Topic 4 Project Cost Estimation

Resources, Plant and Machinery, Labour workforce and all other activities tied to the project has a cost attached to it therefore correct cost estimation is a must.

According to Nagarajan (2008) Correct estimation of the capital cost of a project is the foundation over which the edifice of financial appraisal stands meaning that resources can and will only be tied up to a project only after all coast factors have been taken into considerations and estimated.

Cost estimation is very important because, if we under estimate on our project cost, there is a risk of the project running out of money and we will have an incomplete project. Incomplete project may come to a halt if the project sponsor is unable to secure additional funds. If on the other hand the project cost is over estimated, there is the risk of more funds available which may be diverted for other purposes which may be detrimental to the interest of both the project sponsor and the financier.

Components of Capital Cost of a Project

Capital cost of any project may come in the following components;

Land – When it comes to land and building, project sponsor and investors may have the options of investing in land by purchasing outright or by leasing. These two options are available to project of any size. The component Land comes into the picture only after having decided to purchase land and construct building instead of starting the project in a leased premise. When choosing land, project sponsor should ensure that the land is neither to large so as to inflate the land price or not too small so that there is no space for future expansion.

Land Development – When it comes to land development, the following development takes place. Land need to be back filled or levelled out, cost of laying internal roads, fencing and gates and landscaping. These areas of activities also need careful cost estimation.

Buildings – There may be different building for different projects. Example: main factory building, Administrative building, Laboratory, Toilet block, health centre, etc. A plant layout of a project should be studied carefully to come up with the right costing. The costing should include all aspects and designs of the building from its size to its heights and different materials required to complete the building.

Plant and Machinery – When it comes to plant and machineries, project managers have to give careful considerations to the different types of machinery that is required for the project. From evaluation and analysis carried out by the project team, some plant and machinery can be easily purchased from suppliers locally while others can be purchased from external suppliers. How can we choose which plant and machinery are the ones applicable for use in our project? Project managers can choose the correct plan and machinery for projects by studying the reputation of the suppliers and through past performances. When machines are to be purchased and imported from outside the country, then all relevant costs have to be included such as import and freight fees etc. It is also important to factor in spare parts and its expected cost.

Electricals – When it comes to electrical work, project managers should ensure that all items relating to electrical work are factored into the costs such as cables, panel board, voltage stabilizers etc. If the project requires an electrician just for the electrical component of the project work then this need to be included into the electrical costs.

Transport and erection charges – When discussing transport and erection charges, you are looking at charges that will be incurred from transporting all the plant and machinery from the suppliers to the project site and setting or erecting them on project site.

Know-how/consultancy fees – Under this category, you will have costs for experts and consult as well as cost for in-house trainings for employees in production and operation process.

Miscellaneous assets – Miscellaneous assets would be the ones that do not form part of the plant and machinery but are allied to the industrial activity. Example; Bond fees paid as part of a lease or deposits in advances for power connectivity and water supply etc.

Preliminary and Pre-operative Expenses – These are preliminary expenses that are incurred before the project takes shape and starts commercial production. Example of such expenses would be; Investigation fees, services charges etc. Other expenses that may come under this category would be pre financed fee that comes before loans are processed and approved, Interest on term loans during implementation period, mortgage expenses, expenses on capital issues, insurance charges and other miscellaneous expenses during the project implementation stages.

Provision for contingencies – There may be variations or deviations to cost assumptions that may have been estimated against costs on land, land development, building, plant and machinery, electrical, transport and erection etc. To take care of any deviation, project managers have to allow for any contingency costs provisions.

Margin Money for Working Capital – Any project need funds for two purposes. Firstly funds are necessary for setting up of the project and secondly funds are required for maintaining the operation of the plant. Let us look at funds for setting up the project; this would consist of investment on fixed assets while funds for maintaining the operations of the plant would consist of investment on working capital.

 In these two types of financing, the financier expects the project promoter to come up with a margin or what is commonly known as equity. The entire requirement is not financed by way of loan. Let us look at an example: If the total working requirement is K50, 000.00, the bank may ask the promoter to come with a 25 percent margin or equity which in this case would be K12, 500.00 towards their share of the working capital and the bank would come up with the 75 percent of the loan requirement which is K37, 500.00. The margin or equity is included as a component of the project cost.

Method of Arriving at the Margin for Working Capital:

Margin Money for Working Capital

Working Capital requirement

Probable working capital loan that can be obtained from the bank

Working Capital Requirement consists of the funds required for maintaining the working capital cycle. A working capital cycle may be depicted as shown below in Figure 4.1 (Adapted from Nagarajan 2008) Funds are locked up in Raw Materials, Work-in-Progress, Finished Goods and Debtors



Figure 4.1

Raw materials: If raw material is readily available from nearby sources, there is no need to stock up heavily however, project manager should at least have enough in stock to last for a week to two weeks and also to meet any unforeseen situation of any emergency that may arise. However, it is important to consider situations and the need for raw materials.

Working in Progress: Work in Progress also means Goods in Progress or goods that are going through the production line. When goods are in the production line, there would be different stages in the production line so you may find some goods almost reaching the end of the process while some are in the middle of the production line while others probably just starting in the production line. When considering the cost of work in progress, project managers have to see the time taken by the raw materials to get converted into a finished product.

Cost of Work in Progress = Cost of Raw Materials + Expenses

= Cost of Raw Materials + (Direct Expenses + Overheads)

Table 4.1 - Example of Cost of Production and Profitability Estimates

Details	Year 1	Year 2	Year 3
Capacity Utilization A. Sales realisation B. Cost of Production Raw Material Power Fuel Consumables Wages & Salaries Repairs & Maintenance Rent & Insurance Factory Supervision Depreciation C. Admin & Sales Expense Admin Expenses Selling Expense D. Gross Profit before Interest & Tax (A – B – C) E. Financial Charges Interest on Term Loan Interest On Working Capital Loan F. Profit after Interest (D – E) G. Preliminary Expense W/Off H. Profit & Loss before Tax (F – G) I. Provision for Tax J. Profit/Loss after Tax (H – I) K. Less: Dividend L. Retained Profit (J – K) M. Add: Depreciation N. Add: Preliminary Expenses (Written Off) O. Net Cash Accrual (L + M + N)

The following components form part of Direct Expenses (Power, Fuel, Wages and Salaries, repairs and Maintenance and factory supervision)

Overheads comprises: Administrative Expenses, Selling Expenses which would include advertisement.

Stock of Finished Goods - Refers to the Cost of Goods produced and stored in the warehouse before dispatching to customers.

Cost of Stock (Finished Goods) = Cost of Raw Materials and Consumables + Expenses

= Cost of Raw Materials + (Direct Expenses + Overheads)

Creditors for Raw Materials and Consumables (Suppliers Credit)

In most business operations, there are suppliers that allow for credit facilities which means that raw materials and consumables are purchased on credits. Credit facilities in most cases are for 30 days or may be longer. Similarly the sales of finished goods sold to others are also sold on credit.

Suppliers' credit is calculated on the basis of raw materials/consumables costs thus the component of working requirements can be summarised as follows;

After having arrived at the working capital requirement, the next step is to arrive at the working capital margin that forms part of the capital cost of the project.

Working Capital Margin = Working Capital Requirement - Probable Working Capital Finance that can be arranged.

General Remarks on Project Cost

As mentioned in these lecture notes, the project costs is arrived at by adding all the estimate cost of individual components that is necessary to achieve the goals and objectives of the project. It is always worthwhile to have the project cost checked with industry standards. By checking with the industry standard will help in identifying at deviation that may occur in the future.

ILLUSTRATION 4.1 (Adaptation from Project Management; Nagarajan 2008)

PNG Industries Ltd, a newly incorporated company has proposed to set up a plant for the manufacturing of plastic moulded chairs. The following are the details of the proposed project. 

• The company has entered into an agreement for the purchase 2 acres of land for the project at the rate of K20, 000.00 per acre.

• The company has proposed to import the plastic moulding machine, which is the main machine at the value of K800, 000.00 Import duty on c.i.f. is 30%. This injection moulding machine is capable of producing moulded chairs at the rate of one chair per minute. Though the machine is capable of producing chairs of different sizes, the company has proposed to concentrate only on the manufacturing normal size due to the good market for the chairs.
• The company proposes to acquire the following machinery indigenously.

• Scrap Grinder (at a price of K50, 000.00)
• Mixing Machine (at a price of K40, 000.00)
• Power Generator (at a price of K350, 000.00)
• The cost of electric motors, starters, switches, cables and other electrical items K70, 000.00
• The cost of dies required for the plant is estimated at K300, 000.00
• The company has proposed to construct the following buildings.
• Main factory building with an open area (375 square metres)
• Store room for storage of raw materials and finish product (95 square metres)
• Office and administrative blocks with reinforced cement concrete (70 square metres)
• Other amenities like toilet block, compound wall, gate, underground water tank
• The raw materials required for the project is polypropylene granules, which is costing around K6.00 per kg. Wastages of raw material during the manufacturing process is estimated at about 3%
• The total power requirement (connected load) is estimated at 200 H.P.
• The selling price of moulded chairs is around K35.00 per chair in the retail market. The company has tied up a selling price of K28.00 per chair with a network of dealers across the country.

Estimate the cost of the project and make suitable assumptions wherever necessary.

SOLUTION:

For arriving at the project cost, each component of the project cost is to be taken up separately and assessed.

a)      Land

Extent of land proposed                                                   :           2.0 acres

Cost of land (at agreed price of K20, 000.00 per acres)   =          K40, 000.00

Add:          Registration Charges at 13% of the

                  (13% of K40, 000.00)                                     =          K 5, 200.00

                                                                                          =          K45, 200.00

b)     Land Development Charges: It has not been indicated that the land needs any developmental work. Hence no provision is made.

 

c)      Building:

 

1)      Main factory Building:     Built up area    -           375 sq. m.

Cost of construction at the rate of K37, 500.00 per sq. m. (estimated cost per sq. m. of construction is to be arrived at based on either detailed estimate or by making an assessment of the prevailing construction cost of similar constructions)

 

=    375      x          K37, 500.00:   K140, 625.00              (A)

 

2)      Store Room:          Built-up area:  95 sq. m

 

Cost of construction at the rate of K37, 500.00 per sq. m

=    95        x          K37, 500.00:   K35, 625.00                (B)

 

3)      Office and Administrative Blocks:           Build-up area: 70 sq. m

 

Cost of Construction at the rate of K53, 000 per sq. m

=    70        x          K53, 000.00:   K31, 700.00                (C)

 

4)      Other Amenities:[i] 

 

Toilet Block (Lump sum)              K15, 000.00

Compound Wall (Lump sum)       K30, 000.00

Gate (Lump sum)                          K 5, 000.00

Underground Water Tank             K12, 300.00

                                                      K62, 500.00                (D)      

Total Investment required for Building (A + B + C + D) = K275, 800.00

a)      Plant and Machinery:

 

1)      Imported machinery

C.I.F value                                                            =          K  800, 000.00

Customs Duty at 30%                               =          K  240, 000.00

*Clearing Charge                                      =          K      5, 000.00

                                                                  =          K1,045,000.00

 

Clearing Charges are the charges payable to the clearing agents for their services rendered in clearing the goods from the port and this may be in the range of 0.5% to 1%.

2)      Indigenous Machinery

Scrap grinder                                             =          K50, 000.00

Mixing machine                                        =          K40, 000.00

Power Generator                                       =          K350, 000.00

Dies                                                           =          K300, 000.00

                                                                              K740, 000.00

 Total Investment on Plant and Machinery                 =          K1, 785, 000.00

b)     Transport and Erection Charges: Expenditure under this head is to be estimated by studying to real situation. The main machine is proposed to be imported. Hence this machine is to be carried to the factory site from the nearest port        = K80, 000.00

 

c)      Electrical – Electric motors, starters, switches, cables and other electrical items for electrical work             =            K70, 000.00

 

d)     Contingencies – Contingencies provision is made to take care of probable increase in cost due to new additions or due to escalation in prices. Such provision allows certain percentage in increase say 10% to 15% on the overall cost of the project or in most cases under the different headings such as:

 

Land

Land Development expenses

Building

Plant and Machinery

Transport and erection

Electricals

Technical know-how fee

Miscellaneous assets

Example using our illustration above, if we decided to put 5% contingencies for building and say 10% on plant and machinery (indigenous), electrical, transport and erection and 15% on plant and machinery (imported), we would have calculation as follows;

 

Building - 5% of K275, 800.00                                              =          K13, 790.00

Plant & Machinery and others

10% of (K740, 000.00 + K80, 000.00 + K70, 000.00)          =          K89, 000.00

Plant & Machinery (Imported)

15% of K1, 045, 000.00                                                         =          K156, 750.00

Total for Contingencies                                                        =          K259, 540.00

 

a)      Miscellaneous Fixed Assets – The given data does not contain any information on the investment under this heading. The following assumptions are made;

 

Miscellaneous Assets                                                                           Price

Office furnitures                                                                     =          K12, 500.00

Office equipments                                                                  =          K14, 000.00

Deposit to Electricity Board                                                   =          K 7, 500.00

                                                                                                =          K34, 000.00   

 

1)      Preliminary and Pre-Operative Expenses – The following assumptions are made;

a)      Service charges on term loan                    :           0.75%

b)      Commitment Charges on term loan          :           1.00%

c)      Rate of Interest on term loan                    :           15% per annum

d)     Project Implementation period                 :           11 months

e)      Insurance premium on fixed assets           :           0.75% per annum

 

2)      Insurance premium on fixed assets: 0.75% per annum

The outlay required to meet items in (a) (b) and (c) depend on the term of the loan amount. Remember, we have not yet arrived at the term of the loan component. The value of fixed assets assessed so far is given below;

Land                                                                      =          K     45, 200.00

Land Development                                               =          K------------------

Building                                                                =          K   275, 800.00

Plant & Machinery

Imported                                                               =          K1, 045, 000.00

Indigenous                                                                        =          K    740, 000.00

Transport & Erection                                            =          K      80, 000.00

Electricals                                                              =          K      70, 000.00

Contingency                                                          =          K    259, 540.00

K2, 515, 540.00

 

The term loan component is not known at present. The following is assumed. Term Loan component (80% of fixed assets)

(i.e. 0.80 x K2, 515, 540.00)                                 =          K2, 012, 432.00

 

Interest during Implementation period (for a term loan of K2, 012, 432.00)[i]

 

15/100 x 11/12 x 200 x ½ [ii]                                   =          K137, 500.00

Commitment Charges at 1.00% of loan amount   =          K 20, 000.00

Service Charge at 0.75% of loan amount             =          K 15, 000.00

                                                                              =          K172, 500.00 

 

Insurance premium on fixed assets at 0.75% per annum

(0.75/100 x (275, 800 + 1, 785, 000 + 80, 000 + 70, 000 + 259, 540)

0.75% of K2, 470, 340.00                                    =          K1, 852, 750.00[iii]

Other Start-Up Expenses                                      =          K    90, 000.00

                                                                              =          K1, 942, 755.00

 

b)     Working Capital Margin – Before arriving at the working capital margin, which is the last component of the project cost, the working capital requirement for the first year of operation is required to be arrived at. From the working capital requirement, if the likely working capital loan component is deducted the balance represents the working capital margin. For arriving at the working capital requirement/margin, usually the data relevant to the first year of operation are taken into account. Let us assume the capacity utilization as follows;

 

Year	1	2	3	4	5	6
Capital Utilisation	50%	60%	70%	80%	80%	80%

 

[iv]The working capital requirement/margin is to be arrived at for the first year of operation viz, for 50% capacity utilization.

The format for arriving at the working capital margin/working capital finance is as under (for working capital limit about K500, 000.00

Total Current Assets                                                               =         K-----------

Less: 25% of the total current assets

(To be met out of long term sources)                                      =          K-----------

                                                                                                            K-----------

Less: Current Liabilities other than bank borrowing              =          K-----------

Maximum permissible bank finance                                        =          K-----------

 

Thus, as per the above method, the working capital margin is nothing but 25% of the total current assets. The different current assets/current liabilities and their period of requirement (assumed) are as under;

Current Assets

Raw Material and Consumables                                 -           1 month

Goods In Progress                                                      -           2 days

Stock of finished goods                                              -           1 month

Debtors                                                                       -           2 months

Current Liabilities

Supplier’s credit for raw materials and consumables  -           1 month

Let us calculate the total current assets using the above data.

Raw Material and Consumables – The raw material used for the production is ‘polypropylene’ and there are virtually no consumable and hence consumable is ignored.

Average weight of one chair                                                               = 2.50 kg

Quantity of raw material required for one chair taking into account wastage of 3% (2.50 x 1.03)                                                                                       = 2.575 kg

·         Output per day (for 3 shifts)                                                               = 1, 440 chairs

·         Output per day for the first year of operations at 50% capacity        = 720 chairs

·         Output per month (assuming 25 working days per month) 720 x 25 = 18, 000 chairs

·         Raw Material requirement for one month (18,000 x 2.575)               = 46,350 kg

·         Cost of Stock of one month requirement of raw material at the rate of K0.60 per kg therefore; (45,350 x 0.60)                                                                = K27, 210.00

Expenses:

a).Direct Expenses

i).Power – Power Charge K3.50 per unit (assumption)

Connected Power       -           200 H.P; 149.20 kilowatt; (1 HP = 0.746 Kilowatt)

Power Consumption per month at the rate of 24 hours working days per month = 149.20 x 25 = 89,520 units

(1 kilowatt-hour = 1 unit i.e., if one kilowatt of power is used for a period of one hour, the power consumption is one unit)

Power consumption per month for the first year of operation at 50% capacity utilization would be; (0.50 x 89,520)            =          44,760 units

Power charges per month for the first year of operation at the rate of K3.50 per unit (44,760 x 3.50)                                             =          K156, 660.00

 

ii).Fuel

Certain industries may need fire-wood, coal, furnace oil, etc.. in their production process. In the given project, the production process requires only electric power and hence no provision is made under this head. Though power generator envisaged in the project will consume diesel which can be provided for under this head, since frequent electric power cut/shortage is not envisaged, provision for fuel is made.

iii).Wages and Salaries

The following personnel and wages/salaries are assumed for the first year of operation.

Personnel	Salary per person Per month (Kina)	Total Salary per Month (Kina)
·         General Manager – 1 person   ·         Production in charge – 6 persons @ the rate of 2 persons per unit   ·         Skilled technicians – 12 persons @ the rate of 2 person per shift   ·         Semi-skilled persons – 15 persons @ the rate of 5 persons per shift   ·         Unskilled workers – 18 persons @ the rate of 6 persons per shift   ·         Wages for persons who are not regularly employed (Lump-sum)	20,000/-     15,000/-         9,500/-     5,000/-         4,000/-	20,000/-     90,000/-         114,000/-     75,000/-         72,000/-           10,000/- 381,000/- K381,000

 

iv. Repairs and Maintenance

The following assumptions are made for the first year operation.

(a)    Repairs and maintenance charges for building for the first year of operation = 0.5% of cost

(b)   Repairs and maintenance charges for plant and machinery for the first year of operation = 4% of the cost. Hence, Repairs and maintenance charges per month for both building and plant and machinery = 1/12[(0.5/100 x 27.58) + (4/100 x 178.50)]

=K6, 100.00

v. Rent, Insurance

Rent does not apply since the project is not set up in leasehold premises. Insurance consists of insurance on fixed assets as well as insurance on inventories.

Total estimated cost of building                                             =          K274, 800.00

Less: Cost of Office and Administration block and others    =          K  99, 600.00

Estimated Cost of Industrial Building                                               =          K176, 200.00

 

Out of the total contingencies provision of K260, 000.00, the proportionate contingency for office and administrative buildings and other amenities is to be excluded.

Total Contingency                                                                  =          K260, 000.00

Less: Contingency on Office and Administrative                  =          K    5, 000.00

Building and other amenities at 5% [5/100 x 9.96]                =          K255, 000.00

Industrial premium on industrial assets at the rate of 0.75%

Other expenses that require calculations and estimates are as follows;

·         Factory Supervisions

·         Overhead Expenses

·         Selling Overheads etc.

 

ORDER OF MAGNITUDE ESTIMATE

So far we have gone through some of the important aspects of project costing and the importance of ensuring all individuals components of the project are taken into considerations.

At the initial stage of project formulation, a project promoter may like to know about the approximate cost of the project and only after knowing the approximate costs, he can go for further detailed study.

There are other methods that can be used to calculate project costs. One such method is known by the term; Order of Magnitude Estimate. This method gives a rough and quick estimates and is use to give first-hand information about capital requirements before the finer details are looked at.

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[i] The loan component assumed is only a rough estimate and if the loan component arrived at after tying up the means of finance differs from this assumed figure by a large extent, the figures of preliminary expenses are to be recalculated.

 

[ii] It is assumed that the loan amount of K2, 012, 432.00 is drawn during the implementation period of 11 months at a uniform phase and hence the interest is arrived at by multiplying simple interest for 11 months by ½.

 

[iii] Transport and erection charges for machinery are also included for arriving at the insurance charges. The entire contingency provision of K259, 540.00 is also included on the assumption that the entire contingency will be used.

 

[iv] Capacity utilisation in the initial years is less due to the following reasons:-

·         Workers need time to get trained in the use of the machine.

·         Some machines normally require to be operated at a slower speed than the designed speed for some time.

·         The product is at the beginning stage and capturing market share will take some time.

 

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[i] The cost of construction of amenities can be obtained by getting detailed estimates from a qualified civil engineer. Under this head, the actual requirement of amenities should be studied carefully, because this is an area where there is likelihood of under estimation due to not envisaging all the amenities required for the project. For example; if water is required for the manufacturing process and if water supply is to be made available at different points in the production line, this will necessitate construction of an overhead water tank. The capacity of overhead water tank is to be ascertained based on the storage capacity required. Other amenities that may be required include loading/unloading platforms, canteen, and restroom for workers, power distribution room, etc. The actual requirement is to be arrived at after giving a thought over the needs of the project.

Sources: Nagarajan (2008) Project Management 3rd Edition (New Age)
D. Lock (2007) Project Management 9th Edition (Gower)