Effect of Cost Engineering on Costs and Rate of Return
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CAN cost engineering REDUCE COSTS and increase the rate of return?
by
- Muhammed Moolla
Table of Contents
1. Determining the viability of the project or best possible project
1.2 Net Present Value / Discounted cash flow Method
1.3 Internal rate of return method
2. The project cost estimate in relation to the financial analysis
2.1 Considerations when preparing the estimate
3. The complete financial analysis process
3.1 Financing of business activities
4. The WACC and the financial analyses
5. Reducing costs by reducing the cost of capital
List of formulae:
Formula 1: Interpolation to determine exact IRR: option 1
Formula 2: Interpolation to determine exact IRR: option 2
Formula 3: Weighted average cost of capital (WACC)
List of tables:
Table 1: Payback period
Table 2: Net Present Value Method
Table 3: Internal rate of return
Table 4: WACC Calculation
Abstract
The business world has encountered many challenges in recent times. All companies have been affected by improvements in communication and travel which has resulted in an increase in the level of competition faced from both local and foreign competitors while the current financial recession has resulted in a decrease in consumer spending. Apart from these common problems, all companies, regardless of location or work the company undertakes has specific challenges which result in the need to investigate every avenue of cost reduction and a better rate of return on invested capital to ensure it remains competitive and survives the ‘brutal’ current business environment.
The question is; how can cost engineering assist a company in achieving this goal?
Introduction
The beginning of August 2012 saw the author starting a new role at a South African gold mining company. The author was one of many individuals employed as part of a new team which was to investigate possible expansions to existing operations. However a short time later, most expansion projects were either postponed or slowed down only to be completely cancelled at a later stage. This was one of many changes made by the company, all of which were aimed at reducing running costs and cash flow requirements.
The Marikana mine tragedy along with the following labor strikes, a substantial drop in the price of gold and company share price as well as a downgrading of the South African economy all resulted in great financial pressure on the company as there was now reduced cash flow inputs from mining activities as well as an increase in the cost of capital for the company. The company was now unable to finance its then planned activities and forecasted cash flow requirements while projects which were once profitable were no longer as the cost of capital had increased. This resulted in an urgent need to reduce costs and identify the projects with the best return on capital spent to increase the rate of return while decreasing the cash flow requirements of the company. The question was then posed, how can project controls as a whole with the focus on cost engineering assist the company with this goal?
This question inspired the author to write about the effect cost engineering can have on reducing the company’s cash flow requirements while increasing the return on investment by selecting the best out of a range of possible projects as well as reduce the overall project costs by reducing the financial costs of a project.
1. Determining the viability of the project or best possible project
Before the execution of any project, a feasibility study / financial analysis into the financial viability of the project should be performed. This not only determines if the project is profitable but also if the project is in line with the organizations overall strategy and meets the organizations requirements in terms of return on investment.
A company is also likely to have financial restrictions which would not allow all viable projects to be executed. These analyses can further determine the best project from a range of potential projects. Preference can then be given to projects yielding the best results. Methods of financial analysis include:
- Payback method
- Net Present Value / Discounted cash flow Method
- Internal rate of return method
An overview of each financial analysis method is given.
1.1 Payback method
The payback method is one of the easier analyses and is considered to be basic. This method calculates the time it will take to recover the costs incurred in completing the project and can be used to compare multiple projects. For example, a residential development will cost $100,000.00 and take 1 year to complete with a yearly return of $25000.00 thereafter while the development of an office block will cost $185,000.00 and take 1 year to complete with a yearly return of $65000.00 thereafter. The payback method is calculated as follows:
Option A Cash flow |
Option B Cash flow |
|||
Year |
Yearly |
Cumulative |
Yearly |
Cumulative |
0 |
-100000 |
-100000 |
-185000 |
-185000 |
1 |
35000 |
-65000 |
60000 |
-125000 |
2 |
35000 |
-30000 |
60000 |
-65000 |
3 |
35000 |
5000 |
60000 |
-5000 |
4 |
35000 |
40000 |
60000 |
55000 |
Table 1: Payback period
Option A has a payback period between year 2 and 3 while option B has a payback period between year 3 and 4. Option A therefore would be the preferred option in this example.
The payback period method is quick and easy. It also depicts the expected cash flow from the project, however, it does not take income beyond the payback period into account neither does it account for the real/time value of money.
1.2 Net Present Value / Discounted cash flow Method
The net present value method is a form of the discounted cash flow method. This method takes into account the time value of money discounted at the selected interest rate or cost of capital. Is simple terms, due to inflation, $100 today is worth less tomorrow and vice versa. Looking back at the payback method example, the cost has been recovered after a certain period; however the real/time value of the same amount of money when it is recovered is less than when it was spent. If we were to use option A from the payback method example with an interest rate of 10%, the result would be as follows.
Year |
Yearly Cash flow |
Discount multiplier |
Discounted value |
Cumulative Discounted Value |
0 |
-100000 |
1 |
-100000 |
-100000 |
1 |
35000 |
0.9 |
31500 |
-68500 |
2 |
35000 |
0.81 |
28350 |
-40150 |
3 |
35000 |
0.729 |
25515 |
-14635 |
4 |
35000 |
0.6561 |
22963.5 |
8328.5 |
Table 2: Net Present Value Method
As can be seen, the ‘payback period’ is now between year 3 and 4 as opposed to between year 2 and 3 as in the previous example.
1.3 Internal rate of return method
The internal rate of return (IRR) method determines the interest rate which equates the value of cash outlays against cash receipts at the same point in time. For example, it is the interest rate which equates the value of spending $100 now, and receiving $30 for the next four years. The IRR is initially found by trial and error and can then be determined exactly by interpolating the initial results, for example, if we were to find the IRR for the spending the $100 dollars today and receiving $30 annually for four years with the receipt beginning from next year, the IRR could be calculated as follows:
Year |
Cash flow |
6.00% |
7.00% |
8.00% |
9.00% |
||||||||
Factor |
NPV |
Factor |
NPV |
Factor |
NPV |
Factor |
NPV |
||||||
0 |
-100 |
1.0000 |
-100.00 |
1.0000 |
-100.00 |
1.0000 |
-100.00 |
1.0000 |
-100.00 |
||||
1 |
30 |
0.9434 |
28.30 |
0.9346 |
28.04 |
0.9259 |
27.60 |
0.9174 |
27.52 |
||||
2 |
30 |
0.8900 |
26.70 |
0.8734 |
26.20 |
0.8573 |
25.39 |
0.8417 |
25.25 |
||||
3 |
30 |
0.8396 |
25.19 |
0.8163 |
24.49 |
0.7938 |
23.36 |
0.7722 |
23.17 |
||||
4 |
30 |
0.7921 |
23.76 |
0.7629 |
22.89 |
0.7350 |
21.49 |
0.7084 |
21.25 |
||||
3.95 |
1.62 |
-2.16 |
-2.81 |
Table 3: Internal rate of return
The IRR is therefore between 7% and 8%. Interpolation can then be used to get the exact IRR value using the results from the initial calculation. The formula for this is:
Percentage below IRR + _ _ X .
(X + (-1 x Y)) x 100
Formula 1: Interpolation to determine exact IRR: option 1
Alternatively
Percentage above IRR - _ _ Y .
(X + (-1 x Y)) x 100
Formula 2: Interpolation to determine exact IRR: option 2
Where:
X = NPV value of % below IRR
Y = NPV value of % above IRR
Note: NPV value of % above IRR is multiplied by negative one to obtain the positive value of this figure as it would be a negative value from the initial calculations.
For example, the calculation can be done as follows using the 7% and 8% IRR values from the initial calculation:
7% + 0.42 _ = 7% + 0.42 = 7.16%
(0.42 + (-1 x -2.16)) x 100 258
Alternatively
8% - 2.16 _ = 8% - 2.16 = 7.16%
(0.42 + (-1 x -2.16)) x 100 258
2. The project cost estimate in relation to the financial analysis
As previously mentioned, the feasibility study / financial analysis is important as it determines the financial viability of a single project or the best out of a range of possible projects. In order to perform this analysis however, a cost estimate of the project or projects is required. The cost engineer must therefore ensure that sound estimating practices and followed to ensure the results of the financial analysis are as accurate as possible while only the necessary resources are expanded and cost kept to a minimum when developing the estimate.
An inaccurate estimate at this stage could result in a project which does not truly meet the companies requirements been approved for execution or on the other hand a project which would be successful being rejected. To simply put it, the basic rule of GIGO (Garbage in, garbage out) applies and as such performing the financial analysis with inaccurate information will result in inaccurate results. However, if great effort was afforded to completing the estimate and the project is later found to be not suitable, all costs incurred in producing the estimate would be of no benefit. The following must therefore be carefully noted with regard to preparation of the estimate:
2.1 Considerations when preparing the estimate
Estimates can be produced in a multitude of methods. The AACE International Recommended Practice No. 18R-97 states that the level of scope definition is the primary factor to consider when determining the type of estimate to produce, while factors such as the end usage of the estimate, methodology applied in preparing the estimate and required accuracy of the estimate are all secondary factors.
While the accuracy of the estimate is important, the scope definition at the financial feasibility/analysis stage is usually low and as such a higher class (less detailed) estimate is usually prepared. Every possible should still be made to ensure the estimate is as accurate as possible. A method of ensuring this is to create a cost data base. This would allow the effective utilization of historic information. The use of this information database as well as adhering to the recommended practice with regard to estimate preparation would result in the cardinal rule of cost engineering, which is that benefits must outweigh costs, been adhered to as costs incurred as spending any additional recourses developing an detailed estimate would not be warranted and would be nothing more that wasteful expenditure.
Once a project passes initial analysis, the scope and therefore estimate can be further developed. This process of performing the financial analysis and further developing the scope if the analysis return positive results can happen multiple times, until a point where no further room for improvement exists. Again, this would ensure the cardinal rule is adhered to as additional costs are only incurred if warranted.
3. The complete financial analysis process
Other than only preparing the estimate for the financial analysis, the cost engineer may be part of a team responsible for performing the entire financial analysis or even solely perform the entire financial analysis of the project. The project objectives always need to be in line with the organizations strategic plan and meet the organizations requirements. This includes the required return on capital investments. To better understand return on investment, an overview of how businesses are financed and its associated costs will be explained.
3.1 Financing of business activities
The cost of running any business, which includes the execution of projects, is funded from multiple sources. Funds/profit generated from business activities, borrowing of funds from financial institutions or utilizing owners/shareholders equity are all methods which are utilized. A combination of funding from the various methods is most often utilized as each method has its advantages and disadvantages. Equity providers expect a higher return than interest bearing accounts and so the cost of this type of finance is higher, however loans provided by banks have fixed repayments while equity finance is more flexible in this regard. Each company would therefore determine the best method or ratio between the methods for its particular situation. The ratio between equity and borrowed funding is known as the financial gearing of the company.
3.2 The cost of finance
Other than the opportunity cost of lost potential income, there is also a financial cost to the business in terms of interest on borrowed capital or dividends to shareholders. The overall financial cost of financing from the particular gearing ratio of the company is known as the ‘weighted average cost of capital’ (WACC). The formula of which is:
WACC = Weighting of source 1 x Interest rate of source 1 + Weighting of source 2 x Interest rate of source 2 ……………………
Formula 3: Weighted average cost of capital (WACC)
Where:
WACC = Weighted average cost of capital
As can be seen from the WACC formula, more than 2 sources of financing can be used, however the total to the weightings of all sources must always equal to 1 or 100%
The following table is an example of a WACC calculation:
Source |
Cost |
Weighting |
WACC |
Equity |
20% |
50% |
10.0% |
Loan (Bank 1) |
10% |
25% |
2.5% |
Loan (Bank 2) |
10% |
25% |
2.5% |
100.0% |
15.0% |
Table 4: WACC Calculation
As can be seen, the WACC is dependent on the financial cost and weighting of the various sources. The value of the WACC can therefore be varied by adjusting the weighing or gearing ratio but there will always be some cost of capital.
4. The WACC and the financial analyses
When analyzing the results of the financial analysis, it is important to ensure the project meets the company’s requirements in terms of profit/returns. If the for example the company expects a project to increase the value of the firm by a minimum of 10% of project value, it is important to note that a project with an estimated profit of 20% may not necessarily be suitable. This is due to the fact that the WACC must be taken into account. If for example, the WACC is 15% and the expected profit is 25%, the nett profit is 10% and therefore meets the companies’ requirements in this regard; however, if the expected profit were to be only 20%, the nett profit is only 5% and as such does not meet company requirements. It also follows that that no project may be found to be suitable and as such no project is selected, again emphasizing the need to follow the estimating guidelines and prepare an estimate of the correct class and spend less time and begin with an estimate of lesser detail and then continue to develop after each stage that the project is found to be suitable.
5. Reducing costs by reducing the cost of capital
Reducing the financing cost is a way of reducing total project costs. Cost overruns due to underestimating is often viewed in a negative light and is rightly done so, however this is not always the case with the reverse when cost under runs occur. For this reason estimates could be ‘fattened’ up to reduce the risk of overspending. The addition of significant contingency without properly determining the contingency value by performing a risk analysis as well as inflation of rates to build in additional contingency is often practiced. This would result in a company paying more for funding than what is required and so this process actually cost the company more than what is required. This over financing is said to be the reason more than 70% of new businesses fail within the first year ^{(2, 3)}. Therefore an accurate estimate and the amount of liquid cash flow a company has at its disposal for a particular period has to be carefully considered to keep the cost of funding to a minimal.
6. Conclusion
While cost engineers may not be able to decrease the direct costs of a project in terms of material costs, labor costs, etc. Appling the principals of cost engineering can reduce project costs by reducing the associated financial costs. Furthermore cost engineering can also assist with improving the rate of return on invested capital and therefore the performance of a company by ensuring that the best possible endeavors are undertaken resulting in a better return on investment while reducing the total cash flow requirements of the company.
Bibliography
- Carlos Correia, David Flynn, Enrico Uliana, and Michael Wormald. 2011. Financial Management 7^{th} Edition. South Africa: JUTA
- BizHelp24. Over-Financing, Overtrading and Over Investment. 2009. http://www.bizhelp24.com/money/cash-flow-control/over-financing-overtrading-and-over-investment.html (Last accessed: January 27, 2014)
- BizHelp24. Avoiding Cash Flow Problems. 2013. http://www.bizhelp24.com/money/cash-flow-control/avoiding-cash-flow-problems.html (Last accessed: January 27, 2014)
- AACE International Recommended Practice No. 18R-97: COST ESTIMATE CLASSIFICATION SYSTEM – AS APPLIED IN ENGINEERING, PROCUREMENT, AND CONSTRUCTION FOR THE PROCESS INDUSTRIES. TCM Framework: 7.3 – Cost Estimating and Budgeting. Rev. November 29, 2011
- AACE International. Skills & Knowledge of Cost Engineering. Fifth Edition Revised
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