In these tough economic times, making every penny count is more important than ever. Local authorities, central Government and businesses up and down the country are under pressure to make sure that every pound spent delivers maximum benefits for society, the economy or their customers.
This is where a good economic appraisal can help. So what exactly is it? According to Wikipedia:
“Economic appraisal is a type of decision method applied to a project, programme or policy that takes into account a wide range of costs and benefits… for which a monetary equivalent can be estimated.”
The idea behind an economic appraisal is to systematically look at the rationale for a project or policy, its objectives and costs and benefits, to work out whether the project or policy in mind is affordable and represents good value for money, given the risks involved.
This post will take you through the basics of putting together an economic appraisal. I’ll explain some of the powerful economic concepts that lie behind this, so that you can take them away and use them in your own appraisals or business cases, to help you get that project off the ground, or that policy up and running.
What I won’t do at this stage is talk about some of the complicated methods available for working out the value of things that don’t have a ‘price’. One reason is that these methods won’t apply to everyone and I want this post to be a general introduction to appraisals, for those who are new to them. Also, to talk about and explain these methods properly really would require a new post to do it justice.
Although similar, business cases and economic appraisals aren’t quite the same. However, I really believe that anyone writing a business case can get a lot out of applying some of the methods used in economic appraisal.
The two methods are very complimentary and if you’re writing a business case, why not use some of the economic appraisal techniques in conjunction with standard business case methodology? It’ll definitely help your business case stand out from the crowd and could lead to better overall decision making, too.
THE FIRST STAGE: THE RATIONALE
One of the most common mistakes that people make when putting appraisals together is that they don’t devote enough time to explaining the rationale for their project or policy. This really is the backbone of any good appraisal. Be clear about what you want to do and why from the start and it will be in the forefront of your boss’s mind when they’re making their decision on whether to back your project. It will also help you think about the costs and benefits you should be identifying.
Make sure you give you appraisal as much strength as possible by always referring back to your rationale wherever you can. Identified a really important benefit? Fantastic! In that case, it’s a good idea to make the link back to the rationale, just to reinforce the point that this will only come as a result of your great idea.
In economics, the rationale for Government intervention generally focuses around market failure, equity and ethical considerations. Governments want to intervene to make sure that markets work in a fair and efficient way, to ensure equality in some way (perhaps through tax and benefits policies designed to redistribute income from the rich to the poor), or because there is an ethical reason for them to do so.
A perfect market works when buyers and sellers have all the information they need and it is easy to enter and exit the market. an optimal outcome for a market is when it delivers a situation where no-one can be made better off without making someone else worse off.
In cases of market failure, it is normally possible to make an individual better off without making others worse off.
Alternatively, the market might ‘fail’ because of a lack of incentive to make the best use of all the available resources. Maybe the same service or product could be delivered at lower cost? Here, Government could intervene to make sure that things happen more efficiently.
For businesses, the key is to try and spot these inefficiencies in the market and to exploit them. What can you do to try and strengthen your position in the market?
The most common concepts are explained, below. Think about your business or your policy responsibilities (if you are in local or national Government). How might these apply to your particular economic appraisal or business case?
There are many types of market failure, such as:
Public goods: Public goods are goods that are non-rival and non-excludable. Non-rival means that the use of a good by one person doesn’t prevent someone else from using that good. Non-excludable means that if a good or service is made available to one person, it has to be made available to all.
This concept is most applicable to the public sector. An example of a public good is national defence. It is non-rival because everyone in the country is defended equally well. It is non-excludable because if the army goes to war to defend one person living in Britain, it has to defend everyone in the country.
Typically, the private sector will under-provide public goods, because it’s often just not possible to make sure that everyone who benefits from a public good pays a fair price for it.
For example, if national defence wasn’t publicly funded then it wouldn’t make sense for any one person to pay a ‘price’ for it: they would benefit from the contributions of others and be defended in the event of a war, regardless. It would only work if everyone cared enough about defending the country to overcome the incentive not to contribute.
Externalities: an externality occurs where the action of an individual or a firm affects someone else, but this isn’t reflected in the price system. Externalities can be positive or negative.
In education, for example, they can occur in the form of spillover effects: where one person’s education benefits another, through informal coaching in the workplace. Sending your staff on training courses doesn’t just benefit those who actually go, but also those who work with them, too.
Government intervention may be needed to increase the provision of something where there is a positive externality or to reduce a negative externality.
For example, because pollution can harm the environment and is a risk to public health, Government may introduce policies to encourage people to use cleaner fuels or drive less.
In business, the key is to spot these externalities and make the most of them.
When you send people on training courses, make sure they give a presentation to their colleagues when they come back to work, so that as many people as possible benefit, for example.
Imperfect competition: this occurs where there are one or a few buyers or sellers that have sufficient market power to influence prices.
A well-known example is the role of big UK supermarkets in the market for milk.
The big supermarkets have so much buying power because the milk producers have few alternative customers for their milk. This means that the supermarkets can essentially make a ‘take it or leave it’ offer to milk producers.
Imperfect / asymmetric information:imperfect information occurs when the information available to individuals or firms is not good enough to help them make the best decision.
For example, an individual may decide that A Levels aren’t for them, but choose not to continue their education because they aren’t aware of other options, like and Apprenticeship.
Is there an information failure in your market that your business could make money from by rectifying?
Asymmetric information occurs when one party involved in a transaction has more information about what is being bought or sold than others.
For example, if you decide to buy a second-hand car, the person selling the car may know a lot more about its history than they are wiling to let on.
Capital market failure:occurs when people don’t have the collateral needed to take out a loan to fund their education or business idea and cannot borrow based on their future earnings potential (which may be uncertain).
This is part of the rationale behind the Government policies that have recently been introduced to help give young entrepreneurs access to funds and advice to start up their own businesses.
Equity issues are also a major consideration in Government intervention decisions. They can take the form of:
Vertical equity: redistribution of income from rich to poor;
Horizontal equity: individuals / families with similar needs should be treated similarly;
Social inclusion: everyone should have access to goods and services that allow them to participate fully in the life of the society in which they live.
Intergenerational equity: balancing the needs of current and future generations.
Individual market failures and equity considerations aren’t mutually exclusive; there may be several reasons for intervention. That’s why it makes sense to explore each possibility fully in the context of the problem under consideration.
STAGE 2: DEVELOPING OPTIONS
The next stage is to consider what you can do to solve the problem or to take advantage of the opportunity.
Start by setting out all the options you can think of and then gradually rule them out based on the costs and benefits of each one. This will help to show people that you’ve arrived at your recommendation in the most rigorous and sensible way.
One important option is the ‘do nothing’ option or the status quo – the counterfactual. In order to assess the benefits of a particular option, it is important to know what would happen if the option didn’t go ahead.
For example, if a particular policy to help young people didn’t get the go-ahead, what would happen to the young people who would have taken part? Unemployment? Prison? Both?
If your idea didn’t get off the ground, how much revenue would your business be losing compared to what it is generating now? Or how much extra would you be spending if your bosses don’t listen to your idea?
Criteria for option selection
Most options are selected based on some kind of success criteria. Some of the most common or important ones to think about are:
Whether the option will achieve the desired outcome:this may seem obvious, but to do it properly requires a robust understanding of why things need to change in the first place.
Cost: again, this seems obvious. However, a number of parties may incur costs and these should be fully taken into account – your bosses may not be comfortable with who has to pick up the tab and for how much; and there could be a valid business reason for this.
Unintended consequences:some options may have unintended side effects which increase or reduce their desirability.
For example, if the Government encourages more people to stay on at school, what happens to those companies who would have employed them? Do they suffer a labour shortage?
Or if a premium clothing company decides to launch a lower cost range to target a different market of consumers, will its existing customers no longer see it as ‘exclusive enough’ for them?
Additionality / Deadweight:it is important to ensure that any costs and benefits included are additional and would not have happened anyway. Otherwise, this could lead to an option being chosen that offers poor value for money.
Distribution:for those in Government, proposals should ensure that they do not disproportionately harm particular groups, especially those who are the most vulnerable in society.
STAGE 3: IDENTIFYING THE COSTS AND BENEFITS
It is important to describe all the costs and benefits associated with each option, compared with the ‘do nothing’ option. Include only those costs and benefits that are additional relative to the status quo.
When thinking about costs and benefits, don’t be afraid to use your imagination – be as creative as you can and don’t worry about attaching a monetary value to them at first. It’s much more important to show that you’ve considered the full range of benefits – both monetary and non-monetary than to have a narrow range of purely monetary costs and benefits.
One good way to identify costs and to benefits is to simply make a list – write down all the people who may be affected by each option, why they are affected and how. Once you feel like you’ve captured everything, then you can start thinking about how to value them.
Costs could include:
Direct and indirect costs to firms: if a firm pays for an employee’s training course, for example, they may incur direct costs through paying tuition fees; and indirect costs through giving them time off to study.
Familiarisation costs: it takes time for people to get to grips with new processes – they might make mistakes along the way.
Burdens to other institutions as a result of government policies: does the policy option mean more paperwork for colleges / schools / councils?
Opportunity cost is also important: the worth of the most valuable alternative. This principle is often not picked up on in accounting, but is very important in economics. This can really help you to make a sound financial decision. If your project gets the go-ahead, what will it be crowding out that could have been done instead? Is your project more or less valuable?
There are also lots of public policy examples of opportunity costs. For example, someone who chooses to go into non-compulsory education gives up the chance to earn money in the labour market. By encouraging young people to do this, the Government also gives up any tax revenue that the young person might have paid.
When costs are incurred is also important, particularly in public spending appraisals. Typically, costs and benefits are valued differently depending on when they occur, to reflect the way that society values costs and benefits incurred now, compared to those incurred in the future.
The benefits of a particular option will obviously be unique to whatever that option is trying to achieve. In a business sense, the most important benefit will be the increase in profit / cost savings that result.
Other potential benefits may include:
The impact on earnings / employment prospects / quality of life of local people
Social benefits: reduced crime, increased civic responsibility, etc; health benefits.
More educated workers increase firms’ productivity
Other ‘spin off’ benefits: more people setting up businesses as a result of training? Any free publicity for your idea that boosts revenues or opens up new opportunities?
One important thing to remember is to try and not be too over-optimistic when estimating the benefits of your proposal. Generally, it is much better to present an appraisal based on cautious thinking and assumptions: showing your boss that your idea generates a strong set of benefits under a cautious scenario can be much more powerful than showing a very large set of benefits based on very optimistic assumptions.
STAGE 4: BRINGING IT ALL TOGETHER – THE NET PRESENT VALUE
The final stage is to offset the costs and benefits of each option. This will give a net benefit (if positive) or a net cost (if negative).
Depending on the way things are done in your organisation, you may have to discount any flows of costs and benefits into the future, with a set discount rate. Discounting is a way of making costs and benefits that occur in different time periods comparable with each other.
Why does discounting make sense?
If I gave you the choice of accepting £100 from me today, or in a year’s time, which would you choose? £100 today would be the better choice, because you could always put the money in the bank and earn interest in the meantime.
Plus, something might happen to me between now and this time next year, which might mean that I am unable to pay you the £100 I promised.
Therefore, it makes sense to value costs and benefits in the future slightly differently than we would value them if they occurred today, if we’re going to make a good forward looking investment decision.
Mathematically, the discount factor can be described as:
Where D is the discount factor, r is the discount rate and T is the time period in question.
Discounting costs and benefits means that you apply the discount factor to the costs and benefits in each year that they occur.
For example, let’s say that our benefit stream is worth £150 every year. Discounted at 2.5 per cent this would be worth:
at the end of year 1.
At the end of year 2, it would be worth:
And so on.
Comparing the discounted costs and benefits gives you the net present value, or NPV of the option. The ‘net’ bit shows that the costs and benefits have been offset against each other. The ‘present value’ bit shows that the costs and benefits have been discounted.
If the overall figure is positive, it shows that the option represents a good investment – so long as all the costs and benefits have been captured properly.
If the overall figure is negative, then it shows the option is likely to make a loss.
If you’re new to economic appraisals or perhaps just a bit rusty, then I hope this post has shown you just how powerful they can be as an ally to good decision-making.
If you’re used to putting business cases together, then why not see if you can make use of these principles, too? They’re sure to add strength to any business case.
As always, if anyone has any questions, feel free to leave any comments below!