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PROJECT COSTS, BUDGETING AND APPRAISAL

ByJude Iheanacho, MNIM, FCA

Learning Objectives

At the end of this session, participants would be able to:

• define project cost and its classifications;• explain cost behaviour and how Managers use

this information in project cost management;• generate budget forecasts;• appraise projects to ascertain financial

viability

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Introduction

• An important aspect of project management is the cost/benefit analysis, which shows project viability.

• This takes place at almost every stage in the project lifecycle, though it is prominent at the feasibility stage.

• For many government projects, other non-financial factors weigh into the decision process.

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Meaning of Project Cost

• Project Costs are resources sacrificed or foregone to achieve specific project objectives, measured in monetary terms.

• Cost = resource usage x resource price.

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Classifications of Project Cost

• Cost can be classified in the following ways:– Natural Classification;– Traceability Classification;– Functional Classification;– Controllability Classification; and– Behavioural Classification.

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Natural Classification (Cost elements)

• Materials and Components- Expenditure on raw materials and supplies;

• Labour cost - Remuneration paid by project owner to project executors;

• Overhead – Other operating expenses.

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Traceability Classification

• Direct cost – Traceable to a specific project or activity.

• Indirect cost – not readily identified with a specific project but grouped into common pools and charged through an allocation process. Cannot be easily or efficiently traced to a specific cost object.

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Functional ClassificationAccording to the functional areas / departments of the business• Production cost;

• Administrative cost;

• Marketing cost;

• Staff cost; and

• Finance cost;

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Controllability Classification

• Controllable cost – can be affected by a Manager at a given hierarchy.

• Uncontrollable cost – cannot be affected by a Manager at a given hierarchy.

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Behavioural Classification

• Fixed cost – the total cost does not change with the level of activity (volume of business).

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Behavioural Classification (cont)

• Variable cost – the total cost changes with the level of activity.

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Behavioural Classification (cont)

• Mixed cost – partly fixed and partly variable.

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Cost Optimization Vs Cost Cutting

• Cost cutting is focussed on reducing expenditure regardless of negative consequences;

• Cost optimization is reducing cost while considering impact on: – revenue generation;– Staff morale; and– Long-term objectives.

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Project Budgeting• Budgeting stems from Strategic Financial Planning

(SFP), a formal process for establishing financial goals and objectives over the long run;

• SFPs are implemented by developing short-term action plans known as budgets.

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Definition of Budget, Forecast, Plan

• ‘’A Budget is a quantitative statement for a defined period of time, which may include planned revenues, expenses, assets, liabilities and cash flows’’ – CIMA

• A forecast is a prediction of future events (business may have little or no control) and their quantification for the purpose of planning;

• Whereas a forecast is simply a prediction, a plan is similar to a budget as it shows what is to be done with the forecast.

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Forecasting Methods - Qualitative

• Opinion of a group of knowledgeable executives

Executive Committee Consensus

• A group of experts who eventually develop a consensus

Delphi Method

• Information from sales persons in the field

Sales Force Composite

• Asking customers their purchasing plans

Customer Surveys

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Forecasting Methods - Quantitative

• Trends, Seasonal, Cyclical factors

Time Series Models

• Cause and effect, regression, y= a + bx

Causal Methods

• Averages

Smoothing Models

• Use of economic indicators, e.g. inflation, demand, GDP

Econometric Models

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Benefits of Project Budgeting

• To establish project priorities, provide direction and promote forward thinking;

• Efficient planning on the use of resources;

• To motivate managers and other employees.

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Benefits of Project Budgeting (cont)

• To communicate project objectives and translate strategy into action;

• Clarification of authority and responsibility; and

• To facilitate management by exception.

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Project Appraisal Techniques or Capital Budgeting

• This is the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not.

• Involves allocating the firm's capital resources between competing projects and investments

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Importance of Project Appraisal

• Involve massive investment of resources

• Are not easily reversible

• Have long-term implications for the firm

• Involve uncertainty and risk for the firm

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Classification of Projects

• According to economic life:– Short-term– Long-term

• According to risk:– Replacement projects– Expansion projects– New products and markets– Mandated projects

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>classification

• According to dependence on other projects:– Independent projects– Mutually exclusive projects– Contingent projects– Complementary projects

• According to cash flows:– Normal cash flow projects– Non normal cash flow projects

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Steps in Project Appraisal

1. Estimate the CFs (inflows & outflows).

2. Assess the riskiness of the CFs.

3. Determine the appropriate discount rate

4. Evaluate the project viability.

5. Accept/Reject based on set criteria

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Project Appraisal Techniques

• Payback Period Approach

• Accounting Rate of Return

• Net Present Value Approach

• Internal Rate of Return

• Profitability Index25

Pay-Back Period

• The number of years it takes including a fraction of the year to recover initial investment is called payback period

• To compute payback period, keep adding the cash flows till the sum equals initial investment

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Pay-Back Period Example• Which of the following investments is preferred,

using the PBP Criterion?

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YEAR CASH FLOW OF PROJECT A (Nm)

CASH FLOW OF PROJECT B (Nm)

0 (50) (50)

1 10 30

2 15 20

3 15 10

4 10 6

5 22 2

PBP strengths & weaknesses

• Strengths– Provides an indication of a project’s risk.– For companies facing liquidity problems, it

provides a good ranking of projects that would return money early.

– Easy to calculate and understand.• Weaknesses

– Ignores the Time Value Money.– Ignores Cash Flows occurring after the payback

period.28

Accounting Rate of Return (ARR)

• Accounting rate of return (also known as simple rate of return) is the ratio of estimated accounting profit of a project to the average investment made in the project.

• ARR is used in investment appraisal.

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• Accounting Rate of Return is calculated using the following formula:

• ARR = Average Accounting Profit Average Investment

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• Average accounting profit is the arithmetic mean of accounting income expected to be earned during each year of the project's life time.

• Average investment may be calculated as the sum of the beginning and ending book value of the project divided by 2.

• Another variation of ARR formula uses initial investment instead of average investment.

• Decision Rule: Accept the project only if its ARR is equal to or greater than the required accounting rate of return. In case of mutually exclusive projects, accept the one with highest ARR.

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ARR strengths and weaknesses

• Strengths– Easy to calculate.– It recognizes the profitability factor of investment.

• Weaknesses– It ignores time value of money. – It can be calculated in different ways. Thus there is

problem of consistency.– It uses accounting income rather than cash flow

information.

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Net Present Value

• Net present value is the present value of net cash inflows generated by a project including salvage value, if any, less the initial investment on the project.

• It is one of the most reliable measures used in capital budgeting because it accounts for time value of money by using discounted cash inflows.

• What is Time Value of Money (TVM)?33

• Time value of money is the concept that the value of a Naira to be received in future is less than the value of a Naira on hand today due to the following reasons:

1. Money received today can be invested thus generating more money.

2. Inflation3. Risk of default/changes in projections

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• Thus, when a future payment or series of payments are discounted at the given rate of interest up to the present date to reflect the time value of money, the resulting value is called present value.

• The formula to calculate present value of a future single sum of money is:

= Future Value (FV)/ (1 + i)n Where, i is the interest rate per compounding period; and n are the number of compounding periods.

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10 8060

0 1 2 310%Cash Flows

-100.00

9.09

49.50

60.08

PV = 118.67 NPV = N18.67

0.909

0.826

0.751

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Computation of NPV

• Before calculating NPV, a target rate of return is set which is used to discount the net cash inflows from a project.

• Net cash inflow equals total cash inflow during a period less the expenses directly incurred on generating the cash inflow.

• NPV = PV of cash inflows – Initial investment

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• When cash inflows are uneven: NPV = R1 + R2 + … − Initial Investment --------- ------- (1 + i)1 (1 + i)2 Where,

i is the target rate of return per period;R1 is the net cash inflow during the first period;R2 is the net cash inflow during the second period;

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• When cash inflows are even:

• NPV = R × 1 − (1 + i) -n − Initial Investment ---------------- i • Where,

R is the net cash inflow expected to be received each period;i is the required rate of return per period;n are the number of periods during which the project is expected to operate and generate cash inflows.

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Present Value Tables

RatePeriods 10% 12% 14%

1 0.909 0.893 0.877 2 0.826 0.797 0.769 3 0.751 0.712 0.675 4 0.683 0.636 0.592 5 0.621 0.567 0.519

Periods 10% 12% 14%1 0.909 0.893 0.877 2 1.736 1.690 1.647 3 2.487 2.402 2.322 4 3.170 3.037 2.914 5 3.791 3.605 3.433

Interest rate per year

Annuity

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NPV strengths and weaknesses

• Strengths– Tells whether firm value is increased.– Considers all cash flows.– Considers the time value of money.– Considers the riskiness of future cash flows.

• Weaknesses– Requires estimate of cost of capital.– Expressed in terms of Naira, not as a

percentage.41

Capital Rationing

• Occurs when a limit is set on the amount of funds available to a firm for investment.

• Firm must rank investments based on their NPVs

• Those with positive NPVs greater than the cost of capital are accepted until all funds are exhausted

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Illustration of Capital RationingPROJECT REQUIRED

INVESTMENTNPV

A 800,000 (30,000)B 1,000,000 100,000C 2,000,000 400,000D 1,000,000 150,000E 2,000,000 380,000F 800,000 40,000

If the company has a budget of N5m, which projects will be accepted?

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Factors that Affect Project Cost

• Armchair cost analysis• Inadequate planning and coordination• Design changes• Unexpected ground conditions• Inflation and Exchange rates• Shortages of materials• Inappropriate contractors• Fund diversion• Force Majeure• etc

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Imperatives of Project Cost Management

• A WRITTEN ,NOT ORAL ,APPROACH TO PLANNING

• CLEARLY AND PROPERLY DEFINED AND VALIDATED PROJECT OBJECTIVES

• RIGOROUS PLANNING WHICH CLEARLY BRINGS OUT COSTS AND BENEFITS

• DOCUMENTATIONS OF ASSUMPTIONS WHICH UNDERPIN PLANS AND COSTINGS

• FORMAL COST AND BENEFIT ANALYSIS

• CLEAR LINES OF INTERNAL CONTROL AND ACCOUNTABILITY

• FORMAL CONTROL OF CHANGES TO PLANS AND THOROUGH DOCUMENTATION

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Conclusion

• A manager must have good knowledge of costs and their behaviour to enhance control of project costs;

• Budgeting lies at the foundation of every financial plan, failure to budget has grave consequences;

• Several methods are used to evaluate project/ investment proposals. The NPV method is superior as it considers the amount and timing of cash flows

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Questions

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THANK YOU