ECONOMIC EVALUATION OF MINERAL PROPERTY

Evaluation of a Mine Development Alternative

Arranged by M.A

Year
————————————————————————————————————
1 2 3 4 5 6 7 8 9 10 Total

————————————————————————————————————

Revenue 8000 8000 8000 8000 8000 8000 8000 8000 64000
Operating cost 2650 2650 2650 2650 2650 2650 2650 2650 21200
————————————————————————————————————Net Income
5350 5350 5350 5350 5350 5350 5350 5350 42800
Depreciation Allowan 2900 2900 2900 2900 2900 14500
————————————————————————————————————
Tax able income 2450 2450 2450 2450 2450 5350 5350 5350 28300
Tax 40 % 980 980 980 980 980 2140 2140 2140 11320

Capital Costs 7700 7700 15400

Return of W.C 900 900

Cash Flow 7700 7700 4370 4370 4370 4370 4370 3210 3210 4110 16980

Find the ROR of the project with the graph?

Cash flow is the difference between benefits and costs for a specified time period. An annual period is
usually suitable for evaluation purpose.

If the annual benefits exceed the annual costs, the net benefit is referred to as a positive cash flow; if the
annual costs exceed the annual benefits, a negative cash flow results.

Benefit Elements: Sale Revenue

Salvage Value
Return of Working Capital

Cost Elements: Capital Expenditure

Operating Cost
Taxation Payment
Revenue = p x Q

Operating cost =

TC = Var. Cost + Fix. cost

Var. Cost = Tot. Cost – Fix. cost

BEP = Break Event Point

Tot. revenue

Tot. cost
BEP
Tot. revenue
Tot. cost
$ Fix. cost

Q (ton)

Profit = rev. - cost

Tot. Profit = tot rev. – tot.cost

Pada saat BEP = total revenue = total cost, profit = nol

 CF
Year Capital Revenue Operating Net Depreciation Taxable Tax 40 % Return of Cash PV= ——
Cost Cost Income Allowan Income Work. Cap Flow (1+i)n
———————————————————————————————————————————
1 7700 7700
2 7700 7700
3 8000 2650 5350 2900 2450 980 4370
4 8000 2650 5350 2900 2450 980 4370
5 8000 2650 5350 2900 2450 980 4370
6 8000 2650 5350 2900 2450 980 4370
7 8000 2650 5350 2900 2450 980 4370
8 8000 2650 5350 5350 2140 3210
9 8000 2650 5350 5350 2140 3210
10 8000 2650 5350 5350 2140 900 4110
———————————————————————————————————————————

NPV=Sum PV1-10

What is the payback period ?

No Cum CF
1 7700
2 7700 -15400
3 4370 -11030
4 4370 -6660
5 4370 -2290
6 4370 2080
7 4370 6450
8 3210 9660
9 3210 12870
10 4110 16980
Based of the Cum CF is 3 + 2290/4370 = 3.5 years

What is the NPV, i = 0 % NPV i = 10% ? NPV, i = 18% NPV, i = 19%

No PV, i = 0% PV, i = 10% PV, i = 18% PV, i = 19%

1 -7700 -7000 -6525.42 -6470.59
2 -7700 - 6363.64 -5530.02 -5437.47
3 4370 3283.246 2659.717 2593.227
4 4370 2984.769 2253.997 2179.182
5 4370 2713.426 1910.167 1831.246
6 4370 2466.751 1618.786 1538.862
7 4370 2242.501 1371.852 1293.161
8 3210 1497.489 853.9825 798.2324
9 3210 1361.353 723.714 670.7835
10 4110 1584.583 785.275 721.7258

NPV = 1-10 16980 4470.481 122.047 -281.637

Tot. invest. 1-2 = 15400 14063.64 12055.44 11908.06

 Tot. Cash in 3-10 = 32380 18834.121 12177.487 11626.42

Ratio tot. Invest to tot. Cahs in

0.475603 0.7467107 0.9899776 1.04224

IRR/RoR
1.1
1
Ratio 0.9
0.7
0.5

0% 5% 10% 15% 20%

IRR based on NPV

20,000

15,000

NPV 10,000
IRR
5,000

0
0% 5% 10% 15% 20%

What is IRR/RoR ?

NPV 18%
18% + (19% -18%)
NPV 18% - NPV 19%

122.0474
18% + (19% -18%) = 18.320%
122.0474 +281.637

Or by using graph
122.0474
RR/RoR = 18.302 %

18% 19%
r

281.637
1%-r

We find aquation like this :

122.0474 281.637
=
r 1%-r

so, r = 0.302 %
RR/RoR = 18% + r
= 18.302%

Dikatakan layak atau tdk layak dari suatu rencana investasi tambang

ditinjau dari 4 hal/kreteria :

1. Payback period, year/s

2.NPV, $ + layak
3. RoR, %, layak apabila suku bunga pasar tidak melampai RoR proyek
4. Ratio antara cum. Discountet Investment to cum. Cash in, layak apabila rationya < 1
 ECONOMIC EVALUATION OF MINERAL PROPERTY
Evaluation of a Mine Development Alternative
Arranged by Muhammad Amin

VALUATION OF NEW OR PARTLY DEVELOP PROPERTIES

Source: Economic Evaluation of Mineral Property, Saml. VanLANDINGHAM, p. 62

Factors for Consideration

The value assigned to new or partly developed property is generally the difference between the total
present value, based on discount of all future earnings, and the value assign to physical assets, working
capital, and other costs that are necessary to get the property into operation. A detailed field examination is
necessary to ascertain any adverse physical conditions that may be met and corrected before the final
decision on methods of mining and milling, the installation of various surface buildings and facilities, and
on the transportation needed to extract and prepare a marketable product. Thus, the valuation of partly
developed mineral property is basically an estimate of potential net income from future exploration of
known ore reserves even though mine facilities, plant, or other surface facilities do not exist. Engineering
skill and experienced judgment are required because nearly all factors must be estimated. Adequate
contingency allowance must be provided. If the ore reserve has not been fully explored, a speculative
element must be considered.
Where there are no production experience records to serve as a guide at a new property, the risk factor
are of course greater than for a going mine for which the mining and processing methods and costs have
been worked out and actually demonstrated. Thus, the investor or buyer is usually justified in demanding a
higher rate of return on such new or prospective mines.
The valuator (appraiser or valuation engineer) is usually confronted with the questions of what
constitutes ore reserves and how much ore is required to justify a project. He is probably faced with
measured ore, partly measured ore, geological ore, or “wildcat” possibilities. Actually, the only firm basis
for valuation will be found in the measured ore category, where volumes and grades can be demonstrated.
Other ore reserve categories, which must be assumed or considered probable, should definitely be assigned
to speculative category. This speculative ores, however, may serve as a basis of trading between the buyer
and seller.
In the ideal situation, a property has sufficient ore blocked out to show clearly that the operation (earning
period) will be adequate to amortize the investment from earnings, provide a return for use of invested
funds, and give some indication of continuation of profitable operations. Where the ore reserves are not
clearly adequate for a reasonable life of operation for a substantial investment for, say,15 to 20 years, then it
rest with the valuator to point out the speculative element or the chances of eventually developing sufficient
additional ores to pay out the investment. Where margin of profit is high, the pay out period may be
correspondingly less than the period just mentioned.
Sometimes it may be necessary to value mineral tracts not large enough to make a mine in themselves.
Adjoining active mine operations are then usually in the market for such tracts and thus create a market for
the limited ore reserves. The valuation can then be considered on the basis or present worth of future
royalties (after provision for federal taxes) or present worth of future (deferred) earnings.
Properties having a limited ore showing may be considered in the speculative development stage; the
valuator must then use his judgment in advising the investor of the amounts that he might be justified in
spending on the prospect to try to bring it to the stage of development for actual valuation of potential
production.
Reminder List for Determining Value of New Mine Venture

The following steps are handy reminders for organizing a commercial valuation:
1) Calculate the ore reserves and indicate grade or quality under the following classifications:
measurable ore and speculative ore. (This requires a preliminary estimate of costs and determination of
mine cut-off-grade.)
2) Estimate recoverable ore, taking into consideration such factors as mine dilution, mine losses, and
cost of making ore available.
3) From study of flow sheets and metallurgical test, calculate the treatment losses or metallurgical
recovery.
4) Estimate rate of production as determined from the mine potential, and the sales possibilities, as well
as limitations, such as availability of power and water.
5) Divide reserves by annual production to obtain life of property or operations.
6) Using recovery and treatment factors, calculate total yield of saleable product.
Calculate the “smelter settlement value” of the ore or concentrate, or saleable products.
7) Estimate average sales price per annum and total average sales volume and total
annual gross revenue.
The following example shows the evaluation of revenue for a lead-zinc-silver deposit.
Mining method cut-and-fill
Geological ore reserves: 120 mil. tonnes
@ 11.7 % Pb, 12.7 % Zn, 124 gpt Ag
dilution factor : 10 %
mine recovery factor : 90 %
mill recoveries : Pb – 94 %
Zn – 76 %
Ag – 90 %
mill capacity : 6,000,000 tonnes per year
metal price Pb – 284 money units/tonne
Zn – 394 money unit/tonne
Ag – 0.0633 money unit/gm
Net smelter return Pb – 50 %
Zn – 40 %
Ag – 80 %
———————————————————————————————————
Geological reserves, mil. tonne 120.0 11.7 % Pb 12.7 % Zn 124 gpt Ag
Mine recovery @ 90 % 108.0 11.7% Pb 12.7 % Zn 124 gpt Ag
Dilution @ 10 % 10.8 - - -
———————————————————————————————————
Recoverable Ore Reserves 118.8 10.6 % Pb 11.5 % Zn 113 gpt Ag
—————
Source: Brian W. Mackanzie, Economic Evaluation Techniques for Investment Decisions.
Annual Revenue Estimate:

Lead – 6.0 (10.6 %) (94 %) (284) (50 %) = 84.89 mil. money units
Zinc – 6.0 ( 11.5 %) (78 %) (394) ( 40 %) = 84.82 mil. money units
Silver – 6.0 (113) (90 %) (0.0633) (80 %) = 30.90 mil. money units
————————————————————————————
Total – = 200.61 mil.money units
8) Estimate cost of sales (per ton basis), labour, materials and supplies, and overhead.
9) Estimate selling (marketing), administrative, and central office costs.
10) Subtract cost of sales from sales income to get gross profit.
11) Subtract selling and administrative expenses from gross profit to get profit before depletion allowance
– also any interest payments.
12) Subtract depletion and depreciation allowances to obtain basis for computing in come tax.
13) Determine the income taxes.
14) Estimate the total annual net profit after taxes.
15) Set up work sheet to show estimated cash flow including payments of such items as interest, principle
on loans, tax allowances for period of operations, and repayment of initial investment though depreciation
and depletion.
16) Consider special risks and hazards to operation and consider a reasonable rate of return on
investment, or discount factor to be used.
17) Estimate ultimate speculative tonnage that may be expected in additional to the measured reserves.
18) Determine the net income before depletion and deduct return on working capital, return on investment
in mine, plant and facilities, and return on investment in non mineral land. This, give the residue earnings
applicable to mineral property.
19) Discount the total residue over the life of operations to get the gross present value of the residue.
20) Adjust for any unrecoverable working capital such as obsolescent spare parts inventory or accounts
receivable.
21) Add present value of salvage and of operations.
22) Adjust for any cost of deferring investment in mineral land and any cost of proving-up mineral
reserves.
23) Compare earnings against investment with those current in alternative enterprises.

DEPRECIATION
Source: Energy Economic, 1983, Seymour Kaplan. P.109
Physical assets, such equipment and machinery acquired by a business or organization, are ordinarily used
over a period of time. Therefore, it is common to allocate the cost of such asset to different time periods
over which such use occurs, rather than at a single point in time, such as when the asset is purchased.
The process of allocating the asset cost over different time periods is called depreciation. Alternative
models for determining the fraction of the total cost to be charged to different time periods result in
different methods of depreciation. The principle methods which will be considered in this chapter are
straight-line depreciation, declining-balance depreciation, and sum-of-the-years’-digit depreciation.
Since the depreciation charges are considered costs in the period where they are taken, even though no
actual cash outlays occur, they will affect the amount of income taxes the business organization must pay to
the government .Generally, all other things being equal, the greater the depreciation during a period, the
less taxes will have to paid, the less taxes paid, the more cash the organization will have for future
investment opportunities. Depreciation policy and allowable rates are formulated by federal government tax
policy and are subject to change from year to year.

DEPRECIATION METHODS
The three most common depreciation methods are called straight-line depreciation, declining-balance
depreciation, and sum-of- the-years’-digits depreciation. We assume in each method that the asset has an
initial cost P and a useful life N. The anticipated value of the asset at the end of its useful life is called its
salvage value. If no appreciable salvage value is anticipated, the salvage value is assumed equal to zero. Let
L denote the salvage value. If the asset is held for N years, the “cost” of holding the asset is (P-L) dollars.
This amount is the total depreciation of the asset over its useful life.

Straight-Line Depreciation
With straight-line depreciation, we assume that the total depreciation is spread uniformly over useful life, so
that the amount taken as depreciation charge in each year is constant and equal to (P-L)/N. That is, if Dn is
the depreciation in year n, than

P- L
Dn = ——— for n = 1,2,…, N
N

The initial cost of the asset less the accumulated depreciation at the end of n years is called the “book
value” of the asset after n years. If Bn represents the book value at the end of n years, for straight-line
depreciation,

P-L
Bn=P- n ( ——) n = 1,2,...., N
N

We note that with this depreciation method, BN = L, the salvage value.

Example 6-1 Facilities cost $800,000, will last 8 years, and have an estimated salvage value of $100,000
after the eighth year. If straight-line depreciation is used, find the depreciation charge in the each year and
the book value at the end of each year

P-L
Solution Dn = ——
N

800,000 – 100,000
D1 D8 is the same that is = 87,500
8

P-L
Bn=P- n ( ——) n = 1,2,...., N
N

Book value the end of each year is :

B1 = 800,000 – 1 x 87,500 = 712,500

B2 = 800,000 – 2 x 87,500 = 625,000
B3 = 800,000 – 3 x87,500 = 537,500
B4 = 800,000 – 4 x87,500 = 450,000
B5 = 800,000 – 5 x87,500 = 362,500
B6 = 800,000 – 6 x87,500 = 275,000
B7 = 800,000 –7 x 87,500 = 187,500
B8 = 800,000 – 8 x 87,500 =100,000 as same L

Figure 6-1 Book values for facilities depreciated by straight-line method

and double-declining balance method
Declining-Balance Depreciation
With this method, the depreciation charge each year is fixed percentage of the book value of the asset at the
beginning of the year. If this fixed percentage is denoted as f, where 0<f<1, then the depreciation during
year n is given by Dn = fBn-1, since Bn-1 is the book value of the asset at the beginning of year n (end of
year n-1). The depreciation in the first year is D1 = fP. Therefore, B1= P-D1= P-fP = (1-f)P. The
depreciation in year 2 is
D2= f(1-f)P. The book value at the end of 2 years is

B2 = B1-D2 = (1-f)P -f(1-f)P = (1-f)2 P

It can be seen that the book value at the end of n years will be given by
Bn = (1-f)n P
The depreciation charge in year n is Dn = Bn-1-Bn
= (1-f)n-1 P-(1-f)n P= f(1-f)n-1 P

If the declining-balance method is used, we are not permitted to depreciate the asset after any point in time
where the book value equals the salvage value. That is, the total depreciation permitted is equal to (P-L) as
in the straight-line method. However, the salvage value L does not explicitly enter into the depreciation
computation for each year, as it does in the straight-line method.
The federal government also has set limits on the maximum allowable value of f.
For newly acquired assets, f cannot exceed the value 2/N. If N = 5 years, then

f ≤ 2/5 = 0.4

If the value of f used is exactly 2/N, the depreciation methodology is called double-declining balance. (For
used equipment or machinery, f ≤ 1.5/N.
Use of the declining-balance method results in grater depreciation charges during the early years of the
life of the asset, when compared with the straight-line method. However, depreciation charges decline each
year and may eventually be less than depreciation by the straight-line method, if the asset has a relatively
long life and a low salvage value.
Example 6-2 Facilities are purchased for $800,000 and have an estimated life of N= 8
years. Salvage value is estimated as $100,000. Double-declining balance
depreciation is used. What is depreciation charge in the each year and the book value at the end of each
year
SOLUTION
Dn = f(1-f)n-1 P

D1 = 2/8(1-2/8)1-1 x 800,000 = 200,000

D2 = 2/8(1-2/82)2-1 x 800,000 = 150,000

D3 = 2/8(1-2/8)3-1 x 800,000 = 112,500

D4 = 2/8(1-2/8)4-1 x 800,000 = 84,375

D5 = 2/8(1-2/8)5-1 x 800,000 = 63,281

D6 = 2/8(1-2/8)6-1 x 800,000 = 47,461

D7 = 2/8(1-2/8)7-1 x 800,000 = 35,596

D8 = 2/8(1-2/8)8-1 x 800,000 = 26,697

Book Value :
Bn = (1-f)n P

B1 = (1-0.25)1x 800,000 = 600,000

B2 = (1-0.25)2x 800,000 = 450,000
B3 = (1-0.25)3x 800,000 = 337,500
B4 = (1-0.25)4x 800,000 = 253,125
B5 = (1-0.25)5x 800,000 = 189,844
B6 = (1-0.25)6x 800,000 = 143,283
B7 = (1-0.25)7x 800,000 = 106,787
B8 = (1-0.25)8x 800,000 = 80,090

Sum-of-the-years’ depreciation

P-L
Dn = (N-(n-1) ——— S = N(N+1)/2
S

Bn = P –D1-D2-….-Dn

Example 6-3 For the asset of example 6-1 and 6-2, find the depreciation in the third year and the book
value at the end of 3 years using sum-of-the-years’-digits depreciation.

SOLUTION
 P-L
Dn = (N-(n-1) ——— S = N(N+1)/2
S

800,000-100,000
D1= (8-(1-1) = 155,556.6
8(8+1)/2
D2 = = 136,111.1
D3 = = 116,666.7
D4 = = 97,222.2
D5 = = 77,777.8
D6 = = 58,333.3
D7 = = 38,888.9
D8 = = 19,444.4

Book Value :

Bn = P –D1-D2-….-Dn
B1 =800,000 – 155,556.6 = 644444.4
B2 =508,333.3
B3 =391,666.6
B4=294,444.4
B5 =216,666.6
B6=1583,33.3
B7=119,444.4
B8=100,000
 Depreciation conclution

Year S-L D-D SY D

1 87,500 200,000 155,556.6

2 87,500 150,000 136,111.1
3 87,500 112,500 116,666.7
4 87,500 84,375 97,222.2
5 87,500 63,281 77,777.8
6 87,500 47,461 58,333.3
7 87,500 35,596 38,888.9
8 87,500 26,697 19,444.4

700,000 719,910 700,000

Book value conclution :

Year S-L D-D SY D

1 712,500 600,000 644,444.4

2 625,000 450,000 508,333.4
3 537,500 337,500 391,666.7
4 450,000 253,125 294,444.5
5 362,500 189,844 216,666.7
6 275,000 142,383 158,333.4
7 187,500 106,787 119,444.6
8 100,000 80,090 100,000.
The depreciation percentages
The depreciation percentages are based on declining-balance depreciation for the first year and straight-
line depreciation for the remaining years. The rate under declining balance is 1.5/N for assets placed in
service during 1981-1984. The rate is 1.75/N for 1985 and goes to 2/N for 1986 and afterward. Furthermore,
the asset is assumed to be placed in service during the middle of the first year of use.
As an illustration of the derivation of the rates, consider an asset placed in service in 1982. Because only
half the first year’s depreciation is allowed in 1982, the 1982 depreciation is (1.5/N)(1/2) = 0.75/N. For N =
3, the first-year depreciation is 0.25 of the cost. For N = 5, the depreciation in 1982 is 0.15 of cost. After the
first year, the remaining value of the asset (75 percent of first coast of the 3-year 1982 asset 85 percent of
first cost of the 5-year 1982 asset) is depreciated by straight-line method over the remaining life. For the 3-
year asset, we take half of 75 percent, rounded to 38 percent for year 2, and the remainder of 37 percent in
year 3. For the 5-year asset, we take one-fourth the 85 percent in each of year 2,3,4 and 5. With rounding in
year 2, this results in the percentages shown in Table 6-1.

Table 6-1 Depreciation Percentages ACRS

————————————————————————
Year placed in service
————————————————————————
1981-1984 1985 1986 and afterwards
————————————————————————

Year 3 5 3 5 3 5
————————————————————————
1 25 15 29 18 33 20
2 38 22 47 33 45 32
3 37 21 24 25 22 24
4 21 16 16
5 21 8 8
————————————————————————

Example 6-4 Smith buys a light-duty truck in 1983 for $10,000. What is the depreciation permitted each
year under the ACRS ?

SOLUTION
1983 depreciation = 0.25 ($10,000) = $2500
1984 depreciation = 0.38 ($10,000) = $3800
1985 depreciation = 0.37 ($10,000) = $3700

Total depreciation = $10,000

DEPLETION
Source: Energy Economic, 1983, Seymour Kaplan. P.109

DEPLETION
For the owner of an oil or gas well, timberland, or mineral deposit, depletion represents a mechanism for
the recovery of the cost of the property. Just as depreciation allows the purchaser of plant, machinery, and
equipment acquired for business use to recover the cost of the asset over its useful life, depletion allows for
the recovery of costs as the extracted resource is sold in the marketplace.

They are two methods of determining the amount of depletion which can be considered as a cost in
calculating income subject to taxes. These methods are cost-depletion and percentage-depletion.
Example 6-6 –– Cost Depletion Suppose a mineral property containing an estimated 50,000 tons, of
recoverable ore is purchased for $4,000,000. Operating expenses during the first year are $900,000, and
gross income of $2,000,000 was received from the sale of 5000 tons of the mineral. What is the income
subject to income taxes (before-tax income) for the year if cost depletion is used?

SOLUTION The $4,000,000 is called the basis of the mineral property. If we divided the basis by the
number of recoverable units in the deposit, we obtain a value of ($4,000,000)/50,000 = $80 per ton as the
cost per unit. This value is called the depletion rate. Under cost depletion, the depletion for the year is found
by multiplying the depletion rate by the number of unit sold during the year. The depletion cost would be
($80/ton) (5000 tons) = $400,000. The income subject to tax would be
$2,000,000-$900,000-$400,000 (depletion) = $700,000.

At the beginning of the second year, the adjusted basis of the property is equal to $4,000,000-$400,000 =
$3,600,000. If the estimate of recoverable mineral ore is 45,000
tons, the depletion rate in the second year will remain at $80 per ton ($3,600,000/45,000) = $80/ton). If
however, the estimate of recoverable ore changes in the second year, the depletion rate could increase or
decrease.
What is the income subject to tax ?

Year Cost $/ton Production Depletion cost Revenue Operating Income

(ton) ($) ($) expenses ($) subject to tax, $

1 4000,000/50,000 5000 400,000 2000,000 900,000 700,000

2 3600,000/45,000 5000 400,000 2000,000 900,000 700,000

3 3200,000/40,000 5000 400,000 2000,000 900,000 700,000

4 2800,000/35,000 5000 400,000 2000,000 900,000 700,000

5 2400,000/30,000 5000 400,000 2000,000 900,000 700,000

6 2000,000/25,000 5000 400,000 2000,000 900,000 700,000

7 1600,000/20,000 5000 400,000 2000,000 900,000 700,000

8 1200,000/15,000 5000 400,000 2000,000 900,000 700,000

9 800,000/10,000 5000 400,000 2000,000 900,000 700,000

10 400,000/5000 5000 400,000 2000,000 900,000 700,000

Example 6-7―Percentage Depletion With percentage depletion, the amount of depletion, subject to
certain limitations, is an allowable percentage of the gross income from property. Allowable percentages
for some of the more common minerals are given in Table 6-2. Suppose the mineral in the mine of Example
6-6 has an allowable percentage of 22 percent. Find the income subject to taxes if percentage depletion is
used.

SOLUTION Since the gross income received is $2,000,000, the depletion for the year is (0.22)
($2,000,000) = $440,000. The income subject to taxes is $2,000,000 - $900,000 - $440,000 = $660,000.

The deduction for depletion under the percentage method cannot exceed 50 percent of the next taxable
income (before-tax income) from the property, calculated without the depletion deduction is $2,000,000 -
$900,000 = $1,100,000, 50 percent of which is $550,000. Since $440,000 is less than $550,000, the
depletion of $440,000 is allowed.
Table 6-2 Depletion Percentage for some of
the more common natural deposits. Source: Tax
Guide for Small Business, Department of the
Treasury, Internal Revenue Service, Publication

————————————————————————
Deposits Percent
————————————————————————
Sulfur and uranium and, if from deposits in
the United States, asbestos, lead, zinc,
nickel, mica, and certain other ores and
minerals 22
If from deposits in the United States, gold,
silver, copper and iron ore, and oil shale 15
Coal and sodium chloride 10
Clay and shale used in making sewer pipe
or bricks or used as sintered or burned
light weight aggregates 71/2
Clay (used or sold for use in manufacture
of drainage and roofing tile, flower pots, and
kindred products), gravel, sand, and stone 5
Most other minerals and metallic ores 14
————————————————————————

Factor Bearing Upon Potential Earnings

In the process of developing all the major elements bearing upon earnings, the data should be set up in a
useful and timesaving manner (as shown herein) since many of these data are used subsequently for various
purposes in the valuation procedure.
Ore Reserves and Life of Project with supporting data must be given both to substantiate the quantity
and grade of the recoverable ore reserves and to indicate the development problems met in making them
available for mining. To take care of considerable variations in the grade of ore, which would appreciably
affect the total earnings, particularly in the early operating stage, the ore reserves should be shown by level
(bench or horizon) and by grade in order to develop a production schedule for specific sections of the
property. Where loan capital is involved it may be desirable to show the possibility of mining high-grade
ore during the early payout period so as to speed up payments if necessary. The possibilities for developing
additional ore should be adequately covered. All yield and mill recovery factors should be supported by test
data and volume factors that demonstrate the tonnage and quality of marketable products. If the physical
nature of the deposit indicates a limited productive capacity for the project, this should be clearly presented.

Table 12.1 will be helpful in developing economic factors such as practical mining rate and volume and
grade trend with deepening of the mine.
In this example ore reserves have been scheduled on 25-full-year basis, largely
dictated by market considerations.
 Markets and Future Price Levels are keys to the future earning of any mining project. To substantiate
the estimates relative to future markets, analysis of statistical data on production and consumption
(consumption-in-use pattern or historical price trends) may be useful. Where the marketing is complex, a
careful study and investigation of consumers and competitors may be required before reasonable estimates
can be made of the time required and possible share of the market (sales volume) anticipated after
launching the project. The market study also convincing evidence about the acceptability of the product
(grade, quality, etc.); this is important not only for metal products but particularly for most non-metallic
products.

Table 12.1 –– Summary Ore Reserves by Levels or Benches

————————————————————————————————
Mine Level Grade
or Quarry Tons Ore or Value
Bench No. Recoverable Yield per Ton
————————————————————————————————
(A) ————— ——— ———— 4.78
Total 23,000,000 Average $5.02 (B)
————————————————————————————————
Note: (A) Data covering each level or bench should be listed here.
(B) Mining staffs nearly always carry out ore reserves estimates to cents. Figures
used herein follow the same practice to facilitate checking. Rounding out to
requisite accuracy is done with final figures.

In highly competitive markets, trade discounts may be important aspects in determination of net sales
income.
If long-term contracts can be made, future prices may be projected with considerable accuracy.
However, some long-term contracts have escalator clause tying in prices with fluctuation in labour and
materials. The valuator must usually estimate future long-term price levels based on the demand and supply
outlook as foreseen at date of valuation. For some large projects, it may be necessary to determine the effect
of increased volume of production on the market price of the product. And because transportation may limit
the market area and sale income, a careful study of delivery costs may be essential. Where mineral products
having a long record of price stability or uniformity of rising price are involved, it may be assumed that
over a long period changes in costs of operation will be accompanied by corresponding change in price of
products. This may be likely for such commodities as gold and oil. Other mineral commodities, however,
have shown rather violent fluctuations in the past, copper for example. Thus, future estimates of prices must
be based on the known facts and trends at the time of the report; but at the same time estimates of operating
costs must be adjusted in line with any price adjustments likely to result from inflation.
The market potential may limit the size of the operations, but the desired payout period and the physical
limitations of the mine may also be factors. If there are not restrictions it may be desirable to schedule the
operations for the optimum economic rate of return.
Development of the sales realization will be required, taking into consideration sales discounts or other
allowances which tend to reduce income from sale of products. In the example given herein the average
sales realization or net sales income is estimated to be $4.78 per ton (compare with $5.02)
Capital costs can be developed only after fairly complete mine and plant layout plans are made (Table
12.2). Consideration must be given (1) use of existing physical assets on the property, if any, as well as (2)
new equipment and facilities. A detailed listing can be made under each of the following major headings:
 1) Cost of Property
2) Preproduction Cost
3) Mining Buildings, Equipment, and Facilities
4) Milling Buildings, Equipment, and Facilities
5) General Buildings, Equipment, and Facilities (includes housing, schools,
recreation buildings, hospitals)
6) Working Capital Requirements

Table 12.2—Design Capacities for Mine and Mill (Tons)

——————————————————————————
Average
Daily Hourly
Capacity, Capacity,
Designed 5-Day 7 ½ Hr
Total Capacity Week per-
Ore Annual 2-Shift Shift
Material Reserves Basis Basis Basis
———————————————————————————
Run-of- 23,000,000 1,000,000 4,000 240
mine
———————————————————————————

To make the foregoing data useful in the subsequent cost analysis procedures, such as developing a
depreciable base, insurable values, and income tax allowances, it is desirable to separate capital costs into
Buildings, Building Equipment, Equipment and Machinery.
The date should be indicated for the estimates covering construction costs involving prices of materials,
labour, and other expenses, so that if is an inflationary trend and the project is delayed, all the figures can be
adjusted.

Initial Working Capital requirements may constitute a substantial portion of the total capital or financing
necessary for a new project. Sufficient working capital must be assured to sustain the project — that is, to
provide funds to “fill the pipe line” or build up operations, including raw material in stock pile or bin, etc,;
inventory stores, usage of materials during tune-up period, semi finished or materials en route to market,
and payrolls (accounts receivable) and other costs. Table 12.3 is an example or reminder list.
 Table 12.3 — Estimated Annual Workings
Capital Requirements (Basic, Tons Annually)
——————————————————
Total
Annual
Amounts,
Item $
———————————————————
1. Inventories
Raw materials (months)
Supplies (months)
Spare parts (months)
Work-in-process (months)
(between usage and monetary
return) including
Payrolls
Raw materials
Supplies
Other operating cost
2. Preparation and training
Payroll (months)
Raw material usage
Supplies usage
Other operating costs
Contingencies
3. Accounts receivable
Total initial working capital
requirements
———————————————————

Total capital cost requirements for financing purposes may be conveniently summarized as in Table 12.4
which may be used as a guide for depreciation and depletion and as an aid in other calculations for earnings
statement purposes.
Costs of Production incurred in producing a marketable product must reflect actual conditions and
difficulties to be experienced in the operation of the property. Each of the major items of operating costs is
discussed in the following:

1) Labour costs, including complete manning requirements or development of the payroll, establish a
basis for ready calculation of such expenses as Public Liability, Workmen’s Compensation, Use and
occupancy, Unemployment, Federal Old Age Benefits, Health and Accident, Holiday and Vacation Pay,
Housing, Medical, Recreation, and Outside Transportation. Table 12.5 is a useful form for developing the
working force
2) Materials and supplies to cover all needs must be estimated on an annual basis. Firsthand knowledge of
operations and of
 Table 12.4 —— Preliminary Estimate Capital Cost M.E. Mine
———————————————————————————————————
Mineral Machinery
Land Buildings Building and
(Or Prepa- and Equip- Equip-
Reserves) ration* Facilities* ment* ment* Total
———————————————————————————————————
Preproduction
expenses $1,900,000 $198,000 $333,000 $9,000 $2,440,000
Mining 106,000 10,000 710,000 826,000
Milling 994,000 45,000 2,470,000 3,509,000
General 475,000 25,000 301,000 801,000
————— ——— ———— ——— ———— ————
Total $1,900,000 $198,000 $1,908,000 $89,000 $3,481,000 $7,576,000
Contingency 5 %
except mineral land
284,000
————
$7,860,000
Working capital 1,300,000
———————
Total investment requirements for financing $9,160,000
———————————————————————————————————
*Includes engineering, supervision, and contactor’s fees
($9,160,000-$1,900,000 = $7,260,000) represents the capital requirements to get the property into
production, exclusive of the cost of the mineral property.
Table 12.5 ― Estimated Working Force and Annual Payroll (Basic Tons ― Annually
———————————————————————————————————
Straight
Number Hourly Total Time Shift
Personal Rate Hours Earnings Differential Payroll
———————————————————————————————————
Production
(a) Mine*
(b) Mill*
(c) General surface*
Engineering*
Selling, administrative,
and accounting (1)
Total
————————————————————————————————――
*Detailed list of jobs or labour categories to be given here.

The equipment is needed here. Table 12.6 gives the general headings to be followed with detailed listing
requiring separate tables.
3) Overhead costs are likely to involve numerous items such as those listed in Table 12.7 for
convenience of checking and estimating.
4) Depreciation (not general, ordinary, special maintenance) involves all mine and mill operations. It
includes only the replacement cost of major equipment and facilities that wear out or become obsolete
before the end of the life period for the project. Such expenditures are necessary to sustain operations but
since they do not occur uniformly, a reserve is set up. Such depreciation is an important cost item that has
an important bearing upon the earnings of the project. Sound judgment should be used in establishing

Table 12.6 — Detailed Estimate of Materials and Supplies

(Basis, working Day Tons Annually)
———————————————————————————
Total
Cost
Freight On
Quanti- Unit and the
Items tity Price Total Handling Job

———————————————————————————
*Detailed items may be listed and allocated
to mining, milling, etc., in cost estimates.

depreciation rates, taking into consideration the life of all equipment and facilities involved. The actual
replacement expenditure may not be made during the first three to five years, perhaps, and it may not be
practical to make any significant replacements at a period when the mineral reserves offer only a few
remaining years of operation, but the depreciation reserve should be adequate to meet these replacements
(even with inflated costs) when necessary to maintain the project in a satisfactory operating condition and
recover the cost of equipment and facilities. The depreciation cost should also allow for replacement of
obsolescent equipment. Table 12.8 is a general check list to ensure that this item is adequately provided for
in the operation cost estimate. (Depreciation, as discussed herein, is not straight-line depreciation as applied
for tax purposes, which takes into account only the original cost of the item purchased.)
5) Selling and Administrative costs are developed separately as they are likely to be off-the-property
costs. In this example, the figure of $105,000 per year or $0.12 per ton of run-of-mine ore is used. To
simplify the calculations at this point, no interest on borrowed money is assumed but if present, this would
affect the cash flow and income tax calculations.
The check list in Table 12.9 gives the summary of the production cost items

Income Taxes
Income taxes must be carefully determined, particularly making allowances for such tax deductions as
depletion, depreciation, and amortization of preproduction expenses.

Table 12.7 — Estimated Overhead Costs (Annual Basis)

———————————————————————————————————
Basis of Calculation: Total Cost per Ton—
Expense Item Quantity, Rate, Other Annual Run-of-Mine Ore
———————————————————————————————————
Telephone and telegraph
Stationary and printing
Miscellaneous office supplies
Traveling expenses
Employee training
Engineering
Research
Property tax
Franchise tax
Fire insurance
Public liability insurance
Use and occupancy insurance
Medical and first aid
Hospitalization
Payroll tax
Workmen’s compensation
Vacation pay provision
Fringe benefit
Holiday pay
Health and accident insurance
Group insurance
Occupational disease insurance
Pension
Total
———————————————————————————————————
 Table 12.8 — Depreciation

—————————————————————————————————
Non depreciable Depreciable Depreciation Annual
Cost Portion Portion Rate Depreciation
Items $ $ $ % $
—————————————————————————————————
Building
Machinery and
equipment
Service systems
Land improvements

Total
——————————————————————————————————

Table 12.9 — Summary Operating and Fixed

Charges (Basis: 265 Working Days, 900,000
Tons Capacity)

———————————————————————
Total
Annual Costs
Costs, per Ton
Average Run-of-
Operating Mine
Element of Cost Basis, $ Ore. $
———————————————————————
Labour
Direct and in direct 902,000 1.00
Raw materials)
Supplies )……… 973,000 1.08
Spare parts )
Overhead 83,000 0.09
Unit depletion 74,000* 0.08
Depreciation (ordinary
and replacements) 520,000** 0.58
Selling and administrative cost 105,000 0.12
———— ——
Total 2,657,000 2.95
———————————————————————
*Unit depletion here provides for the return of all original
costs of the mineral land. This is obtained by dividing
original cost (1,900,000) by total ore reserves (23,000,000) tons
to be produced for sale over life of property. That is (1,900,000/23,000,000) x 900,000.
**This figure can best be derived by first-hand
knowledge of the particular industry: knowing the
life of the type of equipment used, knowing the
amount of replacements and adjustments experienced
from obsolescence (this is substantial in some
industries where the treatment is not well
developed)). and making provision for any inflationary trends
in prices. In this particular case the unit depreciation figure
includes depreciation of original investment in plant and facilities
($5,960,000) as well as investment for replacements and
obsolescence ($7,300,000). That is $5,960,000+$7,300,000)

mineral land cost

notes : ($5,960,000), found from $7,860,000 – $1900,000
so total depreciable is $5,960,000 + $7,300,000 = $13,260,000

for replacements and obsolescence

so the depreciation is $13,260,000 : 25.5 = $520,000

The impact of these items may well be a critical factor in financing. Income taxes must be estimated
and deducted to obtain the amount of net earnings and to establish the actual return on the investment.
Current tax rates should be obtained from reliable sources and the tax computed and applied in the
prescribed manner, since there is considerable variation according to the mineral involved for each state and
for each country. Knowledge income tax application will allow proper handling of deductible items like
depletion and depreciation and permit taking advantage of tax-free periods where these deductions are
allowed. Such knowledge will also enable one to secure maximum benefits from fast write-offs, and tax
deduction for interest on loans where such are involved. Detailed of U.S. income taxes are discussed in
Chap. 4.17.
In the example of the M.E. Mine cited herein, a Canadian case used to show how the tax-free period and
the other tax allowance for depletion and depreciation create unequal annual earnings. For those who wish
to compare United States Taxes with Canadian taxes, an example of United States application is presented:
U.S. Income Tax —— Percentage Depletion.
Example— The percentage depletion allowance for purpose of estimating Federal In come Tax is based on a
percentage of gross income from the sale of product and has no relation to costs.
For the product involved herein, the percentage allowed in 23 % (if the mine wire in the United States),
not to exceed 50 % of taxable income computed with depletion. The data for calculation of the Federal
Income Tax as given in Table 12.10 are from Work Sheet II.
In considering foreign investment the taxes of both the country of operation and the country of residence
must be considered.

Time factors
Time factors are of utmost importance to the investor and are:
1) Time required for preproduction work to reach the first production stage.
2) Time required to get the property up to the designed production stage or rate.
3) Time required to recoup the investment or to pay debt retirement.
 The answers to the foregoing will allow the valuator to (1) estimate the interest
charges during the preproduction period, and (2) to establish the deferment period
before the earnings start and to calculate present worth of future earnings; and (3) to indicate the
financing problems or the possibility of financing the project. If the analysis of the cash flow in relation to
time shows that the income to the investor is likely to be inadequate during the early period of operations or
is too long delayed, the project might prove difficult to finance. If the analysis shows that the property can
pay for itself in three to ten years, the project probably can be financed.

If we try to arange cash flow table :

————————————————————————————————————

Cash Profit Net Pv, pv pv pv

Year, Earning Depreciation Taxable After Cash
n Sn-Cn S-L Income Taxes Flow 10 % 15% 20% 25%
D epletion (40%)

————————————————————————————————
0 7,860,000 7,860,000 7,860,000 7,860,000 7,860,000 7,860,000
1 2,239,000 520,000 74,000 2,113,000 1,267,800 1,861,800 1,843,366.3 1,618,956.5 1,551,500 1,489,440
2 2,239000 520,000 74,000 2,113,000 1,267,800 1,861,800 1,825,115.2 1,407,788.3 1,292,916.7 1,191,552
3 2,239000 520,000 74,000 2,113,000 1,267,800 1,861,800 1,807,044.7 1,224,163.7 1,077,430.56 953,241.6
4 2,239000 520,000 74,000 2,113,000 1,267,800 1,861,800 1,789,153.2 1,064,490.2 897,858.796 762,593.28
5 2,239000 520,000 74,000 2,113,000 1,267,800 1,861,800 1,771,438.8 925,643.65 748,215.664 610,074.62
6 2,239000 520,000 74,000 2,113,000 1,267,800 1,861,800 1,753,899.8 804,907.52 623,513.053 488,059.7
7 2,239000 520,000 74,000 2,113,000 1,267,800 1,861,800 1,736,534.5 699,919.58 519,594.211 390,447.76
8 2,239000 520,000 74,000 2,113,000 1,267,800 1,861,800 1,719,341.1 608,625.72 432,995.176 312,358.21
9 2,239000 520,000 74,000 2,113,000 1,267,800 1,861,800 1,702,317,9 529,239.76 360,829.313 249,886.57
10 2,239000 520,000 74,000 2,113,000 1,267,800 1,861,800 1,685,463,3 460,208.49 300,691.094 199,909.25

24 2,23900 520,000 74,000 2,113,000 1,267,800 1,861,000 1,466,290.6 65,040.648 23,419.7967 8,792.1019
.
25 2,239000 520,000 74,000 2,113,000 1,267,800 1,861,800 1,451,722.9 56,557.085 19,516.4973 7,033.6815

Payback period 4 + 0.222 = 4.222 years

1367681,20
IRR = 20 % + (25%-20%)
1367681,20+435307,8

IRR = 20 % + 0.75 x 5% = 23.75 %

IRR = 23.75 %

Pada saat IRR = 23.75 %, NPV nya = nol

Ratio antara Investasi dengan DCF in adalah

Pada i 0 % = 0.135
10 % = 0.185
15 % = 0.650
20 % = 0.851
25% = 1.058

IRR = 23.75 %

Investment 1.0
Ratio 0.75
DCFin 0.5
0.25

10% 15% 20% 25%

Interest rate

Kesimpulannya adalah : Investasi dapat dilakukan apabila interest rate pasar tidak melebihi
angka 23.75 %
General Engineering Economy Models
Source; Phillip F. Ostwald, Cost Estimating for Engineering and Management, p. 324.
Without any further ado, the following general engineering economic model is proposed:

N (Sn-Cn) N A(d)n Fs
Px = (1-t) [ ∑ ——— ] + t ∑ ——— + —— (10-9)
n=1 (1+i)n n=1 (1+i)n (1+i)N

Where Px = present worth for reference year x; total discounted cash flow, dollar
Sn = sales or revenue in nth year, dollar
Cn = total cost (except depreciation charge) required to obtain Sn sales for nth
Substituted, dollars
Fs = Future value of salvageable items (land, working capital, physical salvage),
year, dollars
A(d)n= annual depreciation in nth year; form allows any depreciation procedure to be
substituted, dollars
i = effective interest rate, decimal
t = tax rate, decimal
n = end-of-year age for which computation is made
N = life of asset, years

The following example considers the discounted cash flow method where
non uniform income is expected. It is seen that it is a trial and error approach to determine the nominal
interest which makes the cash flow receipts equivalent to the initial disbursements for an investment. A
machine will cost $175,000 installed and will be capitalized prior to the installation. The earnings as
anticipated are not uniform since the market will not be prepared for the product until several years have
passed. Additionally, it is presumed that technology will improve on the product and that the income peak
will decline. The economic life of investment is forecast to be 12 years, while the depreciable investment
will be recovered over 10 years by accelerated method such as sum-of-the-years’-digits (SYD). Salvage is
estimated to return no value over disposal costs at the end of 12 years. The composite tax rate, including all
relevant taxes, is assumed to be 55%.

Using

2(N-n+1)(P-Fs)
A(d)n = ——————— (10-10)
N(N+1)

Where A(d)n = annual depreciation amount varying with year n

N = useful life
P = investment costs
Fs = salvage value
n = current year number from start of investment, n = 1,…., N
Depreciation charges can be calculated. Using various nominal values for yearly interest, the present worth
can be computed. In the iterative plan, value of 0%, 10%, 15% are used
 Analysis is given in Table 10.3. Using a linear graph of Figure 10.1 the rate of return

is found to be 11.6 %. The summation procedure of Equation (10-9) must be followed year by year for each
term from zero time to the last year of the project. The several forms of depreciation from Table 4.7 can be
substituted for A(d )n. Straight-line depreciation, sum-of-the-year digits, or other accelerated procedures can
be considered. The refinements of non uniform depreciation (other than straight-line) are shown to be and
advantage, particularly with larger interest values.
Model (10-9) may be further broadened by having it describe the un recovered balance or net cash flow
position at any time. The each cash flow positions are discounted to time 0 whit a predetermined interest
rate. This model shows the number of earning periods to have a zero unrecovered balance between
discounted revenues and the initial asset value.
INTERATIVE METHOD FOR EQUATION (10-9)
————————————————————————————————————
1 1
Cash Profit Net —— Discounted —— Discounted
Year, Earning Depreciation Taxable After Cash (1+i)n Cash (1+i)n Cash
n Sn-Cn A(d)n Income Taxes Flow 10 % Flow 15% Flow
————————————————————————————————————
0 (175,000) (175,000) 1.000 (175,000) 1.000 (175,000)
1 35,000 31,818 3,182 1,432 33,250 0.909 30,224 0.869 28,894
2 35,000 28,636 6,364 2,864 31,500 0.826 26,019 0.756 23.814
3 35,000 25,454 9,546 4,296 29,750 0.751 22,342 0.658 19.575
4 40,000 22,273 18,727 8,427 30,700 0.683 20,968 0.572 17,560
5 45,000 19,091 25,909 11,659 30,750 0.621 19,096 0.497 15,283
6 45,000 15,909 29,091 13,091 29,000 0.565 16,385 0.342 12,528
7 45,000 12,727 32,273 14,523 27,250 0.513 13,979 0.376 10,246
8 50,000 9,545 40,455 18,204 27,749 0.467 12,959 0.326 9,046
9 40,000 6,364 32,636 14,686 21,050 0.424 8,925 0.284 5,978
10 35,000 3,183 31,817 14,317 17,500 0.386 6,755 0.247 4,322
11 25,000 – 25,000 11,250 11,250 0.351 3,949 0.215 2,419
12 25,000 – 25,000 11,250 11,250 0.319 3,589 0.187 2,104
——— ——— ————
$300,999 $185,190 $151,769
————————————————————————————————————
Investment
———————— 0.58 0.94 1.15
Total discounted CF 1-12

1.00 determine with the graph, like Figure 10.1

NPV 10% = -175,000+185,190 = 10190

NPV 15 % = -175,000+151,769 = - 23231

NPV1
RoR = i1 + x (i2-i1)
NPV1-NPV2

10190
= 10 % + x (15-10)%
10190+ 23231

= 11.524 %
 ECONOMIC EVALUATION OF MINERAL PROPERTY
Evaluation of a Mine Development Alternative

A case study

Year
————————————————————————————————————
1 2 3 4 5 6 7 8 9 10 Total

————————————————————————————————————

Revenue 8000 8000 8000 8000 8000 8000 8000 8000 64000
Operating cost 2650 2650 2650 2650 2650 2650 2650 2650 21200
Net Income 5350 5350 5350 5350 5350 5350 5350 5350 42800
Depreciation Allowan 2900 2900 2900 2900 2900 14500
————————————————————————————————————
Tax able income 2450 2450 2450 2450 2450 5350 5350 5350 28300
Tax 40 % 980 980 980 980 980 2140 2140 2140 11320
After tax income 1470 1470 1470 1470 1470 3210 3210 3210 16980

Capital Costs 7700 7700 15400

Return of W.C 900 900

Cash Flow 7700 7700 4370 4370 4370 4370 4370 3210 3210 4110 16980

Find the ROR of the project with the graph?

Cash flow is the difference between benefits and costs for a specified time period. An annual period is
usually suitable for evaluation purpose.

If the annual benefits exceed the annual costs, the net benefit is referred to as a positive cash flow; if the
annual costs exceed the annual benefits, a negative cash flow results.

Benefit Elements: Sale Revenue

Salvage Value
Return of Working Capital

Cost Elements: Capital Expenditure

Operating Cost
Taxation Payment
BREAK-EVEN ANALYSIS
Source: Seymour Kaplan, Energy Economics, 1983

The relative importance of fixed and variable costs in the energy field depends on the area of application. In
transporting natural gas and oil via pipe lines, the fixed costs, represented by the capital investment
required, predominate. In such situations, the facility must be operated at or close to capacity in order to
ensure a reasonable return to investors in the facility. In other applications, the variable cost may
predominate.

Example 4-1, consider a 500-mil natural gas pipeline having a maximum capacity
of 80,000,000 ft3/day. The total fixed costs for this pipeline are $50,000 per day and the variable costs,
consisting primarily of pumping charges, amount to $100 per million cubic feet. Output is measured in
million cubic feet per day. The total cost function for the pipe line is shown in Fig. 4-8 and the average cost
in Fig. 4-9. If the pipeline is operated at full capacity, the average cost is $58,000/80 or 725 per million
cubic feet. If the pipe line is operated at one-half capacity, the average cost increases to $1350 per million
cubic feet. Note, the marginal cost is constant at $100 per-million cubic feet(since the variable cost is
constant), whereas the average cost decreases with output, reaching its lowest value at full capacity (Fig. 4-
9). Suppose the pipe-line company receives a price of $900 per million cubic feet. With this price, and with
income taxes neglected, what is the minimum daily output required to show a profit? The daily profit is
equal to the daily revenue (unit price times daily output) minus daily cost (fixed cost plus variable cost). If
we let V represent this minimum output, then we desire the value of V for which daily profit equal to zero.
For any output greater than V, there will be a positive profit, while any output below V will result in a loss.

SOLUTION. The value V is called the break-even output or break-even point. We solve for V as follows.
Let p = unit revenue from output (dollars per million cubic feet), a = fixed cost (dolar per day), and b =
variable cost per unit of output (dollars per million cubic feet). Then,

Profit = 0 = pV-(a+bV)

a
V = ―――
p-b

In our example, since a = $50,000, p = $900 and b = $100, the break even value for the pipeline company is

$50,000
V = ――――――
$900 - $100

= 62.5 million cubic feet per day.

The daily revenue curve and the break-even volume V are shown in Fig. 4-8.
The quantity (p - b) is often called the “contribution margin” per unit of output.
 Figure 4-8 Daily total revenue and total
cost function for a natural gas pipeline

TC = a + bV

TC
AC =
V

a
AC = +b
V
Q F.C V.C TR T.C T.P AC

0 50,000 0 0 50,000 -50,000

1x106 50,000 100 900 50,100 -49,200 50,100
10x106 50,000 1,000 9,000 51,000 -42,000 5,100
20x106 50,000 2,000 18,000 52,000 -34,000 2,600
30x106 50,000 3,000 27,000 53,000 -26,000 1,767
40x106 50,000 4,000 36,000 54,000 -18,000 1,350
50x106 50,000 5,000 45,000 55,000 -10,000 1,100
60x106 50,000 6,000 54,000 56,000 -2,000 933.333
70x106 50,000 7,000 63,000 57,000 6,000 814.286
80x106 50,000 8,000 72,000 58,000 4,000 725.000

Figure 4-9 Average cost function for

a natural gas pipeline