SOCIAL COST BENEFIT ANALYSIS

The economic evaluation of any investment proposal involves an analysis of social profitability arising out of the investment. Apart from the direct financial benefits as a result of revenue which will flow in the national exchequer from duties and taxes levied, there are various indirect benefits which will accrue such as opening up of employment opportunities in downstream/ancillary industries, transport and other secondary and tertiary sectors of commercial activity. This analysis which basically determines whether an investment is worthwhile from the point of view of the society as a whole, involves adjustment on cost and return to the enterprise taking into account the direct and indirect benefits leading to revalued inputs and outputs. Thus, Social cost benefit analysis (SCBA) is a methodology for evaluating project from social point of view. It is also referred as economic analysis and is developed for evaluating investment project from the point of view of the society. In recent years particularly in the developing countries where !"# is playing significant role in economic development (SCBA) is playing a very important role. It is concerned with tactical decision ma$ing within the framewor$ of broad strategic choice defined by planning at the macro level. Rationale for SCBA n !"#A the focus is on social cost and benefits of a project. These often tend to differ from the cost incurred in monetary terms and benefits earned in monetary terms by the project. The principle reasons for discrepancies are $% Market imperfections -: The common market imperfections found in developing countries are Rationin -: rationing means control over the prices and distribution of a commodity. The price paid by the consumer in case of rationing is much less than the price prevailing in the competitive market. !rescription of minim"m #a e rates -% in case of minimum wage rates the wages paid to the labourers are more than what the wages would be in a competitive labour market free from such wage legislation. Forei n e$c%an e re "lations $% the official rate of foreign exchange in most of the developing countries which exercise close regulation over foreign exchange is typically less than the rate that would prevail in the absence of foreign regulation. E$ternalities: - a project may have beneficial external effects, for e.g. a project may create certain infrastructure facilities like roads which benefit the neighbouring areas, or a may have harmful external effects like it may create environmental pollution. !uch benefits/losses are ignored in assessing the monetary benefits to the project sponsors but such externalities are relevant in !"#A because in such analysis all cost and benefits, irrespective to whom they accrue and whether they are paid for or not, are relevant. Ta$es an& s"'si&ies $% in case of monetary cost and benefit of a project taxes and subsidies are to be considered because they are definite monetary gains, however, taxes and subsidies are ignored in case of !"#A because they are considered as transfer payments. Concern for sa(in s -: in case of monetary cost benefit analysis a private firm is least concerned as to how its benefits are divided between consumption and savings, but from social point of

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view, however, the division of benefit between saving and consumption is relevant because while doing !"#A it is assumed that a rupee of benefit saved is more valuable than a rupee of benefit consumed. Thus a higher concern of society for saving and investment is duly reflected in !"#A where higher valuation is put on saving than on consumption. Concern for re&istri'"tion -: while doing monetary cost and benefit analysis a private firm is least concerned about as to how its benefits are being distributed among various groups of the society, but while doing !"#A this factor is kept in mind because it is assumed that a rupee of benefit going to the poor section is considered more valuable than a rupee of benefit going to an affluent section. Merit #ants -: while merit wants are not relevant from the private point of view, they are important from the social point of view. &.g. '()T may prefer to promote an adult education programme even though they are of no benefit to the consumers in market, but from the point of view of the society they are important. A!!ROAC)ES to SCBA *. .. 2. A. i, +, -( Approach / 0 1 Approach Approach Adopted #y 3inancial nstitutions *NI+O Approac% -: the +, -( approach was first articulated in the guidelines of project evaluation. t involves five stages % "alculation of financial profitability of the project, measured at the market prices of resources and output. "alculation of the net benefit of project measured in terms of economic prices. !ome resources are priced at international prices and for others shadow prices are considered. Adjustment for the impact of the project on saving and investment. Adjustment for the impact of project on income distribution. Adjustment for the impact of project on merit goods and demerit goods whose social value differ from their economic values. Financial Anal-sis -: to judge a project from the financial angle, we need following information. "ost of the project 1eans of financing &stimates of sales and production "ost of production 4orking capital requirement and its financing &stimates of working results 5profitability projections6 #reak even point 7rojected cash flow statements 7rojected balance sheets

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Cost of pro.ect -: represent the sum of all items of outlays associated with a project, which are supported by long term funds. t is the sum total of following% 8 /and and site development #uilding and civil work 7lant and machinery Technical know$how and engineering fees &xpenses on foreign technicians abroad 1iscellaneous fixed asset 7reliminary and capital issue expenses 7re$operative expenses 7rovisions of contingencies 1argin money of working capital nitial cash losses

Means of financin -: to meet the cost of the project9 the following sources of finances may be available $% !hare capital 5equity and preference share capital6 Term loan 5rupee term loan and foreign currency loans6 -ebenture capital -eferred credit ncentive sources 5seed capital, capital subsidy etc 6 Tax deferment 1iscellaneous sources 5unsecured loans, public deposits6

Estimates of sales an& pro&"ction -: the starting point for profitability projection is the forecast of sales revenues. n estimating sales it is reasonable to assume that capacity utilisation will be somewhat low in the first year and rise thereafter gradually to reach the maximum level in the third and fourth year of operation. Cost of pro&"ction -: the major components of cost of production are $% 1aterial cost /abour cost 3actory overhead cost

/orkin capital re0"irement an& its financin -: to estimate the working capital requirement and planning for its financing, the following points must be borne in mind $% The built of current assets till the rated level of capacity utilisation is reached. The maximum permissible bank finance.

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1argin requirement against various current assets.

!rofita'ilit- pro.ections -: the profitability projections are based on the following lines 8% "ost of production Total administrative expenses Total sales expenses :oyalty and know$how payable Total cost of production &xpected sales 'ross profit (ther incomes 7reliminary expenses written off 7 0 / before tax 7rovision for taxation 7AT -ividend :etained profits ,et cash accrual

Break e(en point -: it is a point at which the project neither makes profit nor incur losses it is calculated as follow 3ixed cost ;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;; +nit selling price 8 unit variable cost The cash flow statement shows the movement of cash into and out of the firm and its net impact on the cash balances of the firm. The balance sheet, showing the balances in various assets means liability accounts, reflects the financial condition of the firm. ii, Net 'enefit in terms of economic prices !tage two is concerned with determination of economic prices also referred as shadow prices. A key issue in shadow pricing is that in what unit the input or output is expressed i.e. in what unit of currency should benefit or cost be expressed, whether the cost and benefit should be valued at current or constant prices. !hadow price is also known as hidden price, a price that is hidden under monetary cost and benefits. Another issue in shadow pricing is whether a good is tradable or not. 3or a traded good the shadow price is the border price translated in the domestic currency at market exchange rate. The shadow price

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in case of non$tradable good is consumer willingness to pay or cost of production depending on the impact of the project on the rest of the economy. :egarding taxes, the +, -( approach says that if a project result in diversion of non$ traded input from the producer or addition of non$traded input, taxes should be included. f a project augment domestic production by other producers, taxes should be excluded and for fully traded goods taxes should be ignored. So"rces of s%a&o# pricin
ncrease/decrease total consumption ncrease /decrease total production ncrease/decrease export or imports

Basis of (al"ation
"onsumer willingness to pay "ost of production 3oreign exchange value

S%a&o# pricin for specific reso"rces Tra&a'le inp"t an& o"tp"t -: a good is fully traded if its domestic changes in demand or supply affect just the level of import or export. 3or a good being tradable the following condition should be met$% The import quota, if any should not be restrictive. The import supply should be perfectly elastic. There is no surplus capacity in the domestic industry. f, additional demand exist inland, the imported goods even after taking into account the cost of transport from port to the point of inland demand should be less than the marginal cost of local production. The imported input cost should be less than the domestic marginal cost of purchase.

Non tra&a'le inp"ts an& o"tp"ts -: a good is non$tradable if following conditions are satisfied $% f its " 3 prices is greater than its domestic cost of production. ts 3(# price is less than its domestic cost of production.

3or traded goods the shadow price border price translated in domestic currency, at market exchange rate. 3or non$traded goods the shadow price is measured in terms of consumer willingness to pay or cost of production, depending on the impact of project on the rest of the economy. E$ternalities -: since !"#A seeks to consider all cost and benefits, to whomsoever they may accrue external effects should also be taken into account. The valuation of external effects is rather difficult because they are often intangible in nature and there is no market price, which can be used as a starting point.

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La'o"r inp"ts -: the principle of shadow pricing may be applied to labour as well, though labour is considered to be services. 4hen a project takes away labour from other employment, the shadow pricing of labour is equal to what other user of labour are willing to pay. The shadow prices associated with inducing additional production of workers consist of the marginal product of labour in previous employment plus certain other costs. The social cost of associated with import of foreign labour is the wage they command. <owever, a premium should be added on account of foreign exchange remitted abroad by these workers from their savings. Capital inp"t -: the shadow pricing in case of capital investment involves $% 4hat is the value of physical assets= 4hat is the opportunity cost of capital= The value of physical assets is determined the way values of other resources are calculated. The opportunity cost of capital depends on how the capital required for the project is generated. To the extent that it comes from additional savings its opportunity cost is measured by the consumption rate of interest. To the extent that it comes from the denial of capital from the alternative project, its opportunity cost is the rate of return that would be earned from those alternative projects. This is also called as investment rate of interest. Forei n e$c%an e -: the +, -( method uses domestic currency as the nume>raire. !o the foreign exchange impact of the project must be identified and valued. The +, -( method determines the shadow price of foreign exchange on the basis of marginal social value as revealed by the consumer willingness to pay for the goods that are allowed to be imported at the margin. iii, Meas"rement of t%e impact on &istri'"tion -: stage three of the +, -( method is concerned with that given the income distribution impact of the project what would be its impact on saving. To facilitate such assessment, we must first measure the income gained or lost by individual groups within the society. 1ro"ps The +, -( approach seeks to identify income gain and losses by the following. !ro.ect Ot%er pri(ate '"siness 1o(ernment /orkers Cons"mers E$ternal sectors

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Meas"re of ain an& loss -: the gain or loss to an individual group within the society as a result of the project. In case of p%-sical reso"rces is the difference between the shadow price and the market price of each input or output. In case of financial transaction it is the difference between the price paid and value received. i(, Impact on sa(in -: most of the developing countries face scarcity of capital. <ence, '()T of these countries are concerned about the impact of a project on saving and its value thereof. t is concerned with the following aspects $% 'iven the income distribution impact of the project what would be the effect on savings which is equal to$: Change in the income of group as a result of the project%&arginal propensity to save of the group. 4hat is the value of such savings to the society $% The value of a rupee of saving is the present value of additional consumption stream produced when that rupee of saving is invested in the margin. #he consumption stream starts with r (' ( a) and grows annually at the rate of ar forever. Its present value when discounted at the social discount rate $ is) r 23-a4 r23-a4 235ar4 r 23-a4 235ar4n-3 I 6 777777 5 77777777777 5 ---------------- 5 7777777777777 5 -----235k4 235k48 235k4n r 23-a 49235k4 6 7777777777777777777 3- 235ar49235k4 6 r23-a4 777777777777 k : ar

#%ere I 6 social (al"e of a r"pee sa(in r 6 mar inal pro&"cti(it- of capital a 6 rein(estment rate on a&&itional income arisin from in(estment k 6 social &isco"nt rate (, A&."stment for merit an& &emerit oo&s -: merit good is one for which the social value exceeds the economic value. 3or e.g. a country may place a higher social value than economic value on production of oil because it reduce dependence on foreign supplies. n case of demerit good the social value is less than the economic value. 3or e.g. alcoholic products. The method of adjusting for the difference between social value and economic value is as follow $% &stimate the economic value "alculate the adjustment factor as the difference between the ratio of social value to economic value and unity.

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1ultiply the economic value with the adjustment factor to obtain the adjustment Add the adjustment to net present value of the project.

The stream of social costs and benefits is obtained after the five steps described above. The discount rate at which the present value of social costs?social benefits , is called as social rate of return5!::6. !:: is then compared with the required rate of return. The !:: of a project forgone may be taken as the desired rate of return. n absence of the opportunity return, the consumption rate of interest can be taken as the cut$off rate. LITTLE- MIRRLEES A!!ROAC) There is a considerable similarity between the +, -( approach and the /$1 approach as both the approach call for $% "alculating shadow pricing "onsidering the factor of equity +se of -"3 analysis

#ut despite of these similarities there are some differences also $% #he *+I,! approach measures cost and benefits in term of domestic rupees price whereas the -.& approach measures cost and benefit in terms of international prices. #he *+I,! approach measures cost and benefit in terms of consumption whereas the -.& approach in terms of uncommitted social income. #he stage by stage approach of *+I,! focus on efficiency/ saving/ and redistribution consideration in different stages. #he -.& approach/ however/ ta$e these consideration together. S)A+O/ !RICIN1 #raded goods and services $% the shadow prices of traded goods and services are the border price. f a good is exported its shadow price is the 3(# price and if a good is imported its border price is the " 3 price. f foreign demand is not perfectly elastic the marginal export revenue is substituted for the 3(# and if foreign supply is not perfectly elastic, the marginal import cost is substituted for " 3 prices. +on traded goods and services 8% accounting prices for non$traded good are defined in terms of marginal social cost and benefit. The marginal social benefit is the value of an extra unit of good from social point of view and the marginal social cost of a good is the value in terms of accounting prices of the resources required to produce an extra unit of the good. To determine the accounting price of a non traded input the following formula is to be used $% ./2 marginal social cost @ */2 marginal social benefit rate$% S01 2 c3 ( '4s (c.m) 4here !4: ? shadow wage rate "> ? additional resources devoted to consumption /abour $% the /$1 approach suggest the following formula for calculating the shadow wage

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*/s c m

? value of a unit committed resources ? consumption ? marginal product of wage earner

SCBA BY FINANCIAL INSTIT*TIONS The all ndia term leading financial institutions$$$ -# , 3" , 0 " " $$ scrutinise projects from larger social point of view. " " was perhaps the first financial institution to introduce a system of economic analysis as distinct from financial profitability analysis. 3" adopted a system of economic appraisal in *ABA. 3inally, -# also introduced a system for economic appraisal of project financed by them. Though there are some minor variations, the three institutions follow essentially a similar approach, which is simplified version of the /$1 approach. -# , in its economic appraisal of industrial projects, consider three aspects% &conomic rate of return &ffective rate of protection -omestic resource cost 5conomic rate of return The economic rate of return is the internal rate of return of the stream of social cost 0 benefit. The method followed by -# to calculate the economic rate of return id a similar approach, which is a simplified version of /$1 approach 0 is described as follows% nternational prices are regarded as economic prices so market price is substituted with international prices for all non$labour input and output. 3or tradable items where international prices are already given " 3 prices are used for inputs 0 fob prices are used for output. 3or tradable items where international prices are not directly available and for non$tradable items social conversion factors are used to convert actual rupee cost into social cost. 'enerally, the social cost of tradable component is obtained by multiplying it by a factor of */*.C. !ocial cost of labour cost is obtained by multiplying it by a factor of D.C. !ocial cost of the residual component is obtained by multiplying it by a factor of D.C. Social con(ersion factors 2SCB4 or proportion of t%ree components; tra&a'le 2T4; la'o"r 2L4; an& resi&"al 2R4 tem /and #uilding and construction ndigenous equipment Transportation !"3 or proportions !"3? */*.C 7roportions% t?D.C, l?D..C, r?D..C !"3 ? D.BD proportions% t?D.EC, l?D..C, r?D.*D

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&ngineering and know how fees #ank charges 7reoperative expenses /abour !alaries 4ater, fuel, etc. &lectricity -omestic stores (ther overheads !"3 ? D.FD :epairs and maintenance

!"3 ? *.CD !"3 ? D..D !"3 ? *.DD !"3 ? D.CD !"3 ? */*.C 7roportions% t?D.CD, l?D..C, r?D..C 7roportions% t?D.B*, l?D.*2, r?D.*E !"3 ? F.D !"3 ? */*.C

Effecti(e rate of protection The extent to which a project is sheltered is measured by the effective rate of protection 5&:76. t is calculated as follows% )alue added at domestic prices 8 value added at world prices ;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;; )alue added at world prices The ratio is multiplied by *DD to express the &:7 in percentage terms. The data required for calculating the &:7 may be arranged as follows% At &omestic prices A, Sellin price B, Inp"t cost Traded ,on$traded C, <al"e a&&e& The domestic selling price is net of taxes and excise duties but inclusive of a reasonable selling commission. The selling price at world price is the " 3 price for import and fob for exports. The input cost consist of the cost of the following inputs% :aw material and stores 7ower, fuel and water :epairs and maintenance 7art of administrative overheads and expenses !elling expenses At #orl& prices

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t may be emphasised that when the value added at domestic prices is same as the value added at world prices, the &:7 is Gero. n such a case it implies that a project does not enjoy any protection from international competition. 4hen the value added at domestic price is higher than the value added at world price, as is often the case, the &:7 takes a positive value. "learly the higher the value of &:7, the higher the implied protection enjoyed by the project. t is generally agreed that the extent of protection given to a project should not exceed 2D per cent. ,omestic resource cost The domestic resource cost is calculated as follow $% )alue added at domestic price ;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;;; H &xchange rate )alue added at world prices +omestic Selling price !perating costs :aw materials 5net of duties 0 taxes6 7ower, fuel, and water :epair and maintenance Administrative overheads and expenses !elling expenses Capital costs "harge on capital employed -epreciation The capital employed consists of fixed assets plus working capital. t is broken down into indigenous and imported components. After deducting taxes and duties from both the components, the charge on capital employed is imputed as *D I. n case of depreciation capital equipment are split into indigenous and imported components. After deducting taxes and duties depreciation is taken as EI. The relationship between &:7 0 -:" is $% -:" ? 5&:7@*6 &xchange rate Importe&

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