HCHE 511 – Lecture 2 – Costing and Project Evaluation

Lecture Objectives:

• Estimate operating and capital costs of a process (Already covered in the

Plant and Equipment Design course).
• Determine if a venture is feasible using a discounted cash flow model.
• Determine the main cost drivers and analyse how the profitability of a
venture/process can be improved.

Introduction

• Every engineer should be able to estimate costs to decide between

alternative designs and for project evaluation.
• Engineers often perform:
o Evaluation of projects
o Planning and controlling budgets
o Cost estimating

Cost Estimating (Capital and Operational)

• During the feasibility stage of a design project, approximate cost estimates

(± 20 – 30%) are required and usually in the minimum time possible.
• Cost correlations and factored estimates are usually sufficiently accurate
for the initial cost estimation study.

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The Nature of Costs

• Fixed costs:

Cost

Volume

• Variable costs:

Cost

Volume

• Semi-variable costs vary with volume, but not directly so (e.g., maintenance,
telephone costs).
• Unit costs (costs per unit e.g., per ton)
• Generally variable cost per unit are constant, but fixed costs per unit decrease
as volume increases.

𝐓𝐨𝐭𝐚𝐥 𝐜𝐨𝐬𝐭
𝐔𝐧𝐢𝐭 𝐂𝐨𝐬𝐭 =
𝐍𝐮𝐦𝐛𝐞𝐫 𝐨𝐟 𝐮𝐧𝐢𝐭𝐬

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 • Direct and indirect costs
o Direct – e.g., in production of product - costs associated with
the production – direct labor, raw material, packing.
o Labor costs include basic salary, fringe benefits, pension, etc.
o Difficulty if some workers work on several products.
o Indirect – indirectly related to work done – salaries of
supervisors, quality control personnel, maintenance, selling &
distribution expenses, research & development, overhead
costs.
o When a number of products are sold, it is difficult to apportion
indirect costs.

Break-even Analysis

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Definitions

Income or sales = unit price x no. units sold

Total cost = fixed + variable costs

Variable cost = unit variable cost x no of units sold

Unit total cost = total cost/ no. of units sold

Profit = income – total cost

𝐅𝐢𝐱𝐞𝐝 𝐜𝐨𝐬𝐭
𝐁𝐫𝐞𝐚𝐤𝐞𝐯𝐞𝐧 𝐮𝐧𝐢𝐭𝐬 =
𝐔𝐧𝐢𝐭 𝐩𝐫𝐢𝐜𝐞 − 𝐔𝐧𝐢𝐭 𝐯𝐚𝐫𝐢𝐚𝐛𝐥𝐞 𝐜𝐨𝐬𝐭

Examples

1. Pete’s hotdog factory has a fixed cost of R 450 per month and each unit
(hot dog) has a variable production cost of R 1.70. Each unit sells for R
2.50. Calculate:
a) Break-even volume per month.
b) The total profit (or loss) made per month when the following number
of units are sold: (i) 440 units (ii) 940 units
c) The increase in profits if the monthly sales of 940 units is increased by
10%.
2. A colliery has a capacity to produce 120 000 tons run-of mine anthracite
(coal with high carbon content) per month. After washing, about two-thirds
of the run-of mine tonnage is sold as prime. The colliery is currently
producing 96 000 run-of-mine tons per month. The fixed cost of the mine
per month are R 4.2 million and the variable cost per run-of mine ton
amounts to R 45. Assume a selling price of R 150 per ton of prime.
Calculate:
a) The current profit per month

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 b) The smallest number of prime tons that have to be sold every month to
avoid losses.
c) The increase in profit and volume (expressed as a percentage) if the mine
runs at full capacity.

Financial Calculations

Interest

Simple interest or compound interest

𝐒𝐈 = 𝐏𝐧𝐢

[P = principal amount; n = number of investment periods; i = interest rate %]

Present Value (PV) and Future Value (FV)

• PV is the value of an asset at the moment.

• FV is the value of an asset when it has earned some interest.
𝐅𝐕 = 𝐏𝐕 + 𝐈𝐧𝐭𝐞𝐫𝐞𝐬𝐭
• What is compound interest?
𝐅𝐕 = 𝐏𝐕(𝟏 + 𝐢)𝐧

Example 1: Determine the amount owing after 4 years and 7 months if R15 800
were borrowed at the beginning of the first year @ 15.5% p.a. compound interest,
compounded monthly.

Example 2: What amount must be invested now at 12.6% p.a. compound interest
(compounded monthly) to yield a lump sum of R 50 000 at the end of 4 years 8
months?

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Annuities

• Series of equal payments (A) made at the beginning or end of

succeeding interest periods. Compound interest assumed.
(𝟏 + 𝐢)𝐧 − 𝟏
𝐅𝐕 = 𝐀 [ ]
𝐢
Example: Calculate the total amount accumulated after 6 years at 8.5 %
p.a. compounded annually if R 2500 are invested at the beginning of each
year.

Sinking Fund
• An amount accumulated by several equal payments at a given interest
rate to cover (redeem, amortise) a wasting asset.
𝐢
𝐀 = 𝐅𝐕 [ ]
(𝟏 + 𝐢)𝐧 − 𝟏
Example: A coal mine will have to spend R 2.5 million in 8 years’ time on
rehabilitation at closure. What uniform annual payments will have to be
made at the beginning of each year if interest is at 12%, compounded
annually, to realise that amount.

Financial Analysis of a Project

• Information required:
PROCESS DETAILS
o Flowsheet incl. unit operations (heating/cooling, stirring,
pumping,
o tanks, separators, etc.)
o Quantities (raw material, product, by-products, waste, catalysts,
etc)
o Prices (raw material, product, by-products, waste, catalysts, etc)

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 INFRASTRUCTURE

o Land
o Buildings
o Equipment
o Utilities
o Prices (of all the above)
CONSTRUCTION COSTS
o Civil
o Building
o Mechanical
o Electrical
o Instrumentation
o Effluent treatment facilities
o Consulting & Project Management
PEOPLE
o Operators
o Artisans
o Technical (engineers, technicians, chemists, laboratory)
o Managers
o Admin staff
o Cleaning staff

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Project Cash Flow

• What is a Cash Flow?

Time (years) R'mill

0 -450
1 26
2 110
3 150
4 130
5 170

300

200
Cash Flow (R’mill)

100

0 Years
0 1 2 3 4 5
-100

-200

-300

-400

-500

• What is the problem with straight addition of cash flows?

Discounting

• Money keeps losing its value. Why?

• To take this into account, we discount its present value.
• The more time that elapses, the less the value.
• Discount rate k% p.a.

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 𝐧
𝐂𝐭
𝐍𝐏𝐕 = ∑
(𝟏 + 𝐤)𝐭
𝐭=𝟎

• Redo the NPV calculation using a discounting rate of 6%:

Time (years) R'mill PVIF (6%) PV
0 -450 1.000 -450
1 26 0.943 25
2 110 0.890 98
3 150 0.840 126
4 130 0.792 103
5 170 0.747 127
136 NPV 28
• Internal Rate of Return (IRR) is the discount rate (k) for which the
NPV is zero.

Calculating IRR manually

• You can try and guess the value of the discount rate that gives an NPV
of zero as attempted in the table below but this is tedious.

Year Discount Discount Discount Discount

rate = 0% rate = 15% rate = 25% rate = 24%
0 -1500 -1500 -1500 -1500
1 900 782.61 720.00 725.81
2 800 604.91 512.00 520.29
3 500 328.76 256.00 262.24
NPV 700 216.28 -12.00 8.34

Using Excel to Determine NPV and IRR

• Excel allows a user to get an internal rate of return and a net present
value of an investment using the NPV and IRR functions.

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 • There are several videos that can take you through steps that you follow
on Excel to calculate NPV and IRR for your project. This is one
example:
https://www.youtube.com/watch?v=qAhV3xG0i8s
• Step by step approach:
o Set up your spreadsheet to clearly showing values of your cash
flows for each year. Year 0 is always negative as no cash flows
are realised.

o The generic formula for the NPV function is:

=NPV(rate, values)

The parameter of the NPV function is:

rate – a discount rate for the investment period

values – values representing an investment (with a negative sign)

and returns over periods.

Using the spreadsheet above, the formula looks like:

=NPV(F2, B4:B10) + B3

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 The parameter rate is the cell F2, while the values are in the range B4:B10.
We omit the first value from B3, as it is negative and add it to the function
result.

To apply the NPV function, we need to follow these steps:

• Select cell E3 and click on it

• Insert the formula: =NPV(F2, B4:B10) + B3
• Press enter.

o The generic formula for the IRR function is:

=IRR(values, [guess])

The parameter of the IRR function is:

values – a range of cells containing values, including initial

investment and incomes. The investment must have a negative
sign, as it is a cost

[guess] – an estimated value for the expected IRR. This

parameter is non-mandatory. If it’s omitted, the function will
take a default value of 0.1 (=10%).

In our example, we want to get the NPV of the values in the range B3:B10.
The result will be in the cell F4.

The formula looks like:

=NPV(F2, B4:B10) + B3

The parameter rate is the cell F2, while the values are in the range B4:B10.
We omit the first value from B3, as it is negative and add it to the function
result.

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 To apply the NPV function, we need to follow these steps:

• Select cell E3 and click on it

• Insert the formula: =NPV(F2, B4:B10) + B3
• Press enter.

Sensitivity Analysis

• The determination of NPV and IRR depends on assumptions that may

not hold.
• Sensitivity analysis enables one to determine how variances in the
inputs to the analysis affects the output.
• To conduct sensitivity analysis, you do the following:
o Find the base case output i.e. the NPV and/or the IRR at the base
value of the input (or cost driver) which you intend to measure
the sensitivity. The cost driver could be tax rate, depreciation,
sales etc. We keep all other inputs constant.
o Find the value of the output at a new value of the input while
keeping other inputs constant.
o Repeat for the other inputs of interest and plot on a line/bar graph.
Examples of a sensitivity analyses on IRR NPV are shown below.
Comment?

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Cash Flow Diagrams

• A cash-flow diagram shows the forecast cumulative net cash flow over
the life of a project.
• The cash flows are based on the best estimated of investment, operating
costs, sales volume and sales price, that can be made for the project.

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A – B The investment required to design the plant.

B – C The heavy flow of capital to build the plant and provides funds for start-
up.

C – D Income starts being generated from sales and the cash-flow curve turns up
at C. Cumulative amount remains negative until the investment is paid off at point
D.

Point D is known as the break-even point and the time to reach the break-even
point is called the pay-back time.

D – E The project is earning a return on the investment.

E – F Toward the end of the project life, the rate of cash flow may tend to fall
off, due to increased operating costs and falling sale volume and price, and the
slope of the curve changes. The point F gives the final cumulative net cash flow
at the end of the project life.

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