5.14 Costs should be expressed in terms of relevant opportunity costs. It is important to explore what opportunities may exist. An example of an opportunity 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 to the employer1, and should include pensions, national insurance and allowances, as well as basic salaries.
5.15 Costs of goods and services that have already been incurred and are irrevocable should be ignored in an appraisal. They are 'sunk costs'. What matters are costs about which decisions can still be made. However, this includes the opportunity costs of continuing to tie up resources that have already been paid for.
5.16 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 (after telephone call volumes reach a certain level, a new call centre may be required).2
5.17 Categorising 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.
5.18 For 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, 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.
5.19 Appraisals 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.
5.20 Cost 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.
5.21 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 (although for resource budgeting purposes they may be important). 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. They should not be included in the decision whether or not to purchase the asset in the first place.
5.22 Even 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.
5.23 Some projects expose the government to contingent liabilities - that is commitments to future expenditure if certain events occur. These should be appraised (and monitored if the proposal goes ahead). One class of contingent liabilities is the cancellation costs for which the government body may be liable if it terminates a contract prematurely. Such liabilities, and the likelihood of their coming about, must be taken into account in appraising the initial proposal. Redundancy payments fall into this category, but as the wider social and economic consequences of these should also be assessed, advice from economists should be sought.3
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1 See Annex 2 on the valuation of time to society.
2 Definitions are taken from Drury (1998)
3 Redundancy payments are also examples of transfer payments, which are those for which no good or service is obtained in return. Transfer payments may change the distribution of income or wealth, but do not give rise to direct economic costs.