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OPTION APPRAISAL
BUILDING OUR FUTURE: SCOTLAND'S SCHOOL ESTATE

2: STAGES

1. The school estate strategy describes the process for preparing a school estate management plan. This guidance expands on step 3: consideration of the options and provides a systematic practical approach to option appraisal for all capital investment projects.

2. Every appraisal should follow this broad process. However, the size and nature of each project will determine the extent of work required at each stage of the appraisal. Every appraisal will cover all these stages but, in practice, some of the stages may take place simultaneously. Consultation is described as a separate stage, but in practice it is likely to take place throughout the course of your appraisal and influence each stage.

3. As information is generated and analysed, it may be necessary to revisit earlier stages of the appraisal: the more complex the project, the more likely it is that the process will evolve.

STAGE 1: DEFINE OBJECTIVES

4. The first stage in all option appraisals should be to define a clear set of objectives. This is the key to actually shaping what you are trying to achieve. The objectives should be sufficiently broad, joined-up and inclusive of all interests. They should not, however, be too general as this can create too much flexibility and lead to unnecessary work. This allows the identification of a full range of options and ensures that realistic potential options are not ruled out.

5. In order to define a clear set of objectives, this stage should incorporate a review of data and consideration of the issues and policies which have implications for investment in the school estate. For example, before objectives are defined for a new school building project, consideration should be given to issues such as recent and future demographic change, likely housing patterns, the condition of existing buildings and their suitability for delivering education and other services. Wider educational policies, commitments or aspirations such as mainstreaming, class size regulations, integrated community schools or ICT initiatives are likely to shape the project's objectives and should be considered fully. A similar process - albeit on a lesser scale - can be equally useful for smaller investment projects.

6. Consideration of wider issues should ensure that individual projects are consistent with the strategic and corporate objectives of the local authority. Indeed, project level objectives should be considered in the context of their contribution to corporate and service objectives and targets.

7. The list of objectives is likely to include some which are essential and others that are desirable but not as important. In this case, you should set out your objectives in order of priority. These priorities can then be used to decide on weightings when you assess the options.

8. You should aim to have a relatively short and focused list of objectives. It is better to have five or six clear and manageable objectives than a much longer list.

9. In developing objectives, it is good practice to make them SMART:

• Specific
• Measurable
• Agreed
• Realistic
• Time bound

10. Setting SMART objectives will help clarify what has to be achieved and will ensure that you are able to consider the full range of available options. A clear set of objectives will also enable the project to be properly evaluated after it has been implemented. However, for some projects it will be more difficult and less practical to define a full set of SMART objectives. For example, if a central objective of a new build school is to contribute towards increasing educational attainment, it will be extremely difficult to make this quantifiable. While clearly an important objective, it would be almost impossible to single out the individual contribution to attainment made by a particular capital investment. Individual judgement should be used during each option appraisal and a full range of SMART objectives set only where it is practical to do so and likely to improve the final outcome.

STAGE 2: DEVELOP OPTIONS

11. Once objectives have been defined, you can begin to consider the different approaches you could take to achieve them: the options. The objectives set out what you want to achieve, the options describe how you could achieve it.

12. The range of options depends on the nature and scale of the objectives. For a major project, such as multi school redevelopment, a wide range should be considered in detail. For a small project, such as repair work to a leaking roof, there will not be a wide range of alternatives.

13. It is important to consider a wide range of initial options, which can then be narrowed down. If you are finding it difficult to develop options, the Green Book provides examples of strategic and operational options and suggests actions to help establish options in practice.

14. The list should always include a base case for comparison. This will normally be an option based on doing nothing or doing the minimum such as maintaining the existing level of service. Comparing options against the base case will help support the case for something more significant to be done and identify what you will be unable to achieve if the project does not go ahead.

15. A shortlist of options may be created to make the process more manageable, usually at the preliminary stages of an appraisal or outline business case stage. The base case option should always be carried through to the short-list.

STAGE 2: DEVELOP OPTIONS

Boiler replacement

Through discussions with the school's management, the caretaker and heating engineers, four possible options were identified:

• let the current situation continue: the base case
• overhaul the existing system
• install electric heaters in all classrooms
• replace the current boiler with a new high-efficiency boiler of higher capacity and with appropriate controls.

STAGE 3: GATHER INFORMATION

16. Once a suitable shortlist of options has been created it will be necessary to gather relevant information on each. This enables a rigorous assessment of the options. The information required on each option may include:

• contribution to the achievement of objectives
• initial capital expenditure
• any capital receipts
• whole life capital and revenue costs
• any expected income generated over the whole life of the asset
• likely impacts on day-to-day activities of existing facilities during project implementation
• design quality issues
• environmental impacts
• any other impacts.

17. The appraisal needs to take account of future projections and forecasts.

18. A range of assumptions will have to be built into appraisals, particularly with larger, more complex and longer-term projects. These assumptions should be clearly set out along with the degree of uncertainty associated with them.

STAGE 4: ASSESS OPTIONS

19. Once a shortlist of options has been created and information gathered, the assessment process can begin. The relevant costs and benefits of each option should be valued and the net benefits or costs calculated. The results can then be used to compare options and help select the best. The techniques and procedures that should be used in this process are outlined below.

Estimating costs

20. It should be possible to place a monetary value on many of the costs relating to the options under consideration. Doing so will enable you to compare the costs on a consistent basis. Costs should normally be based on market prices as these usually reflect the best alternative use that the goods or services could be put to (the opportunity cost). They should also be valued in real terms - the price level that applies at the time of the appraisal. Generally, the impact of inflation should be ignored.

21. Costs should normally be extended to cover the period of useful life of the assets under consideration. However, if the appraisal concerns the contractual purchase of outputs and outcomes, for example in a PPP, the appraisal period may be different.

22. The cost of goods and services that have already been incurred and are irrevocable should be ignored in an appraisal. These are sunk costs. Appraisals should only consider those costs about which decisions can still be made. This includes the opportunity cost of continuing to tie up resources that have already been paid for.

23. Estimating costs can be difficult and, for substantial proposals, will normally involve input from accountants, economists and other specialists. The appraiser needs to understand and communicate clearly the scope of the appraisal to ensure that any specialists provide relevant information, and that opportunities are thoroughly explored.

Estimating benefits

24. The new Green Book places strong emphasis on the identification, management and realisation of benefits. Wherever possible, the benefits associated with each option should be valued in money terms in the same way as costs. This will enable you to calculate the net cost or benefit associated with each option systematically.

25. For many school estate investments, it may not be practical or feasible to attribute monetary values to the benefits of each option. It is likely these will identify some educational benefits, and some costs, for which there is no readily available monetary data. A range of techniques can be applied to elicit values, even though in some cases the values will be subjective. The Green Book provides further advice on these techniques.

26. The non-quantifiable benefits for each option should not be ignored and should be set out in a consistent format so that comparisons can be made when analysing the options through weighting and scoring or other systematic approaches.

Discounting

27. When comparing options, it is likely that some costs and benefits will occur in different time periods. The technique of discounting should be used to convert these costs and benefits to present values, so they can be compared. Discounting is a separate concept from inflation and is based on the principle that generally, people prefer to receive goods and services sooner rather than later - the time preference.

28. The Green Book has 'unbundled' the discount rate, introducing a rate of 3.5% in real terms. This is based on social time preference and takes account separately of the other factors which were, in practice, often bundled up in the old 6% real figure. In particular, the book includes an explicit adjustment procedure to redress the systematic optimism - optimism bias - that historically has affected the appraisal process. For larger or more complex schemes you may wish to seek specialist advice on this and other more technical aspects of option appraisal.

Risk, uncertainty and optimism bias

29. In any appraisal, there is always likely to be some difference between what is expected, and what eventually happens, because of bias inherent in the appraisal. A structured approach to risk management should therefore be adopted to enable the proper identification, assessment and control of the risks that emerge during the course of the project.

30. As options are considered, the degree to which risks and uncertainties vary between them should be assessed. It is possible that a low risk option is preferred to one that has the potential to deliver a broader package of benefits, but with greater risk that it will not succeed. When the risks associated with different options are being assessed, you should consider possible counter measures that could be introduced to manage risks and keep the project on course.

31. In both the public and private sectors, there is a demonstrated, systematic, tendency for project appraisers to be overly optimistic: benefits tend to be overstated whilst timings and costs are understated. To redress this tendency, appraisers should make explicit adjustments for this optimism bias. These will take the form of increasing estimates of costs and decreasing and delaying receipt of estimated benefits. The Green Book provides further information on risk management and optimism bias and the Treasury's Supplementary Guidance on the Treatment of Optimism Bias ⁴ provides further information on the latter.

32. Sensitivity analysis should be used to test the vulnerability of options to future risks that would be unavoidable. This should consider how conclusions might alter if the values of key variables changed. The calculation of switching values will show how much a benefit would have to fall or a cost rise before an option becomes unattractive. This should be seen as central to the decision on whether a proposal should proceed. Sensitivity analysis is fundamental to option appraisal and is to be dismissed only in exceptional circumstances.

STAGE 5: ANALYSE OPTIONS

33. Once all options have been assessed, they must be analysed in a consistent way. Many of the benefits and some costs which are expected to accrue as a result of investments in the school estate may be difficult to value but they should still be analysed within the option appraisal framework.

Weighting and scoring unvalued costs and benefits

34. A weighting and scoring approach will be suitable for analysing the options for most projects, in particular those where valuing important benefits is difficult, such as major capital investment in the school estate.

35. Weighting and scoring enables a consistent comparison of unvalued costs and benefits. The basic approach involves assigning weights to the project objectives, based on their relative importance, and then scoring each option in terms of how well it performs against those weighted objectives. It is good practice to weight individual objectives since it is unlikely that they are of equal importance within the project. The weighted scores are then totalled and the options ranked.

36. Setting weightings will normally involve the judgements of stakeholders and decision makers and can be decided upon through reasoned discussions. Using a weighting of 1-5 for each objective will usually be sufficient to ensure that an accurate result is achieved.

37. The scale used to score the options should be wide enough to reflect differences between options, even if these are quite small. A scale of 0-10 will usually be appropriate, where a rating of 0 refers to a complete failure to deliver an objective, while 10 would indicate that an option fully delivers an objective.

38. If a scoring and weighting approach is adopted, it is important to make sure that it does not discourage people from using their judgement when considering the different options. All the influencing factors should be taken into account in order to identify a preferred option on the basis of sound reasoning.

This example illustrates the importance of weighting objectives. While all three options have the same basic total score (31), option 3 has the highest weighted score (89), reflecting its high rating against the most important objective.

STAGE 6: CONSULTATION

39. Throughout the course of an option appraisal, you will need to ensure that all those people with an interest in the outcome of the project are consulted. A lot of options can be generated through consultation, while others may be ruled out before a detailed appraisal takes place as a result of stakeholder feedback.

40. The consultation process should begin at an early stage and continue as the appraisal develops. If new information becomes available it is important to revisit the consultation process with all interested parties.

41. Where major changes are planned it will be helpful to involve a wide range of stakeholders such as teachers, pupils, parents, community and voluntary groups and local business representatives.

STAGE 7: CHOOSE PREFERRED OPTION

42. The final part of the analysis is to combine the financial and non-financial factors to help identify the preferred option. Value for money rating can be used to combine the weighted scores for non-financial factors with the net present value of each option.

43. Value for money rating is a simple method for combining financial and non-financial factors and helps to promote consistency at an important stage of the option appraisal. Once the total weighted score has been calculated for each option, it should be divided by the total financial cost to give a value for money rating. The project with the highest value for money rating should be the preferred option. This is a useful indicator of the comparative attractiveness of different options but, the approach is somewhat rigid and should therefore not be viewed as a definitive test. It implies that we would always be willing to pay twice as much for an option which doubled the weighted score; clearly this would not always be the case.

44. Combining financial and non-financial elements does, however, assist in decisions between options that have very similar cost levels, or deliver similar levels of benefits.

45. For some small-scale projects it may be necessary to establish a value for money rating for all options. Under these circumstances, an informal approach can be sufficient to identify the preferred option. Examples of both an informal approach and a value for money rating approach are provided below.

STAGE 8: REPORTING

46. The final stage is the report to decision makers. The report should set out the process you have undertaken and the results it has produced - in other words, how you have arrived at the preferred option. The report should quantify all costs and benefits where appropriate; the weighting and scoring approach should be fully documented and presented in tabular form for ease of comparison between options; and assumptions inherent in the process should be outlined.

47. The appraisal report should be proportionate to the appraisal carried out. It should also reflect the use that you will be making of the report: for example, it is likely that it will either be used to recommend an internal decision, or to support an external funding bid.

48. The aim in producing the final appraisal report should be to ensure that it includes the level of detail required to support the decision on the preferred option. If it is not clear why a particular choice has been selected, you should include further information.

49. The report should set out the key decisions and messages of the option appraisal process. An executive summary can be included to highlight the preferred option and other key findings. Diagrams, tables and charts can be included to increase the clarity of the report. Where appendices are used, clear references should be made at the appropriate point in the main text.

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