Economic Analysis

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Economic Analysis
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Economic Analysis(Analysis of Alternatives)
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Economic Analysis

• A systematic approach to the problem of choosing
  the best method of allocating scarce resources to
  a given objective
• Recognizes that there may be alternative ways of
  meeting an objective
• Each alternative requires different resources and
  produces different results
• Economic analysis examines and compares the
  benefits, costs, and uncertainties of each
  alternative
• Objective to determine the most cost effective
  means of meeting the objective

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Elements of Economic Analysis

• Definition of the Objective
• Assumptions and Constraints
• List of Alternatives
• Analysis of Benefits
• Analysis of Costs
• Comparison of Alternatives
• Sensitivity and Risk Analyses
• Conclusions/Recommendations

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Definition of the Objective

• Should clearly define and quantify, to the
  maximum extent possible, the function to be
  accomplished
• Must be as objective as possible
• Should not assume a specific means of achieving
  the desired result
• Must be worded to reflect a totally unbiased
  point of view

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Assumptions and Constraints

• Assumptions Explicit statements used to
  describe the present and future environment upon
  which the economic analysis is based
• Required Assumptions
• (1) Economic life
• the period of time over which benefits from an
  alternative are expected to accrue. Usually
  constrained by physical, mission or technological
  life
• (2) Period of Comparison (period of analysis)
• begins when money is spent on the first
  alternative requiring expenditure of funds and
  ends when the alternative with the longest
  economic life ceases to produce benefits
• There is one period of comparison for an economic
  analysis

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Limits on Economic Life

• Physical life
• The estimated number of years that an asset can
  physically be used
• Mission life
• The estimated number of years over which the need
  for the asset is anticipated
• Technological life
• The estimated number of years a facility, piece
  of equipment, or automated information system
  will be used before it becomes obsolete due to
  changes in technology

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Constraints

• External factors that limit alternatives to
  problem solutions
• Physical
• a fixed amount of space
• Time-Related
• a fixed deadline
• Financial
• a limited amount of resources
• Institutional
• policy or regulation
• Conditions that are beyond the control of the
  decision maker that limit the number of available
  alternatives

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List of Alternatives

• All reasonable ways of satisfying the objective
  should be documented and discussed
• At a minimum, each of the following alternatives
  must be considered
• Status quo
• the existing way of meeting the objective must be
  included even if its considered to be infeasible
• Modification of existing assets
• renovation, conversion, upgrade, expansion, or
  other forms of improvement of existing assets or
  services
• Leasing or privatization
• New acquisition
• Alternatives dismissed as infeasible must be
  discussed, but need not be formally compared in
  the analysis

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Analysis of Benefits

• Benefits outputs expected for the costs
  incurred
• Synonymous with results, effectiveness, or
  performance
• Should present the decision maker with an
  objective, orderly, comprehensive, and meaningful
  display of the benefits expected for each
  alternative

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Analysis of Costs

• Includes identification and evaluation of all
  anticipated expenditures associated with each
  alternative over its entire life cycle
• Encompasses costs of research and development,
  investments in procurement facilities,
  operating and support, and disposal
• Magnitude and timing of expenditures are equally
  important

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Comparison of Alternatives

• Four conditions are possible
• (1) Both benefits and costs are equal
• A subjective choice may be made
• (2) Benefits are equal and costs are unequal
• Recommend the least cost alternative
• (3) Benefits are unequal and costs are equal
• Recommend the alternative with greater benefits
• (4) Both benefits and costs are unequal
• The most common outcome and the most difficult to
  analyze

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Comparison of Alternatives

• Benefits and costs are unequal
• Rank order the alternatives in terms of benefits
  and also in terms of costs
• recommend an alternative based on the relative
  importance of benefits and costs
• Compare cost benefit ratios
• divide the quantifiable benefits by the uniform
  annual cost
• provides a measure of efficiency of resource
  utilization

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Sensitivity and Risk Analyses

• Uncertainty is always present in economic
  decision making because of the assumptions
  required in conducting the analysis and
  estimating benefits and costs
• It is important to analyze whether changes in
  assumptions, quantitative values, or priorities
  will affect the recommendation
• A range of expected benefits and costs will
  provide more information of which to base a
  decision than the basic analysis alone

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Benefits Analysis

• Presents the decision maker with an objective,
  orderly, comprehensive, and meaningful display of
  the benefits expected for each alternative
• Benefits
• Outputs or measures of effectiveness or
  performance
• Should not be quantified in terms of dollars
• Costs and benefits must be defined so that they
  are mutually exclusive
• Cost savings or avoidances, which are reductions
  in the resources used, should be reflected in
  cost analysis
• such savings should not be counted again as a
  benefit

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Identification of Benefits

• (1) Develop a conceptual viewpoint
• Inputs (Costs) ? Resources used
  Outputs (Benefits) ? Effectiveness,
  Readiness, Throughput
• (2) Examine the project from various viewpoints
• Benefits should relate to the mission need that
  has been identified, the combat capability that
  is lacking, the problem that needs to be solved
• Benefits should be clearly defined and distinct
  and directly relate to mission success
• cruising range vs. fuel capacity
• (3) Quantify benefits to the maximum extent
  possible
• Numerical measures are preferred
• descriptions such as high, average, or low may be
  the best available measures in some instances

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Categories of Benefits

• Production of items produced for each
  alternative
• Productivity of items produced per hour of
  work, volume of output per hour of work, flight
  hours per month
• Operating efficiency the rate at which a system
  consumes resources (miles per gallon)
• Reliability MTBF, number of service calls per
  year
• Accuracy error rate (errors per time period,
  per 100 records, per 100 items produced)
• Maintainability difficulty of repair (average
  of hours necessary for repairs, crew size
  necessary to maintain the system)

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Categories of Benefits

• Manageability impact on organizational workload
  resulting from changes in supervision or
  inspection times associated with the new system
  Integratability impact that integration of a
  new system will have on organizational workload
  and output
• Availability when will the system 1st be
  available for use vs. when its use is required
• Service Life when does the system become
  obsolete?
• Quality will a better quality or service be
  obtained, can it be quantified?
• Acceptability will the new system interfere
  with operations within the organization, parallel
  organizations, or higher headquarters?

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Categories of Benefits

• Ecology environmental impact, are current
  requirements met?
• Economic benefits including employment, impact
  on economically depressed areas, small business
  obligations Morale opinion surveys to impact
  effects on employee morale
• Safety is the system secure, will more security
  precautions be needed?
• Flexibility how adaptable is the system to
  various modes of operation?

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Decision Making With Multiple Attributes

• Normally there will be more than one objective or
  attribute to achieve
• Several techniques can be used for evaluating
  multiple objectives
• Additive weighting and ranking
• Additive weighting and scaling
• Reduce complexity of the evaluation process by
  eliminating alternatives if possible
• If an alternative fails to meet the requirement
  for even one benefit, it is an unacceptable
  alternative and can be eliminated from further
  consideration.
• If an alternative is rated the best in every
  attribute being considered, that alternative
  dominates all others. No additional benefits
  analysis will be necessary. Can proceed directly
  to cost analysis.

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Weighting Schemes

• Weights can be assigned in any logical manner
  that reflects the priorities of the decision
  maker
• A higher number will always represent better
  performance
• Ties are allowed
• Ordinal Rankings
• Benefits are arrayed from most to least important
• if 5 benefits are being considered, the most
  important benefit would receive a weight of 5
• Percentages
• Each benefit is assigned a weight between 0 and 1
  to reflect the benefits relative importance
• weights, when summed, equal 1.0

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Weighting Schemes

• Scores
• Benefits are assigned a weight (score) within
  some specified range to indicated its relative
  importance
• Pick one benefit and arbitrarily assign its
  weight
• Determine the other weights one at a time by
  estimating their relative importance compared to
  the starting benefit

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Additive Weighting and Ranking

• For each alternative, assign a weight based on
  how important the benefit is to the overall
  objective of the project.
• A higher number indicates greater relative
  importance
• For each benefit, multiply the weight by the rank
  to determine the weighted rank.
• Add the weighted ranks for each alternative.
• The alternative with the largest sum is the
  preferred alternative based on benefits.

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Additive Weighting and Scaling

• A refinement of Additive Weighting and Ranking to
  reflect quantitative data rather than just
  rankings
• Inconsistencies in benefits requires a way of
  scaling raw data to attain comparable units of
  measurement
• Data collected on different benefits will likely
  be in different units of measure
• pounds, miles, pk
• Some benefits may have verbal descriptions (high,
  average, low) rather than numerical descriptions
• For some benefits a high number is good (pk), for
  others a low number is good (breakdowns per 100
  hrs of operation)

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An Example

• Three contractors are competing to build
  observation helicopters for the Army and Marine
  Corps. The alternatives are named A, B, and C.
  The benefits under consideration include speed,
  range, survivability, reliability, and crew size.
• Speed is maximum airspeed measured in knots per
  hour.
• The survivability rating is based primarily on
  the helicopters armaments.
• Reliability ratings area based on estimates of
  equipment readiness.
• Crew size is expressed in number of crew members.
• The decision maker has stated that survivability
  is the most important benefit.
• Based on additional guidance from the decision
  maker, a percentage weighting scheme is devised.

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Additive Weighting and Scaling
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Additive Weighting and Scaling

• Data for survivability and reliability is
  qualitative
• Can be converted to quantitative data using the
  following scale

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Additive Weighting and Scaling

• Two data problems remain
• Units of measure are not compatible
• miles, knots, people, and dimensionless scores
  for survivability and reliability
• A small number is good with respect to crew size
  but bad for all other benefits
• adding numbers scaled where low is good will
  distort the analysis
• Normalization of the raw data is required

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Data Normalization

• One technique linear proportional scaling
• Raw values are transformed to scaled values
  between 0 and 1, with a high number always the
  best .

If a high number is good where Sij the scaled
value for benefit i and alternative j Xij the
raw value for benefit I and alternative j Xi
max the highest (best) raw value for benefit j
If a low number is good where Sij the scaled
value for benefit i and alternative j Xij the
raw value for benefit I and alternative j Xi
min the lowest (best) raw value for benefit j
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Normalized Data
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Alternative B is preferred, followed by
Alternative A. Alternative C, which has the
lowest score, is last.
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Benchmarked Additive Weighting and Scaling

• Additive Weighting and Scaling technique can be
  refined if standards have been established which
  the project must meet.
• Alternatives are rated against project standards
  (minimum requirements/maximum limits) vice other
  alternatives.

If a high number is good
where BSij the benchmark-scaled value for
benefit i and alternative j Xij the raw
value for benefit I and alternative j Xi
required the minimum required raw value for
benefit j
If a low number is
good where BSij the benchmark- scaled value
for benefit i and alternative j Xij the
raw value for benefit I and alternative j Xi
limit the maximum limit raw value for benefit j
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Cost Analysis

• Begins with the life cycle cost estimate for each
  alternative
• Encompasses RD, investments in procurement
  facilities, operating and support, and disposal
• Analogy, industrial engineering, parametric
• Sunk costs may be mentioned in the narrative but
  are not included in the cost analysis
• Only costs influenced by the decision maker are
  included
• Residual value the value of an asset at any
  given point in time
• Counted as an offset only if money is expected to
  change hands, representing a positive cash flow
  for the investment
• Salvage Value the expected value of an asset at
  the end of its useful life
• Terminal Value the estimated value of an asset
  at a point in time subsequent to its initial
  fielding

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Special Considerations

• Phase-out costs costs that must be incurred
  for parallel operations of the status quo while
  the development or modification is taking place
• must be added to the life cycle cost for the new
  system
• When the magnitude and timing of a cost is
  identical for all alternatives, it can be
  considered a wash cost and excluded from the
  cost analysis
• Such exclusions must be carefully documented to
  ensure that cost figures from the cost analysis
  are not taken out of context

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Special Considerations

• Inflation is an important consideration
• Analyses normally done using constant
  (uninflated) dollars of a particular base year
• Can also be done using current (inflated) dollars
  by applying compound inflation indices
• Constant dollars are preferable to current
  dollars
• Do not use then-year dollars

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Special Considerations

• The time value of money must also be considered
• Time phasing of expenditures is important
• when money must be paid out, it is preferable to
  pay it at some future date rather than now
  because of the opportunity to earn interest on
  money held
• Costs should be allocated according to the fiscal
  year in which payment will be made
• To compare the value of a dollar in the future to
  the value of a dollar held now, an adjustment to
  a common point in time must be made using a
  technique called discounting

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Special Considerations

• By discounting, present values of future cash
  streams can be calculated to facilitate valid
  comparisons
• The discount rate is the interest rate used to
  determine the present value of a future cash
  stream
• represents the opportunity cost of making the
  investment
• The governments cost of borrowing is the basis
  for discount rates used in conducting economic
  analysis within DoD
• discount rate used represents the average
  interest rate on Treasury securities of maturity
  similar to the expected project length

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Discount Rates

• If expenditures are assumed to occur at the end
  of the fiscal year, the following formula
  applies
• If expenditures are assumed to occur at mid-year,
  the following formula applies
• Fn the present value factor for year n, i
  the discount rate, n the
  project year

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Inflation vs. Discounting

• Inflation and time value of money are two
  different effects
• Two different reasons why a dollar today is worth
  more than a dollar to be received in the future
• Inflation causes a loss of purchasing power due
  to a general rise in prices
• A dollar held today can be invested interest
  earned makes it more valuable than a dollar
  received in the future
• Effects of inflation are already removed when
  performing constant dollars analysis
• Constant dollars must still be discounted to
  obtain their present value
• Effects of inflation and discounting must be
  accounted for when performing current dollar
  analysis
• Current dollars must be deflated and discounted
  to derive the present value of future cash flows

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A Cost Analysis Example

• Due to a shortage of office space, a decision
  must be made whether to lease office space off
  base (Alternative A) or buy temporary buildings
  (Alternative B).
• Alternative A Lease 10,000 square feet of
  office space for 12.00 per square foot per year
  for six years beginning 1 October 1997.
  Maintenance and utility costs will be paid by the
  owner.
• Alternative B Purchase five temporary buildings
  for 190,000. Buildings can be delivered by 1
  October 1997 for a cost of 7,500. Maintenance
  and utilities are expected to total 18,000 per
  year. The buildings have an economic life of
  seven years and can be disposed of in the eighth
  year for a net salvage value of 10,000

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TDPC Total Discounted Project Cost
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Salvage Value of Buildings must also be
considered Net Present Value of salvage dollars
received in year eight (10,000)(0.8207)
8,207 Net TDPC 306,972 - 8,207 298,765
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Uniform Annual Cost

• Must also account for differences in economic
  life by computing a Uniform Annual Cost for each
  alternative
• Uniform Annual Cost a constant amount that, if
  paid annually throughout the economic life of an
  alternative, would yield a total discounted
  project cost (less discounted salvage value)
  equal to the actual present value cost of the
  alternative
• UACs are directly comparable

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A Practical Exercisein Economic Analysis

• Dinwiddie Army Depot is contemplating the
  purchase of four new forklift trucks to move
  supplies and equipment in a maintenance yard.
  The new trucks will replace four worn out
  machines that are currently in service. The new
  vehicles must have a usable service life of at
  least seven years and can be electric, gasoline,
  or propane powered. FY99 is the base year for
  the project. The vehicles are to be delivered
  the first week of October 2000 and used
  immediately. Three alternatives are being
  considered
• Zimco Roadrunner
• High Lift Mfg. Co., Mark III
• Watley Motormule

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Alternative A Zimco Roadrunner

• Description and Particulars The Zimco
  Roadrunner is a propane powered vehicle having a
  lift capacity of 4,000 lbs and a max speed of 12
  mph. It is manufactured in the U.S. Special
  pallets are required to accommodate the extra
  wide blades of the fork, which are too wide to
  pick up existing pallets from the sides. A total
  of 300 pallets is required. There are currently
  60 of this type pallet on hand. Due to current
  operational policies, only 160 pallets will be
  needed in FY01. The remainder will be acquired
  in FY02. The Roadrunner has a salvage value of
  1,400/vehicle and an economic life of 10 years.
  During the 5th year, a 1,600 overhaul is
  required for each vehicle.

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Alternative B Mark III

• Description and Particulars The Mark III is an
  electric powered vehicle having a lift capacity
  of 5,000 lbs and a max speed of 12.5 mph. It is
  manufactured in the U.S. and has an economic life
  of 9 years. It is a highly reliable vehicle and
  has a salvage value of 1,450. A little
  development must be completed to determine the
  changes needed for operation of the Mark III.
  The cost of each vehicle includes the charging
  facilities and their estimated cost of
  installation. This vehicle must be overhauled in
  the 6th year at a cost of 1,400 per unit.

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Alternative C Watley Motormule

• Description and Particulars The Motormule is a
  gasoline powered vehicle having a lift capacity
  of 2,500 lbs and a max speed of 7.5 mph. It is
  manufactured in Great Britain. The Motormule,
  which is a highly reliable machine, has a salvage
  value of 1,500. It does not require overhaul
  until the 8th year of operation. A complete
  overhaul costs 1,425 and can be completed in the
  United States. The low cost of this alternative
  plus its 12-year economic life, makes it a very
  attractive choice.

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Benefits Analysis
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Benefits Analysis
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