CHAPTER 4: PROJECT COSTS &BENEFITS
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At the end of this chapter student will be able to explain:
Objectives ,Costs & Benefits
Financial & Economic Analysis of the
project
Intangible Costs & Benefits
Tangible Benefits of projects
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To compare costs with benefits & determine which among alternative
projects have an acceptable financial & economic return
the costs and benefits of a project must be identified
Once costs and benefits are known
they must be priced and their economic value can be determined.
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4.1: Objectives, cost and benefits
In identifying costs & benefits of the project’s, objectives play an
important role.
In project analysis, the objectives of the project provide
the standard against which cost & benefits are defined.
Cost is anything:- that reduces an objective &
benefit is anything that contributes to an objective.
The problem with such simplicity, however, is that:
each participant in the project has many objectives.
E.g.- A private business firm can have objectives such as:
Maximizing net income (profit), Increasing market share, Improving
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customer satisfaction , Reducing risk, etc.
A society /nation as a whole may want to achieve the f/f objectives as:
Increasing national income
Ensuring equitable distribution b/n persons, regions, generations, etc.
Improving balance of payments
Improving regional integrity
Reducing inflation
Reducing unemployment
Maintaining environment etc.
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However, the problem with such a number of objectives is
there is no formal analytical system for project analysis :-
o that could possibly take into account all the various objectives of
the society & private business firm &
it is not possible to address the objectives of d/t stakeholders at the
same time
Thus, we will take
Maximization of net incremental income (profit) for a private firm &
Maximization of national income for a nation as the fundamental
objectives in the analysis of a project.
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In financial analysis:-
the project will be evaluated in terms of its contribution
o to net income (profit) of the private owner.
The project that will generate the highest profit for the owner
will be given priority than other alternative projects.
In economic analysis:-
Evaluation of project is made by its contribution to national income.
o Projects that contributes the highest to the national income & which
makes a significant contribution to other social objectives will be
selected.
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E.g. If two projects contribute equal income to national income, we
will choose:-
o the one that favor equitable distribution or the one that creates
the most jobs, etc.
In the economic analysis we will assume that:
all financing for a project comes from domestic sources &
all returns from the project go to domestic residents,
o thus we identify cost & benefits in terms of GDP instead of GNP
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4.2: Costs & benefits: In financial and economic analysis.
Financial revenues and cost of the project are good starting point for
identifying economic benefits and costs.
But two types of adjustments are necessary.
adjustments necessary for identifying economic benefits & costs are:
1. to include (or exclude) some costs and benefits.
2. to revalue inputs & outputs at their opportunity cost.
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Financial analysis: looks the project from the perspective of the
implementing agency and it used to identifies:-
1. the project’s net money flows to the implementing entity
2. the entities ability to meet its financial obligations and
3. the entities ability to finance future investments.
Economic analysis: by contrast, looks the project from perspective of
the entire economy (“society”) and
Measures the effects of a project on the economy as a whole.
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These d/c viewpoints require that analyst:-
have to take into consideration d/t items when looking at the
costs of a project,
use d/t valuations for the item considered, and
use d/t rates to discount the streams of costs and benefits.
In financial analysis we are interested in the items that entail/ need
monetary outlays.
In economic analysis, we are interested in the opportunity costs for
the country.
Even if the project entity does not pay for the use of resources,
this does not mean that the resource is free good.
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If a project diverts resources from other activities that produce goods
or services:-
the value of what is given up represents an opportunity cost of the
project to society.
The important d/c b/n financial and economic analysis is:
the price that the project entity uses to value the inputs & outputs.
Financial analysis is simply based on:-
the actual prices that the project entity pays for inputs and receives for
outputs.
The prices used for economic analysis, however, are based on :-
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The economic values of both inputs & outputs usually differ from
their financial value (market prices) b/c:
o There are different market imperfections
o There are government interventions for various kinds (taxes,
subsidies, tariff, price control, etc…) and;
o Some goods are public goods by their nature.
The divergence b/n financial & economic prices show
o the extent to which someone in society, other than the project
entity, enjoys a benefit or pays a cost of the project.
hence it enable the analyst to identify ‘gainers’ and ‘losers’.
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4.3: Categories of Costs and Benefits
1. Direct transfer payments
o Taxes
o Subsidies
o Credit transactions
o Depreciation allowances
2. Costs of inputs
3. Contingency allowance
4. Sunk costs
5. Tangible benefits of projects
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4.3.1: Direct transfer payments
Some entries in financial accounts really represents shifts in claims to
goods & services from one entity to another (a transfer of the control
over resources from one group in society to another).
It does not reflect changes in national income.
These are called direct transfer payments.
It appear in cost streams of financial analysis but don’t in economic
costs.
Common transfer payments in projects are:
taxes, subsidies, loans & debt services (the payment of interest
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I. Taxes
Payment of taxes is cost in financial analysis.
When a firm pays a tax, it’s net benefit is reduced.
o But the firm’s payment of tax doesn’t reduce the national income.
Thus, in economic analysis we would not treat the payment of taxes as a cost
in project accounts.
II. Subsidies
Is direct transfer payment that flow in the opposite direction of taxes.
If a farmer is able to purchase fertilizer at a subsidized price:-
that will reduce his costs & thereby increase his net benefits.
o thus it is a benefit but the cost of the fertilizer in the use of the
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society’s real resources remain the same.
III. Credit transactions
o From the standpoint of the project owner:- receipt of a loan increases
the production resources s/he has.
o But from the standpoint of the economy:- these are merely transfers
of control over resources from the lender to the borrower.
Financial analysis of projects is based on cash flow analysis.
For every period during the expected life of the project, the financial
analyst estimates:-
o the cash likely generated by the project and subtracts the cash
likely to be needed to sustain the project.
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In economic analysis, debt service is treated as a transfer within the
economy even if the project will actually be financed by a foreign loan
& debt service will be paid abroad.
This is b/c of the convention of assuming that:-
all financing for a project will come from domestic sources and
returns from the project will go to domestic residents.
IV. Depreciation allowances: is the amount in decreasing of the total
(initial) value of a material due to its service value.
Depreciation may not correspond to actual use of resources.
therefore be excluded from the cost stream in economic analysis.
o But it is cost in financial analysis.
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4.3.2 Costs of inputs
This includes costs of:
Physical goods
Labor
Land
In financial analysis, we directly take the market price if the use of
these inputs involves cash outlays.
If there are no cash payments for these inputs, it will not
considered as a cost.
In economic analysis:-Since the use of these inputs is related with the
use of real resources,
they will be valued at their economic price & entered into economic
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accounts.
4.3.3. Contingency allowance
Sound project planning requires that:- provision be made in advance for
possible adverse changes in physical conditions or prices that would add to
the baseline costs.
Contingency allowance may be divided into
1. Those that provide for physical contingencies &
2. Those for price contingencies.
In turn, price contingency allowances comprise two categories,
1. Those for relative changes in price and
2. Those for general inflation.
I. Physical contingency allowance: it increase the use of real goods & services.
It is a real cost & reduce final goods & services available for other purposes.
It included as a regular part of the project cost estimates.
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society.
II. Price contingency (Change in price): In most practical cases, in
project cost estimation it is assumed that
1. There will be no relative changes in domestic or international prices &
2. No inflation during the investment period.
It is unrealistic to estimate project cost on assumptions of stable price
1. Relative changes in price .
The change in the price of a commodity relative to the other.
o A rise in the relative cost of an item implies that:- its productivity
elsewhere in the society has increased, that is,
• its potential contribution to national income has risen.
o Thus, costs that may be incurred due to possible relative changes in prices
will be considered as a cost in both financial & economic analysis.
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II. General change in price (inflation): it assumed that all prices will be
affected equally by any rise in the general price level.
It does not affect national income in real terms &
in project analysis the most common means of dealing with it is to
work in constant prices,
o on the assumption that :- all prices will be affected equally by any
rise in the general price level.
If inflation is expected to be significant:- provision for its effects on project
costs needs to be made in project financial plan
o Therefore an adequate budget is obtained.
o Do not affect national income thus it is not considered in economic
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analysis because it is not real change it is simply a nominal
4.3.4 Sunk costs
Are those costs incurred in the past upon which a proposed new
investment will be based.
When we analyze a proposed investment, we consider only future
returns to future costs;
o expenditure in the past, or sunk costs, do not appear in both
financial and economic accounts.
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4.4 Tangible benefits of projects
I. Increased production: - increased physical production is the most
common benefit of projects.
Whether the increased output is marketed or consumed at
home, it represents the benefit of a project.
II. Quality improvement: - to account as a benefit in both financial &
economic analysis
this must be reflected in the market price of the good.
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III. Change in time of sale: - In some projects, especially in agriculture,
benefits will arise from improved marketing facilities
allow the product to be sold at a time when prices are more favorable.
Benefits of these projects arise out of the change in “temporal value”.
IV. Change in location of sale: - Projects on transport facilities to carry
products from where price are low to where prices are higher.
Benefits of such projects arise from the change in “location value”.
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V. Change in product form:- Projects involving agricultural processing
industries expect benefits to arise from a change in the form of the
agricultural products.
VI. Cost reduction:- The classical example of a benefit arising from cost
reduction in projects is gained by
investment in agricultural machinery to reduce labor costs.
VII. Losses avoided: - The ‘with and’ without’ project analysis tends to point
out such costs avoided by the project.
Similarly risks avoided or reduced can be considered as benefits;
sometimes such benefits are reflected by output increment through loss
reduction.
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4.5 : Externalities
4.5.1 Secondary costs and benefits
o Projects can lead to benefits created or costs incurred outside the
project itself.
o Economic analysis must take account of these external or secondary
costs & benefits so they can be properly attributed to the project
investment.
It is not necessary to add on the secondary costs &benefits separately;
to do so would constitute double counting.
Thus, instead of adding on secondary costs and benefits,
we have to adjust the market prices into ‘economic’ prices.
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Although by using efficiency prices based on opportunity cost or
willingness to pay we can deal with secondary costs and benefits.
However there still many valuation problems related to goods and
services not commonly traded in competitive markets.
Price effects caused by a project are also part of externalities.
The project may lead to higher prices for inputs it requires and
lower price for the outputs it produces.
Generally:-Project may have wide-ranging consequences on demands
of inputs and outputs and
cause losses and gains for producers and consumers and other
than those involved in the project itself.
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Examples of such costs and benefits are:
Technological spill-over or technological externalities
Negative or positive ecological effects in construction of dam:
Multiplier effects of projects - if there had been excess capacity
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4.5.2: Intangible costs and benefits
Almost all projects have costs & benefits that are intangible.
These may include
creation of job opportunities,
better health and reduced infant mortality,
better nutrition,
reduced incidence of disease,
national security, etc.
These benefits do not, however, provide themselves to valuation.
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Likewise in the cost side, a project may
Displace workers
It may increase disease incidences
It may increase regional income inequality
It may destroy or reduce the scenic beauty of an area, etc.
All these are intangible costs of the project, which are not captured by
market prices.
All these intangible benefits & costs must be carefully identified &
where possible, be quantified although valuation is impossible.
These costs and benefits will not usually appear in financial accounts
and are excluded from financial analysis
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However, they should be included in the economic analysis.
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