Addis Ababa University
Faculty of technology
Department of Chemical Engineering
Project Management
Addis Ababa, 2004
Project Management
Dr. (PhD) Reynerio Alvarez Borroto
______________________________________________________________________________________
1. Assuming the cost of the water we feed to the process is negligible, we see a MPP
of about 72 to 82 million per year. This maximum profit has to cover our annual
operating costs and our annualized costs for investment in equipment for the
process. Assuming a five-year payout time and an eight-year depreciable life
(ignoring the time value of money), we can convert the money unit in investment
into annualized money unit by dividing roughly by 3. Thus, we need a process
where
equipment cos ts
annual operating cos t 72.10 6 to 82.10 6
3
The MPP calculation indicates that the process is economically favorable so we continue
with our project. If the PPM had very small or negative values we would stop the project
so it is not profitable. Note that the MPP is very strongly affected by the substance prices.
Thus, we must establish how much these prices might change, and determine the range of
MPP we might see for the process.
2. Economic Evaluation
In the previous paragraph we introduced the concept of MPP in order to determine
whether is possible to continue with a project or not. This is the first bound in the
hierarchy to develop a process. Once we calculated MPP and defined that the process is
profitable (MPP is not very small or negative) we must apply more refined evaluation
techniques for the process. By making these calculations we first define some terms and
classify a number of items.
Costs related with the process can be divided into two general categories:
Fixed Costs (FC), and
Variable Costs (VC).
FC are direct investment as well as overhead and management associated with this
investment. In particular, we are interested in capital investment costs, which are incurred
initially at the start of the project.
Within VC we have raw materials, labor, utilities, and other costs that are dependent on
operations. Here we are concerned with manufacturing costs (MC), which are continuous
expenses given on annual basis.
2.1 Capital Investment
Capital investment (CI) represents all expenses made at the beginning of the plant life.
The total CI is given by fixed capital (FC) and working capital (WC). Thus,
CI FC WC 5
2
Project Management
Dr. (PhD) Reynerio Alvarez Borroto
______________________________________________________________________________________
Further classification of these categories is given below,
Manufacturing capital (MC), and
Nonmanufacturing capital (NMC).
MC may be expressed as Bare Module Cost (BMC) of equipment as well as a 25 percent
contingency on this figure. NMC-buildings, services, land. Typically 40 percent of BMC.
Working capital (WC) represents funds required to operate the plant due to delays in
payment maintenance of inventories. As these funds are replaced by additional revenues,
the WC represents the money available to fill the tanks and meet the initial payroll and
expenses. This varies from reference to reference and is usually 10 to 20 percent of the
total IC (fixed and working capital). We will standardize on the following:
Raw materials and product inventories (typically 7 days).
Goods in process.
Account receivable (30-day lag in payment that is equal to 1 month manufacturing
production. This signifies 10 to 20 percent of total investment with depreciation.
Douglas (1988)1 also suggests a simpler form:
WC 0.15. CI 0.194. FC 6
These costs include all expenses that are made on a continuous basis over the life of the
plant. They involve expenses that directly relate to the day-to day operation of the plant
as well as indirect expenses such as taxes, insurance, and deprecation. A typical
classification of manufacturing costs is given:
Raw materials-represent feedstocks for the process that are consumed on a
continuous basis.
Credits-include usable purge gases (fuel) as well as utilities (steam, electricity,
etc.) and by-product that are generated on a continuous basis.
Direct expense-Include labor, supervision, payroll (typically, 20 percent of labor
and supervision) utilities (electric, steam, coding water), maintenance (repair),
supplies (2 percent of fixed investment), and royalties (typically on a licensed
operation or on catalyst).
Indirect expenses-Include depreciation (8 percent per year), local taxes, and
insurance (3 percent per year).
One item that needs further mention is depreciation. This can be considered to be a cost
prorated throughout equipment life.
2.2 Capital Cost Estimates
1
Douglas
3
Project Management
Dr. (PhD) Reynerio Alvarez Borroto
______________________________________________________________________________________
According to their accuracy the capital cost estimates can be classified into five
categories:
Order-of-magnitude estimate: < 40 % (error)
Study estimate: < 25 %
Preliminary estimate: < 12 %
Definitive estimate: <6%
Detailed estimate: <3 %
Moreover, the difficult and expense of obtaining more accurate estimates increases by
order of magnitude and only can be justified for final design stages. Douglas (1988) says
that for candidate flowsheet screening and preliminary design, an order-of –magnitude
estimates is sufficient. Therefore, we will concentrate on simplified costing correlations
in order to allow fast determination of cost estimate at the 25 to 40 percent level of
accuracy.
Cost estimation of the Unit
Here the sized equipment will be costed using power correlation developed in Guthrie2
(1969). In addition to unit capital costs we will also consider operating cost such as utility
charges. This information, together with the feedstock costs and product sales, will be
used in the subsequent economic evaluation.
Modular Method of Guthrie
To account for direct and indirect costs related with the cost of equipment, Guthrie
proposed a simple factoring method for add-on-costs. A typical cost module (with
representative numbers) is given below.
1) Free on board equipment (FOB): 100
(Base cost, BC, or equipment cost, E, from graph).
Table 1. Base Costs for Pressure Vessels
Equipment type C0, $ L0, ft D0,
MF2 MF4 MF6 MF8 MF10
ft
Vertical fabrication 4.23 4.12 4.07 4.06 4.02
1 D 10, 4 L 10001000 4.0 3.0 0.81 1.05
Horizontal fabrication 3.18 3.06 3.01 2.99 2.96
1 D 10, 4 L 1000 690 4.0 3.0 0.78 0.98
Tray stacks
2 D 10, 1 L 500 180 10.0 20 0.97 1.45 1.00 1.00 1.00 1.00 1.00
2
Guthrie
4
Project Management
Dr. (PhD) Reynerio Alvarez Borroto
______________________________________________________________________________________
Data from Guthrie (1969).
Table 2. Installation, labor and other
Item Factor
2) Installation:
62.2
a) Piping instruments, etc.
b) Labor 58.8
3) Shipping, taxes, supervision 74.9
Total cost 295.1
As a result, we define de Bare Module Cost (BMC):
BMC BC * MF 7
Table 2. Base costs for process equipments
Equipment type
C0,
($103)
S0
Range
()
MF2 MF4 MF6 MF8 MF10
Process furnaces
100 30 10-300 0.83 2.72 2.19 2.16 2.15 2.13
Absorbed duty: 106 Btu/h
Direct fire heaters
20 5 1-40 0.77 2.23 2.15 2.13 2.12 2.10
Absorbed duty: 106 Btu/h
Heat exchangers
5 400 100-104 0.65 2.39 3.18 3.14 3.12 3.09
Shell and tube, S(ft2)
Heat exchangers
0.3 5.5 2-100 0.024 1.83 1.83 1.83 1.83 1.83
Shell and tube, S(ft2)
Air coolers
Here the module factor is 2.95 (a typical value). That is, the equipment cost is almost
three times the base cost3. This module factor is affected by the base cost (BC). In the
following tables we give module factors for the following base costs (BC in 1968 prices):
Factor Range, $
MF 2 Up to 200 000
MF 4 200 000 to 400 000
MF 6 400 000 to 600 000
MF 8 600 000 to 800 000
MF 10 800 000 to 100 000
3
When we calculated the MPP in the previous example the value that we took for this factor was 3.
5
Project Management
Dr. (PhD) Reynerio Alvarez Borroto
______________________________________________________________________________________
Moreover, for special materials and high pressures, we have already defined material and
pressure correlation factors (MPF) for several types of equipment. Here the BMC is
modified by the following factors given in the table.
Finally, we do not treat contingency cost and indirect capital costs as Guthrie does.
Instead, for preliminary designs we apply overall indirect cost factors and a flat 25
percent contingency rate after all the equipment is costed.
Item Equation No.
Uninstalled cost (BC).(MPF) (8)
Installation4 (BC).(MF)- BC = BC.(MF- 1) (9)
Total installed cost (BC).(MPF + MF-1) (10)
Update BMC UF.(BC).(MPF + MF – 1) (11)
2.3 Measures for Profitability
We can divide the methods to estimate the profitability of a project into two categories:
Static, and
Dynamic.
The static methods no consider the time value of the money, and they can be used at the
first stages (or first bounds) for preliminary design and in other specific situations. This is
the case, for example, by estimating the MPP to determine the profitability of a process.
Once we decided to continue with the process we must employ other more refined
techniques in which are considered the time value of the money.
The dynamic methods are based on the time value of money, and we must apply these
methods when we are dealing with a more rigorous analysis.
Static methods
First, we define the following concepts:
Pgross S gross C manuf 12
Pnet Pgross 0.10 S gross 13
E net Pnet t 14
Where,
4
This is usually calculated on a carbon steel basis)
6
Project Management
Dr. (PhD) Reynerio Alvarez Borroto
______________________________________________________________________________________
Pgross = gross profit; Pnet = net profit before taxes; E net = net annual earnings;
and t = taxes on net profit.
With these concepts and defined above we have following simple economic measures:
Return on investment (ROI)
Return on investment is given by the equation
E net
ROI 15
CF CW
It is only useful for mature plant project when startup costs are not significant. The
accepted values of ROI are 15 percent or 30 percent before taxes, respectively.
Payout Time (PT)
Payout time is expressed by,
CI
PT 16
Pnet d
Where, d = depreciation.
Note that the depreciation was part of the manufacturing cost is added back and
cancelled. Therefore, this measure represents the total time to recovery investment based
on the net income without depreciation.
Dynamic methods
The simple economic indicators given above are often not a good basis comparison for
projects. Hence, we have to deal with a more rigorous analysis. To consider the schedule
of payments and income, we know that the value of money changes due to:
a) Interest, which reflects rent paid on the use of money
b) Returns received for competing investment (the investment must compensate the
loss of opportunity to invest elsewhere), and
c) Inflation, which can be compensated in the interest rate.
The interest rate is chosen according to the specific conditions of the organization.
Generally, the interest rate is selected considering the rate that the organization receives
for its money when the money is setting in reserve. Therefore, based on its history, the
organization may know it can virtually analysis invest in projects somewhere, with a
guarantee rate. It often terms this interest rate as the acceptable return for any project.
7
Project Management
Dr. (PhD) Reynerio Alvarez Borroto
______________________________________________________________________________________
Present values
For this economic analysis first we need to consider the effect of a compound interest
rate. We define P as the present value of a sum end S as its future worth. Compounding
interest after a one-year period gives
S P.(1 i )
For multiple compounding periods (n) we derive
Year S Interest end year
0 p i.P
P i.P i.1 P .P
1
1
2 P i.P .1 i i.1 i .P
2
For n years
1
S 1 1 .P or P 17
n
.S
1 i n
1
Where, f = discount factor; i = interest rate; and n = number of years.
1 i n
In order to find the present value P on distributing an equal payment on a regular basis R,
we consider the following time-line and derive the following relation applying the
discount factor to each payment:
n
R R 1
P ... R. 18
1 i 1 i 2
k 1 1 i
k
Or, after simplification
p.i
R 19
1 1 i
n
Where the term multiplying P represents the capital recovery. Consider the following
case-the present value of an expenditure that needs to be made for an infinite time
period. To find such a payment schedule, that the interest that accrues in each interval
needs to be support each payment. If the payment interval is made after a multiple Z of
compounding periods, then over Z years, interest learned on P should pay for C,
C
C P.1 i P 20
2
P
or
1 i Z 1
8
Project Management
Dr. (PhD) Reynerio Alvarez Borroto
______________________________________________________________________________________
These cases occur in the period replacement of process equipment. Here C is the
replacement cost for equipment (cost-salvage value) and C0 is the original price. The
capitalized cost for the equipment, K is given by
C
K C0 21
1 i 1
Z
The use of perpetuity calculations is also useful for comparing equipment with different
lives.
Example 2 (Simple economic measures for process evaluation)
Consider the following process with a capacity of 120.106 lb/yr and a product price of 20
cent/lb.
The data for the problem is given below:
Item $/year
Fixed capital 15.106
Working capital 3.106
FIXED AND WORKING CAPITAL 18.106
Raw material (8 cent/lb prod) 9.6(106)
Utilities (1.2 cent/lb prod) 1.44(106)
Labor (1.5 cent/lb prod) 1.8(106)
Maintenance (6 % yr f.c) 900 000
Supplies (2 % yr f.c.) 300 000
Depreciation (8%/yr over 12 years) 1.2(106)
Taxes, insurance (3 %/yr) 450 000
TOTAL MANUFACTURING COST 15.69(106)
Gross sale (120.10)(0.2) 24.10
Manufacturing cost -15.69(106)
GROSS PROFIT 8.31(106)
SARE expenses (at 10 % sales tax) -2.4(106)
NET PROFIT BEFORE TAXES 5.91(106)
Taxes (50 % net profit) -2.96(106)
NET PROFIT AFTER TAXES 2.95(106)
Then,
2.95(10 6 )
ROI .100 16.4 %
18.10 6
18.10 6
Payout time 2.53 years
5.91 1.2 .10 6
9
Project Management
Dr. (PhD) Reynerio Alvarez Borroto
______________________________________________________________________________________
While the above measures are very easy to calculate, they lead to inconsistent results
when trying to compare alternative projects. One area of disagreement occurs when a
person decides to invest a lot of money with a modest return or a little money with large
return.
Example 3 (Comparison of a project alternatives)
Item Project 1 Project 2
Foxed capital 2.5(106) 250 000
Working capital 500 000 50 000
Net income before taxes 106 200 000
Depreciation 500 000 50 000
10 6 200000
ROI (pretax) 0.33 0.66
3.10 6 300000
3.10 6 300000
2 yr 1.2 yr
Payout period
1.5. 10 6
250000
For all indicators, alternative (2) is better. However, we know that by paying $2.7(106)
more we make $450 000 more per year. Clearly, we need a better basis for comparison.
2.3.2. Using Time Value of Money for Cost and Project Comparison
To evaluate the profitability of a process we will use discounted cash flow calculations
based on the concepts outlined above. Even here there are different criteria for
comparing project. We will consider three approaches:
1) Net present value (NPV) of project with a given rate of return.
2) Annualized payments with a given rate of return.
3) Calculated rate of return (i*) with NPV = 0.
The first criterion (NPV) gives the present value of all payments and provides a basis of
comparison for projects with different payment schedules but similar lifetimes. The
project with the highest NPV project or lowest NPV cost is superior.
The method of annualized payments has the same benefits as the NPV but also allows
comparison of projects with different lifetimes. The rate of return calculating can be
interpreted as the interest rate that can be compared with a competing investment. Here a
typical investment (i.e., bond for savings account) has a NPV = 0 for its rate return. The
higher rate return is clearly favored, but this criterion does not consider the magnitudes
in the investment.
Some times it is useful to calculate rate of return to compare projects, as the discounted
cash flow (DCF) rate of return does not need to be specified in advance. However, the
rate of return calculation is only useful for projects with both costs and income.
10
Project Management
Dr. (PhD) Reynerio Alvarez Borroto
______________________________________________________________________________________
Example 4 (Project comparison)
Consider two investments both with a 5-year lifetime to be evaluated before taxes
according to the following data:
Item Project A Project B
Capital, fixed and working 3(106) 3(106)
Income before taxes 106 200 000
11
