Chapter 1

Basic Management Concepts and Industrial

Organization

• Introduction to management;
• Functions of management;
• Organizational structure;
• Basics of productivity.

1
 Introduction to management
 Management is the process of getting things
done through the efforts of other people in
order to achieve the predetermined objectives
of organization.
• Management may also be define as:
“The process by which execution of given purpose
put into operation and supervise”.

2
 Cont’d…
• Another statement: Management may be
defined as “A technique by which the purpose
and objectives of particular human group are
determined, defined, clarified and completed”
Complete definition of management:
 Management is a distinct process consisting of
planning, organizing, staffing, leading and
controlling utilizing both in each science and art
and followed in order to accomplish
predetermined objectives of the organization.
3
 Function of Management
 There are those who view management as a
function rather than a process.
 Dunn, Stephens and Kelly contend that
“Management is a role which includes a set of
duties, responsibilities, and relationships-involved in
work organizations”.
 These duties and responsibilities constitute the
function a manager performs.
 The duties and responsibilities a manager performs
are quite different from those performed by
managerial employees.
4
 Necessity of Management
 Management is an essential activity of all
organizational level (Low, middle, and upper level)
• Management Needs Conceptual Skills.
• Middle Management Needs Human Relations Skills.
• Low Management Needs Technical Skills.
 Management applies to:
(i) Small and large Organizations.
(ii) Profit and non profit Organization.
(iii) Manufacturing Organization.
(iv) Service rendering Organization.
5
 Levels of Management
1. Top management
 Is the ultimate source of authority and it lays down goals, policies and
plans for the enterprise.
 Consists of a company consists of owners/shareholders, Board of
Directors, its Chairman, Managing Director, or the Chief Executive, or the
General Manager or Executive Committee having key officers.
2. Middle management
 The job of middle management is to implement the policies and plans
framed by the top management.
 Consists of a company consists of heads of functional departments viz.
Purchase Manager, Production Manager, Marketing Manager, Financial
controller, etc. and Divisional and Sectional Officers working under these
Functional Heads.
3. Lower level or operative management of a company consists of
Superintendents, Foremen, Supervisors, etc. 6
 Management Entity

Management is a distinct process consisting of

Planning Organizing Staffing Leading Controlling

Applied to
Efforts of a group of people to utilize effective available recourses

Man Money Material Method Machine

In order to achieve predetermined objectives of an organization

7
 Classification of management

There are five functions of management

 Planning,
 Organizing,
 Staffing,
 Leading, and
 Controlling.
 The functions of managers provide a useful
structure for organizing management knowledge.

8
 (1) Planning
 Planning involves selecting missions and objectives
and the action to achieve them it requires decision
making, that choosing future courses of action from
among alternatives.
There are five types of planning:
1. Missions and objectives.
2. Strategies and polices.
3. Procedures and rules.
4. Programs.
5. Budgets.
9
 (2) Organizing
 Organizing is the part of managing that involves
establishing an intentional structure of roles for
people to fill in an organization.
• The purpose of an organization structure is to
creating an environment helpful for human
performance.
• It is then management tools and not an end.
• Many problems arises in making structures fit
situations.
10
 (3) Staffing
 Staffing involves filling and keeping filled, the
positions in the organization.
 This is done by identifying the work force
requirement inventorying the people available
and recruiting, selecting, placing, promoting,
appraising, planning the careers, compensating
and training.

11
 4. Leading/Directing
 Is the function of leading the employees to
perform efficiently, and contribute their optimum
to the achievement of organizational objectives.
• Leading or directing is a way of:
Supervision
Motivation
Leadership and
Communication the concerned organization/
Industry
12
 (5) Controlling
 Controlling is measuring and correcting individuals and
organizational performance.
• It involves measuring performance against goals and plans,
showing where the deviations from standards exit and
helping to correct them.
• In short controlling facilitates the accomplishment of plans.
• Controlling activity generally relate to the measurement of
achievement.
• Some means of controlling like the budget for expenses,
inspection, record of labors-hours lost, are generally familiar.
• Each shows whether plans are working out.

13
 ORGANIZING
• Organizations are experimenting with different
approaches to organizational structure and design.
• Organizational structure can play an important role in an
organization’s success.
• The process of Organizing—the second management
functions—is how an organization’s structure is created.
The nature of organization structure
• Managers are seeking structural designs that will best
support and allow employees to effectively and
efficiently do their work.
• Organizing is the process of creating an organization’s
structure.
14
 Cont’d…
 Organization structure is the formal pattern of
interactions and coordination designed by
management to link the tasks of individuals and
groups in achieving organizational goals.
 An organizational structure is the formal
framework by which job tasks are divided,
grouped, and coordinated.
 This formal pattern designed by management is to
be distinguished from the informal pattern of
interactions that simply emerges within an
organization.
15
 Cont’d…

 Organization structure consists primarily of four

elements:
a. Job design
b. Departmentalization
c. Vertical coordination
d. Horizontal coordination
 Organization design is the process of developing
an organization structure.
 Organizational design is the process of developing
or changing an organization’s structure.
16
 Cont’d…
 It involves decisions about six key elements:
work specialization,
 departmentalization,
 chain of command,
 span of control,
 centralization/decentralization, and
 formalization.
 We need to take a closer look at each of these
structural elements.
17
 Cont’d…

• The organization chart is a line diagram that depicts

the broad outlines of an organization’s structure.
• While varying in detail from one organization to
another, typically organization charts show the
major positions or departments in the organization,
the way positions are grouped together, reporting
relationships for lower to higher levels, official
channels for communications, and possibly the titles
associated with major positions in the organization.

18
 Facts about organizational chart
1. The organization chart provides a visual map of the
chain of command, the unbroken line of authority that
ultimately links each individual with the top
organizational position thorough a managerial position
at each successive layer in between.
2. Nearly all organizations having just a few members
have an organization chart.

 Responsibility is the obligation or expectation to

perform and carry out duties and achieve goals related
to a position.
19
 Cont’d…
 Authority is the right inherent in a managerial position to
tell people what to do and to expect them to do it, right to
make decisions and carry out actions to achieve
organizational goals.
 While part of a manager’s work may be delegated, the
manager remains accountable for results.

 Accountability is the requirement of being able to answer

for significant deviations from duties or expected results.
 The fact that managers remain accountable for delegated
work may cause them to resist delegation.
20
 Cont’d…
 Delegation is assignment of part of manager’s work to others along
with responsibility and authority.
1. In addition to issues of accountability, managers may resist
delegation for a number of reasons.
a. Managers may fear if subordinates fail.
b. Managers may think they lack time to train subordinates.
c. Managers may want to hold on to their power.
d. Managers may enjoy doing the tasks subordinates could do.
e. Managers may feel threatened by subordinates.
f. Managers may not know how to delegate.
2. Subordinates may resist delegation because of fear of failure or of
risk taking.
3. Failure to delegate may have serious negative consequences for a
manger’s career. 21
 Building Blocks of Organizing
1. Job design
Job design is an essential part of organizational structure.
It is the specification of task activities, usually repeated on
a regular basis, associated with each particular job.
a. Task activities need to be grouped in reasonably logical
ways for each job.
b. The way the jobs are configured influences employee
motivation.
2. Work specialization is the degree to which the work
necessary to achieve organizational goals is broken down
into various jobs.
22
In Work specialization the tasks in an organization
are divided into separate jobs. Another term for
this is division of labor.
1. Work specialization can be traced back to the
writings of Adam Smith.
2. Work specialization was seen as a way to make
the most efficient use of workers’ skills because
workers would be placed in jobs according to
their skills and paid accordingly.

23
3. Other advantages of work specialization included
improvement in employees’ skills at performing a
task, more efficient employee training, and
encouragement of special inventions and machinery
to perform work tasks.
4. Work specialization was viewed as a source of
unending productivity improvements. And it was— up
to a certain point.
5. The human diseconomies from work specialization
included boredom, fatigue, stress, lowered
productivity, poor quality of work, increased
absenteeism, and higher job turnover.

24
 Production
 Production is the application of tools and a
processing medium to the transformation of raw
materials into finished goods for sale.

Raw materials Completed

Capital equipment Production Products
Production tooling Process
Energy Scrape
Labor

Production Process
25
 Introduction…Cont’d
Differences of production process will be based on
- product (goods or service)
- technology
Production Vs Manufacturing- it is only different on
the output

Clearly manufacturing systems should not be

classified in terms of the above, as there will be
enormous types

26
 Introduction…Cont’d
 In modern context manufacturing involves
making products from raw material by using
various processes, by making use of hand
tools, machinery or even computers.
 It is therefore a study of the processes
required to make parts and to assemble them
in machines.

27
 Manufacturing Process

External Disturbances Internal Disturbances

Material
Social-Political Products
Environment A Manufacturing Process

OUTPUTS
is a complex arrangement Service
INPUTS

Knowledge of physical elements

Knowledge
Demand characterized by measurable
parameters Return
Energy

Physical Elements Measurable Parameters

Machine Tools e.g., Production Rate
Tools Percent on Time Delivery
Mat Handl. Equ. Manufacturing Lead Time Customer
People Defects per Million
Unit Cost

28
 Recall the Value Adding Process

Inputs
Outputs
Material
Material
Product
Product
Workforce
Workforce Value
ValueAdding
Adding
(Transformation)
(Transformation)
Process
Process
Capital
Capital
Service
Service

Knowledge
Knowledge

29
 PRODUCTIVITY
 Productivity is a relationship between the output
(product/service) and input (resources consumed in
providing them) of a business system.
 The ratio of aggregate output to the aggregate input is
called productivity.
Productivity = output/Input

 For survival of any organization, this productivity ratio

must be at least 1.
 If it is more than 1, the organization is in a comfortable
position.
30
 Productivity

 Applied in an enterprise, a sector of economic activity or the

economy as a whole, productivity may be defined as an output
and input relation.
 The term productivity can be used to asses or measure the extent to
which a certain output can be extracted from a given input.

31
 Productivity…Cont’d
 Productivity: Productivity is the ratio of output
to some or all of the resources used to produce the
output.
Types of productivity:
1. Labor productivity: units produced / hours worked
2. Capital productivity: output / capital input
3. Material productivity: output /material input

32
 IMPORTANCE OF PRODUCTIVITY
  Benefits derived from higher productivity are as
follows:
1. It helps to cut down cost per unit and thereby improve
the profits.
2. Gains from productivity can be transferred to the
consumers in form of lower priced, Products or better
quality products.
3. These gains can also be shared with workers or
employees by paying them at higher rate.
4. A more productive entrepreneur can have better
chances to exploit expert opportunities.
33
 Cont’d…
5. It would generate more employment opportunity.
6. Overall productivity reflects the efficiency of
production system.
7. More output is produced with same or less input.
8. The same output is produced with lesser input.
9. More output is produced with more input.
10. The proportional increase in output being more
than the proportional increase in input.

34
 PRODUCTIVITY MEASUREMENT
• Productivity may be measured either on aggregate
basis or on individual basis, which are called total
and partial measure.

Total productivity Index/measure =

Total output/Total input
 
= Total production of goods and services
Labour + material+ capital + Energy + management . 
35
 Cont’d….

Labour productivity Index/Measure = Output in unit

Man hours worked
 
Management productivity Index/Measure = Output
Total cost of management
 
Machine productivity Index/Measure = Total output
Machine hours worked

36
 FACTORS AFFECTING PRODUCTIVITY
  All the factors which are related to input and output
components of a production process are likely to affect
productivity.
 These factors can be divided into 2 main categories, namely:
Category 1
 Primary factors are effort and working capacity of an individual.
• Organization factors are related to the design and
transformation process required to produce some item, the
nature of training and other skill imported to workers to
perform certain operations in a production process, control and
various other incentives.
• Conventions and traditions of the organization e.g. activities of
labor unions, medical facilities, worker and executive
understanding etc. 37
 Cont’d…
Category II
• Factors related to output: research and development
techniques, improvement in technology and efficient sales
strategy of the organization will lead to improvement in output.
• Efficient use of input resources , better stores control ,
production control policy , maintenance of machines etc will
minimize the cost of production.
 The factors listed in category I and II can be further divided into
4 major classes viz.
• Technological
• Managerial
• Labor, and
• External factors
38
 Cont’d…

• The technological factors can increase the

output per unit of input substantially. They can
be defined in terms of technology employed,
tools and raw material used.
 
• The labor factors are characterized by the degree
of skills of the works force, health, and attitude
towards management, training and discipline.

39
 Tools and techniques used to improve productivity

 Following tools and techniques are used to improve

productivity of the organization by optimum utilization of
resources.
1. Method Study.
2. Time Study (Work Measurement).
3. Motion Economy.
4. Financial and Non Financial Incentives.
5. Value Analysis.
6. Production, Planning and Control.
7. Inventory Control.
8. Job Evaluation.
9. Material Handling Analysis.
10. Ergonomics (Human Engineering).
11. System Analysis.
12. Operations Research Techniques. 40
 End OF
Chapter One!!

41
 UNIT 2
Forecasting

• Meaning and use of forecasting

• Forecasting techniques

42
 Forecasting
• If you are asked to determine how many units of tires
will be produced in May, how do you estimate it?
• easy or difficult question?
• The marketing people said 20,000, but the production
manager doesn’t agree with the marketing people’s
prediction.
• How could you determine a better estimate? There are
several ways to get a better answer.
• One is to simply guess. Ask a person who has long
experience in the production department.
• As he said, in May the number of automobiles sold is
very low, due to this reason, 20,000tires is too much.
43
 Forecasting
• Every organization invariably engages in annual
planning exercise.
• The heads of various functional areas such as
marketing, production, materials and finance
take part in this exercise with specific objectives.
• The marketing function provides data on sales
that the organization should target in coming
year.
• This is primarily achieved through forecasting.

44
 Forecasting
• A forecast = some definite method of predicting future events
• In today’s market driven production system, forecasts are more
important than ever.
• The survival of a manufacturing enterprise depends on its
ability to assess the market trend with reasonable accuracy
several years a head.
• Forecasting is the art and science of Predicting the future
• Forecasting is one input and to all types of business planning
and control.
• Marketing uses for planning -products, promotion and pricing
• Finance uses forecasting as an input for financial planning.
• Forecasting is an input for operation decisions on process
design, capacity planning and inventory.
45
 The Forecasting System

• Identify the problem

– Forecasts provide information to make better
decisions  impact of decision?  relevant or not
– One-time or on a regular basis? short term, long
term
– Examples: sales, income, expenses, energy, prices, …

46
47
 Understand the problem ….cont’d

• The underlying process: process that

creates demand  gain insight
– Problem characteristics
• time frame
• level of detail
• accuracy needed
• number of items to forecast

48
 Understand the problem ….cont’d
• Data: examining data can provide much insight of;
– Company records
– Commercial records
– Government records
– Analyze and check data!!
• causal factors: advertising, rebates, long waiting time, poor
quality, …
Forecast goal
• A good forecasting system will react to actual changes but
ignore chance variations à check what is going on !!!

49
 Classification of Forecasting
• In this section we will discus three classes of
forecasting methods:
1. Qualitative methods which is composed of judgmental or
opinion of experts.
 In simplest term using expert’s opinion to get a forecast such
as asking the experienced production operator.
2. Time series methods: use the past sales to try to determine
the future.
 Statistical techniques that use historical demand data to
predict future demand
3. Causal methods/ Regression methods : tries to relate the
variables being forecast to something else.
 Relating the automobile sales to tires
50
 Forecasting Methods
The above classes of forecasting can be broadly divide in
to two categories:
1. Qualitative forecast methods
– Rely on managerial Judgment and they don’t use specific
models
– Thus different individual can use the same qualitative
methods and arrive at different forecasts.
2. Quantitative forecast methods
This techniques include the time series and causal method of
forecasting
– based on mathematical formulas
– Useful when there is a past data or when past data are
reliable to predict of the future

51
 Forecasting techniques can depend on:
• Time frame
– Indicates how far into the future is forecast.
• Short- to mid-range forecast
– typically encompasses the immediate future
– daily up to two years
• Long-range forecast
• usually encompasses a period of time longer than two
years
• Demand behavior
– Trend: a gradual, long-term up or down movement of demand
– Random variations: movements in demand that do not follow
a pattern
– Cycle: an up-and-down repetitive movement in demand
– Seasonal pattern: an up-and-down repetitive movement in
demand occurring periodically
52
 1. Qualitative Methods
 Management, marketing, purchasing, and engineering
and other relevant personnel are sources for internal
qualitative forecasts.
 The two common techniques are:
1. Delphi method
– involves soliciting forecasts about technological
advances from experts
2. Market survey
– Both consume time and costly, but the only
forecasting method for new product .
– Useful when there is a lack of data or when past
data are not reliable to predict of the future. 53
 Market survey

• Several steps:
– developing a questionnaire
– carrying out the survey
– results should be tabulated and analyzed,
and interpreted

54
 DEMAND FORECASTING
• Demand forecast is an estimate of sales in monetary
or physical units for a specified future period under a
proposed business plan or program or under assumed
set of economic and other environmental forces,
planning premises outside the business organization
for which the forecast estimate is made.
• Demand forecasting also helps evaluating the
performance of the sales department.
• Thus, demand forecasting is a necessary and effective
tool in the hands of management of an enterprise to
have finished goods of right quality and quantity at
right time with minimum cost. 55
 STEPS IN FORECASTING
 The following are the main steps in demand
forecasting;
Determine the objective of forecast,
Select the period over which the forecast is to
be made,
Select the technique to be used for
forecasting,
Collect the information to be used,
Make the forecast.
56
 SALES FORECASTING
• Sales forecast is an estimate based on some past
information, the prevailing situation and prospect of future.
• It is based on an effective system and is valid only to some
specified period.
• The following are some main components of a sales
forecasting system:
(i) Market Research Operations to get the relevant and reliable
information about the trends in the market
(ii) A data processing and analyzing system to estimate and
evaluate the sales performance in the various markets.
• Proper co-ordination of steps (i) and (ii) and then to place the
findings before the top management for making final
decisions. 57
 WHY FORECAST?
• Since forecasting activity typically precedes a
planning process one can identify specific
reasons for the use of forecasting in
organizations.
• Organizations face a different set of issues while
they engage in planning and in each of these,
forecasting plays an important role as a tool for
planning process.

58
 Cont’d…
• The key areas of application of forecasting are
summarized below:
Dynamic and complex environment
Short term fluctuation in production
Better material management
Rationalized man-power decisions
Basis for planning and scheduling
Strategic decisions

59
 Elements of Forecasting
• Forecasting consists basically of analysis of the
following elements;
Internal factors:
• Past
• Present
• Proposed or future
External Factors:
• Controllable: (a) Past (b) Present (c) Future
• Non controllable: (a) Past (b) Present (c) Future

60
 Forecasting Models
1. Extrapolative models: They make use of past data
and essentially prepare future estimates by some
methods of extrapolating the past data.

Example 1, The demand for soft drinks in a city or a

locality could be estimated as 110 percent of the
average sales during the last three months.
Example 2, The sale of new garments during the
festive season could be estimated to be a
percentage of the festive season sales during the
previous year.
61
 Cont’d…
2. Casual models: It analyses data from the point view of
cause-effect relationship.
• For instance, to the process of estimating the demand for
the new houses, the model will identify the factors that
could influence the demand for the new houses and
establish the relationship between these factors.
• The factors, may include real estate prices, housing finance
options, disposable income of families, and cost of
construction and befits derived from tax laws.
3. Subjective judgments models: Another set of models
consist of subjective judgment using qualitative data.
• In some cases, it could be based on quantitative and
qualitative data. 62
 Cont’d…
• Forecasting methods involve construction of
suitable mathematical relationship to describe
the appropriate demand pattern.

FORECASTING TECHNIQUE:
1. Weighted moving averages
2. Casual forecasting model
3. Linear regression analysis
4. Multiple regression analysis

63
 1. Weighted Moving Average
• Equal weights are assigned to all periods in the
computation of simple moving average.
• The weighted moving average assigns more weight to
some demand values usually more recent ones.
• Weights are assigned to most recent data.

A. Naive forecast: demand in current period is used as

next period’s forecast
B. Simple moving average
• Uses average demand for a fixed sequence of periods.
• Stable demand with no pronounced behavioral
patterns.
64
A. Naïve Approach
Example: Forecast the order for the month of November by Naïve approach.

Solution: Forecast order for the month of November,

(F)Nov = 90 units
B. Simple Moving Average
 
n = number of periods taken to evaluate the moving average
Dt or Di = Actual demand in that period.
 
65
66
67
End OF Chapter One!!

68
 Unit 3.
Manufacturing Operations and Plant Design

 Manufacturing Operations
 Basics of Plant Layout;
 Study of Plant Layout;
 Design of Industrial Plant
 Ergonomics and Industrial Safety

69
 Classification of Industries
1. Primary industries – cultivate and exploit natural
resources
– Examples: agriculture, mining
2. Secondary industries – convert output of
primary industries into products
– Examples: manufacturing, power generation,
construction
3. Tertiary industries – service sector
– Examples: banking, education, government, legal
services, retail trade, transportation
70
 Manufacturing Industries
ISIC Code
• Food, beverages, tobacco 31
• Textiles, apparel, leather and fur products 32
• Wood and wood products, cork 33
• Paper, printing, publishing, bookbinding 34
• Chemicals, coal, petroleum, & their products 35
• Ceramics, glass, mineral products 36
• Basic metals, e.g., steel, aluminum 37
• Fabricated products, e.g., cars, machines, etc. 38
• Other products, e.g., jewelry, toys 39

71
 More Industry Classifications
• Process industries, e.g., chemicals, petroleum, basic
metals, foods and beverages, power generation

• Discrete product (and part) industries, e.g, cars, aircraft,

appliances, machinery, and their component parts

72
 Manufacturing Industry
• Transformation Operations
– Machine Processing
– Assembly
• Adding value*
• Other Operations
Material handling Raw Part or
Inspection and testing Material Transformation Process Product
Coordination and control

Scrap or
Power Waste
Tools
Machine
s
Labour

74
 Assembly Operations
• Joining processes
– Welding
– Brazing and soldering
– Adhesive bonding
• Mechanical assembly
– Threaded fasteners (e.g., bolts and nuts, screws)
– Rivets
– Interference fits (e.g., press fitting, shrink fits)
– Other

76
 Material Handling
• Material transport
– Vehicles, e.g., forklift trucks, AGVs, monorails
– Conveyors
– Hoists and cranes
• Storage systems
• Unitizing equipment
• Automatic identification and data capture
– Bar codes
– RFID
– Other AIDC

77
 Inspection and Testing
Inspection – conformance to design
specifications
– Inspection for variables - measuring
– Inspection of attributes – gauging
Testing – observing the product (or part,
material, subassembly) during operation

78
 Production Facilities and Layout
• Facilities organised in the most efficient way to
serve the particular mission of the plant and
depends on:
– Types of products manufactured
– Production quantity
– Product variety

79
 Production Quantity (Q)
• Number of units of a given part or product
produced annually by the plant
• Three quantity ranges:
1. Low production – 1 to 100 units
2. Medium production – 100 to 10,000 units
3. High production – 10,000 to millions of units

80
 Product Variety (P)
• Number of different product or part designs or
types
• ‘Hard’ product variety – products differ greatly
– Few common components in an assembly
• ‘Soft’ product variety – small differences between
products
– Many common components in an assembly

81
 Low Production Quantity (Qlow)
Job shop – makes low quantities of specialized and
customized products
• Products are typically complex (e.g., specialized
machinery, prototypes, space capsules)
• Equipment is general purpose
• Plant layouts:
– Fixed position
– Process layout

83
Fixed-Position Layout

84
Process Layout

85
 Medium Production Quantities (Qmed)
1. Batch production – A batch of a given product is
produced, and then the facility is changed over to
produce another product
– Changeover takes time – setup time
– Typical layout – process layout
– Hard product variety
2. Cellular manufacturing – A mixture of products is made
without significant changeover time between products
– Typical layout – cellular layout
– Soft product variety

86
Cellular Layout

87
 High Production (Qhigh)
1. Quantity production – Equipment is dedicated to
the manufacture of one product
– Standard machines tooled for high production (e.g.,
stamping presses, molding machines)
– Typical layout – process layout
2. Flow line production – Multiple workstations
arranged in sequence
– Product requires multiple processing or assembly steps
– Product layout is most common

88
Product Layout

89
 PQ Relationships

90
 Manufacturing Capability
– Technological processing capability - the available
set of manufacturing processes
– Physical size and weight of product
– Production capacity (plant capacity) - production
quantity that can be made in a given time

91
 Lean Production

Operating the factory with the minimum possible resources and

yet maximizing the amount of work accomplished

• Utilisation of Resources - workers, equipment, time, space,

materials
• Minimising time
• Maximising quality (accuracy)
• Minimising cost

• Doing more with less, and doing it better

92
 Programs Associated with
Lean Production

• Just-in-time delivery of parts

• Worker involvement
• Continuous improvement
• Reduced setup times
• Stop the process when something is wrong
• Error prevention
• Total productive maintenance

93
End OF Chapter One!!

94
Plant Layout

95
CLASSIFICATION
CLASSIFICATION OF
OF LAYOUT
LAYOUT PROBLEMS
PROBLEMS
A layout problem might arise because of:

 A change in the design of product,

 The addition or deletion of a product from a company’s

product line,

 A significant increase or decrease in the demand for a

product,

 Changes in the design of process,

 Replacement of one or more pieces of equipment,

96
 CONT’D

 Adoption of new safety standards,

 Organizational changes,

 A decision to build a new plant, or

 Gradual changes over time developing bottlenecks

in production, crowded conditions, delays, idle

time, back-tracking, poor housekeeping, excessive

temporary storage space, obstacles to materials

flow, failure to meet schedule etc. 97

 CONT’D

Product
Design

Layout
Design

Schedule Process
Design Design

Communication links among product, process, schedule and layout design

98
 CONT’D
In addition, there may also exist a number of constraints on the solution:

 Local, state, and federal governmental restrictions on allowable air and

noise pollution level,

 Standards concerning aisle widths, ventilation, temperature, lighting etc

 Building geometry,

 Building site and building construction in an existing building,

 Building site can restrict the shape of the building, and consequently,

and

 Cost of relocating the existing facilities should be weighed with the

advantages derived from the relocation.

99
PLANT LAYOUT PROCEDURE

Steps to consider in designing a plant layout:

1. Procure the basic data

• The basic data to be obtained must be related to

products, materials, manufacturing process, existing

machines, production schedule, existing material

storage and handling equipment, existing plant

services, existing building and existing layout.

100
 CONT’D

2. Analyze the product and production process

3. Make or Buy parts decision

4. Plan the material flow pattern

5. Consider general material handling plan

6. Calculate equipment requirement

7. Plan individual work stations

8. Select specific material handling equipment

9. Coordinate groups of related operations

101
 CONT’D

10. Construct flow diagram for production centers

11. Plan service and auxiliary activities

12. Determine the space requirements

13. Allocate activity area and plot plan

14. Consider building types

15. Construct master layout

102
 CONT’D
16. Seek opinions and suggestions

17. Evaluate adjust and select the best layout

18. Check final layout

19. Obtain official approval

20. Installation of the layout

21. Follow-up the implementation of layout

103
LAYOUT
LAYOUT OF
OF A
A NEW
NEW PLANT
PLANT
1. Select equipment on the basis of product design and expected

volume of production

2. Collect layout data: machine data, machine load charts and

templates of equipment

3. Develop process chart

4. Develop an overall flow plan of operations for processing and

material handling

5. Select best suited type of building

6. Develop a tentative plot plan

104
 CONT’D
7. Layout template or models of individual product machines

according to flow-plan of operations

8. Layout templates and space for a service activities: materials

handling, receiving and shipping, inspection, storage, maintenance,

building services, offices and employees facilities

9. Develop building specifications to house the layout, and modify

floor plan considering building limitation

10. Make a detailed layout drawing, plot plan drawing, and a layout

model (if required)

105
 CONT’D
11. Make a flow-process chart and flow-diagram to verify the

attainment of the objectives of an efficient layout

12. Seek opinions and suggestions on these layout drawings and

charts from specialist in various fields, and make

modification if necessary

13. Seek management approval on final layout drawing

14. Construct plant and install equipments

15. Make a test run and adjust layout where required

106
REVISING
REVISING AND
AND IMPROVING
IMPROVING EXISTING
EXISTING LAYOUT
LAYOUT

• Layout changes are necessary due to various

reasons including expansion, for adopting
technological improvements, and changes in
production method.

107
 CONT’D
Technological improvement
• Influence the operating industrial plant,
1. Increasing mechanization
2. Developments in fuel and energy
3. Developments in processes
4. Developments in materials
5. Improvements in product design
6. Developments in scientific management

108
REASONS
REASONS FOR
FOR INEFFICIENT
INEFFICIENT LAYOUT
LAYOUT
1. Non qualified or un-exprienced personnel when
assigned with the task of layout
2. When layout revisions is delegated to various
department head and foremen, each department
makes whatever revisions it feels necessary.
3. A poor site for a particular plant may mean the
inaccessibility to the street and rail lines, illogical
arrangement of shipping and receiving facilities …

109
 CONT’D
4. When layout has no provision for future expansion
5. Due to poor judgment or inadequate forecast of
future sales
6. The use of a building unsuited to the layout
requirement also accounts for high production costs

7. Inefficient plant maintenance practices

8. When management fails to adopt farsighted
equipment replacement programmes

110
REASONS
REASONS FOR
FOR REDESIGN
REDESIGN OF
OF LAYOUT
LAYOUT

1. Expansion of capacity
2. Shrinkage in output

3. Change in product design

4. Replacement of equipment
5. Poor working environment

6. To reduce material handling

7. Frequent accidents

111
 CONT’D

8. Delay in process and idle time

9. Relocation of department
10. Backtracking and bottlenecks in material flow
11. Poor lighting, ventilating, heating, housekeeping
facilities in the layout.

112
 CONT’D

4. Analyze all the data on the present layout, study

current problems with the help of:
• Flow process chart analysis
• Flow diagram analysis
• Man-machine chart
• Analysis of service activities

5. Examine feasibility of change

113
 CONT’D

6. Develop the improved and revised layout that attains:

• An improved flow diagram
• An improved process chart
• Improved productivity

7. Installed the new improved method

114
CONT’D

115
 CONT’D

In general…
• The proper location of essential facilities such as
lockers, washrooms, toilets and medical service in
reference to the work areas and the provision of
sufficient amount of space for the will tend to
prevent waste of time in their use.

116
 Engineering Ergonomics

117
117
 What is Ergonomics?
Common Definition

118
What is Ergonomics?

119
 What is Ergonomics?
Ergonomics is concerned with the interaction between human and
technology
Ergonomics integrates knowledge delivered from the human science
to match systems, environments, jobs, and products to the physical
and mental abilities and limitation of people.
Ergonomics, also known as human engineering or human factors
engineering, the science of designing machines, products, and
systems to maximize the safety, comfort, and efficiency of the people
who use them.
Ergonomists draw on the principles of industrial engineering,
psychology, anthropometry (the science of human measurement), and
biomechanics (the study of muscular activity) to adapt the design of
products and workplaces to people’s sizes and shapes and their
physical strengths and limitations.
Ergonomists also consider the speed with which humans react and
how they process information, and their capacities for dealing with
psychological factors, such as stress or isolation. 120
 Ergonomic
• Ergonomist view people and the objects they use as one
unit, and ergonomic design blends the best abilities of
people and machines.
• Humans are not as strong as machines, nor can they
calculate as quickly and accurately as computers.
• Unlike machines, humans need to sleep, and they are
subject to illness, accidents, or making mistakes when
working without adequate rest.
• But machines are also limited—cars cannot repair
themselves, computers do not speak or hear as well as
people do, and machines cannot adapt to unexpected
situations as well as humans.
• An ergonomically designed system provides optimum
performance because it takes advantage of the strengths
and weaknesses of both its human and machine
components.
121
 Definition: Ergonomic
IEA (International Ergonomics Association)
”the scientific discipline concerned with the
understanding of the interactions among human and
other elements of a system, and the profession that
applies theory, principles, data and methods to design
in order to optimize human well-being and overall
system performance”

122
 Origin of Ergonomics
• The name ergonomics officially proposed at a 1949
meeting of the British Admiralty (July 12), by Prof.
Hugh Murrell.
• The name 'Ergonomics' officially accepted in 1950.
• The name Ergonomics was derived from the Greek
words:
Ergon/ergos - work;
Nomikos/nomos - natural laws - control and orderly
assignment.

123
 A Hierarchy of goals in ergonomics

• To generate tolerable working conditions that do not

pose known dangers to human life or health.
• To generate acceptable conditions
• To generate optimal conditions which are so well
adapted to human characteristics, capabilities and
desires that physical, mental and social well-being is
achieved

124
Anatomy Anthropometry Industrial Engineering
Orthopedics Biomechanics Bio-engineering
Physiology Work physiology Systems engineering
Medicine Industrial hygiene Safety engineering
Psychology Management Military engineering
Sociology Labor relations Computer Aided Design

Origins, developments and application of ergonomics

125
 Typical losses from failure to apply ergonomic

1. Lower production output

2. Increased lost time
3. Higher medical & material cost
4. Increased absenteeism
5. Low quality work
6. Injuries, strains
7. Increased probability of accidents & errors

126
 Areas of involvement for industrial ergonomic

1. Physical ergonomic
2. Information ergonomic
3. Design of work space and work method
4. Product design
5. Macroergonomics: job performance,
motivation job & worker

127
 Determining the costs
1. Personnel:
• Outside consultant
• Internal personnel
• Employee downtime
2. Equipments and material
3. Reduced productivity and sales
4. Overhead

128
 Determining the benefits
1. Personnel-related benefits
• Increased output per worker: work station
design, equipment redesign, software redesign
• Reduced errors
• Reduced accidents, injuries and illness
• Reduced training time
• Reduced skill requirements
• Reduced maintenance time
• Reduced absenteeism
• Reduced turnover

129
 Determining the benefits
2. Equipments and material
• Reduced scrap,
• Reduced equipment,
• Reduced production parts and materials,
• Reduced stocking and storage of parts,
• Reduced maintenance tools and materials,
• Reduced equipment damage

130
 History of Ergonomics

• The name ergonomics officially proposed at a 1949 meeting of

the British Admiralty, by Prof. Hugh Murrell.

• The name 'Ergonomics' officially accepted in 1950.

• The Ergonomic Society was formed in 1952 with people from

psychology, biology, physiology, and design in UK.

• The Human Factors Society was formed in 1957 in US. Now

evolve as Human Factor and Ergonomics Society (HFES).

131
 History of Ergonomics…
• In Europe  started with industrial application
– Focus on well being of workers and manufacturing
productivity
– Ergonomics
• In US  developed from military problems
(Korean War – around 1950s)
– Enhance the system performance
– Human Factors Engineering

132
 Timeline of Ergonomics

2000-
1950s 1960s 1970s 1980s 1990s
2010?

Military Ergonomics
Industrial Ergonomics
Consumer Product Ergonomics
HCI and Software Ergonomics
Cognitive and Macro Ergonomics
Eco and Pleasure Ergonomics?
133
 The cost of BAD ERGONOMICS

POOR WORKER LESS EFFICIENCY,

SATISFACTION PRODUCTIVITY

MOSTLY INCREASE IN ACCIDENT RATE,

BAD QUALITY  COST OF QUALITY

134
 The cost of BAD ERGONOMICS

• One day’s absence cost at least 2 – 3 times

one day payment (Oxenburgh, 1991)
• Total cost of work related accidents and illness
in Industrial Country is 5-10% of all industrial
company trading profit (UK Health & Safety
Executive, 1995)

135
 Economic Nature of Ergonomics

Optimum use of human energy Higher performances

Regulation of Rest and

Higher productivity
Recovery

Elimination of Fatigue Better quality of product

Elimination of undue illness

Hygienic aspect of ergonomics
and absteeism
136
 The Twelve Simplified Principles of Ergonomics

Providing background on the field of ergonomics, itemized in

twelve different principles.
Many of principles appear simple, but one should not
underestimate the power of a few fundamental ideas applied
systematically.
It is much more important to learn the underlying principles rather
than the details of current prescriptions for specific problems.
By learning the principles you will understand how to evaluate
changes in technology and new products that will come to the
market.
The principles will help you to evaluate any task, whether at
home, in the office environment, or in general industry.
The principles will remains the same, even when advancements
in knowledge are made in the field of ergonomics.
137
 The Twelve Simplified Principles of Ergonomics

1. Work in neutral posture

2. Reduce excessive force
3. Keep everything in easy reach
4. Work at proper heights
5. Reduce excessive motion
6. Minimize fatigue and static load
7. Minimize pressure points
8. Provide clearance
9. Move, exercise, and stretch
10. Maintain a comfortable environment
11. Make display and controls understandable
12. Improve work organization

138
At the end of the storm
There is a golden sky

139
 Chapter 4

Materials Management

140
 Contents
• Inventory and the Flow of Materials
• Supply and Demand Patterns
• Objectives of Inventory Management
• Inventory Costs
• Economic Order Quantity (EOQ)

141
 What is inventory?
• Inventories are those materials and supplies
carried on hand by a business or institution
either for sale or to provide inputs or supplies
to the production process.

• Inventory management is responsible for

planning and controlling inventory from the
raw material stage until it reaches the
consumer.
142
 Classifying Inventories
• One way of classifying inventories used often
is related to the flow of materials into,
through, and out of a manufacturing
organization.
• Raw materials , they include purchased
materials, component parts, and
subassemblies.
• Work in process (WIP): Raw materials that
have entered the manufacturing process and
are being worked on or are waiting to be
143
worked on.
 Supply and Demand Patterns
 In batch or lot manufacturing the basic purpose of
inventories is to decouple supply and demand.
• The purpose of inventories is thus to serve as a
buffer:-
 Between customer demand and finished goods.
 Between finished goods and component
availability.
 Between requirements for an operation and the
output from the preceding operation.
 Between parts and materials to begin production
and the suppliers of materials. 144
 The role of inventory
 A quantity of commodity in the control of an
enterprise, held for some time to satisfy
some future demand for manufacturing:-
• raw material,
• purchased items,
• semi-finished and finished products,
• spare parts, and
• supplies inventory is buffer between supply
and demand.
145
 …Cont’d
 On this basis inventories can be classified
according to the function they perform.
i) Anticipation Inventory: These inventories
are built up in advance of a peak selling
season, a promotion program, vacation
shutdown, or possibly the threat of a strike.
 They are built up to help level production
and to reduce the costs of changing
production rates.
146
 …Cont’d
ii) Fluctuation Inventory: Inventory is held to
cover random unpredictable fluctuations in
supply and demand or lead time.
 If demand or lead time is greater than
forecast, then a stockout will occur.
 Safety stock is carried to protect against the
possibility of a stockout.
 Its purpose is to prevent disruptions in
manufacturing or deliveries to customers.
147
 …Cont’d
iii) Lot Size Inventory: Items that are
purchased or manufactured in quantities
greater than needed immediately create lot
size inventories.
 Items will be ordered in lots or batches to get
quantity discounts, to reduce shipping,
clerical, and setup costs and in cases where
it is impossible to make or purchase items at
the same rate they will be used or sold.

148
 …Cont’d
iv) Transportation Inventory: These
inventories exist because of the time required
to move stock from one location to another
such as from a plant to a distribution center
or a customer.
 They are sometimes referred to as pipeline
or movement inventories.

149
 …Cont’d
v) Hedge Inventory: Some products such as
minerals and commodities (e.g., grains or
animal products) are traded on a worldwide
market.
 The price for these products fluctuates
according to world supply and demand.
 If buyers expect that prices will rise, they can
purchase hedge inventory when prices are
low.
150
 Objectives of Inventory Management
1. Maximum customer service
2. Low-cost plant operation,
 Inventories allow operations with different rates
of production to be operated separately and
thus more economically.
• In the case of production planning for seasonal
products the demand varies non uniformly
throughout the year.
• One strategy was to level production and build
anticipation inventory for sale in the peak
periods. 151
 …Cont’d
 Inventories permit manufacturing to run
longer production runs, which result in the
following:
• Lower setup costs per item
• An increase in production capacity
 Inventories allow manufacturing to purchase
in larger quantities, which results in lower
ordering costs per unit and quantity
discounts.
152
3. Minimum inventory investment
• Customer service: The lower the inventory,
the higher the likelihood of a stockout and the
lower the level of customer service.
• The higher the inventory level, the higher
customer service will be.
• Costs associated with changing production
levels:
• Excess equipment capacity, overtime, hiring,
training, and layoff costs will all be higher if
production must fluctuate with demand.
153
 …cont’d
• Cost of placing orders: Lower inventories can be
achieved by ordering less more often, but this
practice results in higher annual ordering costs.
• Transportation costs: Goods moved in small
quantities cost more to move per unit than those
moved in large quantities.
• However, moving large lots of goods implies
higher inventory.
• If inventory is carried, there has to be a benefit
that exceeds the costs of carrying that inventory.
154
 Inventory Costs
• Costs relevant to inventory mgt decisions are:-
• Item cost/Purchase cost: The price paid for a
purchased item consists of the cost of the item and
any other direct costs associated in getting the item
into the plant.
• Purchasing cost: per-item cost paid to the supplier.
• Let c be the unit cost and Q the numbers purchased
(lot size).In the linear case cQ.
• Carrying costs: These costs include all expenses
incurred by the firm because of the volume of
inventory carried. They can be broken down into three
categories: frequently calculated as a % I of
purchasing cost: h = ic can go up to 25-40 percent.155
 Ordering costs
• These are costs associated with the placing of
an order either with the factory or a supplier.
• The cost of placing an order does not depend
upon the quantity ordered, however, the annual
cost of ordering depends upon the number of
orders placed in a year.
• Cost of preparing and monitoring the order, each
time an order is incurred.
• It is a fixed cost A (independent of the lot size
ordered, also called fixed cost). Has $/year unit.
• Total cost for purchasing or producing a lot is A
156
+ cQ
 …Cont’d
• Stock out costs:- If demand during the lead
time exceeds forecast, then we can expect a
stockout.
• Potentially a stockout can be expensive
because of back-order costs, lost sales, and
possibly lost customers.
• Capacity-related costs:- When output levels
must be changed, costs can be incurred for
overtime, hiring, training, extra shifts, and
layoff.
157
 Measures of effectiveness
• Inventory = service entity
• Trade-off analysis between benefits and
costs of carrying inventory.
• The modeling approach optimizes the
inventory system minimum average total cost
per unit time.
• The managerial approach multi-item systems
• Months of supply
• Annual inventory turnover
• Inventory turnover 158
 Inventory policies
Three important factors:
• What to order? – variety decision
• When to order? – timing decision
• How much to order? – quantity decision
Also other factors:-
 Periodic review policy
 Continuous review policy

159
…Cont’d

160
 Inventory Models
 Single period inventory models
• Assumes the planning horizon is a single period
and decision are made a single time
 Multi period inventory models
• Consider multiple period and decision
 Depending on the nature of demand
– Deterministic
– Probabilistic/Stochastic
• Inventory under risk (the distribution is known)
• Inventory under uncertainty (the distribution is not
know, but mean and variance are known) 161
 Inventory Models
• How much to order– Order quantity Q
• When to order—Reorder level r
• The time difference between placing an
order and receiving an order is called Lead
Time.
• The reorder level is the demand required for
the lead time; also called reorder demand.

162
 Deterministic demand
• The annual demand remains the same
• The other information such as;
Item cost (purchasing cost)
Holding/carrying cost
Ordering cost and others are also remain
the same.

163
 Quantity decisions
• Static lot sizing models
– uniform (constant) demand over the planning
horizon
• Economic order quantity (EOQ)
• Economic production quantity with extensions
• Quantity discounts
• Resource-constrained multiple-item models
• Multi-item ordering
– Dynamic lot sizing models
– changing demand over the planning horizon
164
 Economic order quantity (EOQ)
• Introduced by1915 Harris / Wilson
– there is a single inventory system
– demand is uniform and deterministic and
amounts to D units per time unit
– no shortages are allowed
– there is no order lead time
– all the quantity ordered arrives at the same
time (infinite replenishment rate)

165
…Cont’d

166
 Model-1 Single Item
• Single Item
• Continuous demand
• Instantaneous replenishment (lead time = 0)
• Annual Demand = Demand/year
• Let Q is the ordering quantity to be order
every day, the graph will be:

167
…Cont’d

168
….cont’d

169
…cont’d

170
…Cont’d

171
…cont’d

172
…cont’d

173
 Cambridge Chowder Co. consumes D = 60,000 cases of
crackers per year. The crackers cost c = $4 per case,
and each order incurs a delivery cost of K = $200.
Money spent on crackers has an alternative investment
with annual interest of 24%.
• Demand: D = 60,000 cases per year
• Fixed ordering cost: K = $200 per order
• Variable ordering cost: c = $4 per case
• Holding cost: h = $0.96 per case per year

• Opportunity cost: alternative investment with 24% annual

interest
•  holding 1 case for 1 year costs 4*24%= $0.96 = h

174
End OF Chapter One!!

175
 Chapter Five

Project Management and

Resource Allocation

176
 Why we need to know about Project

• “Any Project Managers, Project Management

team members, Program Managers or
Executives must Know how Project behaves”
• Understanding about the Project is a
foundation knowledge for managing it.

177
 What is Project?
• A project is a temporary (which has a
beginning and an end) endeavor undertaken
to create a unique (Distinct) product,
service, or result.

*Definition according to PMI*

178
 Where do we need Project ?
• Projects are undertaken:
at all levels of the organization and they can involve a single
person or many thousands.
• Their duration ranges:
few weeks to several years.
• Projects can involve:
one or many organizational units, such as joint ventures and
Encode
partnerships

Decode

179
 Characteristics of a Project ?
• Temporary:
– Definite beginning and End
– Duration of either few weeks or several years
– Ends when project objectives are met, cannot be met or no longer
needed.
• Unique
– Different from other products and services. (unique deliverables)
– Never done before
• Progressive Elaboration (iterative process) begins as a concept….
– Gradual development of the detailed characteristics of the product
or service

180
 Projects and Project Management
Projects and Project Management

Proposed in Project Specified in Project Designed

Charter Scope

Programmed Installed at user site What the user wanted!

1-181
 Project Attributes
 A project:
Has a unique purpose
Is temporary
Is developed using progressive elaboration
Requires resources, often from various areas
Should have a primary customer or sponsor
The project sponsor usually provides the
direction and
Funding for the project
Involves uncertainty

182
 Projects and Project Management
Types of Projects
 Computer related hardware and software projects
• Include networking, infrastructure, and software
design and development projects
• Computer software projects include system software
projects,
• programming software projects, and
• application software projects.
• New Product Development
• Construction
1-183
Construction project

184
185
186
187
188
189
Manufacturing project

190
191
Agricultural project

192
 Project Life Cycle

What is Successful Project ?

193
 Project Life Cycle
More on Project Phases
In early phases of a project life cycle:
Resource needs are usually lowest
The level of uncertainty (risk) is highest
Project stakeholders have the greatest opportunity to influence the project
In middle phases of a project life cycle:
The certainty of completing a project improves
More resources are needed
The final phase of a project life cycle focuses on:
Ensuring that project requirements were met
The sponsor approves completion of the project

194
The World Bank model Project life cycle

Identification

Preparation
Evaluation

Implementation Appraisal/
financing

195
Archibald's Project Life Span
196
Wideman's corporate business, facility/product and
project life spans compared
197
Allen's generic project life span
198
PMI Standard Committee's sample generic project life span

199
Kapur's information system project life span

200
Project Cost and Staffing Level Across the
Project Life Cycle

201
 Project will be successful if…
• Purposeful (Objective)
Well defined set of desired end result, which is measurable.
Note: This quality of objective will enable to mark the project complete.
• Have Life cycle
Progress from an idea, through planning and execution, until they
are complete.
Have definite beginning and ending
• Have interdependencies: Have defined sequence.
• Progressive Elaboration
Developing in steps and continuing by increments. Project entities are
described in broad terms at the start of the project but detailed as project
progress. Initially this may look failure prone as the details are not detailed, but
will eventually

202
 What is Operation
• An operation is a work
performed repetitively and is an
on-going process.
• It shares some characteristics with
project , like it is performed by people

203
 Project VS Operation
• Similarities
• Both are performed by people
• Both have deliverables
• Both have limited resources
• Both are Planned, Executed and Controlled (need to be
managed)
• Differences:
• Project is temporary in nature , whereas an operation is ongoing
• Projects have temporary teams , whereas operations have
permanent teams (relatively)
• Each project is unique in nature, whereas operation steps are
identical

204
 Project VS Operation
Projects Operations
• To attain its objectives and terminate • To sustain the business
• Create own character, organization, and goals • Semi permanent charter, organization,
• Catalyst for change and goals
• Unique product or services • Maintain status quo
• Heterogeneous teams • Standard product or services
• Start and end date • Homogeneous teams
• Ongoing
Examples Examples
• Producing a News letter • Responding to customers requests
• Writing and publishing a book • Writing a letter to a Prospect
• Implementing a LAN • Hooking up a Printer to a computer
• Hiring a sales man • Meeting with an employee
• Arrange for a conference • Attending a conference
• Opening for a new shop • Opening the shop
• Producing the annual report • Writing a progress update memo 205
 Project and Production

 Idea  Concrete entity

 Design – Factory
 Plan – Building
– Highway
– Prototype
– Products
– Services

206
 Project  Production
– Automobile factory – Produce
– Build a house automobiles
– Construct a hospital – Operate household
– Conceive new – Treat patients
product – Manufacture
– Develop prototype – Manufacture
multiples

207
 How is the Project Initiated

 A Market Demand & Organizational Need

 A Customer Request
 A Technological Advancement
 A Legal Requirement
 Ecological Impacts
 Social need

208
 Project and Strategy
• Projects are a means of organizing activities that
cannot be addressed within the organization’s
normal operational limits.

• Projects are therefore often utilized as a means of

achieving an organization’s strategic plan,
whether the project team is employed by the
organization or is a contracted service provider.

209
 Project Management
• Project management is: the application of
knowledge, skills, tools and techniques to
project activities to meet project
requirements.
• The discipline of project management is
about providing the tools and techniques
that enable the project team (not just the
project manager) to organize their work to
meet these constraints

210
 Why Project Management?
• It consists all type of management in one
package

• It requires a minimum of Five area expertise

• Since project is UNIQUE in nature, it requires

unique management

• It is a management of Project constraint

211
 What is managed in Project
• Performance, Cost, and Time Project Targets
(According to other Versions)

Performance

Required Performance

Target

Cost
Budget limit

Due date
Decode

Time / Schedule

212
 How Do We Accomplish Project
Management?

It can be accomplished through the use

of the processes of initiating, planning,
executing, monitoring and controlling,
and closing.

213
Who is Responsible for Project Management

• Project Manager is an individual Responsible/

Accountable for Managing the Project

• Project Management can be performed by Individual

or Team .

However,
• Project must be done in Team

214
 Competence required for Project
Management
• The Project Management Body of knowledge
• Application area Knowledge, Standards and
Regulations
• Project Environment Knowledge
• General Management Knowledge and skills
• Soft skill and human relations skill

215
 Project and Program Management

• A Program is: a group of related projects managed in a

coordinated way to obtain benefits and control which is not
available from managing them individually.

Programs may include elements of related work outside of the

scope of the discrete projects in the program.

• Program may include elements of ongoing operations, as well

as projects.

216
 Project Portfolio and Project Management

• Project portfolio management refers to

the selection and support of projects or
program investments. These investments in
projects and programs are guided by
organization’s strategic plan and available
resources.

* The projects or programs in the portfolio may

not necessarily be interdependent or directly
related.
217
 Projects Programs Portfolios
Projects have defined Have a larger scope and Portfolios have a
objectives. Scope is provide more significant business scope that
Scope progressively elaborated benefits changes with the
strategic goals of the org
throughout the life cycle

Project managers expect The program manager Portfolio managers

change and implement must expect change continually monitor
Change processes to keep from inside and outside changes in the broad
change managed and the program and be environment
Controlled prepared to manage it

Project manages Program managers Portfolio manages create

progressively elaborate develop the overall and maintain necessary
high level information program plan and create processes and
Planning into detailed plans high level plans to guide communication relative
throughout the project detailed planning at the to the aggregate portfolio
life cycle end of the component
level
35
218
 Project
Project managers
Projects
manage the project team
to meet the project
Management
objectives
Success is measured by
product and project
quality , timelines ,
Success
budget compliance, and
degree of customer
satisfaction
Project managers monitor
and control the work of
producing the products ,
Monitoring
services , results that the
project was undertaken to
produce
Program Portfolio
Program managers
Portfolio managers may
Programs
manage the program staff Portfolios
manage or coordinate
and the project managers
portfolio management
; they provide vision and
staff
overall leadership
Success is measured by
Success is measured in
the degree to which the
terms of aggregate
program satisfies the
performance of portfolio
needs and benefits for
components
which it was undertaken
Program managers Portfolio managers
monitor the progress of monitor aggregate
program components to performance and value
ensure the overall goals , indicators
schedules, budget&
benefits of the program
will be met 219
 Project Life Cycle

Project Initiation
 Initiating a project includes recognizing and starting a new project or
project phase.

 Some organizations use a pre-initiation phase, while others include

items such as developing a business case as part of the initiation.

 The main goal is to formally select and start off projects.

 Key outputs include:

 Assigning the project manager.

 Identifying key stakeholders.

 Completing a business case.

 Completing a project charter and getting signatures on it.

220
Project Initiation Documents

 Every organization has its own variations

of what documents are required to initiate
a project.
 It’s important to identify the project need,
stakeholders, and main goals.

221
 Project Planning

The main purpose of project planning is to guide

execution
Every knowledge area includes planning information
Key outputs include:
A team contract
A project scope statement
A work breakdown structure (WBS)
A project schedule, in the form of a Gantt chart with all dependencies
and resources entered
A list of prioritized risks (part of a risk register)

222
 Project Executing

Usually takes the most time and resources to perform

project execution
Project managers must use their leadership skills to
handle the many challenges that occur during project
execution
Many project sponsors and customers focus on
deliverables related to providing the products, services,
or
results desired from the project
A milestone report can help focus on completing major
milestones

223
 Project Monitoring and Controlling

Involves measuring progress toward project objectives,

monitoring deviation from the plan, and taking correction
actions

Affects all other process groups and occurs during all

phases of the project life cycle

Outputs include performance reports, requested changes,

and updates to various plans

224
 Project Closing

Involves gaining stakeholder and customer acceptance of

the final products and services

Even if projects are not completed, they should be closed

out to learn from the past

Outputs include project archives and lessons learned, part

of organizational process assets

Most projects also include a final report and presentation to

the sponsor/senior management

225
 Project Integration

Project Integration Processes

Integration Management

HR Management
Scope Management

Risk Management Communication

Time Management Cost Management Management
Procurement
Quality Management Management

226
 Work Breakdown Structures (WBS) and
Risk Assessment

 The WBS assists project leaders, participants, and

stakeholders in the development of a clear vision of
the end products or outcomes to be produced by the
project.
 A deliverables-oriented grouping of project elements
that organizes and defines the total work scope of the
project.
 It provides the framework for all deliverables
throughout the project life cycle.
 Each descending level represents an increasingly
detailed definition of the project work.
227
 Project Management Processes
(Initiation)
Project Management Plan

Initiation Scope WBS

(definition)
Project Charter
ect Scope
Pro j
ent
Statem

Cost Time Human Resources

(estimates, …) (activity diagrams, …) (Labour and professional matrix, …

• Also to consider: Quality, Risk, Communication,

Procurement, Integration (knowledge areas)

228
 Possible levels in a WBS

Project
Sub-projects
Deliverables
Sub-deliverables
Work packages
Work units

229
 Work Breakdown Structure (WBS)
Design:

The WBS provides a graphical representation or textual outline of the project scope.

Some of the main roles the WBS plays in supporting clarity for project definition are that it:

Decomposes: the overall project scope into clearly defined deliverables.

Defines: the scope of the project in terms that the stakeholders can
understand.

Provides: a structure for organizing information regarding the project’s

progress, status, and performance.

Supports: tracking of risks to assist the project manager in identifying and

implementing necessary responses.

230
 Work Breakdown Structure (WBS)
Levels:

The depth of the WBS is dependent upon the size and complexity of the project
and the level of detail needed to plan and manage it.

The 100% Rule:

This rule states that the WBS includes 100% of the work defined by the project
scope and captures all work deliverables to be completed, including project
management.

The rule applies to all levels within the hierarchy.

231
WBS for Software development Project

232
 Purpose of a WBS
• An instrument for tracking costs and work
performance.
• Provides a coordinating framework for the
various parts of a project.
• Defines authority and responsibilities for the
details of the project.
• Provides the capacity to sum or “roll up” the
cost of each project phase.
• Identifies “work packages.”

233
Purpose of a WBS CONT’D

 It helps prevent work from slipping through the cracks.

 It provides the project team members with an understanding of where their pieces fit into the overall project management plan.
 It facilitates communication and cooperation among team members.
 It helps prevent changes.
 It provides a basis for estimating staff, cost, and time.
 It gets team buy-in and builds the team.
 It helps people get their minds around the project.

234
 BENEFITS OF WBS
1. It helps prevent work from slipping through the
cracks.
2. It provides the project team members with an
understanding of where their pieces fit into the
overall project management plan.
3. It facilitates communication and cooperation among
team members.
4. It helps prevent changes.
5. It provides a basis for estimating staff, cost, and
time.
6. It gets team buy-in and builds the team.
7. It helps people get their minds around the project.235
 Identifying Work Packages
• Identify major project work deliverables/systems. Then the
sub-deliverables necessary to accomplish the larger
deliverables are defined.
• The process is repeated until the sub-deliverable detail is small
enough to be manageable and where one person is
responsible. This lowest deliverable usually consists of several
work packages.
• Work packages within a deliverable are grouped by type of
work: foundation, framing, finish; hardware, programming,
testing, etc.
• Also referred to as cost accounts, work packages facilitate a
system for monitoring project progress by work completed, cost
and responsibility.
236
 In summary:
1. Most commonly, the project title goes at the top of the WBS.

2. The first level is normally the same as the project life cycle.

3. The following levels break the project into smaller pieces.

4. This is a top – down effort to decompose the deliverables and

5. the work required to produce them.

6. The complete scope of the project (product, project, and

management efforts) are included.

7. Note that each work package consists of nouns (things) rather than
actions.
237
 NETWORK TECHNIQUES

PERT CPM
-Program Evaluation and Critical Path Method
Review Technique Developed by El Dupont
- developed by the US for Chemical Plant
Navy with Booz Shutdown Project- about
Hamilton Lockheed same time as PERT
- on the Polaris
Missile/Submarine
program 1958

Both use same calculations, almost similar

Main difference is probabilistic and deterministic in time
estimation
Gantt Chart also used in scheduling 238
 NETWORK SCHEDULING

• Graphical portrayal of activities and event

• Shows dependency relationships between.
tasks/activities in a project.
• Clearly shows tasks that must precede (precedence)
or follow (succeeding) other tasks in a logical
manner.
• Clear representation of plan – a powerful tool for
planning and controlling project.

239
 DEFINITION OF TERMS IN A NETWORK DIAGRAM

• Activity: any portions of project (tasks) which required by

project, uses up resource and consumes time – may
involve labor, paper work, contractual negotiations,
machinery operations Activity on Arrow (AOA) showed as arrow,
AON – Activity on Node
• Event: beginning or ending points of one or more
activities, instantaneous point in time, also called ‘nodes’

• Network: Combination of all project activities and the events

PRECEEDING SUCCESSOR
ACTIVITY

EVENT

240
 Emphasis on Logic in Network Construction
• Construction of network should be based on logical or
technical dependencies among activities
• Example - before activity ‘Approve Drawing’ can be
started the activity ‘Prepare Drawing’ must be completed
• Common error – build network on the basis of time logic
(a feeling for proper sequence ) see example below

WRONG !!!

CORRECT 
241
 Example 1- A simple network
Consider the list of four activities for making a simple product:

Activity Description Immediate

predecessors
A Buy Plastic Body -
B Design Component -
C Make Component B
D Assemble product A,C

Immediate predecessors for a particular activity are the activities

that, when completed, enable the start of the activity in question.

242
 Sequence of activities
• Can start work on activities A and B anytime, since
neither of these activities depends upon the
completion of prior activities.
• Activity C cannot be started until activity B has been
completed
• Activity D cannot be started until both activities A and
C have been completed.
• The graphical representation (next slide) is referred to
as the PERT/CPM network

243
 Network of Four Activities

Arcs indicate project activities

A D
1 3 4

B C

Nodes correspond to the beginning

and ending of activities

244
 Example 2
Develop the network for a project with following activities and
immediate predecessors:
Activity Immediate
predecessors
A -
B -
C B
D A, C
E C
F C
G D,E,F
Try to do for the first five (A,B,C,D,E) activities

245
Network of first five activities

A D
1 3 4

E
B

C 5

2
We need to introduce
a dummy activity

246
 Network of Seven Activities
1 A 3 D 4 G
7
dummy E
B
C 5 F
2 6
• Note how the network correctly identifies D, E, and F as the
immediate predecessors for activity G.
• Dummy activities is used to identify precedence relationships
correctly and to eliminate possible confusion of two or more
activities having the same starting and ending nodes
• Dummy activities have no resources (time, labor, machinery, etc) –
purpose is to PRESERVE LOGIC of the network

247
 EXAMPLES OF THE USE OF DUMMYACTIVITY
Network concurrent activities
a
a 2

1 2 1 Dummy

b 3
b
WRONG!!! RIGHT 

Activity c not WRONG !

required for e
a
a e
d
1
b b
1 e
d
c
2
c
WRONG
RIGHT
!!!

RIGHT 

248
 WRONG!!! RIGHT!!!

a d a d
1 1

b e b
2 2 4
e

c f c f
3 3

a precedes d.
a and b precede e,
b and c precede f (a does not precede f)

249
 Project Crashing
■ Project duration can be reduced by assigning more
resources to project activities.
■ However, doing this increases project cost.
■ Decision is based on analysis of trade-off between
time and cost.
■ Project crashing is a method for shortening project
duration by reducing one or more critical activities to a
time less than normal activity time.
■ Project crashing is a method for shortening project
duration by reducing one or more critical activities to a
time less than normal activity time.
250
The Project Network
Number Activity Predecessor Duration
1 Design house and obtain -- 12 months
financing
2 Lay foundation 1 8 months

3 Order and receive materials 1 4 months

4 Build house 2,3 12 months

5 Select paint 2, 3 4 months

6 Select carper 5 4 months
7 Finish work 4, 6 4 months
251
Project Crashing and Time-Cost Trade-Off
Example Problem

The project network for building a house

252
Project Crashing and Time-Cost Trade-Off
Example Problem

Normal activity and crash data for the network

253
Project Crashing and Time-Cost Trade-Off
Example Problem
Total Crash Cost $2000
  $400 / week
Total Crash Time 5 weeks
Crash cost & crash time
have a linear relationship

Time-cost relationship for crashing activity 1 254

Project Crashing and Time-Cost Trade-Off
Example Problem

Network with normal activity times and weekly crashing costs

255
Project Crashing and Time-Cost Trade-Off
Example Problem
As activities are crashed, the critical path may change
and several paths may become critical.

Revised network with activity 1

crashed
256
Project Crashing and Time-Cost Trade-Off
QM for Windows Output

257
Project Crashing and Time-Cost Trade-Off
QM for Windows

258
Project Crashing and Time-Cost Trade-Off
General Relationship of Time and Cost

■ Project crashing costs and indirect costs have an inverse

relationship.
■ Crashing costs are highest when the project is
shortened.
■ Indirect costs increase as the project duration increases.
■ The optimal project time is at the minimum point on
the total cost curve.

259
Project Crashing and Time-Cost Trade-Off
General Relationship of Time and Cost

The time-cost trade-off

260
 Gantt Charts
 Establish a time-phased network
 Can be used as a tracking tool

Benefits of Gantt charts

1. Easy to create and comprehend
2. Identify the schedule baseline network
3. Allow for updating and control
4. Identify resource needs
10-261
Create a Gantt chart based on the
activities listed in the table.

Task Time Pred

A 8 --
B 5 A
C 8 A
D 4 B,C
E 5 D

10-262
 Crashing
The process of accelerating a project

Principal methods for crashing

 Improving existing resources’ productivity
 Changing work methods
 Increasing the quantity of resources

10-263
 Managerial Considerations
• Determine activity fixed and variable costs
• The crash point is the fully expedited activity
• Optimize time-cost tradeoffs
• Shorten activities on the critical path
• Cease crashing when
– the target completion time is reached
– the crashing cost exceeds the penalty cost
10-264
What is the lowest cost to complete this project in 52
weeks? Times are in weeks and costs in dollars. Plot the
AON & AOA networks and the GANTT chart.
Activity Pred Normal Min Normal Crash
Time Time Cost Cost
A -- 14 9 500 1500
B A 5 2 1000 1600
C A 10 8 2000 2900
D B, C 8 5 1000 2500
E D 6 6 1600 1600
F D 9 6 1500 3000
G E, F 7 4 600 1800
H G 15 11 1600 3600

10-265
 Activity on Arrow Networks
 Activities represented by arrows
 Widely used in construction
 Event nodes easy to flag
 Forward and backward pass logic similar to AON
 Two activities may not begin and end at common
nodes
 Dummy activities may be required
10-266
1. Use AOA to sketch the network that represents the project
as described in the table.
2. Calculate early and late event times for all activities.

Activity Time Pred Activity Time Pred

A 4 -- F 15 E
B 2 A G 4 E
C 10 A H 7 D,F,G
D 3 B I 11 H
E 15 B,C

10-267
 Activity on Arrow Network

B D I
A H
E F

C
G

10-268
 Controversies in the Use of Networks

Networks can be too complex

Poor network construction creates problems
Networks may be used inappropriately
When employing subcontractors
– The master network must be available to them
– All sub-networks must use common methods
Positive bias exists in PERT networks
10-269
End OF Chapter One!!

270
 CHAPTER 6
Envestment Evaluation

Project Financing & Evaluation

Department of Mechanical Engineering

271
WU Institute of Technology
 Preliminaries

• STELLAR access: to be announced

• AS1 Survey due by tonight 12 pm
• TP1 and AS2 are out

272
 AS 2: Student Presentation
 10 minute presentation followed by 5 minute discussion
 1 or 2 presentations from Feb. 20 to Mar. 19
 Topics
 Your past project experience (strongly recommended if you have any)
 Size of project is not important!
 Project main figures
 Main managerial aspects
 Project management practices
 Problems, strengths, weaknesses, risks
 Your learning
 Emerging construction technologies (e.g., 4D CAD, Virtual Reality, Sensing,
…)
 Volunteers for next week?
273
 Preliminaries

• STELLAR access: to be announced

• AS1 Survey due by tonight 12 pm
• TP1 and AS2 are out
• Pictures will be taken before you leave
• Who we are
• Don’t memorize course content. Understand it.

274
 Outline
 Session Objective & Context
 Project Financing
 Owner
 Project
 Contractor
 Additional Issues

 Financial Evaluation
 Time value of money
 Present value
 Rates
 Interest Formulas
 NPV
 IRR & payback period
275
 Session Objective

• The role of project financing

• Mechanisms for project financing

• Measures of project profitability

276
 Project Management Phase

DESIGN DEVELOPMENT OPERATIONS

FEASIBILITY CLOSEOUT
PLANNING

Financing & Evaluation

Risk

277
 Context: Feasibility Phases
– Project Concept
– Land Purchase & Sale Review
– Evaluation (scope, size, etc.)
– Constraint survey
• Site constraints
• Cost models
• Site infrastructural issues
• Permit requirements
– Summary Report
– Decision to proceed
– Regulatory process (obtain permits, etc)
– Design Phase
278
 Lecture 2 - References

More details on:

– Hendrickson PM for Construction on-line textbook
• Chapter 7

279
 Outline
 Session Objective & Context
 Project Financing
 Owner
 Project
 Contractor
 Additional Issues

 Financial Evaluation
 Time value of money
 Present value
 Rates
 Interest Formulas
 NPV
 IRR & payback period
280
 Financing – Gross Cashflows
years 1 2 3 4 5 6 7 8 9 10
OWNER
investment ($10,000,000) ($20,000,000)
operation incomes $2,000,000 $4,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000
owner cashflow $0 ($10,000,000) ($20,000,000) $2,000,000 $4,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000
owner cum cashflow $0 ($10,000,000) ($30,000,000) ($28,000,000) ($24,000,000) ($18,000,000) ($12,000,000) ($6,000,000) $0 $6,000,000

CONTRACTOR
costs ($4,000,000) ($7,000,000) ($14,000,000) $0 $0 $0 $0 $0 $0 $0
revenues $0 $10,000,000 $20,000,000 $0 $0 $0 $0 $0 $0 $0
contractor cashflow ($4,000,000) $3,000,000 $6,000,000 $0 $0 $0 $0 $0 $0 $0
contractor cum cashflow
($4,000,000) ($1,000,000) $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000

Owner investment = contractor revenue

$10,000,000
$5,000,000
$0
($5,000,000) 1 2 3 4 5 6 7 8 9 10 11

($10,000,000) owner cum cashflow

($15,000,000) contractor cum cashflow

($20,000,000)
($25,000,000)
($30,000,000)
281
($35,000,000)
 Financing – Gross Cashflows
Design/Preliminary Construction

years 1 2 3 4 5 6 7 8 9 10
OWNER
investment ($10,000,000) ($20,000,000)
operation incomes $2,000,000 $4,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000
owner cashflow $0 ($10,000,000) ($20,000,000) $2,000,000 $4,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000
owner cum cashflow $0 ($10,000,000) ($30,000,000) ($28,000,000) ($24,000,000) ($18,000,000) ($12,000,000) ($6,000,000) $0 $6,000,000

CONTRACTOR
costs ($4,000,000) ($7,000,000) ($14,000,000) $0 $0 $0 $0 $0 $0 $0
revenues $0 $10,000,000 $20,000,000 $0 $0 $0 $0 $0 $0 $0
contractor cashflow ($4,000,000) $3,000,000 $6,000,000 $0 $0 $0 $0 $0 $0 $0
contractor cum cashflow
($4,000,000) ($1,000,000) $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000

Owner investment = contractor revenue

$10,000,000
$5,000,000
$0
($5,000,000) 1 2 3 4 5 6 7 8 9 10 11

($10,000,000) owner cum cashflow

($15,000,000) contractor cum cashflow

($20,000,000)
($25,000,000)
($30,000,000)
282
($35,000,000)
 Financing – Gross Cashflows
Design/Preliminary Construction

years 1 2 3 4 5 6 7 8 9 10
OWNER
investment ($10,000,000) ($20,000,000)
operation incomes $2,000,000 $4,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000
owner cashflow $0 ($10,000,000) ($20,000,000) $2,000,000 $4,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000 $6,000,000
owner cum cashflow $0 ($10,000,000) ($30,000,000) ($28,000,000) ($24,000,000) ($18,000,000) ($12,000,000) ($6,000,000) $0 $6,000,000

CONTRACTOR
costs ($4,000,000) ($7,000,000) ($14,000,000) $0 $0 $0 $0 $0 $0 $0
revenues $0 $10,000,000 $20,000,000 $0 $0 $0 $0 $0 $0 $0
contractor cashflow ($4,000,000) $3,000,000 $6,000,000 $0 $0 $0 $0 $0 $0 $0
contractor cum cashflow
($4,000,000) ($1,000,000) $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000 $5,000,000

Owner investment = contractor revenue

$10,000,000
$5,000,000
$0
($5,000,000) 1 2 3 4 5 6 7 8 9 10 11
• Early expenditure
($10,000,000) owner cum cashflow • Takes time to get revenue
($15,000,000) contractor cum cashflow

($20,000,000)
($25,000,000)
($30,000,000)
283
($35,000,000)
 Project Financing

Aims to bridge this gap in the most beneficial

way!

284
 Critical Role of Financing

• Makes projects possible

• Has major impact on
– Riskiness of construction
– Claims
– Prices offered by contractors (e.g., high bid price for late
payment)
• Difficulty of Financing is a major driver towards alternate
delivery methods (e.g., Build-Operate-Transfer)

285
 How Does Owner Finance a Project?

• Public
• Private
• “Project” financing

286
 Outline
 Session Objective & Context
 Project Financing
 Owner
 Project
 Contractor
 Additional Issues

 Financial Evaluation
 Time value of money
 Present value
 Rates
 Interest Formulas
 NPV
 IRR & payback period
287
 Public Financing
• Sources of funds
– General purpose or special-purpose bonds
– Tax revenues
– Capital grants subsidies
– International subsidized loans
• Social benefits important justification
– Benefits to region, quality of life, unemployment relief, etc.
• Important consideration: exemption from taxes
• Public owners face restrictions (e.g. bonding caps)
– Major motivation for public/private partnerships
• MARR (Minimum Attractive Rate of Return) much lower (e.g.
8-10%), often standardized

288
 Private Financing
• Major mechanisms
– Equity
• Invest corporate equity and retained earnings
• Offering equity shares
– Stock Issuance (e.g. in capital markets)
• Must entice investors with sufficiently high rate of return
• May be too limited to support the full investment
• May be strategically wrong (e.g., source of money, ownership)
– Debt
• Borrow money
• Bonds
• Because higher costs and risks, require higher returns
• MARR varies per firm, often high (e.g. 20%)
289
Private Owners w/Collateral Facility Distinct
Financing Periods
• Short-term construction loan
– Bridge Debt
• Risky (and hence expensive!)
• Borrowed so owner can pay for construction (cost)
• Long-term mortgage
– Senior Debt
• Typically facility is collateral
• Pays for operations and Construction financing debts
• Typically much lower interest
• Loans often negotiated as a package

construction operation time

w/o tangible w/ tangible 290
 Outline
 Session Objective & Context
 Project Financing
 Owner
 Project
 Contractor
 Additional Issues

 Financial Evaluation
 Time value of money
 Present value
 Rates
 Interest Formulas
 NPV
 IRR & payback period
291
 “Project” Financing
• Investment is paid back from the project profit rather than the
general assets or creditworthiness of the project owners
• For larger projects due to fixed cost to establish
– Small projects not much benefit
• Investment in project through special purpose corporations
– Often joint venture between several parties
• Need capacity for independent operation
• Benefits
– Off balance sheet (liabilities do not belong to parent)
– Limits risk
– External investors: reduced agency cost (direct investment in project)
• Drawback
– Tensions among stakeholders
292
 Outline
 Session Objective & Context
 Project Financing
 Owner
 Project
 Contractor
 Additional Issues

 Financial Evaluation
 Time value of money
 Present value
 Rates
 Interest Formulas
 NPV
 IRR & payback period
293
 Contractor Financing I
• Payment schedule
– Break out payments into components
• Advance payment
• Periodic/monthly progress payment (itemized breakdown
structure)
• Milestone payments
– Often some compromise between contractor and owner
– Architect certifies progress
– Agreed-upon payments
• retention on payments (usually, about 10%)
– Often must cover deficit during construction
– Can be many months before payment received
294
 S-curve Work

Man-hours

months
295
 S-curve Cost
8 100

90
7
80
6
70
5

Cumulative costs $K
60

4 50 Daily cost
$K

Cum. costs
40
3
30
2
20
1
10

0 0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22

Working days
296
Expense & Payment

297
 Contractor Financing II
• Owner keeps an eye out for
– Front-end loaded bids (discounting)
– Unbalanced bids

Contractor Revenue Projection Contractor Revenue Projection

120 140

100 120

100
80

80
Revenue

Revenue
60
60
40
40

20
20

0 0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18
Month Month

298
 Contractor Financing II
• Owner keeps an eye out for
– Front-end loaded bids (discounting)
– Unbalanced bids
• Contractors frequently borrow from
– Banks (Need to demonstrate low risk)
• Interaction with owners
– Some owners may assist in funding
• Help secure lower-priced loan for contractor
– Sometimes assist owners in funding!
• Big construction company, small municipality
• BOT

299
 Contractor Financing III

• Agreed upon in contract

– Often structure proposed by owner
– Should be checked by owner (fair-cost estimate)
– Often based on “Masterformat” Cost Breakdown Structure
(Owner standard CBS)
• Certified by third party (Architect/engineer)

300
 Outline
 Session Objective & Context
 Project Financing
 Owner
 Project
 Contractor
 Additional Issues

 Financial Evaluation
 Time value of money
 Present value
 Rates
 Interest Formulas
 NPV
 IRR & payback period
301
 Latent Credit
• Many people forced to serve as lenders to owner
due to delays in payments
– Designers
– Contractors
– Consultants
– CM
– Suppliers
• Implications
– Good in the short-term
– Major concern on long run effects
302
 Role of Taxes

• Tax deductions for

– Depreciation - Link
• the process of recognizing the using up of an asset
through wear and obsolescence and of subtracting
capital expenses from the revenues that the asset
generates over time in computing taxable income
– Others

303
 Outline
 Session Objective & Context
 Project Financing
 Owner
 Project
 Contractor
 Additional Issues

 Financial Evaluation
 Time value of money
 Present value
 Rates
 Interest Formulas
 NPV
 IRR & payback period
304
 Develop or Not Develop

• Is any individual project worthwhile?

• Given a list of feasible projects, which one is the

best?

• How does each project rank compared to the others

on the list?

305
 Project Evaluation Example:

• Project A • Project B
• Construction=3 years • Construction=6 years
• Cost = $1M/year • Cost=$1M/year
• Sale Value=$4M • Sale Value=$8.5M
• Total Cost? • Total Cost?
• Profit? • Profit?
306
 Quantitative Method

• Profitability
– Create value for the company

307
 Profit
TOTAL
EQUIVAL. $

REVENUES 5,500,000.00
COSTS 4,600,000.00
Project management 400,000.00
Engineering 800,000.00
Material & transport 2,200,000.00
Construction/commissioning 1,300,000.00
Contingencies 200,000.00

GROSS MARGIN 900,000.00

Time factor? 308

 Quantitative Method

• Profitability
– Create value for the company
• Opportunity Cost
– Time Value of Money
• A dollar today is worth more than a dollar tomorrow
– Investment relative to best-case scenario
• E.g. Project A - 8% profit, Project B - 10% profit

309
 Money Is Not Everything

• Social Benefits
– Hospital
– School
– Highway built into a remote village
• Intangible Benefits (E.g, operating and competitive
necessity)
– New warehouse
– New cafeteria

310
 Outline
 Session Objective & Context
 Project Financing
 Owner
 Project
 Contractor
 Additional issues

 Financial Evaluation
 Time value of money
 Present value
 Rates
 Interest Formulas
 NPV
 IRR & payback period
311
 Basic Compounding

• Suppose we invest $x in a bank offering interest rate i

• If interest is compounded annually, asset will be worth
– $x(1+i) after 1 year
– $x(1+i)2 after 2 years
– $x(1+i)3 after 3 years ….
– $x(1+i)n after n years

0 1 $x(1+i) 2 $x(1+i)2 … n $x(1+i)n

$x
312
 Time Value of Money

• If we assume
– That money can always be invested in the bank (or some
other reliable source) now to gain a return with interest
later
– That as rational actors, we never make an investment
which we know to offer less money than we could get in
the bank
• Then
– Money in the present can be thought as of “equal worth”
to a larger amount of money in the future
– Money in the future can be thought of as having an equal
worth to a lesser “present value” of money
313
 Equivalence of Present Values

• Given a source of reliable investments, we are

indifferent between any cash flows with the
same present value – they have “equal worth”

• This indifferences arises because we can

convert one to the other with no extra
expense
314
 Preliminaries

• STELLAR access:
http://stellar.mit.edu/S/course/1/sp07/1.040/
• Next Tuesday Recitation: Skyscraper Part I
• Please set up an appointment to discuss your AS2
if you choose emerging technologies (MF
preferred)
• Office: 1-174
• TA (50%) for our class
– Send your resume (or brief your experience) by this
Sunday 315
 Outline
 Session Objective & Context
 Project Financing
 Owner
 Project
 Contractor
 Additional issues

 Financial Evaluation
 Time value of money
 Present value
 Rates
 Interest Formulas
 NPV
 IRR & payback period
316
 Time Value of Money: Revisit

• If we assume
– That money can always be invested in the bank (or some
other reliable source) now to gain a return with interest
later
– That as rational actors, we never make an investment
which we know to offer less money than we could get in
the bank
• Then
– Money in the present can be thought as of “equal worth”
to a larger amount of money in the future
– Money in the future can be thought of as having an equal
worth to a lesser “present value” of money
317
 Present Value (Revenue)

• How is it that some future revenue r at time t has a “present

value”?
• Answer: Given that we are sure that we will be gaining
revenue r at time t, we can take and spend an immediate loan
from the bank
– We choose size of this loan l so that at time t, the total size of the loan
(including accrued interest) is r
• The loan l is the present value of r
– l = PV(r)

318
 Future to Present Revenue
If I know this is coming…
x

I can borrow this from the bank now

PV(x) t
0 I’ll pay this back to the bank later
-x

The net result is that I can convert a sure x at time t

PV(x) into a (smaller) PV(x) now! t

319
 Present Value (Cost)

• How is it that some future cost c at time t has a “present

value”?
• Answer: Given that we are sure that we will bear cost c at
time t, we immediately deposit a sum of money x into the
bank yielding a known return
– We choose size of deposit x so that at time t, the total size of the
investment (including accrued interest) is c
– We can then pay off c at time t by retrieving this money from the bank
• The size of the deposit (immediate cost) x is the present value
of c.

320
 Future to Present Cost

0 t

If I know this cost is coming… -x

I retrieve this back from the bank later

I can deposit this in the bank now x

PV(x) t

t
PV(x) The net result is that I can convert a sure cost x at time t
into a (smaller) cost of PV(x) now!
321
 Summary
• Because we can flexibly switch from one such value to
another without cost, we can view these values as equivalent

FV v’
0
PV v t

322
 Summary
• Because we can flexibly switch from one such value to
another without cost, we can view these values as equivalent

FV v’ = v(1+i)t
0
PV v t

 Given a reliable source offering annual return i (i.e., interest)

we can shift without additional costs between cash v at time 0
and v(1+i)t at time t

323
 Outline
 Session Objective & Context
 Project Financing
 Owner
 Project
 Contractor
 Additional issues

 Financial Evaluation
 Time value of money
 Present value
 Rates
 Interest Formulas
 NPV
 IRR & payback period
324
 Rates
• Difference between PV (v) and FV ( =v(1+i)t ) depends on i and t.

325
 Rates
• Difference between PV (v) and FV ( =v(1+i)t ) depends on i and t.
• Interest Rate
– Contractual arrangement between a borrower and a lender
• Discount Rate (real change in value to a person or group)
– Worth of Money + Risk
– Discount Rate > Interest Rate
• Minimum Attractive Rate of Return (MARR)
– Minimum discount rate accepted by the market corresponding to the
risks of a project (i.e., minimum standard of desirability)

326
 Choice of Discount Rate
r = rf + ri + rr

Where:

r is the discount rate

rf the risk free interest rate. Normally government bond
ri Rate of inflation. It is measured by either by consumer price
index or GDP deflator.
rr Risk factor consisting of market risk, industry risk, firm
specific risk and project risk
Market Risk
rr = Industry Risk
Firm specific Risk
Project Risk

GDP = Gross Domestic Product 327

 Outline
 Session Objective & Context
 Project Financing
 Owner
 Project
 Contractor
 Additional issues

 Financial Evaluation
 Time value of money
 Present value
 Rates
 Interest Formulas
 NPV
 IRR & payback period
328
 Interest Formulas

• i = Effective interest rate per interest period (discount rate or MARR)

• n = Number of compounding periods
• PV = Present Value
• FV = Future Value
• A = Annuity (i.e., a series of payments of set size) at end-of-period

329
 Interest Formulas: Payment

• Single Payment Compound Amount Factor (F=P×Factor)

– Factor that will make your present value future value in single payment
– (F/P, i, n) = (1 + i )n

0 1 2 … n
F
P

330
 Interest Formulas: Payment

• Single Payment Present Value Factor (P=F×Factor)

– Factor that will make your future value present value in single payment
– (P/F, i, n) = 1/ (1 + i )n = 1/ (F/P, i, n)

0 1 … n-1 n
P
F

331
 Interest Formulas: Payment
- Example

• If you wish to have $100,000 at the end of five

years in an account that pays 12 percent annually,
how much would you need to deposit now?

332
 Interest Formulas: Payment
- Example

• If you wish to have $100,000 at the end of five

years in an account that pays 12 percent annually,
how much would you need to deposit now?

0 n
P=? F=$100,000

 (P/F, 0.12, 5) or (F/P, 0.12, 5)?

333
 Interest Formulas: Payment
- Example

• If you wish to have $100,000 at the end of five

years in an account that pays 12 percent annually,
how much would you need to deposit now?

 P = F×(P/F, 0.12, 5)
 P = 100,000 × (P/F, 0.12, 5)
 P = 100,000 × 0.5674 = $56,740

334
 Interest Formulas: Series

• Uniform Series Compound Amount Factor (F=A×Factor)

– Factor that will make your annuity value future value in series payment
– (F/A, i, n) =[(1+i)n - 1]/ i

F
0 1 2 … n

A A A A

 Annuity occurs at the end of the interest period 335

 Interest Formulas: Series

• Uniform Series Compound Amount Factor (F=A×Factor)

– Factor that will make your annuity value future value in series payment
– (F/A, i, n) =[(1+i)n - 1]/ i

F=A
F
0 1 2 … n

A A A A

336
 Interest Formulas: Series

• Uniform Series Compound Amount Factor (F=A×Factor)

– Factor that will make your annuity value future value in series payment
– (F/A, i, n) =[(1+i)n - 1]/ i

F = A+A(1+i)
F
0 1 2 … n

A A A A

337
 Interest Formulas: Series

• Uniform Series Compound Amount Factor (F=A×Factor)

– Factor that will make your annuity value future value in series payment
– (F/A, i, n) =[(1+i)n - 1]/ i

F = A + A(1+i) + … + A(1 + i )n-1

0 1 2 … n

A A A A

338
 Interest Formulas: Series

• Uniform Series Sinking Fund Factor (A=F×Factor)

– Factor that will make your future value annuity value in series payment
– (A/F, i, n) = i / [ (1 + i )n – 1] = 1 / (F/A, i, n)

0 1 2 … n
A A A A
F

339
 Interest Formulas: Series

 Uniform Series Present Value Factor (P=A×Factor)

 Factor that will make your annuity value present value in series payment
 (P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ]

P
0 1 2 … n

A A A A

340
 Interest Formulas: Series

 Uniform Series Present Value Factor (P=A×Factor)

 Factor that will make your annuity value present value in series payment
 (P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ]

P = A/ (1 + i )

0 1 2 … n

A A A A

341
 Interest Formulas: Series

 Uniform Series Present Value Factor (P=A×Factor)

 Factor that will make your annuity value present value in series payment
 (P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ]

P = A/(1 + i ) + A/(1 + i )2

0 1 2 … n

A A A A

342
 Interest Formulas: Series

 Uniform Series Present Value Factor (P=A×Factor)

 Factor that will make your annuity value present value in series payment
 (P/A, i, n) = [ (1 + i )n -1 ] / [ i (1 + i )n ]

P = A/(1 + i ) + A/(1 + i )2 + … + A/(1 + i )n

0 1 2 … n

A A A A

Verify it!
343
 Interest Formulas: Series

 Uniform Series Capital Recovery Factor (A=P×Factor)

 Factor that will make your present value annuity value in series payment
 (A/P, i, n) = [i (1 + i )n / [(1 + i )n – 1] = 1 / (P/A, i, n)

0 1 2 … n
A A A A
P

Verify it!
344
 Interest Formulas: Series
- Example
• A ranch is offered for sale in Mexico with a 15 year
mortgage rate at 40% compounded annually, and 20%
down payment. Annual payments are to be made. The first
cost of the ranch is 5 million pesos. What yearly payment
is required?

345
 Interest Formulas: Series
- Example
• A ranch is offered for sale in Mexico with a 15 year
mortgage rate at 40% compounded annually, and 20%
down payment. Annual payments are to be made. The first
cost of the ranch is 5 million pesos. What yearly payment
is required?

 Down Payment = 5,000,000 * 0.2 = 1,000,000

 P = 5,000,000 – 1,000,000 = 4,000,000
 A = P * (which factor?)

346
 Interest Formulas: Series
- Example
• A ranch is offered for sale in Mexico with a 15 year
mortgage rate at 40% compounded annually, and 20%
down payment. Annual payments are to be made. The first
cost of the ranch is 5 million pesos. What yearly payment
is required?

 Down Payment = 5,000,000 * 0.2 = 1,000,000

 P = 5,000,000 – 1,000,000 = 4,000,000
 A = P * (which factor?) = P * (A/P, 0.4, 15)
 A = 4,000,000 * 0.40259 = 1,610,400 pesos/year

347
 Equipment Example

• $ 20,000 equipment expected to last 5 years

• $ 4,000 salvage value
• Minimum attractive rate of return 15%
• What are the?
– A - Annual Equivalent
– P - Present Equivalent

348
Equipment Example

349
 Equipment Example

• A = -20,000 * (A/P, 0.15, 5) + 4,000 * (A/F, 0.15, 5)

= -20,000 * (0.2983) + 4,000 * (0.1483)

= -5,373

• P = -20,000 + 4,000 * (P/F, 0.15, 5)

= -20,000 + 4,000 * (0.4972)

= -18,011

350
 Outline
 Session Objective & Context
 Project Financing
 Owner
 Project
 Contractor
 Additional issues

 Financial Evaluation
 Time value of money
 Present value
 Rate
 Interest Formulas
 NPV
 IRR & payback period
351
 Net Present Value

• Suppose we had a collection (or stream, flow) of

costs and revenues in the future
• The net present value (NPV) is the sum of the
present values for all of these costs and revenues
– Treat revenues as positive and costs as negative

352
Calculation of Net Present Value
Total Revenue (R) (+) Various Costs (C) (-)

Calculate Gross Return

Tax (-)
Calculate Net Return
Discount Rate (r)
PV of Net Return
Initial Invest (-I)
NPV of the Project

353
Net Present Value Decision Rule

> Accept the project

NPV = 0 Indifferent to the project
< Reject the project

• Accept a project which has 0 or positive NPV

Alternatively,
• Use NPV to choose the best among a set of
(mutually exclusive) alternative projects
– Mutually exclusive projects: the acceptance of a project
precludes the acceptance of one or more alternative projects.
354
 Project Evaluation Example
Revisit: Which one is better?

• Project A • Project B
• Construction=3 years • Construction=6 years
• Cost = $1M/year • Cost = $1M/year
• Sale Value = $4M • Sale Value = $8.5M
• Total Cost? • Total Cost?
• Profit? • Profit?
355
 Drawing out the examples
• Project A
$4M
0 1 2 3

$1M $1M $1M

• Project B $8.5M

0 1 6

$1M $1M $1M $1M $1M $1M

• Assume 10% discount rate
• Link 356
 Or Using Interest Formulas

• Project A
– -$1M * (P/A, 0.1, 3) + $4M * (P/F, 0.1, 3)

• Project B
– -$1M * (P/A, 0.1, 6) + $8.5M * (P/F, 0.1, 6)

• Assume 10% discount rate

357
 Four Independent Projects

• The cash flow profiles of four independent projects are shown

below. Using a MARR of 20%, determine the acceptability of
each of the projects on the basis of the net present value
criterion for accepting independent projects.

358
 Solution
[NPV1]20%
= -77 + (235)(P/F, 0.2, 5) = -77 + 94.4
= 17.4 $235 M

NPV1 – Cash Flow Year 0 1 2 3 4 5

-$77 M

[NPV2]20%
= -75.3 + (28)(P/A, 0.2, 5) = -75.3 + 83.7
= 8.4
$28 M each year

NPV2 – Cash Flow Year 0 1 2 3 4 5

359
-$75.3 M
 Solution
[NPV3]20%
= -39.9 + (28)(P/A, 20%, 4) - (80)(P/F, 20%, 5)
= -39.9 + 72.5 - 32.2
= 0.4 $28 M each year

NPV3 – Cash Flow

Year 0 1 2 3 4 5

-$39.9 M
-$80 M
[NPV4]20%
= 18 + (10)(P/F, 20%, 1) - (40)(P/F, 20%, 2)
              - (60)(P/F, 20%, 3) + (30)(P/F, 20%, 4)
+ (50)(P/F, 20%, 5)
= 18 + 8.3 - 27.8 - 34.7 + 14.5 + 20.1 = -1.6 $50 M
$30 M
$18 M $10 M

NPV4 – Cash Flow

Year 0 1 2 3 4 5

-$40 M
-$60 M 360
Source: Hendrickson and Au, 1989/2003
 Solution

[NPV1] = 17.4
[NPV2] = 8.4
[NPV3] = 0.4
[NPV4] = -1.6

361
Source: Hendrickson and Au, 1989/2003
 Discount Rate in NPV

• NPV (and PV) is relative to a discount rate

• In the absence of risk or inflation, this is just the interest rate of the
“reliable source” (opportunity cost)
• Correct selection of the discount rate is fundamental. If too high, projects
that could be profitable can be rejected. If too low, the firm will accept
projects that are too risky without proper compensation.
• Its choice can easily change the ranking of projects.
– Example

362
 Selection of Discount Rate: Example

• 2 pieces of equipment: one needs a human operator (initial cost $10,000, annual
$4,200 for labor); the second is fully automated (initial cost $18,000, annual #3,000 for
power). n=10years.
• Is the additional $8,000 in the initial investment of the second equipment worthy the
$1,200 annual savings? (discount rate: 5 or 10%)

Link

363
 Selection of Discount Rate: Example

• 2 pieces of equipment: one needs a human operator (initial cost $10,000, annual
$4,200 for labor); the second is fully automated (initial cost $18,000, annual #3,000 for
power). n=10years.
• Is the additional $8,000 in the initial investment of the second equipment worthy the
$1,200 annual savings? (discount rate: 5 or 10%)
• There is a critical value of i that changes the equipment choice (approximately 8.15%)
• Example: The US Federal Highway Administration promulgated a regulation in the early
1970s that the discount rate for all federally funded highways would be zero. This was
widely interpreted as a victory for the cement industry over asphalt industry. Roads
made of concrete cost significantly more than those of made of asphalt while requiring
less maintenance and less replacement [Shtub et al., 1994] - Link

364
 Outline
 Session Objective & Context
 Project Financing
 Owner
 Project
 Contractor
 Additional issues

 Financial Evaluation
 Time value of money
 Present value
 Rate
 Interest Formulas
 NPV
 IRR & payback period
365
 Internal Rate of Return (IRR)

• Defined as the rate of return that makes the NPV of the

project equal to zero
• To see whether the project’s rate of return is equal to or
higher than the rate of the firm to expect to get from the
project

366
 IRR Calculation Example

• NPV = -20,000 + 5,600 (P/A, i, 5) + 4,000 (P/F, i, 5)

• Link

367
Relationship between NPV & IRR

IRR

368
 IRR Investment Rule
> Accept
r- =
r* Indifferent
< Reject
- r = IRR,
* r = MARR

“Accept a project with IRR larger than MARR”

Alternatively,

“Maximize IRR across mutually exclusive projects.”

369
 IRR vs. NPV
• Oftentimes, IRR and NPV give the same decision/ranking among
projects.
• IRR only looks at rate of gain – not size of gain
• IRR does not require you to assume (or compute) a discount
rate.
• IRR ignores capacity to reinvest
• IRR may not be unique
NPV

Discount Rate

370
Link
 IRR vs. NPV
• Oftentimes, IRR and NPV give the same decision/ranking among
projects.
• IRR only looks at rate of gain – not size of gain
• IRR does not require you to assume (or compute) a discount
rate.
• IRR ignores capacity to reinvest
• IRR may not be unique

 Use both NPV (size) and IRR together (rate)

 However, Trust the NPV: It is the only criterion that ensures
wealth maximization. It measures how much richer one will
become by undertaking the investment opportunity.

371
 Payback Period

• Payback period (“Time to return”)

– Minimal length of time over which benefits repay costs
– Typically only used as secondary assessment

372
 Payback Period

• Payback period (“Time to return”)

– Minimal length of time over which benefits repay costs
– Typically only used as secondary assessment
– Important for selection when the risk is extremely high
– Drawbacks
• Ignores what happens after payback period
• Does not take into account discounting

373
 Comparing Projects

• Financing has major impact on project selection

– Suppose that one had to choose between 2 investment
projects
• How can one compare them?

374
 Comparing Projects

• Financing has major impact on project selection

– Suppose that one had to choose between 2 investment
projects
• How can one compare them?
– Use NPV
– Verify IRR
– Check payback period

375
 Other Methods

• Benefit-Cost ratio (benefits/costs)

– Discounting still generally applied
– Accept if >1 (benefits > costs)
– Common for public projects
– Does not consider the absolute size of the benefits
• Cost-effectiveness
– Looking at non-economic factors
– Discounting still often applied for non-economic
• $/Life saved
• $/Life quality

376
 Inflation & Deflation

• Inflation means that the prices of goods and services increase

over time either imperceptibly or in leaps and bounds.
Inflation effects need to be included in investment because
cost and benefits are measured in money and paid in current
dollars, francs or pesos. An inflationary trend makes future
dollars have less purchasing power than present dollars.

• Deflation means the opposite of inflation. Prices of goods &

services decrease as time passes.

377
 Inflation & Deflation
→ discount rate excluding
i inflation
i '  i  j  ij
If i, A(y=0) will be A*(1+i) after one i'inflation
→ discount rate including
year. Then, if j, A will be
A*(1+i)*(1+j).
j → annual inflation rate

378
 Inflation & Deflation
→ discount rate excluding
i inflation
i '  i  j  ij
If i, A(y=0) will be A*(1+i) after one i'inflation
→ discount rate including
year. Then, if j, A will be
A*(1+i)*(1+j).
j → annual inflation rate

When the inflation rate j is small, these relations can be approximated by:
i'  i  j or i  i'  j

n
NPV  A0   At / (1  i ) t
t 1
n
NPV  A0   At' / (1  i ' ) t
t 1

At → cash flow in year t expressed in terms of constant (base year) dollars

A't → cash flow in year t expressed in terms of inflated (then-current)
379
dollars
 Inflation Example
• A company plans to invest $55,000 initially in a piece of
equipment which is expected to produce a uniform annual
constant dollars net revenue before tax of $15,000 over the
next five years. The equipment has a salvage value of $5,000
in constant dollars at the end of 5 years and the depreciation
allowance is computed on the basis of the straight line
depreciation method (i.e., $10,000 during next five years). The
marginal income tax rate for this company is 34%. The
inflation expectation is 5% per year, and the after-tax MARR
specified by the company is 8% excluding inflation. Determine
whether the investment is worthwhile.

Link 380
 Solution

Depreciation costs are not inflated to current dollars in conformity with the practice recommended
by the U.S. Internal Revenue Service.

• With 5% inflation, the investment is no longer worthwhile because the

value of the depreciation tax reduction is not increased to match the
inflation rate.
• Verify that the use of MARR including inflation gives the same result
(credit by next Monday – send me one-page excel sheet) 381
• Whether taking into account inflation or not, NPV could be different.
Impact of Inflation: Boston Central Artery
Price Price Project Project Project
Year  
Index   Index   Expenses   Expenses   Expenses  
t
1982 $ 2002 $ ($ K) (1982 $ k) (2002 $ K)
1982 100 53
1983 104 55
1984 111 59
1985 118 62
1986 122 65 33,000 27,000 51,000
1987 123 65 82,000 67,000 126,000
1988 130 69 131,000 101,000 190,000
1989 134 71 164,000 122,000 230,000
1990 140 74 214,000 153,000 289,000
1991 144 76 197,000 137,000 258,000
1992 146 77 246,000 169,000 318,000
1993 154 82 574,000 372,000 703,000
1994 165 88 854,000 517,000 975,000
1995 165 88 852,000 515,000 973,000
1996 165 87 764,000 464,000 877,000
1997 175 93 1,206,000 687,000 1,297,000
1998 172 91 1,470,000 853,000 1,609,000
1999 176 94 1,523,000 863,000 1,629,000
2000 181 96 1,329,000 735,000 1,387,000
2001 183 97 1,246,000 682,000 1,288,000
2002 189 100 1,272,000 674,000 1,272,000
2003 195 103 1,115,000 572,000 1,079,000
2004 202 107 779,000 386,000 729,000 382
Source: Hendrickson and Au, 1989/2003
 Outline
 Session Objective & Context
 Project Financing
 Owner
 Project
 Contractor
 Additional issues

 Financial Evaluation
 Time value of money
 Present value
 Rates
 Interest Formulas
 NPV
 IRR & payback period
383
 What are we Assuming Here?

• That only quantifiable monetary benefits matter

• Certainty about future cash flows

– Main uncertainties:
• Financial concerns
– Currency fluctuations (international projects)
– Inflation/deflation
– Taxes variations
• Project risks

384
 Project Management Phase

DESIGN DEVELOPMENT OPERATIONS

FEASIBILITY CLOSEOUT
PLANNING

Financing & Evaluation

Risk

385
 Risk Management

• Case Study

386
Chapter
19-387
 CHAPTER 7

MANAGERIAL
ACCOUNTING
Chapter
19-388
 Study
Study Objectives
Objectives

1. Explain the distinguishing features of managerial

accounting.
2. Identify the 3 broad functions of management.
3. Define the 3 classes of manufacturing costs.
4. Distinguish between product and period costs.
5. Explain the differences between a merchandising
and a manufacturing income statement.

Chapter
19-389
 Study
Study Objectives
Objectives

6. Indicate how cost of

goods manufactured is
determined.
7. Explain the difference
between a merchandising
and a manufacturing
balance sheet.
8. Identify trends in
managerial accounting.

Chapter
19-390
 Preview
Preview of
of Chapter
Chapter
Managerial Accounting Basics
Compare managerial and financial accounting
Management functions and Business Ethics

Managerial Cost Concepts

Manufacturing costs
Product vs. period costs

Manufacturing Costs in Financial Statements

Income Statement and Balance Sheet
Cost concepts – A review

Managerial Accounting Today

Service industry trends
Managerial accounting practices
Chapter
19-391
 Managerial
Managerial Accounting
Accounting

Manufacturing
Managerial Managerial Managerial
Costs in
Accounting Cost Accounting
Financial
Basics Concepts Today
Statements

Compare Manufacturing Income Service

Managerial and Costs Statement Industry
Financial Product vs Balance Sheet Trends
Accounting Period Costs Managerial
Cost Concepts
Management – A Review Accounting
Functions Practices
Business Ethics

Chapter
19-392
 Managerial
Managerial Accounting
Accounting Basics
Basics

Definition of Managerial Accounting

A field of accounting that provides economic and

financial information for managers and other
internal users.

Also called Management Accounting

Chapter
19-393
 Managerial
Managerial Accounting
Accounting Basics
Basics

Managerial Accounting Activities

Explain manufacturing and nonmanufacturing costs and

how they are reported (Chapter 19)

Compute cost of providing a service or manufacturing

a product. (Chapters 20 and 21)

Determine behavior of costs and expenses as activity

changes. (Chapter 22)

Chapter
19-394
 Managerial
Managerial Accounting
Accounting Basics
Basics

Managerial Activities: Continued

Assist management in profit planning and formalizing

these plans in the form of budgets. (Chapter 23)

Help to control costs by comparing actual results with

planned objectives and standard costs. (Chapters 24 and 25)

Accumulate and present data for making decisions.

(Chapter 26)

Chapter
19-395
 Managerial
Managerial Accounting
Accounting Basics
Basics

Distinguishing Features

Applies to all types of business -

Service, Merchandising, and Manufacturing
Applies to all forms of businesses –
Proprietorships, Partnerships, and
Corporations
Applies to not-for-profit and profit
oriented companies
Chapter
19-396
 Managerial
Managerial Accounting
Accounting Basics
Basics

Distinguishing Features: Continued

More responsible for strategic

cost management

Teams with people from production,

marketing, engineering, etc.

Aid in making critical decisions

Chapter
19-397 LO 1 Explain the distinguishing features of managerial accounting.
 Comparing
Comparing Managerial
Managerial and
and Financial
Financial Accounting
Accounting

Similarities

Both deal with economic events of a business –

Thus, interests overlap

Both require that economic events be

quantified and communicated to
interested parties –
Determining unit cost is part of
managerial accounting,
Reporting cost of goods manufactured
is a part of financial accounting

Chapter
19-398 LO 1 Explain the distinguishing features of managerial accounting.
 Comparing
Comparing Managerial
Managerial and
and Financial
Financial Accounting
Accounting

Differences

Chapter
19-399 LO 1 Explain the distinguishing features of managerial accounting .
 Managerial
Managerial Accounting
Accounting Basics
Basics

Review Question
Managerial accounting:

a. Pertains to the entity as a whole and is highly

aggregated.
b. Places emphasis on special-purpose information.
c. Is limited to cost data.
d. Is governed by generally accepted accounting
principles.

Chapter
19-400 LO 1 Explain the distinguishing features of managerial accounting.
 Managerial
Managerial Accounting
Accounting Basics
Basics

Management Functions

Management’s activities and responsibilities can be

classified into the following three broad functions:

Planning
Directing
Controlling

Chapter
19-401 LO 2 Identify the 3 broad functions of management.
 Management
Management Functions
Functions

Planning

Look ahead and establish objectives such as –

Maximize short-term profit
Commit to environmental protection

Key Objective: Add value to the business

Value measured by trading price of stock
and by potential selling price of the company

Chapter
19-402 LO 2 Identify the 3 broad functions of management.
 Management
Management Functions
Functions

Directing

Coordinate diverse activities and human resources

Implement planned objectives

Provide incentives to motivate employees

Hire and train employees including

executives, managers, and supervisors

Produce smooth-running operation

Chapter
19-403 LO 2 Identify the 3 broad functions of management.
 Management
Management Functions
Functions

Controlling

Keep activities on track

Determine whether goals are met

Decide changes needed to get back on track

May use an informal or formal system of evaluations

Good decision making is the outcome of good judgment

in planning, directing, and controlling.

Chapter
19-404 LO 2 Identify the 3 broad functions of management.
 Good
Good Ethics
Ethics –– Good
Good Business
Business

Business Ethics
Business scandals caused massive investment
losses and employee layoffs.
Corporate fraud has increased 13% in last 5 years.
Employee fraud – 60% of all fraud
Intentional misstatement of financial reports
Aka financial reporting fraud
Most costly to companies

Chapter
19-405
 Good
Good Ethics
Ethics –– Good
Good Business
Business

Creating Proper Incentives

Systems to monitor and evaluate employees
may produce incentives for unethical actions.
Employees may feel that they must succeed no
matter what.
Ineffective and unrealistic controls may result
in declining product quality.

Chapter
19-406
 Good
Good Ethics
Ethics –– Good
Good Business
Business
Code of Ethical Standards

Sarbanes-Oxley Act of 2002

Clarifies management’s responsibilities.
Certifications by CEO and CFO -
fairness of financial statements and
adequacy of internal control
Selection criteria for Board of Directors and Audit
Committee
Substantially increased penalties for misconduct
IMA Statement of Ethical Professional Practices

Chapter
19-407
 Management
Management Functions
Functions

Review Question
The management of an organization performs several
broad functions. They are:

a. Planning, directing, and selling.

b. Directing, manufacturing, and controlling.
c. Planning, manufacturing, and controlling.
d. Planning, directing, and controlling.

Chapter
19-408 LO 2 Identify the 3 broad functions of management.
 Managerial
Managerial Cost
Cost Concepts
Concepts
Manufacturing Costs
Manufacturing consists of activities to convert raw
materials into finished goods.
In contrast, a merchandising firm sells goods in the
form in which they were bought.
Categories of manufacturing costs include:

Chapter
19-409 LO 3 – Define the three classes of manufacturing costs.
 Manufacturing
Manufacturing Costs
Costs

Materials

Raw Materials
Basic materials used in manufacturing

Direct Materials
Raw materials that can be physically and
directly associated with the finished product

Chapter
19-410 LO 3 Define the three classes of manufacturing costs.
 Manufacturing
Manufacturing Costs
Costs

Materials
Indirect Materials
Raw materials that cannot be easily associated
with the finished product
Not physically part of the finished product or
they are an insignificant part of finished
product in terms of cost
Considered part of manufacturing overhead

Chapter
19-411 LO 3 Define the three classes of manufacturing costs.
 Manufacturing
Manufacturing Costs
Costs

Labor
Direct Labor
Work of factory employees that can be
physically and directly associated with converting
raw materials into finished goods

Indirect Labor
Work of factory employees that has no
physical association with the finished product or
for which it is impractical to trace to the goods
produced

Chapter
19-412 LO 3 Define the three classes of manufacturing costs.
 Manufacturing
Manufacturing Costs
Costs

Manufacturing Overhead
Costs that are indirectly associated
with manufacturing the product
Includes all manufacturing costs except
direct materials and direct labor

Chapter
19-413 LO 3 Define the three classes of manufacturing costs.
 Manufacturing
Manufacturing Costs
Costs

Review Question
Which of the following is not an element of
manufacturing overhead?:

a. Sales manager’s salary.

b. Plant manager’s salary.
c. Factory repairman’s wages.
d. Product inspector’s salary.

Chapter
19-414 LO 3 Define the three classes of manufacturing costs.
 Product
Product Versus
Versus Period
Period Costs
Costs

Product Costs
Components: direct material cost,
direct labor cost, and manufacturing
overhead
A necessary and integral part of
producing the product
Recorded as inventory when incurred
Not an expense until the finished goods
inventory is sold then cost of goods sold

Chapter
19-415 LO 4 Distinguish between product and period costs.
 Product
Product Versus
Versus Period
Period Costs
Costs

Period Costs
Matched with revenue of a specific
time period and charged to expense as
incurred
Non-manufacturing costs
Deducted from revenues in period
incurred to determine net income
Includes all selling and administrative
expenses

Chapter
19-416 LO 4 Distinguish between product and period costs.
 Product
Product Versus
Versus Period
Period Costs
Costs

Chapter
19-417 LO 4 Distinguish between product costs and period costs .
 Manufacturing
Manufacturing Costs
Costs in
in Financial
Financial Statements
Statements

Income Statement
The income statement for a manufacturer is
similar to that of a merchandiser except
for the cost of goods sold section.

Chapter
LO 5 Explain the difference between a merchandising
19-418 and a manufacturing income statement.
 Manufacturing
Manufacturing Costs
Costs in
in Financial
Financial Statements
Statements
Cost of Goods Sold Components
Merchandiser versus Manufacturer

Chapter
LO 5 Explain the difference between a merchandising
19-419 and a manufacturing income statement.
 Manufacturing
Manufacturing Costs
Costs in
in Financial
Financial Statements
Statements

Cost of Goods Sold Section of the Income Statement

Chapter
LO 5 Explain the difference between a merchandising
19-420 and a manufacturing income statement .
 Manufacturing
Manufacturing Costs
Costs in
in Financial
Financial Statements
Statements

Determining the Cost of Goods Manufactured

Work in Process – partially completed units of product

Total Manufacturing Costs – sum of direct material costs,

direct labor costs, and manufacturing overhead; all incurred
in the current period

LO 6 Indicate how cost of goods manufactured is determined .

Chapter
19-421
 Manufacturing
Manufacturing Costs
Costs in
in Financial
Financial Statements
Statements

Chapter

LO 6 Indicate how cost of goods manufactured is determined .

19-422
 Manufacturing
Manufacturing Costs
Costs in
in Financial
Financial Statements
Statements
Balance Sheet - Inventories

Merchandising Company Manufacturing Company

One category of May have three
inventory: inventories:
Merchandise Inventory Raw Materials
Work in Process
Finished Goods

Chapter
19-423
LO 7 Explain the difference between a merchandising and a
manufacturing balance sheet.
 Manufacturing
Manufacturing Costs
Costs in
in Financial
Financial Statements
Statements

Balance Sheet - Inventories

Chapter
LO 7 Explain the difference between a merchandising and a
19-424 manufacturing balance sheet
 Manufacturing
Manufacturing Costs
Costs

Review Question

Direct Materials are a:

Product Manufacturing Period

Cost Overhead Cost
a. Yes Yes No
b. Yes No No
c. Yes Yes Yes
d. No No No

Chapter
19-425
 Managerial
Managerial Accounting
Accounting Today
Today

Service Industry Trends

U.S. economy has shifted toward an emphasis on
providing services rather than goods
Over 50% of U.S. workers are now employed by
service companies
Trend is expected to continue in the future
Most of the techniques learned for manufacturing
firms are applicable to service companies

Chapter
19-426 LO 8 Identify trends in management accounting.
 Managerial
Managerial Accounting
Accounting Today
Today

Managerial Accounting Practices

Value Chain
Refers to all activities associated with providing a product or
service
For a manufacturing firm these include the following:

Chapter
19-427 LO 8 Identify trends in management accounting.
 Managerial
Managerial Accounting
Accounting Today
Today

Managerial Accounting Practices

Just-In-Time (JIT) Inventory Methods
Inventory system in which goods are manufactured
or purchased just in time for use

Quality
Increased emphasis on product quality because
goods are produced only as needed
Total Quality Management (TQM)
- a philosophy of zero defects -

Chapter
19-428 LO 8 Identify trends in management accounting.
 Managerial
Managerial Accounting
Accounting Today
Today
Managerial Accounting Practices
Activity-Based-Costing (ABC)
Allocates overhead based on use of activities
Results in more accurate product costing and
scrutiny of all activities in the value chain

Balanced Scorecard
Evaluates operations in an integrated fashion
Uses both financial and non-financial measures
Links performance measures to overall company
objectives

Chapter
19-429 LO 8 Identify trends in management accounting.
 Managerial
Managerial Accounting
Accounting Today
Today

Review Question
Which of the following managerial accounting techniques
attempts to allocate manufacturing overhead in a more
meaningful manner?
a. Just-in-time inventory.
b. Total-quality management.
c. Balanced scorecard.
d. Activity-based costing.

Chapter
19-430 LO 8 Identify trends in management accounting.
 Chapter
Chapter Review
Review -- Brief
Brief Exercise
Exercise 19-5
19-5
Indicate whether each of the following costs of an
automobile manufacturer would be classified as
direct materials, direct labor, or manufacturing
overhead.
______
DM a. Windshield
______
DM b. Engine
______
DL c. Wages of assembly line worker
______
MO d. Depreciation of factory machinery
______
MO e. Factory machinery lubricants
______
DM f. Tires
______
DM g. Steering wheel
______
MO h. Salary of painting supervisor
Chapter
19-431
 Chapter
Chapter Review
Review -- Brief
Brief Exercise
Exercise 19-6
19-6
Identify whether each of the following costs
should be classified as product costs or period
costs.

____________
Product a. Manufacturing overhead
____________
Period b. Selling expenses
____________
Period c. Administrative expenses
____________
Period d. Advertising expense
____________
Product e. Direct labor
____________
Product f. Direct material

Chapter
19-432
 Copyright
Copyright

Copyright © 2008 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted
in Section 117 of the 1976 United States Copyright Act
without the express written permission of the copyright owner
is unlawful. Request for further information should be
addressed to the Permissions Department, John Wiley & Sons,
Inc. The purchaser may make back-up copies for his/her own
use only and not for distribution or resale. The Publisher
assumes no responsibility for errors, omissions, or damages,
caused by the use of these programs or from the use of the
information contained herein.

Chapter
19-433
 Capital Budgeting Decisions

Chapter 8

Chapter
19-434
 Typical Capital Budgeting Decisions

Plant expansion

Equipment selection Equipment replacement

Lease or buy Cost reduction

Chapter
19-435
 Typical Capital Budgeting Decisions

Capital budgeting tends to fall into two broad

categories.

1. Screening decisions. Does a proposed

project meet some preset standard of
acceptance?

2. Preference decisions. Selecting from

among several competing courses of action.

Chapter
19-436
 Time Value of Money

A dollar today is worth

more than a dollar a
year from now.

Therefore, projects that

promise earlier returns
are preferable to those
that promise later
returns.

Chapter
19-437
 Time Value of Money

The capital
budgeting
techniques that best
recognize the time
value of money are
those that involve
discounted cash
flows.
Chapter
19-438
 Learning Objective 8-1

Evaluate the
acceptability of an
investment project using
the net present value
method.

Chapter
19-439
 The Net Present Value Method

To determine net present value

we . . .
• Calculate the present value of cash
inflows,
• Calculate the present value of cash
outflows,
• Subtract the present value of the
outflows from the present value of
Chapter
the inflows.
19-440
 The Net Present Value Method

If the Net Present

Value is . . . Then the Project is . . .
Acceptable because it promises
Positive . . . a return greater than the
required rate of return.

Acceptable because it promises

Zero . . . a return equal to the required
rate of return.

Not acceptable because it

Negative . . . promises a return less than the
required rate of return.
Chapter
19-441
 The Net Present Value Method

Net present value analysis

emphasizes cash flows and not
accounting net income.
The reason is that
accounting net income is
based on accruals that
ignore the timing of cash
flows into and out of an
organization.
Chapter
19-442
 Typical Cash Outflows

Repairs and
maintenance

Working Initial
capital investment

Incremental
operating
Chapter
costs
19-443
 Typical Cash Inflows

Salvage
value

Release of
Reduction
working
of costs
capital

Incremental
revenues
Chapter
19-444
 Recovery of the Original Investment

Depreciation is not deducted in computing

the present value of a project because . . .

• It is not a current cash outflow.

• Discounted cash flow methods automatically

provide for a return of the original investment.

Chapter
19-445
 Recovery of the Original Investment

Carver Hospital is considering the purchase

of an attachment for its X-ray machine.

Cost $3,170
Life 4 years
Salvage value zero
Increase in annual cash inflows $1,000

No investments are to be made unless they

have an annual return of at least 10%.

Chapter
19-446 Will we be allowed to invest in the
 Recovery of the Original Investment

Present
Value of
Amount of 10% Cash
Item Year(s) Cash Flow Factor Flows
Initial investment (outflow) Now $ (3,170) 1.000 $ (3,170)
Annual cash inflows 1-4 $ 1,000 3.170 3,170
Net present value $ -0-

Present Value of $1
Periods 10% 12% 14%
1 0.909 0.893 0.877 Present
Present value
value
2 1.736 1.690 1.647
3 2.487 2.402 2.322
of
of an
an annuity
annuity
4 3.170 3.037 2.914 of
of $1
$1 table
table
5 3.791 3.605 3.433
Chapter
19-447
 Recovery of the Original Investment
(1) (2) (3) (4) (5)

Recovery of Unrecovered
Investment Investment Investment at
Outstanding Return on during the the end of the
during the Cash Investment year year
Year year Inflow (1)   10% (2) - (3) (1) - (4)
1 $ 3,170 $ 1,000 $ 317 $ 683 $ 2,487
2 2,487 1,000 249 751 1,736
3 1,736 1,000 173 827 909
4 909 1,000 91 909 0
Total investment recovered $ 3,170

This implies that the cash inflows are sufficient to recover the $3,170
initial investment (therefore depreciation is unnecessary) and to
Chapter
19-448
provide exactly a 10% return on the investment.
 Two Simplifying Assumptions

Two simplifying assumptions are usually made in net

present value analysis:

All cash flows other All cash flows

than the initial generated by an
investment occur at investment project
the end of periods. are immediately
reinvested at a rate of
return equal to the
discount rate.

Chapter
19-449
 Choosing a Discount Rate

• The firm’s cost of capital

is usually regarded as
the minimum required
rate of return.

• The cost of capital is the

average rate of return
the company must pay
to its long-term creditors
and stockholders for the
Chapter
use of their funds.
19-450
 The Net Present Value Method

Lester Company has been offered a five year contract

to provide component parts for a large manufacturer.

Cost and revenue information

Cost of special equipment $160,000
Working capital required 100,000
Relining equipment in 3 years 30,000
Salvage value of equipment in 5 years 5,000
Annual cash revenue and costs:
Sales revenue from parts 750,000
Cost of parts sold 400,000
Salaries, shipping, etc. 270,000

Chapter
19-451
 The Net Present Value Method

At the end of five years the working capital will

be released and may be used elsewhere by
Lester.

Lester Company uses a discount rate of 10%.

Should the contract be accepted?

Chapter
19-452
 The Net Present Value Method

Annual net cash inflow from operations

Sales revenue $ 750,000

Cost of parts sold (400,000)
Salaries, shipping, etc. (270,000)
Annual net cash inflows $ 80,000

Chapter
19-453
 The Net Present Value Method

Cash 10% Present

Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)

Net present value

Chapter
19-454
 The Net Present Value Method

Cash 10% Present

Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280

Net present value

Present value of an annuity of $1

factor for 5 years at 10%.

Chapter
19-455
 The Net Present Value Method

Cash 10% Present

Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280
Relining of equipment 3 (30,000) 0.751 (22,530)

Net present value

Present value of $1
factor for 3 years at 10%.

Chapter
19-456
 The Net Present Value Method

Cash 10% Present

Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280
Relining of equipment 3 (30,000) 0.751 (22,530)
Salvage value of equip. 5 5,000 0.621 3,105

Net present value

Present value of $1
factor for 5 years at 10%.

Chapter
19-457
 The Net Present Value Method

Cash 10% Present

Years Flows Factor Value
Investment in equipment Now $ (160,000) 1.000 $ (160,000)
Working capital needed Now (100,000) 1.000 (100,000)
Annual net cash inflows 1-5 80,000 3.791 303,280
Relining of equipment 3 (30,000) 0.751 (22,530)
Salvage value of equip. 5 5,000 0.621 3,105
Working capital released 5 100,000 0.621 62,100
Net present value $ 85,955

Accept the contract because the project has a

positive net present value.

Chapter
19-458
 Quick Check 

Denny Associates has been offered a four-year contract to

supply the computing requirements for a local bank.
Cash flow information
Cost of computer equipment $ 250,000
Working capital required 20,000
Upgrading of equipment in 2 years 90,000
Salvage value of equipment in 4 years 10,000
Annual net cash inflow 120,000

• The working capital would be released at the end

of the contract.
• Denny Associates requires a 14% return.
Chapter
19-459
 Quick Check 

What is the net present value of the contract with

the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
d. $132,916

Chapter
19-460
 Quick Check 

What is the net present value of the contract with

the local bank?
a. $150,000
b. $ 28,230
c. $ 92,340
Cash 14% Present
Years Flows Factor Value
Investment in equipment d. $132,916
Now $ (250,000) 1.000 $ (250,000)
Working capital needed Now (20,000) 1.000 (20,000)
Annual net cash inflows 1-4 120,000 2.914 349,680
Upgrading of equipment 2 (90,000) 0.769 (69,210)
Salvage value of equip. 4 10,000 0.592 5,920
Working capital released 4 20,000 0.592 11,840
Net present value $ 28,230

Chapter
19-461
 Learning Objective 8-2

Evaluate the
acceptability of an
investment project using
the internal rate of
return method.

Chapter
19-462
 Internal Rate of Return Method

• The internal rate of return is the rate of

return promised by an investment project
over its useful life. It is computed by
finding the discount rate that will cause
the net present value of a project to be
zero.

• It works very well if a project’s cash

flows are identical every year. If the
annual cash flows are not identical, a
Chapter
19-463
trial and error process must be used to
 Internal Rate of Return Method

General decision rule . . .

If the Internal Rate of Return is . . . Then the Project is . . .

Equal to or greater than the minimum

Acceptable.
required rate of return . . .

Less than the minimum required rate

Rejected.
of return . . .

When using the internal rate of return,

the cost of capital acts as a hurdle rate
that a project must clear for acceptance.
Chapter
19-464
 Internal Rate of Return Method

• Decker Company can purchase a new

machine at a cost of $104,320 that will save
$20,000 per year in cash operating costs.
• The machine has a 10-year life.

Chapter
19-465
 Internal Rate of Return Method

Future cash flows are the same every year in this

example, so we can calculate the internal rate of
return as follows:

PV factor for the Investment required

=
internal rate of return Annual net cash flows

$104, 320 = 5.216

$20,000

Chapter
19-466
 Internal Rate of Return Method

Using the present value of an annuity of $1 table . . .

Find the 10-period row, move across

until you find the factor 5.216. Look
at the top of the column and you
find a rate of 14%.

Periods 10% 12% 14%

1 0.909 0.893 0.877
2 1.736 1.690 1.647
. . . . . . . . . . . .
9 5.759 5.328 4.946
10 6.145 5.650 5.216
Chapter
19-467
 Internal Rate of Return Method
• Decker Company can purchase a new
machine at a cost of $104,320 that will save
$20,000 per year in cash operating costs.
• The machine has a 10-year life.

The internal rate of return on

this project is 14%.

If the internal rate of return is equal to

or greater than the company’s required
rate of return, the project is acceptable.
Chapter
19-468
 Quick Check 
The expected annual net cash inflow from a
project is $22,000 over the next 5 years. The
required investment now in the project is
$79,310. What is the internal rate of return on
the project?
a. 10%
b. 12%
c. 14%
d. Cannot be determined

Chapter
19-469
 Quick Check 
The expected annual net cash inflow from a
project is $22,000 over the next 5 years. The
required investment now in the project is
$79,310. What is the internal rate of return on
the project?
a. 10%
b. 12% $79,310/$22,000 = 3.605,
c. 14% which is the present value factor
for an annuity over five years
d. Cannot be determined
when the interest rate is 12%.

Chapter
19-470
 Comparing the Net Present Value and
Internal Rate of Return Methods

• NPV is often simpler to

use.

• Questionable
assumption:
Internal rate of return
method assumes cash
Chapter
inflows are reinvested at
19-471
the internal rate of
 Comparing the Net Present Value and Internal Rate of Return Methods

• NPV is often simpler to

use.

• Questionable
assumption:
Internal rate of return
method assumes cash
Chapter
inflows are reinvested at
19-472
the internal rate of
 Expanding the Net Present Value Method

To compare competing investment projects

we can use the following net present value
approaches:
1. Total-cost
2. Incremental cost

Chapter
19-473
 The Total-Cost Approach

White Company has two alternatives:

1. remodel an old car wash or,
2. remove the old car wash and install a new
one.
The company uses a discount rate of 10%.
New Car Old Car
Wash Wash
Annual revenues $ 90,000 $ 70,000
Annual cash operating costs 30,000 25,000
Annual net cash inflows $ 60,000 $ 45,000

Chapter
19-474
 The Total-Cost Approach

If White installs a new washer . . .

Cost $ 300,000
Productive life 10 years
Salvage value $ 7,000
Replace brushes
at the end of 6 years $ 50,000
Salvage of old equip. $ 40,000

Let’s look at the present value

of this alternative.
Chapter
19-475
 The Total-Cost Approach

Install the New Washer

Cash 10%
Year Flows Factor Present Value
Initial investment Now $ (300,000) 1.000 $ (300,000)
Replace brushes 6 (50,000) 0.564 (28,200)
Annual net cash inflows 1-10 60,000 6.145 368,700
Salvage of old equipment Now 40,000 1.000 40,000
Salvage of new equipment 10 7,000 0.386 2,702
Net present value $ 83,202

If we install the new washer, the

investment will yield a positive net
present value of $83,202.
Chapter
19-476
 The Total-Cost Approach

If White remodels the existing washer . . .

Remodel costs $175,000

Replace brushes at
  the end of 6 years 80,000

Let’s look at the present value

of this second alternative.
Chapter
19-477
 The Total-Cost Approach

Remodel the Old Washer

Cash 10%
Year Flows Factor Present Value
Initial investment Now $ (175,000) 1.000 $ (175,000)
Replace brushes 6 (80,000) 0.564 (45,120)
Annual net cash inflows 1-10 45,000 6.145 276,525
Net present value $ 56,405

If we remodel the existing washer, we

will produce a positive net present
value of $56,405.

Chapter
19-478
 The Total-Cost Approach

Both projects yield a positive

net present value.
Net Present
Value

Invest in new washer $ 83,202

Remodel existing washer 56,405
In favor of new washer $ 26,797

However, investing in the new washer will

produce a higher net present value than
remodeling the old washer.
Chapter
19-479
 The Incremental-Cost Approach

Under the incremental-cost approach, only those

cash flows that differ between the two alternatives
are considered.

Let’s look at an analysis of the White Company

decision using the incremental-cost approach.

Chapter
19-480
 The Incremental-Cost Approach

Cash 10% Present

Year Flows Factor Value
Incremental investment Now $(125,000) 1.000 $(125,000)
Incremental cost of brushes 6 $ 30,000 0.564 16,920
Increased net cash inflows 1-10 15,000 6.145 92,175
Salvage of old equipment Now 40,000 1.000 40,000
Salvage of new equipment 10 7,000 0.386 2,702
Net present value $ 26,797

We get the same answer under either the

total-cost or incremental-cost approach.

Chapter
19-481
 Quick Check 

Consider the following alternative projects. Each project

would last for five years.
Project A Project B
Initial investment $80,000 $60,000
Annual net cash inflows 20,000 16,000
Salvage value 10,000 8,000

The company uses a discount rate of 14% to evaluate

projects. Which of the following statements is true?

a. NPV of Project A > NPV of Project B by $5,230

b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000
Chapter
19-482
 Cash 14% Present
Differences in cash flows Quick Check 
Years Flows Factor Value
Investment in equipment Now $ (20,000) 1.000 $ (20,000)
Annual net cash inflows 1-5 4,000 3.433 13,732
SalvageConsider
value of the following5alternative
equip. projects.0.519
2,000 Each project1,038
Difference in net present value $ (5,230)
would last for five years.
Project A Project B
Initial investment $80,000 $60,000
Annual net cash inflows 20,000 16,000
Salvage value 10,000 8,000

The company uses a discount rate of 14% to evaluate

projects. Which of the following statements is true?

a. NPV of Project A > NPV of Project B by $5,230

b. NPV of Project B > NPV of Project A by $5,230
c. NPV of Project A > NPV of Project B by $2,000
d. NPV of Project B > NPV of Project A by $2,000
Chapter
19-483
 Least Cost Decisions

In decisions where revenues are not directly

involved, managers should choose the
alternative that has the least total cost from a
present value perspective.

Let’s look at the Home Furniture Company.

Chapter
19-484
 Least Cost Decisions

Home Furniture Company is trying to decide

whether to overhaul an old delivery truck now or
purchase a new one.

The company uses a discount rate of 10%.

Chapter
19-485
 Least Cost Decisions

Here is information about the trucks . . .

Old Truck
Overhaul cost now $ 4,500
Annual operating costs 10,000
Salvage value in 5 years 250
Salvage value now 9,000

New Truck
Purchase price $ 21,000
Annual operating costs 6,000
Salvage value in 5 years 3,000

Chapter
19-486
 Least Cost Decisions

Buy the New Truck

Cash 10% Present
Year Flows Factor Value
Purchase price Now $ (21,000) 1.000 $ (21,000)
Annual operating costs 1-5 (6,000) 3.791 (22,746)
Salvage value of old truck Now 9,000 1.000 9,000
Salvage value of new truck 5 3,000 0.621 1,863
Net present value $ (32,883)

Keep the Old Truck

Cash 10% Present
Year Flows Factor Value
Overhaul cost Now $ (4,500) 1.000 $ (4,500)
Annual operating costs 1-5 (10,000) 3.791 (37,910)
Salvage value of old truck 5 250 0.621 155
Net present value $ (42,255)
Chapter
19-487
 Least Cost Decisions
Home Furniture should purchase the new
truck.

Net present value of costs

associated with purchase
of new truck $(32,883)
Net present value of costs
associated with overhauling
existing truck (42,255)
Net present value in favor of
purchasing the new truck $ 9,372

Chapter
19-488
 Quick Check 

Bay Architects is considering a drafting

machine that would cost $100,000, last four
years, provide annual cash savings of $10,000,
and considerable intangible benefits each year.
How large (in cash terms) would the intangible
benefits have to be per year to justify investing
in the machine if the discount rate is 14%?
a. $15,000
b. $90,000
c. $24,317
d. $60,000
Chapter
19-489
 Quick Check 

Cash
Bay Architects is considering a14%
draftingPresent
Years Flows Factor Value
machine
Investment that would
in machine Now cost $100,000,
$ (100,000) last $four
1.000 (100,000)
years,
Annual provide
net cash inflows annual
1-4 cash savings
10,000 of $10,000,
2.914 29,140
Annual intangible
and benefits intangible
considerable 1-4 ? benefits2.914
each year.?
Net present value $ (70,860)
How large (in cash terms) would the intangible
benefits have to be per year
$70,860/2.914 to justify investing
= $24,317
in the machine if the discount rate is 14%?
a. $15,000
b. $90,000
c. $24,317
d. $60,000
Chapter
19-490
 Learning Objective 8-3

Evaluate an investment
project that has
uncertain cash flows.

Chapter
19-491
 Uncertain Cash Flows – An Example
• Assume that all of the cash flows related to an
investment in a supertanker have been
estimated, except for its salvage value in 20
years.
• Using a discount rate of 12%, management has
determined that the net present value of all the
cash flows, except the salvage value is a
negative $1.04 million.

How large would the salvage value need to be to make

this investment attractive?
Chapter
19-492
 Uncertain Cash Flows – An Example

Net present value to be offset $1,040,000

= = $ 10,000,000
Present value factor 0.104

This equation can be used to determine

that if the salvage value of the supertanker
is at least $10,000,000, the net present
value of the investment would be positive
and therefore acceptable.

Chapter
19-493
 Real Options

Delay the start of Expand a project

a project. if conditions are
favorable.
Cut losses if
conditions are
unfavorable.
The ability to consider these real options adds value to
many investments. The value of these options can be
quantified using what is called real options analysis, which
Chapter is beyond the scope of the book.
19-494
 Learning Objective 8-4

Rank investment
projects in order of
preference.

Chapter
19-495
 Preference Decision – The Ranking of Investment Projects

Screening Decisions Preference Decisions

Pertain to whether or Attempt to rank

not some proposed acceptable
investment is alternatives from the
acceptable; these most to least
decisions come first. appealing.

Chapter
19-496
 Internal Rate of Return Method

When using the internal rate of return

method to rank competing investment
projects, the preference rule is:

The higher the internal

rate of return, the
more desirable the
project.

Chapter
19-497
 Net Present Value Method

The net present value of one project cannot

be directly compared to the net present
value of another project unless the
investments are equal.

Chapter
19-498
 Ranking Investment Projects

Project Net present value of the project

=
profitability Investment required
index
Project A Project B
Net present value (a) $ 1,000 $ 1,000
Investment required (b) $ 10,000 $ 5,000
Profitability index (a) ÷ (b) 0.10 0.20

The
The higher
higher the
the profitability
profitability index,
index, the
the
more
more desirable
desirable the
the project.
project.

Chapter
19-499
 Other Approaches to
Capital Budgeting Decisions

Other methods of making capital budgeting

decisions include:
1. The Payback Method.
2. Simple Rate of Return.

Chapter
19-500
 Learning Objective 8-5

Determine the payback

period for an
investment.

Chapter
19-501
 The Payback Method

The payback period is the length of time that it

takes for a project to recover its initial cost out
of the cash receipts that it generates.

When the annual net cash inflow is the same

each year, this formula can be used to compute
the payback period:
Investment required
Payback period =
Annual net cash inflow

Chapter
19-502
 The Payback Method

Management at The Daily Grind wants to install an

espresso bar in its restaurant that
1. Costs $140,000 and has a 10-year life.
2. Will generate annual net cash inflows of
$35,000.

Management requires a payback period of 5 years

or less on all investments.

What is the payback period for the espresso bar?

Chapter
19-503
 The Payback Method

Investment required
Payback period =
Annual net cash inflow

$140,000
Payback period = $35,000

Payback period = 4.0 years

According
According to
to the
the company’s
company’s criterion,
criterion,
management
management would
would invest
invest in
in the
the espresso
espresso bar
bar
because
because its
its payback
payback period
period is
is less
less than
than 55 years.
years.
Chapter
19-504
 Quick Check 

Consider the following two investments:

Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 14-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined

Chapter
19-505
 Quick Check 

Consider the following two investments:

Project X Project Y
Initial investment $100,000 $100,000
Year 1 cash inflow $60,000 $60,000
Year 2 cash inflow $40,000 $35,000
Year 14-10 cash inflows $0 $25,000
Which project has the shortest payback period?
a. Project X
b. Project Y
c. Cannot be determined
•Project X has a payback period of 2 years.
•Project Y has a payback period of slightly more than 2 years.
Chapter
19-506 •Which project do you think is better?
 Evaluation of the Payback Method

Ignores the
time value
of money.

Short-comings
of the payback
period. Ignores cash
flows after
the payback
period.

Chapter
19-507
 Evaluation of the Payback Method

Serves as
screening
tool.
Identifies
Strengths investments that
of the payback recoup cash
period. investments
quickly.
Identifies
products that
recoup initial
investment
quickly.
Chapter
19-508
 Payback and Uneven Cash Flows

When the cash flows associated with an

investment project change from year to year,
the payback formula introduced earlier cannot
be used.
Instead, the un-recovered investment must be
tracked year by year.
$1,000 $0 $2,000 $1,000 $500

Chapter 1 2 3 4 5
19-509
 Payback and Uneven Cash Flows

For example, if a project requires an initial

investment of $4,000 and provides uneven net
cash inflows in years 1-5 as shown, the
investment would be fully recovered in year 4.

$1,000 $0 $2,000 $1,000 $500

Chapter 1 2 3 4 5
19-510
 Learning Objective 8-6

Compute the simple rate

of return for an
investment.

Chapter
19-511
 Simple Rate of Return Method

Does not focus on cash flows -- rather it focuses on

accounting net operating income.

The following formula is used to calculate the

simple rate of return:
Simple rate Annual incremental net operating income
of return = Initial investment*

*Should be reduced by any salvage from the sale of

the old equipment

Chapter
19-512
 Simple Rate of Return Method

Management of The Daily Grind wants to install an

espresso bar in its restaurant that:
1. Cost $140,000 and has a 10-year life.
2. Will generate incremental revenues of
$100,000 and incremental expenses of
$65,000 including depreciation.

What is the simple rate of return on the investment

project?

Chapter
19-513
 Simple Rate of Return Method

Simple rate $35,000

= = 25%
of return $140,000

Chapter
19-514
 Criticism of the Simple Rate of Return

Ignores the
time value
of money.

Short-comings
of the simple
The same project
rate of return.
may appear
desirable in some
years and
undesirable
in other years.

Chapter
19-515
 Postaudit of Investment Projects

A postaudit is a follow-up after the project

has been completed to see whether or not
expected results were actually realized.

Chapter
19-516
 End of Chapter 8

Chapter
19-517