• Management decision framework
• Decision guidelines
Financial and economic techniques
These techniques fall into two g roups – fi nancial and economic. The financial techniques were already discussed in Chapter 8 and are just listed below:
• Payback – The length of time it will take for returns from a capital invest- ment to repay the initial capital cost.
• Accounting rate of return ( ARR) – The returns over the whole life of a project assessed by providing a comparison of the overall profit generated by the investment, over its lifespan, with the cost of the investment. This is then expressed as a percentage return.
• Net present value ( NPV) – This approach is the recognition that cash flows have a time value as well as a magnitude and, thus, earlier cash inflows have greater value than later inflows and earlier cash outflows have greater cost than later outflows. The NPV approach converts all cash flows to a single point of reference in time ( the present time) through a process called
discounting. The discounted cash flows can be added together to give an NPV. While NPV is the theoretically correct approach for financially appraising possible investments, it is not always used. The discounting approach is not always well understood and there are doubts about the veracity and reliability of the discount rate used. Many managers prefer methods like payback and ARR because they can easily understand them.
Other techniques for appraising strategic investment projects are termed eco- nomic techniques. Two such techniques are outlined below.
Cost– benefit analysis ( CBA)
The above techniques are concerned only with the income and costs associated with an investment project. However, public services are usually concerned with the benefits to be derived from public service provision as well as financial costs.
CBA is a tool of economic appraisal which involves, as its name suggests, iden- tifying both the costs and benefits associated with a project. In addition, the identification of costs should incorporate social costs as well as financial costs.
As a consequence, CBA is, largely, a tool which is used in the public sector rather than the private sector.
A full CBA for a large infrastructure project like a new motorway or a new urban tram line would utilise a variety of techniques to quantify and monetar- ise the benefits. This is a complex and expensive process which can take many months ( or even years) to complete. Thus, it is usually reserved for l arge- scale infrastructure projects. For smaller ( but not small) projects, a simpler approach can be applied which is as follows:
1. Identify and quantify the financial costs associated with the project and any cost savings that can also be identified.
2. In collaboration with key stakeholders, identify what are seen as the key benefits and social costs that might be associated with the project.
3. Identify and utilise any quantitative data that are already available con- cerning the benefits and social costs associated with the project.
4. Where such data are lacking, undertake a survey of stakeholders asking them to give their opinion of the level of benefits that have accrued to the project on the basis of a number of agreed criteria and utilising a five- point ranking scale.
5. Present all of the results obtained in an appropriate manner to indicate the cost– benefit aspects of the project.
CBA evaluations may also need to address two other important issues:
• Attribution effect – b enefits can be attributed to a number of causal factors.
Thus, it is important that we consider what level of benefits can realistically be attributed to the investment project as opposed to other causal events that may take place at the same time. It may be difficult to obtain sufficient numeric data to have any degree of precision about this issue but it might be possible to get a qualitative “ feel” about what can be achieved. Also, a
CHAPTER 9 Public service strategy 151 scenario analysis may be undertaken using a range of different attribution factors to estimate extent of effect to estimate the extent of impact.
• Distributional effect – CBA is essentially a utilitarian tool which looks at the overall benefits and overall costs associated with a particular invest- ment project. However, with any project there will, inevitably, be gainers and losers. Some individuals/ groups may realise benefits, while others do not. In the same way, some individuals/ groups may incur costs ( financial or social), while others do not. Hence, whatever the overall results of the CBA, it is also important to pay some cognisance to the distribution of benefits and costs associated with the change. Again, in the absence of nu- meric data, having a qualitative “ feel” is important as well as undertaking a scenario analysis similar to the above.
Cost– utility analysis ( CUA)
CUA is a method which is most often used when benefits cannot be expressed in monetary or metric values. It is commonly used in the healthcare sector. As its name suggests, it involves a comparison of options in terms of their costs and the utilities they generate. These utilities are often expressed in terms of what are termed quality- adjusted life years ( QUALYs). QUALYs indicate the average number of years of quality life which a person with a defined health status will be able to live if a certain health intervention is carried out. The intervention could be a new drug, a surgical technique, an implant etc. CUA, therefore, shows the cost of intervention with regard to a specific outcome – quality of life.
It is commonly used in the healthcare sector particularly in relation of pharma- ceuticals but could be applied to some capital investment options.
Capital investment appraisal – conflicting perspectives
As already noted, financial appraisal and economic appraisal of potential capital investments have different perspectives. Financial appraisal is concerned with the financial impact on the service delivery organisation of undertaking the in- vestment, while economic appraisal is concerned with the broader impact on so- ciety of undertaking the investment. These perspectives can sometimes conflict as illustrated by the example of an urban tram system in Case study 9.1
In Chapter 3, there was a discussion of situations in public services where there is a separation of the service commissioner from the service provider and, consequently, different perspectives about service provision. In these situa- tions, to some extent, these different perspectives are reflected in the respec- tive standpoints of the service commissioner and the service provider. Basically, since service- provider organisations are quasi- commercial in nature and have business- type objectives, to achieve the objectives they are more likely to find the financial appraisal technique of discounted cash flow as being of greatest relevance to them. For example, a s ervice- provider organisation needs to assess whether investment in a new piece of equipment will generate savings and/ or additional income streams that will outweigh the costs of investment and, there- fore, improve its financial performance. On the other hand, commissioners are more concerned with need for service and whether a piece of equipment will improve the quantity, quality etc. of service provision. Hence, they are likely to
find the economic techniques of CBA of greatest relevance. In this case, there are likely to be situations where such conflicts arise where projects which are eco- nomically desirable do not provide the delivery organisation with a financially sound case for proceeding.
CASE STUDY 9.1
Financial versus economic evaluation
In a large European city, an old bus line has been replaced by a modern tramway.
Simultaneously, the road- space has been narrowed by about a third. A survey of users of the tramway indicated that the tramway hardly generated any shift from private cars towards public transit mode but it did generate shifts from bus and subway towards the tramway, and from existing roads towards the ring road for cars. The various benefits and costs of these changes were evaluated.
The welfare gains made by public transport users are more than compensated by the time losses to the motorists, and in particular, by the additional cost of road congestion on the ring road. The same conclusion applies with regard to CO2
emissions. The reductions caused by the replacement of buses and the elimination of a few car trips are less important than the increased pollution caused by the lengthening of the automobile trips and increased congestion on the ring road.
The results of the economic evaluation are summarised below:
Initial
( millions of euros) Annual
( millions of euros) Initial investment
Transport company operating surplus
– 444.34
1.00 Benefits to public transport users
Time savings 2.69
Comfort gains 2.69
Subway decongestion 5.71 to 9.43
Car user benefits Welfare losses
Time losses
– 6.73 – 1.83
Externalities
Time losses on ring road – 30.00
Additional CO2 emissions – 0.10
Total – 443.58 – 27.33 to – 23.61
CHAPTER 9 Public service strategy 153