Construction Economics & Financial Management

[CEM-6105]

Adama Science and Technology University

MSc Civil Engineering

[Construction Engineering and Management] 1

Targeted Students: Instructor:

1st Year CEM Students Dr. Meseret Getnet

January, 2020
 Course Contents

1. Introduction to Construction Economics and Finance

– Prelude
– Why Construction Economics and Finance?
– Fundamental Economics and Cost Concepts
2
2. Time Value of Money and Economic Evaluation
– Basic Economic Principles
– Concepts; Processes; Decisions Vs Methods
– Methods and Techniques
3. Depreciation and Inflation Rate
– Depreciation
– Rate of inflation
 Course Contents

4. Benefit-Cost Analysis
– Benefit-Cost Ration Method
– Evaluating Public Projects

5. Construction Financial Management

– Basic Financial / Accounting Principles 3

– Major functions of construction finance

– Financing big public projects: Sources; Processes and Risks

6. Construction Economics and Finance in Ethiopia

– Laws and Regulations
– Financial Institutions
– Appraisal Methods
– Contextual Situations
 Introduction to
Construction Economics
and Financial Management
[CE+FM]

Prelude to this Discipline

 WHAT DO THE
FOLLOWING
BUILDINGS HAVE IN
COMMON ?
 ‘Hydropolis Underwater’ Resort Hotel - Dubai UAE
A
Estimated price -$440M
200 Guest Suites
22M underwater
US$5,500 per night
‘BURJ
B DUBAI’ UAE – WORLD’S
TALLEST BUILDING
Estimated price -$1.5B
828M high
160Nr Levels

RICHARD O’CARROLL
‘SKIC DUBAI’ UAE – WORLD’S LARGEST
INDOOR SNOW PARK
Estimated price -
$275M 32,290 Sq foot
2 foot of snow
Has own ‘black slope’

RICHARD O’CARROLL
 YES….. YOU SPOTTED IT …
RICHARD O’CARROLL
Yes….. you spotted it … ‘DUBAI’
 Yes….. you spotted it … ‘DUBAI’

Well not quite what we wanted you to notice

LOOK AGAIN !!!

$1.5 Billion
$275 Million
They all needed ‘Budget Estimates’
to be established

(to ‘Confirm feasibility or

otherwise the Client’s
Objective’).
They all needed to be Measured and
Evaluated
(to confirm the
Client’s Budget).

Comparative Cost
Planning based on
Analysis on previous
completed Contracts

Cost per Cost per Cost per Car

Hospital Bed Theatre Seat Park Space
They all needed the most, time and cost
efficient methods to be procured

(to comply with the

Client’s requirements)

Fishing for the Best Price

and Best Contractor
They all needed the most, time and cost
efficient methods to be
constructed

(to ensure it is coming

In on Budget)
Bringing in the Contract
Cost on Budgetary Target
They all needed ‘Finance’

(to support the Objective)

Based on soundly established and
balanced Cost Plans and
Projected Cash Flow forecasts
They all needed Financial Control

(to satisfy the financiers)

Based on a proper financial monitoring

system as well as a pool of change
control facilities to incorporate changes
whilst still maintaining Budget and
Programme
They all need to be administered to a
pre- agreed contract

(to

(bring the dream to fruition)

Via suites of Construction

&/or Design Contracts
ALL CONTRACTS NEED TO BE
NEGOTIATED BASED ON A SOUND COST
BASED KNOWLEDGE

(to maximise the chances

of being within Budget)
RICHARD O’CARROLL From Main Contractor to
Nominated/Specialist Contractors
From Pre-Award to Final Account
All Contractors need to be paid a
fair
assessment of the value of Work
done on an interim basis

(to ensure the continued liquidity

of the Contractor and
completion of the Objective).

Cash flow is the Life

Blood of the Contractor
ONCE COMPLETE, OVER TIME, BUILDINGS
WILL NEED MAINTENANCE, REPAIR,
RENOVATION, RECTIFICATION.

(To ensure the maximum life of

the original Capital Investment
but with the most economic means
of design
RICHARD and
O’CARROLL construction).
 SO WHERE DOES IT ALL

RICHARD O’CARROLL
START ?
CLIENTS (ENTREPRENEURS,
DEVELOPERS, CONTRACTORS) START
WITH AN IDEA
Clients idea
WISH TO PROCURE / ATTAIN IDEA

RICHARD O’CARROLL
Clients idea
Wishes to procure
Little or no Capital
Clients idea
Wishes to procure
Little or no Capital

Seeks finance
Clients idea
Wishes to procure
Little or no Capital

Seek finance
 WHAT HAPPENED BEFORE
CONSTRUCTION ECONOMICS ??
 BEFORE

CONSTRUCTION ECONOMISTS
This is how they Forecasted Costs
before Construction Economists
These were their
Negotiation
Experts
before
Construction
Economists
This is how they Controlled Costs on Site
before Construction Economists
 WHAT DID CONSTRUCTION
ECONOMISTS BRING TO
RICHARD O’CARROLL
CIVILISATION ?
What did Construction Economists bring to Civilisation ?

Be careful ……
Serious Learning Section
Now
RICHARD O’CARROLL
Cost Time
Labour Programme
Plant Methodology
Materials Resources
Preliminaries Outputs
Overheads Holidays
Inflation Acceleration
Weather
Quality
Standard
Finishes
Mech &
Elec
Services
Cost
Labour
Plant
Materials
Preliminaries
Overheads
Inflation
Time
Programm
e
Methodolo
gy
Resources
Outputs
Holidays Master Programme
Jan Feb Mar Apr Jun Jul Aug Sept Oct
Acceleratio Nov

n
Weather
Quality
Standards
Finishes
Mech &
Elec
Services
Useful Life
/
Maintenan
ce
We navigate away from foreseeable
dangers
Construction Economics

We identify alternative action

should conditions change
 We determine the underline
features of any venture project
We protect our Clients Interests
What is an Industry?

An "Industry" is way of classifying businesses that have something in

common.

Firms are included in or excluded from an industry classification based on

the degree of similarity in the products they make or sell and types of
45
customers they service, and the market place in which they compete.
What is Construction Industry?

A more useful question is: What isn't the construction industry?

The construction industry isn't just about buildings. It's about roads,
bridges, tunnels and railways as well as houses, offices, supermarkets and
leisure centres.
46

The construction industry isn't just about new roads, houses, bridges,
offices, tunnels, supermarkets, railways and shopping centres.

It's also about repairing, refurbishing, renovating and restoring the ones that
are already there.
What is Construction Industry? Cont’d…

So even in times of recession, when there isn't much new construction

going on, we still need the industry ... and

all the people who work in it.

When the construction industry is about buildings, it isn't just about the
47
outsides. Buildings also have to be fitted out, ready for people to work or live
in them.

So construction isn't just about bricks and mortar, foundations and roofs. It's
about paint and plaster, floors and ceilings as well.
What is Construction Industry? Cont’d…

48
What is Construction Industry? Cont’d…

49
Construction Industry Groups

I. Industrial Construction

 Petroleum refineries
 Petrochemical plants
 Synthetic fuel plants
 Nuclear power plants 50

 Steel mills
 Heavy manufacturing plants
Construction Industry Groups Cont’d…

II. Heavy Engineering Construction

 Dams
 Tunnels
 Bridges
 Highways
51
 Airports
 Urban transit system
 Ports
 Pipelines
 Water treatment plants
 Communication networks
Construction Industry Groups Cont’d…

III. Residential Construction

 Single family homes

 Multi-unit town houses
 Highrise apartments
 Condominiums 52
Construction Industry Groups Cont’d…

IV. Building Construction

 Schools
 Universities
 Hospitals
 Commercial office towers
53
 Ware houses
 Light manufacturing plants
 Theatres
 Government buildings
 Commercial malls
 Recreation centres
Stakeholders in the Construction Industry

54
What is Economics?

.
A system of human Practical fields The different kinds of
activities related to include economic activities
the production, manufacturing, are categorised into
distribution, construction, various economic
exchange and management, sectors (also called
consumption of finance, business industries) 55

goods and services administration,

applied sciences etc.
The Three Main Economic Sectors

Primary Secondary Tertiary

industries:  industries:  industries:

involves the provision of

changing process of create a finished and
services to businesses
natural resources into usable product, e.g.
56
and final consumers e.g.
primary products e.g. uses the output of the
transport, tourism, retail,
agriculture, fishing, primary sector e.g.
health, education,
forestry, mining & manufacturing,
government services,
quarrying construction 
restaurant,
entertainment
57
58
Construction Industry Characteristics

Huge investment and employment opportunity

Highly fragmented

Organization structure is highly specialized and layered

59
Project-based and every project is unique - Desire for uniqueness of
Product (not Mass Production)

Complex interlocking of interests and traditions

Largely built on-site

Construction Industry Characteristics Cont’d…

Multiple stakeholders with changing priorities

Low profitability- Due to its fragmented nature and lack of training and
innovation

Research & development (R&D) has not been a priority - Lack incentive
60
for investment for R&D

Conservative by nature – Set in its way and reluctant to change

61
62
Introduction to CE+FM
Prelude
 We should no longer construct buildings, roads and water works the way
we used to;
 The Cost, Time, Quality and Safety of such constructions should no longer
be left to chances and mere guesses or risks;
63
 Construction projects should no longer be recognized as only support to
businesses;
 Investments should not be left to chances of successes;

 Economics and Finance are not any longer limited to the disciplinarians;

 Construction time and cost becomes essential constraints; etc

Introduction to CE+FM

Prelude
Construction Economics:
 …is a subject dealing with the concepts, skills, methods and techniques
of economics in order to support decisions made by investors,
implementing agents, etc.; through indicating the feasibility and priority 64

of their engagements in construction related businesses.

Introduction to CE+FM

Prelude
Construction Finance:
 …is a subject dealing with the concepts, skills, methods and techniques
of Accounting in order to indicate the financial health of an
organization / a company through their financial statements, balance 65

sheet and available cash flows; and at the same time support decision
making on how to plan and control finance using budgeting and
financial ratios.
Introduction to CE+FM
Why Construction Economics and Finance?
Construction Economics and Finance is important because:
 Cost Consciousness need to be build in the majority and decisive
professionals, participants / stakeholders of the construction industry: such
as Architects, Civil Engineers, Construction Management, Construction
66
Technology and Urban Planning professionals; Consultants and Contractors.

 To enable such professionals, participants / stakeholders to acknowledge

their limits to the discipline and when to involve Economists and Accounts
and able to work with them interactively and integrativily.
Introduction to CE+FM

Why Construction Economics and Finance?

Construction Economics and Finance is important because:
 To create awareness that all construction projects are:
• Components of a certain business;
• Constrained by Cost, Time, Scope and Quality requirements;
• The first inputs to the businesses they are called for;
67
• Cost extensive;
• Key to economic development;
• Creating both tangible and intangible benefits and costs;
• Subject to interdisciplinary values;
• Subject to financial, performance and ethical audits

 To create awareness that construction industry is the most affected during economic
imbalances or crises
Introduction to CE+FM

Why Construction Economics and Finance?

Construction Economics and Finance is important because:
 Construction Economics because:
• Investments need to be appraised and shown viable;
• Demands need to be studied and try to much with supplies;
• Alternatives need to be compared to reach into optimal choices; 68

• Projects need to be prioritized due to scarcity of resources / inputs and increasing and
dire demands;
• Accountability of using such scarce resources demands proof of utmost ethical
considerations; and
• Decision of investments based on the above requirements called for the importance of
Construction economics.
Introduction to CE+FM

Why Construction Economics and Finance?

Construction Economics and Finance is important because:
 Construction Finance because:
• It clearly indicates the financial health of an organization / a company based on one of
its most important resource; Finance
69
• It enables to plan and monitor this most important resource through well developed,
acknowledged and enforced for use financial accounting system; Financial Statement,
Balance Sheet, Cash flow, Ledgers, Journals, Budgeting, Financial ratios, etc.
• It enables the determinations of costs, expenses and profits on the one hand; assets,
liabilities and equities on the other hand which are the bases for formulating the
financial accounting system.
Introduction to CE+FM

Economic Concepts and Terminologies

 Utility is the level of satisfaction i.e. obtained by consuming a commodity
[good or service]

 Value designate the worth that a person attaches to an object or service.

70
Value is a measure or appraisal of utility in some medium of exchange.

 Consumer goods are the goods and services that directly satisfy human
wants.
• Example: TV, shoes, houses, roads etc. The goal of the consumer is to
maximize his utility.
Introduction to CE+FM

Economic Concepts and Terminologies

 Producer goods are the goods and services that satisfy human wants
indirectly as a part of the production or construction process.
• Example: factory equipment, industrial chemicals ands materials.

71
 Economy of exchange
• It occurs when utilities are exchanged by two or more people.

• It is possible because consumer utilities are evaluated subjectively.

• Mutual benefit in exchange

• Persuasion in exchange. Salesperson

Introduction to CE+FM

Economic Concepts and Terminologies

 Economy of Organization: Through organizations, ends can be attained or
attained more economically by:
• Labour saving

• Efficiency in manufacturing (or construction) or capital use

72

 Cost [Classification]
• First [or initial] cost: Cost to get activity started such as property improvement,
transportation, design, construction, installation, and initial expenditures

• Operation and maintenance cost: Experienced continually over the useful life of
the activity
Introduction to CE+FM

Economic Concepts and Terminologies

• Fixed cost: It does not depend on output volume and usually established by
contract agreements, are costs that do not change with production levels a
company produces.
It is subject to change when larger changes in the operating conditions
73
involved such as construction expansion or shutdown.

• Variable cost: Vary in total with the output units, e.g. material cost. [It is per
unit of output]

 Incremental or marginal cost: the additional costs that result from increasing the
output level by one or more units. It is determined from the variable cost.
Introduction to CE+FM

Economic Concepts and Terminologies

 Sunk cost: It cannot be recovered or altered by future actions. Usually this cost
is not a part of engineering economic analysis.

 Life-cycle cost: Feasibility, design, construction, operation and disposal costs

74
 Recurring Costs: Repetitive and occur when a company produces similar goods
or services on a continuing basis, e.g., variable cost and a periodic fixed cost like
office rent.

 Nonrecurring Costs: Not repetitive, e.g., construction cost of the asphalt plant.
Introduction to CE+FM

 Example

75
Introduction to CE+FM

Economic Concepts and Terminologies

 Direct costs: Attributed to a specific activity or output, e.g., labour and material costs
directly associated with the a product.

 Indirect costs: Cannot be attributed to a specific activity or output.

• Allocated through a selected formula, such as by proportion to the outputs or work
76
activities. E.g. Profit cost, overhead cost

 Standard costs: Planned costs per unit of output that are established in advance of
actual production.
• Play an important role in cost control and other management functions.

• One typical use is to measure operating performance by comparing actual cost per unit with
the standard unit cost
Introduction to CE+FM

Economic Concepts and Terminologies

 Cash Costs: involve payment of cash and would result in a cash flow.

 Book Costs: do not involve cash transaction and is reflected in the accounting
system as a noncash cost, e.g., depreciation.
77
 Opportunity cost is incurred because there are only limited resources
available.
• The opportunity cost of the selected alternative is the value of the next best
alternative opportunity that is forgone [given up].
• The value of the scarified alternative [Something is what you sacrifice to get it]
 Introduction to CE+FM

Example [Opportunity Cost]

 Suppose you have 2,000 Birr in your bank account, you can
either keep it in the bank or invest it in stock market.

What is the opportunity cost of investing in stock market?

 You will earn the accrued interest of $2,000 if you choose to
keep it in the bank instead of investing it in stock market.
 Therefore, The opportunity cost of investing in stock market is
MESERET G. [CENG 5011] 11/23/2020 78
the accrued interest of $2,000.
Introduction to CE+FM

Option 1:
 To keep $2,000 in the bank and earn a guaranteed interest of $100 at
the end of 1 year.
Option 2:
 To invest $2,000 in stock market and earn the expected profit of $200
at the end of 1 year.
A. Opportunity cost of Option 1 = $200
B. Opportunity cost of Option 2 = $100
 B< A, could we conclude that we SHOULD choose option 2?
 No! We have to take the uncertainly of $200 in Option 2 into account.
11/23/2020 79
Introduction to CE+FM

Price-demand relationships
Model 1: Selling price per unit [p] is a linear function of
demand [D]

p = a - bD for 0 < D < a/b , and a > 0; b > 0

Model 2: Selling price per unit is independent of demand
Maximizing total revenue [TR]: [Use Model 1]

TR = p * D = [a – bD] * D = aD - bD2 80

MESERET G. [CENG 5011]

11/23/2020
 Introduction to CE+FM

TR is a concave function. [Check the second derivative:

d2TR = - 2b < 0
dD2
 Find the maximizer D^ from the first derivative:
dTR = a - 2bD = 0  D^ = a /2b
dD
Maximizing profit: [Use Model 1]
Profit = TR - TC, what is Total Cost [TC]? Assumption:
MESERET G. [CENG 5011] 11/23/2020 81

TC = CF + Cv D
 Introduction to CE+FM

Where CF is the fixed cost and Cv is the variable cost per unit. Thus,
Profit = aD - bD2 – [CF + CvD]
Maximizing profit:
Profit = aD - bD2 – [CF + CvD] = - bD2 + [a – Cv]D -CF
In order for a positive profit to occur and to avoid negative demand,
a - Cv > 0 or a > Cv.
From the first derivative, we have
dProfit = a - Cv - 2bD = 0  D* = a – Cv
dD 2b
MESERET G. [CENG 5011] 11/23/2020 82
Introduction to CE+FM

Since d2Profit = -2b < 0 for all D,

dD2
D* = a – Cv  is the maximizer of the Profit.
2b

Remark: Companies may also gain insights from Breakeven

points other than the profit-maximizing points.

At a breakeven point, total revenue is equal to total cost.

MESERET G. [CENG 5011] 11/23/2020 83
 Introduction to CE+FM

Breakeven Analysis
Finding the breakeven points: [Model 1]
Solve, - bD2 + [a – Cv]D - CF = 0. We obtain two roots:
D’ = - [a – Cv] {[a – Cv]2 - 4bCF}1/2 [See Scenario 1]
- 2b
Finding the breakeven points: [Model 2]
p is independent of D.
TR = p * D
TC = CF + CvD
TR = TC  D’ = CF [See Scenario 2]
MESERET G. [CENG 5011] 11/23/2020 84

P - Cv
 Introduction to CE+FM

Figure 2-1 Combined cost and revenue functions and

breakeven, as functions of volume, and their effect on typical
profit [Scenario 1]

MESERET G. [CENG 5011] 11/23/2020 85

 Introduction to CE+FM

Figure 2-2 Typical breakeven chart with price [p] a constant

[Scenario 2]

MESERET G. [CENG 5011] 11/23/2020 86

87