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8/2/2019 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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Cost / Benefit Analysis
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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Cost / Benefit Analysis
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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Cost / Benefit Analysis
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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Cost / Benefit Analysis
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