Cost-Benefit Approach to Project Assessment - Essay Example

Project Assessment The Cost-Benefit approach involves determination of the benefits of a project and then comparing those to the costs associated with the project. This is a quick and simplified approach to reach certain financial decisions. Some of the project areas that a cost-benefit analysis may be applicable include: determining the viability of a capital purchase, evaluation of a new project initiative, and deciding whether to hire additional employees. The approach takes a short process: brainstorming of the benefits and costs, assigning of monetary values to the benefits, assigning monetary values to the costs, and comparing the costs and the benefits. According to Boardman(2004), cost-benefit analysis is a methodical process used in the calculation and comparison of the costs and benefits of a project (p.165). It serves two main purposes: to identify the soundeness of a decision, and to provide a foundation for the comparison of projects. The tool is used most often by governments to evaluate the appeal of any given project. The analysis includes an account of the forfeited choices and the planned project. Heseltine, the former deputy prime minister, criticized the cost-benefit analysis of the HS2 high-speed railway line. He even suggested that the expected cost of £42.6 billion could be reduced by £10 billion. The comment came after the heightened debate about the certainty of the estimated benefits of the HS2 project. Heseltine also pointed out that the analysis did not consider consequential growth in the project these included later expansion to connect London and Birmingham in 2026, and Manchester and Leeds by 2033. This attracted undying criticism from many quarters. However, the government was insistent that the benefits the project will bring outweighs the project’s cost. One of the latest criticisms was that the government overestimated the value of time that people travelling for business would save for short journeys. The assumptions at the time did not consider that a person could still work on transit using their laptops or other mobile devices. This has seen the time savings on business travel cut down by about a third (Mason & Watt 2013). According to Overman (2012), when a country’s government wants to undertake a big project, its first step is always to conduct a cost-benefit analysis to evaluate the benefits to its citizens and determine whether this outweighs the cost (p.18). For the high-speed rail link project, HS2, that will link London to the North the benefits were outlined as more capacity, less disruptions and faster journeys. These deemed the project highly beneficial, but the accompanying costs were as high. In addition, both the costs and benefits were said to be highly ambiguous. The project’s supporters reckon that the costs have been overstated and the eventual subsidies and revenue overlooked. For instance, they observe government costs on fares will be reduced by £13 billion. Other supporters indicate that the number of expected passengers has been greatly underestimated. However, its opponents reckon that the benefits have been overstated as part of the calculations include “valuation” of time savings. They argue that the numbers for time savings are too high due to the assumption that train passengers are unproductive. Opportunity cost is an important economic concept that relates to scarcity and choice. Scarcity arises when resources, whether capital, financial or human, fall below the sufficient quantity to satisfy the project’s requirements. Therefore, a project manager must determine the desired results from particular resources. Therefore, in making the opportunity cost decision the project manager should appreciate that the next best alternative is not feasible. The opportunity costs, is normally the net value of the chosen alternative against the net value of the second best alternative. In projects, it involves the costs of choosing an alternative, thus foregoing the possible benefits of the second-best alternative. Opportunity costs may be divided into implicit and explicit costs. Implicit costs are the implied opportunity costs through the use of existing resources in a project. Explicit costs are the opportunity costs that comprise of direct payments in a project. Option 1 Option 2 Figure 1: Opportunity cost of two project alternatives cited from http://www.economicsonline.co.uk/Competitive_markets/Production_possibility_frontiers.html By evaluating the HS2 project’s opportunity costs, there are many transport or other projects that would be undertaken with lower amounts than the anticipated £47 billion which will be used on the rail project. For instance, £30 billion could be used in transport projects such as the construction of additional intra-city schemes (Dassanayake, 2013). Figure 1 above illustrates the opportunity costs of two project alternatives. It is visible that considering option 2 from A to B attaches little opportunity cost. However, a movement from C to D has a corresponding high opportunity cost. Another transparent and efficient way of estimating the costs of a project is to compare it with those of previous and similar projects. If a similar project had been undertaken in the past, all the corresponding information could be retrieved from the project’s documentation. However, if a similar task has not been undertaken, other unrelated projects that might have been carried out could help in determining the costs of the new projects. A friendly country or an agency that has carried out a similar project may be helpful if its offers its historical data. This method is called historical costing and most often has high precision in forecasting future costs. In evaluating the cost-benefit analysis, Eddington report, which was published in 2006, compared figures in the HS2 project with those of projects that were in the books of the DoT (Department of Transport). The results proved to be quite shocking as they indicated that HS2 at its best would fall in the bottom quartile in terms of the associated benefits. Indeed, the benefits were determined to be closer to the bottom 10% (Overman, 2012.p. 20). The marginal social cost (MSC) of a project is the value in terms of additional prices of the resources that are needed to complete the project. On the other hand, the marginal social benefit (MSB) is the social value attached to the completion of the project. When consumers use the outcome of a project without incurring costs, the MSB value is equal to previous market prices multiplied by a number that represents an increase in the income of the users. This additional price is based on the ratio of the project’s benefits and the decrease in expenses. This introduces externalities that result from people feeling either better off or worse off because other people are served by the project. COSTS BENEFITS A B Figure 2: Marginal social costs and Marginal social benefits as cited from http://www.economicsonline.co.uk/Competitive_markets/Production_possibility_frontiers.html From the illustration above, we can conclude that as long as the government can establish that the targeted people are benefiting from the project, then it is bound to implement the project. This implies that the government will ensure its completion. McDermott (2013), states that there are increasing arguments that HS2’s capacity will benefit London’s residents more than those in other cities. Studies have shown that it will be easier to get to the capital than to other cities. In addition, the shortened travel times could be negated by London’s housing prices, as not many people would consider residing in London and commuting to other cities (GREAT BRITAIN, 2011). The concept of opportunity cost is connected to the fact that economic analysis is basically concerned with evaluating trade-offs among the environmental, social and economic impacts of the alternatives. For instance, this can involve the trade-offs between the implementation of the project and the costs of controls required to achieve it. The trade-offs concept implies that this needs full consideration for opportunity costs of resources utilized in its achievement. This presents possible “win-win” situations like shorter travel times, which leads to economic, social and environmental benefits. Thus, there should be a thorough analysis of why such situations had not been exploited before. Conversely, it is important to determine the reason behind this, which could be market failure or hidden costs (GREAT BRITAIN, 2011). Beyond certain points, the project may experience a rise in costs as the reduction of negative impact goes on, in order to create benefits. The law of diminishing returns impacts the selection of alternatives for the improvement, as the trade-offs between reduction of negative impacts and the rising costs are rising the benefits continue (GREAT BRITAIN, 2011). Economic analysis will illuminate such trade-offs. In the figure below, after point X, the resources added into the project generate lower benefits than those employed earlier. Output X Resources Figure 3: Diminishing marginal returns There have been various controversies raised over the HS2 rail link project. There are questions raised about the underestimation of project’s costs and overestimation of the project’s benefits. The project has been divided into two phases. The government should consider executing the phases concurrently in order to lower costs and bring the benefits sooner. Therefore, I support the project as it is bound to bring immense benefits in the long run. Bibliography Dassanayake, D., 2013. Controversial HS2 high speed rail project could be scraped, says PM David Cameron. [Online] Available at: http://www.express.co.uk/news/uk/439303/Controversial-HS2-high-speed-rail-project-could-be-scrapped-says-PM-David-Cameron [Accessed 21 January 2014]. GREAT BRITAIN. (2011). High speed rail: tenth report of session 2010-12. Vol. 2, Vol. 2. London, Stationery Office. Mason, R. & Watt, N., 2013. HS2 cost-benefit estimates are mumbo jumbo, says Heseltine. [Online] Available at: http://www.theguardian.com/uk-news/2013/nov/12/hs2-cost-benefit-estimates-mumbo-jumbo-heseltine [Accessed 14 January 2014]. McDermott, J., 2013. The only cost-benefit analysis of HS2 that matters. [Online] Available at: http://blogs.ft.com/off-message/2013/10/29/the-only-cost-benefit-analysis-of-hs2-that-matters/ [Accessed 20 February 2014]. Overman, H., 2012. HS2: assessing the costs and benefits. Centrepiece, pp. 18-20. Read More