Short Answers for Cost Analysis - nEED IN 5 HOURS
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LECTURE.NOTES.docxThe Concept of Costs
The value of what is given up or sacrificed represents the cost of an alternative. The “cost” of pursuing an intervention is what we must give up by not using these resources in some other way.
The cost of a specific intervention will be defined as the value of all the resources that it utilizes had they been assigned to their most valuable alternative use.
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The Concept of Costs
All costs represent the sacrifice of an opportunity that has been forgone. It is this notion of opportunity cost that lies at the base of cost analysis in evaluation.
By using resources in one way, we are giving up the ability to use them in another way.
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The Concept of Costs
In cost analysis, we wish to ascertain the cost of an intervention in terms of the value of the resources that were used or lost by applying them in one way rather than in another.
This can be done by using the “ingredients” model.
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Inadequacy of Budgets for Cost Analysis
Why should we estimate costs when programs and projects have budgets and expenditure statements that can be used to address cost issues?
Although the existence of budgets is universal, the assumption that they contain all the cost information that is needed is usually erroneous.
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Inadequacy of Budgets for Cost Analysis 1. Budgets do not include cost information on all the ingredients that are used in the intervention, since contributed resources such as volunteers, donated equipment and services, and other “unpaid” inputs are not included in budgets.
2. When resources have already been paid for or are included in some other agency’s budget, they will not be discernible. For example, a building that is provided by some other unit of government or one that is fully paid for will not be found in usual budgets.
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Inadequacy of Budgets for Cost Analysis
3. The standard budget practices may distort the true costs of an ingredient. Typical budgets and expenditure statements charge the costs of major rehabilitation only to the year in which the cost was incurred.
Example: When the heating system of a building is replaced, the expenditures are found in the budget for the year in which the repairs were made. Yet, a new heating system may have a 30-year life, so only about 1/30 of it should be charged to the cost in a given year.
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Inadequacy of Budgets for Cost Analysis
4. The costs of any particular intervention are often embedded in a budget or expenditure statement that covers a much larger unit of operation.
It may be difficult to isolate the unique costs of a new program in a budget since the budget is not constructed according the costs of particular interventions or activities.
Expenditures are usually classified according to functions (administration, maintenance, training) or objects (supplies, clericals, administrators).
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Inadequacy of Budgets for Cost Analysis
4. The costs of any particular intervention are often embedded in a budget or expenditure statement that covers a much larger unit of operation.
It is often difficult to tie budget listings to particular activities or interventions, and often impossible to ascertain what the costs are for a given program if breakdowns are not provided.
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Inadequacy of Budgets for Cost Analysis
5. Most budgetary documents represent plans for how resources will be allocated rather than classifying expenditures after they have taken place.
They refer to planned disbursements rather than actual ones.
Actual statements or expenditure documents may be more accurate but they are still subject to shortcomings mentioned before.
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Inadequacy of Budgets for Cost Analysis
For these reasons, cost analysis cannot primarily rely on budgetary or expenditure documents to ascertain the costs of interventions.
These documents may still provide data that will be very useful but they cannot serve as a principal source for constructing cost estimates.
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Purpose and Principles of Cost Valuation
Recall: The definition of costs is the sacrifice equal to the value of something that is given up by using resources in a particular way.
Cost is the value of what must be given up by using the ingredients in one way rather than in their best alternative use.
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Possible Sources of Ingredients Information
• Market Prices • Shadow Prices • Written Reports • Observations • Interviews
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Possible Sources of Ingredients Information Written reports may contain a brief history and description of the intervention. Information can be both supplemented and corroborated from these reports.
If the project is nearby, an analyst can visit and gather additional information on ingredients via observation.
Interviews are extremely helpful. Present and former personnel are asked to identify resources from among a number of different classifications.
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Market Prices
Using market prices is the most common method for placing monetary values on ingredients .
Economic theory: When markets for a particular good or service are perfectly competitive, the equilibrium price established by that market will represent the value of that good.
Market Prices
Perfect competition – a market structure in which a very large number of firms produce a standardized product and there are no restrictions on entry.
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Market Prices
Two attractive features of using market prices: 1. Availability Prices are readily available that can be used to determine the costs of inputs/ resources. There are reasonably competitive markets for many of the ingredients (personnel, facilities, equipment)
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Market Prices
Two attractive features of using market prices: 2. Simplicity Using market prices of ingredients is a simple way to derive cost data.
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Shadow Prices
There are markets which do not meet the criteria for perfect competition: • Relatively few buyers or sellers • Unique product/ No close substitutes • Difficult entry
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Shadow Prices
In cases of imperfect competition, the existing market price may be an inaccurate reflection of the cost of obtaining the ingredients, and adjustments must be made to provide a more appropriate cost measure.
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Shadow Prices
Example: Assume that a talented program directly is presently receiving salary valued at $60,000 a year, but there are few persons who possess such talents.
To ascertain the cost of using such talent, one would have to take into account of the fact that the scarcity of such talent may generate considerably higher cost for additional qualified persons as demand for such talent increases.
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Shadow Prices
Also, there may be no obvious market for a particular ingredient/ input.
When attempts are made to ascertain the value of a good that does not have a competitive market price, the estimated value is called a shadow price.
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Shadow Prices Example: Using an old facility that was purchased a long time ago to a new program There is no financial transaction and no market is exists for this type of facility. In these cases, it is necessary to ascertain what the value of the ingredient would be if there were a market.
Both market and shadow prices can be used to ascertain the value of ingredients for cost estimation.
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The Ingredients Approach
The idea behind this approach is that every intervention uses ingredients that have a value or cost.
The ingredients approach to estimating cost relies on identification of all resources or ingredients consumed in an intervention and the valuation of each ingredient.
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The Ingredients Approach
It’s a three-phased estimation approach that requires the identification of ingredients, determination of the value or cost of the ingredients and the overall costs of an intervention; and an analysis of the costs in an appropriate decision-oriented framework.
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Methods for Valuing Ingredients
When ingredients have market prices, the best measure of cost is usually that price. Market prices exist whenever goods or services can be offered for sale and purchased openly by buyers and sellers.
If one can obtain an ingredient of a given quality at a given price in an open market, one can use that price to evaluate the cost of the ingredient.
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Methods for Valuing Ingredients
If market prices are inaccurate reflections of the true costs, one must adjust the market price appropriately.
In the case of using a scarce talent, an increase in demand will result in a higher price.
In a single intervention case, the use of an ingredient will not generally affect the market; however, in the case of numerous duplications of the intervention, demand for the ingredient may increase enough to raise its market price.
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Methods for Valuing Ingredients
If market prices are not available, one must use shadow prices.
There may be no specific market for an old facility, but there are ways that we could ascertain what the market price would be if there were a market.
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Methods for Valuing Ingredients
Personnel Personnel usually account for a large portion of the total costs.
The services of most personnel are purchased in the marketplace, so it is data derived for such transactions that should first considered.
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Methods for Valuing Ingredients
Personnel
When a personnel position can be filled by attracting persons with the appropriate education, experience, and other characteristics at the prevailing salary and benefits generally paid for such talent in the market, the cost of such person is considered to be the monetary value of the salary and benefits.
However, it is important to know that the price of obtaining personnel in different locations and situations is also affected by working conditions and other factors.
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Methods for Valuing Ingredients Personnel The salary and benefits and usually be obtained from normal payroll or expenditure data. However, in other cases, such as new interventions that are being proposed or the use of volunteers, expenditure data are obvious. In the case of a new program, one can use data from other existing interventions or the marketplace to calculate the expected costs for each type of personnel.
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Methods for Valuing Ingredients Personnel The value of a volunteer can be determined by estimating the market value of services that the volunteer will provide.
In summary, most personnel costs can be obtained by ascertaining the expenditures on salaries and benefits for each of the personnel ingredient.
When such data are not available, costs can usually be estimated by considering the market value of the services that will be utilized.
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Methods for Valuing Ingredients Facilities Rented If rented, the market value is evident. The annual cost is the expenditure on such facilities.
When a portion of a leased facility is used for the intervention, the cost value can be determined by ascertaining the portion of the lease cost that should be allocated to the intervention.
For example, if 25% of the building is used, about a quarter of the annual cost should be allocated to the intervention.
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Methods for Valuing Ingredients Facilities Owned In many cases, facilities are owned by the sponsoring agency.
Facilities are usually purchased or constructed in the past. There is no current financial transaction.
Methods for Valuing Ingredients
Facilities Owned The simplest way is to estimate the cost is to ask what the cost would be for a similar space. It is possible to ascertain what space in similar types of buildings might cost to lease.
One may need a local real state agent.
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Methods for Valuing Ingredients
Facilities Owned An alternative way is to compute its annual cost by taking account of depreciation and the interest on the remaining, undepreciated value. This procedure requires knowledge in: 1. The replacement cost of the facility 2. The life span of the facility 3. Rate of interest that is forgone by investing in a building rather than in another investment
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Methods for Valuing Ingredients
Facilities Owned
Replacement cost – the amount that would take to construct a similar facility If only a part of the facility is being used for the intervention, one should estimate that portion of the overall facility and its cost should be allocated to the intervention.
Alternatively, one can get estimates of facility costs on the basis of the cost per square foot and multiply this amount by the square footage used for the intervention.
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Methods for Valuing Ingredients Facilities Owned Depreciation – the amount of the facility that is “consumed” in a year. It is estimated by determining the life of the facility and dividing the total replacement cost by the number of years of use.
Example: If a building has a useful life of 30 years, about 1/30 of the facility is used up every year. The depreciation cost would equal to 1/30 of the replacement value.
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Methods for Valuing Ingredients Facilities Owned Depreciation is not the only cost involved. The undepreciated portion of the facility represents an investment in resources that could have been used in some other way. These forgone income opportunities can be reflected by asking, “What interest rate could have been earned had the investment been made in the best alternative project?” (Opportunity cost)
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Methods for Valuing Ingredients Facilities Owned Alternative ways of using those resources would have yielded a financial return that is approximated by multiplying the interest rate by the undepreciated portion of the facility investment.
This is the second component of costs: the forgone income an investment that could have been realized if the resources had been used for some other alternative.
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Methods for Valuing Ingredients Facilities Owned
In summary, the method of determining the annual value of an “owned” facility is to take the following steps:
1. Determine the replacement value of the facility. 2. Determine the life expectancy of the facility. 3. Divide the replacement value by the number of years of life to obtain the cost of depreciation for each year of use. 4. Multiply the undepreciated portion by an appropriate interest rate to obtain the opportunity cost of having resources invested in the undepreciated portion of the facility. 5. Add the annual cost of depreciation and the annual interest forgone on the remaining investment to obtain the annual cost.
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Methods for Valuing Ingredients Facilities Owned
Although the procedure above is valid and is used by businesses to estimate annual costs of facilities and equipment, the cost estimate will depend crucially upon the age of the facilities.
The greater the undepreciated portion, the higher the opportunity cost. Yet, the value of the services received in any one year may not differ substantially from that of other years.
For this reason, “annualized” costs is used to estimate an average of the combination of depreciation and interest on the undepreciated portion over the life of the facility.
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Methods for Valuing Ingredients Facilities Owned
You can use the annualization factors for facilities with different lifetimes at different interest rates. A table is available on CANVAS under ‘Files’.
The annualization formula is:
a = [ r (1 + r)n ] / [ (1 + r)n – 1]
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Methods for Valuing Ingredients
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Annualization Factors for Determining Annual Cost of Facilities and Equipment for Different Periods of Depreciation and InterestRates
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Methods for Valuing Ingredients Facilities Owned
You can use the annualization factors for facilities with different lifetimes at different interest rates.
Example: If a facility has a 20-year life and the appropriate interest rate is 5%, the annualization factor is 0.0802. One need to multiply this factor by the replacement cost of the facility ($100,000) to obtain an annual cost.
Annual cost = $100,000 X 0.0802 = $8,020
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Methods for Valuing Ingredients Equipment
The rules for estimating the costs of equipment are quite similar to those for estimating the costs for facilities:
1. Using the annual cost of all leased equipment 2. Using rental or lease value to obtain estimates of the value of equipment that is donated or borrowed. 3. Use the replacement cost of equipment to estimate the annual cost by applying the annualization factors.
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Methods for Valuing Ingredients Equipment
Example: Equipment’s replacement cost = $10,000 Useful life = 10 years Annualization factor for a 5% interest rate = 0.1295
Annual cost = $10,000 x 0.1295 = $1,295
This figure reflects both the cost of equipment depreciation and the cost of income that was forgone because funds were unavailable for alternative uses.
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Methods for Valuing Ingredients Supplies
The costs of supplies (paper, pencils, pens, toner cartridges, etc.) are often difficult to estimate using the ingredients method.
It would take enormous resources to list each item and determine market prices.
Supplies also typically account for less than 5% of the total cost, so errors in estimating their costs do not create very much distortion in the total cost figure.
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Methods for Valuing Ingredients Supplies
One might estimate the cost of supplies by simply adding the total expenditures on supplies to the estimated value of those that are contributed.
Only in the case in which supplies are a large part of the intervention would one wish to devote greater effort to the details of this category.
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Methods for Valuing Ingredients Required Client Inputs
- Ingredients that must be provided by clients, such as transportation.
The usual approach to ascertaining the costs of transportation is to include the total expense.
Example: if clients must have a laptop computer, this can be assessed according to the method for costing out equipment.
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Summary of Cost Valuation of Ingredients
Particular costing methods for each category are used in order to obtain the total cost of the intervention.
The total cost can be divided into the number of clients to a obtain a per-person cost for the intervention.
