UNIT 2: Economic Analysis

Cost implication to different forms of construction and maintenance and maintenance and
replacement lives of material, Installation and running cost of services, Capital investment
in project, Cost analysis by traders and by functional element, Cost planning techniques,
Cost control during design and Construction, Depreciation, Various Appraisal Criteria
Methods. Break-even analysis, Cash flow analysis, Risk Analysis and Management
Practice, Role of Lender’s Engineer.

An economic analysis is a process to understand how key economic factors affect the functioning of
an organization, industry, region or any other particular population group, with the purpose of making wiser
decisions for the future. It is a broader term that can mean simple and concise or sophisticated and complex
identification, study and projection of economic variables.
In business, economic analysis allows to incorporate
elements from the economic environment such as inflation,
interest rates, exchange rates and GDP growth into the
corporate planning. Every organization is an open system
that impact and is impacted by the external context. This
means that a proper assessment of economic variables
facilitates the identification of opportunities and threats that
could affect the company’s performance.
Organizations tend to carry out corporate planning processes
every one or two years and often define two or three possible economic scenarios for short and medium
terms. Then they evaluate how each scenario would affect company decisions and achievement of goals.
Economic analysis is also made when evaluating specific projects in order to consider economic and
financial feasibility.

Objectives of the Economic Analysis

Good management consists primarily of making wise decisions; wise decisions in turn involve
making a choice between alternatives. Engineering considerations determine the possibility of a project
being carried out and point out the alternative ways in which the project could be handled. Economic
considerations also largely determine a project's desirability and dictate how it should be carried out. A
feasibility study determines either the which or the whether of the proposed project: which way to do it, or
whether do it at all.
In an engineering sense, feasibility means that the project being considered is technically possible.
Economic feasibility, in addition to acknowledging the technical possibility of a project, further implies that
it can be justified on an economic basis as well. Economic feasibility measures the overall desirability of
the project in financial terms and indicates the superiority of a single approach over others that may be
equally feasible in a technical sense.

In the study, the project is considered in an engineering sense. The ultimate objective of the economic
analysis is to provide a decision-making tool which can be used not only for the pilot project but also for
demonstration purposes.

Cost implications refer to the amount of time, money, and energy required to obtain, produce and maintain
a product or service.

Factors Affecting Construction Cost Implication:

There are many factors, which affect the construction cost implication and have significant impact
on project cost and they are as following:

1. Similar Construction Projects

For the construction estimate, the best reference will be similar construction projects. The final cost
of those similar projects can give the idea for the new construction project cost calculation. The final cost
of past project needs to be factored with current construction cost indices.

2. Construction Material Costs

Construction material cost consists of material cost, shipping charges and taxes applicable if any.
So, it is important consider all these variations while calculating construction material cost.

3. Labor Wage Rates

Labor wages varies place to place. So, local wage rate should be considered in calculation. If the
project has to be started after several months of estimating the project cost, the probable variation in wage
rates has to be considered in the calculation.

4. Construction Site Conditions

Project site conditions can increase construction costs. Site conditions such as poor soil conditions,
wetlands, contaminated materials, conflicting utilities (buried pipe, cables, overhead lines, etc.),
environmentally sensitive area, ground water, river or stream crossings, heavy traffic, buried storage tanks,
archaeological sites, endangered species habitat and similar existing conditions etc. can increase the project
cost during construction phase if these variations are not considered during estimation.

5. Inflation Factor
 A construction project can continue for years before completion. During the construction period, the
cost of materials, tools, labors, equipments etc. may vary from time to time. These variation in the prices
should be considered during cost estimation process.

6. Project Schedule

Duration of construction project is affects the cost. Increase in project duration can increase the
construction project cost due to increase in indirect costs, while reduction in construction cost also increases
the project cost due to increase in direct costs. Therefore, construction project schedules also need to be
considered during project cost estimation.

7. Quality of Plans & Specifications

Good quality construction plans and specifications reduces the construction time by proper execution
at site without delay. Any vague wording or poorly drawn plan not only causes confusion, but places doubt
in the contractor’s mind which generally results in a higher construction cost.

8. Reputation of Engineer

Smooth running of construction is vital for project to complete in time. The cost of projects will be
higher with sound construction professional reputation. If a contractor is comfortable working with a
particular engineer, or engineering firm, the project runs smoother and therefore is more cost-effective.

9. Regulatory Requirements

Approvals from regulatory agencies can sometimes be costly. These costs also need to be considered
during cost estimate.

10. Insurance Requirements

Cost estimation for construction projects should also need to consider costs of insurance for various
tools, equipments, construction workers etc. General insurance requirements, such as performance bond,
payment bond and contractors general liability are normal costs of construction projects. In some special
projects, there can be additional requirements which may have additional costs.

11. Size and Type of Construction Project

For a large construction project, there can be high demand for workforce. For such a requirements,
local workmen may not be sufficient and workmen from different regions need be called. These may incur
extra costs such projects and also for the type of construction project where specialized workforce is
required.

12. Location of Construction

 When a location of construction project is far away from available resources, it increases the project
cost. Cost of transportation for workers, equipment, materials, tools etc. increases with distance and adds to
the project cost.

13. Engineering Review

Sometimes it is necessary to carry out technical review of construction project to make sure the
project will serve the required purpose with optimum operational and maintenance cost. This review cost
shall also be added to the project cost.

14. Contingency

It is always advisable to add at least 10% contingency towards the total project costs for unforeseen
costs and inflation.

Maintenance

The combination of all technical, administrative

and managerial actions during the life cycle of an item
intended to retain it in, or restore it to a state in which it
can perform the required function.

Maintenance has had a tremendous impact on

company’s proficiency to optimize its production
system in order to meet its long-term objectives.
Generally, a production system in which maintenance
is not given attention may easily lead to the system
producing defective product as a result of machine
defect

Maintenance and Replacement life

Organizations providing goods/services use several facilities like equipment and machinery which
are directly required in their operations. In addition to these facilities, there are several other items which
are necessary to facilitate the functioning of organizations.
 All such facilities should be continuously monitored for
their efficient functioning; otherwise, the quality of service
will be poor. Besides the quality of service of the facilities,
the cost of their operation and maintenance would increase
with the passage of time

Hence, it is an absolute necessity to maintain the

equipment in good operating conditions with economical
cost. Thus, we need an integrated approach to minimize the
cost of maintenance. In certain cases, the equipment will
be obsolete over a period of time

If a firm wants to be in the same business competitively, it

has to take decision on whether to replace the old
equipment or to retain it by taking the cost of maintenance
and operation into account. There are two basic reasons for
considering the replacement of an equipment physical
impairment of the various parts or obsolescence of the
equipment.
Physical impairment refers only to changes in the physical
condition of the machine itself. This would lead to a
decline in the value of the service rendered, increased
operating cost, increased maintenance cost or a
combination of these. Obsolescence is due to improvement
of the tools of production, mainly improvement in technology.
So, it would be uneconomical to continue production with the same machine under any of the above
situations. Hence, the machines are to be periodically replaced. Sometimes, the capacity of existing facilities
may be inadequate to meet the current demand. Under such situation, the following alternatives will be
considered.

 Replacement of the existing equipment with a new one.

 Augmenting the existing one with an additional equipment.

Types of Maintenance
Maintenance activity can be classified into two types:

 Preventive maintenance and

 Breakdown maintenance.

Preventive maintenance (PM) is the periodical inspection and service activities which are aimed to detect
potential failures and perform minor adjustments or repairs which will prevent major operating problems
in future.
Breakdown maintenance is the repair which is generally done after the equipment has attained down
state. It is often of an emergency nature which will have associated penalty in terms of expediting cost of
maintenance and down time cost of equipment.
In breakdown maintenance, no maintenance or repair work is done until a component or equipment
fails or it cannot perform its normal performance. It is established that the maintenance work is called upon
when the machine is not working and repairs are required to bring back the equipment to its original
working condition. If the system is alone followed, it will lead to poor operational availability of the
equipment, as spare parts may not be readily available. Breakdown maintenance describes the process flow
which occurs when maintenance tasks are executed that usually precede a malfunction at technical object.
Preventive maintenance will reduce such cost up to a point. Beyond that point, the cost of preventive
maintenance will be more when compared to the breakdown maintenance cost.
the planned maintenance is described as an organized type of maintenance. In this category of maintenance,
the maintenance actions are planned well in advance in order to evade accidental failure. It will be pre-set
not only the when and what kind of the maintenance work, but also by whom it would be undertaken. The
requirements for planned maintenance include conduction of work-study that decides the periodicity of
maintenance work. Additionally, the conduction of Time Study assists in recommending ways and means
of planning optimal maintenance schedules for the given system. In planned maintenance, instructions is
given in detail and specific for each type of equipment.
In the case, where safety is of utmost importance, the equipment condition should be checked every
day. Therefore, the type of maintenance activity to be performed will depend upon the nature of equipment
and its working conditions.
The total cost, which is the sum of the preventive
maintenance cost and the breakdown maintenance
cost, will go on decreasing with an increase in the
level of maintenance up to a point.
Beyond that point, the total cost will start increasing.
The level of maintenance corresponding to the
minimum total cost is the optimal level of
maintenance. The concepts are demonstrated in
adjacent diagram.
The planned maintenance is classified into following
types:
1. Scheduled Maintenance (SM)
2. Preventive Maintenance (PM)
3. Corrective Maintenance (CM)
4. Reliability Centred Maintenance (RCM)

Scheduled Maintenance
This type of maintenance activity is a stitch-in-time procedure to avoid break-downs. The actual
maintenance program is planned in discussion with the production department, so that the appropriate
equipment is made available for maintenance work.
Preventive Maintenance
It is also important category of planned maintenance. Preventive maintenance is planned and
coordinated inspections, repairs, adjustments, and replacements which are carried out to minimize the
problems of breakdown maintenance. Preventive maintenance is a basic maintenance system which is
commonly applied in manufacturing environment in order to facilitate the production flow as well as
enhancing the equipment productivity

Corrective Maintenance
Corrective maintenance is used in repetitive failures of a certain part of the equipment. When such
repetitive type of failures are observed, corrective maintenance can be applied in order to avoid
reoccurrence of such failures. Corrective maintenance is explained as a dominant approach where
equipment is allowed to run without interruptions and maintenance activities are conducted only when
equipment fails
Reliability Centred Maintenance
This type of maintenance is used to recognise the maintenance requirements of equipment. The
Reliability Centred Maintenance establishes the functional requirements and the desired performances
standards of equipment and these are then related to design and integral reliability parameters of the
machine.
Challenges faced by organization in maintaining equipment:
The maintenance function of contemporary industry faces numerous challenges which include:
1. Rapid growth of technology resulting in current technology becoming obsolete. Such a challenge is a
frequent one in Information and Communications Technology industry where computers and
computers based system (hardware and Software) are the main components.
2. Initiation of new advanced diagnostic tools, rapid repair systems.
3. Advance store management methods to integrate modular technologies.
4. Requirements of retaining both out-of-date and modern machines in service.
Replacement Problem
The replacement problems are associated with the issues that develops when the performance of an
item decreases, failure or breakdown occurs. The decline in performance or breakdown may be gradual or
sometimes sudden. There is a need for replacement of items when;
 The existing item or system has become inefficient or require more maintenance.
 The existing equipment has failed due to accident or otherwise and does not work at all.
 The existing equipment is expected to fail shortly.
 The existing equipment has become obsolete due to the availability of equipment with latest technology
and better design. The solution to replacement problem is to device best policy that determines the time
at which the replacement is most economical instead of continuing at an increased maintenance cost.
Types of Replacement Problem
Replacement study can be classified into two categories:
(a) Replacement of assets that deteriorate with time (Replacement due to gradual failure, or wear and tear
of the components of the machines).
This can be further classified into the following types:
i. Determination of economic life of an asset.
ii. Replacement of an existing asset with a new asset.
(b) Simple probabilistic model for assets, which fail completely (replacement due to sudden failure).
There are numerous reasons for equipment replacement. The first reason is the equipment is depleted of
function. Second reason for replacing equipment is if the equipment becomes obsolete.
 For example, older computers are much slower and have fewer features than their modern counterparts. In
addition, older computers are harder to maintain because replacement parts and qualified technicians are
much harder to find. Another reason for replacement is deterioration due to aging. Equipment is inadequate
and does not meet needs, increased demand. Then it is replaced with a larger asset.
There are many types of failure in equipment:
i. Gradual Failure: In this, the failure mechanism is progressive. As an equipment becomes old, its
performance deteriorates. This results in increased operating cost, decreased productivity of the item
and decrease in resale value of item.
ii. Sudden Failure: This type of failure occurs in equipment that do not deteriorate gradually with age
but which fail suddenly after some period of service. The time period between installations and failure
will not be constant for any particular equipment. However the failure pattern will follow certain
frequency distribution that may be progressive, retrogressive or random in nature.
iii. Progressive failure: progressive failure occurs when probability of failure increases with the age of
an item.
iv. Retrogressive failure: Certain items will have more probability of failure in the early years of their
life and with the increase in the life of an item the chances of failure become less. That is, the ability
of the item to survive in the initial years of life increases its expected life.
v. Random failure: Random failure occurs when continuous probability of failure is related with
equipment that fails because of random causes such as physical shocks that are independent of age.
In the case of random failure, virtually all items fail before aging has any effect.
Installation and running cost of services
A business budget helps entrepreneurs determine how much money they need to start and operate
from the day they decide they want a business, to the day the business begins to generate a profit. A budget
also helps determine how many sales a business needs to make before it breaks even and begins operating
at a profit. Aspiring entrepreneurs, no matter the industry or size of the business, create business budgets
based on start-up and operating, or running, costs.
 Rent and Facilities
Renting, leasing or purchasing a space to conduct your business is an ongoing expense that you pay
monthly, quarterly or annually, depending on the arrangements you make. Businesses who operate inside
of shopping malls, office buildings and even local shops on main streets in their towns, incur this expense.
 Utilities and Other Operating Costs
Water, electricity and heat are running utility costs that business owners incur regardless of how
many sales they bring into the business for the month or quarter. These are necessary expenses that affect
whether the business is operable and ready to serve customers on a day-to-day basis. Even as a home-based
business owner, these expenses exist as operating costs.
 Salaries and Labor Costs
Whether full-time or part-time, the individuals who work as employees or contractors for your
business are paid a salary or hourly rate for the work they do. These salaries are a part of the operating
costs your business has to pay for, depending on the pay schedule you have in place for your business.
 Supplies and Equipment
Supplies and equipment are necessary expenses for both small and large businesses in any industry.
While the cost of supplies and equipment vary, the fact remains that this start-up cost has a great impact
on the quality of the services and products you offer your customers. Faulty equipment and a lack of
supplies can damage your brand's reputation with its existing and potential customers.
 Equipment Repair and Maintenance
Equipment you use to perform services and create products for your customers may show signs of
normal wear and tear as time goes on, and your business develops. Equipment maintenance fees may cover
periodic updates to your equipment, or may include any money paid toward insurance or warranty
coverage.
 Costs of Legal Compliance
There are some start-up costs a small business cannot avoid before it begins offering services.
Registering your business as a legal entity with the taxing authority in your area is a one-time fee that's a
part of your business start-up costs. Additional licenses, such as health or professional permits may also be
annual expenses and attorney and accountant services may be needed to set up business structure and
business books.
 Marketing and Promotion
While businesses incur monthly marketing and promotion expenses, there are some that are
considered start-up costs, rather than operating costs. Paying a graphic designer to create a website and
business card template are start-up costs, as there's a one-time fee in exchange for a product or service.
Signs you order for your store, venue or business vehicle also count as start-up costs, as are pre-opening
ads and grand opening offers to attract clientele to the new business.
Operating costs are expenses associated with the maintenance and administration of a business on a
day-to-day basis. The total operating cost for a company includes the cost of goods sold, operating expenses
as well as overhead expenses. The operating cost is deducted from revenue to arrive at operating income
and is reflected on a company’s income statement.
Formula and Calculation for Operating Cost
Use the following formula to calculate the operating cost of a business. One can find this information
from the firm's income statement that is used to report the financial performance for the accounting period.
Operating cost = Cost of goods sold + Operating expenses
From a company's income statement take the total cost of goods sold, which can also be called cost
of sales.
Find total operating expenses, which should be farther down the income statement.
Add total operating expenses and cost of goods sold or COGS to arrive at the total operating costs for the
period.
Operating Costs Components
While operating costs generally do not include capital outlays, they can include many components of
operating expenses including:
 Accounting and legal fees
 Bank charges
 Sales and marketing costs
 Travel expenses
 Entertainment costs
 Non-capitalized research and development expenses
 Office supply costs
 Rent
 Repair and maintenance costs
 Utility expenses
  Salary and wage expenses
Operating costs can include the cost of goods sold, which are the expenses directly tied to the production
of goods and services. Some of the costs include:
 Direct material costs
 Direct labor
 Rent of the plant or production facility
 Benefits and wages for the production workers
 Repair costs of equipment
 Utility costs and taxes of the production facilities
Capital Investment Projects:
Capital investment projects are those business projects that would give the company returns for more than
a year in future. Decisions regarding planning for different investment projects, collection of funds, and
distribution of the money over different projects are called capital budgeting or capital investment
decisions.

Capital investment is a sum of money provided to a

company to further its business objectives. The term also
can refer to a company's acquisition of long-term assets
such as real estate, manufacturing plants, and machinery.
Capital investment is having enough cash, loans or
assets to fund a company's operations. Banks, investors,
financial institutions, angel investors and venture
capitalists are all sources of capital investment.
Establishment of new factories, purchase of machines,
means of transport or computers—all these may be the
objects of capital investment projects. Expenditures for research and development or those on
advertisement programmes may also be called investment expenditures, if, however, returns are to be
obtained from these expenditures for more than a year.
Classification of Investment Projects:
(i) Investment planning for reduction in expenditures—for example, planning for the training of the
employees.
(ii) Investment projects for increasing production—for example, planning for installation of new plants
or for expansion of the existing plant.
(iii) Planning for expansion through innovations of new products and/or new markets.
(iv) Planning for compliance with government regulations in respect of security, environment, etc.

Importance and Use of Capital Budgeting:

From the definition of capital budgeting or capital investment decisions, it can be easily understood
that the importance and usefulness of capital budgeting to a modern business firm cannot be overestimated.
The main reasons for this are:
(i) Usually, a huge sum of money is involved in each investment decision and, in general, the decisions are
irreversible. That is why in the event of a correct decision, the firm can earn profit for a long period, but if,
on the other hand, the decision proves to be wrong, it would have to suffer losses for a long time. That is,
every investment decision has a long-term significance.
(ii) If the firm wants to undertake an investment project, then generally, it would have to borrow money to
bear the cost of that investment. On the other hand, the firm has to get over the uncertainties of the business
world to make that investment profitable. Efficient capital budgeting is one of the main instruments which
can ensure the profitability of the project.
(iii) It is clear from the above discussion that every investment decision of the firm in-creases the risk-
bearing of the firm. Because of this also, the firm has to minimise the risk- bearing with help of a systematic
capital budgeting.
The Goal of Capital Investment:
The firm intends to increase and maximise its value. By the value of the firm, we mean the present value
of the net profit that the firm expects to earn in different periods in future

Cost Analysis:

Total costs should be provided for each element and sub-elements as appropriate. Costs should be shown
separately where required in the elemental definitions and for different forms of construction.

Cost planning
Cost planning is a management process that seeks to control design development in line with the client’s
budget. It does this by helping the client decide how it wants to allocate the budget to the various parts of
the project.
The objectives of cost planning are:
a. To ensure the client obtains an economical and efficient design in accordance with the agreed brief and
budget
b. To make the design process more efficient, thus reducing the time needed to produce a successful design
c. To ensure that everything within the client’s brief is included in the cost planning process
Advantages of Cost Planning
• To find out cost
• To keep within budget
• Close gap between budget estimate and Contractor’s tender
• Efficient design process
• Value for money
• Helping the client decide how it wants to allocate the budget to the various parts of the project.

Cost planning covers:

1. Establishing the budget
2. Cost modelling ahead of any design
3. Establishing a cost plan, i.e. distributing the budget over the functional elements of the project
4. Benchmarking
5. Obtaining sign-off by the client and the project team
6. Cost checking design development against the cost plan
7. Value engineering the design to meet the cost plan
8. Re-assessing the cost plan at key design stages

The Cost Planning Process

The cost planning process consists essentially of three phases:
a. The first of these involves the establishment of a realistic first estimate (Preliminary Approximate
Estimate)
b. The second stage plans how this estimate should be spent among the various parts or elements of the
project (Cost Plan)
c. The final stage is a checking process to ensure that the actual design details for the various elements can
be constructed within the cost plan (Cost Checking)
The cost planning process commences with the preparation of an approximate estimate by the quantity
surveyor, and then the setting of cost targets, which are based upon elements. As the design evolves these
cost targets are checked for any under-or-overspending against the architect’s details. The prudent quantity
surveyor will also always be looking for ways of simplifying the details, without altering the design, in an
attempt to reduce the tender sum.
Cost planning over the last decade is increasingly becoming a valuable service that the client is expecting
from the quantity surveyor, to ensure that he receives better value-for-money, expenditure is controlled, and
that the project cost is kept within the agreed budget. To undertake this service effectively it is necessary
for the quantity surveyor to be appointed at the earliest possible stage, in order to make positive contribution
at the brief and feasibility stages. It attempts to keep the designer fully informed of all the cost implication
of the design.

Cost control during design and Construction

 A development budget study is undertaken to determine the
total costs and returns expected from the project. A cost plan is prepared
to include all construction costs, all other items of project cost including
professional fees and contingency.
All costs included in the cost plan will also be included in the
development budget in addition to the developer’s returns and other
extraneous items such as project insurance, surveys and agent’s or other
specialist advisers’ fees.
The objective of cost control is to manage the delivery of the project within the approved budget. Regular
cost reporting will facilitate, at all times, the best possible estimate of:

 Established project cost to date.

 Anticipated final cost of the project.
 Future cash flow.
In addition, cost reporting may include assessments of:

 Ongoing risks to costs.

 Costs in the use of the completed facility.
 Potential savings.
Monitoring expenditure to any particular date does not exert any control over future expenditure and,
therefore, the final cost of the project. Effective cost control is achieved when the whole of the project team
adopts the correct attitude to cost.
Effective cost control will require the following actions to be taken:

1. Establishing that all decisions taken during design and construction are based on a forecast of the cost
implications of the alternatives being considered, and that no decisions are taken whose cost implications
would cause the total budget to be exceeded.
2. Encouraging the project team to design within the cost plan at all stages and follow the variation/change
and design development control procedures for the project. It is generally acknowledged that 80% of cost
is determined by design and 20% by construction. It is important that the project team is aware that no
member of the team has the authority to increase costs on its section or element of the work. Increased
costs on one item must always be balanced by savings on another.
3. Regularly updating and reissuing the cost plan and variation orders causing any alterations to the brief.
4. Adjusting the cash flow plan to reflect alterations in the target cost, the master schedule or the forecast
of inflation.
5. Developing the cost plan in liaison with the project team as design and construction progress. At all times
it should comprise the best possible estimate of the final cost of the project and of the future cash flow.
6. Reviewing contingency and risk allowances at intervals and reporting the assessments is an essential part
of risk management procedures. Developing the cost plan should not involve increasing the total cost.
7. Checking that the agreed change management process is strictly followed at all stages of the project. The
procedure should only be carried out retrospectively, and then only during the construction phase of the
project, when it can be demonstrated that otherwise significant delay, cost or danger would have been
incurred by awaiting responses.
8. Arranging for the contractor to be given the correct information at the correct time in order to minimise
claims. Any anticipated or expected claims should be reported to the client and included in the regular
cost reports.
9. Contingency provisions are based on a thorough evaluation of the risks and are available to pay for events
which are unforeseen and unforeseeable. It should not be used to cover; changes in the specification,
changes in the client’s requirements or variations resulting from errors or omissions. Should the
consultants consider that there is no alternative but to exceed the budget, a written request must be
submitted to the client and the correct authorisation received.

This must include the following:

1. Details of variations leading to the request.
2. Confirmation that the variations are essential.
3. Confirmation that compensating savings are not possible without having an unacceptable effect on the
quality or function of the completed project.
4. Submitting regular, up-to-date and accurate cost reports to keep the client well informed of the current
budgetary and cost situation.
5. Ensuring that all parties are clear about the meaning of each entry in the cost report. No data should be
incorrectly entered into the budget report or any incorrect deductions made from it.
6. Ensuring that the project costs are always reported back against the original approved budget. Any
subsequent variations to the budget must be clearly indicated in the cost reports.
7. Plotting actual expenditure against predicted to give an indication of the project’s progress.

Depreciation
In accounting terms, depreciation is defined as the reduction of recorded cost of a fixed asset in a systematic
manner until the value of the asset becomes zero or negligible.
An example of fixed assets are buildings, furniture, office equipment,
machinery etc. A land is the only exception which cannot be
depreciated as the value of land appreciates with time.
Depreciation allows a portion of the cost of a fixed asset to the
revenue generated by the fixed asset. This is mandatory under the
matching principle as revenues are recorded with their associated
expenses in the accounting period when the asset is in use. This helps
in getting a complete picture of the revenue generation transaction.
An example of Depreciation – If a delivery truck is purchased a
company with a cost of Rs. 100,000 and the expected usage of the
truck are 5 years, the business might depreciate the asset under
depreciation expense as Rs. 20,000 every year for a period of 5 years.

How to calculate depreciation in small business?

When a company buys an expensive fixed asset -- such as costly software, new computers, or manufacturing
equipment -- the asset will depreciate (i.e. wear down or become obsolete) over time. Rather than record
one large expense in the first year, company accountants will typically depreciate the asset and spread out
its expense over several years.
While there are many methods to calculate depreciation , the most basic is the "straight line" method. Under
the straight line method, the depreciation of a given asset is evenly divided over its useful lifetime.
There three methods commonly used to calculate depreciation. They are:
1. Straight line method
2. Unit of production method
3. Double-declining balance method

Three main inputs are required to calculate depreciation:

1. Useful life – this is the time period over which the organisation considers the fixed asset to be
productive. Beyond its useful life, the fixed asset is no longer cost-effective to continue the operation
of the asset.
2. Salvage value – Post the useful life of the fixed asset, the company may consider selling it at a
reduced amount. This is known as the salvage value of the asset.
3. The cost of the asset – this includes taxes, shipping, and preparation/setup expenses.

Why should small businesses care to record depreciation?

As we already know the purpose of depreciation is to match the cost of the fixed asset over its productive
life to the revenues the business earns from the asset. It is very difficult to directly link the cost of the asset
to revenues, hence, the cost is usually assigned to the number of years the asset is productive.
Over the useful life of the fixed asset, the cost is moved from balance sheet to income statement.
Alternatively, it is just an allocation process as per matching principle instead of a technique which
determines the fair market value of the fixed asset.
 Some of the methods of project appraisal are as follows
1. Economic Analysis:
Under economic analysis, the project aspects highlighted include requirements for raw material, level of
capacity utilization, anticipated sales, anticipated expenses and the probable profits. It is said that a business
should have always a volume of profit clearly in view which will govern other economic variables like sales,
purchases, expenses and alike.
It will have to be calculated how much sales would be necessary to earn the targeted profit. Undoubtedly,
demand for the product will be estimated for anticipating sales volume. Therefore, demand for the product
needs to be carefully spelled out as it is, to a great extent, deciding factor of feasibility of the project concern.

2. Financial Analysis:
Finance is one of the most important pre-requisites to establish an enterprise. It is finance only that facilitates
an entrepreneur to bring together the labour of one, machine of another and raw material of yet another to
combine them to produce goods.
In order to adjudge the financial viability of the project, the following aspects need to be carefully analysed:
I. Assessment of the financial requirements both – fixed capital and working capital need to be properly
made. One might be knowing that fixed capital normally called ‘fixed assets’ are those tangible and
material facilities which purchased once are used again and again. Land and buildings, plants and
machinery, and equipment’s are the familiar examples of fixed assets/fixed capital
II. In accounting, working capital means excess of current assets over current liabilities. Generally, 2: 1 is
considered as the optimum current ratio. Current assets refer to those assets which can be converted into
cash within a period of one week. Current liabilities refer to those obligations which can be payable within
a period of one week.

3. Market Analysis:
Before the production actually starts, the entrepreneur needs to anticipate the possible market for the
product. He/she has to anticipate who will be the possible customers for his product and where and when
his product will be sold. There is a trite saying in this regard: “The manufacturer of an iron nails must know
who will buy his iron nails.” This is because production has no value for the producer unless it is sold. It is
said that if the proof of pudding lies in eating, the proof of all production lies in marketing/ consumption.
In fact, the potential of the market constitutes the determinant of probable rewards from entrepreneurial
career.
The commonly used methods to estimate the demand for a product are as follows:

I. Opinion Polling Method:

In this method, the opinions of the ultimate users, i.e. customers of the product are estimated. This may be
attempted with the help of either a complete survey of all customers (called, complete enumeration) or by
selecting a few consuming units out of the relevant population (called, sample survey).
(a) Complete Enumeration Survey:
(b) Sample Survey:
(c) Sales Experience Method:
 (d) Vicarious Method:

II. Life Cycle Segmentation Analysis:

It is well established that like a man, every product has its own life span. In practice, a product sells slowly
in the beginning. Backed by sales promotion strategies over period, its sales pick up. In the due course of
time, the peak sale is reached. After that point, the sales begin to decline. After, some time, the product loses
its demand and dies. This is natural death of a product. Thus, every product passes through its ‘life cycle’.
This is precisely the reason why firms go for new products one after another to keep themselves alive.
Based on above, the product life cycle has been divided into the following five stages:
i. Introduction
ii. Growth
iii. Maturity
iv. Saturation
v. Decline

4. Technical Feasibility:
While making project appraisal, the technical feasibility of the project also needs to be taken into
consideration. In the simplest sense, technical feasibility implies to mean the adequacy of the proposed plant
and equipment to produce the product within the prescribed norms. As regards know-how, it denotes the
availability or otherwise of a fund of knowledge to run the proposed plants and machinery.
It should be ensured whether that know-how is available with the entrepreneur or is to be procured from
elsewhere. In the latter case, arrangement made to procure it should be clearly checked up. If project requires
any collaboration, then, the terms and conditions of the collaboration should also be spelt out
comprehensively and carefully.
While assessing the technical feasibility of the project, the following inputs covered in the project should
also be taken into consideration:
(i) Availability of land and site.
(ii) Availability of other inputs like water, power, transport, communication facilities.
(iii) Availability of servicing facilities like machine shops, electric repair shop, etc.
(iv) Coping-with anti-pollution law.
(v) Availability of work force as per required skill and arrangements proposed for training-in-plant and
outside.
(vi) Availability of required raw material as per quantity and quality.

5. Management Competence:
Management ability or competence plays an important role in making an enterprise a success or otherwise.
Strictly speaking, in the absence of managerial competence, the projects which are otherwise feasible may
fail.
On the contrary, even a poor project may become a successful one with good managerial ability. Hence,
while doing project appraisal, the managerial competence or talent of the promoter should be taken into
consideration.

What is a Break-Even Analysis?

A break-even analysis is a financial tool which helps you to
determine at what stage your company, or a new service or a
product, will be profitable. In other words, it’s a financial
calculation for determining the number of products or services
a company should sell to cover its costs (particularly fixed
costs). Break-even is a situation where you are neither making
money nor losing money, but all your costs have been covered.
Break-even analysis is useful in studying the relation between
the variable cost, fixed cost and revenue. Generally, a company
with low fixed costs will have a low break-even point of sale.
For an example, a company has a fixed cost of Rs.0 (zero) will automatically have broken even upon the
first sale of its product.

Components of Break Even Analysis

Fixed costs
Fixed costs are also called as the overhead cost. These overhead costs occur after the decision to start an
economic activity is taken and these costs are directly related to the level of production, but not the quantity
of production. Fixed costs include (but are not limited to) interest, taxes, salaries, rent, depreciation costs,
labour costs, energy costs etc. These costs are fixed no matter how much you sell.
Variable costs
Variable costs are costs that will increase or decrease in direct relation to the production volume. These cost
include cost of raw material, packaging cost, fuel and other costs that are directly related to the production.

Calculation of Break-Even Analysis

For an example:
Variable costs per unit: Rs. 400
Sale price per unit: Rs. 600
Desired profits: Rs. 4,00,000
Total fixed costs: Rs. 10,00,000
First we need to calculate the break-even point per unit,
so we will divide the Rs.10,00,000 of fixed costs by the Rs. 200 which is the contribution per unit (Rs. 600
– Rs. 200).
Break Even Point = Rs. 10,00,000/ Rs. 200 = 5000 units
Next, this number of units can be shown in rupees by multiplying the 5,000 units with the selling price of
Rs. 600 per unit.
We get Break Even Sales at 5000 units x Rs. 600 = Rs. 30,00,000. (Break-even point in rupees)

When is Break even analysis used?

Starting a new business: If you wish to start a new business, a break-even analysis is a must. Not only it
helps you in deciding, whether the idea of starting a new is viable, but it will force you to be realistic about
the costs, as well as guide you about the pricing strategy.
Creating a new product: In the case of an existing business, you should still do a break-even analysis
before launching a new product—particularly if such a product is going to add a significant expenditure.
Changing the business model: If you are about to the change your business model, like, switching from
wholesale business to retail business, you should do a break-even analysis. The costs could change
considerably and this will help you to figure out the selling prices need to change too.

Breakeven analysis is useful for the following reasons:

 It helps to determine remaining/unused capacity of the concern once the breakeven is reached. This
will help to show the maximum profit on a particular product/service that can be generated.
 It helps to determine the impact on profit on changing to automation from manual (a fixed cost
replaces a variable cost).
  It helps to determine the change in profits if the price of a product is altered.
 It helps to determine the amount of losses that could be sustained if there is a sales downturn.
Additionally, break-even analysis is very useful for knowing the overall ability of a business to generate a
profit. In the case of a company whose breakeven point is near to the maximum sales level, this signifies
that it is nearly impractical for the business to earn a profit even under the best of circumstances.
Therefore, it’s the management responsibility to monitor the breakeven point constantly. This monitoring
certainly reduces the breakeven point whenever possible.

Ways to monitor Breakeven point

 Pricing analysis: Minimize or eliminate the use of coupons or other price reductions offers, since
such promotional strategies increase the breakeven point.
 Technology analysis: Implementing any technology that can enhance the business efficiency, thus
increasing capacity with no extra cost.
 Cost analysis: Reviewing all fixed costs constantly to verify if any can be eliminated can surely help.
Also, review the total variable costs to see if they can be eliminated. This analysis will increase the
margin and reduce the breakeven point.
 Margin analysis: Push sales of the highest-margin (high contribution earning) items and pay close
attention to product margins, thus reducing the breakeven point.
 Outsourcing: If an activity consists of a fixed cost, try to outsource such activity (whenever possible),
which reduces the breakeven point.

Benefits of Break-even analysis

 Catch missing expenses: When you’re thinking about a new business, it’s very much possible that
you may forget about few expenses. Therefore, if you do a break-even analysis you have to review
all your financial commitments to figure out your break-even point. This analysis certainly restricts
the number of surprises down the road.
 Set revenue targets: Once the break-even analysis is complete, you will get to know how much you
need to sell to be profitable. This will help you and your sales team to set more concrete sales goals.
 Make smarter decisions: Entrepreneurs often take decisions in relation to their business based on
emotion. Emotion is important i.e. how you feel, though it’s not enough. In order to be a successful
entrepreneur, your decisions should be based on facts.
 Fund your business: This analysis is a key component in any business plan. It’s generally a
requirement if you want outsiders to fund your business. In order to fund your business, you have to
prove that your plan is viable. Furthermore, if the analysis looks good, you will be comfortable
enough to take the burden of various ways of financing.
 Better Pricing: Finding the break-even point will help in pricing the products better. This tool is
highly used for providing the best price of a product that can fetch maximum profit without
increasing the existing price.
 Cover fixed costs: Doing a break-even analysis helps in covering all fixed cost.
Cash Flow Analysis
The statement of cash flow shows how a company
spends its money (cash outflows) and from where a
company receives its money (cash inflows). The cash
flow statement includes all cash inflows a company
receives from its ongoing operations and external
investment sources, as well as all cash outflows that
pay for business activities and investments during a
given quarter.

Cash Flow Analysis is the evaluation of a company’s

cash inflows and outflows from operations, financing activities, and investing activities. In other words,
this is an examination of how the company is generating its money, where it is coming from, and what it
means about the value of the overall company.

What Does Cash Flow Analysis Mean?

A cash flow statement is a listing of cash flows that occurred during the past accounting period. A
projection of future flows of cash is called a cash flow budget. You can think of a cash flow budget as a
projection of the future deposits and withdrawals to your checking account.

A cash flow statement is not only concerned with the amount of the cash flows but also the timing of the
flows. Many cash flows are constructed with multiple time periods. For example, it may list monthly cash
inflows and outflows over a year’s time. It not only projects the cash balance remaining at the end of the
year but also the cash balance for each month

Working capital is an important part of a cash flow analysis. It is defined as the amount of money needed
to facilitate business operations and transactions, and is calculated as current assets (cash or near cash
assets) less current liabilities (liabilities due during the upcoming accounting period). Computing the
amount of working capital gives a quick analysis of the liquidity of the business over the future accounting
period. If working capital appears to be sufficient, developing a cash flow budget may not be critical. But
if working capital appears to be insufficient, a cash flow budget may highlight liquidity problems that may
occur during the coming year

Cash Flow Statement Components

The cash flow statement components provide a detailed view of cash flow from operations, investing, and
financing:
Cash Flow from Operating
Activities
The net amount of cash coming in or
leaving from the day to day business
operations of an entity is called
Cash Flow From Operations.
Basically it is the operating income
plus non-cash items such as
depreciation added. Since
accounting profits are reduced by
non-cash items (i.e. depreciation
and amortization) they must be
added back to accounting profits to
calculate cash flow.
Cash flow from operations is an
important measurement because it
tells the analyst about the viability Cash Flow Analysis Format
of an entities current business plan and
operations. In the long run, cash flow from operations must be cash inflows in order for an entity to be
solvent and provide for the normal outflows from investing and finance activities.
Before you start thinking about cash flow statement analysis, have a look at the income statement first.
Now start with net income.
 You need to add back non-cash expenses like depreciation, amortization, etc. The reason behind
adding back non-cash expenses is they are not actually expensed in cash (but in the record).
 This is the same with any sort of sale of assets. If there is any loss on the sale of assets, we need to
add back and if there is any gain on sale of assets, we need to deduct.
  And then we need to take into account any changes in non-current assets.
 Finally, we need to include changes in current assets and in current liabilities

Cash Flow From Investing Activities

Cash flow from investing activities would include the outflow of cash for long term assets such as land,
buildings, equipment, etc., and the inflows from the sale of assets, businesses, securities, etc. Most cash
flow investing activities are cash out flows because most entities make long term investments for operations
and future growth.
 First, we need to add back losses (if any) while selling any long term assets or marketable securities.
These losses should be added back as there is no cash outflow for the losses.
 Second, we need to deduct profits (if any) while selling any long term assets or marketable
securities. These profits should be deducted because there is no cash inflow for the profits the
company has made.

Cash Flow From Finance Activities

Cash flow from finance activities is the cash out flow to the entities investors (i.e. interest to bondholders)
and shareholders (i.e. dividends and stock buybacks) and cash inflows from sales of bonds or issuance of
stock equity. Most cash flow finance activities are cash outflows since most entities only issue bonds and
stocks occasionally.
 First, if there is any buying back or issuing stocks, it will come under financing activities in cash
flow analysis.
 Borrowing and repaying loans on a short term or long term issuing notes and bonds etc.) will also
be included under financing activities.
 We also need to include dividend paid (if any). However, we need to make sure that we don’t
include accounts payable or accrued liabilities (because they would be taken into account in net
cash flow from operating activities).

What Is Risk Analysis?

Risk Analysis is a process that helps you identify and manage potential problems that could undermine key
business initiatives or projects.
To carry out a Risk Analysis, you must first identify the possible threats that you face, and then estimate
the likelihood that these threats will materialize.
Risk Analysis can be complex, as you'll need to draw on detailed information such as project plans,
financial data, security protocols, marketing forecasts, and other relevant information. However, it's an
essential planning tool, and one that could save time, money, and reputations.

When to Use Risk Analysis

Risk analysis is useful in many situations:
 When you're planning projects, to help you anticipate and neutralize possible problems.
 When you're deciding whether or not to move forward with a project.
 When you're improving safety and managing potential risks in the workplace.
 When you're preparing for events such as equipment or technology failure, theft, staff sickness, or
natural disasters.
  When you're planning for changes in your environment, such as new competitors coming into the
market, or changes to government policy.

To carry out a risk analysis, follow these steps:

1. Identify Threats

The first step in Risk Analysis is to identify the existing and possible threats that you might face. These can
come from many different sources. For instance, they could be:

 Human – Illness, death, injury, or other loss of a key individual.

 Operational – Disruption to supplies and operations, loss of access to essential assets, or failures in
distribution.
 Reputational – Loss of customer or employee confidence, or damage to market reputation.
 Procedural – Failures of accountability, internal systems, or controls, or from fraud.
 Project – Going over budget, taking too long on key tasks, or experiencing issues with product or
service quality.
 Financial – Business failure, stock market fluctuations, interest rate changes, or non-availability of
funding.
 Technical – Advances in technology, or from technical failure.
 Natural – Weather, natural disasters, or disease.
 Political – Changes in tax, public opinion, government policy, or foreign influence.
 Structural – Dangerous chemicals, poor lighting, falling boxes, or any situation where staff, products,
or technology can be harmed.

You can use a number of different approaches to carry out a thorough analysis:

 Run through a list such as the one above to see if any of these threats are relevant.
 Think about the systems, processes, or structures that you use, and analyze risks to any part of these.
What vulnerabilities can you spot within them?
 Ask others who might have different perspectives. If you're leading a team, ask for input from your
people, and consult others in your organization, or those who have run similar projects.

2. Estimate Risk
Once you've identified the threats you're facing, you need to calculate out both the likelihood of these threats
being realized, and their possible impact.

One way of doing this is to make your best estimate of the probability of the event occurring, and then to
multiply this by the amount it will cost you to set things right if it happens. This gives you a value for the
risk:

Risk Value = Probability of Event x Cost of Event

As a simple example, imagine that you've identified a risk that your rent may increase substantially.
You think that there's an 80 percent chance of this happening within the next year, because your landlord
has recently increased rents for other businesses. If this happens, it will cost your business an extra $500,000
over the next year.

So the risk value of the rent increase is:

0.80 (Probability of Event) x $500,000 (Cost of Event) = $400,000 (Risk Value)

How to Manage Risk

Risk management is the decision-making process involving considerations of political, social, economic
and engineering factors with relevant risk assessments relating to a potential hazard so as to develop,
analyze and compare regulatory options and to select the optimal regulatory response for safety from that
hazard.

Project risk management is about identifying new risks or changes in the threat level of existing business
processes. The challenge for project managers is how to get teams, functional areas, business processes,
systems, and vendors aligned to new goals

Steps of risk management are

1. Establish the context,
2. Identification,
3. Assessment,
4. Potential risk treatments,
5. Create the plan,
6. Implementation,
7. Review and evaluation of the
plan.

The risk management system has

seven(7) steps which are actually
is a cycle.

Steps of risk management process

1. Establish the Context

Establishing the context includes planning the remainder of the process and mapping out the scope of the
exercise, the identity and objectives of stakeholders, the basis upon which risks will be evaluated and
defining a framework for the process, and agenda for identification and analysis.
2. Identification

After establishing the context, the next step in the process of managing risk is to identify potential risks.
Risks are about events that, when triggered, will cause problems. Hence, risk identification can start with
the source of problems, or with the problem itself.

Risk identification requires knowledge of the organization, the market in which it operates, the legal, social,
economic, political, and climatic environment in which it does its business, its financial strengths and
weaknesses, its vulnerability to unplanned losses, the manufacturing processes, and the management
systems and business mechanism by which it operates.

Any failure at this stage to identify risk may cause a major loss for the organization.

Risk identification provides the foundation of risk management.

The identification methods are formed by templates or the development of templates for identifying source,
problem or event. The various methods of risk identification methods are.

3. Assessment

Once risks have been identified, they must then be assessed as to their potential severity of loss and to the
probability of occurrence.

These quantities can be either simple to measure, in the case of the value of a lost building, or impossible to
know for sure in the case of the probability of an unlikely event occurring. Therefore; In the assessment
process, it is critical to making the best-educated guesses possible in order to properly prioritize the
implementation of the risk management plan.

The fundamental difficulty in risk assessment is determining the rate of occurrence since statistical
information is not available on all kinds of past incidents. Furthermore; Evaluating the severity of the
consequences (impact) is often quite difficult for immaterial assets. Asset valuation is another question that
needs to be addressed. Thus, best educated opinions and available statistics are the primary sources of
information.

Nevertheless, a risk assessment should produce such information for the management of the organization
that the primary risks are easy to understand and that the risk management decisions may be prioritized.
Thus, there have been several theories and attempts to quantify risks.

Numerous different risk formula exists but perhaps the most widely accepted formula for risk quantification
is the rate of occurrence multiplied by the impact of the event.

4. Potential Risk Treatments

Once risks have been identified and assessed, all techniques to manage the risk fall into one or more of these
four major categories;

 Risk Transfer
 Risk Transfer means that the expected party transfers whole or part of the losses consequential o risk
exposure to another party for a cost. Insurance contracts fundamentally involve risk transfers.

Apart from the insurance device, there are certain other techniques by which the risk may be transferred.

 Risk Avoidance

Avoid the risk or the circumstances which may lead to losses in another way, Includes not performing an
activity that could carry risk.

Avoidance may seem the answer to all risks, but avoiding risks also means losing out on the potential gain
that accepting (retaining) the risk may have allowed. Not entering a business to avoid the risk of loss also
avoids the possibility of earning the profits.

 Risk Retention

Risk-retention implies that the losses arising due to a risk exposure shall be retained or assumed by the party
or the organization.

Risk-retention is generally a deliberate decision for business organizations inherited with the following
characteristics. Self-insurance and Captive insurance are the two methods of retention.

 Risk Control

Risk can be controlled either by avoidance or by controlling losses. Avoidance implies that either a certain
loss exposure is not acquired or an existing one is abandoned. Loss control can be exercised in two ways.

5. Create the Plan

Decide on the combination of methods to be used for each risk. Each risk management decision should be
recorded and approved by the appropriate level of management.

For example,

A risk (concerning the image of the organization should have a top management decision behind it whereas
IT management would have the authority to decide on computer virus risks.

The risk management plan should propose applicable and effective security controls for managing the risks.

A good risk management plan should contain a schedule for control implementation and responsible persons
for those actions.

The risk management concept is old but is still net very effectively measured.

Example: An observed high risk of computer viruses could be mitigated by acquiring and implementing
antivirus software.

6. Implementation
 Follow all of the planned methods for mitigating the effect of the risks.

Purchase insurance policies for the risks that have been decided to be transferred to an insurer, avoid all
risks that can be avoided without sacrificing the entity’s goals, reduce others, and retain the rest.

7. Review and Evaluation of the Plan

Initial risk management plans will never be perfect.

Practice, experience and actual loss results will necessitate changes in the plan and contribute information
to allow possible different decisions to be made in dealing with the risks being faced.

Risk analysis results and management plans should be updated periodically. There are two primary reasons
for this;

 To evaluate whether the previously selected security controls are still applicable and effective, and,
 To evaluate the possible risk level changes in the business environment. For example, information risks
are a good example of the rapidly changing business environment.

Role of Lender’s Engineer

The lender’s engineer (LE) is a representative of lending institutions such as banks and NBFCs. His function
is to audit a project from the technical standpoint when a developer seeks funding for it. This is a process
which risk/compliance teams have, over time, hard-wired into funding proposals by developers.

The obvious intention behind this requirement is to identify, mitigate and hedge the lending institution’s
risks with regards to the technical aspects of construction.

The key risks include:

 The developer’s potential inability to service the debt

 The potential use of the funds for purposes other than what they were allocated for
 Construction progress not keeping pace with disbursement

What To Look For In a Lender’s Engineer

 Ethics is the key quality. Innumerable areas in a construction project can remain invisible to the untrained
eye and can only be identified with technical involvement. These areas must not only be brought to light
but also brought to the notice of all stakeholders.
 A construction project has various components to success. The technical aspects range from geological
factors, architectural design aspects, civil construction and the use of the most efficient mechanical and
electrical equipment & services. The appointed LE must be able to understand these complexities and help
ensure that the project has the benefit of an optimal mix of architects, civil engineers and mechanical and
electrical engineers.
 A technical analysis is incomplete without use of technology. The LE must be proficient in the use of
technology to be able to ensure sound risk management and progress mapping.
 The LE must be able to translate technical information into inputs that are relevant to the financial
participants in the project – these could include payback period and factors that impact returns.

The primary scope of a LE includes providing expert insights on the availability and applicability of
statutory approvals for a project. The LE must have deep knowledge of statutory aspects and approvals, and
must utilize a system to review such approvals through predefined checklists.