Topic 3 Project Appraisal

 

Project appraisal is a process of detailed examination of several aspects of a given project before recommending the same. The sponsor or the lender that is going to fund the project has to satisfy itself that the project is financially viable and is able to generate sufficient return before they can provide financial assistance for the project. Nagarajan (2008)

TECHNICAL APPRAISAL

Technical appraisal broadly involves a critical study of the following aspects;

• Selection of process/technology
• Scale of operations
• Raw Materials
• Technical know-how
• Collaboration agreements
• Product Mix
• Selection and procurement of plant and machinery
• Plant layout
• Location of the project
• Project scheduling and Implementation

Selection of Processes/Technology

Selection of processes or technology refers to a situation where one or more process or technologies are available for use. For example; in the process of manufacturing cement, there is the possibilities of manufacturing cement either by dry process or wet process.

The choice of technology also depends upon the quality and quantity of the product proposed to be manufactured. If the quantity to be produced is large, mass production techniques should be followed and the relevant technology is to be adopted. The quality of the product depends upon the use to which it is meant for. Example: If you require pharmaceutical product grade or laboratory grade to have high quality, then you require sophisticated technology to achieve this quality.

Students should be aware that when it comes to technology there are options of whether to purchase a certain technology outright if costs are affordable or resort to some other arrangements.

Checklists

Checklists are a very useful way of ensuring that no important task or cost item is forgotten when a new project is being evaluated. Contractors who have amassed a great deal of experience in their particular field of project operation will learn the type of questions that must be asked to fill most of the information gaps and they can develop comprehensive checklists for use in project cost estimates and proposals.

See separate Notes on Checklist.

Appropriate Technology

Always remember one technology maybe appropriate for use in one country however; it may not be appropriate for use in another country. Appropriate technology refers to the suitable technology that a project may require to accomplish the objectives of the project. Besides the project objectives, it has to be suitable for use within the local economy and able to meet social and cultural conditions.

When considering whether a technology is appropriate or not, the following questions may be able to guide you in your selection;

• Does the technology make use of the available raw materials produce locally?
• Can the technology be implemented and maintained locally?
• Is the technology in tune with the local social and cultural conditions?
• Is the technology safe for use within the environment?

Appropriate care must be given when considering what type of technology is appropriate and necessary for use in a project. 

Scale of Operations

Scale of operations refers to the size of a particular project, in term of plant size and market for project outputs. Example; In Papua New Guinea, LNG project  is considered a significant project because it has propelled PNG as an exporter of LNG to the world and its contribution to the economic development of the country.

Source: pesa.com.au

 

Nagarajan (2008) Economic size of the plant varies from project to project and this can be arrived at by analysing the capital and operating costs as a function of the plant size. If the funds required to implement the project at its economic size is too big a size for the promoter to manage, the promoter is bound to limit the size of the project that will suit his finance and managerial capabilities.

Raw Material

Selection of Raw Materials: Depending on the different type of projects investors can get involved in, the selection of raw materials is important due to the fact that a product can be manufactured using alternative materials and alternative processes. Raw materials can be accessed locally or imported from another location however, it is important that there is continuous supply of the required raw materials.

When considering raw materials, project managers have to ensure that they have the right equipment, plant and machinery is chosen and this is factored into the costs for the project.

 Technical Know-how

There are technical experts in different fields and professions that is why we see consultancy companies and businesses that are offering this type of service. When it comes to technical know-how, projects managers in most cases require the advice of experts. Care should be exercised so that the right expert is being engaged. Project managers need to check the expert’s background from other sources such as professional associations or from other referees or from past and current work that has been carried out by the expert.  Also care should be exercised to avoid self-styled, inexperienced consultants.

Collaboration Agreement

Careful considerations have to be given to instances where project promoters have entered into agreement with foreign collaborators. The word collaborator refers to a person who works with another person to create or produce a product. When project managers enter into such an arrangement or agreement, there need to be conditions stipulated in the agreement such as penalty clause, clause for non-performances etc.

Following points need careful considerations when projects enter into such an agreement;

• The competence and reputation of the collaborators need to be ascertained. This can be ascertained through foreign embassies or banks.
• Technology proposed to be imported should suit local conditions. Example: In Papua New Guinea, there are a lot of challenges when it comes to technology given the geographical nature of this country and infrastructural issues such as connectivity etc.
• Collaborative Agreement need to include laws and regulations of the host country so as to ensure projects are protected under the necessary laws of the country.
• The agreement should ensure that Training and technical know-how are part of the agreement.
• The collaborative agreement should ensure the agreement does not infringe on any patent rights.
• Any financial participation by the collaborators must be clearly understood by all parties and adhere to laws.
• Agreement should include any back-up arrangements from the collaborators to ensure quality of output.

Product Mix

Consumers differs in taste and preferences and these differences should be taken into considerations when planning the manufacturing line of a manufacturing project so that there is flexibility to modify or change when necessary or when requested by customers.

Example: A plastic container manufacturing industry can be planned to have more number of different sizes of soft drink bottles to be produced according to the market requirements. In Papua New Guinea, you can see good examples in the different sizes of coke bottles we have in the market as well different sizes of lunch packs.

Selection and Procurement of Plant and Machinery

Selection of Machinery: The selection of machinery would depend on the project requirements, size and capacity of the plant or factory being proposed. The following factors need to be considered;

• Planned Output
• Operations and Machine hours
• Machine Capacity and allowances for maintenance, break-down, and rest-time for workers

Once the above factors have been taken into considerations, the project managers can then survey the market and search if the type of machine required is available.

Processes - When there are many different processes involved in a particular plant of factory, then the project managers have to ensure that the right type of machine are selected for the different process requirements. The following points should be considered;

• The machine can do the processing and it is of quality. It can be easily be handled by the workers. Parts and accessories is easily be purchased and stocked and the machine can easily be disposed.
• Stand by arrangement in place for any critical situation.
• Supplier is able to provide training and technical back up services if and when required.
• The machine is in good and workable condition.

Procurement of Machinery – All project whether large or small require some form machineries and equipment to carry out work on the project. It is therefore important to remember that machine and equipment are needed and they form the backbone for any project.

Project managers should remember that the quality of output depends upon the quality of the machine used in the processing of the raw materials. We also must remember that interruption in production can cause delays and affect other component of the project thus procurement of the right equipment is very important.

How can you know if the supplier of the equipment and machine are reliable? By checking out the reputation of the supplier and ensuring that the suppliers has a good back up service, and performance is guaranteed. It is also guaranteed that he can be available to provide technical assistance if needed. 

Plant Layout

Efficiency of a manufacturing plant or factory operation depends upon the layout of the equipment and machinery and therefore it is important as to how and where the machine and equipment are installed. Plant layout arrangements normally take into account easy accessibility, safety requirement for the plant and workers, ventilations and movement of materials in and out of the plant. There need to be easy access in and out of the plant etc. When deciding on plant layout the following factors need to be considered;

• Future expansion can be done without much alteration.
• Layout should facilitate effective supervision of work.
• Noisy equipment should be located away from the plant site
• Adequate clearances between adjacent machines
• Ensure there is smooth flow of men and materials from one stage to another.
• Ensure maximum safety to workers within the plant site.
• Proper lighting and ventilations
• Smooth flow of electricity and water supply 

Location of Projects

Many factors are taken into account when deciding on location for new projects and there are two major factors; Regional factors and Site factors

Regional factors – Raw Materials constitute a huge component of the cost for a product therefore it is important to minimize cost when it comes to raw materials. When you look at minimizing costs, you would normally look at transport costs, locations of where the raw materials is stored, distances to transport raw materials and so many other factors. When all these factors are taken into considerations, the location of the project can then be decided.

In Papua New Guinea, students would have noticed that few of our extractive industries have plants near sea ports. This is for easy accessibility of raw materials in and out from the plant and also easy to export product out of the country.

Other considerations that students need to keep in mind when considering location of project are proximity to the market as well as availability of labour, availability of supporting industries and availabilities of infrastructural facilities.



Source: energydeals.file.word

 

Power – For any intensive industry, there need to be reliable and regular power supply and whether this can be made available through the feeder lines or whether the project need to access power through other sources.

Water – Water is necessary in any plant or factory site therefore, water source, water quality and regular supply must be guaranteed and taken into consideration. There are other ways of accessing water and these can be done by using underground water source, from rivers or from the sea.

Transport facilities – Transport costs can be divided into two categories, the first cost is the transportation of raw materials and fuel into the plant site and the second is for the movement of finished products outside the plant site.
 

Site Factors – Site factors have to be advantageous for the location of the project and considerations have to be given to the following factors;

• Cost and availability of land
• Availability and suitability of water source
• Facilities for affluent disposals

Choice of Location – After consideration has been given to all the issues mentioned above, and then choice of location can be considered. Choice of location based on tangible factors;

Illustration by way of Examples;

A team of four entrepreneurs joined together in partnership arrangement to set up a new project for manufacturing, processing and exporting of lime stone in Papua New Guinea. They have studied many different locations for the project and finally, after weighing the pros and cons have arrived at four different locations; A, B, C, D. The tangible and intangible factors relating to the four locations are listed in the table below in PNGKina.

Factors	A	B	C	D
Tangible Factors:- a)      Investment on land and land development b)      Investment on Building c)      Investment on Plant, Machinery, transport and erection charges d)      Expenses on Raw Materials per annum e)      Salaries and Wages per annum f)       Expenses on Utilities (per annum) g)      Distribution Expenses (per annum) h)      Sales (per annum)   Intangible Factors:- a)      Attitude of labourers b)      Recreational Facilities c)      Community Services (health, Schools, Transport)	100,000.00   700,000.00   330,000.00   200,000.00   80,000.00   70,000.00   30,000.00   600,000.00     Poor Good Fair	120,000.00   800,000.00   320,000.00   240,000.00   80,000.00   50,000.00   10,000.00   530,000.00     Indifferent Good Poor	150,000.00   750,000.00   340,000.00   260,000.00   85,000.00   40,000.00   25,000.00   550,000.00     Good Bad Fair	70,000.00   800,000.00   330,000.00   220,000.00   90,000.00   30,000.00   5000.00   600,000.00     Good Bad Good

 Identify the suitable locations considering only the tangible factors.

SOLUTION

When tangible factors of the different locations are considered, rate on investment comes handy as a leading indicator to decide upon the choice of the location.

Location

PROJECT APPRAISAL	A	B	C	D
Sales	600,000.00	530,000.00	550,000.00	600,000.00
Factors
Expenses (d) Expense of Raw Materials	200,000.00	240,000.00	260,000.00	200,000.00
Expenses (e) Expense for Salaries & Wages	80,000.00	80,000.00	85,000.00	90,000.00
Expenses (f) Utilities per annum	70,000.00	50,000.00	40,000.00	30,000.00
Expenses (g) Distribution Expenses per annum	30,000.00	10,000.00	25,000.00	5,000.00
Total Expenses	380,000.00	380,000.00	410,000.00	325,000.00
Profit	220,000.00	150,000.00	140,000.00	275,000.00
a)      Investment on land and land development	10,000.00	12,000.00	15,000.00	70,000.00
b)      Investment on Building	70,000.00	80,000.00	75,000.00	80,000.00
c)      Investment on Plant, Machinery, transport and erection charges	330,000.00	320,000.00	340,000.00	330,000.00
Total Investment	410,000.00	412,000.00	430,000.00	480,000.00
Return on Investment. (Profit x 100/Total Investment)	53.7	36.4	32.6	57.3

Based on the return on investment, locations B and C score comparatively less, therefore location A and D will be considered. Out of these two locations we then can make a final decision after taking the intangible factors into account.

Choice of location based on Tangible and Intangible Factors

When looking at choice of location we have to take into account both the tangible and intangible factors, the solution to the problem takes the nature of a subjective decision. This is due to the fact that intangible factors  cannot be accurately quantified.

Dimensional Analysis -  This method of analysis is used for comparing two locations and deciding which of the two location is the most favoured. When carrying out this analysis, we have to keep in mind both the tangible as well as intangible factors.

Example:

Let us look at the two locations A and B.

CAı, CA2, CA3, …. Are the different costs associated with the tangible factors of location ‘A’ and/or other different scores associated with intangible factors of location ‘A’.

CBı, CB2, CB3, …. Are the different costs associated with the tangible factors of location ‘B’ and/or other different scores associated with intangible factors of location ‘B’.

Wı, W2, W3, …. are the weights given to the tangible and intangible factors. Then the relative merit of location A and location B is given by;

(CA1/CB1)^W1   x (CA2/CB2) ^W2   x (CA3/CB3)^W3 x………

If the value of the above relationship is more than 1, it means that location ‘A’ gains more points when both tangible and intangible factors are combined which in turn means that location ‘A’ is comparatively costlier than location ‘B’ and hence location ‘B’ is preferable to location ‘A’.

SOLUTION:

Let us look at our Illustration 3.1 and the two locations that we have identified as favourable and that is location A and location D.

To apply dimensional analysis, scores for the intangible factors (in the range of 1 to 10) and weight for the tangible and intangible factors are to be assigned.

Intangible Factors	A	D
Attitude of labours   Recreation Facilities   Community Facilities	Adequate (5)   Good (2)   Fair (4)	Good (2)   Bad (8)   Good (2)

 Nagarajan (2008) Assigning scores is a subjective phenomenon and has to be done judiciously. It is like giving marks to a feature. If a feature is very good, excellent, and rare to find, it is treated as the best and score is assigned as 1. On the other extreme, if a feature is very bad and highly unfavourable it is treated as the worst and score is assigned as 10. Features having qualities in-between the best and the worst conditions are assigned scores in the range of 2 to 9.

After having assigned the scores for the intangible factors, weights for the tangible and intangible factors are to be assigned. The weight for all tangible factors is assigned as 1 since all tangible factors are measured in terms of the common units, money. The intangible factors are compared among themselves and weights are assigned depending upon relative importance.

If we assume weights for the intangible factors as under;

Intangible Factors	Weights
Attitude of labours   Recreation Facilities   Community Facilities	2   3   2

 

Then the merit of site A to D is given by the following relationship.

(100,000/70,000)¹ x (700,000/800,000)¹ x (330, 000/330,000)¹ x (200,000/220,000)¹ x (800,000/900,000)¹ x (700,000/300,000)¹ x (300,000/50,000)¹ x (5/2)² x (2/8)³ x (4/2)²

= 5.5239 or 5.5146

Since the factor works out to be more than1.00, location is preferable to location A.

Observation

When only the tangible factors are considered location A scored marginally higher over location D as evidenced by marginally higher return on investment. However, when both tangible and intangible factors are considered, location D becomes preferable to location A.

Project Scheduling

Schedule according to the Oxford Advanced Learners Dictionary refers to a plan that lists all the work that you have to do and when you must do each thing. When we are referring to project scheduling, we are looking at the arrangement of activities of the project in the order of time in which they are to be performed.

Students will come across project scheduling in logical sequences. In most case, it will be in the following order;

• Land acquisition
• Site development
• Preparing building plans, estimates, designs, getting necessary approval from relevant government agencies, and putting out tenders for contractors.
• Construction of building, machinery foundation and other related civil works
• Placing order for machinery
• Receipt of machines on site
• Erection of machinery
• Commissioning of plant and taking trial runs
• Commencement of regular commercial production

All activities noted above consume resources these are time, money, and effort and every attempt should be made to minimize resource consumption. That means there has to be efficient and effective ways of utilizing the available resources within the project time span.

When there is no project scheduling, resources will be wasted because the project team may not know which activities have to be carried out first and which one follow and so forth.

As part of the technical appraisal, financial institutions normally calls for a detailed project implementation schedule indicating the various steps to be taken in a chronological order of sequence.

As we study further into the topic, we will come across techniques that can be used in project scheduling.

COMMERCIAL APPRAISAL

When we look at commercial appraisal, we are now concerned with the marketing aspect of the project that you may be working on whether it is a new product, a new building and you are now appraising the commercial viability in the market.

Market appraisal is now an important aspect in project appraisal because the very survival and success of any project depends on the question as to whether the product or services offered by the project is or will be successful commercially. Commercial Appraisal or Market Appraisal of a project can be carried out from different angles;

• Demand for the product.
• Supply position for the product
• Distribution Channels
• Pricing of the product
• Government policies

Demand

Economists define demand for a commodity as the desire backed by the necessary purchasing power.

D. Moynihan, B Titley (2000) Demand is the want or willingness of consumers to buy goods and services. To be an effective demand, consumers must have enough money to buy commodities given a number of possible prices.

Nagarajan (2008) One of the most important determinants of a firm’s profitability is the demand for its products. Because of the important role played by demand as a determinant of profitability, estimates of expected future demand for the product proposed to be manufactured constitutes a key element in all the planning processes. Hence demand analysis forms a major part of project appraisal.

If you consider the above explanation, you can define demand as the number of units of a particular good or service that consumers are willing to purchase during a specified period under a given set of conditions.

Demand Forecasting Techniques

Forecasting is trying to predict or estimate what would happened in the future. No forecasting can be accurately predicted therefore different methods of forecasting techniques have been designed to assist managers and planners with some certainty future events.

Nagarajan (2008) In business you can use two approaches to the problem of business forecasting.  One approach is to obtain information about the intentions of consumers through collection of views and opinions of experts in the field or by conducting interviews with consumers. Such an approach is known as Survey Methods. The other approach is known as the Statistical Approach. This approach uses past experiences as a guide to arrive at the future demand by extrapolating the past statistical data.

The survey methods is suitable for short-term forecasting while the statistical method is suitable for long-term forecasting.

Survey Methods

There are few ways to conduct a survey and we will go through them briefly; 

Jury of Expert's Opinion Methods - In this particular method, experts in a particular field or industry are asked a series of questions whereby they have to give their expert opinions. Given the expert knowledge in a particular product or industry, the experts may be able to predict the outcome based on expert knowledge and past experiences. One disadvantage with using the Expert Opinion survey method is that one person who is very vocal during discussion may easily persuade his opinion over other experts.

Delphi Method – Is a group decision by experts in which individual experts are given questionnaires separately and they provide their views and answers independently. Their answers are pooled together and if results are consistent than the data may be use further to predict an outcome. If there are inconsistencies in the result, then the experts are further required to provide further explanation. The advantages of the Delphi method are that the experts do not interact or talk to each other. The answers are provided independently by the experts.

Consumer’s Survey Method – The consumer’s survey approach is the most direct approach to demand forecasting. In this type of survey, the consumer is approached and asked to express his or her opinion of a particular product. Depending on the size of your consumers, you can carry out the survey on every customer that you have or you can select a specific group. In this type of survey the person carrying out the survey does not have any influence since the surveyor collates and aggregates the information to find the result. Students should remember that statistical data only give indication of trends or possible trend. It does not provide answers to key questions such as to why consumers prefer a specific product or not.

A formula to forecast sales as provided by Nagarajan (2008) is as follows;

Sales Forecast = [Total Population size] divided by [Sample Size] times [Number of Respondents who said Yes] times [% of those who said yes who will actually purchase] times [Average quantity that will by purchased by a buyer]

Sales Forecast Composite – In this type of survey, the forecast is provided by the sales representative who has a fair idea of what is happening within his or her geographical location and can be able to provide a realistic forecast. The forecast are pooled together and are given a weight to arrive at the composite forecast.

Statistical Methods – In this type of forecasting, past data are used. Past data are arranged in chronological order and some statistical method is used to identify the trend indicated by past data to project future trend. The process of extending past trends to the future is called extrapolation. There are two types of statistical methods; The Trend Analysis and Regression Technique.

Trend Analysis – Under the trend analysis, some of the methods used are; Curve fitting; Moving Average Method; Weighted Moving Average Method and Exponential Smoothing Method.

 

Example of Moving Average Method

Actual Sales		Forecast
Year	Sales
1994 1995 1996 1997	2219 2302 2007	(2219 + 2302 + 2007)/3 = 2176

 

The forecast for the year 1997 would be 2176. Determining the period of moving average is an important factor in calculating the trend values in the moving average method. This method may be used when the past data fluctuate and do not show or exhibit an increase or decrease in trend over time.

Today there are many different programs on the market that can easily do the calculation for the many different type of forecasting mentioned above.

Other Methods of Forecasting

Other methods of forecasting that students may come across are; End use method, Leading Indicator Method, Merits, Demerits.

Students are encourage to check out the different methods of forecasting in text books and the web.

 

Other Aspects to be Considered in Demand Forecasting of a Project

 a) If the project has a component that would be dealing with Imported products, then care must be taken to identify the past demand trends in imports in relation to that particular product.

 b) Another factor that need to be considered also is the exportability of the product being manufactured. How can we analyse the exportability? We can consider the following; 

• Past Trends in volume of trade
• Importing countries and quantity imported
• Any excise, tariff concession in existence
• trends in international price etc 

Demand in term of Industry vs. Firm Demand

When looking at an industry, there may be many firms out there producing similar product to what we manufacturing. Care must be taken to come up with marketing strategies to ensure that what we are producing is the product in demand.

ECONOMIC APPRAISAL

When we look at economic appraisal, we are looking at how the project will impact a particular economy as a whole.

In economics, students would have studied scarcity of resources. Scarcity of resources is faced by both developed and developing countries therefore in the best interest of the country the limited resources should be put into the best possible use. Irrespective of the size of the project, whether it is a public infrastructure of whether it is a small project undertaken by an entrepreneur, project sponsor whether it is the government or the investors must ensure there would be sound economic return from the project.

A public project funded by the government would ensure service is delivered to the target community and would result in economic growth and stimulate further economic development. For an investor of a small business, profit maximization and investment returns would be the main objective.

Example: In Papua New Guinea, students may have heard of so many proposed impact projects such as the lime stones in Simbu province or the New Britain ring road. If these projects come on stream what would be the economic impact to PNG as whole?. If investors are interested in part taking in these projects, what area of the project would they get involve in?. We will look at this question when we discuss Social Cost Benefit Analysis later in this topic.

FINANCIAL APPRAISAL

There are two major areas in financial appraisal that you would come across when looking at this area. 1) Arriving at the cost of the project 2) Arriving at the appropriate means of financing the project.

 When discussing the financing aspect of any project, we are looking at the combination of equity and debt. How would you know if you have the right combination of equity and debt? The proper equity-debt combination would depend upon the revenue earning capacity of the project.

Students should remember that equity does not attract any interest and does not involve any repayment obligation however, the debt obtained for financing the project has to be repaid over a period or number of years and does incur interest over the term of the debt.

We will look further into financial appraisal in our future topic.

MANAGEMENT APPRAISAL

The success and failure of any project depend on the management and its team. A good project can become a failure if we have the wrong management team in place.

When it comes to financing of a project, financiers and lenders normally emphasis more on the management component of a project and the capacity of the project to repay back the loan and interest within the stipulated term of the loan.

While other appraisal techniques are quantitative  and objective in nature, management appraisal is purely qualitative and subjective in nature, so how then can we evaluate and appraise people for management positions for a project?

Firstly, the person to be evaluated for the management appraisal depends upon the constitutions of the firm or enterprise and may vary according to the structure of the firm, example; Sole Trader, Partnership, Company, Joint Venture etc
.
Sole Trader - Would be managed by the proprietor himself, therefore appraisal can be carried out on the proprietors themselves.

Partnership - Management appraisal can be carried out on the management partners.
Companies - It would be the managing director or the chief executive directors that would be appraised.

There are some attributes and skills that would be important factors when it comes to management appraisal and some are listed as follows; Integrity, foresightedness, leadership qualities, inter-personnel relationship, technical and financial skills, commitment, perseverance etc.

SOCIAL COST BENEFIT ANALYSIS

When it comes to Project Appraisal, Investors may be interested in analysing the Social cost-benefit analysis of the project. Social cost-benefit analysis is also referred to as socio-economic analysis. Why social cost benefit analysis? Project promoters are interested in maximum return on their investment.

Objectives of Social Cost Benefit Analysis

Following objectives that a project is anticipated to provide are as follows;

• Contribution of the project to the GDP o f the economy
• Contribution of the project to improve the standard of living in society
• Justification of the use of scarce resources for economic development
• Improvement in protecting environmental conditions

Approach to Social Cost Benefit Analysis

Nagarajan (2008) Two main approaches 1) UNIDO Approach and 2) Little-Mirrlees Approach.
Famous economists Stephen Marglin, Amartya Sen and Partha Dasgupta came up with a manual based on UNIDO experience in cost benefit analysis of projects and students are encouraged to look up this particular approach.

UNIDO Approach to Social Cost benefit analysis consist of the following stages;

1. Arriving at the financial profitability of the project based on market prices
2. Using shadow prices for the resources to arrive at the net benefit of the project at economic prices 
3. Adjustment of the net benefit for the project's impact on savings and investment
4. Adjustment of the net benefit for the project's impact on income distribution
5. Adjustment of the net benefit for the goods produced whose social values differ from their economic values.

The second approach mentioned is the Little - Mirrlees Approach. This approach was developed by Little and James A. Mirrlees who came up with the Manual of Industrial Project Analysis in Developing Countries in 1968 for the Development Centre of the Organization for Economic Cooperation and Development (OECD).

Students are encouraged to read further into these two different approaches.

 

PROJECT RISK ANALYSIS

When it comes to project appraisal, risk analysis is very important given the fact that there are all sorts of risks that the project management may have not thought about during the initial stages of project initiation or during the planning stages. As discussed in earlier topics, no two projects are the same. Each project is unique in all respects and assumptions made may be different.

Students should remember that projects may be similar however; they won’t be exactly the same.

 

Listed below are some elements of assumptions on which project appraisal are made;

• Periodic cash-inflows (the cash inflows against plant output in a given period)
• Periodic cash-outflows (expenditure incurred to purchase materials, cost of operations e.g. power, wages etc.)
• Life of machinery and the depreciation values
• Salvage value of machinery

Assumptions made are assumptions meaning they are prone to risks. Example; we assume that sales of the particular product will provide us a cash-inflow of $500,000.00 per month which should give us $6.0 million yearly and we end up with only $3.0 million, our assumption either was not projected well or we may not have taken into account other considerations such as increase in fuel and gas or land compensation demands etc. In Papua New Guinea land issues such as ownership can be considered a risk factor and this need to be sorted out well in advance before projects are implemented.

 

Risk vs. Uncertainty

 

Risk according to Oxford Advanced Learner’s Dictionary is defined as “the possibility of something bad happening at some time in the future; a situation that could be dangerous or have a bad result”.

 

Uncertainty from the same dictionary is defined as “feeling doubt about something; not sure. Something may likely to change”

 

Nagarajan (2008) Risk can be defined as the variability of return from an investment.

 

Given the above definitions for risk and uncertainty, we can conclude by saying that when the probabilities of a possible outcome are known, the problem or issue contain risk, therefore the problem is risky. On the other hand, if the possibilities of possible outcomes of a given problem are not known that we can conclude that the problem has some elements of uncertainty and that means the problem cannot be predicted.

 

Kinds of Project Risks

Some important project risks that project managers need to be aware of are as follows;

 

Project completion risk – The risk is when the project is not completed within the time fame. When this happens, the flow on impact to the project may have major repercussion example; costs may increase and project sponsor may not be able to come up with additional funding. The project may come to a halt which lead to other problems. It is therefore important that any risk factors are iron out and project are completed in time and within time. 

 

Resource Risk – When discussing resources, we look at resources that are used in order to get the project completed. Resources used by most projects are; raw materials, electricity, fuel, manpower etc., and are important that we have continuous supply on hand to get the project completed in time. Shortage in any of these resources may result in delays which may lead to delay in other area of operations within the project.

 

Price Risk – Fluctuation in prices in the input and output can have an adversely affect a project. For example price fixation by the government can affect our income and profitability estimates and our cash inflows.

 

Technology Risk – Technology may not be right for the project in term of local usage due to lack of capacity or the technology used is out dated and out of production therefor we have to look for a new technology. Such issue if encountered can have an impact of project delay and completion time.

 

Political Risk – Political environment differs from country to country and there are always risks. Such risks as political intervention in the form of levy, price control, expropriations, nationalization etc. and political instability in the form of change of government and changes in economic policies can have an impact on the overall development of a project.

 

Interest Rate Risk – Fluctuation in interest rates can affect the ability to pay off loan and also will impact the cash flow situation of the project. Interest rates can be minimised by entering into hedging agreement like interest cap, swaps etc.

 

Exchange Risk – Fluctuation in currency can have an impact on the cost of the project. Volatile exchange rates will impact cost and will also impact the profitability of the project.

 

Techniques of Risk Analysis

There are some simple tools that can come handy when analysing small to medium sized projects.

• Break Even Analysis
• Sensitive Analysis
• Decision tree analysis
• Money-carlo technique
• Game theory

Break Even Analysis – Nagarajan (2008) The financial viability of a project is estimated by making various assumptions like the cost of raw materials, cost of consumables. Cost of labour, expected sales etc. Student should remember that costs of inputs and the prices of outputs are decided or influenced by the market forces. The only thing that is under the control project promoter is the level of output.

 

Under the break even analysis we can divide the costs into two broad headings; 1) Fixed Costs and 2) Variable Costs

 

Fixed Costs – These are costs that are fixed in nature for a period of time say 12 months, or 24 months such as Rent payable for land; Lease payable for office premises, Insurance premium Interest on long term loans etc.

 

Variable Costs – These are costs that vary directly with the level of output. Examples of such costs are; Power, fuel, water charges, selling expenses etc.

 

 

 

The blue line represents Total Cost; The red line represents Sales; The green line represents Fixed Costs. Break even occurs at the point where the blue and red line meets on the graph.

 

At Break Even Point (Adaptation from Project Management, Nagarajan (2008)

 

Sales Realization = Fixed Cost + Variable Cost

That is (Output) x Selling Price per Unit = Fixed Cost + (Output) x Variable Cost per Unit

That is Output x (Selling price per Unit – Variable Cost per Unit) = Fixed Cost

That is Output = Fixed Cost divided by (Selling Price per Unit – Variable Cost per Unit)

That is Break Even Point in terms of No. of Units = Fixed Cost divided by (Selling Price per Unit - Variable Cost per Unit)

 

Contribution – Contribution is the difference between the sales realization and the variable cost. Excess of selling price over variable cost is called by the term contribution since it contributes towards fixed cost and profit. Example if selling price per unit is K12.00 and the variable cost is K7.00, the contribution per unit is K5.00 (12 – 7) given this explanation, one unit of production contributes K5.00 towards fixed cost and profit. If the fixed cost is say K50, 000.00 the BEP (in terms of number of units) is K10, 000.00 [50,000/5]. This means that at the level of output 10,000 units the contribution covers exactly the fixed cost hence there is no profit, no loss situation.

 

Contribution first goes to meet the fixed cost up to BEP and subsequently to reaching of BEP, contribution adds to profit.

 

BEP (in term of no. of units) = Fixed Cost divided by (selling price per unit minus Variable cost per unit)

 

= Fixed Cost divided by Contribution per Unit

 

BEP (in terms of Kina) = Fixed Cost divided by Contribution per Unit times Selling price per unit.

 

Illustrations (Adaptation from Project Management, Nagarajan (2008)

The details of production costs and revenues of a project are as follows;

Total Cost                   =          K65, 000.00

Fixed Cost                  =          K25, 000.00

Sales (8000 units)        =          K80, 000.00

Find the BEP in terms of number of units. What should be the output if the profit desired is K20, 000.00?

 

Solution

Variable Costs (8000 units)    =          Total Cost – Fixed Cost

                                                =          K65, 000.00 – K25, 000.00

                                                =          K40, 000.00

Variable Cost per Unit            =          K40, 000.00/8000

                                                =          K5.00

 

BEP (in terms of number of units)      =          Fixed Cost divided by (Selling price per unit minus Variable Cost per Unit)

                                                            =          25, 000.00/10 – 5

                                                            =          5000 units

 

 

 Output for a desired profit of K20, 000.00

Let X be the number of units required to be produced for achieving a profit of K20, 000.00

Profit               =          Sales – Total Cost

                        =          Sales – (Fixed Cost + Variable Cost)

                        =          (10X) – (25, 000.00 + 5X)

i.e. 20, 000.00 =          15X – 25, 000

            15X     =          45, 000.00

            X         =          9000

 

 

 

From the above chart, students will see that the BEP is reach at the point where the Sales and Total Cost meets at K50, 0000 at 5000 units.

Therefore, the output required for achieving a profit of K20, 000.00 is 9000 units. The K20, 000.00 is the difference between K70, 000.00 and K90, 000.00 after the BEP.

Students are encouraged to read into the other methods mentioned such as;

·         Sensitivity Analysis

·         Decision Tree Analysis

·         Monte-carlo technique

·         Game theory 

 

SWOT Analysis – Every organization regardless of size and sales volume operates in a very competitive environment and they have to ensure their position in the market is maintained or improve on if and where necessary and that is where the SWOT Analysis becomes very useful. SWOT analysis is of immense help when it comes to project appraisal.

Let us look at some of the factors worth considering when it comes to project Strength, Weaknesses, Opportunities and Threats.

Strengths:

• Location advantages of the organization (Near source of raw materials, services etc)
• Goodwill developed among clients
• Buy-back arrangement
• Lower Capital Investments
• Good network of dealership, distributors and suppliers
• Committed and Reliable workforce
• Global Operation
• High-tech operation etc.

Weaknesses:

• Obsolete Technologies
• Scarcity of Raw Materials
• Location disadvantage
• Labour Unrest
• Absence of entry barriers to new entrants
• Opportunities:
• Cost of Raw Materials
• Liberalization of import of raw materials
• Growth in per capita income and consumption level
• Cost Savings technologies
• Costlier imports
• Alternative use for products

Threats:

• Imports become cheaper
• Withdrawal of government incentives
• Raw materials becoming costlier
• Economy going into recession
• Pollution control measure by government
• Possible increase in power charges etc.

Though SWOT analysis is subjective in nature, it helps identify some important points for decision making when it come to investment decisions.

 

STUDENTS should take note that some analytical methods mentioned are available through different program and students are encouraged to read further into these different methods if interested.

 

Sources:

Project Management; Nagarajan (2008) New Age International Publisher

Project Management; D.Lock (2007) Gower

HBR Guide to Project Management (2012)