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VII. COST ANALYSIS AND LONG-TERM RESOURCE COMMITMENTS

Effective capital facilities planning requires analytical techniques that can accommodate the risk and uncertainty associated with long-term public resource commitments.

DIMENSIONS OF COST

No program decision is free of cost, whether or not the decision leads to the actual commitment of organizational resources.

o Tendency is to consider costs in terms of dollar inputs--financial resources required to support capital investments, personnel, equipment, materials, etc.

o Future costs that cannot be easily measured in dollar terms may have important implications beyond their measurable monetary value.

Factors Influencing Future Costs Future costs are influenced by the following factors:

(1) Methods, facilities, and organizational structure required to deliver services.

(2) Scope and quality of the services or activities.

(3) Volume of activity required to deliver these services or activities.

(4) Qualities and types of labor, materials, equipment, and other cost elements.

(5) Price levels of the various cost elements.

Many activities can be measured in terms of units of production--in some cases, more extensive analyses of the nature and scope of the activities may be necessary.

Monetary Costs and Economic Costs

Monetary costs include research and development costs, investment costs, and the costs of operations, maintenance, and replacement.

Research and development costs are "front-end" costs which if incurred for a given project should be included as a project expense.

o R&D costs that benefit more than one project or program must be considered as sunk costs and should not be included in the direct cost estimate for a specific project or program.

o Sunk costs can become an inheritable asset if previous investments can be used to the advantage of one alternative over another.

Investment costs are incurred to obtain future benefits.

o Investment costs vary with the size of a project, but not with its duration.

o Such investments may be classified as sunk costs or actual project outlays, depending on their timing.

Recurring costs include operating and maintenance costs that vary with both size and duration of the program.

o Recurring costs include salaries and wages, employee benefits, maintenance and repair of equipment, miscellaneous materials and supplies, transfer payments, insurance, and direct overhead costs.

o Recurring costs should be considered over the life of the project or program, not just in the initial fiscal period.

Marginal or incremental costs of increasing the size or scope of a program or project.

Fixed costs are the same regardless of the size or duration of the program; as a project increases in size or scope, these costs are distributed over a larger number of service units.

Variable costs may change significantly as the scope of the project or program is increased.

Opportunity costs occur if the commitment of resources to one program preempts their use elsewhere.

Associated costs are any costs involved in utilizing facilities or services; for example, the cost that users must pay to travel to public recreational facilities, or the cost that government incurs to provide highway access to such facilities.

Social costs are subsidies that would have to be paid to compensate persons adversely affected by a project or program for their suffering or "disbenefits."

Social costs can be treated as:

(1) external costs and subtracted from the market value of the output of the project to obtain a net social value, or

(2) opportunity costs, by examining the potential benefits to those who are likely to be adversely affected if the project funds were spent on some other program.

ACTIVITY-BASED COSTING

Most accounting systems currently in use capture and distribute costs by one of the following methods:

o Under an organization-based accounting system , identifiable direct costs are applied to the elements/units of the organizational structure, while indirect costs are captured and paid in a central repository with no attempt to further distribute these costs to the various units

o Budgetary accounting systems became a safeguard mechanism to capture commitments, undelivered orders, and expenditures, the major objective being to fully use assigned resources rather than enhance productivity or to reduce expenses--any attempt to conserve resources may lead to a reduction in the future budget allocations.

o Cost accounting procedures were established to capture and distribute costs to the output goods or services, using the classic model of cost distribution designed around the major factors of production: direct labor, direct materials and overhead.

ABC: A Process-Oriented Approach

The Activity-Based Costing (ABC) model re-configures how organizations manage costs by attaching costs to activities carried on in support departments.

o A fundamental premise of ABC is that managers can learn how to identify and eliminate waste by focusing on the root cause of a cost rather than merely addressing the symptoms.

o ABC is a process-oriented method, based on the recognition that labor-intensive processes may represent the single largest contribution to the increasing cost of doing business.

ABC recognizes that the pro-rating method used in traditional cost accounting does not truly account for the usage variance in process costs that may exist in different units.

The first step in applying Activity-Based Costing is to identify the management issues and decision-making needs for which better cost information is being sought.

Cost drivers are any events that cause changes in the total cost of an activity..

o Inputs are the resources that are consumed by activities (usually measured as costs).

o Outputs are the products (goods or services) that an activity supplies to its customers (internal or external).

ABC provides a more representative distribution of resource use since cost allocations are based on the direct cost drivers inherent in the work activities that make up the organizational structure.

Costs must be traced from the traditional cost accounting structure (which identifies what resources are being used) to the activities (which relates why resources are being consumed--for what purpose).

The allocation basis is called a first-stage driver (e.g., square feet of floor space).

The next step is to quantify the volume of each activity's output, either as an actual (historical) volume or as a projected volume (define an output measure).

o Total cost divided by total volume determines the average cost per unit of output.

o The output measure (e.g., cost per unit of output) is a second-stage driver rate.

Performance measures are identified to determine the results achieved by an activity or activity center (e.g., average cost per patient treated for a particular ailment).

The ABC approach is likely to produce a more accurate representation of indirect costs attributable to final cost objectives than using surrogate measures, such as direct labor hours or direct material dollars, as a means for allocating costs to products.

What does ABC Provide to the Decision-Maker?

Activity-Based Costing captures quantified cost and time and performance data and translates these data into decision information.

ABC measures the cost and performance of activities, resources and cost objects, including when appropriate, overhead.

ABC captures organizational costs for the factors of production and administrative expenses, and applies them to the defined activity structure.

One drawback is that ABC is not readily supported by accounting systems currently in use by most organizations.

Organizations implementing a business process reengineering program may be able to build the framework for understanding ABC and to adopt some form of ABC accounting.

o These organizations must build an "activities dictionary" as one of the first stages of process reengineering.

o They must compile estimates of the time spend within the functional units in the performance of these various activities which can provide an indication of where and how labor costs are incurred.

Activity-based costing represents a radical new way of doing business, but can complement and extend the benefits of both process reengineering and responsibility center management.

Benefit Investment Analysis

Discounted cash flow techniques apply principles of compound interest to take into account differences in the worth of money over time and to examine the future negative and positive cash flows (costs and benefits) required to produce the desired returns.

The equivalent present value of future streams of both costs and benefits must be determined by multiplying each stream by an appropriate discount factor, which can be expressed as:

1/(1+i)^n

where i is the relevant interest rate per year and n is the number of periods into the future that the benefits and costs will accrue.

The net present value (NPV) method gives the algebraic difference of both outward cash flows and inward flows of income or benefits.

o An investment may have a terminal value (T) at the end of the analysis period; annual expenses (K) for the administration, operation, and maintenance of the project and the annual income (R) from sales revenues, receipts, or their equivalent must also be discounted to present values to be included in the analysis.

o The formula for calculating net present value can be expressed as:

NPV = -I + T/(1 + i)^n - K [(1 + i)^n - 1/i(1 + i)^n] + R [(1 + i)^n - 1/i(1 + i)^n]

whereby I represents the initial investment, the present worth of the terminal value is calculated by multiplying (T) times the appropriate discount factor, and K and R are multiplied by the present worth factor of a uniform series.

The equivalent uniform annual net return (EUANR) combines all investment costs and all annual expenses into one single annual sum that is equivalent to all disbursements uniformly distributed over the analysis period.

o The EUANR also includes an income or benefit factor--the solution to the formula indicates the amount by which the equivalent uniform annual income (or benefits) exceeds (or is less than) the equivalent uniform annual cost.

o This formula can be represented as follows:

EUANR = -I [i(1 + i)^n/(1 + i)^n -1] + T [i/(1 + i)^n -1] - K + R

whereby the initial investment (I) is multiplied times a capital recovery factor, the terminal value (T) is multiplied by a sinking fund factor, with K and R representing uniform annual expenses and uniform annual income respectively. R includes return on investment (depreciation and net profit).

To illustrate the application of these two method of discounted cash flow analysis, assume that management is confronted with two alternative investment decisions, as shown in Exhibit 2.

Exhibit 2. Cash Flow Data for Rurbana Analysis

Alternative A has an EUANR of $22,786, whereas alternative B has a EUANR of $17,671.

EUANR/Alt. A = -$1,100,000(0.1168295) + $600,000(0.0368295) + $129,200 = -$128,512 + $22,098 + $129,200 = $22,786

EUANR/Alt. B = -$2,000,000(0.1168295)+$1,000,000(0.0368295) + $214,500 = -$233,659 + $36,830 + $214,500 = $17,671

Similarly, alternative A has a net present value of $195,030, whereas alternative B has a net present value of $151,250.

NPV/Alt.A = -$1,100,000 + $600,000(0.3152417) + $129,200(8.5594798) = -$1,100,000 + $189,145 + $1,105,885 = $195,030

NPV/Alt.B = -$2,000,000 + $1,000,000(0.3152417) + 214,500(8.5594798) = -$2,000,000 + $315,242+ $1,836,008 = $151,250

The EUANR for any project can be converted to the NPV by multiplying the EUANR by the present work factor for a uniform series (which in the above example is 8.5594798).

COST-BENEFIT ANALYSIS

Cost-benefit analysis requires that estimates be made of both the direct and indirect costs and the tangible and intangible benefits which must then be translated into a common measure, usually (but not necessarily) a monetary unit.

Basic Components

Costs and benefits are compared by computing:

(1) a benefit-to-cost ratio (benefits divided by costs),

(2) net benefits (benefits minus costs,) or

(3) some other value (such as, internal rate of return) which summarizes the results of the analysis.

The cost-benefit approach, first outlined by Otto Eckstein, involves an identification of: (1) an objective function, (2) constraints, (3) externalities, (4) time dimensions, and (5) risk and uncertainty. [1]

Selecting an objective function involves the identification and quantification of the benefits and costs associated with each alternative.

o Benefits are often diffuse, intangible, and difficult to define and measure.

o Costs usually are somewhat easier to identify since they are the direct and indirect inputs--the resources required to carry out the program or project.

Constraints are the "rules of the game"--the limits within which a solution must be sought. Solutions that are otherwise optimal frequently must be discarded because they do not conform to these imposed rules.

Projects may have external or spill-over effects--unintended consequences that may be beneficial or detrimental--which may be difficult to identify and measure. They may be excluded from the analysis initially in order to make the problem statement more manageable.

Discounting Future Costs and Benefits

Benefits that accrue in the present usually are worth more than anticipated benefits.

Resources invested today cost more than those invested in the future, since one option would be to invest the same funds at some rate of return that would increase their value. Two common bases can be used for discounting, reflecting both local conditions and the market-place for investments:

(1) Cost of borrowing the capital necessary to finance a project or program, and

(2) Rate of return based that could be realized if an equivalent amount were invested for the same period of time.

The selection of the discount rate can significantly affect the final decision (see Exhibit 3).

Exhibit 3. Discounting $100,000 Annually Over Ten Years

Criteria for Analysis

The next step in cost-benefit analysis is to select an indicator of "success"--an index that will yield a higher value for more desirable alternatives.

Three obvious choices for a composite criterion are:

o Maximize benefits for given costs.

o Minimize costs while achieving a fixed level of benefits.

o Maximize net benefits (benefits minus costs).

A benefit/cost ratio is defined as the present value of benefits divided by the present value of costs (or average annual benefits over average annual costs).

o A variation on the basic benefit/cost ratio emphasizes the return on invested capital by segregating operational costs and subtracting them from both sides of the ratio.

o The net benefit/cost ratio becomes larger as operational costs account for an increasingly larger proportion of total costs.

Net benefits measure difference, whereas benefit/cost calculations produce a ratio.

Limitations of Cost-Benefit Analysis

Cost-benefit analyses provide only limited assistance in establishing priorities among various goals.

Such analyses are of limited usefulness in evaluating programs of relatively broad scope or in comparing programs with widely differing objectives.

Other factors must be considered in selecting an appropriate or "best" decision, including:

(1) the time stream of costs and benefits and the time preference for present as opposed to future consumption of goods or services;

(2) limitations imposed by revenue (budgetary) constraints; and

(3) the question of whether goals and objectives can be specified in sufficient detail to permit a fuller identification of direct and indirect costs and benefits.

Cost-benefit analyses should include:

(1) the examination of expenditures in terms of programs and objectives, instead of merely by spending entities, and

(2) the consideration of total benefits of expenditures alongside total costs of inputs for alternative programs.

COST-EFFECTIVENESS ANALYSIS

The preferred alternative either (1) produces a desired level of performance at the minimum cost or (2) achieves the maximum level of performance possible for a given level of cost.

Output Orientation

Costs can ordinarily be expressed in monetary terms.

Levels of achievement are usually represented by nonmonetary indexes, or measures of effectiveness, that is, the direct and indirect effects of resource allocations.

Life-cycle costing involves an analysis of costs over the duration of the program or project.

o Cost-effectiveness analysis must move from some base that represents existing capabilities and existing resource commitments.

o The objective is to determine what additional resources are required to achieve some specified additional performance capability.

Effectiveness measures involve a basic scoring technique for determining increments in output achieved relative to additional increments of cost and are often expressed in relative terms--e.g., percentage increase in some measure of educational attainment, percentage reduction in the incidence of a disease, or percentage reduction in unemployment.

Three supporting analyses are required under the cost-effectiveness approach:

(1) Cost-goal studies attempt to identify feasible levels of achievement.

(2) Cost-effectiveness comparisons assist in the identification of the most effective program alternative.

(3) Cost-constraint assessments determine the cost of employing less than the most optimal program.

Objective of a cost-goal study is to develop a cost curve for each alternative which approx-imates the sensitivity of costs (inputs) to changes in the level of goal achievement (outputs).

Cost-effectiveness analysis relates incremental costs to increments in achievement.

o For some types of problems, practical models can be developed with relative ease; for other problems, cost curves can be approximated from historical data.

o It may not be possible to choose between two alternatives simply on the basis of cost-effectiveness unless one alternative dominates at all levels of goal achievement.

o Either a desired level of performance must be specified and then costs minimized for that effectiveness level, or a cost limit must be specified and achievement maximized for that level of resource allocation.

Cost-constraint assessments compare the program costs that might be adopted if no constraints were present with the cost of the constrained program.

o This assessment gives decision makers an estimate of how much would be saved by the relaxation of a given constraint.

o The cost of the constraint suggests of amount of resources that might be committed to overcoming it.

o In some cases, maintaining a constraint may be more important for social or political reasons than implementing a more effective program.

Converting Uncertainty to Risk

Certainty can be defined as a state of knowledge in which the specific and invariable outcomes of each alternative course of action are known in advance (although under some circumstances, various strategies maybe applied to achieve that state).

Uncertainty can be defined as a state of knowledge in which one or more courses of action may result in a set of possible specific outcomes, the probabilities of which are neither known or meaningful.

Risk is a state of knowledge in which each alternative leads to one of a set of specific outcomes, each outcome occurring with a probability that is known to the decision maker, and is measurable when decision expectations or outcomes can be based on statistical probabilities.

Risk and uncertainty must be confronted from two primary sources:

(1) statistical uncertainty, and

(2) uncertainty about the state of the real world in the future.

The first type of uncertainty arises from chance elements in the real world and would exist even if the second type of uncertainty were zero.

Establishing a probability function can bring problems within more manageable bounds by reducing uncertainty to some level of risk that may be tolerable, depending on the risk threshold.

To establish a posteriori probability (by induction or empirical measurement): (1) the number of cases or observations must be large enough to exhibit statistical stability; (2) the observations must be repeated in the appropriate population or universe; and (3) the observa-tions must be made on a random basis.

Under the deductive, or a priori approach, a probability statement is not intended to predict a particular outcome for a given event. Rather, in a large number of situations with certain common characteristics, a particular outcome is likely to occur.

Uncertainty and Cost Sensitivity

When the environment is uncertain, an expected value approach often must be applied by multiplying the value products across all possible outcomes.

In mathematical terms, expected value (EV) can be expressed as:

EV = P1$1 + P2$2 + . . . Pn$n.

where P stands for probability, $ stands for the value of an outcome, and P1 + P2 + . . . Pn = 1.

Sensitivity analysis --designed to measure (often quite crudely) the possible effects that variations in uncertain decision elements (for example, costs) may have on the alternatives under analysis. In most strategic decisions, a few key parameters exhibit considerable uncertainty (see Exhibit 3).

Contingency analysis --designed to examine the effects on choices when a relevant change is postulated in the evaluation criteria; also used to determine the effects of a major change in the general decision environment, or "ground rules."

A fortiori analysis (from the Latin, meaning "with stronger reason")--a method of "stacking the deck" in favor of one alternative to determine how it might stand up in comparison to other approaches.

Uncertainty, Risk, and Expected Utility

Kassouf has observed that an individual with "clear-cut, consistent preferences over a specified set of strategies. . . will act as if he has assigned probabilities to various outcomes." [2]

The values for the probabilities will be unique for each individual and are not unlike the values of utility that might be assigned through a study of social preferences.

Strategic choice under uncertainty is a threefold process. [3]

(1) Probabilities and payoffs must be determined for individual members of the organization and its clientele.

(2) Attitudes toward risk of these individuals must be evaluated to determine the certainty equivalents of these probabilities and payoffs.

(3) Having estimated the equivalent benefits that each alternative offers, the decision maker must select the preferred outcome.

Reduction of uncertainty may cause the risk associated with a particular choice:

(1) to remain unchanged;

(2) to decrease (where a reduction in uncertainty permits the assessment of more definitive probabilities); or even

(3) to increase (when the additional information reveals risk factors previously unknown).

Risk and uncertainty are interrelated, but must be treated independently in many situations.

Endnotes

[1] Otto Eckstein, Water Resource Development (Cambridge, MA: Harvard University Press, 1958).

[2] Sheen Kassouf, Normative Decision-Making (Englewood Cliffs, NJ: Prentice-Hall, 1970), p. 46

[3] Edith Stokey and Richard Zeckhauser, A Primer for Policy Analysis (New York: Norton, 1978), p. 252.