Transportation Systems Management and Operations Benefit-Cost Analysis Compendium

CHAPTER 3. USE OF DISCOUNTING, PRESENT VALUE, CONSTANT AND CURRENT DOLLARS IN BENEFIT-COST ANALYSIS

Benefit-cost analysis is a method and framework for collecting and evaluating project cost and benefit data and presenting the results of the analysis to decision makers. For the base project and project alternatives process benefit-cost analysis (BCA) involves:

• The listing of benefit categories.
• The identification of Measures of Effectiveness.
• The quantification of benefits in dollar values.
• The identification of costs.
• The quantification of costs in dollar values.
• Estimation of net present value of costs and benefits.
• The presentation of results Benefit-Cost Ratios and Net Benefits.

It is important to present benefit-cost analysis results in tabular and graphic format as well as narratives. Some policy analysts and the public often prefer such formats as it makes it easier to understand the relationships between project investments, alternatives, and benefits. For tips on BCA results visualization, see Chapter 3 for some good examples.

Benefits

BCA of transportation operations projects requires the estimation of benefits which represent the monetized estimates of the changes in the Measures of Effectiveness (MOE) identified for the project that are directly attributable to the project investment. These benefits may accrue to the transportation system users (e.g., travel time savings, reduction in crash risk, decreased operating costs); the deploying agency (increased agency efficiency); or society at large (reductions in emissions). The benefits may be either positive (e.g., a net decrease in travel time) or negative (a net increase in travel time) in value. Negative benefits are known as disbenefits.

Some benefit cost analysts improperly assign negative benefits (e.g., an increase in the amount of emissions) to the cost component of the benefit cost equation (denominator); however, the cost measure should exclusively represent the investment necessary to implement and operate the improvement. All changes in MOEs should be valued and accounted for in the benefit (numerator) portion of the benefit-cost ratio. This may include changes in agency efficiency (measured in reduced agency costs) or productivity as well. For example, if a transit agency deploys a transit vehicle automatic vehicle location (AVL) system to track and record the real-time location of buses, the agency may predict an efficiency gain because it will no longer have the need to conduct some manual data collection activities. The cost savings associated with the elimination of the manual data collection activity should properly be treated as a change in benefits rather than a cost reduction, as these savings are a direct result of the project.

Costs

The Costs or the denominator value in benefit-cost ratio for transportation systems management and operations (TSMO) projects represents the life-cycle costs of implementing and operating the project. This is important for TSMO projects since they typically incur a greater proportion of their costs in years after deployment to operate and maintain the system, and replace obsolete equipment, when compared to more traditional improvements. These life-cycle costs represent:

• The upfront Capital Costs of implementing the project or improvement, including planning, design, construction/installation, and equipment costs.
• The continuing Operations & Maintenanc (O&M) Costs necessary to keep the project operational, including items, such as power, communications, labor, and routine maintenance (excludes replacement costs).
• The Replacement Cost of equipment that reaches the end of its useful life during the time horizon of the analysis.
• The End of Project Costs necessary to close down temporary projects or any residual or salvage value of equipment at the end of the time horizon of the analysis.

These project life-cycle costs should include an accounting of all public-sector and private-sector costs, if applicable. The TOPS-BC has the capability to estimate life-cycle costs associated with many types of TSMO strategies. The use of these capabilities is also discussed in the TOPS-BC User's Manual.

The Monetization of Benefits and Costs

On aspect of benefit-cost analysis that can be challenging is the monetization of cost and benefits. In the analysis we seek to compare a potential project to a baseline condition or to an alternative solution. In order to analyze costs and benefits as well as alternative projects, it is necessary to have costs and benefits on a common unit basis. In order to explain this, we need to define a few terms. These include:

• Inflation is the increase in prices for goods and services over time. It implies a loss in the nominal value of money over time, as it erodes the purchasing power of a currency. Benefit-cost analysis for public-sector projects generally controls for inflation, using estimates of future costs and benefits that are expressed in terms of today's (or some base year's) prices. These are referred to as "constant" or "real" dollars. Consistent with this approach, the discount rate used in benefit-cost analysis represents the time value of money after adjustment for inflation.
• The Discount Rate is the recognition that a dollar today is worth more than a dollar five years from now, even if there is no inflation because today's dollar can be used productively in the ensuing five years, yielding a value greater than the initial dollar. Future benefits and costs are discounted to reflect this fact.
• Year of Expenditure Dollars (YOE) are the current dollar in the year during which an expenditure is made or a benefit is realized. These are used in financial analysis, but not usually in BCA. YOE dollars are needed to know if agency revenues will be sufficient to meet agency outlays.

TSMO and other transportation projects usually entail a stream of expenditures and benefits over time. Initial capital cost may occur in the early project years with O&M costs continuing over the project life. Benefits usually occur over the full life of the project. TOPS-BC is designed to simplify these conversions between current and future dollars. TOPS-BC estimates average annual benefits and costs, or projects the benefits and costs to a stream of costs that may be used with a time horizon selected by the user. The user can also select the inflation rate and the discount rate.

Benefit cost analyses typically ignore inflation because the prediction of future prices introduces unnecessary uncertainty into the analysis. Therefore, discount rates are typically based on interest rates or borrowing with the inflation component removed, yielding the "real" interest rate. This rate is typically calculated by subtracting the rate of inflation (consumer price index) from the interest rate of an investment, such as a 10-year U.S. Treasury bill. For example, if the interest on a 10-Year Treasury bill is 5.5 percent and the inflation rate is 3 percent, then the discount rate would be 2.5 percent.

The discount rate for most projects in based on guidance provided by the U.S. Office of Management and Budget (OMB). The rate to be applied is related to the type of the project and the expected benefits and costs. If the project is anticipated to have benefits to the general public (societal benefits such as travel time savings or crash reductions), the OMB currently suggests a discount rate of 7 percent, which represents the real discount rate on private investment. However, if the analysis includes benefits and costs exclusively related to the public agency, for example, an analysis of an investment that would bring about a cost savings to the agency, the OMB suggests using the real discount rate for public-sector investments, which is often lower due to the lower risk associated with government borrowing. The OMB publishes "real" interest rates on its web site http://www.whitehouse.gov/omb/circulars_a094_a94_appx-c/. Generally, if there is a mix of societal and agency benefits within the same analysis, only the private-sector investment discount rate (7 percent) is used.