Week 1 Lecture: Introduction to CBA (Part2)

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Army Cost Management Certificate CourseMN4354: Financial Analysis & Cost ManagementCost Benefit AnalysisConcept & Course Introduction : 

Army Cost Management Certificate CourseMN4354: Financial Analysis & Cost ManagementCost Benefit AnalysisConcept & Course Introduction Dr. Peter J. Coughlan Associate Professor pjcoughl@nps.edu (571) 296-7662

Introduction to Cost Benefit Analysis : 

Introduction to Cost Benefit Analysis Principles of Cost Benefit Analysis Necessity of Cost Benefit Analysis Process of Cost Benefit Analysis Cost Benefit Analysis: Step-by-Step Revising the CBA Process Challenges and Pitfalls in CBA The Role of the Cost Benefit Analyst Summary 2 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 1: Define and Scope the Problem or Opportunity : 

Step 1: Define and Scope the Problem or Opportunity Clearly define the problem, need, or opportunity that requires a solution Try to use as few words as possible Collaborate closely with decision maker Describe the objective that the effort is intended to accomplish Improve some aspect of an existing process, procedure, or program? Identify a solution to a problem not currently being addressed? Frame the problem as a question “What should the Army use for the next water purification system?” 3 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 1: Define and Scope the Problem or Opportunity : 

Step 1: Define and Scope the Problem or Opportunity Provide the policy rationale How will this improve efficiency? Why are we the right entity to do it? Determine the scope to establish or limit the range of the COAs & analysis Along various relevant dimensions Time, location, organization, function … Questions to ask in reviewing a CBA: Do the problem statement and scope define a clear, unambiguous issue? As appropriate, does the objective reflect an enterprise perspective? Which stakeholders are impacted and who should take action? 4 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 2: Formulate assumptions and identify constraints : 

Step 2: Formulate assumptions and identify constraints Assumptions = necessary evil of cost benefit analysis (or any analysis) Essential to simplify complex world Impossible to know all relevant parameters or details Especially in advance With sufficient time, we can convert some assumptions into facts Or at least reduce uncertainty But time (resources) for analysis limited And even hindsight isn’t truly 20/20 5 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 2: Formulate assumptions and identify constraints : 

Step 2: Formulate assumptions and identify constraints Important to make good assumptions “One disturbing feature of CBA is that, as history unfortunately shows, it offers no automatic protection against heroically bad assumptions” (Stokey & Zeckhauser) But making good assumptions is difficult, given infinite potential sets of assumptions If assumptions are given to you … Challenge them when you disagree If assumptions are not given to you … Clearly identify assumptions made Justify why you made each assumption Fortunately, sensitivity analysis helps correct for inaccurate assumptions 6 Professor Peter J. Coughlan Cost-Benefit Analysis

An Aside on Assumptions : 

Truth: All economic models or analyses are wrong But: Many are nonetheless useful May provide useful insight about a complicated reality Help at least steer decision-maker in the right direction Approach: “Ready, aim, fire, aim again, fire again, …” Make initial “quick and dirty” assumptions (best guess) Conduct complete analysis Identify results and recommendations Go back and change assumptions Conduct analysis again See how results and recommendations change  This is sensitivity analysis (also the OODA loop) Bottom Line: Only assumptions that matter are those that significantly change the results and recommendation An Aside on Assumptions 7 Professor Peter J. Coughlan Cost-Benefit Analysis

Some Examples of CBA Assumptions : 

Some Examples of CBA Assumptions CBA for the Clean Air Act has assumptions on: Number of lives saved for each level of emission reduction Number of illnesses prevented How air quality and visibility will improve CBA on whether Ft. Belvoir library should be closed would have assumptions on: How often people on base want access to a library Value of time lost for personnel driving to off-base library Vehicle and gas cost of extra driving distance Lost productivity and/or performance among those who decide not to use a library at all if they have to go off-base 8 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 2: Formulate assumptions and identify constraints : 

Step 2: Formulate assumptions and identify constraints So what about constraints? Constraints are usually limits placed on resources available for the project Usually beyond control of the analyst Not necessarily beyond the control of the organization Constraints ≈ assumptions that are given to you Budget constraint: $1M to spend Space constraint: 600 sq. ft. available 9 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 2: Formulate assumptions and identify constraints : 

Step 2: Formulate assumptions and identify constraints Questions to ask in reviewing a CBA: Are assumptions/constraints realistic? Do they identify appropriate limits on possible COAs and/or outcomes? What type of analysis was used to formulate the assumptions? Were assumptions provided by an appropriate subject matter expert? Do the assumptions or constraints create bias in favor of certain COAs? Which assumptions have significant influence on the results? How does the recommendation change if important assumptions change? 10 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 3: Define Alternatives : 

Step 3: Define Alternatives Alternatives are COAs that offer a potential solution to the problem Alternatives usually include status quo If problem addresses a future need, there might not be a status quo Doing nothing may always be an option Don’t limit yourself to the alternatives given to you by the decision-maker Seek input from other stakeholders Different perspectives may yield new and different options Be innovative: Think “outside the box” 11 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 3: Define Alternatives : 

Step 3: Define Alternatives Don’t just consider available options, create new potentially better ones See “Create Better Alternatives” by Henderson and Hooper (on Sakai) Focus on objectives & needs before concentrating on specific alternatives When someone buys a drill, they don’t want a drill, they want a hole (or holes)! Think broadly about various ways to satisfy the need or objective Used vs. new, rent vs. own, in-house vs. outsource, go-it-alone vs. partner Create hybrid options that combine best elements of other options 12 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 3: Define Alternatives : 

Step 3: Define Alternatives This step may be iterative as well Analyze the obvious options first Revise options and analyze revisions See if analysis brings others to mind Often must narrow the set of options Number of potential COAs can be huge Analysts typically select at most 6 or 7 Key is to select the right narrow set Throw out infeasible alternatives Let go of what should happen and focus only on what can happen Consider “good enough” alternatives The perfect is the enemy of the good 13 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 3: Define Alternatives : 

Step 3: Define Alternatives Questions to ask in reviewing a CBA: Have all feasible alternatives been considered? Have creative or innovative options been developed? Is the status quo included, or is its absence explained? Is there a promising but unexamined “hybrid” among the alternatives? Do the alternatives span a reasonably wide range of potential solutions? Are alternatives defined clearly & with sufficient detail to allow identification & precise quantification of all impacts? 14 Professor Peter J. Coughlan Cost-Benefit Analysis

Creating Alternatives: An Example : 

Creating Alternatives: An Example Situation Because of BRAC moves, the transportation office will have to process property shipments for three times the number of people that it normally services. The current process is based on face-to-face meetings with individuals and manual preparation of forms. The increased workload level will last for 3-4 years. Conventional Solution Since workload is increasing by a factor of three, the solution is to triple the office's manpower. Innovative Problem Solving Don’t assume that existing policies, procedures, and standards cannot be changed. Consider wide range of solutions, such as: Increase manpower staffing Outsource part of the process Automate the preparation of forms Reduce time for meetings by enabling individuals to conduct part of the interview online Challenge existing requirements for forms and data collection Etc. “Some men see things as they are and ask why. Others dream of things that never were and ask why not.” – George Bernard Shaw

Step 4: Develop Cost Estimates for Alternatives under Consideration : 

Step 4: Develop Cost Estimates for Alternatives under Consideration Must capture total cost of each alternative over relevant timeframe Relevant life cycle often extends beyond POM or budget time horizon Include one-time and recurring costs One-time: Costs of developing the solution and putting it in place Recurring: Costs of performing the new process or solution Ensure apples-to-apples comparison Develop robust cost element structure Use same structure for all alternatives Don’t change scope, assumptions, or constraints from one COA to another 16 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 4: Develop Cost Estimates for Alternatives under Consideration : 

Step 4: Develop Cost Estimates for Alternatives under Consideration Questions to ask in reviewing a CBA: Does the analysis consider all relevant costs to all relevant stakeholders? Does the cost estimate span the appropriate life cycle? Are the cost estimates for each COA structured in a way that supports apples-to-apples comparison? Is the cost estimate backed up by supporting documentation: Data sources identified? Rationale and methodology explained? Analysts/POCs identified? 17 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 5: Identify Quantifiable andNon-Quantifiable Benefits : 

Step 5: Identify Quantifiable andNon-Quantifiable Benefits Benefits = positive results expected from implementing an alternative May be quantitative or qualitative Consult subject matter experts Categories of benefits: Objective or subjective Quantifiable or non-quantifiable Questions to ask in reviewing a CBA: Do the perceived benefits reflect an enterprise perspective? Are the benefits consistent with the problem statement? Has some effort been made to quantify subjective benefits? 18 Professor Peter J. Coughlan Cost-Benefit Analysis

Categories of Potential Benefits : 

Categories of Potential Benefits 19 Professor Peter J. Coughlan Cost-Benefit Analysis Objective Benefits Cost savings Cycle time or material usage Revenue from sales of assets Improved readiness ratings Faster documents processing Subjective Benefits Customer satisfaction Morale Mission capability Quality of service Risk to Army personnel Public perception of the Army All objective benefits are usually quantifiable Some subjective benefits may be quantifiable Some subjective benefits may not be quantifiable

The Truth about Costs and Benefits : 

The Truth about Costs and Benefits There are 3 types of costs and benefits: Easy to quantify Makes for simpler CBA with fewer assumptions Difficult to quantify, but can be estimated Examples: Cost of lost time, probability of future event, value of a life, value of providing child care May require big assumptions No idea how to quantify Examples: Benefit of 4 guns vs. 3 guns on a destroyer, value of readiness, cleaner air, improved aesthetics Need special decision criteria when these impacts are significant 20 Professor Peter J. Coughlan Cost-Benefit Analysis

The Truth about Costs and Benefits : 

The Truth about Costs and Benefits Even if you can quantify impact, can you monetize it? Example: Can measure improved targeting (e.g., increase from 80% to 90% accuracy), but how to convert to dollars? For full calculation of net benefits, costs and benefits must all be measured in the same units (preferably dollars) Anything not traded in a market (life) is difficult to monetize Measuring costs and benefits requires forecasting Very hard to predict precise impacts years in advance “Prediction is very difficult, especially about the future.”– Nobel Prize winning physicist Neils Bohr Often unclear if impact factors into costs or benefits Some so-called “benefits” are also reduced costs Some so-called “costs” are actually reduced benefits 21 Professor Peter J. Coughlan Cost-Benefit Analysis

Measuring Costs and Benefits : 

Measuring Costs and Benefits Start with clear understanding of the process and likely impact of each alternative COA What resources are used to carry out the operation? What stakeholders and/or other processes are likely to be affected? How? Discount the value of costs or benefits in the future Much more on this later … Be sure to consider: One-time and recurring impacts Impacts on all relevant stakeholders Impacts associated with technology, safety, security, etc. The greater the uncertainty, the greater the importance of sensitivity analysis 22 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 6: Define Alternative Selection Criteria : 

Step 6: Define Alternative Selection Criteria Identify criteria upon which optimal alternative will be chosen Along what dimensions will alternative COAs be compared? How will optimal alternative be chosen? Note: Confusing title for this step Not defining “alternative criteria to be used for selecting” Defining “criteria for selecting an alternative” CBAs must contain: Documentation that identifies the recommended decision criteria Extent to which each alternative satisfies each of the criteria 23 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 6: Define Alternative Selection Criteria : 

Step 6: Define Alternative Selection Criteria If all costs and benefits monetizable, this step is straightforward Compare COAs according to their net benefits (total benefits – total costs) Select COA with highest net benefit If not all impacts are monetizable, this step becomes much more difficult Full comparison of COAs requires that all impacts be measure in same units Perhaps reconsider how costs and benefits are measured Perhaps leave certain impacts identified but not monetized 24 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 6: Define Alternative Selection Criteria : 

Step 6: Define Alternative Selection Criteria 25 Professor Peter J. Coughlan Cost-Benefit Analysis Questions to ask in reviewing a CBA: Are selection criteria appropriately tailored to the problem statement? Has consideration been given to both cost and non-cost criteria? How are monetizable and non-monetizable impacts compared? If weighting of selection criteria has been used, are weights appropriate? Do selection criteria seem unfairly skewed to favor one alternative?

Step 7: Compare Alternatives : 

Step 7: Compare Alternatives 7a. Compare COAs using chosen selection criteria to identify the preferred COA 7b. If there is a bill associated with the selected COA, identify the billpayer 7c. Determine 2nd and 3rd order effects and how to manage these impacts 7d. Determine robustness of the conclusions (sensitivity analysis) 7e. Identify high-risk aspects of selected COA & define appropriate risk mitigation measures 26 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 7a: Compare COAs Using Selection Criteria to Identify Preferred COA : 

Step 7a: Compare COAs Using Selection Criteria to Identify Preferred COA 27 Professor Peter J. Coughlan Cost-Benefit Analysis Preferred COA is generally the alternative that with the greatest net benefit (total benefits minus total costs)

Step 7b: Identify the BillpayerStep 7c: Determine 2nd and 3rd Order Effects : 

Step 7b: Identify the BillpayerStep 7c: Determine 2nd and 3rd Order Effects 28 Professor Peter J. Coughlan Cost-Benefit Analysis Billpayer = funding source that has been identified to cover the cost of the recommended COA In most cases, the individual or team developing the CBA won’t have the authority to identify billpayers Requires collaboration with the organization’s resource manager and prioritizer Second and third order effects are the “ripple effect” of the recommended COA Recommended COA may solve the problem, but may also create additional factors that must be addressed Ideally, should have been included in Steps 4 and 5 (identifying and quantifying costs and benefits)

Step 7d: Sensitivity / Robustness Analysis : 

Step 7d: Sensitivity / Robustness Analysis Sensitivity analysis reveals how uncertainties affect the CBA results and recommendations Determines level of confidence in the final conclusions Identifies impact of changes in assumptions, constraints, costs, benefits, criteria weights, etc. Any variable can be subjected to sensitivity analysis Should focus on only those elements for which there is considerable uncertainty or risk If recommendation is the same within a reasonable range of scenario, it is considered “robust” 29 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 7e: Risk Assessment : 

Step 7e: Risk Assessment Risk assessment analyzes the risks that can affect expected outcome or impacts of the selected COA Affect achievement of stated benefits Influence cost of solving the business problem For each risk … Assess likelihood of occurrence Estimate magnitude of effect Develop a mitigation strategy 30 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 7: Compare Alternatives : 

Step 7: Compare Alternatives 31 Professor Peter J. Coughlan Cost-Benefit Analysis Questions to ask in reviewing a CBA: Does CBA demonstrate how preferred COA best satisfies selection criteria? Are 2nd and 3rd order effects identified, and are negative impacts acceptable? How sensitive is the recommendation to changes in assumptions, constraints, costs, benefits, criteria weights, etc.? How large a change can occur before the recommendation changes? Have all reasonably likely risks and their impacts been identified? Are the recommended risk mitigation approaches adequate and affordable?

Step 8: Report Results and Recommendations : 

Step 8: Report Results and Recommendations 32 Professor Peter J. Coughlan Cost-Benefit Analysis The results and recommendations report summarizes the analysis Describes how alternatives were ranked using chosen selection criteria Presents firm recommendation regarding the preferred alternative All data and supporting information should be adequately documented Decision makers and analysts must understand how steps were conducted And how results and recommendations were reached

Elements of a Good CBA Report : 

Elements of a Good CBA Report Fully documented CBA in narrative form How alternative COAs were measured and ranked Which COA is ultimately recommended and why Why & how you chose assumptions & alternative COAs Provide enough detail so analysis could be replicated Spreadsheet used for any calculations Summary presentation for decision maker Can use Army CBA template Table summarizing the major assumptions used Detailing why and how each assumption was made Explaining how each assumption was used Describing how changes in each assumption affect results 33 Professor Peter J. Coughlan Cost-Benefit Analysis

Step 8: Report Results and Recommendations : 

Step 8: Report Results and Recommendations 34 Professor Peter J. Coughlan Cost-Benefit Analysis Questions to ask in reviewing a CBA: Does report contain all key elements (narrative, spreadsheet, summary presentation, table of assumptions)? Is a firm recommendation provided? Does the recommended COA clearly and effectively address the problem? Does report explain how recommended COA best satisfies selection criteria? Are all assumptions fully documented and explained? Does report provide enough information to replicate the analysis?

Overview of the Army CBA Process : 

BENEFITS The total of quantifiable and non-quantifiable benefits Quantifiable benefits Cost Savings Cost Avoidances Non-quantifiable benefits Greater capability Faster availability Better quality Improved morale Other? CBA – Using analysis to make the case for a project or proposal: Weighing the total expected costs against the total expected benefits over the near, far, and lifecycle timeframes from an Army enterprise perspective. BENEFITS MUST BALANCE OR OUTWEIGH COSTS Overview of the Army CBA Process COSTS Quantifiable costs Direct Indirect Initial/Start up Sustainment Procurement Non Quantifiable costs Life/Safety/Health Perception/Image Opportunity Risk/Uncertainty Political

Introduction to Cost Benefit Analysis : 

Introduction to Cost Benefit Analysis Principles of Cost Benefit Analysis Necessity of Cost Benefit Analysis Process of Cost Benefit Analysis Cost Benefit Analysis: Step-by-Step Revising the CBA Process Challenges and Pitfalls in CBA The Role of the Cost Benefit Analyst Summary 36 Professor Peter J. Coughlan Cost-Benefit Analysis

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