Catalog

	Table of Contents
p. 24 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 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

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IX. Least-Cost and Cost-Effectiveness Analysis

116. After determining the scope of the project on the basis of demand and other factors, and having identified, quantified, and valued the costs and benefits of the project alternatives, the next step is to identify the least-cost or most cost-effective alternative to achieve the purpose of the project. A comparative analysis of the scale, location, technology, and timing of alternative project options or designs is often required. Such an analysis will take into account both market and nonmarket costs in testing for least-cost or productive efficiency. In cases in which alternatives can be defined that deliver the same benefits, it is possible to estimate the equalizing discount rate between each pair of mutually exclusive options for comparison. Alternatively, if the effect or outcome of a project can be quantified but not valued, the average incremental economic cost can be estimated, with the aim of establishing the project alternative with the lowest per unit cost.

117. Least-cost analysis aims at identifying the least-cost project option for supplying output to meet forecast demand. Least-cost analysis involves comparing the costs of the various mutually exclusive, technically feasible project options and selecting the one with the lowest costs. For example, it may be that the cheapest way of increasing water supply is through more efficient management of the existing supply system rather than through augmenting capacity.

118. Mutually exclusive project options must be alternative ways of producing the same output of a specified service quality. If differences in output or service quality exist, a normalization procedure that takes the foregone incremental benefits of one option relative to another as a cost to the deficient option must be followed to ensure equivalence.

119. Procedures for the calculation and interpretation of the equalizing discount rate should be made explicit, with the least-cost project being identified by comparing the capital and operating costs of the project alternatives and calculating the equalizing discount rate for the difference in cost streams. The project with the highest equalizing discount rate for all comparisons is the least-cost alternative. Using a more straightforward approach, the alternative with the lowest present value of costs, is the least-cost alternative.

120. Alternatively, the average incremental economic cost for each alternative can be estimated, with the aim of identifying the alternative with the lowest per unit costs. The average incremental economic cost is the present value of incremental investment and operation costs, with and without the project alternative, divided by the present value of incremental output, with and without the project alternative.

121. Because of the uncertainty involved in forecasting future demand and the complex interrelationships between the cost of output and the price charged, least-cost analysis should also take into account the value of flexibility. For example, in the case of uncertain demand in a water supply project, it may be more costly but preferable to consider staging construction. Adding capacity in small amounts gives the water enterprise flexibility, but is also more costly. Hence, it is important to be able to value this flexibility. One way to do this is to find out how much lower the capital cost of the smaller plant would have to be to make it the preferred choice. The economies of scale associated with the larger cheaper-cost option would have to be equal to, or greater than, that amount to make giving up the flexibility of the smaller project economical (see Appendix 19).

122. Least-cost analysis applies to projects where the benefits can be valued or to projects where the benefits take the form of a single commodity, such as treated water or power. Cost-effectiveness analysis also deals with alternative means of achieving given ends. However, the ends may be estimated only indirectly. For example, different means of organizing activities to raise reading abilities in primary schools may be under discussion. The costs associated with each alternative can be calculated on a without project / with project basis. The effectiveness of each alternative may be measured through setting reading tests for groups of students subject to the different methods.

123. Cost-effectiveness analysis requires the increase in reading test scores to be divided by the costs for each method. The most cost-effective method is the one that raises reading test scores by a given amount for the least cost. If this method is chosen and applied to all similar students, the same increase in reading test scores can be obtained for the lowest cost, in other words, there would be the largest overall improvement in reading test scores per unit of cost expended. However, it should also be noted that the most cost effective method is not necessarily the most effective method of raising reading test scores. Another method may be the most effective, but also cost a lot more, so it is not the most cost effective. The cost effectiveness ratios - the cost per unit increase in reading test scores for each method - can be compared to see how much more it would cost to implement the most effective method. Which method is chosen for implementation then depends jointly on

• the desired target increase in reading test scores, and
• the extra cost involved in implementing the most effective method.

124. There will be circumstances where project alternatives have more than one outcome. For example, there are different dimensions of literacy - comprehension, writing, speed. Different interventions to improve literacy may have different impacts on each dimension. In order to assess the cost effectiveness of the different interventions it is necessary to devise a testing system where the results for the different dimensions can be added together. It is also necessary to decide on some weights for adding the different dimensions together, reflecting their importance in relation to the objectives of the project. Such a use of cost-effectiveness analysis is called weighted cost-effectiveness analysis. It introduces a subjective element, the weights, into the comparison of project alternatives, both to find the most cost-effective alternative and to identify the extra cost of implementing the most effective alternative.

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