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Principles of Cost Measurement

2.5.8Costs should generally be valued on an opportunity cost (or economic cost) basis. The opportunity cost of using a resource is its value in its next best alternative use (i.e. its most valuable use other than as proposed in the project). In other words, the cost to the economy of using a resource in one investment is the benefit foregone by keeping it from use in the next best investment opportunity. An emphasis on opportunities foregone is central to the way of thinking that underpins all the costings in an economic appraisal.
2.5.9It is important to explore what opportunities may exist. An example is to use land in a different, more valuable, way than in its current use. Another is the alternative use of an employee's time. Full time equivalent (FTE) costs should be used to estimate the costs of employees' time, which should include not only basic salaries but also accommodation, superannuation, employer's national insurance contributions, allowances, and any other overheads.
2.5.10Current market prices should generally be used to measure opportunity costs, because they reflect what firms, households or other entities are willing to pay to draw resources into the next best alternative use. Households and firms generally know their own costs and preferences best and have strong incentives to respond to market signals by putting their resources to their best possible use.
2.5.11It is important to cost all the public resources used in each option, not just those for which cash will change hands, or which fall to a particular Government Department or budget. Resources should be costed even if they are already owned by the public sector; they have an opportunity cost because they could be sold or put to another use.
2.5.12Costs and benefits considered should normally be extended to cover the period of the useful lifetime of the assets encompassed by the options under consideration, although, if the appraisal concerns the contractual purchase of outputs and outcomes (e.g. in PFI), the appraisal period may be different.
2.5.13

It can be useful to distinguish between fixed, variable, semi-variable and step costs:

  • Fixed costs remain constant over wide ranges of activity for a specified time period (such as an office building);
  • Variable costs vary according to the volume of activity (external training costs, for example, varying with the number of trainees);
  • Semi-variable costs include both a fixed and variable component (maintenance is an example, where there is usually a set planned programme, and a responsive regime whose costs vary in proportion to activity, i.e. the number of call-outs); and,
  • Semi-fixed, or step costs, are fixed for a given level of activity but they eventually increase by a given amount at some critical point (e.g. after telephone call volumes reach a certain level, a new call centre may be required).
2.5.14Categorising costs in this way can aid sensitivity analysis, but the categorisation should be used carefully. A cost that is fixed relative to one factor may change with another. More complex modelling may be required to describe how costs change over time and with different variables.
2.5.15For substantial proposals, the relevant costs are likely to equate to the full economic cost of providing the associated goods and services, and for these proposals, the full economic cost should be calculated, net of any expected revenues, for each option. The full cost includes direct and indirect costs, and attributable overheads. The full cost of the base case for each option (i.e. the best estimate of its costs and benefits), as built up in this way, should also equal the total of the analysis of costs into their fixed, variable, semi-variable and stepped elements. A dual cost analysis of this kind enables opportunity costs to be fully considered, and sensitivity analysis to be conducted later on.
2.5.16Appraisals leading to short-term or non-strategic decisions are likely to have a smaller set of relevant costs. The relevant costs are likely to be those that are marginal to the organisation's overall activity.
2.5.17Cost estimation can be difficult, depending on the class of costs under consideration. It will normally involve input from accountants, economists and other specialists, depending on the type of appraisal. The appraiser needs to understand and communicate clearly the scope of the appraisal to ensure that specialists provide relevant cost information, whilst ensuring that opportunities have been thoroughly explored.
2.5.18

Depreciation and capital charges should not be included in an appraisal of whether or not to purchase the asset that would give rise to them. This is because:

  • Depreciation is an accounting device used to spread the expenditure on a capital asset over its lifetime.
  • Capital charges reflect the opportunity cost of funds tied up in capital assets, once those assets have been purchased. They are used to help test the value for money of retaining an asset.

Neither depreciation nor capital charges should be included in the analysis of economic costs and benefits informing the decision whether or not to purchase the asset in the first place. However, once that decision has been taken, they should be accounted for separately in relevant resource budgeting analyses and other affordability assessments.
2.5.19Even where an appraisal covers the full expected period of use of an asset, the asset may still have some residual value, in an alternative use within an organisation, in a second-hand market, or as scrap. These values should be included, and tested for sensitivity, as it may be difficult to estimate the future residual value at the present time.
2.5.20Base case costs and benefits should reflect opportunity cost values. Affordability analysis should be conducted separately. Cash flows are important for this purpose. Proposals are also likely to require resource budgets, so that it is clear how they will be funded, and, ex post, accounted for. However, cash flows and resource budgets do not reflect opportunity costs. See Step 9 for further details on appraisal of affordability.
2.5.21Public spending should be cost-effective, that is, the ratio of outputs to costs should be satisfactory in relation to experience of similar cases. Judgement of this is aided by comparing the ratios for the proposal in view with those for other similar cases e.g. cost per job, cost per m2 of floor space, cost per trainee place, cost per dwelling. If unit costs appear too high, the costings may need to be reviewed, or the proposal re-designed or rejected.
2.5.22Assessment of cost-effectiveness is an important element in appraisals concerning assistance to the private, voluntary and community sectors and is explained in more detailed in section 4.4 below.
2.5.23Expenditures that have already been incurred on goods and services, or resources that are already irrevocably committed, should be ignored in an appraisal. They are "sunk costs". What matters are costs about which decisions can still be made. However, the latter includes the opportunity costs of continuing to tie up resources that have already been purchased. For example, assets such as land, buildings, machinery or vehicles that are already owned have an opportunity cost, because, if the project were not to proceed, these assets could be sold or put to an alternative use. Current market values of such assets should therefore be included as opportunity costs when appraising any option that will make use of them.

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