UNIT-1

Engineering economic analysis (EEA)An analysis of alternatives for a proposed engineering

project or service
to determine the relative worth of net economic gains expected from each alternative in relation to the
net economic costs required to produce those gains, all compared for a designated analysis period.
principles
Engineering economic analysis applies economic concepts and methods to engineering
problems to support decisions on a best course of action. Within highway transportation, these
decisions typically involve selection of the preferred alternative among projects or levels of service
affecting highways, roads, or streets. Engineering economic analysis provides a way of comparing the
economic gains expected from an investment with the cost of that investment; providing an objective
understanding of value to be expected for cost incurred. Because the service lives of highway facilities
that are properly maintained extend for decades, and the value gained from highway investments and
subsequent expenditures may not be fully realized until years after the actual outlays, engineering
economic analyses (EEAs) cover a period of time sufficient to capture these positive and negative
economic flows. In contrast with private-sector investments, public-sector projects and services,
including those analyzed in highway transportation, do not generate tangible income streams or direct
monetary payments as economic gains. Rather, the economic value of a highway project or service is
reflected in benefits to the public, typically gauged as reductions in their costs of travel, or in potential
costs to the highway user or the highway agency that are avoided. Avoided costs occur, for example,
when an existing level of congestion is reduced, when the potential risk of an accident is removed,
when sources of harmful pollution are eliminated, or when
potential deterioration of the highway facility is prevented.
Engineering economic concepts and methods include, but are not limited to, life-cycle cost
analysis (LCCA), benefitcost analysis (BCA), present-worth analysis, measures of cost-effectiveness,
and cost avoidance as a concept of benefit. These may be applied at one or more stages of a project
life cycle, such as planning, project scope development, programming (including ranking, project
selection, and budgeting), resource allocation, best-value procurement, projectdesign and
development [including value engineering (VE) at the preliminary engineering or concept development
stage], construction (e.g., analysis of options for accelerated project delivery), and operation and
maintenance. Engineering economic analysis may also be used as a tool following completion
of a project or service to infer corrected values of key parameters. It can provide the framework to
synthesize information and knowledge from a completed effort, enabling development of a new
analytic tool to analyze similar projects or services in the future. Economic analysis algorithms may be
embedded in an agencys infrastructure management, congestion management, and safety
management systems, or may be part of an overall asset management approach.
Analyses of highway investments benefit from EEAs in
several ways:
Highway investments provide benefits that extend into the future, typically measured in years or
decades.
Engineering economic analysis provides the multi-year framework needed to capture these benefits in
a fair
comparison of benefits to costs.
A level of long-term structural performance can be provided by different patterns of road investment,
varying the purpose, magnitude, and timing of capital and maintenance expenditures. Engineering
economic
analysis provides a way to analyze these alternative investment streams, identifying the most efficient
approach to achieving desired performance and road-user costs or benefits.
Budget limits and other constraints may prompt an examination of what level of performance might
be
sought in a highway investment. Tradeoffs exist among project and corridor location, design concept,
level of
highway development, maintenance policy, operating policy, and costs and benefits accruing to road
users as
well as nonusers. Engineering economic analysis provides a way to sort through these options on a
level playing
field, using the common metric of monetary value.
Highway programs consist of different needs and types of projects and services. Tradeoffs exist in the
funding
of these competing needs, a process state departments of transportation (DOTs) face in programming,
budget

development and recommendation, and resource allocation. Engineering economic analysis can
provide
information on the consequences of different levels of investment among a diverse set of programs in
a consistent,
monetized framework to help in these decisions.
Highway investments also may entail significant impacts in environment, energy, materials usage,
economic vitality, and quality of life, in both monetary and nonmonetary terms. Even when it is not
possible to quantify all
impacts in dollars, the framework provided by an engineering economic analysis can provide a useful
point of
departure for organizing qualitative as well as quantitative information about highway investment
options.
Discounted Cash Flow Methods

Computational methods have been developed to perform EEAs according to the principles described
earlier. These
methods include :
net present value (NPV),
equivalent uniform annual cost (EUAC),
BCA (or B/C), and
internal rate of return (IRR).
Only a brief commentary on these methods is provided in this synthesis, consistent with the study
scope outlined in chapter one. The focus of this report is rather on the application of these methods to
support highway investment decisions as illustrated in the several case examples in chapter three. The
methods are well described in the general engineeringeconomics literature. They are also described
in references providing transportation- and highway-specific guidance. Risk analysis methods are
covered in the next section.
Although the four methods listed entail somewhat different data and procedures, they all will yield the
same decision when applied correctly (Grant et al. 1990, chapters 47).
This synthesis adopts this position, which is based on the following precepts:
All of the engineering economic methods are based on a LCCA of investment alternatives. The LCCA
is a discounted cash flow analysis of monetized cost and benefit streams. The analysis period or
analysis horizon, in
years, is sufficiently long to capture a reasonable representation of the significant costs and benefits
of each
alternative through equivalent periods of performance. The four methods identified previously (NPV,
EUAC,
BCA, IRR) all meet these stipulations. Other methods (such as project payback periods) have their uses
in
other contexts, but generally do not meet these characteristics of LCCA. (Project payback periods may
or
may not depend on discounted cash flows; they do not analyze alternatives through equivalent
performance
periods; and they therefore do not capture the full representation of costs and benefits through a
performance
period.)
Net benefits and net costs are used to assess the differences in consequences among alternatives.
Both
costs and benefits may take on positive or negative values, and bookkeeping conventions could be
established
to treat the respective quantities consistently and correctly. For example, the consequences of
highway
investments on passenger and freight travel are measured in road user costs. When comparing
alternative
investments, reductions in these costs (or avoidance of these costs) are treated as benefits.
Conversely, actions
that increase road user costs are said to incur disbenefits. Case examples in chapter three involving
use of the
California DOTs (Caltrans) Cal-B/C model will illustrate how these net-value calculations in tallies of
discounted
agency and road user costs are interpreted for the economic analysis results.

 In comparing alternative solutions, BCA and IRR analysis are both properly done on an incremental
basis.
There is considerable literature covering both simple B/C or IRR and incremental B/C or IRR
calculations.
If a project is being compared solely with a No-Build or Do Nothing option, the incremental case
reduces
to the simple case, and both yield the identical result. The same decision on whether or not the
investment
is economically justified will also be produced by the NPV and EUAC methods.
When there are a number of investment alternatives addressing a particular need or problem,
however, the
proper approach is to conduct the B/C or IRR analysis incrementally. The simple B/C result can be used
as a
screen: a simple B/C of less than 1.0 will not bear out on an incremental basis either. However, in the
general
case that is not subject to a budget constraint, a solution with the highest simple B/C may not
necessarily
be the optimal solution. Rather, the theoretically optimal result is the investment with an incremental
B/C
exceeding 1.0.

Cost-benefit analysis (CBA)

Introduction
Cost-Benefit Analysis (CBA) is a method to measure and evaluate all relative direct economic impacts of public
investment projects. A useful tool for decision-making in planning and evaluation of projects, CBA can be
used to determine whether and when a project should be undertaken and to rank and prioritize projects.

CBA Process

Following is a description of the CBA process.

1. Identify project needs. Clearly state project needs so that key relationships are identified and a wide range of alternatives
can be examined. The projects objective should not be too broad, making it difficult to examine all of the trade-offs, or too
narrow, excluding key relationships.
2. Identify project constraints. Constraints include policy and legal initiatives, and require specific assumptions about the
future, such as expected regional traffic growth.
3. Define the base case. This is also known as the no action casethe continued operation of the current facility without
any major investments
4. Identify alternatives. Identify project alternatives, which can vary from major rehabilitation of existing facilities to new
construction, full reconstruction, or replacement.
5. Define a time period. Set the analysis period over which the life cycle costs and benefits of all of the alternatives will be
measured. It should be long enough to include at least one major rehabilitation project.
6. Define work scope. Define the level of effort for screening alternatives. A complete analysis of all options is neither
achievable nor necessary. Screening alternatives allows a wide range of initial options to be considered with only a reasonable
level of effort. The level of effort is proportional to the expense, complexity, and controversy of the project.
7. Analyze alternative traffic effects. Analyze traffic effects that the alternative would have on the future traffic to calculate
the project costs and benefits.
8. Estimate benefits and costs. These estimates include investment costs, hours of delay, crash rates, and other effects of
each alternative relative to the base case (Table 6.3). An error in estimating costs and benefits could lead to project failure.
9. Evaluate risk. Look at the risks associated with uncertain costs, traffic levels, and economic values.
10. Conduct sensitivity analysis. Conduct a sensitivity analysis to find
factors that have an important effect on the output.
11. Find benefit/cost ratio. Compare net benefits with net costs and rank alternatives based on the benefit and cost ratio
(B/C ratio). The benefit cost ratio is calculated by dividing total discounted benefits by total discounted costs. Options with B/C
ratios greater than 1.0 are
preferable. In cases where the B/C ratios of some mutually exclusive alternatives are greater than 1.0, the incremental B/C ratio
should be used. In this method, the alternatives are ranked in order of investment from the smallest to the largest. Then, the
incremental benefits and costs between two alternatives are calculated (X-Y) where X is a previously justified alternative. If
(B/ C) X-Y is greater than 1.0, alternative Y is selected. If not, alternative X will be the output of CBA.
12. Make recommendations. Recommendations are based on the B/C ratios.

Identifying the main project options

This is a fundamental step in the CBA process where the decision-makers compile a list of all relevant
feasible options that they wish to be assessed. It is usual to include a do-nothing option within the
analysis in order to gauge those evaluated against the baseline scenario where no work is carried out.
The dominimum option offers a more realistic course of action where no new highway is constructed
but a set of traffic management improvements are made to the existing route in order to improve the
overall traffic performance. Evaluation of the do-nothing scenario does however ensure that, in
addition to the various live options being compared in relative terms, these are also seen to be
economically justified in absolute terms, in other words their benefits exceed their
costs.
The term feasible refers to options that, on a preliminary evaluation, present themselves as viable
courses of action that can be brought to completion given the constraints imposed on the decisionmaker such as lack of time, information and resources.
Finding sound feasible options is an important component of the decision process. The quality of the
final outcome can never exceed that allowed by the best option examined. There are many procedures
for both identifying and defining project options. These include:
* Drawing on the personal experience of the decision-maker himself as well as other experts in the
highway engineering field
* Making comparisons between the current decision problem and ones previously solved in a
successful manner
* Examining all relevant literature.
Some form of group brainstorming session can be quite effective in bringing viable options to light.
Brainstorming consists of two main phases. Within the first, a group of people put forward, in a relaxed
environment, as many ideas as possible relevant to the problem being considered. The main rule for
this phase is that members of the group should avoid being critical of their own ideas or those of
others, no matter how far-fetched. This non-critical phase is very difficult for engineers, given that they
are trained to think analytically or in a judgmental mode (Martin, 1993). Success in this phase requires
the engineers judgmental mode to be shut down. This phase, if properly done, will result in the
emergence of a large number of widely differing options. The second phase requires the planning
engineer to return to normal judgmental mode to select the best options from the total list, analysing
each for technological, environmental and economic practicality. This is, in effect, a screening process
which filters through the best options. One such method is to compare each new option with an
existing, tried-and-tested option used in previous similar highway proposals by means of a T-chart
(Riggs et al., 1997). The chart contains a list of criteria which any acceptable option should satisfy. The
option under examination is judged on the basis of whether it performs better or worse than the
conventional option on each of the listed criteria. It is vital that this process is undertaken by highway
engineers with the appropriate level of experience, professional training and local knowledge in order
that a sufficiently wide range of options arise for consideration.

Identifying all relevant costs and benefits

The application of cost-benefit for project assessment in the highway area is made more complicated
by the wide array of benefits associated with a given road initiative, some easier to translate into
monetary values than others. Many of the benefits of improvements to transport projects equate to
decreases in cost. The primary grouping that contains this type of economic gain is termed user
benefits. Benefits of this type accrue to those who will actively use the proposed installation.
This grouping includes:
* Reductions in vehicle operating costs
* Savings in time
*Reduction in the frequency of accidents.
This is the main group of impacts considered within a standard highway CBA. Other studies might
address in some way a secondary grouping of benefits those accruing to non-users of the proposed
facility.
These include:
*Positive or negative changes in the environment felt by those people situated either near the new
route or the existing route from which the new one will divert traffic. These can be measured in terms
of the changes in impacts such
as air pollution, noise or visual intrusion/obstruction.
* The loss or improvement of recreational facilities used by local inhabitants, or the improvement or
deterioration in access to these facilities.
The costs associated with a proposed highway installation can fall into similar categories. However, in
most evaluations, construction costs incurred during the initial building phase, followed by

maintenance costs incurred on an ongoing basis throughout the life of the project, are sufficient to
consider.
The three primary user benefits listed above are normally estimated relative to the without project or
do-nothing situation. The definition and description of the without project scenario should be such
that it constitutes an entirely feasible and credible course of action. Let us examine each of these
benefits in some detail.

Reductions in vehicle operating costs

This constitutes the most direct potential benefit derived from a new or upgraded highway project. It is
often the most important one and the one easiest to measure in money terms. While the users are the
initial beneficiaries of these potential reductions, circumstances dictated by government policies or
competition, or the drive to maximise profits, might lead to other groups within the broader
community having a share in the ultimate benefit.
For a highway scheme, the new upgraded project leads to lower levels of congestion and higher
speeds than on the existing roadway, usually resulting in lower fuel consumption and lower
maintenance costs due to the reduced wear
and tear on the vehicles.
Within a highway cost-benefit analysis, a formula is used which directly relates vehicle-operating costs
to speed. Costs included are both fuel and non-fuel based. The higher speeds possible on the new road
relative to the existing one lead to potential monetary savings for each road user.

Savings in time
The upgrading of a highway installation will invariably reduce travel time as well as improving the
reliability of transport services. For transport users, time has some connection with money. The degree
of correlation between the two
depends primarily on the manner in which the opportunities made possible by the increased
availability of time are utilised.
In general, analyses of the value of time-savings within the cost-benefit framework focus on
distinguishing between travel for work and travel for non-work
purposes. Non-work time includes leisure travel and travel to and from work. Within developed
economies, the value of working time is related to the average industrial wage plus added fringe
benefits, on the assumption that time saved will be diverted to other productive uses. There is no
broad agreement among economic evaluation experts regarding the valuation of non-work
time. Since there is no direct market available that might provide the appropriate value, values must
be deduced from the choices members of the public make that involve differences in time. Studies
carried out in industrialised countries have indicated that travellers value non-working time at between
20% and 35% the value attributed to working time (Adler, 1987). Less developed
countries may, however, set the valuation at a lower percentage. In the worked example presented in
section 3.3.6, an average value for time savings is used which supplies a single value covering both
workers and non-workers using the highway.

Reduction in the frequency of accidents

Assessing the economic benefit of accident reduction entails two steps. In the case of a highway, this
requires comparison of the accident rate on the existing unimproved highway with that of other
highways elsewhere in the country (or abroad) constructed to the higher standard of the proposed new
road. Normally, the higher the standard of construction of a highway, the lower its accident rate. The
second step involves the monetary valuation of the accident reduction.
Three types of damage should be considered:
*Property damage
* Personal injuries arising from serious accidents
*Fatal accidents.
Property damage to vehicles involved in accidents is the most easily measured in money terms.
Reduced breakage of cargo can also be a significant benefit in proposed rail-based and seaport
installations. Valuations can be obtained directly from the extent of claims on insurance policies. The
cost of serious but non-fatal accidents is much more difficult to assess.
Medical costs and the cost of lost output and personal pain and suffering constitute a large proportion
of the total valuation.
There is major disagreement on which method is most appropriate for estimating the economic cost to
society of a fatal accident. In recent times, stated preference survey techniques have been employed
to estimate this valuation. In most cases, an average cost per accident, covering fatal and non-fatal, is
employed, with damage costs also accounted for within the final estimated value.

Advantages and disadvantages of cost-benefit analysis

Advantages

*The use of the common unit of measurement, money, facilitates comparisons between alternative
highway proposals and hence aids the decision making process.
*Given that the focus of the method is on benefits and costs of the highway in question to the
community as a whole, it offers a broader perspective than a narrow financial/investment appraisal
concentrating only on the effects of the project on the project developers, be that the government or a
group of investors funding a toll scheme.

Disadvantages
* The primary basis for constructing a highway project may be a societal or environmental rather than

an economic one. If the decision is based solely on economic factors, however, an incorrect decision
may result from the
confusion of the original primary purpose of a proposed project with its secondary consequences,
simply because the less important secondary consequences are measurable in money terms.
* The method is more suitable for comparing highway proposals designed to meet a given transport
objective, rather than evaluating the absolute desirability of one project in isolation. This is partly
because all estimates of costs
and benefits are subject to errors of forecasting. A decision-maker will thus feel more comfortable
using it to rank a number of alternative highway design options, rather than to assess the absolute
desirability of only one option relative to the existing do-nothing situation, though this in some cases
may be the only selection open to him/her.
* Although some limited recognition may be given to the importance of costs and benefits that cannot
be measured in monetary terms, say, for example, the environmental consequences of the project in
question, they tend to be neglected, or at best downgraded, within the main economic analysis. Those
goods capable of measurement in monetary terms are usually attributed
more implicit importance even though, in terms of the overall viability of the project, they may be less
significant.

Net Present Value (NPV)

A net present value (NPV) calculation is used to state a projects worth or cost for its entire life cycle in todays dollars or
at some specific point in time.
NPV is calculated as follows:

Currently benefit assessment methods at TxDOT do not monetize benefits such as crash and air emissions reductions.
Therefore, most transportation projects do not have direct monetized benefits (e.g., toll revenue) and the NPV covers only
expected costs at a specific point in time.
To calculate the present value of money, the following formulas can be used, where F is future value, P is present value, i is the
discount rate per period, and N is the number of compounding periods.

Single Payment
To calculate the present value of a single payment in the future:

In the net present value method, the cost and the benefits of the individual years are discounted to the present value and compared
across various alternatives. The Net Present Value (NPV) at the base year can be written as:

NPV

Bi Ci
n
i 0 (1 r )

where, Bi is the benefit of the ith year, Ci is the cost of the ith year and n is the number of years.

Internal Rate of Return (IRR)

the projects Internal Rate of Return (IRR) determines the discount rate at which the sum of discounted costs equals the
sum of discounted benefits (at their presentyear worth):
Essentially, IRR is the effective (equivalent) interest rate used to measure the value of an investment. IRR can be used only when
the project will generate income. To evaluate alternatives using IRR, the alternatives IRRs should be greater than the minimum
accepted rate of return (MARR), which is also known as the hurdle rate. MARR is the lowest interest rate that investors
would accept, given the risk of the investment and the opportunity cost of foregoing other projects.
Internal rate of return is that discount rate, for which the NPV value is zero. This can be obtained by setting the value of NPV in
Equation (5) as zero, and solving (by trial and error) for the value of r. If the rate of return thus calculated is more than the market
interest, then the project is adjudged to be acceptable.

Comparison of various methods

The cost-benefit model is simple to use, but sometimes when the cost-benefit ratio of two models are close to each other,
it becomes difficult to interpret, and choose the best option.

Some components whether will be treated as benefit or cost (i.e. whether it will go to the numerator or denominator),
sometimes appear confusing. This is because savings in cost is benefit in other words.

In the NPV or cost-benefit ratio methods, some discount rate is assumed, and various alternative projects are compared. If
different discount rate is assumed instead, the order of choice among the alternatives may change.

IRR method itself finds out the discount rate, and therefore inaccuracy in analysis in assuming some arbitrary discount
rate (as is done in cost-benefit ratio or in NPV method) is taken care.
Thus, IRR method seems to be the most preferred economic analysis tool.

Methods of

economic analysis:

Two common overall methods of economic analysis are the deductive and
inductive methods. More specific ways of conducting an analysis include fiscal impact
analysis, cost-benefit analysis, cost-effectiveness analysis, and cost analysis. These
methods are used to determine how to maximize resources for optimum benefit.
The deductive and inductive methods draw economic generalizations in dramatically
different ways. Deductive analysis involves drawing a conclusion from the study of general
facts and principles. Inductive analysis starts with specific facts and then uses them to
expand to a study of general principle. Many analysts will use both of these methods
together in order to compensate for the weaknesses found in each method.
Fiscal impact analysis is one of the most comprehensive methods of economic analysis,
and it is used to determine if a new program or policy is worth the cost. This includes
studying every known potential expenditure or financial benefit and determining what its
impact would be from a governmental point of view.
Cost-benefit analysis is used for comparison. The method weighs the pros and cons of
various programs and policies so that it can be decided which action provides the greatest
value. In essence, the process attaches a dollar amount to a series of concepts.
Another comparison tool is the cost-effectiveness analysis. This method explores different
ways of using resources in order to find the most economical way to accomplish a goal.
Similar to the cost-benefit method, the process puts a dollar amount on multiple options in
order to enable comparison.
Cost analysis is the process of determining all expenses associated with a particular policy
or program. While this is a simple goal, there are often several different kinds of analysis

that must be performed in order to reach an accurate final estimate. This analysis is often
performed before the other methods are used.
A thorough cost analysis will include an accounting of both direct and indirect costs, as
well as an estimate of costs to be expected in the future, such as increasing salaries and
expenses. When the analysis is for a new venture, then the one-time start-up costs would
need to be considered as well. If there are any loans attached to the project or program,
then the capital costs, which include any related fees or interest, will also be incorporated
into the total amount.