Comparison of economic and commercial appraisal

Introduction

14.1.1 Differences between economic appraisal and commercial appraisal can be a source of confusion for practitioners. The purpose here is to highlight the key differences with the aim of dispelling some of the confusion that surrounds them. Discussion of each type of appraisal is followed by a checklist showing how various items are treated under each type.

Economic appraisal

14.2.1 Appraisal should always include an assessment of value for money in terms of the Northern Ireland economy as a whole. This is the perspective of economic appraisal and its scope therefore is very wide. In fact it seeks to identify all the costs and benefits to NI resulting from a project, policy or programme.

14.2.2 Step 5 in Section 2 of NIGEAE explains how costs and benefits should be estimated in an economic appraisal, so there is no need to duplicate all that information here. However, here is a summary of the key features:

• all NI impacts, whatever their nature, are taken into account, including not only economic factors like income and employment, but also social, health and environmental factors, and any other important identifiable effects
• costs and benefits are valued according to their economic cost or opportunity cost (see para. 2.5.8 of the main text for explanation).
• costs and benefits are included whether they fall to the public or private sector and whether they are quantifiable in money terms or not
• benefits are adjusted to account for displacement of competing activity, so that a proposal's net impact on NI is calculated
• economic appraisal is not restricted to the narrow perspective of a particular public body, it is about putting the nation's resources to the best use

14.2.3 Economic appraisal always values costs and benefits on an economic cost basis. However, the approach to costs and benefits may fall into one of the following three main categories:

• cost benefit analysis (CBA) which attempts to quantify all the costs and benefits in money terms
• cost utility analysis (CUA) which is like CBA except that it seeks to measure benefits using non-monetary indicators of utility. Utility is an economist's term for the satisfaction or usefulness derived from a product. An example of CUA is the calculation of the cost per quality-adjusted life year (QALY) resulting from a surgical intervention
• cost effectiveness analysis (CEA) in which either the benefits or the costs are held constant. In the former case CEA compares the costs of different ways of producing the same or similar outputs, which are not necessarily given a monetary value; in the latter case various ways of allocating a fixed sum are considered in order to maximise the benefits

14.2.4 CBA is rarely amenable in its purest form because relevant costs and benefits are often difficult to measure in money terms. Sometimes benefits can only be indicated in terms of intermediate outputs such as numbers of trainee places provided, or numbers of hospital cases treated. Even when appraising projects producing tradable goods and services (for example, investments by the nationalised industries, grants to commercial firms) there may be non-monetary effects to take into account, such as environmental impacts and other qualitative outputs. CEA is used to some extent, particularly when the emphasis is upon choosing the least cost method of achieving particular objectives. However, many appraisals fall somewhere between CEA and CUA. They involve options which vary regarding both costs and outputs, and it is a matter of judging which of the alternatives is best by comparing the different costs and outputs which they offer.

14.2.5 There are some specific forms of appraisal which do not amount to a full economic appraisal, but are nevertheless designed to contribute to the aim of assessing how best to use resources in the national interest. For instance, an environmental appraisal (or environmental impact assessment) assesses the environmental effects of various options. Impact assessments may be conducted on a variety of other specific issues such as equality, health, and so on. Another example is regulatory impact assessment, which assesses the costs to industry of proposed changes to regulations and standards. Partial analyses like these may be used to feed into a fuller economic appraisal.

Commercial appraisal

14.3.1 Commercial appraisal shares some of the characteristics of economic appraisal but is much narrower in scope. Its purpose is to establish whether a proposed activity will be viable in a commercial sense. A proposal may be considered commercially viable if, over its useful life, it is expected to earn sufficient revenue to cover its costs and yield an acceptable financial rate of return. Although it generally reflects the perspective of a private company rather than government, commercial appraisal is relevant to the public sector in some circumstances.

14.3.2 Firstly, assessment of commercial viability is a necessary element of the appraisal of proposals to provide grant assistance to commercial activities. As indicated in section 4.5 of the NIGEAE, commercial viability (or project viability) should be assessed to help ensure that public money is not wasted on projects that will fail prematurely. Secondly, there exist some public trading bodies who sell goods or services into private markets or are subject to financial targets which require them to undertake commercial appraisal. Thirdly, some activities which are promoted primarily for social or other non-commercial purposes may include commercial elements and it is appropriate to seek to establish these on a firm commercial basis, to help avoid premature project failure.

14.3.3 Commercial appraisal undertaken to establish a project's viability covers several elements including analysis of projected cash flows, examination of the financing, marketing and management arrangements for the specific proposal in view, and assessment of the historical performance and general financial position of the relevant company or public sector trading body. Commercial appraisal may address several of the steps at 1.4.1 of the NIGEAE, but will usually do so from a perspective of self-interest. Thus, for instance, it may take no account of the impact of its own activities upon other players in the market, and may ignore environmental and other wider costs and benefits to NI.

14.3.4 It is specifically in the assessment of cash flows and calculation of net present values (NPVs) that confusion most often arises over differences in approach between economic and commercial appraisal. Both types of appraisal include identification of streams of costs and benefits over time and calculation of NPVs. Some of the figures used in the economic appraisal streams may be identical to those used in the corresponding commercial appraisal streams. This happens when economic costs and financial values coincide. For example, this is often the case with annual operating costs. However, the fundamental basis for measurement of costs and benefits is substantially different, and this is where confusion often arises. The crucial differences of substance are that costs and benefits are generally estimated:

• based on economic cost values in economic appraisal, but financial values in commercial appraisal
• for NI as a whole in economic appraisal, but only for an individual public sector trading body or private company in commercial appraisal

14.3.5 Many of the mistakes made in appraisals arise from failure to recognise these differences. Some of the more common errors are listed below under common errors in economic appraisal.

14.3.6 Confusion can also arise through misuse of terminology. In commercial appraisal, an NPV calculation is often referred to as a financial appraisal. This can confuse in two ways:

• firstly, the term financial appraisal is sometimes used to describe the NPV calculations in an economic appraisal, which is misleading because NPVs in an economic appraisal are not based on financial values
• secondly, financial appraisal may be used to describe a variety of financial assessments, including, for example, an affordability assessment, or an analysis of sources of funds

14.3.7 The distinction between economic and commercial appraisal is well illustrated by their use in projects involving assistance to industry, such as inward investment projects and industrial expansions. In these cases economic appraisal is used to assess the economic efficiency of the project, that is, its VFM from a broad economic perspective; and commercial appraisal is used to help assess project viability which focuses on the proposal's financial soundness as a business proposition from the narrower perspective of the assisted company. These cases demonstrate how economic and commercial appraisals should complement each other in the process of assessing the overall soundness of a project. However, a commercial appraisal should not generally be used as a substitute for an economic appraisal.

Checklist

14.4.1 The checklist provides an aide-memoire on whether particular costs and benefits should or should not be included in each type of appraisal. It is in the nature of a checklist like this that it cannot cover every eventuality, so it should not be regarded as a substitute for more detailed guidance on the treatment of costs and benefits which is included elsewhere in NIGEAE.