Unit V - Module 13 Economic Analysis

Question 1

Economic Analysis

Key Concepts

Answer 1

Alternatives Analysis
Time Value of Money
Cost and Benefit Analysis
EA Process

Question 2

What is Economic Analysis (EA)?
Economic Analysis (EA) is an objective study performed to
compare the costs and benefits of multiple alternatives.

EA aims to:

Answer 2

• Select the best solution using data
• Compare cost and benefits over time for various alternatives
• Evaluate the net present value of alternatives

Because two key components of an EA are the cost estimate
and the benefits estimate, it is sometimes referred to as a
Cost Benefits Analysis (CBA).

Question 3

Why Conduct an EA?

Answer 3

Time-phased Cost and Benefits

Decision Making

Assess Timing
of Funding

Question 4

Economic Analysis (EA) is an objective study performed to compare the costs and benefits of multiple alternatives.

EA aims to:

Answer 4

*provide decision makers with the data needed to select the best solution for solving a problem or accomplishing a given objective or set of objectives;

*compare time-phased, economically-adjusted costs and benefits of
solutions/alternatives for a defined problem/objective; and

*assess the timing of costs and benefits and adjust the data economically for the
present value of money.

Because two key components of an EA are the cost estimate and the benefits
estimate, it is sometimes referred to as a Cost Benefits Analysis (CBA). However,
governing documents vary by each organization with some organizations
distinguishing between the two, while others view them as the same.

Question 5

The primary purpose of EA is to facilitate
decision making.

Even when not required, EA can benefit programs when:

Answer 5

• Budget constraints are tight
• There is more than one competing objective or problem
• There is more than one competing alternative solution

Question 6

Even if an EA is not required, conducting one can be very beneficial, especially if:

Answer 6

• budget constraints are tight,

*there is more than one competing objective or problem to address, or

*there is more than one competing alternative which addresses a given problem or objective.

The EA process facilitates the identification and thorough examination of all possible solutions to a given problem. By conducting an EA, an organization can better
allocate resources among competing programs or a program can select a solution that best meets its needs.

Decision-making support is the primary benefit of EAs. Another key benefit is objective documentation as to why a given alternative was chosen, thus making the decision more defensible. An EA also provides a baseline of data against which program execution can be measured

Question 7

There are considerable dependencies between each
step, with green arrows representing possible
feedback to prior steps.

Answer 7

Objective
assumptions
Alternatives
Cost/Benfit estimates
Compare alternatives
Sensitivity Analysis
Recommendation

There are considerable dependencies between the EA steps, and it is common to revisit steps as the analysis progresses. Analysts should continually revisit earlier
steps and recalibrate to the objective. The orange arrows show the primary path
from setting the objective to the final recommendation, and the green arrows show possible feedback to previous steps.

Risk and uncertainty should also be addressed while developing an EA. The EA
process does not specifically address risk and uncertainty completely, but any good
analysis inherently includes them.

Question 8

Step 1: Objective
* Define the objective

Answer 8

• Understand the problem
• Describe the problem in clear, achievable and measurable terms
• Objective should:
• Allow for multiple alternatives and not presuppose a solution
• Address the problem versus addressing a symptom of the problem
• Objective is important for focusing and loosely bounding
  the analysis

Question 9

The Objective is the key to a successful EA. If an objective is ill‐defined, EA results will be questionable. Therefore, it is important to spend time properly addressing this first step.

Answer 9

The Objective usually highlights a problem or new mission need. The statement should be
broad enough not to constrain the analysis unnecessarily. At the same time, it needs to be narrow enough to focus the analysis on a discrete number of relevant alternatives.

Care should be taken to ensure it does not presuppose one of the alternatives.

Question 10

Step 2: Assumptions & Ground Rules
* Formulate assumptions and ground rules

Answer 10

Examine problem thoroughly
* Develop complete list of assumptions and ground rules
* Mathematical/methodology assumptions
* Limits of analysis based on problem characteristics
* Address both strict constraints and assumptions of convenience
* Scrutinize assumptions for relevancy, necessity, and reasonableness

• Assumptions provide the groundwork for defining the
  alternatives
• Alternatives bound the analysis
  Document all assumptions!

Question 11

The next step in the EA process is to formulate and examine the assumptions. To develop assumptions, one must understand the problem well.

Answer 11

The assumptions will generally fall into one of two categories: mathematical or
methodological assumptions which govern the mechanics of the analysis; or “limits of
analysis”‐type assumptions which capture constraints that limit the analysis. Often
assumptions will be made out of convenience rather than being strict constraints directly
connected to program or external realities.

Note that often assumptions are gathered slowly as the analysis is conducted because not
all assumptions are known up front. Regardless of when an assumption is identified, the
assumptions should be scrutinized for relevancy and reasonableness.

Documenting and defining all assumptions well is critical to conducting a sound EA. . If too
many or too strict assumptions are used, the ideal solution could be overlooked. On the
other hand, if assumptions are poorly‐defined, analysis could be too loosely bounded to
produce effective results. Assumptions should be confirmed to confirm relevancy, validity
and appropriateness.

Finally The status quo should be considered a viable option even if it is not the desired solution.

Question 12

Step 3: Alternatives
* Identify and examine alternatives

Answer 12

Examine problem with the assumptions to help identify
possible solutions
* Develop alternatives without boundaries
* Examine alternatives for unfeasible options
* Document reasons for eliminating alternatives in case
circumstances change to cause an alternative to be viable again
* Note that alternative list may change during analysis

• Alternatives are critical, as they inherently are the first
  step in the decision-making process
• They define what actions could be taken

Question 13

Now that we have a solid objective and a preliminary set of assumptions, we can begin to define the candidate alternatives

Answer 13

It’s important to include all possibilities, then downselect. Equally important is the need
not to limit the brainstorming

Once a candidate list is developed, the alternatives can be examined for infeasibilities. All
alternatives, including those eliminated, should be documented. Sometimes an eliminated
alternative becomes feasible in the future, and since most EAs are updated with each
review, there are opportunities for alternatives to make it back on the list.

Note that cost alone should not be a reason for determining an alternative is infeasible. If
there are significant reasons that make an alternative not favorable due to costs, this will
come out in the cost analysis

Question 15

Minimum Number of Alternatives
* Must always have at least two alternatives

Answer 15

• Status quo:
• Change nothing
• Alternative to status quo:
• Includes desired capabilities
• Best to consider four alternatives if applicable
• Status quo
• Modernize existing assets
• Lease/privatization
• New acquisition

Question 16

Number of Alternatives
* Can have many alternatives
* Often have more than one variant of new acquisition or
modernization
* As number of alternatives increases, so does time and
effort required to develop cost and benefits
* Important to consider everything, but…
* Consider factors for down-selecting early if analysis
proves to be cumbersome or too exhaustive

Answer 16

However, an EA is not limited to four alternatives.
Often there is more than one “new acquisition” option to consider, or more than one type
of “modernization.” One word of caution, however: as the number of alternatives
increases, so does the time and effort involved in conducting the EA, especially the next
step of developing cost and benefit estimates.
Also, if there are too many options, some are likely to be “too similar,” and it will not be
clear which is the best alternative – ranking may be too close to formulate strong
recommendations. The bottom line is that it is important to consider the pros and cons to
the number of alternatives before deciding on a list to analyze.

Question 17

Common Alternatives
* Many variants of binary alternative pair
* Examples include:
* Repair or replace
* Buy or lease
* Manual or automated
* Make or buy
* Centralize or decentralize
* Centralized or distributed architecture
* Status quo or system A or system B

Answer 17

There are many variants of the basic binary pair of EA alternatives, Status Quo and
Alternative. Should you repair an old system to keep it in service or should you get rid of it
and replace it with a new one? When acquiring a new system, should you buy or lease it?
Should you implement (or stick with) a manual process, or should you automate it? Should
you make a new item within your organization, or should you buy it from another
organization? Should you centralize a function within your organization, or should you
decentralize?
As you can see, the possible set of alternatives to which EA can be applied is nearly
boundless. Commonly, the Status Quo can be compared with at least a couple of new
system alternatives – call them System A and System B.

Question 17

Step 4: Cost and Benefits Estimates
* Develop cost and benefits estimates:
* Define cost and benefits estimating parameters (or
mathematical assumptions)
* Develop comprehensive cost estimate for each alternative
* Define and quantify benefits for each alternative
* Cost and benefit estimating involves several non-
trivial sub-steps
* Cost and benefit estimates are important as they serve
as the objective basis for comparing alternatives

Answer 17

Once the alternatives have been defined, the cost/benefits estimates can be developed.
This is the most analytical and time‐consuming part of the EA process. It often involves
extensive data gathering and analysis, including interviews with future users, program
personnel, and other people with knowledge of the problem or new mission.

The first major step in the process is to define the estimating parameters. This step
involves determining mathematical and methodological rules that will govern the analysis.
More details will be provided on the next slide.

Once parameters have been developed, the cost/benefits estimates must be developed for
each alternative. Developing the estimates will involve data gathering and analysis,
development of CERs, and other activities that are not covered in detail in this module. The
portions of estimating specifically related to an EA are discussed in more detail in upcoming
slides.

The Cost and Benefits Estimate are important to the EA process as they provide the
mathematical foundation for comparing and ranking the alternatives. This is the
quantitative, analytical, and objective heart of the EA process, and we’ll spend a good bit of
this module exploring it. If the estimates are poorly done, a decision could be made to
implement a non‐optimal solution. Contrariwise, if the estimates are done well, thedecision‐maker can be confident that the alternative selected is the best one given all the
circumstances.

Question 18

Estimating Parameters
* Define estimating parameters (mathematical assumptions)
* Determine economic life cycle for each alternative
* Economic life cycle is period during which alternative provides benefits
* Usually constrained by:
* Physical life,
* Mission life, and/or
* Technological life
* Determine period of analysis for each alternative
* Period of analysis is the time required to develop/implement the
alternative plus the economic life during which benefits accrue
* Economic life cycles and periods of analysis can differ between
alternatives

Answer 18

An important estimating parameter to establish is the Economic Life Cycle of an
alternative. The economic life cycle is defined as the period during which an alternative is
providing benefits. It is usually constrained by the system physical life, mission life, and/or
technological life.
Physical life is the time a system will work before physically wearing out.
Mission life defines how long a system will support a mission before the mission either
changes or is no longer required.
The end of technological life is defined as the time when the technology becomes
obsolete.

Once an economic life is defined for each alternative, the Period of Analysis for each
alternative can be defined. The Period of Analysis is the Economic Life plus any lead time
required to develop the system or get it implemented in order to provide the benefits. For
military systems, the lead time is usually defined by when the project will achieve Initial
Operating Capability. At IOC, most systems begin to offer some benefits.

Note that alternatives can and frequently do have different economic lives and periods of
analysis. This information is taken into consideration when determining the EA Period of
Analysis, which we turn to next.

Question 19

Parameters – EA Period of Analysis
* When alternatives have differing periods of analysis, need to
determine what the common period of analysis will be for
comparing the costs and benefits
* Options include:
* Shortest life: estimate residual value for alternatives with
longer lives
* Common denominator life: assume replacement of worn
out material and equipment and chain together multiple
economic lives until reach point where all alternative end
concurrently.
* Uniform annual cost: economically adjusts dollars to
account for different life cycles between alternatives – more
discussion later

Answer 19

Once the Economic Lives and Periods of Analysis are determined for all alternatives, the EA
Period of Analysis can be defined. Usually one of the following methods is employed:
*Shortest Life, which sets the EA period of analysis equal to the shortest period of analysis
for all the alternatives. Because the analysis is confined to a period of time that does not
account for all of the benefits in the other alternatives, Residual Value for other
alternatives is estimated and included in the benefits estimate.
*Common Denominator Life, which assumes that the systems will continue to replace
themselves until a point when all alternatives end at the same time. For example if there
are three systems with lives of 3, 4, and 6 years, the common denominator period of
analysis would be 12 years. The first system, would be replaced 3x; the second system
would be replaced twice; and the third system would be replaced once.
*Uniform Annual Cost: This most common method economically adjusts dollars to
account for the different length lives. There will be more discussion on how to accomplish
this later.

Question 20

Parameters - Type of Dollars
* Constant dollars or current dollars
* Constant Dollars
* Adjusted for the effects of inflation (reflects the
purchasing power of the dollar in a specified year)
* Most common
* Current Dollars
* Cost or benefits data expressed in terms of future
purchasing power of the dollar
Warning: Do not mix
Constant and Current Dollars
in the same analysis

Answer 20

Another important estimating parameter is the type of dollars ($) that will be used for the
analysis. Constant dollars are used most often, however, sometimes there is justification
for using current dollars. For example, if the data gathered is in current dollars or is
expressed in relative terms that do not take away the effects of inflation, then current
dollars could be used for the analysis. Either type of dollars is fine to use in the estimates,
but the EA should absolutely not mix both constant and current dollars in the same
analysis.

As we’ll see shortly, the type of dollars used will dictate which set of discount rates should
be used.

More information on different types of dollars and how to account for the effects of
inflation can be found in Module 5 Inflation and Index Numbers

Question 21

Parameters – Base Year
* Determine base year for analysis
* Year to which estimates are adjusted:
* De-escalation – constant $ estimates only
* Discounting – both constant and current $ estimates
* More information on discounting and net present value
(NPV) on upcoming slides
* Mandated as the first year of analysis, or the first fiscal
year in which there is a difference in expenditures
between alternatives

Answer 21

Finally, the Base Year of analysis must be chosen. The Base Year is usually the first year in
which there is a difference in expenditures among the alternatives. If this is the first EA
conducted for a program, the Base Year is usually one or more years in the future. If this is
an update to an estimate, the Base Year is typically the current or a past year. If constant
dollars are used for the estimate, it is critical to establish Base Year up front as this is the
year to which all estimates are adjusted for inflation. If current dollars are used, the Base
Year can be decided upon later, but it still needs to be defined because discounting is made
according to the Base Year of the estimate.
More information on inflation can be found in Module 5 Inflation and Index Numbers.

Question 22

Cost Estimates
* Develop comprehensive cost estimate for each alternative
* Use a work breakdown structure (WBS) / cost element structure (CES) to
help organize and capture all costs
* Identify all applicable cost categories
* EA cost estimate typically more extensive than life cycle cost estimate
(LCCE)
* Costs to include:
* Traditional LCCE costs such as development, acquisition, operations,
support, maintenance, disposal
* Opportunity costs of existing assets/resources used if those
assets/resources could be used elsewhere
* Imputed costs, which are value of services provided without charge to a
project (e.g., base operating support)
* Status quo phase-out costs for any alternative that requires the status quo
system to continue to operate while the alternative is developed
* Parallel operations costs should be captured with a potential transition plan

Answer 22

The next part of this EA Process step is to develop a comprehensive Cost Estimate for each
alternative. It is useful, and usually required, to use a WBS or Cost Element Structure as
the framework for the estimate. While determining the WBS/CES we need to ensure that
all applicable costs are captured. Here is where an EA Cost Estimate sometimes differs
from a Life Cycle Cost Estimate (LCCE):
An EA estimate is typically more extensive in terms of types of costs captured. Costs to
include in an EA are “traditional” LCCE costs such as development, acquisition, operations,
support, maintenance, and disposal, but also opportunity costs of existing assets and
resources that are used in a particular alternative if those assets/resources could be used
elsewhere….
….and imputed costs, which represent the value of services provided without charge to a
project (e.g., Base Operating Support). Finally, for any alternative that requires a
development and phase-in period he Operations and Phase-out costs of the Status Quo
system must be included in the Alternative’s cost estimate.
A significant cost element that needs to be addressed is “Parallel Operations” and how
it’s defined. Usually you’re not going to drop the status quo scenario and, the same day,
assume the alternative. A parallel operations scenario needs to be documented in the
assumptions section as well.

Question 23

Cost Estimates
* Develop comprehensive cost estimate for each alternative
* Identify all applicable cost categories (continued)
* Costs to exclude:
* Societal costs and benefits outside of the US federal government
are usually not included in a DoD analysis
* Sunk costs –These should be addressed in the assumptions for the
analysis.
* Costs captured under benefits estimate
* Optional costs
* Wash costs, which are costs that accrue equally by all alternatives
* Include if required to report total program costs
* Exclude if required to streamline decision making material

Answer 23

Costs to exclude (per DoD Instruction):
1) Societal Costs and benefits outside the Federal Government are usually not included in a
DoD analysis. A project whose primary purpose is to produce benefits outside the Federal
Government falls under OMB Circular A‐94‐could be different if you are doing an EA for
HHS or EPA
2) Sunk costs and realized benefits are not included, but should be discussed in the
assumptions for the analysis. Even though sunk costs are not counted as part of the cost
estimate, they should be documented in the assumptions.
One cost that is optional to include or exclude are wash costs. These are costs that are
realized by all alternatives equally (as in, “It’s a wash”). Normally, if there is a requirement
to show total program funding, wash costs are included. However, if these is no such
requirement, it is often easier to remove the costs from the analysis to avoid “too much
information” being presented to the decision maker. If the costs are not included, a note
should be made to that effect in the documentation. Note that the inclusion or exclusion
of wash costs will affect multiplicative measures such as the Cost/Benefit Ratio (CBR),
which is one reason we prefer additive measures such as Net Present Value (NPV)..

Question 24

Cost Estimates * Develop comprehensive cost estimate for each alternative * Develop cost estimate for all applicable cost categories within the WBS/CES framework * Level of detail of may be less than for LCCE * Level of detail depends on: * Data availability * Size of project * Level of oversight * Amount of effort available/desired for developing the EA * Use traditional cost estimating methods such as analogy, parametric * Cover entire EA period of analys

Answer 24

With all parameters established, the final step is to actually develop the cost estimate. The level of detail of the estimate varies, and the amount of effort required to develop the EA is largely dependent on the level of detail of both the cost and benefits estimates. The level of detail is typically less than that of an LCCE, simply because multiple estimates need to be developed and developing estimates to such detail is usually cost‐prohibitive. Traditional cost estimating methods are used, such as analogy, CERs, etc. (cf. Module 2 Costing Techniques). Another differentiating factor between the EA CE and LCCE is that the EA CE must cover the entire Period of Analysis, which at times can be longer than the period used by a LCCE depending on how the economic life is defined.

Question 25

Benefits Estimate * Define and quantify benefits for each alternative * Define alternative benefits * Quantify benefits * Phase benefits Best to quantify in terms of dollars if possible.

Answer 25

The most difficult part of an EA is to define and quantify the benefits. Benefits tend to be naturally expressed in non‐quantifiable terms, and one must be disciplined about really thinking about how to measure the performance of a given alternative in quantifiable terms. Of course, non‐quantifiable benefits are OK and useful, but anything quantifiable tends to make the analysis more objective. Even when benefits are quantifiable, it may be hard to put them in monetary terms

Question 26

Benefits Estimate – Define Benefits * Benefits to include * Residual/terminal/salvage values for assets at end of the period of analysis * Residual value: value of an asset at any time before the end of its economic life * Terminal value: value of asset at the end of its economic life * Salvage value: value of an asset at the end of its physical life (scrap/parts) * Residual values may be tied to depreciation * Various methods are detailed in Related and Advanced Topics * Straight-line depreciation is usually sufficient for estimating residual/terminal/salvage values

Answer 26

Monetary benefits that should be included in the Benefits Estimate include the Residual, Terminal, and/or Salvage Values of any equipment used in the alternative. Residual value is defined as the value of an asset at any time before the end of its economic life. This would be used, for example, in a case where there were alternatives with different economic lives and the “shortest life” was the method chosen for determining the EA period of analysis. In this case, any alternative with a longer economic life would include the residual value of its equipment at the end of the EA period of analysis. Terminal value is the value of an asset at the end of its economic life. If physical life is used to determine the end of the economic life, then terminal value equals salvage value. However, if mission or technological life is used to determine the end of the economic life, there could be some value left in the equipment over and above salvage value. Finally, salvage value, as already alluded to, is defined as the value of an asset at the end of its physical life. This is sometimes viewed as the value of scrap metal, parts, etc. Residual values may be tied to depreciation Various methods are detailed in Related and Advanced Topics Straight‐line depreciation is usually sufficient for estimating residual/terminal/salvage values Copyright ICEAA, 2023 www.iceaaonline

Question 27

Benefits Estimate – Define Benefits * Down-select to avoid overlap between benefits and cost estimate * Categorized into: * Quantifiable, monetary * Quantifiable, non-monetary * Non-quantifiable * Monetary Benefits can be categorized as: * Cost savings - An alternative that generates a reduced budget requirement in the future * Cost avoidance - a future cost savings or reduction in future resource requirements * Improved productivity – an improvement in ability, efficiency and/or quality of getting work done * Where to include monetary benefits? Generally speaking… * Cost savings should be addressed in cost estimate * Cost avoidance can be addressed in either section * Improved productivity should be addressed in benefits estimate

Answer 27

t often helps to categorize the benefits in one of three buckets: *Quantifiable, monetary *Quantifiable, non‐monetary *Non‐quantifiable If possible, it’s best to use monetary benefits as it causes the benefits estimate to be in the same units as the cost estimate, which allows for much easier comparison of alternatives (“apples to apples”). However, often its not possible to express benefits in terms of dollars. In those cases, at least trying to define benefits as quantifiable is very helpful. Monetary benefits can be further defined as cost savings, cost avoidance, or productivity improvements. 1‐ A cost avoidance avoids additional costs in the future. An example of a cost avoidance would be an alternative that finds a way to accomplish additional workload with existing manning that would have otherwise generated overtime or additional manpower costs in the future had the initiative not been put in place. A productivity improvement could reduce the need for manpower (if positions cut), or energy consumption, or supplies, etc., which would generate a cost savings

Question 28

Benefits Estimate – Define Benefits * Benefits to include * Residual/terminal/salvage values for assets at end of the period of analysis * Residual value: value of an asset at any time before the end of its economic life * Terminal value: value of asset at the end of its economic life * Salvage value: value of an asset at the end of its physical life (scrap/parts) * Residual values may be tied to depreciation * Various methods are detailed in Related and Advanced Topics * Straight-line depreciation is usually sufficient for estimating residual/terminal/salvage values

Answer 28

Monetary benefits that should be included in the Benefits Estimate include the Residual, Terminal, and/or Salvage Values of any equipment used in the alternative. Residual value is defined as the value of an asset at any time before the end of its economic life. This would be used, for example, in a case where there were alternatives with different economic lives and the “shortest life” was the method chosen for determining the EA period of analysis. In this case, any alternative with a longer economic life would include the residual value of its equipment at the end of the EA period of analysis. Terminal value is the value of an asset at the end of its economic life. If physical life is used to determine the end of the economic life, then terminal value equals salvage value. However, if mission or technological life is used to determine the end of the economic life, there could be some value left in the equipment over and above salvage value. Finally, salvage value, as already alluded to, is defined as the value of an asset at the end of its physical life. This is sometimes viewed as the value of scrap metal, parts, etc. Residual values may be tied to depreciation Various methods are detailed in Related and Advanced Topics Straight‐line depreciation is usually sufficient for estimating residual/terminal/salvage values

Question 29

Benefits Estimate – Define Benefits * Benefits to exclude: * Societal costs and benefits outside the US federal government are usually not included in a DoD analysis * Realized benefits - however, these should be addressed as part of the assumptions * Monetary benefits that are already captured in cost estimate * Optional Benefits * Wash benefits * Benefits realized equally by all alternatives * Can include if required to report total program benefits * Can exclude if required to streamline decision making material

Answer 29

As with the cost estimate, there are some benefits that should be excluded from the analysis, including societal benefits outside of the organization; benefits that have already been realized by one or more alternatives; and any monetary benefit that is captured under the Cost Estimate. As a reminder, it can be easy to double‐count items in both the cost estimate and benefits estimate, so it is important to keep CE and BE in sync. As with the cost estimate, it is optional to include or exclude “wash benefits.” These are benefits that are realized by all alternatives equally.

Question 30

Benefits Estimate – Quantify Benefits * Quantifying monetary benefits is like developing a cost estimate * Collect data, draw analogies, etc. * For non-monetary but quantifiable benefits * Soliciting expert assessment of capability parameters * Objectivize the assessment as much as possible * Multiple interviews to same group * Interview to different groups * Review and scrubbing of results * Rank benefits according to the degree to which they achieve the objective or use weights to reflect relative value

Answer 30

Quantifying the monetary benefits is similar to developing the cost estimate in that data is gathered, analogies are drawn, relationships are developed, etc. For non‐monetary but quantifiable benefits, it is best to develop questionnaires and solicit expert assessment of benefits. Soliciting assessment is, by its very nature, a subjective process. However, one can “objectivize” the data to a great extent by talking to multiple people/groups, conducting reviews of the data, and scrubbing the results. Techniques can be borrowed from similar approaches used for cost (see the Expert Opinion section of Module 2 Costing Techniques). Another very useful step in the quantification process is to rank of assign weights to the benefits. This becomes particularly important when comparing and ranking alternatives with unequal costs and unequal benefits. For any non‐quantifiable benefits, address the benefit and how to compare alternatives as part of the EA documentation. Ranking or assigning weights to non‐quantifiable benefits is also very useful when comparing alternatives. Further guidance on identifying and quantifying benefits may be found in the Resources section at the end of this module.

Question 31

Benefits Estimate – Phase Benefits * Phase benefits according to when they will be realized * Phasing is critical for discounting and comparison reasons * Phasing of benefits should coincide with phasing of implementation of alternative system * Benefits should be phased through entire economic life

Answer 31

The last step in the benefits estimate is to define when the benefit will be realized. As with the cost estimate, phasing is critical for discounting (if monetary) and comparison reasons. The phasing in of benefits usually coincides with the phasing in of the alternative system. Benefits should last through to the end of the economic life.

Question 32

Step 5: Compare Alternatives * Compare and rank alternatives * Phase costs and benefits by year * Adjust for inflation (if needed) * Discount costs and benefits * Select comparison technique that accommodates estimating assumptions (such as different economic lives) * Comparing and ranking alternatives involves several non- trivial sub-steps * Comparing alternatives is important because it provides the first look at the concluding recommendation

Answer 32

to compare and rank the alternatives, the costs and benefits must be phased by FY and adjusted for inflation Costs and benefits are then discounted to represent the data in “Net Present Value” terms, and the alternatives are compared using a comparison technique the suits the estimate assumptions. Comparing the alternatives provides data to develop a draft of the recommendations. [KEEP IN MIND, Recommendations should not be finalized until sensitivity analysis is performed]

Question 33

Comparison – Time Phasing * Phase costs and benefits by year * What costs and benefits occur in each FY for every alternative * Inflationary and discounting adjustments are dependent on year in which costs/benefits occur * Accuracy of costs/benefits phasing could impact the recommendation * Any uncertainties should be identified as candidates for sensitivity analysis * For non-monetary but quantifiable and non-quantifiable benefits, phasing still critical for comparing relative benefits between alternatives

Answer 33

All costs and benefits must be time phased by year (usually fiscal year). This is important for inflationary and discounting adjustments. The accuracy of the phasing could impact the recommendation, so it is critical to estimate phases as best as possible. Any uncertainties regarding the phasing should be noted as candidates for sensitivity analysis. For non‐monetary and non‐quantifiable benefits, phasing is not required, but is still critical for comparing alternatives.

Question 34

Comparison – Discounting * Discount costs and benefits * To equitably compare alternatives, costs and monetary benefits must be discounted to reflect the time value of money * Discounting “puts the E in EA” * Adjusts estimates based on economics to allow for an economics-free comparison of alternatives

Answer 34

Costs and benefits must be discounted to account for the time value of money. This step is essentially what “puts the E in EA” because it economically adjusts the estimates to allow for an “apples‐apples” comparison. Discounting is sometimes referred to as present value analysis

Question 35

Discounting Concept * Resource outlay (or gain) in the future is worth less than a similar outlay/gain today * Using funds today prevents the investment of those funds in an interest-growing opportunity, resulting in less resource availability a year from now * Similarly, gaining funds today (via benefits) allows investment of those funds in an interest-growing opportunity resulting in larger return than if benefits are realized a year from now * Discounting transforms gains and losses that occur in different years to a common unit of measurement

Answer 35

The concept behind discounting is based on opportunity gained or lost. The idea is that a resource in the future is worth less than that same resource today. To obtain a given resource level in the future, I would need less of it today. Therefore, if I use my resources today to develop a project, those same resources cannot be invested, resulting in fewer resources in the future. Similarly, gaining resources today (via monetary benefits) provides the opportunity for investment, which results in greater resources in the future.

Question 36

Comparison – Inflation * Adjust for inflation * If needed, adjust costs and monetary benefits to * Constant $ using same base year; or * Current $ depending on assumption made regarding use of constant/current $ * Escalation often accomplished during estimating step * Should be verified as part of comparison step * If using constant $, forward-priced amounts need to be de-escalated * If using current $, amounts reflecting today’s prices need to be escalated

Answer 36

Proper escalation should be verified as part of this step. If Constant $ are being used, then any future Cost or Benefits that are forward‐priced need to be de‐escalated to base year dollars. If instead Current $ are being use, then any Costs and Benefits that were priced out at today’s rates need to be escalated to the time frame in which they are expected to occur. See Module 5 Inflation and Index Numbers for more information on escalation

Question 37

Step 6: Test Sensitivity * Test sensitivity of recommendations * List assumptions and constraints on which to perform sensitivity analysis * Most likely to change * Most uncertain / least-understood * Significant cost or benefits drivers * Factors with key relationships to the analysis results * Recalculate analysis using discounted costs * Compare and rank alternatives using new data * Sensitivity analysis is important because: * Highlights recommendation strengths/weaknesses * Could lead to further analysis on validity of assumptions

Answer 37

With alternatives ranked, we now have a set of preliminary recommendations. But how do we know how strong the justification is for those recommendations? They are only as strong as the assumptions upon which the analysis is based. Therefore, it is important to test those assumptions Sensitivity analysis is the study of how the variation (uncertainty) in the output of a model can be apportioned to different sources of variation in the input of a model. Sensitivity analysis can take time, and sometimes providing “too much information” to the decision maker only creates more confusion. So it is important to limit the analysis to the most critical and important factors. A candidate list of assumptions to test should include any assumption or constraint that is likely to change, that is most uncertain or least understood, that proves to be a significant cost or benefits driver, or that otherwise possesses a key relationship with the analysis results.

Question 38

Sensitivity – Assumptions and Constraints * Most likely to change * Include assumptions based on external factors out of the control of the program office * Include discount rates * Include any assumption that is known to have a significant probability of change * Most uncertain / least understood * Include any assumption known to have a significant degree of risk * Include any assumption that was made “for lack of better knowledge” * Significant cost or benefits drivers * Determine major cost drivers by calculating % of total cost * If known/used, can perform sensitivity analysis on cost estimating relationship independent variables to calculate range of cost for a given cost element * Factors with key relationships to the results of the analysis * Objective statement * Program requirements * System pperations * Residual value, if significant due to unequal economic lives

Answer 38

Assumptions to consider for sensitivity analysis include those most likely to change, such as those based on factors outside of the program office’s control, discount rates, and any assumption that is known to be volatile with a high chance of changing. one needs to consider assumptions that are most uncertain or least understood. This would include any assumptions about which there is a significant degree of risk or any assumption made “for lack of better knowledge.” Assumptions that prove to be key cost or benefits drivers are candidates for sensitivity analysis. Cost/benefits drivers can be calculated by determining what % of the total a given cost or benefit represents. If CERs were used to develop the estimates, the independent variable in those CERs can be varied to see how the cost estimate differs. Finally, factors with a “key relationship” to the results should be included on the candidate list. This would include things such as the objective statement, program requirements, operations, and residual value, if that is significant due to drastically different economic lives.

Question 39

Step 7: Formulate Recommendations * And finally…Formulate Recommendations * Synthesize all data * Baseline cost/benefit comparisons * Sensitivity analysis results * Discussion on non-quantifiable benefits * Rank all alternatives * Select recommended course of action and provide a solid foundation of analysis on which that recommendation is based * Good to have justification material ready to support second and third place alternatives in case of questions * Providing the decision-maker information to help them make an informed decision is the goal of the economic analysis

Answer 39

The final step in the EA process is to formulate the recommendations. All data is synthesized at this point including baseline comparisons, sensitivity cases, and benefits. The alternatives have been ranked, and we can present both the recommended action and a solid foundation of analysis on which that recommendation is based. The economic analysis report should begin with a summary of the analysis (based on the benefits and costs of the alternatives), and an interpretation of the results (to include a recommendation of the preferred alternative).

Question 40

A company is having difficulties with its email system. The email server has crashed 5 times in the last two months. Each time, it has taken over 8 hours to restore the system and on one occasion an entire day's worth of sent and received emails were lost. Users are frustrated with the situation. The technical support personnel are complaining about the difficulty in maintaining the system. They say the structure is antiquated and the memory is drastically low for the number of users the system supports. What would be a good objective for addressing this problem? A. Upgrade memory B. Minimize server crashes * C. Improve technical support personnel's ability to address problem * D. Maximize system availability and integrity *E. Minimize user frustration by providing free counseling services * F. Minimize size of incoming and outgoing messages

Answer 40

* D. Maximize system availability and integrity

Question 41

An Economic Analysis is being conducted to select the best alternative for Program X-Wing fighter. The company Skywalker has come forth with a proposal that promises delivery of the first spacecraft at the very beginning of the sixth year (beginning of FY06). So, the development period is from FY01 through FY05. Production of the remaining 10 crafts will occur over the next 2 years, with the final one scheduled for delivery at the end of FY07. Each spacecraft is estimated to last 20 years at which time the spacecraft's physical life is considered at an end. What is the economic life for this alternative? A. 5 years * B. 7 years * c. 20 years D. 22 years * E. 27 years

Answer 41

D. 22 years This physical life of these planes will begin in FY06 (first plane delivered) and end at the end of FY27 (last plane's life at the end)

Question 41

Using the same problem as described in Question 1, which of the following alternatives is most likely not feasible/inappropriate? A. Upgrade existing infrastructure and memory * B. Replace entire network infrastructure * C. Outsource technical support * D. Replace email server system E. Lease additional equipment to add storage and processing capacity F. B and C only G. None - all are feasible

Answer 41

F. B and C only replacing the entire network infrastructure to fix the email problem is wasteful and outsourcing the technical support does not really address the problem

Question 42

Using the same problem as described in Question 3, what is the period of analysis for the alternative A. 5 years * B. 7 years * c. 20 years D. 22 years * E. 27 years

Answer 42

* E. 27 years physical life plus the development time before first plane delivery

Question 43

True or False. When conducting an EA using Current $, it is unncessary to choose a Base Year

Answer 43

False

Question 44

I am conducting an EA that has two options: Status Quo and Alternative System. The Status Quo system realizes benefits immediately however the Alternative System will not begin realizing benefits for another three years due to development lead time. Which of the following types of costs should be excluded from the Alternative System Cost Esimate A. Recurring costs B. Disposal costs C. Imputed costs D. Sunk costs E. Opportunity costs F. Status Quo Phase Out costs * G. None -they all shour pennciuea

Answer 44

D. Sunk costs

Question 45

Which of the following statements regarding the treatment of benefits in an Economic Analysis is incorrect A. Monetary, Non-monetary but quantifiable, and non-quantifiable are all important B. Benefits that can be expressed in monetary terms are the easiest to use when comparing alternatives * C. Benefits that can be quantified are preferred over benefits that cannot be quantified * D. Steps can be taken to minimize the amount of subjectivity in non-monetary but quantifiable benefits *E. Benefits realized equally by all alternatives can but do not have to be excluded F. Benefits that cannot be quantified should be excluded

Answer 45

F. Benefits that cannot be quantified should be excluded

Question 46

I have an EA estimate in Constant $ with a 20 years Period of Analysis. What discount rate should I use? Use the discount rate table shown to the right to answer this question. 3-Year 5-Year 7-Year 10-Year 30-Year Nominal 5.4% 5.5% 5.5% 5.6% 5.8% Real 2.7% 2.7% 2.8% 2.8% 3.0% A. 2.8% * B. 5.8% * C. 5.6% D. 2.9% * E. 3.0% * F. 5.7%

Answer 46

D. 2.9% linear interpolation between 10 and 30 year rates. Average of 2.8 and 3.0 is 2.9

Question 47

I have an EA estimate in Current $ with a five-year period of analysis. What is the mid-year discount factor for year #4? Use the discount rate table shown to the right to answer this question 3-Year 5-Year 7-Year 10-Year 30-Year Nominal 5.4% 5.5% 5.5% 5.6% 5.8% Real 2.7% 2.7% 2.8% 2.8% 3.0% A. 0.8072 B. 0.8291 * c. 0.8305 * D. 0.8319 * E. 0.8989 * F. 0.9110

Answer 47

B. 0.8291 use nominal because we have current year dollars. Use 5-year rate and n=4 0.829118091 0.787572189 Possible mistake if you use 4-year interpolated rate and n=5

Question 48

: I have an EA estimate in Constant $ with a seven-year period of analysis. What is the end-year discount factor for year #1? Use the discount rate table shown to the right to answer this question 3-Year 5-Year 7-Year 10-Year 30-Year Nominal 5.4% 5.5% 5.5% 5.6% 5.8% Real 2.7% 2.7% 2.8% 2.8% 3.0% A. 0.9488 B. 0.9728 C. 0.9737 * D. 0.9740 * E. 0.9863 F. 0.9868

Answer 48

B. 0.9728 use real rate for 7-year because of constant year dollars 0.972762646

Question 49

I am comparing two alternatives in an Economic Analysis. Phased cost and benefits information has been gathered and is shown to the right. All costs and benefits are in Constant Year 1 dollars and have not been discounted. What is the total present value of the AS IS costs? Use the discount rate table shown to the right to answer this question. Total Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 AS IS Cost 90 10 10 10 15 15 15 15 0 0 0 AS IS Benefits 35 5 5 5 5 5 5 5 0 0 0 TO BE Cost 165 20 100 10 5 5 5 5 5 5 5 TO BE Benefits 75 0 0 5 10 10 10 10 10 10 10 Discount Factors: Total Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 6 Yr 7 Yr 8 Yr 9 Yr 10 8.7378 0.9863 0.9594 0.9333 0.9079 0.8831 0.8591 0.8357 0.8129 0.7908 0.7692 A. 81.08 B. 90.00 C. 100.19 D. 154.29

Answer 49

A. 81.08

Question 50

: Given the set of discounted data shown to the right, which alternative would you recommend? UAC Cost UAC Benefits Option 1 129.5 130.2 Option 2 150.4 190.4 Option 3 189.4 250.3 Option 4 210.5 279.2 A. Option 1 B. Option 2 * C. Option 3 * D. Option 4 * E. Option 2 or 3 - too close to recommend one over the other F. Option 3 or 4 - too close to recommend one over the other G. None - because none of the options are cost effective

Answer 50

F. Option 3 or 4 - too close to recommend one over the other UAC Cost UAC Benefits B/CR Option 1 129.5 130.2 1.005405405 Option 2 150.4 190.4 1.265957447 Option 3 189.4 250.3 1.321541711 Option 4 210.5 279.2 1.326365796

Question 51

Cost Savings should be addressed in: A. Cost Estimate * B. Benefits Estimate * C. Either Section

Answer 51

A. Cost Estimate

Question 52

Given the set of discounted data shown to the right, which alternative would you recommend? Option 1 Option 2 Option 3 Option 4 PV Benefits 48 1000 3896 5489 PV Costs 292 1144 2995 4369 NPV -244 -144 900 1120 S (Discount Factors) 1.9457 4.6700 8.7378 8.7378 A. Option 1 * B. Option 2 * C. Option 3 * D. Option 4 * E. Option 2 or 3 - too close to recommend one over the other * F. Option 3 or 4 - too close to recommend one over the other G. None - because none of the options are cost effective

Answer 52

* F. Option 3 or 4 - too close to recommend one over the other If pressed, you would certainly say that Option 4, with the best NPV, is the recommendation. However, without further context, it is hard to know whether sensitivity analysis could produce a reversal between Options 3 and 4. Also, the budget requirements for Option 4 appear to be greater, which might need to be taken into consideration.

Question 53

: Which of the following should be excluded from the benefits estimate per DODI 7041.3: A. Societal costs and benefits outside the Federal Government B. Realized benefits C. Monetary benefits captured in Cost Estimate * D. None of the above * E. All of the above

Answer 53

* E. All of the above

Question 54

Which of the following must be documented in the EA? A. Assumptions and Ground Rules * B. Objective Statement * C. Costs and Benefits Estimate * D.Alternatives E. Sensitivity Analysis Outcome F. Recommendation G. All of the Above

Answer 54

G. All of the Above

Question 55

True or False. Terminal Value = Salvage Value for an asset the end of whose Economic Life coincides with the end of its Physical Life.

Answer 55

True True. In general Terminal Value is the value at the end of an asset's Economic Life, while Salvage Value is the value at the end of its Physical Life.

Question 56

What is the primary alternative comparison method to use for an EA as per OMB Circular A-94 A. Net Present Value B. Cost/Benefit Ratio C. Uniform Annual Cost D. Savings to Investment Ratio E. Discounted Payback Period F. Return on

Answer 56

A. Net Present Value

Question 57

This module discusses the application of an analytical process called Economic Analysis (EA) designed to facilitate decision-making regarding the allocation of scarce resources. The goal of EA is to maximize program or organizational objectives and facilitate the selection of the best investment option from a group of alternatives. There are always alternatives as to how an agency can spend its investment dollars; a highly structured EA process ensures decision makers make an informed selection. The key ideas in this module are

Answer 57

competing investment alternatives (i.e., choosing how to spend investment dollars), the time value of money (i.e., money is worth more today than tomorrow because it can be invested to earn a rate of return), and the corresponding nature of costs and benefits (i.e., benefits must be monetized in order to compare them to costs). The primary analytical construct is that of discounting, wherein a discount factor is applied to future-value costs and benefits to convert them into equivalent present values.

Question 58

Purpose Many organizations such as the Department of Defense (DoD) (e.g., for milestone decision reviews for most major defense programs) and the Federal Aviation Administration (FAA) as part of its acquisition life cycle process require EAs. But even if an EA is not required, conducting one can be very beneficial, especially if:

Answer 58

budget constraints are tight, there is more than one competing objective or problem to address, or there is more than one competing alternative which addresses a given problem or objective. The EA process facilitates the identification and thorough examination of all possible solutions to a given problem. By conducting an EA, an organization can better allocate resources among competing programs or a program can select a solution that best meets its needs. Decision-making support is the primary benefit of EAs. Another key benefit is objective documentation as to why a given alternative was chosen, thus making the decision more defensible. An EA also provides a baseline of data against which program execution can be measured

Question 59

Definition Economic Analysis (EA) is an objective study performed to compare the costs and benefits of multiple alternatives. EA aims to

Answer 59

provide decisions makers with the data needed to select the best solution for solving a problem or accomplishing a given objective or set of objectives; compare time-phased, economically-adjusted costs and benefits of solutions/alternatives for a defined problem/objective; and assess the timing of costs and benefits and adjust the data economically for the present value of money. Because two key components of an EA are the cost estimate and the benefits estimate, it is sometimes referred to as a Cost Benefits Analysis (CBA). However, governing documents vary by each organization with some organizations distinguishing between the two, while others view them as the same

Question 60

The essential EA process is similar across various organizations but the requirements such as level of detail and completeness vary within each organization. Regardless, organization-specific guidelines should be followed in all cases. Fig. 13.1 shows this general process. There are considerable dependencies between the EA steps, as shown, and it is common and expected to revisit steps as the analysis progresses. Analysts should continually revisit earlier steps and recalibrate to the objective. The orange arrows show the primary path from setting the objective to the final recommendation, and the green arrows show possible feedback to previous steps. Risk and uncertainty should also be addressed while developing an EA. The EA process does not specifically address risk and uncertainty completely, but any good analysis inherently includes them. The sensitivity analysis step in the EA process handles some of estimating uncertainty via testing discrete cases. The risk and uncertainty of technical parameters, estimating assumptions, estimating methodologies, and any other facet of the analysis that is considered subject to uncertainty or risk should also be evaluated. More information on risk and uncertainty analysis can be found in Module 9 Cost and Schedule Risk Analysis. This section provides a more detailed look at the process of conducting an EA. The seven major steps are:

Answer 60

Define the objective. Formulate the assumptions and ground rules. Identify and examine the alternatives. Develop the cost and benefits estimates. Compare and rank the alternatives. Test sensitivity of the alternatives' rankings. Formulate the recommendation

Question 61

Step 1: Define the Objective

Answer 61

The objective identifies the problem to solve or the mission need and is the key to a successful EA. If an objective is ill-defined, the EA results will be questionable and possibly unusable. Therefore, it is important to spend time properly addressing this first step. The objective statement concisely identifies the goal of the program or project. The statement should be broad enough not to constrain the analysis unnecessarily but, at the same time, needs to be narrow enough to focus the analysis on a discrete number of relevant alternatives. Care should be taken to ensure the objective statement does not presuppose any of the alternatives. A common mistake when defining objectives is to address a symptom of the problem and not the problem itself. Therefore, time should be taken to understand the problem or mission requirement well.

Question 62

Step 2: Formulate the Assumptions and Ground Rules The next step in the EA process is to formulate and examine the assumptions and ground rules, things the program assumes to be true without evidence or proof. Ground rules are concise statements that describe the basis from which the estimate is made. Assumptions are suppositions about unknown variables that are required in order to complete the analysis. To develop assumptions, one must understand the problem well, do an analysis of the problem and, if needed, perform research regarding the problem. From this research, develop a list of possible assumptions. The assumptions will generally fall into one of two categories:

Answer 62

mathematical or methodological assumptions which govern the mechanics of the analysis, and bounding assumptions which capture physical, political, and other constraints that bound or limit the analysis. Often assumptions are made out of convenience rather than being strict constraints directly connected to program or external realities. Regardless, both types of assumptions are important and should be carefully documented and reevaluated throughout the analysis process. Ground rules are generally established upfront. Assumptions are gathered throughout the process because not all assumptions are known upfront. Regardless of when an assumption is identified, continuously scrutinize the assumptions for relevancy, necessity, and reasonableness. When needed, eliminate inappropriate assumptions and ground rules. Defining the assumptions well is critical to conducting a sound EA. Assumptions limit the analysis. If too many or too strict assumptions are used, the ideal solution could be overlooked. On the other hand, if assumptions are poorly defined, the analysis could be too loosely bounded to produce effective results.

Question 63

Step 3: Identify and Examine Alternatives After developing a solid objective and a preliminary set of assumptions, define the candidate solutions to consider as alternatives. Alternatives are important to the EA process as they provide the first step towards making a decision. They define what actions could be taken. It is important to include all possible alternatives and then down select. Equally important is the need to not limit the brainstorming. The best solutions sometimes come from innovative thinking. If an alternative does not make it on the list, it will most likely not be examined further, at least not during the current analysis. After developing the complete list of alternatives, examine them for infeasibilities. All alternatives, including those eliminated, should be documented. Sometimes an eliminated alternative becomes feasible in the future, and since most EAs are updated with each milestone review, there are opportunities for alternatives to make it back on the list. Note that cost alone should not be a reason for determining feasibility. If there are significant reasons that make an alternative not favorable due to costs, they will come out in the cost analysis. Minimum Number of Alternatives Every EA must have at least two alternatives: the status quo or baseline alternative, which is the existing system/program with no changes made, and an alternative possible solution that contains desired capabilities. When there are only two choices, the alternatives are sometimes referred to as the as is and to be systems. If the status quo solution includes minor modifications, on a smaller scale than the alternative(s), it may be referred to as status quo plus or baseline plus. It is best to consider at least four alternatives when possible. Usually, these options can be categorized as one of the following: Status quo or status quo plus: Change nothing or make only minor modifications to the system. Modernize existing assets: Upgrade or recapitalize the system without replacing it entirely. Lease/Privatization: Outsource the function to another organization (e.g., government agency and a vendor). New Acquisition: Replace the current system or otherwise procure a material solution for the system. Total Number of Alternatives EAs can have many alternatives. Often there is more than one new acquisition option to consider or more than one type of modernization solution. However, increasing the number of alternatives also increases the time and effort involved in conducting the EA. Also, if there are too many options, some are likely to be too similar. Alternatives must be distinct solutions, not variations of one solution. Otherwise, it will not be clear which is the best alternative because the ranking may be too close to formulate a strong recommendation. Consider the pros and cons of the number of alternatives before deciding on a list to analyze. Common Alternatives There are many variants of the basic binary pair of EA alternatives, the status quo and the alternative:

Answer 63

Programs can repair an old system to keep it in service or dispose of the system and replace it with a new one. When acquiring a new system, programs can choose to buy or lease it. Programs can implement or sustain a manual process or choose to automate it. Programs can make a new item within the organization or buy (procure) it from another organization. Programs can centralize a function within your organization or decentralize it. This last example can even apply to system architecture. In a storage-intensive Automated Information System, alternatives may include centralized storage of all information which may create latency concerns for remote users. Conversely, decentralized storage of information at various sites may introduce redundancies and associated costs.

Question 64

Step 4: Develop the Cost and Benefits Estimates Once the alternatives have been defined, develop the cost estimates and benefits estimates. This step is the most analytical and time-consuming part of the EA process. It often involves extensive data gathering and analysis, including interviews with future users, program personnel, and other people with knowledge of the problem or new mission being examined. The first major step in the process is to define the estimating parameters. This step involves determining mathematical and methodological rules that will govern the analysis.

Answer 64

Once parameters have been defined, develop the cost estimate and benefits estimate for each alternative. Developing the estimates involves data gathering and analysis, development of Cost Estimating Relationships (CERs), and other estimating-related activities covered in detail in Units I-III. The cost estimate and benefits estimate are important to the EA process as they provide the mathematical foundation for comparing and ranking the alternatives. This step is the quantitative, analytical, and objective core of the EA process. If the estimates are poorly done, a decision could be made to implement a non-optimal solution. Conversely, if the estimates are done well, the decision-maker can be confident that the alternative selected is the best one given all the circumstances.

Question 65

Step 4: Develop the Cost and Benefits Estimates Estimating Parameters An important estimating parameter to establish is the economic life cycle of an alternative. The economic life cycle is defined as the period during which an alternative is providing benefits. It is usually constrained by the system physical life, mission life, and/or technological life. Physical life is the time a system will mechanically work as designed. Mission life defines how long a system will support an activity before the service either changes or is no longer required. The end of technological life is defined as the time when the system becomes obsolete because it is replaced by a newer system, is no longer supported by the developer or is otherwise rendered obsolete.

Answer 65

Once an economic life is defined for each alternative, define the period of analysis for each alternative. The period of analysis is the economic life plus any lead time required to develop the system or get it implemented in order to provide the benefits. For many government systems, the lead time is usually defined by when the project will achieve Initial Operating Capability (IOC). At IOC, most systems begin to offer some benefits. Note that alternatives can and frequently do have different economic lives and periods of analysis. This information is taken into consideration when determining the EA period of analysis.

Question 66

Step 4: Develop the Cost and Benefits Estimates EA Period of Analysis Once the economic lives and periods of analysis are determined for all alternatives, define the EA period of analysis. Usually, one of the following methods is employed:

Answer 66

Shortest Life: This approach sets the EA period of analysis equal to the shortest period of analysis for all the alternatives. Because the analysis is confined to a period of time that does not account for all of the benefits in the other alternatives, Residual value for other alternatives is estimated and included in the benefits estimate. Common Denominator Life: This approach assumes that the systems will continue to replace themselves until a point when all alternatives end at the same time. For example, if there are three systems with lives of 3, 4, and 6 years, the common denominator period of analysis would be 12 years. The first system would be replaced thrice, the second system would be replaced twice, and the third system would be replaced once. Note that the term "denominator" is a bit of a misnomer here. In precise mathematical terms, we are talking about the least common multiple of the periods of analysis for the alternatives. Uniform Annual Cost: This method economically adjusts dollars to account for the different lengths of each alternative's life and assumes the longest period of analysis among the alternatives.

Question 67

Step 4: Develop the Cost and Benefits Estimates Type of Dollars

Answer 67

Another important estimating parameter is the type of dollars that will be used for the analysis. Constant year dollars are used most often; however, sometimes there is justification for using current year dollars which are defined as money or prices expressed in terms of values actually observed in the economy at any given time (i.e., 2010 current year dollars are are the actual amount of dollars paid in 2010 to purchase an item of a given value). For example, if the data gathered is in current year dollars or is expressed in relative terms that do not take away the effects of inflation, then current year dollars could be used for the analysis. Either type of dollars is fine to use in the estimates, but the EA should never mix both constant and current year dollars in the same analysis. See Inflation and Index Numbers for more information about constant versus current year dollars.

Question 68

Step 4: Develop the Cost and Benefits Estimates Base Year

Answer 68

Finally, choose the Base Year (BY) of analysis. The BY is usually the first year in which there is a difference in expenditures among the alternatives. If the EA is the first one conducted for a program, the BY is usually one or more years in the future. If the EA is an update to an estimate, the BY is typically the current or a past year. If each estimate uses constant year dollars, it is critical to establish BY at the start of analysis as this year is the one to which all estimates are adjusted for inflation. If current year dollars are used, the BY can be determined later, but it still needs to be defined because discounting is made according to the BY of the estimate. Note that the definition of the BY for an EA is different than that typically used in the acquisition world. For a new program, a BY is often defined as the year in which a major contract is awarded. Sometimes the contract is awarded in the same year in which alternative expenditures begin to differ, but not always.

Question 69

Step 4: Develop the Cost and Benefits Estimates Cost Estimates The next part of the EA process is to develop a comprehensive cost estimate which captures all anticipated expenses for each alternative. It is useful and usually required to use a Work Breakdown Structure (WBS) or Cost Element Structure (CES) as the framework for the estimate. While determining the WBS/CES, ensure that all applicable costs are captured. An EA cost estimate sometimes differs from a Life Cycle Cost Estimate (LCCE). An EA estimate is typically more extensive in terms of types of costs captured. Costs to include in an EA are: traditional LCCE costs such as development, acquisition, operations, support, maintenance, and disposal; opportunity costs of existing assets and resources that are used in a particular alternative if those assets/resources could be used elsewhere, and imputed costs, which represent the value of services provided without charge to a project (e.g., base operating support). Finally, if an alternative requires a development period and phase-in period (in other words, does not phase in immediately), that alternative's cost estimate must include the operations and phase-out costs of the status quo system to account for the cost to change from the status quo. Costs to exclud

Answer 69

Societal Costs: Non-government entities realize societal costs and benefits. A government project whose primary purpose is to produce benefits outside the federal government falls under Office and Management and Budget (OMB) Circular A-94 in the paragraph entitled "Special Guidance for Public Investment Analysis[1]." Sunk Costs: Sunk costs are those already realized. Even though the estimate does not include them, document the sunk costs in the assumptions. One type of cost that is optional to include or exclude is wash costs. These are costs that are realized by all alternatives equally. Normally, if there is a requirement to show total program funding, wash costs are included. However, if there is no such requirement, it is often easier to remove the costs from the analysis to avoid presenting excessive information to the decision maker. The documentation should include a note if wash costs are not included. Note that the inclusion or exclusion of wash costs will affect multiplicative measures such as the Cost/Benefit Ratio (C/BR), which is one reason additive measures such as Net Present Value (NPV) are preferred. [2] With all parameters established, the final step is to develop the cost estimate. The level of detail of the estimate varies, and the amount of effort required to develop the EA is largely dependent on the level of detail of both the cost and benefits estimates. The level of detail depends on: data availability, the size of the project, the level of oversight, and the amount of effort available/desired for developing the EA. The level of detail is typically less than that of an LCCE because multiple estimates need to be developed and developing estimates to such detail is usually cost-prohibitive. Traditional cost estimating methods are used, such as analogy, CERs, etc. (see Module 2 Costing Techniques). Another differentiating factor between the EA cost estimate and LCCE is that the EA cost estimate must cover the entire period of analysis, which at times can be longer than the period used by a LCCE depending on how the economic life is defined.

Question 70

Step 5: Compare and Rank the Alternatives Once the cost and benefits estimates are complete, compare and rank the alternatives. This process includes:

Answer 70

phasing costs and benefits by year, adjusting for inflation (if needed), discounting costs and benefits, and selecting a comparison technique that accommodates estimating assumptions. To do so, phase and adjust the costs and benefits for inflation (if not already done as part of the estimating step). Next discount the costs and benefits to represent the data in present value terms and compare the alternatives using a comparison technique that suits the estimate assumptions. Comparing the alternatives provides data to develop a draft of the recommendations. Recommendations should not be finalized until sensitivity analysis is performed.

Question 71

Step 4: Develop the Cost and Benefits Estimates Benefits Estimate The most difficult part of an EA is to define and quantify the benefits or advantages gained by implementing the program under analysis. Benefits tend to be naturally expressed in non-quantifiable terms, and one must consider how to measure the performance of a given alternative in quantifiable terms. Of course, non-quantifiable benefits are still useful, but anything quantifiable tends to make the analysis more objective. Even when benefits are quantifiable, it may be hard to put them in monetary terms. A non-monetary benefits matrix example is shown in Related and Advanced Topics. Once a list of candidate benefits has been defined, examine and down-select to ensure no benefits overlap with costs captured in the cost estimate. It often helps to categorize the benefits in one of three buckets: quantifiable and monetary, quantifiable and non-monetary, or non-quantifiable but qualitative. If possible, use monetary benefits. The benefits estimate will then be in the same units as the cost estimate which allows for much easier comparison of alternatives (i.e., dollars to dollars). However, often it is not possible to express benefits in terms of dollars. In those cases, it is helpful to at least try to define benefits as quantifiable. Monetary benefits can be further defined as cost savings, cost avoidance, or productivity improvements. Cost savings denotes a reduced future budget requirement. Cost avoidance eliminates additional costs in the future. An example of a cost avoidance would be an alternative that finds a way to accomplish additional workload with existing manning that would have otherwise generated overtime or additional manpower costs in the future had the initiative not been put in place. A productivity improvement could generate cost savings or cost avoidance depending on how the productivity improvement affects the budget. If a productivity improvement allows an office to absorb additional workload without increasing manpower or using overtime, this alternative would produce a cost avoidance. A productivity improvement could reduce manpower requirements (if positions are cut) or energy consumption, or supplies, etc., which would generate cost savings. Note that reductions in the workforce are rare, and often productivity improvements which could reduce the workforce cannot be counted unless a workforce reduction will actually result.

Answer 71

Note that: cost savings should be addressed in the cost estimate, cost avoidance can be addressed in either section, and improved productivity should be addressed in the benefits estimate. Monetary benefits that should be included in the benefits estimate include the residual, terminal, and/or salvage values of any equipment used in the alternative. Residual value is defined as the value of an asset at any time before the end of its economic life. This method would be used, for example, in a case where there were alternatives with different economic lives and the shortest life was the method chosen for determining the EA period of analysis. In this case, any alternative with a longer economic life would include the residual value of its equipment at the end of the EA period of analysis. Terminal value is the value of an asset at the end of its economic life. If physical life is used to determine the end of the economic life, then terminal value equals salvage value. However, if mission life or technological life is used to determine the end of the economic life, there could be some value left in the equipment over and above salvage value. Salvage value is defined as the value of an asset at the end of its physical life. This value is sometimes viewed as the value of scrap metal, parts, etc. As with the cost estimate, some benefits should be excluded from the analysis, such as: societal benefits outside of the organization that are incidental to accomplishing the objective, benefits that have already been realized by one or more alternatives, and any monetary benefit that is captured under the cost estimate. As a reminder, it can be easy to double-count items in both the cost estimate and benefits estimate, so it is important to keep the cost estimate and benefits estimate teams in sync[2]. Quantify Benefits Quantifying the monetary benefits is similar to developing the cost estimate in that data is gathered, analogies are drawn, relationships are developed, etc. For non-monetary but quantifiable benefits, it is best to develop questionnaires and solicit an expert assessment of benefits. Soliciting assessment is, by its very nature, a subjective process. However, one can help make the data significantly more objective by talking to multiple people/groups, conducting reviews of the data, and scrubbing the results. Techniques can be borrowed from similar approaches used for estimating cost (see the Expert Opinion section of Module 2 Costing Techniques). Another very useful step in the quantification process is to rank or assign weights to the benefits. This step becomes particularly important when comparing and ranking alternatives with unequal costs and unequal benefits. For any non-quantifiable benefits, address the benefit and how to compare alternatives as part of the EA documentation. Ranking or assigning weights to non-quantifiable benefits is also very useful when comparing alternatives. Further guidance on identifying and quantifying benefits may be found in Resources. Several of the guides listed there contain checklists or question-based benefits identification lists to facilitate this process. Additional approaches are covered in more detail in Related and Advanced Topics. Phase Benefits The last step in the benefits estimate is to define when the benefit will be realized and phase in the benefits by year. As with the cost estimate, phasing is critical for discounting (if monetary) and comparison reasons. The phasing in of benefits usually coincides with the phasing in of the alternative system. Benefits should last through to the end of economic life.

Question 72

Step 5: Compare and Rank the Alternatives Comparison Using Inflation Costs and monetary benefits need to be properly adjusted for inflation. Usually, this adjustment occurs as part of the estimating step, but proper escalation should be verified as part of this step. See Module 5 Inflation and Index Numbers for more information on escalation. Comparison Using Discounting Costs and benefits must be discounted to account for the time value of money. This step economically adjusts the estimates to allow for an economics-free comparison. Discounting is sometimes referred to as present value analysis

Answer 72

The concept behind discounting is based on opportunity gained or lost. The idea is that a resource in the future is worth less than that same resource today. Similarly, to obtain a given resource level in the future, one would need less of it today due to investment opportunities. Therefore, if one uses resources today to develop a project, those same resources cannot be invested to accrue interest, resulting in fewer resources in the future and preventing an interest-growing opportunity. Similarly, gaining funds today (via benefits) provides the opportunity for investment in an interest-growing opportunity which results in greater future resources. Discounting transforms gains and losses that occur in different years to a common unit of measuremen

Question 73

Step 5: Compare and Rank the Alternatives Comparison Using Time Phasing All costs and benefits must be time-phased by year, usually by fiscal year (FY):

Answer 73

If not already done as part of the estimating step, identify what costs and benefits occur in each FY for every alternative. Inflationary and discounting adjustments are dependent on the year in which the costs or benefits occur. The accuracy of costs and benefits phasing could impact the recommendation. Any uncertainties should be identified as candidates for sensitivity analysis. For non-monetary but quantifiable and non-quantifiable benefits phasing is still critical for comparing relative benefits between alternatives.

Question 74

Step 6: Test Sensitivity of the Alternative's Rankings Ranking the alternatives provides a set of preliminary recommendations. To determine how strong the justification is for those recommendations, test those assumptions and see if any assumption significantly influences the outcome of the analysis. Sensitivity analysis can take time, even when estimates are fairly automated. Additionally, sometimes providing excess analyses to the decision maker creates more confusion. Therefore, limit the analysis to the most critical and important factors. Once the list of assumptions to test is generated, recalculate the analysis as many times as needed and compare and rank the alternatives using the new data. Sensitivity analysis is important because it highlights recommendation strengths and weaknesses. Synthesize the results of the sensitivity analysis exercise as these can sometimes lead to further research regarding the validity of certain constraints/assumptions. Sensitivity Analysis Assumptions and Constraints The assumptions and constraints on which to perform sensitivity analysis are:

Answer 74

Elements that are most likely to change: Include assumptions based on external factors out of the control of the program office. Include discount rates. Include any assumption that is known to have a significant probability of change. Elements that are the most uncertain or least understood: Include any assumption which is known to have a significant degree of risk. Include any assumption that was made for a lack of better knowledge. Significant cost or benefits drivers: Determine major cost drivers by calculating each element's percentage of the total cost. If known or used, perform sensitivity analysis on Cost Estimating Relationship independent variables to calculate the range of cost for a given cost element. Factors with key relationships to the results of the analysis including: the objective statement, program requirements, system operations, and residual value if significant due to unequal economic lives.

Question 75

Step 5: Compare and Rank the Alternatives Escalation vs. Discounting Escalation applies the effects of inflation. Discounting is not the same, even though they are sometimes confused. Discounting is a technique for converting forecasted amounts to economically comparable amounts at a common point in time, considering the time value of money. Money today is worth more than money tomorrow since the inflation rate generally rises over time. Once cost estimates have been generated, they must be time-phased to reflect expenditure patterns. The time value of money is considered by computing the Present Value (PV) costs which are calculated by applying a discount rate to each year's cost in a cost stream. The discount rate is the interest rate used to reduce the full amount of future costs and benefits in order to arrive at present values based on the time value of money. Discount rates are usually developed to closely approximate the current cost of money in the financial marketplace. The purpose of discounting is to determine if the time value of money is sufficiently great to change the ranking of alternatives; a ranking that has been established based on all other considerations.

Question 76

Step 7: Formulate the Recommendation

Answer 76

The final step in the EA process is to formulate the recommendations. This step is the goal of the EA: to provide the decision-maker enough information to enable them to make an informed decision. Synthesize all data at this point, including baseline comparisons, sensitivity cases, and benefits. The alternatives have been ranked, and the analyst can present both the recommended action and a solid foundation of analysis on which that recommendation is based. It is good to have justification material ready to support second and third place alternatives in case of questions. DODI 7041.3, section E2.2.g. Results and Recommendations [4] states: The economic analysis report should begin with a summary of the analysis (based on the benefits and costs of the alternatives), and an interpretation of the results (to include a recommendation of the preferred alternative). The actual decision is based on qualitative as well as quantitative factors. The results of the economic analysis, including all calculations and sources of data, must be documented down to the most basic inputs to provide an auditable and stand-alone document.

Question 77

Depreciation Depreciation is the phenomenon wherein assets with finite lives lose value over time and roughly corresponds to normal wear and tear of an item. An example of depreciation is automobiles, whose value decreases over time. Depreciation is a non-cash expenditure important for accounting, tax, and capital planning purposes. Depreciation methods calculate the path from the initial value to the terminal value where: Depreciation = ( Cost − Residual value ) / Useful life {\displaystyle {\text{Depreciation}}=({\text{Cost}}-{\text{Residual value}})/{\text{Useful life}}} The cumulative depreciation is calculated as: Cumulative Depreciation = Initial Value − Current Value {\displaystyle {\text{Cumulative Depreciation}}={\text{Initial Value}}-{\text{Current Value}}} Some methods of depreciation include:

Answer 77

straight-line, the simplest and most common; sinking fund, which calculates like an annuity so that the total depreciation equals the residual value at end of life; increasing rate of depreciation; declining balance, where each period’s depreciation equals the residual value times a factor divided by N {\displaystyle N} number of periods (usually, the factor is 2, a double-declining balance); decreasing rate of depreciation, which is advantageous for tax purposes; Modified Accelerated Cost Recovery System (MACRS), a variant used for U.S. Income Tax; sum of the years' digit, where each period’s depreciation equals the total depreciation times the period number over the sum; historical method, which is fairly easy to compute; units of production; and units of time.