Basic Economics for the Recycling Manager: Decision-making...

Basic Economics for the Recycling Manager: Decision-making, Program Evaluation, and Advocacy

by Loch McCabe Resource Recycling Systems, Inc.

Ann Arbor, Michigan

Recycling is fundamentally a business. Whether profit or non-profit, recycling organizations collect and process inputs, incur costs, gain benefits, make investments, take risks, and operate in

act to accomplish their tasks in a manner which maximizes their benefits and minimizes their costs. To this end, economic concepts and methodologies may be very effective aids to recycling managers making short and long term production decisions, evaluating program alternatives to maximize their investment resources, and promoting their visions and strategies.

or a manager's choice. Economic tools place too high a reliance upon the quantification of benefits and costs to adequately incorporate all of the social, cultural, political, and institutional factors which are part of many management decisions. Despite this limitation, however, these tools can provide invaluable insight and support for recycling managers and should accompany all significant decision-making, evaluation, and advocacy efforts.

The purpose of this mini-course is to help recycling managers use basic microeconomic theory to make better production decisions. Specifically, we will address the following topics:

a e environment. Like all business managers, recycling managers

c

Decision-Making: 0

0

Project Evaluation: 0

Advocacy: e

e

Maximizing profits in the short run Maximizing profits in the long-run

Cost-Benefit Analysis Net Present Value Analysis Sensitivity Analysis

How to use economic analysis as an advocacy tool How the question the economics of others

Some graphs and examples supporting this discussion are presented at the end of the text.

Part I: Decision-making in the Short and Long Term

A key economic concept for decision-making in both the short and long term is "economic efficiency." Production decisions are economically eficient when they maximize overall profits. To maximize profits, a decision must have the potential to maximize net revenues and be achieved at the lowest possible costs.

Profit (K): The difference between total benefits and total costs. To "I * ' z q p f i & & & - simpiy get the most for your dollar spent.

Revenues (R): Monetary benefits and non-monetary social gains from the produced good or Benefits (B) service. Benefits are the money you earn and non-monetary gains enjoyed by

you and others.

costs (C): Explicit monetary payments, non-monetary payments, and opportunity costs. They are the cash you pay, the costs of other negative affects, and the penalty of not doing something else.

Profit maximization occurs when the manager:

(1) Chooses the production level which maximizes the potential difference between revenues and costs, and

(2) Achieves that production level at the lowest possible cost.

500 1 .Ooo 1 .SO0 2.000 2.500

Total Revenues ($40/ton) 20,000 40,000 60,000 80,000 100,000 Total Costs 20.000 u m 5' Q@Q 11c

The profit maximizing level of production would be 1,500 tons (see Graph 1). To actually maximize profits, however, this level of production must be achieved at the lowest possible costs.

In economic analysis, the revenues and costs are usually down further. While this makes things more complicated, it allows us to do much more detailed, in-depth analysis.

The change in total revenues from selling an additional unit of output (MR = AR + AQ).

Payments for equipment, land, and be changed in the short run. These costs are "sunk."

Payments for personnel, fuel, maintenance, and other factors which can vary as production changes in the short run.

Total cost divided by the level of production (AC = C -L Q).

The change in total cost from produci

The change in total

Total Profits 0 15,000 20,000 15,000 - 15,000

nal Revenue (MR):

Fixed Cost (FC):

Variable Cost (VC):

Average Cost (AC):

factors which can not

one additional unit of t (MC = ATC +. AQ).

a1 Profit (Mn): fit from producing one additional bnit of

Marginal revenue indicates the additional revenues gained by producing and selling one more unit of output. Fixed and variable cost describe different compone f total cost, and add up to total

ge variable cost ate how efficieritly costs are tes the additional

output. (MK = MR - MC).

k" you are getting. Marginal cost uce one more unit. Marginal profit indica

The profit maximizing point is the production level which maximizes the difference between revenues and costs. It also occurs as marginal profits approach zero (see Graph 2). This is the production level at which margidal revenues equals marginal costs (MR = MC).

Resource Recycling Systems, Inc. January, 1990

Costs a nd Revenues to Bale Around 1 SO0 To ns of Paper

1.497 1.498 1.499 1.500 1.50 1 1 .SO2

F i x 4 Costs 10,000 10,000 10,Ooo 10,000 10,000 10,000 Variable Costs 29.945 29.950 29.960 30.000 30.080 30.120 Total Costs 39,945 39,950 39,960 40,000 40,080 40,120

Average Cost 26.68 26.67 26.66 26.57 26-70 27.76;

Marginal Cost __ 5 10 4 0 80 120 Marginal Revenue I 40 40 40 40 4Q

This can be shown on the table above. Focusing around the production of 1,500 tons of paper, it is calculated tb~mtKafitS than marginal costs (1,497 t a additional profit. If marginal benefits are less than marginal costs, (1,502 tons of paper), the firm should cut back production to avoid losing more money. It might also consider another baler.

Marginal Profit - 35 30 0 40 -80

-

If . . . Then Expanding Production Will Therefore . . . MB >MC Increase Profits Increase Production MB = MC Stop! Profits Are Maximized Maintain Production MB < MC Decrease Profits Decrease Production

The amount of profit generated at a given production level can also be calculated by multiplying the difference of average revenue (AR = R + Q) and average cost times quantity (n = (AR - AC) * Q). As prices change, the production decisions you make will be dependent upon your costs and your competition. As the price changes, you will still adjust production to maximize profits, to produce where MR = MC. If your profits are high, expect prices to lower as others "get their piece of the pie" (i.e. your customers) and new firms entering the market from less profitable enterprises. If profits are negative, you can expect less efficient firms (who are also experiencing losses) to leave the industry. This will reduce competition, and eventually allow prices to rise again. This is shown on Graph 3. As prices change,

If . . . Then Expect Competition to. . . And Prices to. . . Profits > 0 Increase Profits = 0 Remain Stable Profits c 0 Decrease

Fall Remain Stable Rise

Economic efficiency in the long run requires managers to select the aptimal scale of production. Production decision-makers want to make sure they invest in the appropriate mix of fixed factors to meet the desired production level at the lowest possible cost. The manager wants to avoid choosing a scale of production which is too small ("undersizing"), for this will limit its ability to produce larger quantities at a competitive price. Nor does the manager what to choose a scale of production which is too large ("White Elephant" syndrome), for this will make costs unnecessarily high. The manager wants to choose an "optimal-sized plant" that will the produce the appropriate quantity at the lowest possible price.

Each scale can be represented by a short run average cost curve; the long run decision is basically the selection of the best short run cost curve. If average cost falls as the scale increases, the firm experiences increasing returns as its expands and is said to enjoy economies of scale. If the average cost increases as the scale increases, the firm experiences decreasing returns and is said to

suffer diseconomies of scale. The plant size which enjoys the lowest possible per-unit costs is an optimal-size plant (see Graph 4).

It pays to invest at the appropriate scale. Say a facility is most cost effective when handling a volume of 5,000 tons. However, because the firm "aimed low" when the plant was built, it is in poor position when demand increases suddenly to 10,OOO tons. If it had invested in a larger plant, it would be able to handle the higher volume at a lower average cost (see Graph 5).

Tangen" nr ptarmhng curve. 'l'his curve represents the lowest possible average production cost at every level of output. Planners should also be aware of the implications rhat the particular shape of the planning curve can have for their industry (see Graphs 6-8).

Part 11: Project Evaluation Methodologies: Benefit-Cost, Net Present Value, and

Improving production efficiency requires managers be able to effectively evaluate their endeavors. Benefit-cost, net present value and sensitivity analysis are tools to quantify the relative values of current and planned projects. While theoretically simple to execute and logical in outcome, the application of these methods is often subject to substantial limitations and shouldn't dictate the manager's decision. However, they can add valuable insight for the decision-making process.

Benefit-Cost Analysis (BCA). The goal of project evaluation is to determine the net benefits a project yields for society. Benefit-cost analysis attempts to estimate a project's net benefits by calculating the value of a project's benefits minus the project's costs (NB = TE3 - TC). To be considered feasible, the project's net benefits must be zero or greater. If more than one project is being considered, the project with the highest net benefits would be most favored.

Net Present Value Analysis (NPV). Benefit-cost analysis works adequately when time is not an important consideration. However, most projects gain benefits and incur costs over many years. Net present value analysis adds a "dynamic" capacity to BCA.

The value of money changes over time. A dollar tomorrow is worth less than an a dollar today. Thus, it is inappropriate to add present values to unadjusted future values. Net present value analysis overcomes this problem by converting "future" dollars into "present" terms. As is well known to investors, there is an opportunity cost to receiving and spending money in the future instead of today. The impact of this opportunity cost is measured by a discount rate, which "discounts" the value of future dollars to present dollars. The formula used to discount future dollars is:

FV = PV(l+r)t where FV = Future Value, PV = Present Value r = Interest Rate, and t = Year (t = 0,1,2, ...)

Say an investor has a choice of (1) $ 1.00 today or (2) $ 1.30 two years from now. If the investor takes the $ 1.00 today and puts it into a bank account which earns 10% interest, the value of that invested dollar would be worth $1.10 in one year ($1.00*(1.10)) and $1.21 in two years [calculated either as ($1.10*1.10) or as 1.00*(1.10)2]. The investor should take the $ 1.30.

Similarly, $1.30 in two years is of equivalent value to $1.07 today. Using a discount rate of 10% (the opportunity cost of waiting instead of investing a dollar today that earns 10% interest), the investor can calculate the present value of $ 1.30 in two years to be:


p V = FV = $1.30 = $1.31 $ 1.07 where d = discount rate (l+d)t (1+0. l o p (1.21)

We can discount the value of any amount of future dollars back to present dollar terms.

Net present value analysis applies the same idea to both future costs and benefits. The NPV formula to discount benefits and costs in one time period is:

NDW P 1 v 1 1 - ana costs in Tear t

And all possible time periods can be accounted fur with:

.~ _.____- - - - _ _ ___

where t = 0, 1,2, . . . T

With this formula, we can easily compare the net present value of the following two projects. Project 1 has upfront costs of $100 and benefits of $70 in years 2 and 3. Project 2 has costs of $50 and benefits in year 4 of $180. The discount rate is 5%.

Proiect 1 Co=-$loO N P V ( 1 ) = -100 + 2(1 + 70 = -100 + 66.66 + 63.52 = 30.18 @=+$70 (1.05)O (1.05)l (1.0512 B3 = + $70

Pro-iect 2

B4=+$180 (1.05)O (1.05)4 CO = - $ 5 0 NPV(2) = -50 + 180 = -5O + 148.08 = 90.08

Thus Project 2 would be the preferred project with a NPV of $90.08.

With this tool, a broad range of quantitative project evaluations can be effectively accomplished. Once assumptions are established and benefit and cost figures are in hand, the actual NPV calculations are simple to execute. However, the planner must be aware of the limitations of this type of analysis:

1. Estimation of Future Costs and Benefits: Future gains and losses are by their nature estimates at best. Many projects also generate "unpriced" benefits and costs that should be theoretically accounted for but are often left out.

2. DeFee of Certainty: Future values should theoretically be modified to account for an uncertain future. Since analysts are often as uncertain about future uncertainties as they are about future values, future values are usually "best guesses" only.

3. The Discount Rate: Higher discount rates weigh near future values more heavily than distant future values. Lower discount rates weigh distant future values relatively heavier than near future values. The net present value of projects with high upfront costs and low long-term benefits becomes progressively higher as the discount rate becomes lower. Projects with high upfront benefits and long-term costs appear better with high discount rates. Choosing the "right" discount rate can have a tremendous impact on the analysis. Generally speaking, long-term "public" projects should use discount rates of 1-4%. Private projects usually use discount rates of 510%.


Sensitivity Analysis. While NPV analysis determines a preferred action, sensitivity analysis checks the "sensitivity" of its even if its assumptions are greatly modified. A "weak" result quickly changes as its assumptions are questioned. The common NPV variables tested in sensitivity analysis are: (1) estimates of future costs and , (2) degrees of future certainties, and (3) the discount rate.

ts by testing the analysis' assumptions. A "strong" result stands

Proiect 1

NPV (1) = 11412 + ur + a > a + a (1 .OS)() (1 .OS) (1.032 (1.05)O (1.0514 -. --

_-______.---- ________- -100 + 66.66 + 63.52 > -50 + (B/1.2 15) 1.215 * (30.18 + 50) > B

97.42 > €3

Thus the benefits in year 4 must be at least $97.42 (54% less than expected) to keep our result.

Additional Notes on Project Evaluation:

Amortization: If a project requires a loan, say to purchase equipment or make site modifications, the cost of the equipment must be represented by amortizing the c of the loan. In other words, one must calculate your annual payments to the bank for the loan. The amortized value of a loan can be calculated as follows:

AmortizedValue = Principal * i * (1 +i )T (1 + i ) T - 1

where i = interest rate of the loan, and T = Year Due

For example, a $500 loan taken for 5 years at 10% bank interest would have an annual amortized value of $131.

= 500 * (.lo * (1.10) 5)/(l.10)

= 500 * .16/.61 = 131

- 11 = 500 * (.lo * (1.61)/(1.61 - 1))

If one paid $131 per year, the loan would be paid off in five years.

Inflation: Net resent value analysis is usually done with "constant" dollars and assumes there is

account for it, and you will still get the same answer (e.g. Project A is better than Project B). no inflation. vsp hile this may not make sense, it is usually much easier to ignore inflation than to

If you amortize or for some other reason have inflation in your analysis, it too can be discounted with the following formula:

Present Value = Future Value where: d = discount rate, r = inflation rate, t = time (id years)

(1 + d + r )


f

For example, a certain program will yield $100 dollars three years from now. With a discount rate of 5% and an inflation rate of 5%, the present value of $100 dollars three years from now is $86.21.

[$100/(1+.05+ = $ l~~/(l.l)~ = $100/(1.33) = $751.

You discount twice, once for waiting and once for inflation.

-2: ~f a vaue repeats itselt trom vear 0 throuph to a finite vear T, you can use the formula:

v.. - -

pv= Fv * [I- -1 1 d (1+ d)T

_ _ __ -__-- -- q L r l e p r t ; s e n r e m s m c x % v e d today andTGr-next five years (year = 0, l , 2,

3,4,5) at a discount rate of 5% would be:

pv= EY * [l- 1 - j = * [l- 1 1 d (l+d)T .05 (1 .05)5

= * [ l - 1 1 = * 0.22 = $220.00 1.28

If the future value repeats itself from year 0 through to infinity, then T = =, and:

PV == d

The present value of $5 received for eternity: PV = 5/.05 = $l,OOO

If a value repeats itself from Year 1 through infinity, then the present value formula must compensate for its later starting date. In other words,

PV (Year 1 through infinity) = PV (Year 0 through infinity) - PV (Year 0).

or

PV(Year1throughinfinity) = - r (1 + r) 0

qnd Advocacy

y used as a central compo on cleanup, and other en

case, or questioning the claims of others.

in arguments for and against recycling, waste mental issues. Economics can be a useful

Using Economics for Advocacy:

Consider Unaccounted or Unquantifiable Benefits: Many projects have benefits which are received by others outside the scope of the project, or may not be quantifiable. As a result, the benefits you count are only a s &e this point clear and

ently large to justify the

For example, say a recycling program will cost $80 per ton to implement. Revenues alone, however, will amount to only $30 per ton.

Is there an additional $50 per ton worth of ben unaccounted for? If the city will enjoys $40 per ton worth of additional landfill space for e verted ton, perhaps you can negotiate a diversion credit from the city to your recycling program. At any rate you know that these diversion benefits will be enjoyed by someone, if not directly by you. Now you can argue that the benefits will be at least $ 7 0 per ton.

Can an additional $10 per ton of benefits be found? Benefits to recycl' in many forms, including: avoided collection costs, depression of disposal rates, exte fill life, preserving land for better uses than waste disposal, greater environmental ethic, etc.

Compare Alternatives: Decisions are often made in a vacuum. Put the decision in context by comparing the alternatives. All choices are made between one project and another. You may

are expensive, that both lose money, but one i s less expe

Run: While recycling may not quite "pay off' in the short run, it will e long run. Reflect this by evalua

of a one or five-year timetable s show we have no choice.

recycling vs. not recycling on a 20 or the short run, recycling may be more

recycling. In the long

Questioning the Economics of Others

Economics, like all tools, has two edges. It can be used to support or to question.

What are your assumptions? Where do your assumptions come from?

Why did you choose that discount rate?

Can we have your data? Where did your data come from? What alternatives did you compare? What level of risk did you assume? What is your discount rate? What if the analysis is wrong?

es in costs or prices i s your result? ng these benefits (or costs)?

confident are you that your are right?

But be careful, for you will be asked the same questions when it's your turn!


I Tc GRAPH 1. TOTAL COSTS, REVENUES, PROFITS GRAPH 2. MARGINAL COSTS AND REVENUES

1,498 1,499 1,500 1,501 Tons of Paper

- MPV (1) = + ]= -1, + 8,

= +$6,

"2 Year Plan"

C a , l = - $ oc1= - $300, q=+$ ,3,4. . . = + $400,000

NPV (2) = - + +

- 285,714 - 285,714 + 95,238 + [ 8, - 400,000 - 380,9521

= - 871,428 + 95,238 + 7,219,047 = + 6

ile to check how great Project

NPV ofProject 1 => - C +7, + 6,442,857 e= NPV of Project 2

- c - - + 6,442,857 -7,600,O - C -

Therefore, Project A's costs would need to rise only by 1 B to be considered economically justifiable.

d amounts for Project

Example: The ACME Sewing Machine Company produces thousands of sewing machines each year. Most of the sewing machine parts come in cardboard boxes. ACME's President has successfully undertaken some waste reduction measures. The company has increased bulk orders and the company's suppliers now ship about one-third of their materials in retumable containers. This has cut ACME's waste by about 40%. Most of the remaining waste, however, is 150 tons per month of cardboard packaging from uncooperative suppliers. To date, the remaining cardboard has been compacted and donated to a hauler. Now the company's president wants to 1 z:Fnds revenue a supplier nom who the agrees

to backhaul baled cardboard for $20 per ton.

-

The baler costs $50,000 and will last 10 years. He will hire one additional person to operate the baler, will buy a conveyor system for $5,000, and make $5,000 worth of site modifications. The program will- revenues of $ a€=-- ' lem-up c o s b y $ 5 4 ~ e + y e a x . Should he proceed with this program? What happens if price of cardboard decreases by 25% to $15 per ton?

Note: The loan is amortized and the analysis must consider inflation. Inflation is 5%, and the company's discount rate is 5%. All operational costs rise at the rate of inflation after Year 0.

Assumptions. The president makes the following assumptions:

The baler will cost $50,000 to purchase and $5,000 to install. It will last 10 years. It will be paid for with a 5-year loan with an interest rate of 10%. The salvage value of the baler in Project Year 6 will be a projected $25,000. The conveyor will be bought by the company and depreciated at a rate of $1,000 / year for 5 years. The additional personnel will cost $20,000 in Year 1 for wages and benefits (others handling cardboard now will continue to do so). Other set up capital costs will be approximately $5,000 in Project Year 0. Other operational costs will be approximately $ 1,000 in Year 1. The program will bale 150 tons of cardboard per month, or 1,800 tons per year. The baler will not affect product quality or sales. The baler will improve the work environment and lower clean-up costs by $5,000 in Year 1. The price for baled cardboard will be an average $20 per ton throughout the prnject- Inflation is 5% per year and the company's discount rate is 5% per year. All operational costs will rise at 5% per year due to inflation. Training costs will be about $500 in Year 0. No additional costs education or downtime will be expended.

Results/Sensitivity Analysis. As shown in the table on page 12, the estimated net present value of the program is $28,674. The project would be considered economically sound. If, however, the price of cardboard falls by 25% to $15 per ton, the net present value of the program is a negative $ 10,523.

Resource Recycling Systems, Inc.

PROJECT YEAR I

Baler and Site Modifications* Conveyor** Other S e t u ~ Cadtal ExDenses

$14,509 $14,509 $14,509 $14,509 $14,509 $l,OOo $l,OOo $1,OOo $l,OOo $1,000

$5.000

I Additional Labor Payments 1 I $20,000 I $21,000 I $22,050 I $23,153 I $24,310 I $25,526 I

* Baler and installation are amortized over 5 years, starting in Project Year 1. ** Conveyor is depreciated at an equal rate over 5 years, starting in Project Year 1.

\TOTAL BENEFITS: I $0 I $41,000 1 $41,250 I $41,513 I $41,788 I $42,078 I $67,381 I

NET PRESENT VALUE OF ENTIRE PROGRAM: I $28,614 I SENSITIVITY ANALYSIS: CARDBOARD = $15/TON

NET PRESENT VALUE OF ENTIRE PROGRAM:


I ($10.523) I

Basic Economics for the Recycling Manager: Decision-making...

Documents

Transcript of Basic Economics for the Recycling Manager: Decision-making...