carry risk.Money spent now for expected savings or returns in the future.As future is uncertain, so are returns or savings.Money spent can be lost. If too often, could lead to bankruptcy.While economics are paramount, many other factors influence decision.

Evaluation Techniques

Payback PeriodNet Present ValueInternal Rate of returnCost Benefit RatioCBA ExampleA country is considering installing a water treatment system in a rural community that is expected to cause environmental and direct benefits of $ 1,000,000 per year for its inhabitants. The system would require an investment of $ 9,000,000 and have operating and maintenance costs of $ 300,000 per year for an expected life of 20 years, after which it would have no value. If money for this type of project costs the county 6%, is the project justified on an economic basis? Suppose an AID Agency is willing to pay $ 4,000,000 of the investment. Now is it justified?

YearCapital CostO&MBenefitNB09,000,00000 (9,000,000)1 300,000 1,000,000 700,000 2 300,000 1,000,000 700,000 3 300,000 1,000,000 700,000 4 300,000 1,000,000 700,000 5 300,000 1,000,000 700,000 6 300,000 1,000,000 700,000 7 300,000 1,000,000 700,000 8 300,000 1,000,000 700,000 9 300,000 1,000,000 700,000 10 300,000 1,000,000 700,000 11 300,000 1,000,000 700,000 12 300,000 1,000,000 700,000 13 300,000 1,000,000 700,000 14 300,000 1,000,000 700,000 15 300,000 1,000,000 700,000 16 300,000 1,000,000 700,000 17 300,000 1,000,000 700,000 18 300,000 1,000,000 700,000 19 300,000 1,000,000 700,000 20 300,000 1,000,000 700,000 NPV($916,089.76)Evaluation based on NPV Method

Thus, it is not justified in total.Based only on benefit and costs to the county

B > (I + C)B (I+ C) > 0PW(i) = B C > 0FOCUS ON THE DIFFERENCESOnly the differences in expected future outcomes among the alternatives are relevant to their comparison and should be considered in the decisionSummaryA benefit-cost analysis is commonly used to evaluate public projects;Difficulties involved in public project analysis include the following:Identifying all the users who can benefit from the project;Identifying all the benefits and disbenefits of the project;Quantifying all benefits and disbenefits in some money unit of measure;Selecting an appropriate interest rate at which to discount benefits and costs to a present value;CBA AND DISASTER RISK REDUCTION

An important aspect in risk evaluation is also:How much do we need to spend in order to reduce the riskRisk reduction

Risk reduction strategiesStructural measures: refer to any physical construction to reduce or avoid possible impacts of hazards, which include engineering measures and construction of hazard-resistant and protective structures and infrastructure Non-Structural measures:refer to policies, awareness, knowledge development, public commitment, and methods and operating practices, including participatory mechanisms and the provision of information, which can reduce risk and related impacts.

Tools to evaluate best risk reduction measuresCost Benefit Analysis (CBA) is used to compare costs and benefits of a one specific measures or a set of alternative measures over a period of time for a. CBA assesses the measure(s) mainly on the basis of the efficiency criterion. It requires the monetization of all the effects. The effects that cannot be expressed in monetary terms will be usually described in their original unit of measurement.Cost Effectiveness Analysis: (CEA) has most of the features of CBA, but does not require the monetization of either the benefits or the costs (usually the benefits). CEA does not show whether the benefits outweigh the costs, but shows which alternative has the lowest costs (with the same level of benefits). CEA is often applied when the norm for a certain level of safety has been set. CEA analyzes which types of solution is the cheapest given a certain level of safety standard.Multi Criteria Analysis (MCE) is a tool that allows comparing alternative measures on multiple criteria. In contrast to CBA, MCE allows the treatment of more than one criterion and does not require the monetization of all the impacts. MCE results in a ranking of Alternatives

Which alternative is economically the most attractive?

Flood proofing relocation.LeveesIf all alternatives are all as effective in terms of risk reduction the cheapest alternative (Cost Effectiveness Analysis, CEA)

If effectiveness in risk reduction differs the cheapest alternative in terms of risk reduced (Cost Benefit Analysis, CBA)Cost Benefit Analysis of Risk Reducing MeasuresCosts for (structural) risk reducing measures are relatively less difficult to estimateEstimating the benefits is a major challenge ! We need to know:Avoided damage Probability of damage We need to estimate: how often natural hazard events occur (frequency)how much damage and losses occur as a result of the event

Do we include all losses?

Flooding ExampleDirect damage

Indirect damage

buildingsinfrastructurecrops and livestockMachineshuman victimslandscape/nature

income forgoneinterruption of economic and social activitiesextra costs of transportation due to infrastructure damage

Damage functions

Damage-probability curveDamage-probability curvein case of flood protectionagainst events upto 1:100 years27Basic CBA steps Define scope of the projectIdentify the type of costs and benefitsPut monetary values on costs and benefitsCompare costs and benefitsCalculate profitability indicators/decision criteriaSensitivity analysisMake recommendationsExample CBA Flood Reducing MeasuresScenario I (removal)removal of housing in the 10-year Return Period flood zone10 year RP flood zone is converted into green areasbuildings are demolished, new terrain to be bought, and new buildings have to be constructed in other hazard free zonesthe set-up of a vigilance group is required The risk in the area that was formerly threatened by a 10 year Return Period flood will be reduced to 0

Scenario II (retention)construction of an upstream storage lakeengineering works flood retention basin and drainage need maintenancethe retention basin will reduce the flood losses.It will retain the discharge for 2 and 5 years RP and reduce the risk to 0. For the other return periods the damage will reduce the losses

Damage without risk reduction, Scenario I and II at different Return PeriodsFloodingReturn PeriodAnnual Probabilitywithout mitigationScenario 1Scenario 220.50.000.050.219.300.0100.134.4019.3250.04100.065.634.4500.02199.0164.6100.01000.01510.0475.6199.02000.0051134.01099.6510.031Risk reductionOnce you have calculated the annual loss for the existing situation, you can now evaluate the reduction in total annual losses for the two scenarios.

Calculate the amount of risk reduction, comparing Scenario 1 and Scenario 2 with the original average annual risk. Risk reductionAverage Annual RiskAnnual Risk Reduction($'000,000)($'000,000)Present Situation 25,927 - Scenario 1 17,165 8,762 Scenario 2 9,737 16,190 3132CostsAfter calculating the risk reduction (benefit) and the investment costs of the two flood scenarios we can now continue to evaluate the cost/benefits. The following table indicates the costs of the two scenarios.

3233Maintenance and operation costsEach of the two scenarios will also require long term investments. Scenario 1 requires the set-up of a municipal organization that controls the illegal spread of housing in highly hazardous areas. It will require staff, office and equipment costs, which will rise over time depending on the increases of salary and inflation. The annual costs are estimated to be 250.000. We consider that these costs will increase with 5 % each year. Scenario 2 also requires maintenance and operation costs. The flood retention basin contains a basin in which sediments are deposited. Annually the sediments from this basin have to be removed using heavy equipment. Also the drainage works needs regular repair. The costs for maintenance are considered to be 500.000 per year. We consider that these costs will increase with 5 % each year. See table below. 3334Investment periodThe investments for both scenarios are not done within one single year. They are spread out over a larger number of years, because normally not all activities can be carried out in the same year.It is quite difficult to remove existing buildings. The municipality would like to buy the land of private owners, but they will resist, and there will be many lawsuits that might take a lot of time. Therefore we consider that the entire relocation of all building might take as much as 10 years. The investment costs are therefore spread out over this period. The construction of the engineering works for scenario 2 will take less time. Still it is considered that the costs are spread over a period of 3 years. The benefits will start in the year that the investments are finished. For scenario 1 this is in year 11 and for scenario 2 it is in year 4.3435Project lifetimeThe lifetime of the scenario 2 is considered to be 40 year. After that the structure will have deteriorated and it needs to be rebuilt. For the relocation scenario it is more difficult to speak about a life time, but we will also keep the same period of 40 years. 35Flood mitigation Scenario Iyearincremental benefitsNPV_10%1-8.333-7.5762-8.333-6.8873-8.333-6.261415.69010.716515.6909.742Until year 40Flood mitigation Scenario IIyearincremental benefitsNPV_10%1-8.333-7.5762-8.333-6.8873-8.333-6.261415.69010.716515.6909.742Until year 40Summary CBA scenario I and IIFlood Risk Reduction ScenarioNPV at 5 % interest rateNPV at 10 % interest rateNPV at 20 % interest rateIRR Scenario I42.23-0.38-14.969.91% Scenario II203.8093.6927.7942.32%NPV and IRR

ResultQuestion:Which Mitigation Scenario would you advice the Municipality?

Elements often overlooked in CBA in Natural Hazard and Disaster ManagementIndirect economic damageSocial effectsIrreplaceable itemsStress induced by disasterTemporary evacuationSocial disruptionEnvironmental effectsEvaluation of non-structural measures

CBA -strengthsSystematic way of thinking and analysisFocus on use of scarce resourcesStrong methodological basisMonetary measurement provides comparisonAppeal to policy makers

One approach to assess the efficiency of (structural) risk reducing measuresTake care of uncertainty of all parameters usedEstimated values of objects at riskProbabilities of the hazardTake care of all aspects NOT considered:Social effectsIrreplaceable itemsStress induced by disasterTemporary evacuationSocial disruptionEnvironmental effectsIndirect effectsDiscounting favours present generationsOne single outcome hides assumptions and value judgements

Limitations Cost-Benefit Analysis43THE ENDTHANK YOUCriterionDecision rule

acceptreject

NPVNPV > 0NPV < 0

IRRIRR >

interest rateIRR <

interest rate