Every day the national news is talking about supply chain issues and shortages around the globe that are creating problems in almost every sector of the economy.
Over the last several decades we have moved to the “just in time” method of procurement to cut down on stocking charges.
The other option is a simple formula that could be considered during these times: Cost = Full Life Expenditure on Item Purchase + Opportunity Cost.
The opportunity cost reflects the discount on the future cost of deferring work to some later time. Full life expenditure must be discounted to reflect that many costs will occur at a point remote in time, while others are of a contingency nature.
Benefit must also be adjusted to reflect both the time element and contingency. For some types of expenditures, primary benefit is immediate and it either declines over time or such residual value as it may possess is slight.
For other types of expenditure, the benefit is derived only in the future. In yet a third class of expenditure, the benefit is dispersed over time, with some of the benefit being received immediately and the rest being deferred.
For instance:
Construction of public buildings (or other capital assets) to a higher specification may extend the life of the building. The additional expenditure thereby incurred confers a future benefit, as the taxpayers of the future are thereby relieved of the cost of replacing or refurbishing the building for the extended period of its life. Building in surplus capacity to meet future needs as is often done, for instance, in the construction of a road or bridge, also generates a deferred benefit.
The opposite extreme, one finds expenditures on items that are expected to be consumed immediately or within the near term. Expenditures on fuel, food, occupation and clothing are frequently expenditures of this type. Although in a very broad sense, they may also be seen to confer some future benefit. That benefit is trivial in comparison to the immediate benefit that is derived.
Most expenditures produce some blend of present and future benefit. For instance, the creation of a park brings into being an asset that may be used for the immediate benefit of those who use it. However, the park will remain after the present generation is gone and thus the benefit also flows to those who come in the future.
In carrying out the cost-benefit calculation to a particular proposed investment, it is necessary to factor both present and deferred benefit properly into the equation. Similarly, there are also likely to have deferred (or future) costs, such as maintenance, refurbishment and other ongoing costs of operation.
These also should be reflected in the purchase decision. An investment should not be made unless the present cost of meeting a long-term need is less than the discounted present value of doing the work at some point in the future (which may, but need not, be the point of critical need).
The investment also should not be made if the present value of the future benefit is not at least equal to the discounted present value of the benefit received by making the investment at a particular point.
Contingencies complicate the process because very often the magnitude of the contingency is purely a matter of speculation.
The difficulty of identifying and prioritizing competing needs is complicated all the more by the role that many organizations are expected to play as the vast resource and wealth transfer engines.
Governments have the ability to conscript resources and re-deploy them to some other uses. In an ideal world, everyone would get what they want, but since we live in a world in which scarce resources must be allocated under conditions of constrained choice, this is impossible.
Stephen Bauld is a government procurement expert and can be reached at swbauld@purchasingci.com. Some of his columns may contain excerpts from The Municipal Procurement Handbook published by Butterworths.
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