A comprehensive Cost/Benefit Analysis provides managers, users, and designers with the information necessary to evaluate alternative system development, enhancement, or improvement approaches. The analysis provides the estimated costs of developing and operating each feasible alternative and the benefits to be derived from each.

Therefore, Cost/Benefit Analysis is not simply a method of determining the least cost alternative, but a means of determining the most cost effective alternative.

Each Cost/Benefit Analysis must begin with the determination of the operational costs of the installed system - the "status quo" alternative. This critical step sets the stage for comparing alternatives against baseline costs.

Costs for the current environment are expressed in terms of total system operational costs, including State costs, projected over the systems life in accordance with the approved State plan and previously approved APDs, if applicable. This requires that States measure current costs and project anticipated costs over a period of time matching the systems life of the project.

Most "status quo" cost worksheets will reflect primarily recurring costs, such as systems support personnel and monthly lease expenses.

However, non-recurring costs may also apply. For example, the State may have approval for contract support services to meet special year-end processing demands.

Special problems arise when the status quo is no longer a satisfactory solution. For example, if the State does not redesign the current system for distributed processing, current processing workload growth will require a major systems augmentation (non-recurring capital expenditure for equipment purchase) and new systems facility (either a non-recurring capital expenditure or recurring site lease expenses, or both) - and may still fail to meet Federal program requirements.

In such instances, the status quo reinforces the need to develop new systems. By costing in the capital expenditure on the status quo alternative, the true systems life cost of the status quo is revealed. By claiming the "cost avoidance" as a benefit of the alternatives, achievement of the cost avoidance will later be measured, as the State compares actual to projected costs and benefits.

A State may at times be required to determine whether to characterize an element as a cost or a benefit. If so, the State should consider the following. If a "benefit" can be depicted as directly affecting a cost element of the status quo and can be predicted with virtual certainty to occur, then it should be factored into the cost side of the analysis. An example would be higher staff costs when a reduced personnel ceiling has been approved for the new system.

On the other hand, cost elements to be characterized as benefits are normally costs or savings which are more indirect or hidden, which may or may not accrue, and which must be monitored. Benefits can derive from elements such as greater productivity, reduced training costs, less overtime, and reduced staffing not planned and approved at the time of the cost/benefit analysis.

Following baseline costing, total systems life costs, including State costs, are defined for each alternative of the two to four found viable in the Feasibility Study's alternatives analysis.

For each alternative approach, costs are calculated for both the system developmental and operational stages. Non-recurring costs will dominate the early months and years of the developmental process. However, as the alternative is tested and moves into implementation, recurring costs will again predominate the cost profile.

In order to develop cost profiles, States must first identify all categories of costs that apply to the status quo and each alternative in each stage of the development and operational cycles. Cost categories include such diverse expenses as those for equipment, personnel, travel, training, utilities, supplies, conversion, site preparation, space, and overhead.

Next, those costs must be identified as either recurring or non-recurring costs.

Recurring costs are those which apply over a range of time - either months or throughout the systems life. Recurring costs will predominate in the "status quo" alternative and in the later years of alternatives as the solutions are implemented.

Non-recurring costs are one-time costs, frequently capital expenditures, expected to occur at a point in the future. Non-recurring costs may be overlooked if future workload growth is not considered. States should be especially careful to consider the effects of rising caseloads and peak transaction volumes on equipment and software capacities, by providing for scheduled upgrades or enhancements to the operational system if required.

(See Tables 3-1 and 3-2 on pages 3-4 and 3-5 for descriptions of recurring and non-recurring costs.)

Finally, to aid in the development of the recurring cost figures, each cost category should be identified as either a fixed, adjusted, or variable cost factor. Adjusted cost factors are those which increase over time, tied (for example) to contractual obligations. Variable factors are those which are volume sensitive.

The Cost Profile Worksheet (page 3-7) can be used to determine cost categories, types, and factors applicable to both the status quo and each feasible alternative. Representative cost categories are included in the worksheet.

Each alternative should be evaluated from the point of view of its developmental and operational costs, and separate worksheets prepared.

In projecting future costs, States should determine whether the analysis will be based on constant (real) dollars or current (nominal) dollars.

Constant dollar costs and benefits are costs and benefits which reflect the prices of the base year of the systems life. Constant dollars do not consider the effect of inflation, are normally used in cost/benefit analyses, and do not require justification to ACF. Constant dollars are then adjusted by present value discounting, described in a following section.

Current dollar costs and benefits are costs and benefits which have been adjusted to reflect the effect of inflation on prices. Current dollars are normally used in budget projections.

The forecasting of future benefits and costs becomes complicated when there has been an appreciable and persistent rise in inflation, significant enough to affect investment considerations. If current dollars are used, a three-step (rather than two-step) approach is required:

• Projecting constant dollar costs and benefits;
• Converting constant dollars to current dollars by factoring in inflation based on price indices, such as the Consumer Price Index or the Producer Price Index; and
• Applying present value to convert future dollars to today's dollars.

• Purchase
• Site Preparation/Modification
• Other

• ADP
• Data Communications
• Environ. Conditioning
• Security
• Other

• Operating System
• Applications
• Utilities
• Other

• Data
• Software
• Services

• Cost of Planning
• Cost of Conducting

• Salaries
• Benefits
• Contract Support Services
• Extraordinary Personnel Costs

• Development
• Trainee Expenses
• Trainer Expenses

• Project and Technical
• Management
• Incremental
• Lost Productivity

• Lease
• Maintenance Fees
• Other

• ADP
• Data Communications
• Environ. Conditioning
• Security
• Other

• Operating System
• Applications
• Utilities
• Other

• Salaries
• Benefits

• Contract
• Detailed/Tasked

• Primary Facilities
• Back-up Facilities

If a State decides to use current dollars, the decision and the proposed inflation factor should be described and justified in submissions to ACF.

The use of present value analysis, which involves the discounting of cash flows, should not be confused with the treatment of the estimated effects of inflation. Present value considers the effect of interest on money over time - not the effect of inflation on money over time. Present value is used in cost/benefit analysis, against both constant and current dollars.

Once costs have been identified and characterized, the challenge is to quantify the factors. Four methods, or a combination, are typically used:

• Estimation - sometimes referred to as the bottom-up method, in which each organization involved in system development, operation, and use estimates, averages, and projects its costs;
• Comparison - in which current costs on comparable systems are used as a baseline for the new system;
• Simulation - in which the process is analyzed and simulated to obtain costs; and/or
• Observation - in which processes are measured and recorded to provide estimates.

If there is a secret to successfully developing costs, it is to rationally and reasonably identify, apply, and project the costs for each alternative. Not all costs will apply - or apply the same way - to each alternative.

For each alternative (including the status quo) and for each year, costs should be developed using a format such as the Annual Cost Worksheet on page 3-9.

The top of the worksheet identifies the alternative, whether the costs are developmental or operational, whether dollars are constant or current, and the year of the cost estimates.

Separate areas in the worksheet provide space for both recurring and non-recurring costs, by month and for the year.

The costs (and later the benefits) of each alternative should be expressed in terms of their "present value." This allows the conversion of benefits and costs occurring at different times in the future to their current (that is, present) value, reflecting the time-value of money. Present value calculations equalize the comparison of alternatives when expenses are distributed unequally over time.

Present value calculations deal not with inflation, but with interest. Present value discounting is the inverse of compounding interest; it shrinks tomorrow's dollars to today's dollars by the difference of the compounded interest. Present value reflects the opportunity cost of money.

Present value analysis is based on two principals:

• Benefits accruing in the future are worth less than the same level of benefits that accrue now; and
• Costs that occur in the future are less burdensome than costs that occur now.

The current year establishes the time reference point for present value calculations.

Present value is calculated by multiplying costs by a predetermined factor (called discounting) based on the established discount rate and time period. The discount rates are published in tables, which factor in the amount of interest earned by the dollar invested today until the future dollar is spent.

For example, if we assume a 7 percent interest rate, $107 in estimated costs or projected benefits for next year would be worth $100 today - the present value.

Therefore, present value calculations discount - that is, reduce - costs or benefits projected to occur in future years to a common point in time so they can be compared.

For consistency in the Federal review and approval processes, ACF requires States to use a 7% present value factor in their submissions.

The year-end discount factors presented in the table assume end-of-year, lump sum costs and returns. When costs and returns occur in a steady stream, applying the mid-year discount factors may be more appropriate.

Once the annual costs for each alternative are identified, totaled, and discounted for present value, the systems life cost profiles (page 3-12) can be prepared.

These system life cost profiles are built from the totals calculated on each yearly cost worksheet. Present value totals are inserted: no recalculation is required.

Once the cost profiles have been developed, the State must identify the categories of benefits that apply to the status quo and each feasible alternative over the systems life. In addition, the State should verify that the benefits are properly categorized and are not, in fact, better described as costs.

Benefits should relate directly to the system objectives defined during the Feasibility Study, such as:

• Reduced Error Rates,
• Increased Collections,
• Reduced Costs,
• Reduced Staffing,
• Improved Security, and
• Improved Access or Interface.

Examples of system objectives are listed in the table on page 2-4.

Benefits, listed for the status quo and for each alternative, should be categorized as either quantitative or qualitative benefits. The Benefit Profile Worksheet on page 3-14 may be used. Note that some benefit categories, such as "more timely reporting" are listed under both quantitative and qualitative benefits, both or either of which might apply to a given situation.

Once the cost profiles have been developed, the State must identify the categories of benefits that apply to the status quo and each feasible alternative over the systems life. In addition, the State should verify that the benefits are properly categorized and are not, in fact, better described as costs.

Benefits should relate directly to the system objectives defined during the Feasibility Study, such as:

• Reduced Error Rates,
• Increased Collections,
• Reduced Costs,
• Reduced Staffing,
• Improved Security, and
• Improved Access or Interface.

Examples of system objectives are listed in the table on page 2-4.

Benefits, listed for the status quo and for each alternative, should be categorized as either quantitative or qualitative benefits. The Benefit Profile Worksheet on page 3-14 may be used. Note that some benefit categories, such as "more timely reporting" are listed under both quantitative and qualitative benefits, both or either of which might apply to a given situation.

Quantitative benefits are those for which a reasonable valuation may be predicted and projected. For example, the State should be able to calculate the value of reduced staffing or increased collections.

The objective of the benefit valuation process is to document the State's experience (the status quo), develop assumptions (such as average overpayment), and present a reasoned prediction of the value of the benefit to the State and Federal governments.

The standard of analysis and documentation should be to analyze, develop, substantiate, and present a logical argument supporting the apparent validity of the predicted value of the benefit - sufficient so that the worksheets would be capable of convincing a third party that the prediction is justified and meritorious.

Quantifying benefits is usually more difficult than estimating and predicting costs. Four methods, or a combination, are typically used:

• Estimation - in which each organization involved in system development, operation, and use estimates and projects the value of benefits, using averaging to reduce the potential for error;
• Comparison - in which current benefit values on comparable systems are used as a baseline;
• Simulation - in which the anticipated benefit is analyzed and simulated to obtain costs and values; and/or
• Observation - in which benefit processes are measured and recorded to provide estimates.

If there is a secret to valuing benefits, it is to rationally and reasonably identify, breakdown, apply, and project the costs and values for each alternative. Not all costs and values will apply - or apply the same way - to each alternative.

States will make their most effective arguments for Federal funding through quantified costs and benefits.

The Annual and Systems Life Quantified Benefits Worksheets on page 3-16 and 3-17 may be used to document the value of quantifiable benefits. Note that space has been allotted on the worksheets for the results of three critical determinations:

• Assumptions - on which the numbers and predictions are based;

• Basis for numbers - such as average value of overpayments during the last complete fiscal year; and
• Source for numbers - which specifies the documents (and their locations) from which numbers or predicted increases or decreases were pulled or calculated.

In most cases, addendum sheets should be attached with narrative and numbers explaining in more detail the origin, derivation, and calculation of the actual and predicted values. In addition, critical documents on which the numbers and predictions are based should be attached to the State's master copy of the Cost/Benefit Analysis.

Since the State is now required by regulation to accrue actual costs and benefits over time and since ACF will oversee cost/benefit actuals, care should be taken to document the process in full. The documentation should be sufficiently detailed so that personnel changes will not affect the State's ability to accrue, measure, and explain costs and benefits.

Once the State has prepared a set of benefit worksheets, the calculated benefits for the status quo and each alternative can be listed on the Annual Benefits Worksheet (see page 3-19).

As with costs, benefits of each alternative should be expressed in terms of their present value. Present value is calculated by multiplying the benefit values by a factor based on the established discount rate and time period. (See page 3-11 for a discount factor table based on 7%.)

Once the annual benefit values for each alternative are identified, totaled, and discounted for present value, the system life benefit profiles can be prepared. (See page 3-20.) These benefits profiles are built from the totals calculated on each yearly benefit worksheet. Present value totals are inserted: recalculation is not required.