FOOD ENGINEERING DESIGN AND ECONOMICS CHAPTER III COST ESTIMATION For a successful plant design, the process should be capable of operating under conditions which will yield a profit. Since net profit is the difference between total income minus all expenses, it is essential that an engineer should be aware of the many types of costs involved in manufacturing processes. Capital must be allocated for direct plant expenses (as raw materials, labor, equipment …) or for indirect expenses (administrative salaries, product distribution costs, cost for communication ….). A capital investment is required for any industrial process and determination of the necessary investment is an important part of the design project. The total investment for any process consists of fixed capital investment for physical equipment and facilities in the plant and working capital which must be available to pay salaries, keep raw materials and products on and and handle other special items requiring a direct cash outlay. •loans •common stock •bonds •other capital inputs net cash flow from the project •other investments •repayment of borrowed capital •stockholders dividends Capital source and sink Manufacturing Fixed Capital Investment Manufacturing Fixed Capital Total capital investment Investment Working capital investment total income from sales Operations for complete project costs for operations depreciation income taxes net profit after taxes Cash flow for industrial operations In the figure, total capital investment is shown as the trunk of a tree . The roots are fed by capital sink. Input to capital sink can be in the form of loans, stock issues, bond releases and other funding sources including the net cash flow returned to the capital sink from each project. Output from the capital source is in the form of total capital investments for each of the company’s industrial operations, dividends to stock holders, repayment of debts and other investments. The total capital investment includes all the funds necessary to get the project underway. This encompasses the regular manufacturing fixed capital investment and the working capital investment along with the investment required for all necessary auxiliaries and non manufacturing facilities. “operations for complete project” represents the overall operations for the complete project with working capital funds moving in and out as needed but not maintaining a constant fund as available working capital. Depreciation charges are to allow eventual replacement of the equipment and, therefore, paid back to company capital sink. These charges are not included in the costs for operation. Depreciation must be recognized as a cost before income tax charges are made and before the net profits are reported to the stock holders. The difference between income and operating costs represents gross profits before depreciation. After depreciation charges, net profit is taxable. The remainder is clear profit which can be returned to the capital sink along with the depreciation charges to be used for; new investments, dividends or repayment of present investment. Land, salvage Cash position Working capital recovery (dollars) Cumulative cash position start of construction Time (years) land Fixed capital investment Working capital investment construction period 0 1 2 3 4 5 6 7 8 9 10 Cumulative cash position The time period chosen is the estimated life period of the project and time value of money is neglected. The zero point on the abscissa represents the time at which the plant has been completely constructed and is ready for operation. The total capital investment at the zero point in time includes land value, fixed capital and auxiliaries investment and working capital. (i.e., cash position is negative) Cash flow to the company in the form of net profits starts to accumulate and gradually pays off the full capital investment. After that time, profits accumulate on the positive side of the cumulative cash position until the end of the project life. At that time the project is theoretically shut down and the operation ceases. After shut down working capital is still available and it is assumed that land can be sold at its original value. The final result on cumulative cash position is a net profit over the total life of the project. Factors Affecting Investment and Production Costs When a design engineer determines costs for any type of commercial process, these costs should be of sufficient accuracy to provide reliable decisions. To accomplish this, the engineer must have a complete understanding of the many factors that can affect costs. 1. 2. 3. 4. 5. sources of equipment price fluctuations company policies governmental policies operating time and rate of production 1. Sources of Equipment One of the major costs involved in any industrial process is for the equipment. In many cases standard equipments are used and a substantial reduction in cost can be made by employing idle equipment or by purchasing second-hand equipment. If new equipment must be bought, several independent quotations should be obtained from different manufacturers. When the specifications are given to the manufacturers, the chance for low cost estimate is increased when engineer does not place strict limitations on the design. 2. Price Fluctuations In the modern competitive economies, prices may vary widely from one period to another and this factor must be considered when the costs for industrial processes are determined. The cost for equipments, salaries and working capital required are to be compared with market values. 3. Company Policies Policies of individual companies have a direct effect on costs. Some concerns have particularly strict safety regulations and these must be met in every detail. Accounting procedures and methods for determining depreciation costs vary among different companies. The company policies with respect to labor unions should be considered, because these will affect overtime labor charges and the type of work the operators or other employees can do. Labor union policies may even dictate the amount material and type of material for the equipments, thus have a direct effect on the total cost. 4. Governmental Policies The national government has many regulations and restrictions which have a direct effect on industrial costs. Some examples are import and export regulations, restrictions on permissible depreciation rates, value added tax (VAT, (KDV)), ? (ÖTV), income tax rules and environmental regulations. Governmental policies with reference to caital gains and gross-earning taxes should be clearly understood when the costs are determined. Each company has its own methods for meeting the regulations, but changes in the laws and alterations in the national and companies economic situation require constant surveillance if optimum cost conditions are to be maintained. 5. Operating time and rate of production One of the factors that has an important effect on the costs is the fraction of the total available time during which the process is in operation. When equipment stands idle for an extended period of time, the labor costs are usually low; however, other costs, such as those for maintenance, protection and depreciation, continue even though the equipment is not in active use. Operating time, rate of production and sales demand are closely interrelated. The ideal plant should operate under a time schedule which gives the maximum production rate while maintaining economic operating methods. In this way, the total cost per unit of production is kept near a minimum because the fixed costs are utilized to the fullest extend. This ideal method of operation is based on the assumption that the sales demand is sufficient to absorb all the material produced. If the production capacity of the process is greater than the sales demand, the operation can be carried on at reduced capacity or periodically at full capacity. Amount per month ($) Total income Total production Break-even cost point Fixed costs Rate of production (amount/month) In the figure, a graphical analysis of the effect on costs and profits are shown when the rate of production varies. As indicated in the figure, the fixed costs remain constant and the total production cost increases as the rate of production increases. The point where the total product cost equals the total income is known ad the “break-even point”. The effects of production rate and operating time on costs should be recognized. By considering sales demand along with the capacity and operating characteristics of the equipment, the engineer can recommend the production rate and operating schedules that will give the best economic results. For the production total cost is the summation of fixed cost and variable cost; CT= CV + CF The variable cost is a function of production rate R, CV= gV .R where gV is the unit variable cost. Income from sales is a function of production; IT= fS .R where fS is the unit selling price. at break-even point, total cost and total income are equal; CT= CV + CF = IT gV. RBEP + CF = fS .RBEP RBEP CF f s gv Example: An industrial operation is working with 70 % capacity. The annual variable production cost is 140 000 $. Total annual fixed cost is 100 000 $. If the unit selling price of the product is 20 $ and with this capacity total annual gain is 280 000 $ what will be the production rate at “break-even point”. If the plant is operated with 100% capacity what will be the gross profit and net profit. For this example tax rate can be taken as 37% over gross profit. RBEP CF f s gv 280000 $ 20 $/unit 140000 $ gv 10 $/unit 14000 unit 100000 ($/year) RBEP 10000 units/year 20 - 10 ($/unit) I T f s .R, R With 100 % capacity, capacity=14 000 (1/0.7)=20 000 units/year This means break even point is reached at 50 % capacity. At this capacity total earnings=20 000 (20)= 400 000 $ total costs= 100 000 + 20 000 (10) = 300 000 $ Gross profit = 400 000- 300 000 = 100 000 $ Net profit = 100 000 (1-0.37) = 63 000 $ Capital Investments Before an industrial plant can be put into operation, a large sum of money must be supplied to purchase and install the necessary machinery and equipment. Land and service facilities must be obtained and the plant must be erected complete with all piping, controls and services. In addition, it is necessary to have money available for the payment of expenses involved in the plant operation. The capital needed to supply the necessary manufacturing and plant facilities is called the fixed capital investment, while that necessary for the operation of the plant is termed the working capital. The sum of the fixed capital investment and the working capital is known as the total capital investment. Fixed Capital Investment Manufacturing fixed-capital investment represents the capital necessary for the installed process equipment with auxiliaries that are needed for complete process operation. Expenses for piping, instruments, insulation, foundations and site preparation are typical examples of costs included in the manufacturing fixed-capital investment. Fixed capital required for construction overhead and for all plant components that are not directly related to the process operation are designated as the non- manufacturing fixed capital investment. These plant components include the land, processing buildings, administrative and other offices, warehouses, laboratories, transportation, shipping and receiving facilities, utility and waste disposal facilities, shops and other permanent parts of the plant. The construction overhead cost consists of field office and supervision expenses, home-office expenses, engineering expenses, miscellaneous construction costs, contactor’s fees and contingencies. In some cases, construction overhead is proportioned between manufacturing and non-manufacturing fixed capital investment. 1. 2. 3. 4. 5. 6. Working Capital The working capital for an industrial plant consists of the total amount of money invested in: raw materials and supplies carried in stock finished products in stock and semi finished products in the manufacturing process. accounts receivable cash kept on hand for monthly payment of operating expenses such as salaries, wages and raw material purchases. accounts payable taxes payable. Since the credit terms extended to customers are usually based on allowable 30 day payment period, the working capital required for accounts receivable ordinarily amounts to the production cost for one month of production. The ratio of working capital to the total capital investment varies with different processes as 10 to 20 %. This percentage may increase up to 50 percent or more for companies with seasonal raw material demand. Estimation of Capital Investment Capital investment estimations are done with several reasons as; i. ii. iii. iv. provide feasibility analysis help investors to decide between alternatives help investigations for money supply for new projects help for probabilities of bidding. The aim for the estimate and the aimed accuracy level directly affects the spent time and money. Type of Estimation Probable Accuracy Level (%) Cost (as percentage of project cost) Prepared by Order of magnitude or ratio estimate Study or factored estimate 30-50 1-0.1 20-30 0.1-0.2 Design engineer A project group Preliminary or 10-25 budget authorization estimate 0.4-0.8 Engineering company Definitive or project control estimate Detailed or contractor’s estimate 5-15 1-3 Contractor 2-5 5-10 Contractor Order of Magnitude Estimate (Based on the Method of Hill, 1956) This estimation method can be applied rapidly and is useful in determining whether a is worth pursuing, especially when there are competing routes. Bench-scale laboratory data is sufficient to determine the type of equipment and its arrangement to convert raw materials to products. To produce the estimate production rate in amount per year and flow sheet are required. Study estimate (Based on the overall Factor Method of Lang, 1948) Study estimate is based on a preliminary process design, where capital cost of a plant is estimated using overall factors that multiply estimates of the delivered cost of the major items of the process equipment. This method requires a process design complete with mass and energy balance and equipment sizing. In addition, materials of construction for the major items of equipment including the heat exchangers and pumps must be known. Considerably more time is required for this estimate than order of magnitude estimate. But, accuracy is improved to ±35%. Preliminary estimate (Based on the Individual Factors Method of Guthrie,1974) This method is best carried out after an optimal process design has been developed, complete with a mass and energy balance, equipment sizing, selection of materials of construction and required process control configuration is incorporated. In this type of estimates accuracy can be improved up to ± 20 %. Cost Indexes The purchased cost of processing equipment is generally obtained from charts, equations or quotes from vendors which are based on conditions at some time in the past. However costs are not static and because of inflation they generally increase with time. To update cost data at past to costs that are representative of the conditions of today cost indexes are used. A cost index is merely an index value for a specific time showing the cost at that time relative to a certain base time. If the cost at some time in the past is known, the equivalent cost at the present time ca be determined by multiplying the original cost by the ratio of the present index value to the index value applicable when the original cost was obtained. Cost indexes can be used to give a general estimate, but no cost index can take into account all factors, such as special technological advancements or local conditions. The common indexes permit fairly accurate estimates if the time period is less than 10 years. present original cost cost index valu e at present ti me index valu e at time original cost was obtained Year 1975 1985 1995 CE 182 325 381 MS 452 813 1037 ENR 207 392 509 2001 395 1110 594 Many different types of cost indexes are published regularly. Some of these can be used for estimating equipment costs, others apply specifically to labor, construction, materials or other specialized fields. Most common indexes for process industries are: The Chemical Engineering (CE) Plant Cost Index (I=100 for 1958) The Marshall and Swift (MS) Equipment Cost Index (I=100 for 1926) Contains all industry average equipment purchase cost. The Engineering News-Record (ENR) Construction Cost Index (I=100 for 1967) This index shows the variations in labor rates and materials costs for industrial construction. In our country such indexes are not provided. However, some indexes are prepared as life index, construction, materials and workmanship prices of some companies. These are published by, TÜİK, DPT, Bayındırlık Bakanlığı, Sanayi ve Ticaret Bakanlığı, Sanayi ve ticaret odaları,etc If the cost indexes are not found for our country, an approximate solution might be the use of the indexes in any country and calculating the amount based on currency exchange rate. Fixed Capital Investment Items 1. 2. 3. 4. 5. 6. 7. 8. 9. 1. 2. 3. 4. Direct Costs Purchased equipment Purchased equipment installation Instrumentation and controls Piping Electrical equipment and materials Building (including services Yard improvements Service facilities Land Indirect Costs Engineering and Supervision Construction expenses Contractor’s fee Contingencies 1. Purchased equipment The cost of purchased equipment is the basis of several pre-design methods for estimating capital investment. It is often necessary to estimate the cost of a piece of equipment based on a different operational capacity involved. Good results can be obtained by using the logarithmic relationship known as the six-tenths factor rule. 2. Purchased equipment Installation The installation of equipment involves costs for labor, foundations, supports, platforms, construction expenses and other factors directly related to the erection of purchased equipment. When very high or very low temperatures are involved, insulation factors can become important and it may be necessary to estimate insulation costs with a great deal of care. 3. Instrumentation and Controls Instrument costs, installation labor costs and expenses for auxiliary equipment and materials constitute the major portion of the capital investment required for instrumentation. Total instrumentation cost depends on the amount of control required and may amount to 6-30 percent of the purchased cost for all equipment. 4. Piping The cost for piping covers labor, valves, fittings, pipe, supports and other items involved in the complete erection of all piping used directly in the process. Piping estimation methods involve either some degree of piping take-off from detailed drawings and flow sheets or using a factor technique when neither detailed drawings nor flow sheets are available. 5. Electrical Installation The cost for electrical installations consists primarily of installation labor and materials for power and lighting, with building service lighting usually included under the heading of building and services costs. 6. Buildings including services The cost for buildings including services consists of expenses for labor, materials and supplies involved in the construction of all buildings connected with the plant One of the important items for building costs arises when huge amounts of storage requirements exist. (in food industry) 7. Yard Improvements Costs for fencing, grading, roads, sidewalks, railroad sidings, landscaping and similar items constitute the portion of the capital investment included in yard improvements. 8. Service Facilities Utilities for supplying steam, water, power, compressed air and fuel are some service facilities of an industrial plant. Waste disposal, administrative offices, fire protection, first aid, cafeteria, shipping and unloading facilities, warehouses, control rooms, storage facilities are included in service facilities cost. 9. Land The cost for land and the accompanying surveys and fees depends on the location of the property. Land is not considered in depreciation charges. Indirect costs 1. Engineering and Supervision The costs for construction design and engineering, drafting, purchasing, accounting, construction and cost engineering, travel, communications and home office expenses including overhead constitute the capital investment for engineering and supervision. 2. Construction Expense Construction expense includes temporary construction and operation, construction tools and rentals, personnel located at the construction site, construction payroll, travel and living, taxes and insurance and other construction overhead. 3. Contractor’s Fee The contractor’s fee varies for different situations. 4. Contingencies A contingency factor is usually included in an estimate of capital investment to compensate for unpredictable events. 1. 2. Startup expense After plant construction has been completed, there are quite frequent changes that have to be made before the plant can operate at optimum design conditions. These changes involve expenditures for materials and equipment and result in loss of income while the plant is shut down or is in operation with partial capacity. The cost of plant startup is typically estimated as 10% of Fixed Capital Investment. Some company accountants may prefer to divide plant startup costs into two categories; those costs incurred by the contractor in checking equipment performance, calibrating controllers and other plant equipment and commissioning the plant (included in capital cost) those costs incurred by plant operating personnel when starting up and shutting down the plant (included in operating costs) Estimation of Total Product Cost The methods of estimating the total capital investment have been discussed up to this time, which constitutes only one part of a complete cost estimate. Another equally important part is the estimation of costs for operating the plant and selling the products. These costs can be combined under the general heading of “total product cost” , which is further divided into categories of manufacturing costs general expenses Total product costs are commonly calculated on one of three bases; daily basis unit of product basis annual basis The annual cost basis is probably the best choice for estimation of total product cost, since: 1. 2. 3. 4. the effect of seasonal variations is smoothed out plant on-stream time or equipment operating factor is considered it permits more rapid calculation of operating costs at less than fully capacity it provides a convenient way of considering infrequently occurring but large expenses. I. Manufacturing Costs All expenses directly connected with the manufacturing operation or the physical equipment of a process plant itself are included in the manufacturing costs. I.1. Direct Production Costs Direct production costs include expenses directly associated with the manufacturing operation. Some of the variable costs listed here as a part of the direct production costs have an element of fixed cost in them. Although their amount changes with production level some part still occurs when the process plant is shut down I.1.1. Raw Materials In food industry one of the major costs of production is for the raw materials in involved in the process. The amount of the raw materials which must be supplied per unit of time or per unit of product can be determined from process material balances. The cost should be mainly based on the amount of raw materials consumed ( some of the materials are recovered, so they are not cost items ). Direct price quotations from prospective suppliers are preferable and freight or transportation charges should be included in the rawmaterial cost. These charges should be based on the form in which the raw materials are to be purchased for use in the final plant. These charges are expressed in four different methods: i.CIF Cost Insurance Freight All cost items are to be paid by the seller. The cost of the material does not depend on the location taxes, municipality charges, housing foundation, education foundation and defending foundations are all included . ii. FOB Free on Board Only the transportation charges are paid by supplier iii. FOB Production Center The purchaser have to pay fort he transportation charges. iv. Shared Freight The seller should bring the materials to the nearest distribution center and the purchaser pays fort he transportation charge from those centers to the factory. If the cost of raw material is an important part of total cost, then the firm should make additional contracts with producers. This may even effect the plant location. The estimations for future changes should also be included in the cost estimation. Other items affecting raw material cost are the amount of order and the quality of raw material. The quality is especially important for food industries and standards should be established and obeyed for each group. If the raw material is obtained within the firm, these might be profit including selling prices or some fictitious prices for taxation purposes. I.1.2. Operating Labor In general operating labor may be divided into skilled and unskilled labor. Labor charges are determined by experience of firm. In some industrially developed countries labor charges are fixed and published periodically. By using the flow sheet of the process the operating labor can be estimated from an analysis of the work to be done. In batch operations operating labor estimation is more important. Primarily, in these operations labor requirements are higher, also worker can be adjusted to be involved in more than one process. In continuous operations need for labor is not affected by amount of production. For such operations labor can be considered as fixed. However, changes in amount of production affect the labor requirements as materials handling, packaging and so on. I.1.3. Direct Supervisory and Clerical Labor A certain amount of direct supervisory and clerical labor is always required for a manufacturing operation. The necessary amount of this type of labor is related to: - total amount of operating labor - complexity of the operation - product quality standards. I.1.4 Utilities The cost for utilities depends on • • • amount of consumption plant location source The utility may be purchased at predetermined rates from an outside source or the service may be available from within the company. If the company supplied its own service and this is utilized for just one process, the entire cost of the service installation is usually charged to the manufacturing process. If the service is utilized for the production of several different products the service cost is apportioned among the different products the service cost is apportioned among different products at a rate based on the amount of individual consumption. Cost for steam is expressed per ton. This cost includes fuel, pretreatment of water, labor, depreciation and maintenance. If the steam is used only for heating purposes, estimation of the cost is easy. However, if it’s used for production of electricity in turbines and the exhaust part will be used for heating the estimation becomes more complex. Cooling water cost includes the cost for water, chemicals, depreciation charges, maintenance and pumping. The use of cooling water for one pass is not feasible. The cooling water itself is cooled by exposing to air and with adiabatic vaporization of some part. Therefore climate is important for water cooling systems design. Another cost will be faced for the conditioning of water. ( as pH adjustment, addition of biocides to prevent growth of microorganisms etc. ). In food processing factories, nitrogen is used as inert gas. It’s sold in pressurized containers and price for each cubic meters is fixed. Another gaseous item is compressed air, it’s cost is a combination of compressor and energy costs. Electricity is obtained from central distribution in most of the cases and in our country it’s supplied by TEDAŞ with fixed rates. I.1.5 Maintenance and Repairs A considerable amount of expense is necessary for maintenance and repairs if a plant is to be kept in efficient operating condition. The cost for maintenance is function of; - complexity of process - material of construction - skills of persons using the equipment - previous maintenance and repair Works at the plant. The cost for maintenance and repair is composed of i, necessary material ii. labor iii. supervision and some general expenses including timing. In the operation of plant, maintenance and repair costs are not stationary, they increase as the time of usage increase as the time of usage increases. On the other hand, if additional installations are made the maintenance and repair costs will be reduced. Therefore, in every plant the records for maintenance and repair should be kept with attention. I.1.6 Operating Supplies In any manufacturing operation, many supplies are needed to keep the process functioning efficiently. Items such as charts, lubricants, test chemicals, laboratory chemicals, guarding supplies can be considered as operating supplies. I.1.7. Laboratory Charges The cost of laboratory tests for control of operations and for product quality-control is covered in laboratory charges. I.1.8. Patents and Royalties Many manufacturing processes are covered by patents and it may be necessary to pay a set amount for patents rights or royalty based on the amount of material produced. if the patent is obtained in the plant, a certain amount of the total expense should be considered as an operating expense. In a manner, these costs are amortized over the legally protected life of the patent. I.1.9. Catalysts and Solvents Depending on the process involved some solvents, preservatives, natural dyes, leavening agents, purified vitamins etc. are used which brings additional costs. I.2. Fixed Charges Fixed charges are expenses which remain practically constant from year to year and do not very widely with changes in production rate. These are also expenses which are always present in an industrial plant whether or not the manufacturing process is in operation. I.2.1 Depreciation Equipments, buildings and other material objects compromising a manufacturing plant require an initial investment which must be written off as a manufacturing expense. In order to write off this cost, a decrease in value is assumed to occur throughout the usual life of the material usage possessions. This decrease in value is designated as depreciation. Since depreciation rates are very important in determining the amount of income tax, allowable depreciation rates based on the probable useful life of various types of equipment and other fixed items involved in manufacturing operations are established. The most widely used method for depreciation is straight-line method. In applying this method, a useful-life period and a salvage value at the end of the useful life are assumed. The difference between initial cost and salvage value divided by the total years of useful life gives the annual cost due to depreciation. I.2.2. Local Taxes These taxes are paid independent of income. Taxes paid for municipalities, (geçici vergi, muhtasar, stopaj, eğitime katkı payı…) I.2.3. Insurance Insurance rates depend on the type pf process being carried out in the manufacturing operation and on the extent of available protection facilities. I.2.4. Rent Annual costs for rented land and buildings show great variations depending on location. I.3. Plant Overhead Costs These costs are similar to the basic fixed chargers in that they do not vary widely with changes in production rate. The expenditures required for routine plant services are included in plant overhead costs. Expenses connected with the following comprise the bulk of the charges for plants overhead. Hospital and medical services Safety and protection janitor and similar services General plant maintenance and overhead. Employment offices, distribution of utilities, shops Payroll overhead Packaging Restaurant, cafeteria and recreation facilities Salvage Control laboratories Plant superintendence Storage facilities; interplant communications and transportation , warehouses, shipping and receiving facilities. These charges are closely related to the costs for all labor directly connected with the production operation. II. General Expenses In addition to the manufacturing costs, other general expenses are involved in any companies operations. II. 1. Administrative Expenses These costs cannot be charged directly to manufacturing costs however it’s necessary to include the administrative costs if the economic analysis is to be complete. executive salaries; administrators, accountants clerical wages; secretaries, typists engineering and legal costs; administrative buildings and other administrative activities. Office maintenance; costs for Office supplies and equipment. Communications; outside communications. II.2. Distribution and Marketing Expenses From a practical viewpoint, no manufacturing operation can be considered a success until the products have been sold or put to some profitable use. Therefore, the expenses involved in selling the products should be considered. Distribution and marketing costs vary widely for different types of plants depending on the particular material being produced other products sold by the company plant location company policies number of consumers II.3. Research and Development Costs New methods and products are constantly being developed in modern industries. Research and development costs include; salaries and wages for all personnel connected with this work fixed and operating expenses for all machinery and equipment involved cost for materials and supplies direct overhead expenses etc. II.4 Financing When the capital investment is supplied with barrowed capital either partially or as a whole, then this amount should be paid back together with interest. A fixed rate of interest is established at the time the capital is barrowed, therefore interest is a definite cost if the capital is to be barrowed. For income tax calculations, interest on owned Money cannot be charged as a cost. II.5. Contingencies Unexpected happenings and expenditures should be combined in this title and an amount is shown as general expenses.