1. education

EDUCATIONAL COSTS AND
FINANCIAL ANALYSIS
J. B. Babalola
Department of Educational
Management, University of Ibadan,
Ibadan, Nigeria
Lecture One: Educational Cost Concepts
• Cost of education is a measure of what is given up in order to be
educated and/or to educate
• Educational costs can be expressed broadly as
– Opportunity cost or sacrifice and
– Money cost or expenditure outlay
• Opportunity cost represents the value of the real sacrifice
that have to be made in the process of receiving education
or in educating people
• Money cost or expenditure is the amount of money
directly spent on educational inputs or resources. Money
cost or expenditure can be classified as (1) capital [durable
inputs such as furniture, equipment and buildings] and (2)
recurrent [less durable inputs that can be used up within a
year such as salary of staff, subsidies to students and other
consumables]
•
•
•
•
Explicit cost versus implicit cost:
 explicit cost involves open cash payment and issuance of a receipt; thus can be
expressed in a clear accounting statement.
 Implicit cost does not involve open cash payment or issuance of receipt and
therefore, cannot be expressed in clear accounting statement
Incremental cost versus marginal cost:
 incremental cost is the change in total cost of education as a result of the total
units of change in the scale of operation may it be expansion or contraction.
Only those costs associated with expansion or contraction is regarded as
incremental.
 Marginal cost is the change in total cost associated with one-unit change in the
level of educational output
Sunk cost is fixed expense borne or to be borne as a result of a past mistake
regarding a contractual agreement or a present decision to change the level or the
nature of activity after we have committed some fixed expenses on the formal
plan.
Unit cost versus total cost:
– Unit cost is an average cost in which the total cost is divided by the number of
units benefiting from the total outlay. If students are the beneficiary, then the
total cost is divided by the number of students; if graduates, then divide by the
number of graduates; if staff, then divide by the number of staff; and if schools,
then divide by the number of schools.
– Total cost of education is a measure of the full monetary outlay and sacrifice
foregone in the process of being educated and/or educating people.
•
Depending on how it is measured, total cost is the addition of either:
–
–
–
•
•
•
direct and indirect costs,
fixed and variable costs, or
capital and recurrent costs
Direct cost versus indirect cost: [allocation vs. apportionment]
– direct cost can be easily allocated directly to different cost units in proportion
to the level of benefit accruable to each of the units involved, whereas,
– Indirect or joint cost cannot be easily allocated to different cost units in
proportion to the level of benefit accruable to each of the units involved.
Indirect cost can only be apportioned among various cost units on a pro-rata
basis
Fixed cost or variable cost: [level of change with operational change in short-run]
– fixed cost does not vary irrespective of change in the level of operation in the
short run. However, fixed cost can become variable when the capacity of the
fixed input is exhausted
– variable cost varies with the change in operational level in the short run
Capital cost versus recurrent cost: [based on the level of durability]
– capital cost is the expenditure incurred on durable resources or inputs with
long length of service, usually more than a year
– recurrent cost is the expenditure incurred on less-durable resources or inputs
with short length of service usually not more than a year
• Current price versus constant price:
– current price is the value of a resource as it appears in the book of account without
any adjustment to reflect the purchasing power of money;
– constant price is the unchanging value of a resource after adjustment of the book
value to reflect the purchasing power of money. During inflation, a trend in
expenditure expressed in current prices gives a wrong picture of the actual value of
money devoted to education over the period. Salary increased from N4000 in 1980
to N7000 in 1990. Given that the price index increased from 100 to 150 during the
period, then N7000 [current price] becomes (7000)100/150 = N4,666.67
• Private, institutional and social costs
– Private cost [direct and indirect] is borne by the individual students and their
families through expenditures on tuition fees, earning foregone, accommodation,
books, uniforms and transport
– Institutional cost [capital and recurrent] is borne by the provider through
expenditures on furniture, equipment, buildings, salaries of staff, subsidies to
students and other consumables
– Social cost is borne by the public through the government to cover all items under
private and institutional costs minus subsidies and tuition fees.
• Hidden cost versus transfer payment:
– Hidden cost appears as “free” real resources in form of men[such as voluntary
services] and materials that are usually concealed from analysts since they are not
paid for by any of the major decision makers.
– Transfer payment refers to movement of money [examples include scholarship and
pension] in trust from one pocket to another without any real expenditure from
the pocket to which the money is moved
Historical , standard and marginal costing
1.
Historical costing is a re-active process in which the following data are collected and
analyzed;
1. students (stock and flows),
2. staff strength and salaries,
3. capital and recurrent expenditures and
4. revenue from various sources
• The purpose of historical costing is to find out past cost behaviours regarding
1. item-by-item breakdown of the total cost,
2. cross and longitudinal analyses of unit cost,
3. Reasons or factors for variation in unit cost,
4. Investigation of economies of scale and cost-effectiveness study.
2. Standard costing is a pro-active process in which the expected or standard norms are
compared with actual data on
1. student,
2. staffing mix,
3. proportion of costs devoted to direct and indirect educational activities
4. and income modes.
• The purpose of standard costing is to
1. estimate cost deviations [positive or negative variance] from the norms,
2. Identify the reasons for variances and take corrective actions in form of
regulations.
3. stipulating appropriate measures for action
TABLE 1:
HISTORICAL COST STRUCTURE BY TYPE AND PURPOSE OF EXPENDITURE
Table 1: Classification of recurrent costs by type and purpose
Personnel cost
a. Teachers
b. Administrative staff
c. Other staff
Non-Personnel cost
a. Materials and supplies
b. Utilities
c. Miscellaneous
GENERAL
MAINTENANCE
HEALTH AND
SPORT
TRANSPORT
FOOD AND
DORMS
ADMIN
TYPE OR OBJECT
INSTRUCTION
PURPOSE [FUNCTION]
TABLE 2:
HISTORICAL COST STRUCTURE AT THE UNIVERSITY LEVEL
INCOME
GRANTS
1.
2.
3.
4.
Federal
State
Local
Private
INTERNALLY GENERATED REVENUE [IGR]
FEES
INVESTMENT
1.
2.
3.
4.
1.
2.
3.
4.
Undergraduate
Postgraduate
Overseas
Rooms/Board
GIFTS
1. Endowment
2. Donations
3. subscriptions
Rent
Payments
Interest
Profits
EXTERNAL AIDS
1. Loan
2. Grant
3. Technical
Assistance
BURSARY
EXPENDITURE
ON ESSENTIAL EDUCATIONAL FUNCTIONS
1.
2.
3.
4.
Direct teaching [Salary and goods]
Indirect teaching [Library, research]
Central administration
General administration
ON SUPPORTIVE FUNCTIONS
1. Works and maintenance [Salary & goods]
2.
3.
4.
5.
Health services
Estate and security
Student services
Retirement benefits
TABLE 3: AN EXAMPLE OF A STANDARD CAPITAL COST OF A PRIMARY SCHOOL
Standard criteria
Typical no of student places
Cost per student place
Land area (mean average)
Total building area (mean average)
Cost- Land and site survey
Cost- Site improvement and utilities
Cost- Construction materials
Cost- Construction labour
Cost- Construction cost per square meter
Cost- Equipment, furniture, etc.
Cost- total
Costs- Construction as percentage of total
Costs- Architects and other fees as % of Construction
Costs-Equipment and furniture as % of total
Costs: Land and site survey as % of total
Costs: Site improvement and utilities as % of total
Ideal
Actual
Deviation
CONCEPT AND CALCULATION OF MARGINAL COST
• Marginal costing provides information on whether or not to adjust [upward or
downward] educational services and how to adapt to changes over time.
• MC focuses on variable costs that are likely to change “as soon as” changes in
service take place, marginal costing begins by distinguishing between fixed and
variable costs of education. It also focuses on the length of time [short or long]
available for adjustment in service production since the degree of adaptation
will depend on the length of time considered for adjustment.
• The longer the time, the greater the possibility of making cost adjustment,
because most of the items classified as fixed in the short run will become
variable with time. At the institutional level, in the short run adjustments can
be made only in labour [salaries to staff and subsidies to students] and
material costs [expenditures on the consumable].
• a department can stop admitting students but cannot fold up business
immediately because time is required for liquidation [dispose off] of its fixed
factors [buildings, equipment and furniture]. Similarly, a contract teacher,
though a labour input, cannot be asked to go before the contract expires.
•
Cost analysts frequently ask: (1) how much of the total educational costs can be
varied immediately? (2) How much of the total costs cannot be varied until several
years later? (3) How soon and how fast will the variable costs change
ANSWERING THE FREQUENTLY ASKED QUESTIONS IN MARGINAL COSTING
• Total cost schedule and total cost function or curve are used to answer the
question of how much of the total cost can and cannot be varied immediately
• Average cost schedule and Cost functions or curves are used to answer the
question of how soon and how fast the variable cost will change as well as
how financially wise to change the enrolment level
• The three diagnostic levels are:
1.
2.
3.
Analysis of trend in total costs into fixed and variable elements in tabular and
graphical forms. Using the trend in total unit produced (Q)and the
corresponding total cost (TC], the analyst can then estimate the trend in
marginal cost (MC)using “MC“= {TCn-1 – TC n ]/[Qn-1-Qn]}
From a table showing the total unit produced and the corresponding total cost
broken down into fixed and variable aspects, the analyst can carry out the
analysis of the resultant average costs in tabular and graphical forms showing
the average total cost, average fixed cost and average variable cost. The last
column of the average cost schedule usually shows the marginal cost
The last diagnostic level is to establish the relationship between each of the
average costs on one side and the marginal cost. This analysis usually start
from the evaluation of the marginal cost using the first derivative of total cost
such that MC= δTC/ δQ, given that TC = ƒ{Q}. From this differential equation
the analyst can estimate (a) the optimum enrolment [Q] that will result in (i)
minimum average total cost [ATC] on one side and especially in (ii) average
variable cost [AVC] on the other side; the idea is that MC intercepts AVC and
ATC at their minimum or turning points (b) given Q the analyst can estimate the
MC and the AVC to see the undesirable event in which MC exceeds AVC
LEVELS OF MARGINAL COSTING
Marginal costing involves the following three levels
of analysis:
1. Total cost analysis
2. Average cost analysis
3. Marginal cost analysis
a) Derivation of marginal cost from differentiating the
total cost function with respect to the enrolment
b) Determination of the relationship between marginal
cost on one side and total cost as well as average
variable cost on the other to know the cost
implication of expansion or contraction in the level
of production
Table 1; Analysis of Total Cost by Adding Total Fixed Cost with Total Variable Cost
Enrolment
0
1
2
3
4
5
6
7
8
Total Fixed
Total Variable
Cost
Cost
1000
0
1000
200
1000
1000
1000
1000
1000
1000
1000
367
510
677
877
1127
1460
2460
Total Cost
1000
1200
1367
1510
1677
1877
2127
2426
3460
TOTAL COST CURVES
4000
AMOUNT IN NAIRA
3000
2000
1000
0
TFC
TVC
TC
0
1000
0
1000
1
1000
200
1200
2
1000
367
1367
3
1000
510
1510
4
1000
677
1677
5
1000
877
1877
6
1000
1127
2127
7
1000
1460
2460
Table 1; Analysis of Average Costs and Marginal Cost
Enrolment
Average Fixed
Cost
Average
Variable Cost
Average Total
Cost
Marginal Cost
0
-
0
-
-
1
1000
200
1200
200
2
500
184
684
167
3
333
170
503
143
4
250
169
419
167
5
200
175
375
200
6
167
188
355
250
7
143
208
251
333
8
125
307
432
1000
Notes: AFC declines as enrolment increases since same cost is spread over
more and more students (2) AVC declines at the beginning because some
variable costs are fixed initially. Beyond a point, AVC begins to increase as
some fixed variable costs defreeze with time (3) ATC declines at the
beginning and later increases. (4) AVC will reach its turning point earlier
than ATC
Chart Title
1400
1200
Axis Title
1000
800
Average
Variable Cost
600
Average Total
Cost
400
2001.
Notes:
b
the MC curve crosses ATC and AVC curvesMarginal
at their
Cost
a and (b) respectively. 2. When MC
lowest 0or turning points (a)
exceeds the1 AVC,2 the3cost4of adding
student
will
5
6 an extra
7
8
become increasingly more than cost of maintaining each of
the existing student
Mid-Semester Class Assignment 2013
1. Given that TC = 1000 + 10E - 0.9E2 + 0.04E3;
– Given that ΔTC/ΔE = MC ; find the enrolment that
results in minimum AVC
– Note that (a) TC = TFC + TVC, therefore, TVC = TC – TFC ;
(b) AVC = TVC/E then TVC = (AVC)(E); [c] MC = AVC = ATC
where enrolments result in minimum AVC and ATC
respectively
2. Given that:
i. ….MC = 10 – 1.8E + 0.12E2
ii. ….AVC = 10 – 0.9E + 0.04E2; Where E = enrolment rate
– Solve equations i and ii given that: E = 10, 11, 12, 13, 14
– From your results, recommend the optimum enrolment
and give reasons for your recommendation
Factors Influencing Costs of Education
• Cross-sectional vs. longitudinal cost analyses
– Cross-sectional cost analysis deals with observation of
variation in unit cost of education from place to place or
institution to institution at a particular time
– Longitudinal cost analysis deals with observation of
variation in unit cost of education in a particular institution
from one year to another year [2000-2010]
• Internal vs. external factors affecting unit cost
– Internal factors affecting variation in cost per student are
those causes that can be controlled by decision makers
– External factors affecting variation in unit cost of education
are those causes that cannot be controlled by decision
makers in education.
•
•
•
Internal factors affecting capital cost
– Location
– Importation
– Norms on space
– Curriculum design
– Style of building
Internal factors affecting recurrent salary cost [education is a labourintensive enterprise]
– Qualification mix
– Utilization [STR]
– Experience mix
– Enrolment [can be used to examine possibility of economies of scale]
– Number [staff]
Factors affecting recurrent non-salary cost such as maintenance , electricity bills and
other consumables are mainly external
– Aids from abroad
– Government policies
– Inflation
– Prices of goods
– Social demand or general demand
Second Mid Semester’s Test
• Briefly compare and contrast the following pair of
cost concepts as related to education:
1. Opportunity cost and expenditure
2. Explicit and implicit costs
3. Incremental and marginal costs
4. Total and unit costs
5. Direct and indirect costs
6. Fixed and variable costs
7. Capital and recurrent costs
8. Current and constant prizes
9. Private and institutional costs
10. Allocation and apportionment of costs
Each correct answer carries 0.5 [total = 10 marks]
PART TWO: FINANCIAL ANALYSIS
Methods of Financing Education Systems
• Centrally financed system • Locally financed system
– Central government bears
the burden
– Such education will be in
the exclusive legislative list.
Thus not a shared
responsibility
– Local governments only
provide and maintain
education
– Prone to financial pressure
– Can enhance uniformity
and equality of educational
opportunity
– Local government bears
the burden
– Such education will be in
the concurrent legislative
list. Thus a shared
responsibility
– Local governments
provide, finance and
maintain education
– Prone to political pressure
– Difficult to maintain
educational standards and
uniform opportunity
Methods of Financing Education Systems
Publicly financed system
•
•
1.
2.
3.
4.
Publicly financed education system
involves the use of tax revenue, often
supplemented by user charges.
Four conditions for public intervention in
education are as follows:
Joint consumption because such
education does not generate gains or
losses that can be assigned to any
particular individual
Equal consumption because such
education generates the same amount of
gain or loss to various recipients
“Ration-less” supply of such education
since no member of the community can
be denied entrance on the basis of
economic and other disabilities
Market failure exists since the forces of
supply and demand cannot determine
the price. Since those who have not paid
for education can get as much as those
who have paid, no motivation to pay
Privately financed system
Conditions for private involvement
• Income of the nation may reduce thus
necessitating fees, subsidy removal,
• Competition among sectors and within
education. Private sources supplement share
• Equity might lead to subsidy removal if subsidy
transfers resources to children of the rich
• Fiscal constraints on expansion makes it
impracticable to continue subsidization
• Revenue drive might become necessary
especially during budget cuts or introduction of
new programmes at the institutional level
• Incentive to be efficient might force the
government to subject public institutions to
competition by deregulating private education
• Social returns to education is expected to be
greater than private return to justify public
funding of education. When private returns are
higher than social returns, then there might be
need to introduce private contributions to
education.
What funding model is best to adopt?
PUBLIC FUNDING MODEL
PRIVATE FUNDING MODEL
Pure Public
Privatized public
Supported by
government
self financed,
non-profit
for profit
-solely
publicly
financed
[ especially
Teaching &
research]
With increasing
funding shortfall
[cost per student
fell $6300 in 1980
to $1241 in 1995 in
Africa]
Sponsored or
aided by
government
-controlled
tuition fees,
-Donations
-Foundations
contributions
To retain
autonomy,
remains
independent
HE companies
quoted on the
stock market
-withdraw of
subsidies
-IGR mobilized
-Cost sharing
introduced
-Request for public
accountability
-Cost measures
-diversification
-Commoditization
-Loan schemes
-Student s
are
subsidized
[to address
inadequate
high-level
manpower
demand and
inequity in
provision]
introduced to
help households
5/15/2015
Solusi & Anna
Malai
[Zimbabwe]
Daystar
[Kenya]
Foreign
Contributions
Foundation
donations
Tuition fees
Friends
donations
TRUSTAFRICA'S DIALOGUE
Specially, these
invest in the
intellectual
stock by paying
students costs
and mentoring
them for work
and life
allowing them
to pay later.
23
Funding Agencies [Spenders]
Public Agencies:
MOE, Education Authority
Federal/State/Local
Private Agencies:
Individuals/Parents/Relatives/
Companies/Communities
Voluntary Agencies, etc
External Agencies
Users of funds
Public
Educational
Institutions
Private
Educational
Institutions
Foreign
Educational
Institutions
Sources and Users of Educational Funds
Source: Akangbou [1987]
FLOW OF FUNDS FROM SPENDERS TO USERS
• Each of the funding agencies has direct link with each
user of funds. The presence of public agencies are
directed felt in public educational institutions, while the
presence of private agencies [individuals, parents,
relatives, companies, communities and voluntary
organizations are usually felt in private educational
institutions. The presence of foreign agencies are usually
felt in foreign educational institutions.
• Nevertheless, some presence of private and foreign
agencies can be felt in public educational institutions
• However, the presence of the public and foreign agencies
in private educational institutions is likely to be very
small because private institutions depend on fees and
very few scholarships are usually awarded by foreign
agencies to individuals studying in private institutions
BURDEN OF EDUCATIONAL FINANCE
• The burden of financing education amongst the
three groups of financiers may not be equal. The
burden will depend on the philosophy guiding the
provision of education in a particular geographical
region.
• In a free-education nation, the public sector is
expected to bear the largest share of educational
expenditure.
• In a fee-paying nation, the private sector will be
very active.
• External agencies participation usually declines
over time with the achievement of high level of
economic development in a nation
FLOW OF FUNDS FROM SPENDERS TO USERS
• Each of the funding agencies has direct link with each
user of funds. The presence of public agencies are
directed felt in public educational institutions, while the
presence of private agencies [individuals, parents,
relatives, companies, communities and voluntary
organizations are usually felt in private educational
institutions. The presence of foreign agencies are usually
felt in foreign educational institutions.
• Nevertheless, some presence of private and foreign
agencies can be felt in public educational institutions
• However, the presence of the public and foreign agencies
in private educational institutions is likely to be very
small because private institutions depend on fees and
very few scholarships are usually awarded by foreign
agencies to individuals studying in private institutions
BUDGET AND RESOURCE ALLOCATION IN EDUCATION
• An educational budget is a document outlining the systematic
scheme for raising and allocating resources for a given future
period in numerical and monetary terms.
• A budget is usually based on an educational operational plan.
The operational plan is usually for three years and the budget
is expected to cover only the first year of the plan.
• The first step after studying the operational plan is to
estimate the expenditures [recurrent and capital] that will be
made to achieve the desired objectives of the plan
• The last step is to prepared the revenue budget or the
estimate of the domestic resources that will be made
available to education during the budget year. The revenue
budget will take into consideration the amount of resources
that can be generated from public, private and foreign
agencies to education
• The three steps in budget preparation is known as the
triangle of budget [starting from analysis of the educational
plan to estimates of resource required and resource available]
Figure 1: Theory of Public Education Finance
Objectives of public finance
To provide funding to institutions so that all
students can learn effectively
Internal Process
Inputs
1. Instructional
conditions
2. Resource
situation
Fund mobilization
Allocation Mechanisms
Targeting Mechanisms
Expenditure Control
Outputs
Sufficiency
Equity
Efficiency
Outcomes
Quantity
Quality
FUNDING SOURCES AND FINANCING MECHANISMS
Public Stream
1.
2.
3.
4.
International
National
State
Local
Direct:
1.
2.
3.
4.
5.
6.
7.
Block grant
Earmarked on specific revenue stream
Marching funds from public/public
Vouchers to providers or families
Subsidy of capital facilities;
Subsidy of curriculum development
Subsidy of quality assurance systems
Indirect:
1.
2.
3.
4.
Private Stream
1.
2.
3.
4.
Families
Community groups
Faith-based groups
Employers
Subsidies to parents
Top-up fee eligibility
Tax credits
Parental leave policies
Direct:
1. Payments of providers
Indirect:
1.
2.
3.
Volunteering or Lower wages
Donations to faith-based organizations
Time
30
How is education transformation funded? [ More Sourcing]
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
–
Public investment
private foundations
Bilateral aid agencies
multilateral aid agencies [Nelson Mandela Foundation]
Multinational in Africa [Shell Oil]
Philanthropic donations and alumni contributions
private providers [for profit and non-profit],
resource diversification through introduction or increases in tuition fees
[in conjunction with provision of scholarships and grants for the
disadvantaged students who merit higher education], and
research and consultancy incomes
other forms of income generation [investment activities].
loan schemes,
charging user fees,
elimination or reduction of less essential student benefits.
Double track
Entrepreneurialism
Information marketing
Innovation in management of funds to reduce cost
1/27/2011
INCOSHE 2011
31
Emerging Mechanisms for Ensuring Sustainable in HE
Conventional
Emerging
Welfare approach funding
Market approach funding
Public HIs
Mixed and private HIs
Public financing
Private financing and public –private partnership
Private state-financed HIs
Private self-financing HIs
Government recognized private HI
Self-recognized private HI
Degree-awarding private HIs
Non-degree awarding private HIs
Philanthropic /educational private HIs
Commercial/ for profit private HIs
No fees
Introduction of fees
Low levels of fess
High levels of fees
No student loan
High levels of fees
Ineffective not-for-profit loan programmes -no
security and high default rates, based on merit and
economic needs
Effective commercial loans-secured/mortgage with high
recovery rates, based on ability to pay or feasibility
Scholarly/academic curriculum
Self-financing, marketable, profitable curriculum
Formal/full-time HE
Open, distance, part-time HE –reduce building costs
Leader’s choice based on academic Leader’s choice based on funding
expertise
1/27/2011
INCOSHE 2011
32
Source: Sanyal & Martin [2006]
FINANCING FLOW CHART
No
Need
Assessment
Are there
problems
Yes
?
Monitoring &
evaluation
Yes
Implement
planned
programme
Additional
Resources
obtained
Are
resources
sufficient?
Additional
Required
Prepare
Project &
find
donors
No
Evaluate
resources
available
Source: Adapted from Udom [2002:437]
PROJECT CYCLE IN EDUCATION
evaluation
Implementation
and supervision
Negotiation
and approval
identification
preparation
appraisal
1. Identification: search for an idea with a development
potential
2. Preparation: begins with specification of the
objectives, targets to be achieved, the actions to be
performed and the responsible agents
3. Appraisal: sponsors review the proposal and it can be
accepted, modified or rejected
4. Negotiation and board approval: both spenders and
users of funds discuss and agree on the conditions for
success including drafting of the implementation
plans
5. Implementation and supervision: one funds are
available, we need to follow agreed procedures. The
financing bodies are to ensure compliance
6. Evaluation: at completion, the financing body
undertakes an independent evaluation to compare
actual with the expected results.
COST-BENEFIT ANALYSIS AS AN APPRAISALTOOL
• Cost-benefit analysis is an appraisal tool for
evaluating alternative allocations of resources to
different levels and type of education
• It attempts to describe, quantify and compare the
social/private costs and social/private benefits of
investment projects, thus, assisting sponsors to
decide whether or not an educational investing
should be undertaken
• Despite its political, human, identification and
measurement problems, cost-benefit analysis has
been widely used in education
• There is the prospect for continuous use of costbenefit analysis in determining investments choice
in education since efforts are on to eliminate its
glaring deficiencies.
STEPS IN COST-BENEFIT ANALYSIS IN EDUCATION
Identificatio
n of present
and future
effects
Quantificati
on of the
tangible
effects in
physical
term
Monetizatio
n of all
commensur
able effects
Aggregation
: Discounted
Cash Flow,
Rate of
Return,
Payback
Period, Size
of Unit
Sensitivity
analysis
Identification
Effects
[what
difference
will this
project
have?]
Present
Future
Change in
Efficiency
[output]
Change in Equity
[distribution]
Change in
employability
[earning]
Change in
enrolment [social
demand]
-ve
-ve
-ve
-ve
+ve
+ve
+ve
+ve
Quantification [in physical unit]
• Changes in output in goods resulting from a project
may be measured in kilogram per year for each year of
the project. Changes may be measured in number of
houses, kilometers of road constructed, number of
graduates produced, number of dropouts prevented,
number of repetitions prevented
• This quantification does not cover some effects such as
contribution to social harmony, democracy, aesthetic
or culture because these might be difficult to measure.
• Such intangible effects, while meriting description
within the cost-benefit study, necessarily remain
outside the quantitative aspect of economic analysis
Monetization [valuation]
• For an increase in output of so many kilograms of some
goods, a monetary value for the change in output is
developed.
• The economic rule governing the determination of
monetary values is the willingness to pay [WTP], which
refers to what society, if perfectly informed, will be willing
to pay to gain a benefit or to avoid a cost.
• Under perfect competition conditions, WTP reflects the
market prices. Under public goods and externalities
conditions, monetary values used are shadow prices
• Incommensurable effects [that are amenable to physical
quantification but not translatable to money] are often
left out at this stage
Aggregation
•
•
This is to reduce costs and benefits over the span [economic life] of the project to a
single summative number that captures the overall worth or desirability of an
investment project.
The most popular quantitative aggregation techniques are
– Discounted cash-flow
– Rate of Return
•
•
•
Internal rate of return
Benefit-cost ratio
Net present value
– Payback Period
– Proportional to Size of Unit
•
The qualitative methods include
– Necessity degree
– Executive judgment and experience
– Squeaky wheel principle
•
•
All quantitative aggregation schemes require discounting future costs and benefits,
that is, placing less weight on an effect the further into the future it is expected to
occur. The following discounting formula used
PVt = 1/(1 + d)1 →0; t →∞; current time is t = 0 so its weight [PV] is 1
The weight during the first year of project is 1 and all future years have weights less
than 1. For example, the weight for effects expected 20 years from now using a
discount rate of 10 percent is roughly 0.15. This means a N100 benefit 20 years from
now would be 0.15 multiplied by N100 or N15 this year