Fm 14 Cost Benefit Analysis

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Financial Management Series

Number 14

Cost / Benefit Analysis

Alan ProbstLocal Government SpecialistLocal Government CenterUW-Extension


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Performing a Cost/Benefit Analysis is basicto all financial decision-making

We each do it consciously or unconsciouslyevery day for every action we take orpurchase we make

Major expenditures of public funds requiresa more formal process


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Cost / Benefit AnalysisA Cost/Benefit Analysis is most

commonly used in localgovernment as part of the CapitalBudgeting process and the Capital

Improvements Program (CIP).


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In local government, the benefit is themaximizing public welfare versusmaximizing profit in business

Broader and more complex

Must estimate the value of benefits andcosts that are indirect and intangible


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At its essence, it is a one to onecomparison of the combined benefitsversus the combined costs of pursuinga course of action or public policy

Realistically determining the costs andbenefits is the challenge in government


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A public project is desirable when thepresent value of its estimated flow ofbenefits, discounted at the

communitys cost of capital, equals orexceeds the projects cost


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Costs Money

Opportunity Time

Personnel/Equipment

Public Reaction

Intangibles


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Money

Opportunity cost of using cash on hand or

cash reserve

1. Interest or investment potential

2. Funds not available for other projects

3. Depleted reserve may affect ability toborrow or issue bonds in the future


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Money Financing: Local loans, state loans,

bond issue1. Interest rates

2. Availability of money to borrow

3. Statutory limits

4. Administrative costs


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Money

Tools/Considerations

Net Present Value determination

Bond Rating Financial Trend Analysis


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Opportunity

What could you do with money if didnt

spend it on this project

What other public need will not be

fulfilled if this project is undertaken


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Time

What is the cost in time

1. Staff time

2. Elected officials time

3. Information technology time

4. Other equipment time5. Other projects postponed time


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Personnel/Equipment

In addition to time cost:

1. Will you need to hire additionalpersonnel?

2. How much wear & tear on equipment?

3. What new equipment will be needed?

4. Insurance costs

5. Fuel costs


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Public Reaction A political reality for elected officials is that

public reaction to pursuing or not pursuing a

project, policy, or course of actions must beconsidered

How the public perceives the cost in taxdollars can be more important than thefinancial considerations


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Intangibles Intangibles are those costs which

cannot readily be assigned amonetary value

1. Loss of historic value

2. Change of appearance

3. Decreased economic developmentopportunity

4. Loss of green space


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Benefits

Monetary profit

Increase in public safety or accessibility Increased capacity Increased recreational opportunities Increased economic development

opportunities Improved quality of life More efficient operations Lower taxes


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Other Considerations

Depreciation/amortization US or state regulations

Precedent


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Example

The City of Wildwood is consideringestablishing an industrial park to spawn

economic development and jobs.

The City wants to determine if the benefits ofsuch an action will outweigh the costs.

The City decides to perform a cost/benefitanalysis to help facilitate the decision.


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Costs (money) Land costs = $12,000 per acre

Acreage needed = 50 acresTotal Land Costs = $600,000

Infrastructure costs (streets, lights, water &sewer) = $1.4 million

Investment building = $326,000

Total industrial park costs = $2,326,000


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Costs (opportunity)

Industrial park dollar cost could beinvested at a rate of 2.7% APR for tenyears for a total interest earned of

$710,054

Industrial park dollar cost could beused to rebuild 9.5 miles of streets.


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Public Reaction

If local unemployment is high, there may be apositive reaction

Some element of the public will invariablyfeel this is a misuse of public funds

The level of the positive and negativereactions must be considered in doing theanalysis


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Anticipated Benefits

For planning purposes we will assume:

Each acre of the park will produce anadditional $1 million in taxable propertyimprovements within ten years at anaverage MIL rate of $11.45 for a benefitof $572,500 in increased property taxes


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Anticipated Benefits (cont.)

Each acre of industrial park land isexpected to produce an average of five(5) new jobs paying an average wage of

$12.75 per hour for an annual income of$26,520 each. Assuming all acres arefilled and jobs created within ten years,

the park would increase the localeconomy by $6,630,000 per year.


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Reality

Industrial parks NEVER fill as fast asprojected so average trends must beconsidered along with holding costs

The overall national economy trendswill greatly affect the realistic results

Wages are decreasing nation-wide. An

average wage of $12.75 my be overlyoptimistic

Intangibles may also have an affect


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More Likely Scenario

Probably only about 15 acres of thepark will be fully developed within 10years. This would produce only an

additional $171,750 in property taxincome.

Those acres will likely only produce anaverage of 3 jobs each with an averagewage of $9.75 for an input to the localeconomy of only $912,600


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More Likely Conclusion

Costs =$2,326,000Ten year benefits = $1,084,350

In this scenario, building the industrial parkdoesnt appear to be a sound financialdecision

You can see by the difference in cost versusbenefits that the assumptions you use inyour projections greatly affect your outcome


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Public Reaction

You can safely assume those who supportan industrial park will want to use the firstprojections while those who think the money

would be better spent on a new library willwant to use the latter projections.

No matter what numbers you use, youultimately will have to answer to citizens whoboth support and oppose your decision


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Conclusion

While business can make decisions based solely

on whether or not a proposed action will make a

profit or minimize a loss, local government

officials must take into account other factorsLocal government officials must consider public

opinion and a variety of other intangibles in

addition to cost comparative data but the

cost/benefit analysis can make those decisionsmuch easier and defensible

Fm 14 Cost Benefit Analysis

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