Spending Wisely: Making Good Public Investment Decisions in a Tough Fiscal Environment
Posted on by Rachel Gretencord
The state’s budget issues have precipitated significant financial tightening for many municipalities and agencies across the state. This environment has generated renewed urgency to realize cost savings, while maintaining or increasing the level of service provided. Similarly, businesses that need to improve their performance need a decision-making process to determine where to most effectively spend limited resources.
There are a number of financial metrics that can assist in the decision-making process to help achieve efficiency in utilization of limited resources. One of the most commonly-referenced performance measures is ROI, or Return on Investment. In simplest terms, return on investment measures the amount of money earned as a percentage of the original investment. While the calculation is simple and the ROI shows the efficiency of the investment (in terms of return per dollar invested), it does not account for the total size of the investment nor the time frame.
Net Present Value, or NPV, is a second measure commonly used in conjunction with ROI. Net present value uses a series of projected cash flows (both outflows and inflows) and applies a discount rate to estimate the value, in today’s dollars, of the project. The benefit of this approach is that it accounts both for the time period in which the money is expended or received, and shows the value in order of magnitude (dollars). However, the choice of discount rate can impact how cash flows farther into the future are valued, and this metric does not account for the return per dollar invested as ROI does.
A number of other metrics can also be applied to prospective investments, including Internal Rate of Return (IRR); Payback Period; Total Cost of Ownership; and others. The appropriateness of each depends on the type of project being contemplated, as well as the goals and financial constraints of the entity engaging in the project.
However, applying these metrics to projects with a public or social objective adds another layer of complexity. While cost and efficiency remain important, measures of social impact, quality of service, and other criteria may need to be evaluated. Thus, a broader approach, known as a Cost-Benefit Analysis, may be appropriate. A Cost-Benefit Analysis takes into account both financial and non-financial considerations, to provide a framework for the decision-making process. For the non-financial portions of the project, techniques used to estimate the public value of non-monetary benefits or considerations can help ensure that these important outcomes are given appropriate weight. The process of determining the correct goals and outcomes to measure can also be beneficial for a community, to make sure their projects and investments align with the community’s most crucial objectives. And of course, accurate, good-quality data is key to making sure that municipalities and agencies are getting the most value for the public dollars expended.
Contact CERC if you have questions about how a cost-benefit analysis can help your community invest wisely.