Pages From Cost Management For Engineers 01-4

Feasibility study for water station project:
1- Market study: 3- Environmental study:

• Customers types • Environmental needs
• Customers needs
• Water quality 4- Economical and financial study:
• Quantity rates • Cost Elements
• Water supply • Economic analysis
• Price rates • Sensitivity Analysis
• Risk analysis
2- Technical study:
• Engineering design 5- Product Management:
• Equipment types • Project target plans
• International standards • Basic design, .. etc
• Cost estimation • Improvements recommendations
PM Cost Management For Engineers 241

Project Financial Analysis
BEP
NPV Net Present value BEP Break even point

IRR Internal rate of return

Cash Flows for Project
Cash Flow
Benefits
Time
Offsets
Investments

Cash Flow - Timing
End of project:
Salvage Value
Annual Revenues/Savings
Year 1 Year 2 Year 3 TIME
Time zero:
Initial Investment

Project Cash Flow Analysis
Revenue
A F
(+)
P (-)
Cost
i = Interest rate (%) n = Life time (year)

P = Present value  Value at time = 0
F= Future value  Value at time > 0
A= Annual uniform value  Equal value over time
• Interest rate  Certain bank  i% given

• Minimum Attractive Rate of Return (MART)
• Internal Rate return  Cash In/out for Certain project
Project Financial Analysis
Short & Medium term: (< 2 years)

• Cost/Benefit Analysis “Profit Index or Benefits/cost ratios (1.3 to 1.8)”
• Pay back period *
Long term: "Time is Money“, (>= 2 years)

• Net present value *  Profitability Index
• Annual present value
• Future present value
• Internal rate of return *
• Break even analysis
* The three most popular investment decision tools

Profitability Index
• Allows a comparison of the costs and benefits of different

projects to be assessed and thus allow decision making to be
carried out
Net Present Value

Profitability Index = ---------------------------
Initial Capital Cost
PI < 1.0  Losses  Rejected (or Service project)

PI = 1.0  Break even point  short term
PI > 1.0  Profit  Accepted (>1.2)
Project Financial Analysis:

Payback Period

Accounting Rate of Return

Net Present Value (NPV)

Cash Flows

Internal Rate of Return (IRR)

Profitability Index

Engineering Industry Average:
• Recovery factor  (0.8 to 0.9) Total capacity

• Base Price  80 % Most Common Price (Mode)
• Pay back period  3 to 7 years
• Net present value  Profitability Index >= 1.2
• Internal rate of return  IRR > MARR
• Break even point  Economic limit Production rate
Minimum Attractive Rate of Return (MARR) =

Best Banking i% + (2 to 8 %) ~ 15%
Catastrophic Case  Health effect (Cement)  MARR > 20%

Oil / Gas Projects:
• Recovery factor  (0.4 to 0.7) Total capacity
• Base Price  50 % Most Common Price (Mode)
• Pay back period  5 to 10 year
• Net present value  Profitability Index >= 1.3
• Internal rate of return  IRR > MARR
• Break even point  Economic limit Production rate
Minimum Attractive Rate of Return (MARR) =

Best Banking i% + (5 to 15%) ~ 20%
Catastrophic Case  Iraq  MARR > 30%

Benefit/Cost Ratio & Payback Period
These two approaches have a common problem.
They do not take into consideration the

“TIME is MONEY”.

The Process of Cost/Benefit Analysis
Calculate the costs
•One time costs
•Ongoing or Repeated Costs
•Opportunity costs
Calculate the Return on
Investment = ROI
= Benefits/Costs × 100%
Calculate the Benefits
•One time benefits
•Ongoing or Benefits
•Savings
•Improved Services

Benefit/Cost Ratio
Simply put it is the financial value of the benefit divided by the
financial cost.
($Benefit / $Cost) = (1.3 to 1.8)

Example:
Project Benefit = $ 7,000 (Total Cash In)

Project Cost = $ 5,000 (Total Cash Out)
Benefit/Cost Ratio = 1.4 (Profitability )
($Benefit / $Cost) = (1.3 to 1.8)

Payback Period:
Payback period is the length of time, usually expressed in years or
fractions there of, needed for a firm to recover its initial investment
on a project.
Example:
Initial Project Expense = $5,000
Payback
Year 1 $1,000 ($4,000)
Year 2 $2,000 ($2,000)
Year 3 $2,000 $0
Year 4 $2,000 $2,000

Example:
Cash flow: $1000
Year 0 Year 1 Year 2 Year 3 Year 4
Cost 1,000 150 150 150 150
Benefit 0 500 500 500 500
Difference (1000) 350 350 350 350

Payback Period
Definition:
The number of years it takes before the cumulative forecasted cash flow equals
the initial investment.
Example: $350 $350 $350 $350
1 2 3 4
years
-$1,000
Payback Period (Investment) = 3 years

MOST COMMON PAYMENT FACTORS
To find Given Symbol Factor
P (t=0) F (t>0) (P/F, i, n) (1+i)-n
F (t>0) P (t=0) (F/P, i, n) (1+i)n
P (t=0) A (equal (P/A, i, n) {(1+i)n -1}/{i (1+i)n }

over time)
A P (A/P, i, n) {i (1+i)n } / {(1+i)n -1}
F A (F/A, i, n) {(1+i)n -1}/ i
A F (A/F, i, n) i / {(1+i)n -1}

Basic Time Value of Money Calculations
To convert future value to present value:
P = F [ 1 / (1 + i)n ]
P = F [P/F, i , n)
Where:
P = Present value
F = Future value
i = (interest) rate of return
n = number of units of time
Basic Time Value of Money Calculations: Example
Calculate the present value of $1.00 to be

paid (or collected) 5-years from now
assuming an interest rate of 8%. Set it up
as follows:
P = 1.00
(1 + .08)5
Thus: $0.68

Net Present Value
Net Present Value (NPV) is a means to calculate
whether the public sector organization will be better or
worse off if it make a capital investment. It does so by
adding the present value of outflows and the present
value of inflows. It shows the value of a stream of future
cash flows discounted back to the present by some
percentage that represents the minimum desired rate of
return, often called the cost of capital.
NPV = PV Inflows – PV Outflows

General decision rule in applying NPV. . .
If the Net Present

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

Zero . . . return equal to the required rate
of return.
Not acceptable, since it

Negative . . . promises a return less than the
required rate of return.

BREAK-EVEN CHART
PV (DOLLARS) PV INFLOWS
PV OUTFLOWS
BREAK-EVEN POINT
NPV = 0
UNIT SALES

Net Present Value (NPV)
Converting Cash Flows to Present Value
Annual Savings End of project

= ??
= ??
= ??
$38,463 $38,463 $38,463
Year 1 Year 2 Year 3 TIME
Time zero:
Initial Investment = $105,000

Net Present Value
Example:
Interest rate of 12%.
$350 $350 $350 $350
1 2 3 4
years
-$1,000
NPV Investment 
350 350 350 350
  1, 000    
1 . 12 1 . 12 2 1 . 12 3 1 . 12 4
  1, 000  350  0 . 89  350  0 . 80  350  0 . 71  350  0 . 64
 63

The Net Present Value Method: Summary

Net Present Value Calculation
NET PRESENT VALUE EQUALS
Some amount of money
Divided by
(1 + interest rate)n
Where “n” equals the number of periods

Net Present Value
The Value of a Future $1
(P/F.i,n)
Discount rate (d): 10% 20% 30% 40%

Years into future (n)
1 .9091 .8333 .7692 .7142
Present
2 .8264 .6944 .5917 .5102 value
3 .7513 .5787 .4552 .3644 factors
4 .6830 .4823 .3501 .2603
5 .6209 .4019 .2693 .1859
10 .3855 .1615 .0725 .0346
20 .1486 .0261 .0053 .0012
30 .0573 .0042 .0004 .0000
Handout: Table with discount rates

Evaluating Capital Investment Proposals: An Illustration
A Company is considering purchasing
a machine with a 5-year life.
Cost and revenue information

Machine cost $ 75,000
Revenue $ 84,375
Cost of goods sold 50,625
Gross profit $ 33,750
Cash operating costs $ 3,350
Depreciation 14,000 17,350
Pretax income $ 16,400
Income tax 6,400
After-tax income $ 10,000
($75,000 - $5,000) ÷ 5 years

Net Present Value
$350 $350 $350 $350
1 2 3 4
years
-$1,000
NPV Investment 
350 350 350 350
 1,000    
1.12 1.12 1.12 1.12 4
2 3
 1,000  350  0.89  350  0.80  350  0.71  350  0.64

 63

Internal Rate of Return - Decision Criteria
The decision rule is: Accept the project when the internal rate of return is
equal to or greater than the required rate of return. Reject the project when
the internal rate of return is less than the required rate.
The Internal Rate of Return Method: Summary

Internal Rate of Return
Example
You can purchase a building for $350,000. The investment
will generate $16,000 in cash flows (i.e. rent) during the first
three years. At the end of three years you will sell the
building for $450,000. What is the IRR on this investment?
16,000 16,000 466,000

0   350,000   
(1  IRR ) 1
(1  IRR ) 2
(1  IRR ) 3

Definition:
The rate of return that yields a Net Present Value of zero.
Example:
$350 $350 $350 $350
1 2 3 4
years
-$1,000
350 350 350 350

    1,000  0  IRR  0.15
1  IRR (1  IRR) 2
(1  IRR) (1  IRR)
3 4

Example
You can purchase a building for $350,000. The investment
will generate $16,000 in cash flows (i.e. rent) during the first
three years. At the end of three years you will sell the
building for $450,000. What is the IRR on this investment?
16,000 16,000 466,000

0   350,000   
(1  IRR ) 1
(1  IRR ) 2
(1  IRR ) 3
IRR = 12.96%

IRR=12.96%

Example : New Car
Period Cash 2 Years 2 Years
0 90,000 50,000 40,000
1 - 25,000 35,000
2 - 25,000 35,000
IRR
Which offer should you accept and why?

(P/F, i, n) (1+i)-n

Example :
Period Project A Project B
0 -500 -400 The required

return for both
1 325 325 projects is 10%.
2 325 200
IRR 19.43% 22.17% Which project

should you accept
and why?
NPV 64.05 60.74

Case Study:
You can purchase a building for $350,000. The

investment will generate $16,000 in cash flows (i.e.
rent) during the first three years. At the end of three
years you will sell the building for $450,000.
What is the IRR on this investment?
Minimum Attractive Rate of Return (MARR) = 20%

450
16 16 16
350
16,000 16,000 466,000

0  350,000   
(1 IRR) (1 IRR) (1 IRR)
1 2 3
IRR=12.96%
IRR = 12.96%
< MARR
“Rejected”

Case Study - Pump Replacement
Assumptions/Calculations:
- Pump 0.5 HP - Average Annual Costs are constant
- Interest rate is 4% - Life 10 years
1- Axial Pump 2- Centrifugal Pump
Model: 607-3 Model: 8000 Series Horizontal Centrifugal
Initial Cost: $4400 Self-Priming Pump
Annual Costs: $100 Initial Cost: $2464
Annual Costs: $400
3- Diaphragm Pump 4- Piston Plunger Pump

Model: 150 Frame Reciprocating Process
Model: LLC-1010 Pump -- 152R060
Initial Cost: $2399 Initial Cost: $61500
Annual Costs: $512 Annual Costs: $1790
Based on this information, discuss & select the best pump.

Economic Analysis
Centrifugal Axial Piston Plunger Diaphragm

Initial Cost 2464 4400 61500 2399
Annual Costs 400 100 1790 512
400 100 1790 512
400 100 1790 512
400 100 1790 512
400 100 1790 512
400 100 1790 512
400 100 1790 512
400 100 1790 512
400 100 1790 512
400 100 1790 512
Based on this information, discuss & select the best pump.

Economic Analysis
Centrifugal Axial Piston Plunger Diaphragm
Initial Cost 2464 4400 61500 2399
Annual Cost 400 100 1790 512
400 100 1790 512
400 100 1790 512
400 100 1790 512
400 100 1790 512
400 100 1790 512
400 100 1790 512
400 100 1790 512
400 100 1790 512
400 100 1790 512
Total NPW (4%) $5,584.54 $5,180.86 $75,461.06 $6,393.02
NPW = Net Present Worth
•Axial Flow Pump (Model 607-3) is the most cost effective model for our application.

Case Study – An Engine
Suppose you intend to purchase a new engine, 3 types of engine
are available on the market:
Item Option A Option B Option C
First Cost $ 60,000 $ 70,000 $ 80,000
Life, year 12 12 12
Salvage value 0 0 0
Annual O & M Cost $ 3000 $ 2500 $2000
MARR is 15%
Which financing option is a better choice?

Item Option A
First Cost $ 60,000
Life, year 12
Salvage value 0
Annual O & M Cost $ 3000
0 1 2 3 4 5 6 7 8 9 10 11 12
3000 3000 3000 3000 3000 3000
60,000

A (12 year) B (12 year) C (12 year)
0 - Initial Cost $ 60,000 $ 70,000 $ 80,000
1- Annual Costs 3000 2500 2000
2- 3000 2500 2000

3- 3000 2500 2000
4- 3000 2500 2000
5- 3000 2500 2000
6- 3000 2500 2000
7- 3000 2500 2000
8- 3000 2500 2000
9- 3000 2500 2000
10- 3000 2500 2000
11- 3000 2500 2000
12- 3000 2500 2000
Total NPW (15%)

First Cost $ 60,000 $ 70,000 $ 80,000
Life, year 12 12 12
Salvage value 10% First cost 10% First cost 10% First cost
Annual O & M Cost $ 3000 $ 2500 $2000
Overhaul #1 $ 5000 / 2 years $ 6000 / 3 years $ 7000 / 5 years
Overhaul #2 $ 8000 / 6 years $ 10,000 / 9 years $ 12,000 / 10 years
MARR is 15%

Item Option A
First Cost $ 60,000
Life, year 12
Salvage value 10% First cost
Annual O & M Cost $ 3000
Overhaul #1 $ 5000 / 2 years
Overhaul #2 $ 8000 / 6 years

6,000
0 1 2 3 4 5 6 7 8 9 10 11 12
3000 3000 3000 3000 3000 3000
3000+ 3000+ 3000+ 3000+

5000 5000 5000 5000
3000+ 3000+
8000 8000
60,000

0 - Initial Cost $ 60,000 $ 70,000 $ 80,000
1- Annual Costs 3000 2500 2000
2- 3000+5000=8000 2500+6000=8500 2000

3- 3000 2500 2000
4- 3000+5000=8000 2500 2000
5- 3000 2500+6000=8500 2000+7000 = 9000
6- 3000+8000=11000 2500 2000
7- 3000 2500 2000
8- 3000+5000=8000 2500+10000=12500 2000
9- 3000 2500 2000
10- 3000+5000=8000 2500 2000+12000 = 14000
11- 3000 2500+6000=8500 2000
12- 3000 -6000= - 3000 2500-7000= - 4500 2000-8000 = -6000
Total NPW (15%)

First Cost $ 60,000 $ 70,000 $ 80,000
Life, year 12 15 20
Annual O & M Cost $ 3000 $ 2500 $2000
Overhaul #1 $ 5000 / 2 years $ 6000 / 3 years $ 7000 / 5 years
Overhaul #2 $ 8000 / 6 years $ 10,000 / 9 years $ 12,000 / 10 years
MARR is 15%

0 - Initial Cost $ 60,000 $ 70,000 $ 80,000
1- Annual Costs 3000 2500 2000
2- 3000+5000=8000 2500+6000=8500 2000

3- 3000 2500 2000
4- 3000+5000=8000 2500 2000
5- 3000 2500+6000=8500 2000+7000 = 9000
6- 3000+8000=11000 2500 2000
7- 3000 2500 2000
8- 3000+5000=8000 2500+10000=12500 2000
9- 3000 2500 2000
10- 3000+5000=8000 2500 2000+12000 = 14000
11- 3000 2500+6000=8500 2000
12- 3000 -6000= - 3000 2500 2000
13- ---- 2500 2000
14- ---- 2500+6000=8500 2000
15- ---- 2500-7000= - 4500 2000+7000 = 9000
16- ---- ---- 2000
17- ---- ---- 2000
18- ---- ---- 2000
19- ---- ---- 2000
20- ---- ---- 2000-8000 = -6000
NAW = Net Annual Worth

Main Steps: Not Equal life, (12, 15, 20 year)
All (P,F,A)  P  Sum NPW  NAW (Net Annual Worth)
A B C
Life, year 12 15 20
NPW
NAW NPW (A/P, 15%, 12) NPW (A/P, 15%, 15) NPW (A/P, 15%, 20)
To find Given Symbol Factor

P (t=0) F (t>0) (P/F, i, n) (1+i)-n
A P (A/P, i, n) {i (1+i)n } / {(1+i)n -1}
NAW = Net Annual Worth

A (12 year) NPW  (T=0  P=P & T>0  (P/F,i%,n)
0 - Initial Cost 60000 60000
1- Annual Costs 3000 3000 (P/F, 15%,1) =
2- 8000 8000 (P/F, 15%,2) =
3- 3000 3000 (P/F, 15%,3) =
4- 8000 8000 (P/F, 15%,4) =
5- 3000 3000 (P/F, 15%,5) =
6- 11000 11000 (P/F, 15%,6) =
7- 3000 3000 (P/F, 15%,7) =
8- 8000 8000 (P/F, 15%,8) =
9- 3000 3000 (P/F, 15%,9) =
10- 8000 8000 (P/F, 15%,10) =
11- 3000 3000 (P/F, 15%,11) =
12- - 3000 - 3000 (P/F, 15%,12) =
13- ----
NPW Sum =
NAW NPW (A/P, 15%,12)
NPW  NAW = Net Annual Worth

Relative Weights
First Cost 60 70 80
Life, year 12 15 20
Annual O & M Cost 3.0 2.5 2.0
Overhaul #1 5 / 2 years 6 / 3 years 7 / 5 years
Overhaul #2 8 / 6 years 10 / 9 years 12/ 10 years
MARR is 20%


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Feasibility study for water station project:

1- Market study: 3- Environmental study:

PM Cost Management For Engineers 241

NPV Net Present value BEP Break even point

PM Cost Management For Engineers 242

PM Cost Management For Engineers 243

Year 1 Year 2 Year 3 TIME

PM Cost Management For Engineers 244

i = Interest rate (%) n = Life time (year)

• Interest rate  Certain bank  i% given

Short & Medium term: (< 2 years)

Long term: "Time is Money“, (>= 2 years)

* The three most popular investment decision tools

• Allows a comparison of the costs and benefits of different

Net Present Value

PI < 1.0  Losses  Rejected (or Service project)

PM Cost Management For Engineers 248

PM Cost Management For Engineers 249

PM Cost Management For Engineers 250

PM Cost Management For Engineers 251

PM Cost Management For Engineers 252

PM Cost Management For Engineers 253

PM Cost Management For Engineers 254

• Recovery factor  (0.8 to 0.9) Total capacity

Minimum Attractive Rate of Return (MARR) =

PM Cost Management For Engineers 255

Minimum Attractive Rate of Return (MARR) =

PM Cost Management For Engineers 256

These two approaches have a common problem.

They do not take into consideration the

PM Cost Management For Engineers 257

PM Cost Management For Engineers 258

($Benefit / $Cost) = (1.3 to 1.8)

Project Benefit = $ 7,000 (Total Cash In)

($Benefit / $Cost) = (1.3 to 1.8)

PM Cost Management For Engineers 259

PM Cost Management For Engineers 260

Cash flow: $1000

Year 0 Year 1 Year 2 Year 3 Year 4

Cost 1,000 150 150 150 150

Benefit 0 500 500 500 500

Difference (1000) 350 350 350 350

PM Cost Management For Engineers 261

Example: $350 $350 $350 $350

Payback Period (Investment) = 3 years

PM Cost Management For Engineers 262

To find Given Symbol Factor

P (t=0) F (t>0) (P/F, i, n) (1+i)-n

F (t>0) P (t=0) (F/P, i, n) (1+i)n

P (t=0) A (equal (P/A, i, n) {(1+i)n -1}/{i (1+i)n }

F A (F/A, i, n) {(1+i)n -1}/ i

A F (A/F, i, n) i / {(1+i)n -1}

PM Cost Management For Engineers 263

To convert future value to present value:

Calculate the present value of $1.00 to be

PM Cost Management For Engineers 265

NPV = PV Inflows – PV Outflows