Thursday 17 February 2022

Alternative cost and its use in project analysis

One of the key provisions of project analysis, especially in the field of economic analysis, is the concept of alternative value. An alternative cost arises in the presence of limited resources on an object or activity that is valuable to someone. If there is no such limitation, then all the needs of society in any period can be met. In this case, there is no need to choose between individual options, coordinate the processes for determining priority needs and select those that require priority satisfaction.

As soon as there is a limited resource, the satisfaction of all requests is impossible. Consequently, the limited resources necessitate choice:

directly from objects where there is an alternative;

indirectly from institutions or procedural organizations for social interactions, which, in turn, affect the choice of final objects.

Since almost any resources are limited in nature, they can potentially be used for various purposes. Thus, the land in the city can be built up with residential buildings, administrative structures, industrial enterprises, etc. Or: if money is borrowed to buy a car, then it is necessary to abandon other opportunities that could appear thanks to borrowed money. Or: the reserves of currency available in the country can be used to import goods, buy the necessary raw materials or finance investment projects.

The concept of alternative value can also extend to intangible things. If someone decides to become a musician and needs to make music for 8 hours a day, then it is unlikely that he will be able to find time to study for a doctor. Because healthcare facilities and resources are limited, it may be necessary to cut health care costs for older members of society in order to increase children's health care. In this case, the alternative cost will be defined as meeting the needs that the elderly could receive.

Thus, the alternative cost is the lost benefit of using limited resources to achieve one goal instead of another, the best of those that remain, the option of their application.

In other words, the alternative cost is a benefit that had to be abandoned with limited resources, it is the price of a lost more profitable alternative.

The use of available limited resources for one purpose necessarily eliminates the possibility of their use with another. Thus, the different use of resources predetermines the different number of net benefits that can be obtained from their use. Therefore, it is necessary to allocate resources among alternative uses in such a way that the net benefits are maximum.

When considering the financial aspect of project analysis, the main goal is to increase to the maximum the difference between income and loss, that is, profit. Each cost reduces this difference, and therefore the price paid for certain costs can act as a means of estimating an alternative value. Thus, when the company acquires raw materials that can be used in the household, the number of available sources of profit for the owners of the company decreases. If we turn to society as a whole, then if the aim of the project is to maximize contribution to the increase in national income, the prices for resources or goods cannot be a means of assessing the alternative value.

 An obvious example is a resource such as labor. In the case when there are unemployed in society, and the project provides for the creation of new jobs, they will be able to receive a salary. For a firm that employs workers, wages are an alternative cost, but from a society perspective, the alternative cost is national income that would not have been generated through the involvement of the former unemployed. Since the unemployed have not made any contribution to national income, we should not neglect the latter when using labor for the project. Thus, the alternative cost from the point of view of national income is zero. Thus, the alternative cost is different for the company and society.

Market prices can be a poor indicator of alternative value from the point of view of society as a whole, for which the alternative value of goods to be sold should be based on marginal value. The latter can be determined on the basis of the price that society must pay for similar imported goods, or the value of other goods that could be purchased through international exchange, if we did not need to use this alternative value for a specified purpose. For example, if we return a certain portion of oil that could be exported for domestic use, its value may differ from the market price. This will be the marginal price due to the cost of foreign exchange, which was neglected for the use of oil for domestic needs.

For some goods, it is very difficult to determine the alternative cost, since there is practically no active competitive market for these goods. Such goods primarily include land, the value of which is usually inadequately estimated at the market price. In many countries, the value of land is influenced by factors of a non-economic nature, including security, traditions, family ties, etc. To determine the alternative value of land, the most common methods are:

rent, possibly capitalized, in the conditions of existence of a developed land lease market;

direct assessment of land productivity by assessing the productivity of crops currently grown on it and determining the contribution of land to the cost of general production;

"residual" method of determining the contribution of land return on the basis of additional value that can be obtained from its use.

Thus, in the project analysis, each cost used for financial (from the point of view of the firm) or economic analysis (based on the impact on national income) is an alternative cost. Therefore, the concept of alternative cost is key in project analysis.

All of the above makes it possible to conclude that in the design analysis it is necessary to take into account not the actual cost of the goods we are considering, but the cost of the goods or services that we refuse. Since the alternative value is expressed by any measure, it is sometimes called "shadow price", "price of missed chance", "price of economic efficiency", etc.

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