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Economic analysis is a formal assessment of the costs and benefits associated with a program or project. The objective of economic analysis is to assess whether the capital outlays (costs) in the current period and the projected benefits for some investment opportunity net an economic advantage to the organization. The intent is to optimize investment decisions by picking worthy projects. In the corporate world, economic analysis is referred to as capital budgeting.
Economic Analysis and Logistics
Application of economic analysis to logistics is receiving increasing emphasis in professional circles. A major focus of recent workshops sponsored by the Logistics Institute at the Georgia Institute of Technology has been financial logistics and economic analysis of logistics investments. (1) Professional logistics organizations, such as the Council of Logistics Management, are now including tracks relating to the financial and economic dimensions of good logistics practices in their annual conferences. (2)
Sound economic analysis is critical because decisions relating to investment projects chart the course of an organization for many years and, in a sense, define the future. Certainly decisions involving a systems engineering tradeoff relating to a Logistics Support Analysis (LSA) task or decisions relating to investing in logistics facilities and other infrastructures, new logistics technologies, or logistics information systems will define a logistics system's efficiency, flexibility, and service levels for many years.
The Time Value of Money
Fundamental to a good economic analysis is the well-established principle that money has a time value. The time-value-of-money principle applies any economic analysis that involves time-distributed benefits or costs. For example, cost avoidance over 5 years in a pattern of, say, $20M-$10M-$10M-$10M-$10M, is clearly preferred over a pattern of $10M-$10M-$10M-$10M-$20M. The first pattern has greater value to the decision-making entity.
Does money have a time value in the public sector as it does in the private sector? Absolutely. In an economic context, funds extracted by the government from the private sector have alternative uses and foregone returns. These resources are not free. The foregone return is the cost of capital and reflective of the time value of money. The society providing funds to government is better served by an investment in system supportability, for example, that returns savings earlier as opposed to later.
In a Federal finance context, the Government's financial resources on the margin generally come from Treasury borrowing. In this context, the Treasury's borrowing rate is reflective of the time value of money. The time-value-of-money concept for the Government is officially recognized by Office and Management Budget (OMB) Circular A-94. (3)
Discounting and the Cost of Capital
Discounting is a technique for comparing, on an equivalent basis, alternative courses of action that have varying cost-and-benefit flows. The equivalent basis is the present value of these flows, discounted by the cost of capital.
The three dimensions to an economic analysis using present value are assessing the magnitudes of the relevant cost or benefit flows, determining the period over which these flows will occur, and selecting the appropriate discount rate.
For defense logistics analyses, the appropriate discount rate is the cost of capital to the Government, which is the Treasury's borrowing rate on marketable securities of comparable maturity to the period covered by the economic analysis. The discount rates to be used are published …