4.

Identifying Costs and Benefits in Agricultural Project

In project analysis, the objectives of the project provide the

standard against which cost and benefits are defined.

Simply put, a cost is anything that reduces an objective, and

a benefit is anything that contributes to an objective.

The problem with such simplicity, however, is that each

participant in the project has many objectives.

1
 Cont.

A farmer may have the following objectives at certain period of

time:
 Increase household income/ Net incremental benefit;

 Educating children;

 Reducing work hours (consuming more leisure);

 Paying debt;

 Reducing risk;

 Meet social obligations; Etc

2
 Cont.

All these considerations affect a farmer’s choice of

cropping pattern and thus the income generating capacity

of a project.

Yet all are sensible decisions in the farmer’s view.

However, since it is difficult to incorporate all objectives, we

will judge the effect of a project on the incremental

income & thus, on the new income generated by the

3
project
 Cont.

A private business firm can have objectives such as:

 Maximizing net income (profit);

 increasing market share;

 improving customer satisfaction;
 reducing risk, etc.

4
 Cont.

A society or a nation as a whole may want to achieve the

following objectives as:
 Increasing national income (growth objective);

 Ensuring equitable distribution between persons, regions,

generations, etc. (distributional objective);
 Improving balance of payments ;
 Improving regional integrity;

5
 Cont.

 Reducing inflation;
 Reducing unemployment; and
 Maintaining environment, etc.

However, the problem with such a number of objectives is there is

no formal analytical system for project analysis that could possibly
take into account all the various objectives of the society or private
business firm.

6
 Cont.

Thus, we will take maximization of net incremental income

(profit) for a private firm and maximization of national
income for a nation as the fundamental objectives in the
analysis of a project.

7
 Cont.

In financial analysis, which is conducted from the viewpoints

of the private project-operator, we will evaluate the project

in terms of its contribution to the net income (profit) of the

private owner (which is usually considered to be the

fundamental objective of the private business firm).

8
 Categories of Costs and Benefits

Direct transfer payments: are entries in financial accounts

that really represent shifts in claims to goods and services
from one entity in the society to another and do not reflect
changes in national income.
Common transfer payments in projects are: taxes, subsidies,
loans, and debt services (the payment of interest and
repayment of principal).

9
 A. Taxes

Payment of taxes is clearly cost in financial analysis.

When a firm pays a tax, its net benefit is reduced.

But the firm’s payment of tax doesn’t reduce the national income.

Rather it transfers income from the firm to the government so that

this income can be used for social purposes presumed to be more

important to the society than the increased individual consumption

(or investment) had the firm retained the amount of the tax.

10
 Cont.

Thus, in economic analysis, we would not treat the payment

of taxes as a cost in project accounts.

Of course, no matter what form a tax takes, it is still a

transfer payment- whether a direct tax on income or an
indirect tax such a sales tax, an excise tax, or a tariff or duty
on an imported input for production.

11
 Cont.

But, whether a tax should be treated as a transfer payment or

as a payment for goods and services depends on whether the
payment is a compensation for goods and services (e.g.
water rates) needed to carry out the project or merely a
transfer, to be used for general social purposes of some part
of the benefit from the project to the society as a whole.

12
 B. Subsidies

Subsidies are simply direct transfer payment that flow in

the opposite direction from taxes.

If a farmer is able to purchase fertilizer at a subsidize

price, that will reduce his costs and thereby increase his

net benefits thus it is a benefit but the cost of the fertilizer

in the use of the society’s real resources remain the same.

13
 Cont.

Again it makes no difference what form the subsidies takes.

One form is that which lowers the selling price of inputs

below what otherwise would be their market price.

But a subsidy can also operate to increases the amount a

firm receives for what he sells in the market, as in the case

of a direct subsidy paid by the government that is added to

what the firm receives in the market.

14
 Cont.

In other cases, the market price may be maintained at a

level higher than it would otherwise be by, say, levying
an import duty on competing imports or forbidding
competing imports altogether.

15
 Cont.

Although it is not a direct subsidy, the difference between the

higher controlled prices set by such measures and lower
price of competing imports that would prevail without such
measures does represent an indirect transfer from the
consumer to the firm.
In all these cases, subsidies are simply transfer payments and
will not be included as a benefit in economic analysis.

16
 C. Credit transactions

From the standpoint of the project owner, receipt of a loan

increases the production resources he has; payment of interest and

repayment of principal reduce them.

But from the standpoint of the economy, these are merely

transfers of control over resources from the lender to the borrower.

The financial cost of the loan occurs when the loan is repaid, but

the economic cost occurs when the loan is spent.

17
 Cont.

Note that financial analysis of projects is based on cash flow

analysis.

For every period during the expected life of the project, the

financial analyst estimates the cash likely generated by the

project and subtracts the cash likely to be needed to sustain

the project.

The net cash flows result in financial profile of the project.

18
 Cont.

Because the financial evaluation of a project is based on

cash flows, omits some important items that appear in

profit-and-loss statements.

In economic analysis, debt service is treated as a transfer

within the economy even if the project will actually be

financed by a foreign loan & debt service will be paid

abroad.

19
 Cont.

This is because of the convention of assuming that all

financing for a project will come from domestic sources and

returns from the project will go to domestic residents.

Thus convention separates the decision of how good a project

is from the decision of how to finance it.

Major form of direct transfer payments in project is receipt of

loan which increases production resources.

20
 Cont.

Repayment of principal and Payment of interest are costs to the

owner but it is cost in economic analysis when only the loan is
spent.

But financial analysis of projects is based on cash flow analysis

which omits some important items that appear in profit and loss
statements.
In project analysis, costs are considered when they are spent.
But in profit and loss statement of an established firm, costs are
accounted when they are incurred.
21
 D. Depreciation allowances

Depreciation is the amount in decreasing of the total (initial)

value of a material due to its service value.

Depreciation may not correspond to actual use of resources

should therefore be excluded from the cost stream in

economic analysis.

The economic cost of using an asset is fully reflected in the

initial investment cost less its discounted terminal value.

22
 Cont.

Depreciation is considered as a cost in only financial analysis but it is

not considered in economic analysis because it is part of transfer

payment.

Suppose the cost of machinery with initial cost 10,000 birr and life

time of machinery is 10 years.

Annual depreciation cost is 1,000 birr using straight line method. 1,000

is saved amount of a machine, then we can replace the machinery

after 10 years because we gain and save 1000 birr every year.

23
 Costs of inputs

Physical goods: - construction materials, raw materials, etc.

Here, valuation is not a problem but the problem is associated with planning the

required amount of input.

Need to adjust market price in to economic price by removing the effects of

market distortion.

Eg. The price of shoe = 90 (producing value), there is 10 birr tax by government =

100birr. Economic cost is 90 birr. Financial cost is 100 birr.

If government subsidizes 30 birr to project: Financial cost = 70 birr. Economic cost

= 90 birr.

24
 Cont.

Labor:- skilled and unskilled.

Here the problem of valuation may arise when the project

uses family labor.

In economic analysis always we have to find economic price

of labour.

25
 Cont.

Suppose a project use labor that was previously employed in

agricultural sector. The project is paying a wage rate of 15 birr

per day per worker. Let the project employed 100 workers.

The financial cost of the project is 1500 birr per day.

Assume also each 100 labour was producing 10 birr value of

output per day before being employed in the project. Then

economic cost of using labour will be 1000.

26
 Cont.

Economic cost means costs which reduce national economy.

Economic benefit means benefits which increase national economy.

The country is losing 10 birr per day because the project takes these

workers.

The 10 birr value is called the opportunity cost of labour.

Opportunity cost is the amount of income forgone from the next

best alternative use.

27
 Cont.

Land: - it is not difficult to identify.

The problem is with valuation of land because of the very special kind

of market conditions that exist when land is transferred from one

owner to another.

In financial analysis, we directly take the market price if the use of

these inputs involves cash outlays.

If there are no cash payments for some of these inputs, it will not be

considered as a cost.

28
 Cont.

In economic analysis, however, since the use of these inputs

is related with the use of real resources, they will be valued at
their economic price and entered into economic accounts.

In this case also we take the opportunity cost of the land that
the amount of income would be obtained if the land was
used for some other alternative use.

29
 Cont.

The problem is valuation of the land due to special kind of

land market conditions.
In financial analysis take market price for inputs, and if no
market prices, then we say it has no cost.
But in economic analysis, we take opportunity cost or
economic prices of that input.

30
 Contingency allowance

Sound project planning requires that provision be made in

advance for possible adverse changes in physical conditions or

prices that would add to the baseline costs.

Contingency allowance may be divided into those that provide for

physical contingencies and those for price contingencies.

In turn, price contingency allowances comprise two categories,

those for relative changes in price and those for general inflation.

31
 Cont.

Physical contingency: allowance is a real cost & will reduce the

final goods and services available for other purposes, i.e. it
will reduce the national income and, hence, is a cost to the
society.
To the extent that physical contingency allowance is a part of
the expected value of the project costs, it should be included
in the economic analysis.

32
 Cont.

Physical Contingencies is a real cost and will reduce the final

goods and services available for other purposes.

It is cost in both financial and economic analysis.

Price contingency (Change in price): In most practical cases, in
project cost estimation it is assumed that there will be no
relative changes in domestic or international prices and no
inflation during the investment period.

33
 Cont.

It would clearly be unrealistic to rest project cost estimates only on

the assumptions of stable price.

Relative changes in price- A rise in the relative cost of an item implies

that its productivity elsewhere in the society has increased, that is, its

potential contribution to national income has risen.

Thus, costs that may be incurred due to possible relative changes in prices

will be considered as a cost in both financial and economic analysis.

34
 Cont.

If the market is perfectly competitive, allocation of resources to

alternative uses will be at a point where the MVP of that resource is

equal in alternative uses.  

MVPX = MPVY = -----

Resources will then have been allocated through the price

mechanism so that the last unit of every good and service in the

economy is in its most productive use or best consumption use.

35
 Cont.

No transfer of resources could result in greater output or more

satisfaction.

But if there are any changes in relative price, the value of

commodities will change as the marginal utility in

consumption changes.

The same holds true for resources.

Price of inputs may increase or price of out puts may decline.

36
 Cont.

Costs may be incurred due to possible relative

changes in prices and will be considered as a cost in

both financial and economic analysis because it is a

real change.

Relative change in price of inputs affects the relative

value of inputs and also affects value of output.

37
 Cont.

General change price (inflation), however, does not affect national

income in real terms & in project analysis the most common means

of dealing with it is to work in constant prices, on the assumption

that all prices will be affected equally by any rise in the general

price level.

If inflation is expected to be significant, however, provision for its

effects on project costs needs to be made in project financial plan

so that an adequate budget is obtained.

38
 Cont.

Do not affect national income thus it is not considered in

economic analysis because it is not real change it is simply

a nominal (supposed) change.

All prices are affected equally.

If it is significant, provision for its effect on project cost

needs to be made so that, an adequate budget is obtained.

39
 Sunk costs

Sunk costs are those costs incurred in the past upon which a

proposed new investment will be based.

When we analyze a proposed investment, we consider only

future returns to future costs; expenditure in the past, or sunk

costs, do not appear in both financial and economic accounts.

Money spent in the past is already gone; we do not have as

one of our alternatives not to implement a completed project.

40
 Cont.

However, ill-advised they may have been, such costs have already

been incurred and can no longer be avoided.

Ignoring sunk costs sometimes leads to seemingly paradoxical, but

correct, results.

If a considerable amount has already been spent on a project, the

future returns to the costs of completing the project may be

extremely high, even if the project should never have been

undertaken.

41
 Cont.

 'Bygones are bygones', only costs that can still be avoided

matter in this regard.
 In project analysis always we have to look in to future
earning or benefit and future cost by forgetting the past cost
and benefits.
 It does not appear in both financial and economic accounts.

42
 Tangible benefits

Increased production:- increased physical production is the

most common benefit of projects.

 Whether the increased output is marketed or consumed

at home, it represents the benefit of a project.

Quality improvement:- to account as a benefit in both

financial and economic analysis this must be reflected in the

market price of the good.

43
 Cont.

 Change in time of sale:- In some projects, especially in agriculture,

benefits will arise from improved marketing facilities that allow the
product to be sold at a time when prices are more favorable
(Marketing function that adds time utility).
 The benefits of these projects arise out of the change in “temporal
value”.
 Change in location of sale:- Such projects as investment on transport
facilities to carry products from the local area where price are low to
distant market where prices are higher.

44
 Cont.

 The benefits of such projects arise from the change in

“location value”.
 Change in product form (grading & processing):- projects
involving agricultural processing industries expect benefits to
arise from a change in the form of the agricultural products.
 Cost reduction (through mechanization):- The classical
example of a benefit arising from cost reduction in projects is
the gained by investment in agricultural machinery to reduce
labor costs.
45
 Cont.

 In other industries also use of improved technologies that

substitute labor could be an incremental benefit from the
reduction in cost of labor as compared to the 'without'
condition.
 Losses avoided:- The ‘with and’ without’ project analysis
tends to point out such costs avoided by the project.

46
 Cont.

 Similarly, risks avoided or reduced can be considered as

benefits; sometimes such benefits are reflected by output
increment through loss reduction.
 Since all these benefits are real increase in value of
commodities or reduction in costs, they will be considered in
both analyses.

47
 Secondary costs and benefits (externalities)

Projects can lead to benefits created or costs incurred outside

the project itself.

Economic analysis must take account of these external, or

secondary, costs and benefits so they can be properly

attributed to the project investment.

It is not necessary to add on the secondary costs and benefits

separately; to do so would constitute double counting.

48
 Cont.

Thus, instead of adding on secondary costs and benefits, we have to

adjust the market prices into ‘economic’ prices there by in effect

converting them to direct costs and benefits.

Although using efficiency prices based on opportunity cost or

willingness to pay greatly reduces the difficulty of dealing with

secondary costs and benefits, there still remain many valuation

problems related to goods and services not commonly traded in

competitive markets.

49
 Cont.

 Price effects caused by a project are also part of externalities.

 The project may lead to higher prices for inputs it requires and
lower price for the outputs it produces.
 What are known as "forward linkages effects" thus may occur in
industries that use or process a project's output, and backward
linkages in industries that supply its inputs, in that such
industries are encouraged or stimulated by increased demand
and higher prices for their output or lower prices for their inputs.

50
 Cont.

Conversely, other producers may lose because they now

face increased competition, and other users of inputs
required by the project may have to pay higher prices.

The project may have wide-ranging repercussions on

demands of inputs and outputs and cause gains and
losses for producers and consumers and other than
those involved in the project itself.

51
 Cont.

Examples of such costs and benefits are:

 Technological spill-over or technological externalities;

 negative or positive ecological effects in construction of dam: -

it can increase spread of schistosomiasis and malaria, it can

increase/decrease in fish catches, many down-stream effects,

etc and

 multiplier effects of projects - if there had been excess capacity.

52
 Intangible costs and benefits

Almost all projects have costs and benefits that are intangible.

These may include creation of job opportunities, better health

and reduced infant mortality, better nutrition, reduced incidence

of disease, national integration, national security, etc.

These benefits do not, however, lend themselves to valuation.

53
 Cont.

 These are not accounted in financial analysis but have to be

accounted in economic analysis at least in qualitative terms.
 Likewise in the cost side, a project may displace workers, it
may increase disease incidences, it may increase regional
income inequality, it may destroy or reduce the scenic
beauty of an area, etc.

54
 Cont.

All these are intangible costs of the project, which are not

captured by or not reflected in the market prices.

All these intangible benefits and costs must be carefully

identified and where possible, be quantified although

valuation is impossible.

These costs and benefits will not usually appear in financial

accounts and are excluded from financial analysis.

55
 Cont.

However, they should be included in the economic analysis at least in

qualitative terms if they are significant and measurable.

Whether or not externalities are quantified, they should at least be

discussed in qualitative terms.

In practice, it is not feasible to trace all externalities arising from

such market imperfections: the analyst can only hope to capture the

grosser distortions on more immediately affected changes in output.

56
 Cont.

Externalities of various kinds are thus clearly troublesome,

and there is no altogether satisfactory way in which to deal

with them.

There is no reason simply to ignore them and if they appear

significant, to measure them.

In some cases, it is helpful to internalize externalities by

considering a package of activities as one project.

57
 International effects

Some external effects of projects may extend beyond the borders of

the country concerned.

Effects on world prices of traded goods (favorable or adverse),

environmental effects, etc such external effects on other countries are

similar in nature to the externalities within the country and raise

similar problem.

Whether accounts should be taken of these benefits accruing to, or of

costs imposed on, other countries depend on value judgment.

58
 Cont.

 Appraising such a project requires several steps.

 First, each separable component needs to be appraised

independently.

 Second, each possible combination must be appraised.

 Finally, the entire project, comprising all of the separable

components, must be appraised as a package.

59
 With and without project comparison

Project analysis tries to identify and value the costs and benefits
that will arise with the proposed project and to compare them
with the situation as it would be without the project.
The difference is the incremental net benefit arising from the
project investment.
This approach is not the same as comparing the situation
"before" and "after" the project.
The before-and-after comparison fails to account for changes in
production that would occur without the project and thus leads
to an erroneous statement of the benefit attributable to the
project investment.

60
 i. Slow growth without the project
A change in output without the project can take place in
two kinds of situations.
Most common-when production in the area is already
growing only slowly, and will probably continue to grow
during the life of the project. E.g. the first Livestock
Development Project in Syria (Sheep flock grow at1 % wo
the project). Then why project?
Objective of intervention-intensify growth With the
project, growth projected to be a rate of 3 %.
Contribution of the project=2 %. If the analyst use
before-and after scenario, would have erroneously
attributed the total increase in sheep production to the
project investment. i.e. 3%. 61
 ii. For the case of loss avoid projects

Projects prepared to avoid losses rather than production

increment. E.g, Sea Defense Project in Guyana, a project designed
to protect strips from soil erosion.
But a simple before-and-after comparison would fail to identify
this benefit.
In some cases, an investment to avoid a loss might also lead to an
increase in production, so that the total benefit would arise partly
from the loss avoided and partly from increased production.
Progressive salinization as a result of heavy irrigation in Pakistan.
Seepage. Aim of the project-arrest salinization
The combination of measures would not only avoid a loss but also
lead to an increase in production. B&A would fail.

62
 iii. For the case of altered projects

If no change in output is expected in the project area without the

project, then the distinction between the before-and-after
comparison and the with-and-without comparison is less crucial.
In the Kemubu Irrigation Project in northeastern Malaysia, a pump
irrigation scheme was built that permitted farmers to produce a
second rice crop during the dry season.
Wo project-grazing. From this value must be deducted the value
forgone from the grazing and the production of cash crops.
Only the incremental value could be attributed to the new
investment in pumps and canals. But B&A comparison fails to
consider grazing.

63
 iv. No change in output without the project

Without the project there may be no economic use

of the area at all.
E.g. Settlement projects
If new settlers base their livelihood at an area which
is formerly idle without economic value (bare land).
In this case, the output without the project would be
the same as the output before the project.
This is the point where the two project comparisons
are identical.

64