Module II PEE

Affiliated to VTU, Belagavi,
Approved by AICTE, New Delhi,

Recognized by UGC with 2(f) & 12(B)
Accredited by NBA & NAAC
Process Engineering Economics

MVJ19CH742
Module - II
Prepared By: Dr. Augusta Pachathu

Assistant Professor
Department of Chemical Engineering
Affiliated to VTU, Belagavi, Approved by AICTE, New Delhi, Recognised by UGC with 2(f) & 12 (B), Accredited by NBA & NAAC 1
An Autonomous Institute
MODULE 2: Cost analysis and Time value money
▪ Elements of project cost - cost information

▪ Factors affecting investment & production cost
▪ Estimation of capital investment
▪ Estimation of operation costs, project financing
▪ Factors in capital investment,
▪ Estimation of working capital and cost index,
▪ Time value of money: Types of interests
▪ Effective and nominal interest rates, Present worth and
discount
Elements of project cost - cost information
A cost is composed of three elements (each of these three elements can be direct and indirect)
▪ Material
▪ Labor
▪ Expenses
Overheads
Net profit = total income - all expenses
Material
The material cost is the cost of commodities supplied to an undertaking
Direct Materials Cost: Any materials purchased and used for a specific purpose are called direct
materials. eg Liquid Nitrogen in the production of Nitric acid
Indirect Material Cost: Materials used for the product other than the direct materials are called indirect
materials eg materials used in maintenance of plant and machinery
Labor
Labor is the remuneration (wages, salaries, commissions, bonus, etc.) paid for physical or mental effort
expended in production and distribution
Direct Labour Cost: the cost of labor directly engaged in production operations. E.g., workmen
engaged in assembling parts
Indirect Labour Cost: the remuneration paid for labor engaged to help the production operations, e.g.,
inspectors, watchmen, sweepers, store keepers, etc.
labor costs of idle time, overtime, holidays, etc., are also taken as indirect cost, clerical and managerial
staff, salesmen, distribution employees
Expenses:
Expenditure other than material and labor is the third element of cost
The cost of service provided to an undertaking and the notional cost of the use of owned assets
Direct Expenses: directly identified with a unit of output, job, process or operation
The direct expenses are also known as chargeable expenses.
Indirect Expenses:
Indirect expenses are expenses other than indirect material and indirect labour, which cannot be directly
identified with units of output, job, process or operation.
E.g., rent, power, lighting, depreciation, bank charges, advertising, etc.
Overhead:
On the basis of functions overhead is classified as:
▪ Factory overhead
▪ Administration or office overhead
▪ Selling and Distribution overhead.
Factory Overhead:
Aggregate of indirect material, indirect wages and indirect expenses incurred in the factory Eg rent,
power, depreciation lighting and heating incurred in the factory.
Administration or Office Overhead:
All the indirect administration expenses, come under this category. Salaries of office staff,
accountants, directors’ fees, rent of office building, stationery expenses incurred in the office
lighting and bank charge
Selling and Distribution Overhead:
This includes indirect selling and distribution expenses. Examples are salaries of salesmen, selling
commission, advertising, warehouse rent, maintenance of delivery vans, warehouse staff expenses,
warehouse lighting, etc.
The following items are excluded from computation of total cost:
(a) Capital Costs and Capital Losses- Purchase of fixed assets, plant and machinery, building, etc. Loss on
sale of fixed assets, abnormal losses, preliminary expenses, patents written off, etc.
(b) Transfer to reserves, income tax, dividend, bonus to shareholders, etc.
(c) Financial items like, cash discount, interest on debentures, interest on loans, interest on own capital,
etc.
FACTORS AFFECTING INVESTMENT AND PRODUCTION COSTS
▪ engineer must have a complete understanding of the many factors that can affect costs
▪ engineer must be aware of actual prices for raw materials and equipment, company policies, government
regulations, and other factors affecting costs
❑ Sources of Equipment
❑ Price Fluctuations
❑ Company Policies
❑ Operating Time and Rate of Production
❑ Government Policies
❑ Sources of Equipment
✓ Major cost involved is equipment’s – reduced by purchasing second hand
✓ New equipment – several independent quotation should be obtained from different manufacturers
❑ Price Fluctuations
✓ In today's economic market, prices may vary widely from one period to another eg. plant operators or
supervisors cannot be hired today at the same wage rate as in 1985
✓ same statement applies to comparing prices of equipment purchased at different time
✓ chemical engineer must keep up to date on price and wage fluctuations
❑ Company Policies
✓ companies have a direct effect on costs eg . Companies have strict safety regulation
✓ accounting procedures and methods for allocating corporate costs vary among companies
✓ Company policies with reference to labor unions must be considered
❑ Operating Time and Rate of Production
▪ Factors that have major effect on the profits is the fraction of time a process is in operation
▪ Equipment stands idle for an extended period,
✓ raw materials and labor costs are usually low,
✓ other costs, designated as fixed costs, for example, maintenance, protection, and depreciation,
continue even though the equipment is not in active use.
▪ The plant that is not producing a product, is also not producing revenue
▪ Sales demand, rate of production, and operating time are closely interrelated
▪ Ideal plant should operate under a time schedule that gives the maximum production rate
consistent with market demand, safety, maintainability, and economic operating conditions
▪ The total cost per unit of production is minimized because the variable costs averaged over time
are low
The effect on costs and profits based on the rate of production
✓ The point where the total product cost

equals the total income is designated as the
breakeven point
✓ a desirable production rate for this
chemical processing plant represents the
point of maximum gross and net profit. B
❑ Government Policies
✓ The national government has many laws and regulations that have a direct effect on industrial costs
eg. import and export tariff regulations, depreciation rates, income tax rules, and environmental
and safety regulations.
✓ Income tax regulations and depreciation have the largest impact on most businesses
CAPITAL INVESTMENT
▪ Traditional economic definition of capital is "a stock of accumulated wealth
▪ In an applied sense, capital is savings that may be used as the owner decides
▪ Savings -to promote the production of other goods, in the view of obtaining an income or profit
▪ The capital needed to supply the required manufacturing and plant facilities is called the fixed-
capital investment (FCI)
▪ That necessary for the operation of the plant is termed the working capital (WC).
▪ The sum of the fixed-capital investment and the working capital is known as the total capital
investment (TCI).
▪ The fixed-capital portion may be further subdivided into manufacturing fixed-capital investment, also
known as direct cost, and nonmanufacturing fixed-capitaI investment, also known as indirect cost.
Total capital investment
fixed-capital
working capital
investment
manufacturing
fixed-capital direct cost
investment
Fixed – capital
investment
nonmanufacturing
fixed-capitaI indirect cost
investment
Fixed-Capital Investment
▪ Manufacturing fixed-capital investment represents the capital necessary for the installed process
equipment with all components that are needed for complete process operation.
✓ Includes site preparation, piping, instruments, insulation, foundations, and auxiliary facilities are
typical
▪ The capital required for construction overhead and for all plant components that are not directly related
to the process operation is designated the nonmanufacturing fixed-capital investment.
✓ plant components include the land; processing buildings, administrative and other offices,
warehouses, laboratories, transportation, shipping, and receiving facilities, utility and waste
disposal facilities, shops, and other permanent parts of the plant
✓ construction overhead cost includes field office and supervision expenses, home office expenses,
engineering expenses, miscellaneous construction costs, contractors' fees, and contingencies.
Working Capital
The total amount of money invested in
1. raw materials and supplies carried in stock
2. finished products in stock and semifinished products in the process of being manufactured
3. accounts receivable
4. cash kept on hand for monthly payment of operating expenses, such as salaries, wages, and raw
material purchases
5. accounts payable
6. taxes payable.
▪ Finished products in stock and semifinished products have a value approximately equal to the total
manufacturing cost for 1 month's production.
▪ The ratio of working capital to total capital investment varies with different companies
▪ Chemical plants use an initial working capital amounting to 10 to 20 percent of the total capital
investment. This percentage may increase to as much as 50 percent or more for companies producing
products of seasonal demand, because of the large inventories which must be maintained for
appreciable periods.
ESTIMATION OF CAPITAL INVESTMENT
▪ Based on the cost of the equipment required.
▪ Significant errors in capital investment estimation are generally due to omissions of equipment,
services, or auxiliary facilities rather than to gross errors in costing
Direct costs
1. Purchased equipment
2. Purchased-equipment installation
3. Instrumentation and controls Purchase- installation, calibration, computer control with software
4. Piping Process piping utilizing suitable structural materials
5. Electrical systems
6. Buildings (including services)
7. Yard improvements
8. Service facilities
9. Land
Indirect costs
1. Engineering and supervision Engineering costs
2. Legal expenses Identification of applicable federal, state, and local regulations
3. Construction expenses
4. Contractor’s fee
5. Contingency
Types of Capital Cost Estimates
1. Order-of-magnitude estimate (ratio estimate) based on similar previous cost data; probable accuracy of
estimate over ±30 percent.
2. Study estimate (factored estimate) based on knowledge of major items of equipment; probable accuracy
of estimate up to ±30 percent.
3. Preliminary estimate (budget authorization estimate or scope estimate) based on sufficient data to permit
the estimate to be budgeted; probable accuracy of estimate within ±20 percent.
4. Definitive estimate (project control estimate) based on almost complete data but before completion of
drawings and specifications; probable accuracy of estimate within ±10 percent.
5. Detailed estimate (contractor's estimate) based on complete engineering drawings, specifications, and
site surveys; probable accuracy of estimate within ±5 percent
Methods for estimating Capital Investment
1. Detailed Item Estimate: (±5)
• Equipment and material needs are determined from completed drawings and specifications and are priced
either from current cost data or preferably from firm delivered quotations.
• Estimates of installation costs
• Accurate estimates of engineering, drafting, field supervision employee-hours, and field-expenses must
be detailed in the same manner.
• Complete site surveys and soil data must be available to minimize errors in site development and
construction cost estimates.
• Large amounts of engineering time required to prepare such a detailed-item estimate
Understanding of fabrication
List of required parts
steps
Estimation of
capital investment
Knowledge of the machinery Understanding of amount of

involved labour
2. Unit Cost Estimate (±10-20%)
• The unit-cost method results in good estimating accuracies for fixed-capital investment provided
accurate records have been kept of previous cost experience.
• Used for preparing definitive and preliminary estimates, also requires detailed estimates of purchased
price obtained either from quotations or index corrected cost records and published data.
• Equipment installation labor is evaluated as a fraction of the delivered equipment cost.
3. Percentage of delivered equipment cost:
• The fixed or total-capital investment requires determination of the delivered-equipment cost.
• The other items included in the total direct plant cost are then estimated as percentages of the delivered
equipment cost.
• The additional components of the capital investment are based on average percentages of the total direct plant
cost, total direct and indirect plant costs, or total capital investment.
• Estimating by percentage of delivered-equipment cost is commonly used for preliminary and study estimates.
• It yields most accurate results when applied to projects similar in configuration to recently constructed plants.
4. “Lang” Factors for Approximation of Capital Investment
• Proposed originally by Lang-/‟ and used quite frequently to obtain order-of-magnitude cost estimates-cost of
a process plant may be obtained by multiplying the basic equipment cost by some factor to approximate the
capital investment.
• Factors vary depending upon the type of process plant being considered.
• Combined to give Lang multiplication factors that can be used for estimating the total direct plant cost, the
fixed-capital investment, or the total capital investment.
• Greater accuracy of capital investment estimates can be achieved in this method by using not one but a
number of factors.
• Another approach is to use separate factors for erection of equipment, foundations, utilities, piping, etc., or
even to break up each item of cost into material and labor factors.
• The chemical engineer must rely on past experience to decide, in each case
5. Power Factor Applied to Plant-Capacity Ratio.
• Order-of-magnitude estimates relates the fixed-capital investment of a new process plant to the fixed-capital
investment of similar previously constructed plants by an exponential power ratio.
• The fixed-capital investment of the new facility is equal to the fixed-capital investment of the constructed
facility C multiplied by the ratio R, defined as the capacity of the new facility divided by the capacity of the
old, raised to a power X.
• This power has been found to average between 0.6 and 0.7 for many process facilities.
• Capacity power factor (x) for various kinds of processing plants is available.
• where f is a lumped cost-index factor relative to the original installation cost.

• D is the direct cost and I is the total indirect cost for the previously installed facility of a similar unit on an
equivalent site.
• The value of x approaches unity when the capacity of a process facility is increased by adding
identical process units instead of increasing the size of the process equipment.
• The lumped cost-index factor f is the product of a geographical labor cost index, the corresponding
area labor productivity index, and a material and equipment cost index
6. INVESTMENT COST PER UNIT OF CAPACITY:
• Various processes per unit of annual production capacity.
• Although these values depend to some extent on the capacity of the individual plants, it is possible to
determine the unit investment costs which apply for average conditions.
• An order-of-magnitude estimate of the fixed-capital investment for a given process can then be obtained by
multiplying the appropriate investment cost per unit of capacity by the annual production capacity of the
proposed plant.
7. TURNOVER RATIOS.
• A rapid evaluation method suitable for order-of-magnitude estimates is known as the “turnover ratio” method.
• The reciprocal of the turnover ratio is sometimes defined as the capital ratio or the investment ratio.
INTEREST
✓ classical definition, interest is the money returned to the owners of capital for use of their capital
✓ Substitute the term return on capital or return on investment for the classical interest.
interest is the cost of borrowed money, or the earnings on money loaned
✓ Engineers define interest as the compensation paid for the use of borrowed capital
✓ The rate at which interest will be paid is usually fixed at the time the capital is borrowed, and a
guarantee is made to return the capital at some set time in the future or on an agreed-upon pay-off
schedule. Interest paid is an expense of business operation that must be included in the analysis of
business profitability.
Simple Interest:
The simplest form of interest requires compensation payment at a constant interest rate based only on the original
principal
I = PiN
where
I is the total simple interest, P is the principle, i is the rate of interest, and N is the time in years.
F is the total amount of principle and interest accumulated during a period N,

F = P + I = P (1+iN)
Compound Interest: (Business transaction)
Compound interest is the interest earned on accumulated, reinvested interest as well as the principal
amount
F = P(1+i)N
The term (1+i)N is commonly referred to as the discrete single payment compound amount factor
or the discrete single payment future worth factor,
(1+i)N = (F/P,i,N)
Hence F = P (F/P, i, N).
Nominal and effective interest Rates:
• An interest rate stated as an annual rate but compounded other than annually is designated as a nominal
interest rate.
• The actual annual return called effective rate of interest would be higher than the nominal rate of
interest.
• The effective interest rate ieff is the rate which, when compounded once per year gives the same amount
of money at the end of 1 year as does the nominal rate r compounded „m‟ times per year.
• The interest rate per period is r/m,
Continuous Interest:
• Although in practice, the time interval for interest accumulation is usually taken as 1 year, shorter periods can
be used such as 1 month, 1 day and so on.
• The extreme case occurs when the time interval becomes infinitesimally small so that the interest is
compounded continuously.
• The concept of continuous interest is that the cost or income due to interest flows regularly and this is just as
reasonable an assumption for most cases as the concept of interest accumulating only at discrete intervals.
• If the interest is compounded continuously m approaches infinity. For N years, The symbol r represents the
nominal interest rate with m interest periods per year
The term erN is known as the continuous single payment compound amount factor or the continuous
single payment future worth factor
Take nominal interest rate as the base and find-out the comparable rate of interest for half-yearly,
quarterly and monthly basis and select that which is most attractive

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Module II PEE

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Affiliated to VTU, Belagavi,

Approved by AICTE, New Delhi,

Process Engineering Economics

Prepared By: Dr. Augusta Pachathu

▪ Elements of project cost - cost information

✓ The point where the total product cost

Knowledge of the machinery Understanding of amount of

• where f is a lumped cost-index factor relative to the original installation cost.

F is the total amount of principle and interest accumulated during a period N,

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