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Traditional economic methods--life-cycle costing, benefit-to-cost ratio, net benefits, adjusted internal rate of return, and discounted payback--are described for evaluating building decisions about accepting or rejectinga given building investment, the economically efficient design or size of a building, and the economically efficient combination of projects competing for a limited budget. Appropriate applications for each economic method are described. Technically correct formulas for the methods are presented. These economic methods are often applied using "best-guess" estimates of project input variables as if they were certain values. Such applications generate single-value, deterministic answers which provide decision makers insufficient information to know their economic risk exposure. Techniques are described that to some extent account for uncertainty in input variables and in some cases risk exposure and risk attitude. The techniques are sensitivity analysis, risk-adjusted discounting, decision analysis, simulation, and portfolio analysis. Advantages and disadvantages of each are described. Additional research is recommended for providing better methods, improving databases, and incorporating risk attitude in evaluating risky projects. A standard practice is needed for measuring uncertainty and risk associated with building investments.

There is no single “best” technique for treating uncertainty and risk in all investment decisions. What is best will depend on the following items of information that you, as an analyst or a decision maker, should consider before selecting a technique.

Replacement analysis is performed to ensure that equipment and facilities are not kept beyond their economic lives. Economic life is the time over which an item is the least-cost alternative for meeting its objective. If kept beyond its economic life, an item may continue to give service, but a replacement could do the job more cost effectively.

One technique used by the business community to account for risk is the risk-adjusted discount rate (RADR). The objective of using the RADR technique is to increase the likelihood that the investor will earn a return over time sufficient to compensate for the extra risk associated with specific projects.

The NB method is reliable, straightforward, and widely applicable for finding the economically efficient choice among building alternatives. It measures the amount of net benefits from investing in a candidate project instead of investing in the foregone opportunity. NB is computed by subtracting the time-adjusted costs of an investment from its time-adjusted benefits. If NB is positive, the investment is economic; if it is zero, the investment is as good as the next best investment opportunity;1 if it is negative, the investment is uneconomic.2 Emphasis is on economic efficiency rather than cost effectiveness because the method is appropriate for evaluating alternatives which compete on benefits, such as revenue and other advantages which are measured in dollars, in addition to costs.

Where to locate is a decision that is made for every building, and it can have an important economic impact. In the short run, location affects initial capital investment costs; in the long run, location affects ongoing operations and profitability. Choosing a location is a complex decision that requires consideration of economic and noneconomic factors.

Taxes can dramatically alter the profitability of a business investment in buildings.1 In this chapter we describe taxes which affect building investments and show how to include them in economic analyses. We also explain when and when not to include financing in economic analyses.

In this chapter we provide guidelines for estimating typical costs and benefits resulting from building decisions. We focus on acquisition costs, capital replacements, residual value, energy costs, maintenance and repair costs, functional use costs, and downtime costs. We also discuss rental income and other benefits. Less emphasis is placed on benefits estimation, but many benefits are in the form of savings computed from cost reductions, and therefore are treated. We also show how to use several published databases. Table 12–1 lists representative types of some of the published data sources we discuss.

We introduced the concept of the time value of money in Part 1 and showed basic discounting operations in the method formulas. Here we explain why, for a valid economic evaluation, it is necessary to discount dollar amounts which occur at different times to time-equivalent amounts at a common time. We discuss the implications of discounting for building decisions. Then we explain how to do it. We begin the “how to” part with guidelines for selecting a common time and modeling cash flows. Then we show how to discount a variety of cash flows with eight time-equivalence formulas. Because discounting operations are often combined with cost estimation, we show how to combine the two.1

The LCC method is used to make cost-effective choices for a given building, facility, or system. Emphasis is on cost effectiveness because the LCC method is used to evaluate alternatives which compete primarily on the basis of costs. Thus target performance standards are defined, and only candidates which meet the standards are considered. The LCC associated with each candidate is computed, and the candidate with the lowest LCC is the cost-effective solution. If revenue and other benefits predominate, one of the other evaluation methods, such as net benefits, is usually more appropriate than LCC.1

The economic objective in allocating a budget is to maximize the total return on investment. In this chapter we illustrate practical approaches to budget allocation under two conditions. First, we illustrate allocation of a single budget, where the objective is to obtain the maximum return for that budget, without regard to future budgets. To do this, it is essential to make design/size increments of projects compete for funding.

This chapter and the rest of Part 3 describe techniques that can be used with capital budgeting methods to treat uncertainty and risk in project evaluation. We examine techniques that use single-value, multiple-value, and probability function estimates of input data and measures of worth. The techniques are generally in order of increasing complexity in Chapters 15 through 17. The set of techniques in any given chapter, however, tends to require a similar level of technical sophistication except for Chapter 17, where we include some less often used techniques that vary in complexity. We describe advantages and disadvantages of each technique and the extent to which each accounts for risk exposure and risk attitude. Chapter 18 treats in detail how to select the best technique for handling uncertainty and risk in evaluating an investment.

Building owners generally wish to lower costs or increase profits. To accomplish this, buildings must be located, designed, engineered, constructed, managed, and operated with an eye to the economic consequences of these decisions. Owners need to select locations which enhance revenue opportunities, or lower costs, or both. Architects need to consider the owning and operating costs of alternative building designs. Mechanical and structural engineers need to take into account the economy of alternative designs and sizes of building systems and components. Architects and engineers need to work together to make economic tradeoffs between the building envelope and mechanical systems. Construction companies and builders need to select cost-effective materials, equipment, and construction techniques. Building managers and operators need to establish cost-effective maintenance, repair, and replacement policies, and to decide when and what to renovate. In short, those who design, engineer, construct, manage, operate, and own buildings are faced with numerous decisions which affect the economics of buildings. Typical examples of decisions that affect the economics of buildings are presented in Chart 1–1.

We give attention to the question of how to deal with changes in price level because it is a much misunderstood and confusing issue. First, we demonstrate the need to adjust for changes in the purchasing power of the dollar.1 Next, we show how to measure changes in the price of a good or service in current dollars and in constant dollars. Finally, we describe two valid approaches for dealing with inflation in an economic evaluation: (1) working in current dollars and removing inflation as part of the discounting operation and (2) working in constant dollars and excluding inflation at the outset.

The study period defines the time over which costs and benefits are considered in a decision. Setting it correctly is critical to obtaining a valid solution. In this section we state the criterion for setting it, identify factors which determine its length, give examples of setting study periods under a variety of circumstances, discuss the need for replacements and residuals, and, in summary, provide a set of guidelines.

The ORR1 is the annual yield from a project over the study period, taking into account reinvestment of interim receipts. Project earnings and earnings from reinvestment are accumulated to the end of the study period and set equal to the present value of cost to compute the ORR.

Investments in long-lived projects such as buildings are characterized by uncertainties regarding project life, operation and maintenance costs, revenues, and other factors that affect project economics. Since the exact values of these variable factors are usually unknown, it is difficult to make economic evaluations with a high degree of reliability.

The discount rate, or MARR,1 imposes a condition of minimum profitability which a project or project increment must meet to qualify for acceptance. Because it affects whether a project will be accepted or rejected and how much will be spent on it, the value of the discount rate is a key ingredient in an economic evaluation. If it is set too high, some projects which are economic will be rejected; if too low, some projects which are uneconomic will be accepted.

In this chapter we demonstrate with two case studies how to determine the economic size of a component of a building or facility. The first case shows how to size attic insulation, i.e., how to choose the economically efficient level. NS is the evaluation measure, and sensitivity analysis is the technique for taking into account uncertainty.

When an organization requires a building, furnishings, or equipment, one question is whether to lease it or buy it. One approach may offer advantages over the other. The economic objective is to choose the alternative which will maximize net present value to the organization.

Designers and managers of buildings frequently must decide whether to accept or reject discretionary investments in buildings—investments which may upgrade quality, extend life, lower costs, or increase revenue relative to the status quo. We call these “accept/reject decisions” because a possible alternative is to do nothing. Accept/reject decisions can be contrasted with design decisions, treated in Chapter 19, which require a selection from among alternative designs. For example, we call deciding whether to add storm windows an accept/reject decision and choosing the window style for a new building a design decision.

You should consider possible interdependences among systems when selecting them for the same building or facility. Systems are interdependent if selecting one affects the economic efficiency of another. Failing to take into account interdependencies can result in selecting systems which are uneconomic or rejecting systems which are economic. In this chapter we explain how to take into account interdependencies among building systems.1

Decision analysis is one of the few techniques for making economic decisions in an uncertain environment that formally treats both risk exposure and risk attitude. It provides a methodology that allows a decision maker to include alternative outcomes, risk attitudes, and subjective impressions about uncertain events in an evaluation of investments.1

Designers must make many choices in planning a building, ranging from global building design to detailed selections of mechanical systems and furnishings. The first case study illustrates the use of LCC, NS, SIR (applied incrementally), and sensitivity analysis to evaluate the choice of alternative building designs. The second case study illustrates the use of NB and decision analysis to decide which package of retrofit designs for energy conservation is economically preferred.

BCR and SIR are numerical ratios whose size indicates the economic performance of an investment. The BCR is computed as benefits, net of future non-investment costs, divided by investment costs.1 The SIR is savings divided by investment costs. The SIR is the BCR method recast to fit the situation where an investment’s primary advantage is lower costs. SIR is to BCR what NS is to NB.

This paper analyzes existing cost-sharing rules for wastewater pollution grants administered by the Environmental Protection Agency under the 1972 Amendments to the Federal Water Pollution Control Act. It identifies and measures biases in the existing cost-sharing rules that encourage nonfederal interests to select particular techniques (e.g., capital-intensive techniques) over others even when the selected techniques are not the least costly to the nation. The paper develops theoretically a cost-sharing condition—that the same percentage cost share be applied to all abatement techniques—that would eliminate the cost-sharing bias. Alternative cost-sharing approaches are evaluated in terms of their biasing effects and their absolute dollar costs for federal and nonfederal project participants.

Harold E. Marshall, Leader of the Applied Economics Group at the National Institute of Standards and Technology in the United States and Rapporteur of economic methods in W55, reviews technically correct methods and techniques that W55 recommends for helping many countries evaluate the economic performance of buildings.

Corrstructiorr planners and building owners use payback frequently as an index of economic pe$ormance. Discounted payback, which considers the time value of money in measuring the time to project payoff, is a more accurate index ofproject cost effectiveness than simple payback. But being more dijficult to calculate, it is used less often than simple payback. This paper provides a unique set of graphs that helps decision makers, find discounted payback quickly and easily without complex calculations. Appropriate applications of simple and discounted payback are described. Examples of economic efficiency losses from using payback instead of more appropriate evaluation measures and from using simple instead of discounted payback are presented.

The Environmental Protection Agency administers a construction grant program to encourage abatement of wastewater pollution by sharing with municipalities the costs of wastewater treatment facilities. The enabling legislation (P.L. 92–500) specifies that EPA's cost share will be 75% of construction costs. It further requires municipalities to collect user fees from industrial users of the facilities to repay that part of the federal grant allocable to the treatment of industrial wastewater. The municipality must return half of the user fees collected to the U.S. Treasury; the municipality is allowed to retain the remaining half. Retention by municipalities of these user fees lowers their effective cost shares and results in the following consequences: (1) a bias for municipalities to select certain kinds of abatement techniques regardless of whether or not they are the least-cost techniques from the national perspective; (2) a bias for municipalities to select larger-than-optimal scales of abatement facilities; (3) a hidden federal subsidy to industry; and (4) grants that favor industrial communities. This article examines the legislative and regulatory requirements for user charges, derives the algebraic expressions for calculating the real federal, municipal, and industrial cost shares with user fees; computes municipal cost shares for selected values of the determinant factors; evaluates efficiency and other consequences of current user fee arrangements; and concludes that the efficiency distortions brought about by the impacts of user fees on cost sharing could be eliminated by requiring that all user fees collected from industry against the federal cost share be returned to the U.S. Treasury.

Energy-conservation standards for new buildings will play a major role in federal and state conservation policies in the coming decade. This article discusses economic-efficiency considerations that can be incorporated into the selection and development of such standards. Three types of energy budgets — ‘fixed energy budgets’, ‘partially variable energy budgets’, and ‘economically efficient energy budgets’ (EEEB) — are examined for use as standards. Economic-efficiency criteria are presented for use in selecting an appropriate energy budget. An illustrative example shows the potential dollar losses in life-cycle terms from failing to apply an EEEB. Research and operational requirements for developing and implementing an energy budget are described. Three energy-budget standards are evaluated in terms of economic efficiency, administrative feasibility, equity, and consistency in design requirements. An EEEB appears optimal in that it ranks highest overall with respect to the four criteria. Failure to begin research for, and development of, EEEBs now would impose unnecessary social costs in the form of extra expenses to achieve any chosen target levels of energy conservation in buildings.

(1977). Energy Conservation through Life-Cycle Costing. Journal of Architectural Education: Vol. 30, Energy and Architecture, pp. 42-53.