Profitability Analysis

➢ Profitability is a term for the measure of the amount of profit that can be
obtained from any given projects.
➢ Aim of profitability analysis is to give a measure of the attractiveness of
the project as compared to other different alternative projects and the
choice of the best investment from various alternatives.
➢ Total profit alone cannot be used as the deciding profitability factor to
make the choice of the best investment from various alternatives.
Therefore, there are the most commonly used methods for profitability
evaluation in addition to total profit.
The most commonly used methods for project (profitability) evaluation are
the following
1) Break even analysis
2) Incremental analysis
3) Ratio analysis (Rate of return on investment and Payback period)
4) Discounting cash flow analysis (Net present value, internal rate of
return, and profitability index)
5) Capitalized costs
 1) Break Even Analysis
A technique that describes at which production capacity and selling price
more profit is earned or profit loss occurs
➢ Through a graphical plot of fixed cost, variable cost, total production cost
and total income as function of production capacity.

Total income or Revenue

Selling price ($/ton)

Breakeven point TPC

Variable cost
Loss

Fixed charge

QBE Production capacity (ton/yr)

 Importance of breakeven point analysis
➢ Used by production management to find the production rate at which the
plant will start making profit.
➢ Used to show the effect of various selling price of product on profit
❖ Breakeven point is the point at which the total production cost equals to
total income/revenue.
❖ Break even quantity/level (QBE) refers to the production capacity at which
the total production cost equals total income/revenue.
At breakeven point, R =TPC,
But R =rQ, TPC =FC +VC, VC = VQ
Therefore R =TPC, rQ = FC +VQ,
rQ -VQ = FC, rearrange and solve for Q
𝐹𝐶
Q = QBE =
𝑟 −𝑣
➢ If break even quantity (QBE) is greater/ increases than planned production
capacity, profit decreases and the project is not viable.
➢ If (QBE) is less/decreases than planned production capacity (Q), the profit
increases but the project needs further consideration.
➢ (QBE) decreases if FC and VC decreases but selling price ( r) increases.
So there is greater profit as a result of.
✓ market monopoly
✓ Efficient process requiring cheaper raw material and utility
✓ Superior and cheaper technology
As a rule for a viable (good) project breakeven quantity is 60 -65% of
planned capacity. This means the breakeven occurs in the first year.
 2) Incremental analysis
Evaluate the increased returns over incremental investment return increases
as investment increases.
Project Initial Profit % return on
investment ($) after tax investment
A 2000 400 20
B 2400 550 22.9
C 2800 600 21.4

Assume desired ROI =20% or high

A B √ Extra 400 investment
√ Earn 150 additional profit
√ Return on extra investment,150/400=37.5%
B C √ Extra 400 investment
√ Earn 50 additional profit
√ Return on extra investment,50/400=12.5%
A C √ Extra 800 investment
√ Earn 200 additional profit
√ Return on extra investment,200/800=25%
Therefore, project B looks more attractive as it has highest investment
returns.
Why incremental analysis is needed?
➢ When two or more mutually exclusive alternatives are evaluated,
incremental analysis can identify the alternative project that is the best
economical.
 3) Ratio Analysis
Two types of ratio analysis
ⅰ) Rate of return on investment
➢ Rate of return on investment is defined as the ratio of annual net profit to
total capital investment.
Net Profit NP NP
ROI = = , ROI(%) = ∗ 100
Total Capital Investment TCI TCI

➢ Sometimes, Net profit is not constant from year to year; total investment
also changes if additional investments are made during project operation.
1/n σ𝑛
𝑗=1(𝑁𝑃𝑗)
In such a case, ROI = σ𝑛
where
𝑗=1(𝑇𝐶𝐼𝑗)

n is the project period, NPj is net profit in year j, TCIj is TCI in year j
➢ The calculated ROI can be compared with minimum acceptable rate of return to
judge on project profitability.
➢ If ROI is greater than or equal to minimum acceptable rate of return then the project
is acceptable and profitable.
Table: Suggested values for risk and minimum acceptable return on investment
 Disadvantages of ROI
The advantage of ROI is its simplicity to make quick profitability analysis
Its disadvantage includes;
✓ The time value of money (interest) is no considered
✓ All projects are assumed to be similar in nature to each other
✓ It does not take into account the fact that profits and costs may vary
significantly over the life of the project
 ⅱ) Payback period (PBP)
➢ PBP is the minimum length of time required to recover the original
capital investment.
Depreciable Fixed Capital Investment FCI
payback period (PBP) = =
Annual Cash flo𝑤 Aj

V+Ax
PBP = if interest is not considered
Aj

,where
V is manufacturing fixed capital investment
Ax is nonmanufacturing fixed capital investment
Aj is annual cash flow = Net profit +depreciation
➢ As a rule PBP =2-3 year for small project and 5-7 for large project
➢ If PBP < Target period then the project is acceptable
➢ If PBP > target period then the project is rejected
 depreciable FCI+interest on TCI
payback period (PBP) =
Aj

V+Ax+i on TCI
PBP = if interest is considered
Aj

Advantage and disadvantage of Payback period

✓ Its advantage is simple and show how soon the investment is
recovered
The disadvantage of payback periods are
✓ It will not consider any of the costs or benefits of investment after
the payback period
✓ It also do not consider the time value of money
✓ Does not give the total profit within all service life of the project.
 4) Discounting cash flow analysis
➢ Is a powerful tool for project evaluation which takes into account the
time value of money.
➢ It basis on the amount of the investment that is unreturned at the
end of each year during the estimated life of the project.
To determine the attractiveness of the project, these technique uses the
following method:-
a) Net present value(NPV)
b) Internal rate of return(IRR) also called discounted cash flow rate of return
c) Profitability index (PI)
 a) Net present value (NPV) Analysis
➢The NPV analysis evaluates the project profitability by converting all the
future cash flows into their equivalent present value.
➢ NPV is the sum of the present value of all cash inflows minus the present
value of all capital investments.
➢In NPV analysis, cash flows CFn earned in different years n is brought to
the present value CFn,0 by using a compound interest present value
discounting formula as follows
CFn CFn
CFn,0 = Thus, NPV =σ𝑛𝑗=1 − 𝑇𝐶𝐼
1+𝑖 𝑛 1+𝑖 𝑛

CF0 CF1 CF2 CFn

NPV = [ + + +…+ ] − 𝑇𝐶𝐼, where
1+𝑖 0 1+𝑖 1 1+𝑖 2 1+𝑖 𝑛

n is the project life,

i is the interest rate (minimum acceptable rate of return or cost of capital)
 1 1
NPV = σ𝑛𝑗=1 𝑆𝑗 − 𝑇𝑃𝐶𝑗 − 𝑑𝑗 1 − Φ + 𝑑𝑗) − σ𝑛𝑗=1[ ]𝑇𝐶𝐼𝑗
1+𝑖 𝑛 1+𝑖 𝑛

A positive NPV means that the present value of the inflows is greater than
the present value of outflows, so the project makes a profit.
➢ For evaluating a single project, NPV value greater than 0 is acceptable
and the project is profitable. If NPV <0 then the project is unfavorable
➢ For multiple project comparison, calculate NPV for each project and
select the one with the largest NPV.
➢ If NPV >0, then the project provides the return at a rate greater than the
minimum acceptable rate of return (i).
➢ If NPV =0, then the project provides the return at rate that matches the
minimum acceptable rate of return.
➢ If NPV <0, then the project is unfavorable with respect to the minimum
acceptable rate of return
 b) Internal rate of return (IRR) or Discounted cash flow rate of return
Internal rate of return is also known as Discounted cash flow rate of return
➢ It is defined as the value of interest (discount) rate (i) at which NPV at
the end of project life is zero.
CFn
NPV =σ𝑛𝑗=1 − 𝑇𝐶𝐼 = 0
1+𝑖 𝑛

➢ If IRR is greater than the assumed/established minimum acceptable rate

of return, then the project is financially viable and acceptable.
➢ For multiple project comparison, calculate IRR for each project and the
one with the largest IRR is preferable and profitable.
 c) Profitability index (PI)
Profitability index is defined as the NPV divided by the total investment.
CFn
NPV σ𝑛 −𝑇𝐶𝐼
𝑗=1 1+𝑖 𝑛
PI = =
𝑇𝐶𝐼 𝑇𝐶𝐼

➢ If PI >1, then project should be accepted b/c NPV is +ve.

➢ If 0<PI<1, then the project should be rejected
Question: What are the merits and demerits of ratio analysis and discount cash
flow project evaluation methods?
Merits (advantage) and Demerits (Disadvantages) of ratio analysis
The advantage of ratio analysis is its simplicity to make quick profitability analysis
Its disadvantage includes;
✓ The time value of money (interest) is not considered
✓ Cost expenses during the construction period prior to startup is ignored
✓Does not adequately consider the later years of the project life, does not consider
working capital,
 5) Capitalized Costs
➢ Capitalized cost represents the amount of money that must be available
initially to purchase the equipment and simultaneously provide sufficient
funds for interest accumulation to permit perpetual replacement of the
equipment.
➢ This may also includes maintenance and operation cost
Let K is the capitalized cost, then the general expression for capitalized cost
CR CR 1+𝑖 𝑛
K =Cv + = +Vs, Where
1+𝑖 𝑛 −1 1+𝑖 𝑛 −1

CV is original cost, I is interest rate, n is useful life of equipment

VS is salvage value
➢ for comparing multiple alternatives, the one with lower capitalized cost is
acceptable.
 Alternative investments and Replacements
ⅰ) Alternative investments
➢ The investment with minimum capital which will give the necessary
functional results and the required rate of return should always be
accepted unless there is a specific reason for accepting an alternative
investment requiring more initial capital.
➢ When alternatives are available, therefore, the base plan would be that
requiring the minimum acceptable investment.
➢The alternatives should be compared with the base plan, and additional
capital would not be invested unless an acceptable incremental return or
some other distinct advantage could be shown.
Replacements:- is a special type of alternative in which facilities are
currently in use and it may be desirable to replace these facilities with
different ones.
➢ The reasons for making replacements can be divided into two general
classes, as follows:
1) In order to continue operation and meet the required demands for
service or production. examples of reasons for this type of replacement
are:
a) The property is worn out and can give no further useful service.
b) The property does not have sufficient capacity to meet the demand placed
upon it.
c) Operation of the property is no longer economically feasible because
changes in design or product requirements have caused the property to
become obsolete
2) An existing property is capable of yielding the necessary product or
service, but more efficient equipment or property is available which can
operate with lower expenses.
 Safety In Process Plant Design

➢ At each stages (such as erection, testing, operation and maintenance) of

plants a variety of accidents and hazards may occurs.
➢ These accidents and hazards may cause and leading to the following
✓ Workers injuries and even loss of human life
✓ Damage to property as well as environment
✓ loss of desired plant production capacity and quality
So, safety in all stages (Process plant design development) is important in order to;
✓ Identify the hazards in a system.
✓ Determine the underlying causes of those hazards
✓ Develop engineering or management controls to either eliminate the
hazards or mitigate their consequences.
✓ Check and verify that the controls are adequate and in place.
✓ Monitor the system after it has been changed and modify further as
needed
Reading Assignment (Slide 23-29)
Safety in chemical industries
➢ Safety is the prevention of accidents through the use of appropriate
technologies to identify the hazards of a chemical plant and eliminate
them before an accident occurs.
Hazard: a chemical or physical condition that has the potential to cause
damage to people, property, or the environment.
Today safety is an important part of any industry .
➢ Developing any process industries from concept stage the following stages are
required;
✓ Designing
✓ Erection
✓ Testing
✓ Operations
✓ Maintenance
Neglecting safety actions at any of the above stages can result into disaster leading to
loss of human life and desired plant production.
In process industries unsafe conditions reduces:-
✓ production rate due to failure of equipment parts, decline of the efficiency the
equipments
✓ Quality of the product
✓ Good working condition for employees (safe place)
Therefore, it is essential to design and incorporate complete safety system in all
stages (Process plant design development)
 Main cause of accident includes
✓ Incorrect design, construction, installation, testing and commissioning
✓ Incorrect use of machinery and industrial facility
✓ Lack of inspection and maintenance
✓ Incorrect plant layout ,(improperly set)
✓ Incorrect functioning of equipments
✓ Poor maintenance practice
✓ Lack of skill, instruction and poor supervisions
✓ Poor working condition
✓ Incorrect working materials (ex, improper raw material substitution)
 Accident prevention methods
Generally, in order of robustness and reliability the main Accident
prevention methods are four :
1. Inherently safer design
2. Passive
3. Active and
4. Procedural
1) Designing inherently safer processes
Strategies of designing inherently safer processes are categorized in to four
groups.
a) Substitution b) Minimization
c) Moderate d) Simplify
a) Substitution: use less hazardous materials, chemistry and process.
➢ For example: water based latex paints eliminate fire, toxicity and
environmental hazards associated with solvent based paints.
b) Minimization: use small quantity of hazardous materials or reduce the
size of equipments operating under hazardous conditions (e.g. high
temperature and pressure)
➢ For instance; Reactive distillation process for manufacturing of methyl
acetate reduces the number of major vessels and columns from ten to
three as compare to an older process when the reaction and distillation
operations performed in separate equipment
c) moderate: Reduce hazardous materials by dilution, refrigeration or
process alternatives that operates at less hazardous conditions.
E.g, combustible solid was handled as a pellet instead of fine powder to
reduce the dust explosion hazard.
d) Simplify: eliminate unnecessary complexity to reduce a risk of human
error
2) Passive: Minimize hazard using process or equipment design features
which reduce frequency or consequence with out the active functioning of
any device.
Location of facilities: separation of ignition sources and fuels from other
facilities.
Design equipment for design pressure in excess of the Adiabatic pressure
from a reaction
3) Active: Minimize hazard by using active functioning of device such as
controls, safety interlocks, automatic shutdown systems and Multiple active
elements
Sensor:- detect hazardous condition
Logic device:- decide what to do
Control element:- implement action, Prevent incidents or mitigate the
consequences of incidents
Example : High level alarm in a tank shuts automatic feed valve
4) Procedural:- minimize hazard by Standard operating procedures, safety
rules and standard procedures, emergency response procedures, training.
Example : confined space entry procedures.
Thank you!!