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UNIT VII

ECONOMIC ANALYSIS: THE INCREMENTAL APPROACH


Project worth analysis normally depends on who the investors and users are. In the point of view of private investors, “financial analysis” (as discussed in Unit VI) play its vital role in assessing whether a proposed project is really a worthdoing investment endeavor or not. In the point of view of the government and/or public investor, however, profitability or financial gains from resource commitment is less important. Normally given emphasis in this regard is the socio-economic contribution of the project to the societal constituents and the economy in general. Through the economic benefit-cost analysis (BCA), the effects of the project on selected development goals are measured and translated into quantitative feasibility indicators, the process called “economic analysis.”


Although numerous methods and techniques of economic analysis with varying degrees of sophistication and theoretical soundness have been developed, this chapter solely deals with economic Benefit-Cost Analysis (BCA) using the incremental approach.

At the end of Unit VII, you should be able to:

q  relate what economic analysis is all about; and

q  demonstrate how BCA technique is used in conducting economic analysis.

THE “BCA” TECHNIQUE OF ECONOMIC ANALYSIS

In essence, BCA is concerned solely with economic efficiency or growth objectives. Its decision rule dictates the acceptance of projects whose aggregate economic cost, irrespective of the individuals to whom they accrue. Profitability in this regard is measured in terms of the project’s capacity to maximize efficient use of nation’s scarce resources to produce national income or value-added. In view of IRR as measure of profitability, Economic Rate of Return (ERR) is instead used as index of profitability, which normally is compared with the Social Discount Rate (SDR) of the economy. Of course, if the ERR is greater than the SDR, the project is considered economically desirable; (undesirable if otherwise)!

The Social Discount Rate

Since benefits and costs occur at different points of time during the project’s lifespan, they must be first converted into their present values. The rate used to discount the future economic B/C streams is known as the Social Discount Rate (SDR).

The Social Discount Rate is a function of the social opportunity cost of capital (OCC) and the social time preference rate (STP), where OCC represents the marginal return on invested capital, while STP rate reflects the diminishing value of consumption over time. The STP rate is also referred to as the consumption rate of interest (CRI).

If the valuation of benefits and costs were in terms of aggregate consumption, then the discount rate is given by the social time preference rate (STP) or the consumption rate of interest (CRI). If, on the other hand, the valuation were in terms of aggregate savings (investments), the discount rate used is the opportunity cost of capital (OCC). Current practice to date makes use of the OCC as the social discount rate.

Identification of Project Costs and Benefits

The basic approach in determining direct costs and benefits is to study the incremental B/C of the “with” and “without” the project.

Since projects are usually evaluated in terms of their effect on national income economic B/C must therefore necessarily reflect the additions to and reductions from national income (or the pool of available real resources) that would result if the project were implemented.

In conducting economic benefit and cost analysis, the following are considered:

§  Only quantifiable benefit and costs are included in the computation of ERR. Non-quantifiables are rather discussed qualitatively.
§  Cost items are usually classified into two types: capital costs, and operating and maintenance costs which may be taken out directly from the financial analysis data. These costs, however, shall be transformed into its economic values by using “shadow prices” instead of market prices (as normally used in financial analysis).
§  Sunk costs are excluded in the BCA analysis. (Sunk costs are defined as all those costs incurred on the project prior to the preparation of the feasibility study. Since these expenses have already been incurred, they are no longer subject to investment decision making).
§  Taxes are treated as transfer payments, while subsidy is a cost (the reverse hold through under financial analysis where taxes is treated as cost and subsidies as return).
§  Yearly depreciation is not treated as operating expense since capital outlay (fixed asset investment) is already accounted as cost (lumpsum) during the pre-operating period. To include depreciation in the economic cost stream when the initial outlay has already been entered would constitute double-counting.
§  Direct benefits are quantified in terms of the project’s favorable effect to the economy (e.g. increased value of output, quality improvement, greater physical production, reduced transportation cost, increased import savings, gains from mechanization, etc.)
Valuation of Benefits and Costs

In the valuation of project costs and benefits, our major concern is to measure the project’s effect on income-generation, regardless of whether such income is saved or consumed, or whether it goes to the private or public sector.

Please take note that the evaluation of costs and benefits appropriate for economic analysis differs from that which is relevant to financial analysis. While financial analysis requires the use of market prices, economic analysis requires the adoption of economic prices, usually called the “shadow price” or “opportunity cost.”

Shadow prices are the values of inputs and outputs reflecting their relative scarcity or availability as well as their relative importance in achieving the various socio-economic objectives. Squire and Van Der Tak define shadow prices as “the value of the contribution to the country’s basic socio-economic objectives made by any marginal change in the availability of commodities or factors of production.”

In conducting economic analysis, only those resources characterized by major price distortions, e.g. labor, foreign exchange, land and capital are subjected to shadow pricing. For the rest of project inputs and outputs, market prices can be used.

Four types of shadow prices are briefly discussed below: foreign exchange, labor, land and capital

(1)  Shadow Price of Foreign Exchange

Studies indicate that the economic value of foreign exchange is 20% higher than the official rate for the peso. Thus, if the official rate is P40 = US$ 1.00, then the shadow price is 1.2 x P40, or P48 for every US dollar.

(2)  Shadow Price of Labor

In an economy suffering from chronic unemployment or underemployment, the economic price of unskilled labor is likely to be lower than the prevailing financial wage rate or the minimum wage rate. The shadow price of labor may be defined as the value of output foregone as a result of its employment in the project. For example, if the project were to hire a farm laborer, and if the hiring would result in a direct reduction of P100 in the daily production in the farm where he works, then the relevant cost of such labor to the economy is P100 per day. On the other hand, if the worker had been idle, hence unproductive, there may be no economic cost attached to his hiring; in this case the shadow wage rate is zero. However, the hiring of labor may involve additional costs such as transport and services related to the movement of labor. Inclusion of these indirect costs would usually make the shadow price of unskilled labor greater than zero but below money income received.

(3)  Shadow Price of Land

The shadow price of land used in a specific project is the value of output foregone that the land could have produced if utilized in its best alternative use. For instance, if the land used by the project would have otherwise remained idle, its opportunity cost from the economic standpoint is zero. On the other hand, if the land would have produced 2,500 of palay per hectare, per year, this would represent its opportunity cost.
For a number of projects, shadow price of land is computed based on the incremental benefits derived from the use of the land. For example if the land is used as a ricefarm and it generates a gross benefit of P100,000 per year, and converting such riceland into an industrial plant will yield a gross benefit of P1,000,000 per year, then the shadow price of the land is equivalent to P900,000.

(4)  Shadow Price of Capital

Like the shadow price of foreign exchange rate, the opportunity cost of capital is to be provided by the central planning office. Current studies indicate the opportunity cost of capital in the Philippines to be in the order of 18 to 20%.
Economic Analysis: An Application

For you to better comprehend the economic analysis, let me show you a sample proposed project where incremental B/C analysis was used. Since our intention is to determine the net contribution (ERR) of the project to the economy in general, our analysis is simply focused on tangible direct benefits and costs associated with the proposed project. Other intangibles or indirect socio-economic benefits may be instead discussed qualitatively under the socio-economic aspect of the Feasibility Study.

Name of the Project : Cooperative Village-Based Tomato Processing Project
Proposed Site : Aliaga, Nueva Ecija Total Project Costs :
§  Initial Capital Outlay P 12.8 M
§  Operating Capital 13.2 M
------
Total P 36.0 M Project Financing : 80% LBP Loan; 20% PMPC Equity Social Discounting Rate : Assumed at 20%
A. Economic Benefits
Increased Farm Income
Increased Value Added
Import Savings
Increased Household
Income
Benefit From Capital
Build up Total per year
(Year 1-10) / Benefits “With” the Project
------
P 7.09 M
17.83 M
13.56 M
1.01 M
0.60 M
------
/ Benefits “Without” the Project
------
P 3.98 M
12.50 M
36.47 M
0
0
------
/ Incremental Benefits
------
P 3.11 M
5.33 M
22.91 M
1.01M
0.60 M
------
P 32.96 M
B. Economic Costs:
Capital Investment
(Incurred only during the
pre-operating period)
Manufacturing and
Operating Costs
(Year 1-10) / Cost “With” the Project
------
P 12.8 M*
13.2 M / Cost “Without” the Project
------
0
0 / Incremental Costs
------
P 12.8 M
13.2 M

Using the incremental approach (B/C of “with” versus “without” the project), the following economic benefits will be generated from the village-based tomato processing project

A. Increased Farm Income P3.11M

Since the project will be engaged in contract growing arrangement, it is expected that the farmer’s income will improve from P3.98M (without the project) to P7.09M (with the project). The main reason for this is the cheaper cost of inputs of farmers due to minimal interest on funds and improved yield as a result of technological assistance and high yielding variety to be provided by the project to the farmer-beneficiaries.

B. Increased Value Added P5.33M

Without the processing plant, the total value of tomato being produced by the farmers in the service site is P12.50M. Since their produce will be acquired and processed by their Cooperative Village-Based Tomato Processing Plant, gross revenue of the farmers will improve to P17.83M, an increased value added of P5.33M

C. Import Savings P22.91M

Since the processing plant aim to produce import-substitute product (tomato paste), the cost of importation (equivalent to the production capacity of the plant) of the country will be reduced by P22.91M. If the plant will instead produce domestically, its cost of production is only P13.56M, hence a savings of P22.91M.

D. Increased Household Income P1.01M

Without the processing plant, no employment will be generated. Through the establishment of the proposed project, housewives and out-of-school youth will have a potential employment. Total additional earnings of household is estimated at P1.01M per year.

E. Benefit from Capital Build-up P0.60M

As a cooperative project, farmer-member beneficiaries will be receiving dividends and patronage refund, estimated at P0.60M per year. Of course, without the cooperative processing plant, these benefits will be forgone.

On the other side of the coin, economic costs of the proposed Tomato Processing Plant will cover the initial capital outlay and the operating expenses. The incremental cost is thereby estimated as follows:

A. Capital Investment P12.8M

Without the project, no capital outlay will be incurred. If this will be put up, however, it will cost the economy around P12.8M for the construction of the plant and acquisition of necessary processing facilities and equipments.

B. Manufacturing and Operating Costs P13.2M

Yearly, the project is estimated to have a manufacturing and operating costs of P13.2M once operationalized (e.g. raw material, labor, overhead, etc.). If the project will not be pursued however, then these costs can be avoided. The incremental economic cost therefore is equivalent to P13.2M per year.

Given the projected economic benefit and cost stream, the ERR of the proposed project is thus computed as follows:

Summary of Incremental Benefit and Costs

Year

------/ Incremental Benefits
------/ Incremental Costs
------/ Net Incremental Benefits (NIB)
------/ Discounted NIB at 20%
------/ Discounted NIB at 160%
------
0
1
2
3
4
5
6
7
8
9
10 / 0
P32.96M
32.96
32.96
32.96
32.96
32.96
32.96
32.96
32.96
32.96 / P12.80 M
13.20
13.20
13.20
13.20
13.20
13.20
13.20
13.20
13.20
13.20 / (12.80 M)
19.76
19.76
19.76
19.76
19.76
19.76
19.76
19.76
19.76
19.76 / (12.8 M)
16.5
13.7
11.4
9.5
7.9
6.6
5.5
4.6
3.8
3.2 / (12.8 M)
7.60
2.92
1.12
0.43
0.17
0.06
0.02
0.02
0.01
0.00

NPW at 20% NPW at 160%

Like IRR, Economic Rate of Return (ERR) is computed using the same formula: