Benefit Cost Ratio

Benefit/cost ratio (B/C) is used in the Feeder Model for Prioritization of spending alternatives. This is relevant only when resources are limited and not all the justified projects can be executed; B/C is not used for Justification of spending. B/C is a ratio of the benefit of a project to its cost. This simple definition obscures the fact that benefit/cost can actually be a very slippery concept. One example may help to illustrate this. Suppose you are asked to provide a benefit/cost ratio for a proposed cable replacement project. Below are some of the questions you’ll have to answer before you can do so.

  • What should be included in “benefits”? How will future benefits be counted?
  • Should “cost” include the capital cost of the project only, or should avoided maintenance and repair costs be included?
  • If avoided costs are to be considered, are they part of the benefit, or should they be subtracted from the cost of the project? If they are subtracted, how will you handle the possibility of a project with net negative cost?
  • Should benefits and costs be counted infinitely into the future? This would seem unrealistic, since the only two options are not to replace the cable next year or to never replace it. You could replace it in two years, for example. Or in ten.
  • In short, what is the baseline? When you are computing costs and benefits, they must be relative measures. But relative to what? Do nothing? Replace in ten years? Something else?

To avoid this confusion we define benefit/cost ratio in terms of the effect of doing a project this year rather than waiting one year. This gives a relative measure of the priority of each spending item without distortion.

Benefit/Cost ratio is the difference in total benefit from doing the project this year rather than next year, divided by one year’s opportunity cost of capital.

Benefit is the difference in cost, including avoided maintenance and risk, between having a new asset next year and having the existing one. In most cases, the net benefit is the difference between next year’s Marginal Cost and the EAC. So total benefit is this difference plus one.

Cost is the opportunity cost of spending capital this year rather than next year. This is normally the cost of the project times the Discount Rate. You can think of this as the interest you forego by doing the work rather than waiting.

Continue to Deferral Analysis.

 

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