2 Ceng 6108

1.
Construction Economics and Finance

Basic Economics Principles
• Selecting a discount rate
– Imposes a condition of minimum profitability for a development to
qualify for acceptance
– Affects whether a project is accepted or rejected
– Reflect the rate of return available on the next best investment
opportunity
– Represents the opportunity cost developer’s expected to obtain
when foregone the next best alternative
– Converting values for equivalent times (PV or FV or Annuity)
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1. Construction Economics and Finance
• Decision Support Processes, Methods and Techniques
– Decision Support Processes
• Defining the problem and objective of the business
• Identify feasible alternatives taking into account constraints
encountered
• Selecting method of economic evaluations
• Selecting risk consideration techniques
• Compile data and make to good to be true assumptions
• Estimate tangible and intangible costs / expenses and benefits /
incomes
• Compute measures of economic performances
• Compare and / or prioritize as part of evaluation to identify the
best alternative
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• Decision Support Methods and Techniques
– Methods and Techniques
• Traditional Methods (Without considering Monetary Values)
– Annual Net Profit and Pay Back (Rate of Return on Capital)
• Methods based on an assumed IRR or discount rate
– Equivalent annual cost method (for regular cash flows)
– Present Worth Method or NPV (for irregular cash flows)
– Capitalized Cost (Particular case of NPV)
• Methods used to determine IRR (To determine IRR)
– IRR based on NPV (Using Trial and Error)
– ERR based on NFV (To alleviate IRR technical Problems)
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• Decision Support Methods and Techniques
– Methods and Techniques
• Methods Considering intangible / irreducible factors
– Benefit Cost Ratio (BCR)
– Breakeven Analysis
– Sensitivity Analysis
• Methods Considering Risks
– Value Analysis
– Decision Tree etc.
• Other Methods
– Life Cycle Cost etc.
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• Economic Feasibility
• Concerned with the ways in which decisions concerning economic choices
between alternative investments, methods and resources utilization
maximizations can be made
• Deals with two aspects of economic feasibilities
– Invest or Don’t Invest or Try Again (Go, No Go, May Go!!!)
– Priorities among or between alternatives where choices can be
• Balances investments which reduces cost and expand incomes to the
society as a whole
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• Economic Feasibility Tools
Traditional Methods
• Rate of Return on Capital
– Annual net profit / Capital invested
– Lack consideration for time value of Money
• Payback (PB) or Payout (PO)
– The payback period is the amount of time it would take for an investor
to recover a project's initial cost.
– Payback period is a quick and easy way to assess investment
opportunities and risk.
– The shorter the payback period, the more attractive the investment
would be, because this means it would take less time to break even
(the point of balance making neither a profit nor a loss).
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Traditional Methods
• Payback (PB) or Payout (PO)
– How fast can the gross capital invested be recovered by the net cash
flow during operations
– Lack consideration on the profitability aspects of an investment after
pay back in addition to the Time value of money and the timing of
cash flows
– Capital Invested / Average Net Profit
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Modern Methods
• Life Cycle Cost (LCC)
– Sums of all significant, time adjusted costs relevant for a selected
evaluation period – target is cost effectiveness
– Suitable when focus is on costs than determining benefits; that is
benefits are assumed constant among alternatives (meet their
performance requirements) or subtracted from costs
– Lowest LCC is considered economically feasible
– Not recommended for evaluating investments which generate
significant revenues or other benefits.
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Modern Methods
• Example: steps in Life Cycle Cost Analysis(LCCA) of a building
or a building system
– Define Initial Investment Costs
– The first step in the completion of the LCCA of a project
alternative is to define all the initial investment costs of the
alternative.
– Initial investment costs are costs that will be incurred prior to the
occupation of the facility. All initial costs are to be added to the
LCCA total at their full value.
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Modern Methods
– Define Operation Costs
– The second step in the completion of the LCCA of a project
alternative is to define all the future operation costs of the
alternative. The operation costs are annual costs, excluding
maintenance and repair costs, involved in the operation of the
facility. Most of these costs are related to building utilities and
custodial services.
– All operation costs are to be discounted to their present value
prior to addition to the LCCA total.
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Modern Methods
– Define Maintenance & Repair Costs
– The third step in the completion of the LCCA of a project
alternative is to define all the future maintenance and repair
costs of the alternative.
– It should be noted that there is a distinct difference between the
two costs.
– Maintenance costs are scheduled costs associated with the
upkeep of the facility. An example of a maintenance cost is
the cost of an annual roof inspection and caulking of the
building’s roof penetrations. This task is a scheduled event
that is intended to keep the building in good condition
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Modern Methods
– Define Maintenance & Repair Costs
– Repair costs are unanticipated expenditures that are required
to prolong the life of a building system without replacing the
system. An example is the repair of a broken window. This is
an unscheduled event that does not entail replacement of the
entire window unit, merely the replacement of the broken
pane.
– For simplicity, maintenance and repair costs should be treated as
annual costs. All maintenance and repair costs are to be
discounted to their present value prior to addition to the LCCA
total.
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Modern Methods
– Define Replacement Costs
– The fourth step in the completion of the LCCA of a project
alternative is to define all the future replacement costs of the
alternative. Replacement costs are anticipated expenditures to
major building system components that are required to maintain
the operation of a facility. (E.g. replacement of a boiler)
– All replacement costs are to be discounted to their present value
prior to addition to the LCCA total.
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Modern Methods
– Define Residual Value
– The fifth step in the completion of the LCCA of a project
alternative is to define the residual value of the alternative.
Residual value is the net worth of a building or building system at
the end of the LCCA study period.
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Modern Methods
• Net Benefit and Net Saving (NB & NS)
– Differences between time adjusted benefits or savings and costs of
courses of actions – target is economic effectiveness
– If NB > 0; the investment is economic
– If NB = 0; the investment is as good as the next best investment
opportunity
– If NB < 0; the investment is non economic
• Benefit to Cost Ratio
– Ratios of time adjusted benefits less future non investment costs to
investment costs – target is economic effectiveness
– If BCR > 1; the investment is economic recast
– Cost – Numerator / Benefits – Denominator
– Can be used for all types of decision choices but its primary use is for
Priority based decisions when constrained by resources
– Take care when used Technology based decision choices
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Modern Methods
• Internal Rate of Return (IRR)
– A measure of yield on investment
– Compared with the Minimum acceptable rate of return (MARR)
– If IRR > MARR; the investment is economic
– Determining Discount rate that will result the NB at Present Value = 0
– Trial and Error + Graphical approaches can be used to determine the
discount rate
• + NB implies reduce the discount rate assumed and vise versa; besides
interpolation can help in minimizing the trial and error steps
– Overstate Profitability or Benefit – Take Care
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Modern Methods
• First Year Rate of Return (FYRR)
– The first year rate of return (FYRR) is a term that is often used to
describe the amount of return that is generated during the first year of
a specific business initiative, project, or contract. The term is often
used to refer to the return after all expenses have been settled that
occurs during the first year of the project. In some cases, the first year
rate of return is utilized as a means of evaluating the effectiveness of
the effort and determining if it will be allowed to continue for another
year.
– Based on the outcome of the calculation, the project may be
authorized to continue, or plans may be made to incrementally shut
down the effort as soon as possible.
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Modern Methods
• First Year Rate of Return (FYRR)
– A measure of yield on investment during the opening year
– Benefit Cost Ratio of the first / opening year
– Uses Concepts similar to Benefit Cost Ratio method
– Reasonable when benefits are not decreasing over the life of the
project dramatically or the differences in development between
benefit components are relatively small
– They are recommended for Transport projects
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ACCOUNTING for financial Resources
• Construction Accounting Systems
– Four purposes
• Processes cash receipts (Cash in) and disbursements (Cash out) to insure
timely revenue collections and billing
• Processes data to prepare company financial statements to indicate the
financial status of the company.
• Processes data to determine regulatory requirements such as taxes,
duties, levies, premiums, etc. in order to avoid penalties
• Processes data to manage the finances of the company
– Cost Reporting Vs Monitoring
• Cost reporting shall base the principle of monitoring in order to insure in
time management of the financial resources, possibility of timely
claiming or negotiations for cost overruns, possibility of sub contracting,
etc
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– Accounting system responding to Cost reporting based on monitoring
must have the following components:
• Job cost and equipment tracking system.
• Principle of management by exception (quick to identify problems)
• Appropriate accounting procedures including how purchasing, inventory
and Billing could be processed together with acceptable limits for
different transactions
• Accessibility of cost related data for monitoring purpose easily and timely
– Three different ledgers
• The general ledger (company financial statement and income taxes)
• The job cost ledger (project specific financial data)
• The equipment ledger (heavy equipments and vehicles financial data)
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– The General Ledger
• Include all accounts necessary to track financial data
• Cash, Capital
• Accounts Receivable, Accounts Retained, Under billing
• Accounts Payable, Over billing
• Revenues, Expenses
– The Job Cost Ledger
• Work, Organization, Material, Labor, Equipment and Cost Breakdown
Structures
• Coding
– The Equipment Ledger
• Rent & Lease Payments; Depreciation; Repairs and Maintenance; Fuel and
Lubrication; Taxes, Licenses and Insurance; and Equipment Cost allocated
for each equipments
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• Construction Accounting Systems (Terms)
– Chart of Accounts - Expenses / Cost
– Balance Sheet / Financial State - Accrual / Accrued
– Income Statement - Debits / Credits
– Asset / Liabilities / Equity - Warranty / Bond / Guarantee
– Cash / Liquid Asset - Purchasing
– Fixed / Variable Asset - Inventory
– Accounts Receivable - Direct / Indirect Cost
– Accounts Retained / Retainable - Depreciation / Amortization
– Accounts Payable - Debts
– Revenue - Taxes
– Under billing - Sub Contract
– Over billing - Reserves
– Incomes / Income Statements - Interest (Discount/ Compound)
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Accounting Methods:
– Cash Accounting Method
• Easy to use, viable for small contractors, defer income taxes (income taxes
on received than revenues) i.e. The business does not realize income
until it actually receives it.
• Revenue is recorded when and only when you receive the money.
• Expenses are recognized when and only when you actually pay.
• Delays in recognizing accurate revenues and expenses
– Accrual Accounting Method
• Recognizes accounts payable, retained, retainable and receivables
• Income taxes on revenues than received
• records revenue as you earn it rather than when you receive it.
– Percentage of Completion Accounting Method
• the ongoing recognition of revenue and income related to longer-term
projects.
• Good for the best picture of a company’s financial health
• Recognizes revenues, expenses and estimated profit through the course
of the project.
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– Completed Contract Method
• Recognizes revenue and expenses at project completions.
• used to recognize all of the revenue and profit associated with a project
only after the project has been completed.
• Prior to completion, this method does not yield any useful information for
the reader of a company’s financial statements.
• It creates large swings in incomes during the course of the project
execution.
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– Balance Sheet
• A snapshot of Company’s Assets, Liabilities and Equity at a specific point in
time
• Assets = Liabilities + Equity (Capital + Retained Earnings)
• Assets
– Resources held and lead to future cash inflows
– Three types (Current, Long Term and Other Assets)
– Current Assets are liquid assets / cash or those assets expected to be
converted into cash, exchanged or consumed within a year
– Current Assets include Cash, Accounts receivable, Inventory, Under billings
– Cash includes demand deposits, time deposits within one year and petty cash
– Accounts Receivable are invoices owed to the company that will likely be paid
within one year (but not yet formalized as in the case of Notes Receivable)
– Inventory includes stocks in store for use or resale the next year
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– Balance Sheet  Assets
• Current Assets
– Under billings, reworks, cost overruns, etc.
• Long Term Assets
– Fixed and Other Assets whose useful life time are more than one year
– Include Building, Land, Construction Equipment, Trucks and Vehicles, Office
Equipment.
– Except Land all are subject to depreciation for financial accounting purposes
to determine accumulated depreciations
– Accumulated Depreciations are losses in values to date of the fixed asset
– Net Fixed Asset / Salvage Value = Fixed Asset – Accumulated Depreciation
• Other Assets
– Prepays/ differed charges (a long-term prepaid expense that is treated as an
asset on a balance sheet and is carried forward until it is actually used.)
– Brand name, Patents.
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– Balance Sheet  Liabilities
• Liabilities are obligations for a company committed to transfer assets or
render services or works at some future time
• Two types: Current and Long Term Liabilities
• Current liabilities include accounts / notes payable, over billings, accrued
payable, warranty reserves, capital lease payments, etc
• Accrued payable: expenses owed but not yet billed such as taxes, rents,
wages, employee vacations, etc
• Long term liabilities includes long term loan, mortgage of equipment,
building etc.
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– Balance Sheet  Owner’s Equity
• Owner’s Equity is claim of net worth of the company’s owner (s) on the
assets that remains after the liabilities are paid
• Capital Stock represents initial investment
• Retained Earnings represent prior accounting periods profits or earnings
retained to invest
• Current period net income represents the profits or losses incurred during
current accounting period
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– Simple Balance Sheet
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– Income Statement
• The income statement shows a company’s revenues, expenses and the
resulting profit generated over a period of time.
• Income statements span over a period of two balance sheets and record
all transactions occurring during the period
• Include Revenue, Expenses and Profits
• Revenue: income recognised from the completion of part or all of a
construction project
• Costs or Expenses: includes direct and indirect costs or overheads in the
case of self executions and Sub Contract Costs in the case for outsourcing
• Profit include Gross Profit, Net Profit from operations, Profit before and
after tax
• Gross Profit = Revenues – Direct Costs or Expenses
• Net Profit from Operations = Gross Profit - Overheads
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– Over billings and Under billings
• Over billings are costs and profits in excess of billings.
• Under billings are billings in excess of costs and profits.
• Current Contract Amount – Total Estimated Cost at Completion =
Estimated Profit
• Estimated Profit x Actual Cost to date / Total Estimated Cost at Completion
= Earned Profit
• Actual Cost to date + Earned Profit = Costs & Earned profit
• Total Billed – Costs & Earned Profit = Over or Under Billing
• Over billing when Total billed > Costs and Earned Profit
• Under billing when Costs and Earned Profit > Total billed
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• Analysis of Construction Financial Statements
– Most Common tools are the Company’s balance sheet and income
statement
– Besides, relationships among financial values (called Financial Ratios)
based on this common tools help to analyse financial statements
– Average balances are recommended to use than ending balances
when determining financial ratios
– Financial Ratios
• Quick Ratio / Acid Test Ratio = (Cash + Accounts Receivable) / Current
Liabilities
• It is a measurement of a Company’s ability to pay current liabilities with
cash or other near cash assets
• QR = 1 is liquid; QR < 1 need to convert inventory, notes receivable, other
current or long term assets to cash or raise cash through dept or equity
financing; QR > 1.5 indicates need to invest more or distribute
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• Current Ratio = Current Assets / Current Liabilities
• It is a measurement of a Company’s ability to use current assets to pay
current liabilities
• CR = 2 is considered a strong indication that a company is able to pay
current liabilities;
• CR < 1 need to convert long term assets to cash or raise cash through dept
or equity financing;
• CR < 1.5 indicates the company is under capitalized and may run into
financial problems during the next year;
• CR > 2.5 indicates need to invest more or distribute.
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• Debt to Equity Ratio = Total Liabilities / Net Worth (total share holder’s
equity)
• It is a measurement of the risk in the company all creditors are taking
compared to the risk the company’s owners are taking.
• D/ER < 2 is recommended ratio
• D/ER >2 is alarming to creditors
• D/ER< 1 is indicative to debt averse or opposed company (company
unwilling to take risk)
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• Fixed Assets to Net Worth Ratio = Net Fixed Assets / Net Worth.
• It is a measurement of the amount of the Owner’s Equity that is tied up in
fixed assets.
• Current Assets to Total Assets Ratio = Current Assets / Total Assets
• It is a measurement of how liquid a construction company’s assets are.
• Collection Period = Accounts Receivable (365) / Revenues
• It is a measure of the average time the company takes to collect its
accounts receivable
• Receivable Turns = 365 / Collection Period
• Average age of Accounts Payable = Accounts Payable (365) / (Materials +
Sub Contract)
• Payable Returns = 365 / Avg. Age of Accounts Payable
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• A recommended collection period and average age of accounts payable
shall be < 45 days.
• Assets to Revenue Ratio = Total Assets / Revenues
• It is a measurement of how efficiently the company is using its assets.
• Higher A/RR indicates over working and need care
• Lower A/RR indicates under working and need more work
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• Working Capital Turns = Revenues / Working Capital; or
• Working Capital Turns = (Revenues – Sub Contract) / Working Capital
• Working Capital = Current Assets – Current Liabilities
• It is a measure of how efficiently a company is using its working capital
• High number of Working Capital Turns indicate under capitalized and
needs to reduce works or increase current assets
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• Accounts Payable to Revenue Ratio = Account Payable / Revenue
• It is a measure of how much a company is using its diversified financial
sources as a source of funds
• The higher the percentage the greater the funding the company is
receiving
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• Gross Profit Margin = Gross Profit / Revenue
• Gross Profit = Revenue – Direct Costs and Expenses
• It is a measure of what percentage of revenue is available to cover
overheads and profits
• Pre tax Profit Margin = Net Profit before taxes / Revenues
• After tax Profit Margin = Net Profit after taxes / Revenues
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• General Overhead Ratio = General Overhead / Revenue
• Return on Assets = Net Profit After Taxes / Total Assets
• Pre Tax Return on Equity = Net Profit Before Taxes / Equity
• After Tax Return on Equity = Net Profit After Taxes / Equity
• Degree of Fixed Asset Newness = Net Fixed Assets / Total Fixed Assets
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Managing Costs and Profits
• Managing Costs
– Costs involved in construction projects
Total
Construction
Cost
Direct Cost Indirect Cost Profit
Gross
Material Cost Labor Cost Equipment Cost Overhead Cost profit=Revenue-
cost
Net
Material Price Buy / Rent /
profitbefore
at suppliers’ Labor Wage Lease Staffs Costs
tax (GP-OH
place Cost Options
costs)
Transportation
Annual leave
+ Utilities and After tax<NPBT-
and Operation Costs
Insurance + Tax facilities PT
Idle times
Costs
Transportation
Loading / + Travel +
Profit / Mark up
Unloading Severance Pay Mobilization +
costs
Costs Demobilization
costs
Other Other Other

Pre-Paid Items
Considerations Considerations Considerations
• Managing Costs
– Material Purchasing process
– Handling Labour on Construction Site
– Handling Equipment on Construction Site
– Sub Contractors Costs
– Overhead Costs
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• Setting Profit Margins
– The Profit Equation
• Revenues = Direct Cost + Over head + Profit
• Profit = Revenues – Direct Cost - Overhead
– Contribution Margin
• Overhead Cost = Fixed overhead + Variable overhead Costs
• Projects Contribution to Fixed Overhead of the Company
• Contribution Margin = Revenues – Direct Cost – Variable Overhead
• Profit = Contribution Margin – Fixed Overhead
– Projecting Revenue
• Contribution Margin Ratio = Contribution Margin / Revenue
• Determine Historical Contribution Margin Ratio and Fixed Overhead
• Projected Revenue = Fixed Overhead / Contribution Margin Ratio
– Adjusting Costs
• If Projected Revenue exceeds the capacity of the company; the
contribution margin ratio need to be increased either by reducing fixed
overhead or increasing the price
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• Setting Profit Margins
– Gross Profit = Revenue – Direct Costs
– Gross Profit Margin = Gross Profit / Revenue
– Gross Profit Margin = Contribution Margin + (Variable overhead /
Revenues)
– Profit and Overhead Mark up = Gross Profit Margin / (1 – Gross Profit
Margin)
– Profit and Overhead Mark up can be 15 – 22 % of Direct Costs
– Profit Margins can be 5 – 12 % of Direct Costs
6/14/2022 49

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Construction Economics and Finance

Direct Cost Indirect Cost Profit

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