Ch. 6
Ch. 6
Ch. 6
I. COST
Operational Cost
Factors to be considered:
The cost structure of the proposed project must enable it to realize an acceptable profit with a
price. The following should be examined in this regard:
Cost of material inputs
Labor costs
Factory overheads
General administration expenses
Selling and distribution costs
Service costs
Economic of scale, etc.
Cost of Capital
Lending means a long medium or short-term commitment reducing the liquidity of the lender and
would also imply uncertainty concerning the full return of the funds lent. To obtain finance, an
investor must, therefore, pay a charge, the cost of capital or finance for the funds lent. This charge
comprises an interest rate, usually expressed as a percentage per annum, as well as certain fixed
charges (commitment fee, charge on capital not drawn, commissions etc.). Interest is usually
computed for the outstanding balance of the corresponding liabilities of a firm, for example, interest
payable on current account.
A feasibility study would serve little purpose if it were not backed by reasonable assurance that
resources are available for a project. The capital outlay of a project can be appropriately determined
only after plant capacity and location have been decided, together with estimates of the costs of a
developed site, buildings and civil works, technology and equipment.
Determining the financial requirements of a project at the operational stage in terms of working
capital is equally necessary. The determination of working capital can be only done once estimates
are made of production cost, on one hand, and sales and income, on the other. These estimates
should cover a period of time and be reflected in a cash flow analysis. Unless both estimates are
available and unless the available resources are sufficient to meet the fund requirements, both in
terms of initial capital investment and working capital needs over a period of time, it would not be
prudent to proceed to the financing decision and project implementation.
Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 1
Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
Sources of Finance
A) Equity
A generally applied financing pattern for an industrial project is to cover the initial capital
investment by equity and long-term loans to varying extents, and to meet working capital
requirements by additional short and medium term loans from national banking sources.
The minimum net working capital requirements should be financed from long-term capital. In
situation where institutional capital is scarce and available only at high cost, equity capital covers
the initial capital investment and net working capital. Anyway, a balance needs to be struck
between long-term debt and equity.
1. The higher the proportion of equity the less the debt service obligations and the higher
the gross profit before taxation.
2. The higher the proportion of loan finance, the higher the interest payable on liabilities.
Therefore, in every project, the implications of alternatives patterns and forms of financing must
be carefully assessed. A financing pattern should be determined to be consistent with both
availability of resources and overall economic returns.
Issuing two types of shares can raise equity: ordinary shares and preference shares. Preference
shares usually carry a dividend at least partly independent from profit, without or with only
limited voting rights.
They can be convertible to common shares; they can be cumulative or non-cumulative in terms
of dividend or can be redeemable or non-redeemable, with the redemption period varying
between 5 and 15 years. Dividends on ordinary shares with full voting rights, however, depend
on the profitable operation of the company.
B) Loan Financing
Since it is relatively easy for a sound project to obtain loans, the process of project financing may
well start by identifying the extent to which loan capital can be secured, together with the interest
rate applicable. Such loan capital needs to be separately defined.
Short and medium term borrowings from commercial bank for working capital or
suppliers credit and
Long-term borrowings from national or international development finance institutions
Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 2
Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
Working capital needs should even be partly net out of long-term fund, since the
largest portion of working capital is tied in inventories (raw material, work
progress, finished goods and spare parts).
In addition to share capital and loan finance, an important financial category at the
operational stage is the internal cash generated by the project itself. This can take the
form of accumulated reserve (retained profits and depreciation).
C) Supplier Credits
Imported machinery and spares can often be financed on deferred credit term. Machinery
suppliers in developed countries are willing to sell machinery on deferred – payment terms with
payments spread over 6 to 10 years.
D) Leasing
Instead of borrowing financial means it is sometimes possible to lease plant equipment or even
complete production units, which is productive assets, are borrowed. Leasing (borrowing of
productive assets) requires usually a down payment and the payment of an annual rent, the
leasing fee. These are, however, contained in balance sheet of the lessor and not in the lessee –
which is off balance sheet financing.
The problem is basically to decide which alternative should be preferred, leasing or
purchasing of capital assets. To evaluate the two alternatives, the discounted cash flow
should be applied.
The initial down payment, the current leasing fees and additional payments under the
leasing agreements are part of the cash outflow (replacing the investment costs).
Since the duration of leasing contracts is in general much shorter than the technical and
economic life of an asset, it is necessary to include the residual value (cash inflow) of the
leased asset when comparing with loan financing.
The inflow for the lessee would usually not be the book value, but either the book value or
the market value (minus the lessors cost of setting the used items) which ever is lower.
If the investor has a choice between loan and leasing financing, he would compare the
discounted cash flow for both flow arrays to determine which alternative would bring the
higher yield (IRR, NPV).
Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 3
Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
III. PROJECT CONTROL
Once the project is launched, control becomes the dominant concern of the project manager. Project
control involves a regular comparison of performance against targets, a search for the causes of
deviation, and a commitment to check adverse variances. It serves two major functions: (1) It
ensures regular monitoring of performance, and (2) It motivates project personnel to strive for
achieving project objectives.
Reliable and accurate data and information are the keys for controlling. The master budget is the
most important tool for the cost control. The master budget has to be broken down into various
components of cost such as material, equipment, labour, office expenditure, technology acquisition,
sundry costs etc. These schedules of cost serve as the basic for controlling cost.
In addition to the schedules of costs, output information is used in cost control. At different
operating levels, important data are collected and converted into management information. Progress
reports, cash flow statements, and reports on cost trends, cost status, and bottlenecks or constraints
etc. are the important pieces of information required for controlling costs. A number of ratios, such
as ratios of total project cost and individual activity costs, are also used for cost control.
Control Functions
The Control Function Includes:
1. Check on activities
2. Measure the qualitative output
3. Compare the results with the budgeted figures
4. Based on the present performance, predict the future costs
5. Ascertain and analysis the past and the predicted variances
6. Investigate and trace the causes of variances to their roots
7. Offset the adverse variances and correct the root causes of the variances to prevent their
recurrence.
Performance Analysis
Effective control over a project requires systematic performance analysis. This calls for answering
the following questions:
1. Is the project as a whole on scheduling, a head of schedule or behind schedule?
2. Has the cost of the project been as per budget estimates or different?
3. What is the trend of performance? What would be the final cost for completion of the project?
Performance analysis may be done for individual components of the project. In performance
analysis, we consider the value of work that has been done. This enables us to know systematically
whether the expenditure incurred was commensurate with progress.
Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 4
Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
Control of Contingency & Changes
Contingency control and changes control are often used interchangeably. Unless an effective control
is exercised on contingencies and changes, the budget and schedule will be thrown out of control.
Project cost control to be effective, should have two streams of accounting, one for the estimated
definitive budgeted cost and the other for the potential contingencies or changes. Approved and
accrued contingency amounts shall get added on to the cost.
Contingency controlling or change controlling is done through a system of continual trending, and
predicting changes, and brining down the level of contingency. The system should identify changes
form the original scope, estimate their impact on the cost budget, evaluate their benefits with
reference of to cost, and provide the management with sufficient information on these variables for
making decisions on giving effect to the changes. There are optional changes like modifications and
additional facilities being incorporated, and inescapable changes like statutory, regulatory, and
inflationary changes.
If approved, the changes shall be implemented as if they were parts of the original scope, with an
additional contingency budget or add on budget. Price escalations may also be combined with
contingency.
The project manager must try to reduce the impact of contingencies and changes through trending
and predicting. They are simple forecasting exercised through which the future performance of
work and cost are predicted.
Variances identified or predicted shall form the basis for management actions of correction and
prevention. In project implementation, there are controllable and uncontrollable factors of variance
either existing at the present time or likely to occur in the future. The manager should always be
alert and be in contact with the external and internal environment to be able to predict the potential
deviations and take preventive measures in times.
As for the past variances and the existing situation, urgent corrective actions must be taken on
controllable factors. A revision of budget is necessary for uncontrollable factors.
Controllable variance factors include wrong resource assessment, poor productivity, etc.
Among Uncontrollable factors we usually find errors in design, un-envisaged events,
statutory changes, wrong selection of equipment, etc.
Management action in variance control shall be aimed at reducing further adverse variance, and
simultaneously accelerating the pace of activities to put the project back on schedule. Preplanning,
rescheduling, closer monitoring, change in project team to induct more number of committed people,
faster decision making, deletion of some work packages, etc. are among corrective measures.
Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 5
Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
The project implementation phase embraces the period from the decision to invest to the
start of commercial production. Implementation planning aims at determining the
technical and financial implications of the various stages of project implementation, with a
view to securing sufficient finance. A series of simultaneous and interrelated activities
taking place during the implementation phase have to be identified together with their
financial impact on the project.
When preparing the implementation plan for the feasibility study, it should be borne in
mind that, at a later stage, this plan will be the basis for monitoring and controlling the
actual project implementation.
The implementation schedule must present the costs of project implementation as well as
the schedule for the complete cash outflows (for all initial investments), in order to allow
the determination of the corresponding inflows of funds.
Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 6
Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
3. Government approvals
Government approval may be necessary for importing machinery and materials. Adequate
time should be provided to obtain the necessary approvals.
5. Financial planning
After the decision to invest has been taken and once the total investment costs and their
scheduling are known, detailed arrangements for financing need to be initiated.
Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 7
Addis Ababa University, College of Business and Economics, Department of Accounting & Finance
9. Construction and installation
Any delays during the actual construction phase will have an impact on the costs and
income projections made in the feasibility study. The sequence of civil works and
construction activities needs to be carefully defined. For scheduling the construction and
installation work, it is important to understand that such work can begin only after
designing the layout, acquiring the land, and getting approval from the authorities.
Implementation Scheduling
The implementation schedules are normally prepared in three steps. In the first step, the
planner determines the logical sequence of events in implementation without paying much
attention to the exact duration of each task. In the second step the planner will analyze how
specific tasks are to be undertaken. Some tasks will be further divided into subtasks. Finally,
the analyst established the implementation schedule showing the correct positioning and
duration of all activities, and tasks.
Lecture note - Project Analysis & Evaluation. Instructors: Dr. Teferi G & Kassaye T. 2023 (2015) P. 8