Fig. 1

The difference between the annualized financial and economic cost of a capital resource. As capital resources (such as vehicles) are bought in 1 year but used over several years, their cost needs to be spread over their useful life. This adjustment is known as annualization and it has two potential components; depreciation (the reduction in the value of the asset over time due to wear and tear) and the opportunity cost associated with tying up the funds in purchasing the capital item (as there is a lost opportunity to generate gains from investing that capital). When calculating financial costs the annualization calculation only captures depreciation, by dividing its replacement cost by its useful lifespan. In contrast, when calculating economic costs, the annualization calculation also aims to capture the opportunity cost. This is done by dividing the replacement cost by an annualization factor, which is based on the resource’s expected lifespan and an assumed discount or interest rate. Because the annualization factor is a smaller number than the corresponding resource’s expected lifespan (here 4.58 vs. 5), the annualized economic cost will be higher than the annualized financial cost. See Walker et al. [11] for further details