Benefit Cost Analysis Guide (Case)

In 1996, the Property Services Program of the Department of Administrative Services evaluated options for future accommodation of the Bureau of Mineral Resources. At the time, the Bureaux occupied several buildings in Ottawa, the main ones being 151 Pond St. and 40 Pond St.

Alternatives:

Three options were considered. Each option was a coherent and self-standing package of accommodation that met the essential needs of the Bureau over fifteen years (a standardised time frame for all options to enable a fair comparison). The benefits of each option were essentially the same - therefore the choice among alternatives hinged on minimum cost.

Viewpoint:

This is a financial analysis from the point of view of the Department of Administrative Services – that is, from the federal government's narrow fiscal point of view. External social costs and benefits such as increasing traffic at a particular site, or providing a catalyst for development in a particular area [items which accrue to the wider community rather than to the department] are not considered in this analysis. They would be considered in an analysis from the local community viewpoint, if there were indications that they might be significant.

Priority and Objectives/Link to Business Plan:

The Bureau is responsible for the collection, storage and dissemination of information on the minerals sector in Canada. Their present building was originally designed for offices but had been converted over time to house laboratories and specimen collections. These modifications however did not meet modern health and safety requirements. As well, there was a risk of fire or water damage to the extensive database and valuable collections. These considerations were the highest priorities, but possible co-location benefits [reduced overhead expenses and increased contact among staff] were also potentially important.

Option 1: Renovate 40 Pond, hold 151 Pond in use in its present configuration, and rent swing space for one year while 40 Pond is being renovated (space is available in 243 Scotch St. and 380 Wills St).

This is the "status quo" option. 40 Pond would be upgraded to make the laboratory space safe, and to improve the efficiency of the rest of the building. While this space was being done, staff from 40 Pond would be relocated in rental "swing space". Disruption would be kept to a minimum; but the end result would be a compromise. 40 Pond can be upgraded to minimum standards, but will never be first-class space for the purpose. The general perception of the managers was that 151 Pond is a better building to meet the department's long-term needs. In this option, both 40 Pond and 151 Pond are held for the full fifteen years of the analysis time frame. There is some financial advantage to this, since property prices are inflating more rapidly than the general inflation rate.

The main uncertainty in this option is the cost to renovate 40 Pond, since renovation costs are more difficult to anticipate than new construction costs. It is doubtful whether the department can obtain a fixed price contract for the sort of renovation needed.

Option 2: Add a floor to 151 Pond and renovate other floors. Sell 40 Pond as soon as 151 Pond is fully ready. Hold temporary "swing" rental space as needed.

In this option the department consolidated its operations in one building by adding a floor to 151 Pond. Adding a floor while keeping parts of the building operational seemed risky. It involved unknown and unstructured risks to personnel safety and continuity of operations. These factors were not incorporated into the financial analysis because they were not quantified nor monetized. Perhaps with more research on similar projects in the past, the analyst might have been able to identify and quantify the risks involved.

Part of the cost was offset by a "consolidation benefit" from having all staff in the same building, a state that would be achieved after two years of operations. The value of this benefit was uncertain, and partly intangible. However, the department's senior managers set it at $500,000 per year on the basis of obvious efficiencies such as simpler core services and decreased communication costs.

Option3: Purchase a new building. Hold 151 Pond in use in present condition. Sell 40 Pond.

This option involves no renovations other than the standard fit-up. 40 Pond is held for a year, while a new building is being purchased, then sold. It is assumed that it would take a further year to sell 40 pond. This seems a reasonable allowance. However, there was some uncertainty whether the estimated market value of 40 pond would prove to be correct since the real estate market was depressed at that time, and some changes and improvements (uncosted) might have to be made to attract a private sector buyer.

Option 1: Renovate 40 Pond
Expected (avg.) value of the net costs:                  -$15.8 million
Minimum net cost possible, given assumptions: -$14.6 million
Maximum net cost possible, given assumptions: -$16.9 million

Option 2: Consolidate in 151 Pond
Expected (avg.) value of the net costs:                  -$7.9 million
Minimum net cost possible, given assumptions: -$5.1 million
Maximum net cost possible, given assumptions -$9.5 million

Option 3: 151 Pond + New Building
Expected (avg.) value of the net costs:                  -$11.8 million
Minimum net cost possible, given assumptions: -$10.4 million
Maximum net cost possible, given assumptions -$13.1 million

Advantage of Option 2 over Option 3
Expected (avg.) NPV for choosing option 2:                $3.9 million
Loss exposure ratio (probability of a negative NPV): Zero
Minimum NPV possible, given assumptions:               $2.4 million
Maximum NPV possible, given assumptions:              $6.3 million
5% probability that NPV will be less than:                     $3.1 million
50% probability that NPV will be less than:                   $3.8 million
95% probability that NPV will be less than:                   $4.8 million

Distribution of Costs and Benefits:

There were no distributional questions of importance in this analysis because of its narrow fiscal point of view.

Sensitivities:

The choice of option 2 is most sensitive to the discount rate and the inflation rates. It is also sensitive to the consolidation benefit, as one would expect. Nothing else seems particularly important to the choice.

Recommendation:

Choose Option 2 because it has the lowest costs under all scenarios. The NPV probability curves do not intersect, so there is no possibility that Option 2 would be worse than another option even if option takes its lowest value (highest cost) and the other option takes its highest value. One can see that the NPV of choosing Option 2 is distributed more or less normally around a central value of $3.8 million. There is only a 5% chance that the NPV will be below $3.1 million, and the NPV is a little skewed toward high-end values (the high end tail of the distribution is long, reaching out to about $6.3 million but the probabilities of the NPV actually being above $4.8 million are only 5%). Based on these numbers, it is an easy decision to make, without much risk.

Unresolved Issues:

We see that the choice is very sensitive to the discount rate so one would have to consider the range of rates carefully. Even for a financial analysis the discount rate used seems low. There would need to be a strong rationale for having such a low average rate over a fifteen-year time horizon. It does not seem plausible that a range of 5.5% to 7.5% adequately captures all the possible variation of average rates over such a long period of time.