Economic Aspects of project management

Elements of project cost

The cost of project may be divided into three principle elements namely

1. Material Cost

2. Labour cost

3. Expenses

Material Cost – It is the cost of commodities supplied to the enterprise. It is of two types

i. Direct material Cost – is one which goes into salable product or its use is directly essential for the completion of that product. E.g. cement, sand, steel etc. The amount paid for this is Direct material cost.

ii. Indirect material cost - is one which is necessary in the production process but is not directly used in the product. E.g scaffolding material, sandpapers, cotton waste, grease etc. The cost associated with such materials is called Indirect material cost.

Labour Cost – It is the cost of remuneration wages, salaries, commissions, bonuses etc of the employees of the concern. This is also classified as direct labour cost and indirect labour cost.

i. Direct labour cost – is the cost of labour who directly takes part in the production, who directly converts material into salable item. Eg.- plumber, electrician, welder, mason etc

ii. Indirect labour cost – is the cost of labour that does not alter construction, composition of direct material but is necessary for the progressive movement and handling of product. E.g- supervisors, maintenance men, foreman etc.

Expenses – include the cost of services provided to an undertaking and the notional cost of the use of owned assets. This is also classified as direct expenses and indirect expenses.

i. Direct expenses – which can be identified with and allocated to cost centers and cost units. E.g designs and layouts preparation, hire of special machine tools etc.

ii. Indirect expenses – which cannot be allocated specific item but consumed by cost units. E.g.- Rent of building, insurance premium, telephone bill. Some fixed expenses are taxes on land and building, rent and depreciation arising from time whereas some variable expenses are royalties paid, depreciation arising from use.

Prime Cost – Direct material cost + Direct labour cost +Direct expenses constitute prime cost.

Overheads – (Indirect costs/Burden) Indirect material + Indirect labour + indirect expenses. Overheads are classified as Production or manufacturing overheads, Administrative overhead, selling overhead, distribution overhead and R&D overhead.

Breakeven analysis

Revenue and cost can be studied by directing attention to total revenue and total cost. Breakeven analysis implies that at some point in the operations, total revenue equals total costs. The point on the graph at which revenue and costs agrees exactly is called breakeven point.

Importance of breakeven point – to know

i. What volume of sales will be necessary to cover a reasonable return on capital employed, preference and ordinary dividends and reserves

ii. Computing costs and revenues for all possible volumes of output to fixed budgeted sales.

iii. To find price of an article to give the desired profit.

iv. To find variable cost per unit.

v. To compare a number of business enterprises by arranging their earnings in order of magnitude.

Breakeven point = F/(1-V/P) where F is fixed cost, V is variable cost and P is selling price of each unit.

Breakeven chart is graphic representation of the relationship between costs and revenue at a given time, it’s an economic concept. It portrays margin of safety, likely profits or losses at various output levels.

Example

There are three lines on the chart – A horizontal line of fixed cost function. Do not change as function of increased volume of production. An increasing linear line of total costs which results from summation of fixed and variable costs. A sales revenue line which indicates that the price at which any quantity of the output can be sold is fixed and does not change with volume of production. T

The breakeven point marks ‘No profit-No loss situation’. The triangular area on left hand side of breakeven point marks loss whereas right hand side area marks profit. Profit appears only when minimum volume of output is reached. Profit increase at faster rate than total costs.

Margin of safety – is the distance between BEP and the output being produced. If this distance is large, it indicates that profits will be there even if there is serious drop in production. If this distance is relatively small it hints that profits will be reduced considerably with small drop in sales.

Limitations of breakeven chart –

i. The breakeven point is difficult to determine at many instances. Because of difficulty in classifying costs as fixed or variable.

ii. This is short term analysis tool not used for 8-10 years projection.

iii. The total cost line need not be a straight line every time.

iv. Breakeven chart represents a static picture whereas real business conditions are dynamic

v. The line representing sale may also mislead the true facts.

Investment – In business money is invested for following reasons

i. To procure land, buildings or expansion of existing project.

ii. To get material, machinery, vehicles.

iii. To get Water, power, gas supplies.

iv. Salaries , Administration and selling

v. Research work

Types of capital –

Fixed capital – in form of land, building, equipment and machinery, tools and furniture etc

Working capital – Once the fixed assets have been procured enterprise needs funds to meet its day to day needs such as purchase of raw material and supplies, payment of employee salaries and wages, storage costs, advertisement and selling, equipment and plant maintenance, transportation and shipping etc.

Investment appraisal – Any investment assumes that this investment will yield future income streams. Investment decision involves risk, because it deals with the future. Investment appraisal is all about assessing these income streams against the cost of the investment. Investment appraisal is a means of assessing whether an investment project is worthwhile or not. This tool is used in both public and private sector. Firms are likely to have a number of alternatives to choose from. Investment appraisal techniques can help them to do choose the best option. Following are the few of them-

Payback period –

Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. All else being equal, shorter payback periods are preferable to longer payback periods. Payback period as a tool of analysis is often used because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavor. When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment to "doing nothing," payback period has no explicit criteria for decision-making

Payback = Cost of Project / Annual cash flow

= Days/Weeks/Months x Initial investment/ Total cost received

Advantages of the method

i. The simplest method of investment appraisal

ii. This measures how quickly the returns from the investment cover the cost of the investment

Disadvantages of the method

i. It ignores any benefits that occur after the payback period and, therefore, does not measure profitability.

ii. It ignores the time value of money

Accounting rate of return

Accounting rate of return, also known as the Average rate of return, or ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Say, if ARR = 7%, then it means that the project is expected to earn seven Paisa out each Rupee invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment.

ARR = Average annual return or Annual profit / Initial cost of investment

Advantages of ARR

· It clearly shows the profitability of a project

· It allows easy comparison between projects

· The opportunity cost of investment can be taken into account

Disadvantages of ARR

· More complex than payback

· It does not take into account the effects of inflation on the

· value of money over a time period

Net Present Value

Net Present Value takes into account the fact that money values change with time. NPV considers how much would you need to invest today to earn x amount in x years time? As value of money is affected by interest rates NPV takes these factors into consideration. Shows you what your investment would have earned in an alternative investment regime.

NPV allows comparison of an investment by valuing cash payments on the project and cash receipts expected to be earned over the lifetime of the investment at the same point in time, i.e the present.

PV = Future value / (1+i)ⁿ Where i = interest rate, n = number of years

NPV is an indicator of how much value an investment or project adds to the firm. With a particular project, if R_t is a positive value, the project is in the status of discounted cash inflow in the time of t. If R_t is a negative value, the project is in the status of discounted cash outflow in the time of t. Appropriately risked projects with a positive NPV could be accepted. This does not necessarily mean that they should be undertaken since NPV at the cost of capital may not account for opportunity cost, i.e. comparison with other available investments. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected.

Discounted Cash flow method

A valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow (DCF) analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, the opportunity may be a good one.