BenefitCost Analysis

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Benefit-Cost Analysis

• Vienna, Austria
• December 11, 2007
• Jeanne Powell, Economic Consultant
• Thomas Pelsoci, Delta Research Co.

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Benefit-Cost AnalysisOverview

• Jeanne Powell
• Economic Consultant
• Montgomery Village, MD
• j.w.powell_at_verizon.net

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Benefit-Cost Analysis OverviewOutline

• Benefit-Cost Analysis
• What is it?
• What type of evaluation tool is it?
• What metrics are computed?
• Advantages and disadvantages
• Steps in benefit-cost analysis
• Benefit-cost analysis in use ATP Studies
• Extension
• Cluster analysis
• Advantages of cluster analysis

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Benefit-Cost AnalysisWhat is it?

• Evaluation tool for
• Assessing the net impact of a policy change or
  program investment
• Estimating net impacts of an RD project or group
  of related projects according to program
• Mission
• Logic Model
• Timeline
• Comparing total estimated costs with total
  estimated benefits over a projects useful life
• Can be Prospective (reflect projected future
  effects), or Retrospective (reflect past
  effects), or a mix of both

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What type of evaluation tool is it?

• Quantitative case study
• Economic estimation
• Usually is based on monetary valuation of
  multiple types of benefits expressed as cash-flow
  analysis
• Generally most suited to long-term evaluation
• Risks and uncertainties of RD are large in early
  phases therefore, the probability distributions
  of the economic estimates are broad until
  technical and business uncertainties are reduced
  over the longer term
• Generally most suited to applied RD, close to
  market

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What does it measure?

• Return on Investment
• Net benefits
• Benefit-to-cost ratio
• Internal rate of return

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Whose Return?

• Private return
• return to project participants on their own
  investment/cost share
• Spillover return
• return to others beyond the project participants,
  including broad societal benefits, on combined
  sources of investment
• Social return
• return to project participants and nation broadly
  on combined public program and private investments

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Whose Return?

• Public return
• Increased social return enabled by public
  investment relative to that public investment
• Additionality effect

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Advantages (Cash-flow analysis approach)

• Provides quantitative estimates of impact that
  complement qualitative analysis
• Based on standard financial analysis used by
  private businesses. (The public finance
  literature has extended them to the analysis of
  public and societal benefits.)
• Models are intuitive and relatively easy to
  understand
• Can be applied systematically and relatively
  uniformly

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Advantages Continued (Cash-flow analysis
approach)

• Data requirements are less than for econometric
  analysis
• Benefit-cost studies are easier for policy makers
  to understand than those based on dynamic
  macroeconomic impact models or other econometric
  models
• Benefit-cost studies are more useful than purely
  qualitative case studies for making project
  comparisons

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Disadvantages(cash-flow analysis approach)

• Modeling of spillover benefits is challenging and
  expensive as with other tools
• Many important spillover benefits may be
  difficult to express in monetary terms
• Private benefits are often confidential
• Results are sensitive to uncertainties about
  technical success, market adoption, and
  inter-industry diffusion

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Advantages and DisadvantagesSummary

• Benefit-cost analysis is a practical choice for
  long-term evaluation of program impacts
• Utility increases as empirical basis increases
• Technical accomplishment
• Product development
• Entrepreneurial activity (including financing)
• Market adoption
• Economic diffusion

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Steps in Conducting Benefit-Cost Analyses
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Step 1

• Define the RD Investment Being Analyzed
• When did investment costs begin?
• Who will benefit?
• Funding recipients performing RD
• Customers of technology products
• General public
• Others
• How will they benefit?

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Step 2

• Determine the timing of benefits
• When did/will benefits begin?
• When did/will benefits end?
• When did/will a new technology displace the
  technology being studied?

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Step 3

• Define the alternative investment and outcomes
  that serve as the counterfactuals for measuring
  additionality i.e., to what degree would these
  benefits have occurred without the public
  investment?
• What benefits can you attribute to the public
  investment?
• What level of investment occurred with the public
  investment versus without it?
• Did public funding affect project timing? Affect
  probability of success? Have other effects?
• What new technological capability exists as a
  result of the public investment versus without
  it?
• What are the gains and losses enabled by the new
  technology (assuming technological change over
  the study period)?

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Step 4

• Identify benefit and cost cash flows (usually
  annually)
• Benefits include
• Private profits to technology innovator
• Benefits to technology users (intermediate and
  final)
• Broader societal benefits (e.g., public goods)
• Costs include
• Technology investment costs, including product
  development
• Losses from displacing the defender technology
  (offsets)

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Cash Flows for Project
Cash Flow Benefits
Time
Offsets
Investments
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Step 5

• State cash flow amounts consistently in constant
  (real) or nominal monetary value (e.g.,
  dollars/euros)
• To remove effects of inflation over the period
  benefits accrue
• Expressing future cash flows in terms of monetary
  value estimates at the time the study is done
  provides an easy way to generate constant dollar
  estimates and avoids guesswork about future
  inflation/deflation
• Energy-based cash flows and others that move
  differently from base inflation require separate
  adjustment based on official estimates of future
  prices of these goods

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Step 6

• Select an appropriate discount rate to adjust for
  the opportunity cost of money
• Cash flows received sooner have more opportunity
  to be reinvested and grow than those earned later
• Factors to consider
• In the U.S., OMB Circular A-94 mandates use of a
  7 real rate. As a result, ATP has used a 7
  real rate in nearly all benefit-cost studies
• Discount rate consistency will be important for
  comparing results of different investments
• Because a high discount rate reduces the value
  assigned to benefits further out in time, public
  policy sometimes assigns a low discount rate to
  projects that address long-run goals

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Step 7

• Discount all cash flows to a common point in
  time
• Generally cash flows are discounted back to the
  time the project started, using the net present
  value (NPV) formula for a cash flow in future
  time t for example,
• BNPV t Bt/(1d)t where Bt benefits in
  future year t and d the discount rate

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Step 8

• Combine time-adjusted cash flows to compute
• Net BenefitsNPV SBenefitsNPV SCostsNPV
• Benefit-to-cost ratio SBenefitsNPV/ SCosts NPV
• Compute internal rate of return
• Calculated by iterative solution for a rate at
  which the PV of investment cost cash flows equals
  the PV of benefit cash flows
• Calculate desired performance metrics for
  different components of return e.g., social
  return, private return, and public return
• Microsoft Excels NPV and IRR functions are
  frequently used and are reliable
• Test Excel on a simple example performed manually
  and with Excel

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Step 9

• Assess risks and uncertainties
• Establish a probability distribution around cash
  flow estimates about which there is significant
  uncertaintyparticularly projections of future
  benefits
• Test sensitivity of study results to estimates
  involving considerable uncertainty.

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Step 10

• Consider potentially important benefits that do
  not seem to be measurable but can be discussed
  qualitatively
• Health, safety, environmental benefits to society
  broadlybeyond direct technology customers or
  direct users

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Benefit-Cost Analysis in UseATPs Studies To
Date
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ExtensionCluster Analysis

• Compares benefits from a small group of related
  projects to investment costs for a broader group
  of similarly related projects
• Generates minimum estimates of return for the
  broader group
• Extends benefit-cost analysis from a single
  project to a broader part of a programs
  portfolio
• ATP has conducted a number of cluster studies
• Individual focused programs (Component-based
  software, Composites, Tissue Engineering)
• Thematic areas (Green Technologies, DNA
  Diagnostics, Photonics)

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Advantages of Cluster Analysis

• In-depth analysis of just a few projects enables
  conclusions about the return from a larger group
  of related projects or small portfolios
• Overcomes comparability issues
• Performed by a single contractor
• Generates a uniform set of metrics computed on a
  consistent basis

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For further information

• Send e-mail to j.w.powell_at_verizon.net
• Visit ATP/TIP website www.atp.nist.gov
• View ATP/TIP publications www.atp.nist.gov/eao/ea
  o_pubs.htm