9

UNIT 2
Basic Concepts
This unit introduces the concepts that are used in translating control
improvement into financial results. The basic concepts and terminology of
capital budgeting are defined. Many terms are also defined in
Appendix C.
Learning Objectives When you have completed this unit you should:
A. Understand the differences among control, process, and economic
performance.
B. Understand the concept of cash flow.
C. Know how projects are evaluated.
D. Know how probabilities can be used to combine cash flows of
differing scenarios into an expected cash flow.
2-1. Measures of Performance
In many fields, measures of performance are used to characterize how
well a given entity meets its objective. The appropriate measure depends
on the objective. For instance, a baseball player's hitting performance may
be measured by batting average, while a team's performance is better
characterized by its won-lost record. When considering the implementa-
tion of a control project, several measures must be considered, including
control performance, process performance, and economic performance.
Control performance is a measure of how well the control system achieves
its objective. This objective is usually regulatory (i.e., holding a measured
or computed quantity at its desired value), and performance is measured
statistically and expressed as some function of deviation from target, or
variability. Among the commonly used functions are range, maximum
error, and standard error. Range is the difference between the maximum
and minimum values. Maximum error is the largest deviation from set
point. Standard error is the root mean square deviation from set point. If
the loop is not biased, standard error is equal to standard deviation
around the mean value. Other measures include percent outside limits
and range within some percentage, typically 95%. Fig. 2-1 shows some of
these measures.
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10 UNIT 2: Basic Concepts
Standard deviation and 95% limits are the best measures for typical pro-
cesses, but other measures are more appropriate in certain cases. For
instance, maximum error is the best measure when a large deviation from
set point can cause catastrophic failure. Percent outside limits is appropri-
ate for processes, such as wastewater pH control and averaging level con-
trol, in which any value within limits is equally acceptable and any value
outside limits is equally unacceptable.
Process performance is a measure of how well the process achieves its objec-
tive. Various criteria can be used as measures. Reverting to the baseball
analogy, a hitter's performance can be measured in terms of production
(number of hits per season) or efficiency (hits per time at bat, or batting
average). Most processes use energy to convert raw material into product.
Measures of process performance include production rate, expressed as
units of product per unit time, and efficiency, expressed as units of prod-
uct per unit of raw material and/or energy.
Improvement of control performance does not necessarily improve pro-
cess performance. Sometimes it does, but usually it only creates an oppor-
tunity. More often, process conditions or operating procedures have to be
changed to take advantage of better control.
Economic performance is measured in financial terms. Processes are oper-
ated to make money. Economic performance, like process performance,
can be stated in terms of production or efficiency. Financial production
rate is expressed as dollars per unit time. Financial efficiency is expressed
as financial production per dollar invested.
The relationship between process performance and economic perfor-
mance is similar to that between control performance and process perfor-
Fig. 2-1. Some Measures of Variability
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UNIT 2: Basic Concepts 11
mance. Improved process performance does not guarantee that the
process will make more money. Operating practice often must be changed
to realize the potential benefits, as shown in Example 2-1.
Example 2-1: A blending plant installs feedback composition control,
which reduces product composition standard deviation before batch cor-
rection by 70% (a control improvement). The controls allow elimination of
delays for product analysis, so the plant can now turn out 20% more prod-
uct per day (a process improvement). There is no market for the additional
product, so unless operating practice is changed, the process improve-
ment will result in a net loss, since the added product will require addi-
tional raw material. One alternative is to change operating practice by
running the plant only four days a week instead of five. Production will be
unchanged, but labor costs will be reduced by 20% (an economic improve-
ment).
2-2. Cash Flows
In economic terms, a project results in a series of cash flows over time.
First, the cash flows out as costs are incurred, then once the project is com-
pleted, cash flows in as revenues are generated. Net cash flow is defined
as the difference between cash inflows (positive) and cash outflows (nega-
tive) over a given period of time, usually one year. Fig. 2-2 shows a cash
flow diagram for a typical Project X with a cost of $100,000, annual reve-
nues of $30,000, annual expenses of $8000, and salvage value after 10 years
of $10,000. Cumulative cash flows for Project X are shown in Fig. 2-3. The
cash flow structure of this project is typical, but subject to many variations.
Not all costs may be incurred initially. Revenues and expenses may vary
from year to year. Salvage value may be zero or negative.
2-3. Costs
Costs are simply outgoing (negative) cash flows. Economists distinguish
among several types of costs. Those used in this text include first cost, which
is the initial cost of a capital project, and operating costs, which are the recur-
ring costs incurred while running a facility. Operating costs are divided
into fixed costs, which are unaffected by production rate, and variable
costs, which vary with production rate.
Two kinds of costs that are often used incorrectly in project evaluation are
sunk costs and opportunity costs. A sunk cost is a cost that has occurred in
the past, before the project under consideration. It has no relevance to
project evaluation and should not be included in the first cost of the
project. Opportunity cost is income that must be forgone because of the
project in question (e.g., income that might be earned by an alternative use
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12 UNIT 2: Basic Concepts
of the resources committed to the project). It is often ignored when it
should be included as a first or operating cost. For example, suppose an
existing supervisory computer can oversee three finishing lines and earns
$10,000 per year per line. If a new control system is connected to the com-
puter and ties up part of the computer's capacity so that it can oversee
only two lines, the forgone earnings of $10,000/year should be counted as
an operating cost of the new system.
Fig. 2-2. Project X Cash Flow Diagram
Fig. 2-3. Project X Cumulative Cash Flow
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UNIT 2: Basic Concepts 13
2-4. Benefits
Benefits are incoming (positive) cash flows. The most common sources of
benefits are added revenue from additional sales and cost savings. Cost
savings are most likely to result from reduced usage of raw materials, util-
ities, or labor.
Some benefits may require ingenious configuring to quantify. Pollution
abatement benefits can often be expressed as avoidance of disposal costs
for unwanted byproducts or avoidance of regulatory penalties for excess
emissions. Benefits must be expressed in cash flow terms for the purposes
of project evaluation.
2-5. Project Evaluation
Estimated costs and benefits can be combined to produce an incremental
cash flow table. This cash flow table lists all the inflows and outflows that
are directly related to a particular project. It is the basis for project evalua-
tion. The cash flows discussed in this course are pre-tax and are not
adjusted for inflation. Tax considerations are ignored for reasons of sim-
plicity, avoidance of rapid obsolescence (tax laws on capital expenditures
change frequently and substantially), and canceling effects (costs and ben-
efits are both reduced by taxes). Taxes do have some effect on viability of
marginal projects. If taxes must be included in the calculation, assistance
should be sought from an accounting or legal department, who are more
likely to be up to date on tax law. Inflation is ignored for simplicity. If cash
flows are presented in current dollars, inflation is often accommodated
implicitly by requiring a higher rate of return or faster payback to com-
pensate for inflated revenues in later years of the project.
Any organization, whether private or public, has only a finite pool of capi-
tal. This pool of capital is subject to myriad demands, of which process
control projects form a small part. The organization must set up some
method of capital allocation. A large number of methods have been pro-
posed, and several are in common use. This text discusses the most popu-
lar, including payback, return on investment, net present value, and internal
rate of return. Application of each method results in a single figure of merit
that characterizes a project. The figure of merit may be used as a decision
tool, to decide whether Project X should be funded, or as a ranking tool, to
decide whether Project X or Project Y is more attractive. Example 2-2
shows how payback, the simplest method, is applied.
Example 2-2: Payback is simply the time required to recover first costs.
Project X, for which cash flows are shown in Figs. 2-2 and 2-3, has a pay-
back period of 4.55 years. This can be seen clearly in Fig. 2-3 as the time at
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14 UNIT 2: Basic Concepts
which cumulative cash flow reaches zero. If the organization's criterion for
investment is a payback period shorter than 5 years, the project qualifies
for investment. In times of easy capital accessibility, this may be sufficient
justification. More commonly, there are more qualifying projects than can
be funded. If $500,000 is available for capital investment and Project X is
competing with Projects A, B, and C described in Table 2-1, then only
projects A and C will be funded. In this case, payback in less than 5 years
is a necessary but not sufficient condition.
2-6. Uncertainty and Probability
All of the discussion to date has assumed that we know what will happen
in the future so cash flows can be estimated with certainty. In fact, no one
can know what will happen. Any of several sequences of events over time,
or scenarios, may occur. One can make an educated guess at the likelihood
of a particular event. This educated guess is an estimate of the probability
of the event. Event probabilities can be used to calculate scenario probabil-
ities. The sum of probabilities of all possible scenarios must be 100%.
Example 2-3: A new on-line analyzer is to be installed. The analyzer costs
$15,000, and is expected to produce benefits of $4000 per year for the next
5 years. The analyzer's sampling system is untried and may fail to work. If
it is unsatisfactory, a tested sampling system can be installed at an addi-
tional cost of $5000. It will take one year to decide whether the original
sampling system is working properly, and the estimated chance of failure
is 30% (event probability).
From this information two scenarios can be constructed. Scenario A, with
a probability of 70%, shows the expected initial expenditure followed by
the expected benefits. Scenario B, with a probability of 30%, shows addi-
tional sampling system expenditure and revised benefit timing.
2-7. Risk
All projects have some risks, technological and/or commercial. Technologi-
cal risks apply to hardware, software, and implementation. A valve that
Project First Cost, $ Payback, Years
A 400,000 2.5
B 200,000 4.4
C 100,000 3.8
X 100,000 4.5
Table 2-1. Competing Projects
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UNIT 2: Basic Concepts 15
may not control flow with the requisite precision is a technological risk; so
is a programmer who may take 6 months longer than scheduled to code
an on-line optimizer. Commercial risks apply to the business climate. A
recession two years after the project is completed may affect product sales.
A competitor may cut prices to increase market share. Technological risks
can affect both costs and benefits. Commercial risks usually affect benefits.
If the risks are negligible, it is reasonable to present a single expected cash
flow scenario for project evaluation. If the risks are significant, multiple
scenarios, accompanied by probability estimates, should be considered. In
most cases, only reasonably likely scenarios with a probability of at least
10% should be included. The threshold probability for a disaster sce-
nario that would result in substantial impairment of the financial health of
the organization should be lower, perhaps 1%. If a single number is
wanted for project ranking, cash flow scenarios can be combined,
weighted according to their respective probabilities.
Exercises
2-1. A vessel temperature is controlled around a set point of 200C. If
temperatures are more than 5C from set point, product is discolored and
must be recycled. What is the most appropriate measure of control
performance for this loop?
2-2. A blending process makes C by mixing A and B. C is required to contain at
least 20% of A, the more expensive component. The present control system
has a composition range of 4% and makes no off-specification material. A
new system will have a range of 2%. Without any changes in operating
practice, how much process improvement will be realized using the new
system?
2-3. What change in operating practice to the process described in Example 2-2
will generate a process improvement using the new system?
2-4. In Example 2-3, what would the cash flows be for Scenario A? For Scenario
B? Assume that if the sample system is not working properly, no revenues
are generated.
2-5. In Example 2-3, what would the payback be for Scenario A? For Scenario
B?
2-6. In Example 2-2, if Project X's first cost, could be reduced to $75,000, which
projects would be funded?
2-7. If the scenarios in Example 2-3 were combined, what would the cash flow
look like?
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