2.10 Incremental cost benefit analysis

Introduction

Where project alternatives and options are mutually exclusive (section 2.13), incremental cost benefit analysis of the alternatives and options shall be used to identify the optimal economic solution.

The incremental BCR indicates whether the incremental cost of higher-cost project alternatives and options is justified by the incremental benefits gained (all other factors being equal). Conversely, incremental analysis will identify whether a lower-cost alternative or option that realises proportionally more benefits is a more optimal solution.

Incremental BCR is defined as the incremental benefits per dollar of incremental cost.

Example

The concept of incremental cost benefit analysis is illustrated in the figure below, which considers two options - A and B.

The BCR for option B is 4.0 (4000/1000). Such a value would usually result in the project receiving a High rating for the economic efficiency criteria considered under Land Transport NZ's funding allocation process. The less-costly option A, with a BCR of 7.5 (3000/400), would receive the same High rating. However, incremental cost benefit analysis demonstrates that the incremental benefits gained by supporting option B ahead of option A represent only a small return on the additional cost, as the incremental BCR is 1.7 ((4000-3000)/(1000-400))

Procedure for calculating incremental BCR

The following procedure shall be used to calculate the incremental BCR of mutually exclusive options:

1. Rank the options in order of increasing cost.
2. Starting at the lowest-cost option, consider the next higher-cost option and calculate the incremental BCR of the PV of the incremental benefits to the PV of the incremental costs.
3. If the incremental BCR is equal to or greater than the target incremental BCR, discard the lower-cost option and use the higher-cost option as the comparison basis with the next higher-cost option.
4. If the incremental BCR is less than the target incremental BCR, discard the higher-cost option and use the lower-cost option as the basis for comparison with the next higher-cost option.
5. Repeat the procedure in (b), (c) and (d) until all options have been analysed.
6. Select the option with the highest cost which has an incremental BCR equal to or greater than the target incremental BCR.

Target incremental BCR

The method for choosing a target incremental BCR for testing project options is provided in appendix A12.4.

Sensitivity testing of incremental analysis

The results of the incremental BCR analysis should be sensitivity tested using a target incremental BCR that is 1.0 higher than the chosen target incremental BCR. If this affects the choice of preferred project alternative or option, the results of this sensitivity test must be described and included in the project report. For example, if the target incremental ratio is 3.0, the choice of project alternative or option should also be tested by using a target incremental ratio of 4.0 and report how this affects the choice of option.

Example of incremental analysis

To analyse five mutually exclusive project options against a target incremental BCR of 3.0, first rank the options in order of increasing cost as follows:

Next, calculate the incremental BCR of each higher cost option, discarding those below the target incremental BCR as follows:

Finally select the option that has the highest cost and an incremental BCR greater than the target incremental BCR, which in this example is option D.