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p. 12 of 74 BACK | NEXT I. Introduction II. Background III. The Economic Rationale of A Project IV. Macroeconomic and Sectoral Context V. An Integrated Approach To Economic Analysis VI. Identification and Quantification of Costs and Benefits A. General B. Identification and Quantification of Benefits C. Identification and Quantification of Costs VII. Valuation of Economic Costs and Benefits VIII. Large Projects, Linkages, and National Affordability IX. Least-Cost and Cost-Effective Analysis X. Investment Criteria: Economic Viability XI. Discount Rate XII. Uncertainty: Sensitivity and Risk Analysis XIII. Sustainability of Project Effects XIV. Distribution of Project Effects XV. Projects and Policies XVI. Appendices XVII. Others

Guidelines for the Economic Analysis of Projects : VI. Identification and Quantification of Costs and Benefits

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C. Identification and Quantification of Costs

43. While several types of cost need to be included in the economic analysis of a project, some types of financial cost must be excluded. The underlying principle is that project costs comprise the difference in costs between the without and with project situation, that is, the extra use of resources necessary to achieve the corresponding benefits.

System Costs

44. If a project is part of a larger system, then the expected benefits may not accrue unless some matching investments are made. For example, power generation benefits rely on investments in transmission and distribution. A highway section may need investment in preceding sections or interchanges for the expected traffic flow and cost savings to occur. The project boundary must include the total system investment required to achieve the benefits and, correspondingly, the total system benefits. If the total system of investments is viable, then the project can also be considered viable.

Sunk Costs

45. A project may require the use of facilities already in existence. The costs of such facilities are sunk costs and should not be included in the project cost, provided their use in the project involves no opportunity cost. Put another way, sunk costs are those costs that would exist both without and with the project, and thus are not additional costs for achieving project benefits.

46. Many projects will be implemented through existing enterprises or agencies. The project analysis must separate the additional agency costs from the whole cost structure of the enterprise. At the same time, the project may succeed only if the enterprise itself is stable. The analysis of the whole enterprise, including sunk costs together with the project, is necessary to determine financial sustainability (see Guidelines for Preparation and Presentation of Financial Analysis, 1989).

Contingencies

47. Contingency allowances, which are determined by engineering and financial considerations, also have implications for economic appraisal. When estimating project costs for financial planning purposes, both physical and price contingencies are included. Since economic returns are measured in constant prices, general price contingencies should be excluded from the economic cost of the project. Physical contingencies represent the monetary value of additional real resources that may be required beyond the base cost to complete the project, and should be treated as part of the economic cost of a project.

Working Capital

48. Working capital is commonly defined in financial analysis as net current assets, consisting of inventories, including goods in process; net receivables; marketable securities; bank balances; and cash in hand. A certain amount of working capital is normally required to run project facilities created by investment in fixed assets. For purposes of economic analysis, only inventories that constitute real claims on the nation's resources should be included in the project economic costs. Other items of working capital reflect loan receipts and repayment flows, and are not included in the economic cost (see Appendix 5).

Transfer Payments

49. Some of the items included in the financial costs of a project are not economic costs, as they do not increase or decrease the availability of real resources to the rest of the economy. These items will, however, affect the distribution of financial costs and benefits between the project entity and other entities, and among project beneficiaries. They are thus referred to as transfer payments, as they transfer command over resources from one party to another without reducing or increasing the amount of resources available as a whole. Taxes, duties, and subsidies are examples of items that, in some circumstances, may be considered to be transfer payments. They can affect the income of the government, and that of the payer and the recipient simultaneously and in opposite and identical amounts, thus canceling out in an economic analysis summation. However, there are circumstances when tax and subsidy elements should be included in the price of an input or output. The economic cost of an input should include the tax (subsidy) element, if the demand is nonincremental. If the government is correcting for an externality by applying a tax or a subsidy to reduce or to increase production, for example, where a tax is levied on project output that is equivalent to the costs of waste processing undertaken by a government agency, the economic cost of the input should also include the tax element. Finally, the economic value of incremental outputs will include any tax element imposed on the output which is included in the market price at which it sells.

Depreciation

50. The financial accounts of agencies implementing a project will include provision for depreciation and amortization on the basis of prevailing accounting practice. However, for project economic analysis, the stream of real investment required to realize and maintain project benefits is included in the resource flow, together with a residual value for these assets at the time they are released from project use at the end of the projects life. The stream of investment assets includes initial investment and replacements during the projects life. This stream of expenditures generally will not coincide exactly with the time profile of depreciation and amortization in the financial accounts.

Depletion Premium

51. Many projects involve the exploitation of a nonrenewable natural resource, such as oil, natural gas, or mineral deposits. The economic cost of using these natural resources must be included in the economic analysis. Because they cannot be replenished, and when depleted must be replaced by imports or domestic substitutes, the opportunity cost of the resource includes the cost of the substitutes when the resource is exhausted. The depletion premium or allowance depends on this economic price and the proportion of the total reserves exploited during each year. It is added to the economic cost of exploitation to arrive at the full economic cost of using the nonrenewable resource. If the resource will not be exploited to exhaustion, the salvage value of the land at the end of the project must include the economic value of any remaining undepleted reserves (see Appendix 6).

External Costs

52. In many projects, effects will go beyond the financial analysis from the point of view of the implementing agency. These external effects may include significant costs that must be accounted for in an economic analysis from the national perspective. For example, increased air and water pollution from an industrial plant may be measured and its effects on surrounding entities estimated. In some cases, it may be helpful to internalize these external costs by including all relevant effects and investments in the project statement, including, in this case, pollution control equipment costs and effects.

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