Unit 14. Valuation & Construction Economics

Certificate Course in Quantity Surveying – Advanced Level
UNIT : VALUE MANAGEMENT , VALUATION & CONSTRUCTION ECONOMICS
Value
Value is the level of importance that is placed upon a function, item or solution. Value is a complex
concept. It is a measure of worth – a relative measure of the usefulness of something in relation to the cost
paid for it. It can be expressed as a function. However, value is like beauty insofar as it depends upon who
is judging it. Value is very much about perspective. This is what makes the concept of value complex in a
business context. Businesses and organizations tend to be multi-faceted comprising a
wide variety of different groups each with their own interests, priorities and perceptions of what is required.
In this context the likelihood of ill-conceived projects, waste and non-congruent business processes, is
high. An operations manager, for example, may have a completely different view of the value of a new
production process to that of a marketing manager or a human resource manager. However, the individual
requirements, perspectives and values of all stakeholders, aligned with the strategic objectives of a
business or organization, are important ingredients in setting objectives for business processes, capital
investments and continuous improvement.
Although the definitions varies, the common focus in all these definitions is that the process of Value
Engineering involves function orientation, organised approach, and creative thinking; and at the heart of it
is the basic equation, that is:
Value = Worth / Cost
The value of a product or service is a quantity, it depends upon what is its worth or the function(s) it
performs, and the cost allocated for performing the function(s). The term “function” is used to mean the
purpose or use of a product. Thus to measure worth, the product or process is first translated into the
functions. Cost is also not simply the initial price but must also include follow-on costs during the life cycle
of the product.
Focus on value varies with the producer and the customer. To a producer value is the art of providing the
required function(s) at lower cost whereas to a customer value is the amount the least amount he spends
to get what he needs.
For the prospective producer:
Value = required function / cost
For the prospective customer:
Value = functional benefits / price
The value of a product can be increased by improving the functional utility without change in cost retaining
the same functions for less cost combining improved functional utility with less cost.
The value management process originated during World War II within the General Electric Company (GEC)
in the USA. GEC was faced with an increase in demand but had a shortage of key materials. Larry Miles of
GEC, instead of asking „how can we find alternative materials‟, asked „what function does this component
perform and how else can we perform that function?‟
L.D. Miles, the founder of Value Analysis, defined Value Analysis as “an organised creative approach
which has for its purpose the efficient identification of unnecessary cost, i.e. cost which provides neither
quality, nor use, nor life, nor appearance, nor customer features”.
The five questions in value analysis process, propounded by L. D. Miles, are:
What is it? It implies defining the problem and components for the analysis.
What does it do? It means identifying the basic and secondary functions of the product.
What does it cost? It involves determining the cost of each function, component-wise.
What else will do the job? It aims at finding alternate solutions that perform the same or better function.
What does that cost? Its focus is to finding costs for alternatives that produce same or higher values.
Chicago Institute For Management Training, UAE Page 1 of 52

This innovative approach led the company to use substituted materials for many of its products. They
found, surprisingly, that the cost of the product was often reduced but the product improved; care and
attention to function provided better value for money.
A spin-off of this approach was the elimination of cost, which did not contribute to performance – this was
known as value analysis. Over the next ten years this was further developed by GEC and became known
as value engineering (VE).
The value management process as illustrated by ICE 1996)

Value management (VM) developed from VE and is now a requirement on many public and private projects
in the USA and Australia. It was only in the late 1980s that VM began to be used in the UK.
With the passage of time, the value analysis practioneers have modified the discipline and process of
Value Analysis, to fit their requirements. In 1954, the U.S. Navy Bureau of Ships applied the Value Analysis
process to cost improvement during design. They called it "Value Engineering." Some refer this as "Value
Management." In the Construction industry, it is generally called "Value Engineering.
Bureau of Indian Standards terms "Value Engineering." as a discipline comprising a series of techniques
aimed at an organised systematic effort directed at analysing the function (s) of items, products,
equipment, processes and procedures for the purpose of accomplishing all the required functions at the
lowest total cost which expression covers not only initial cost but also ownership cost covering operation /
maintenance, disposal costs etc. throughout the desired or specified life cycle of the articles or subject
under study.
The Society of American Value Engineers (SAVE), defines Value Engineering as the systematic application
of recognised techniques by multi-disciplined team(s) which identify function of a product or service;
establish a worth for that function; generate alternatives through the use of creative thinking and provides
the needed function reliably at the lowest cost. The Value Engineering and Management Digest of USA
defines Value Engineering as the process of problem identifying and solving techniques that achieve the
required function at the lowest cost.
The Australian and New Zealand Standard AZ/NZS (1994) defines Value Management as “ a structured,
and analytical process which seeks to achieve value for money by providing all the necessary functions at
the lowest total cost consistent with the required levels of quality and performance.”
Norton (1995:11) describes Value Management as a systematic, multi-disciplinary effort directed towards
analysing the functions of projects for the purpose of achieving the best value at the lowest overall life cycle
costs.

In a Value Management study, the object is not to reduce cost but to improve value. This means cost is just
one element relative to value on a construction project. Two other important aspects are time and function
or quality. It is necessary to achieve a proper balance between all of the important aspects, which
contribute to a project design.
Elements of Value Management
There are three major ways to improve value by applying VM. (Norton1995:14))
1. To provide for all the required project functions but at a lower cost
2. To provide additional functions without increasing the cost
3. To provide additional functions and at the same time to lower the cost
Value management (VM) is the wider term used to describe the overall structured, team-based approach to
a construction project. It addresses the value process during the concept, definition, implementation and
operation phases of a project. It encompasses a set of systematic and logical procedures and techniques
to enhance project value throughout the life of the facility.
VM embraces the whole-value process and includes value planning (VP), VE and value reviewing (VR).
The basic steps are as follows:
1. To determine the functional requirements of the project or any of its constituent parts;
2. To identify the alternatives;
3. To examine the cost and value of each alternative to enable the best value selection.
Terminology
Confusion has arisen in the definitions of value depending on geographic location; VM/VE, VP, value
auditing are often interchangeable. The following definitions are preferred:
_ VE: value engineering is the process of analysing the functional benefits a client requires from the whole
or parts of the design.
_ VP: value planning is applied during the development of the brief to ensure that value is planned into the
project from the beginning.
_ VM: VM is a systematic and creative procedure operating on the relevant aspects of the value process
through the life of the project or facility.
_ Function: a mode of action or activity by which a thing fulfils its purpose. Understanding the concept of
function is important as this can provide the catalyst to introducing innovative solutions. For example,
consider the function of an internal wall, it can: separate space, secure space, maintain privacy, support
heating systems, support fittings and fixtures, transfer load, reduce noise etc. If we merely required to
separate floor space we could use a row of potted plants or different floor material.
The optimization of value is addressed through the process of
function analysis. The process is aimed at identifying, and synthesizing
through consensus, the objective criteria required from
a business process, an asset, a product or a project.
Causes of poor value and waste in business include
● Politics
● Stakeholder rivalry (lack of congruence)
● Lack of information
● Inappropriate/insufficient briefing
● The prevalence of habits, attitudes and customs
● The adoption of temporary solutions
● Management complacency.
The objective, team approach of value management helps overcome these problems, improve value,
reduce waste and provide competitive advantage.

Elements of Value (Kelly 1993)
Benefits of a Value Management Study are:

 A better understanding of needs and the functions necessary to meet those needs
 A better definition of program or project objectives
 A better definition of quality and performance standards
 Clearer briefs
 Reduced wastage of resources
 Capital funds savings
 Improved operational efficiencies
 Team building and strategies which
Advantage of Value Management

 VM creates a clearer focus on the project objectives
 VM works towards arriving at a more effective design
 Identification of alternative methods of construction
 Discovery and discussion of project issues, constraints and risks involved
 Clearer project brief and decision making
 Identifies and removes unnecessary costs associated with the project
 VM deals with lifecycle costs also, not only initial project cost and provides an authoritative review
of the project in its totality and not just a few elements.
 All options, alternatives and innovative ideas are considered
 Over specification is addressed and an improved building programme can be developed leading to
time being saved and ultimately savings in cost
 If properly implemented it can identify possible problems early on in the project

Disadvantages of Value Management
 It is time consuming and therefore not suitable for projects with time constraints
 VM workshop team must requires a high technical expertise with sufficient work experience
 Extra cost on the client for professional fees
 Disruption of project team
The following Figure shows the introduction of the parties into the project cycle under the traditional
procurement route; this highlights the importance of involving all the key parties early in the process under
a partnering agreement or better still a long-term alliance.
Studies at the early stages of a project are much more effective and of shorter duration than those
conducted later on. This is because the opportunities for making changes reduce as the project
progresses, and the cost of making such changes increases. Indeed, once the concept has been frozen,
about 80% of the total cost has been committed – even though no design exists.
All client bodies operate a capital-approval process that calls for certain criteria to be met before passing
from one stage to the next – known as approval gateways. Each approval gateway presents a natural
opportunity to conduct a VM study to verify that the scheme, as it has evolved so far, represents optimum
value to the client. It is unusual to conduct a formal study at all of these gateways – usually two, or at most
three, are sufficient.
The first stage in any project is to establish that a project is the most appropriate way in which to deliver the
benefits which are required and then consider the following questions. Is it likely to be viable? Do the
conditions exist to enable the project to stand a chance of success? Is it affordable? Answering these sorts
of questions is the main purpose of Gateway 0 in the OGC‟s Gateway Review Process. VM can play a
significant contribution at this stage. Table identifies the key questions which should be asked at each
stage of the VM study throughout the project cycle.
Typical questions to be asked at each stage of the value management (VM) study on a new urban highway
project.

Source: Adapted based on Dallas, M., 1998.

Value planning (VP)
Value planning establishes an early consensus between stakeholders about the need for a capital project,
its scope, the deliverables, the key functions and risks, all in the context of overall business or
organizational strategy. It explores opportunities for innovation and identifies the most cost effective means
of implementation, consistent with desired time and quality requirements. Value planning considers the
whole and its relationship to business need rather than the individual components.
Value planning (VP) is applied during the concept phase of a project. VP is used during the development of
the project brief to ensure that value is planned into the whole project from its inception. Several outline
designs are assessed to select a preferred option which best meets the functional and other requirements.
At this stage the value criteria are identified and concept proposals are put forward to satisfy the client‟s
needs and wants. The needs are those items which are fundamentally necessary for the operation of the
project, whereas the wants are items which the client would like to have but are not essential. Best value is
provided by delivering a solution which delivers all the needs and as many of the wants as possible within
the permitted budget. In order to achieve maximum benefit from the effort applied by the individuals, it is
common practice to apply the principle of the Pareto rule (80% of the value lie in 20% of the items.
Value engineering (VE)
Value engineering is a procedure aimed at providing an organized, systematic process of technical
appraisal of a developing project, product or process to eliminate unnecessary costs and add value while
maintaining or enhancing quality, scope and performance.
The objectives of value engineering studies vary but commonly include
● achieving agreement on a project‟s objectives and deliverables;
● selecting the best design from the available options;
● optimizing the value of a chosen option;
● maximizing the efficiency of a chosen design and its delivery.
VE is applied during the definition stage and, as required, in the implementation phases of a project. VE
investigates and analyses in order to identify the required function and then compares and selects from the
various options to produce the owner‟s best value requirements.

During the VE phase any unnecessary cost is eliminated from the proposed design. This is usually
undertaken in the VE workshop where a separate review team from that which developed the outline
design reviews the work to date. Since this review is generally undertaken at approximately the 30% stage,
there is still a good opportunity to adjust the design before it proceeds to the definitive and detailed design
stage. The basic premise of VE is that a certain amount of unnecessary cost is inherent in every design. It
is usually only possible to eliminate this by identifying another option, which provides the same function at
lesser cost.
Specific causes of unnecessary cost include the following:
1. Cost of unnecessary attributes (attributes which provide no useful function);
2. Cost of unnecessary specification (due to needlessly expensive materials/components);
3. Unnecessary cost of poor buildability (failure to consider construction implications during design);
4. Unnecessary life-cycle cost (failure to consider future operational costs);
5. Unnecessary opportunity cost (the cost of losing potential revenue).
The VE workshop follows the broad principles of the VP workshop. The information phase usually involves
a debriefing from the original design team to the VE team, who then consider, in the functional analysis, the
function of each part of the proposed works. In the speculation phase, they have a brainstorming session
and consider alternative methods of providing the same function. There follows an evaluation phase in
which the proposed alternative solutions to providing the function are analysed to determine the viability of
each one. Where a suitably viable alternative is possible at a significantly reduced cost, it is included in the
proposal phase.
Ideally, every design decision should be subject to VE, but 80% of cost is often contained in 20% of the
design decisions. On building projects, services in particular account for a very large percentage of the
overall cost (28–40%). This element can be further broken down into mechanical services (17–28%),
electrical services (6–13%) and lifts (0–3%). On road projects, the three highest-cost elements are typically
earthworks (28–31%), structures (18–32%) and sub-base and surfacing (21–28%) (CIRIA, 1996).
VR is applied at planned stages to check and record the effectiveness of the value process and its
management.
The „value manager‟ usually has a responsibility to review the value process throughout the project to
ensure that the value identified in the VP and VE are actually provided within the executed works.
Value analysis
Value analysis is the application of the procedures to an existing project, product or process. It is a source
of benchmarking and can act as a structured basis for achieving continuous improvement.
Timing is of the essence. Fig. illustrates the substantial scope to

reduce cost, and hence improve value, in the project definition and early design phases. This scope
diminishes to point when the cost of change exceeds the saving. Any construction project should only be
commissioned following a careful analysis of need. Failure to carry out this analysis will cause problems at
subsequent design and construction stages.
Many projects suffer from poor definition through lack of time and thought at the earliest stages. This is
likely to result in cost and time overruns, claims, user dissatisfaction or excessive operating costs. VM can
help to avoid these problems.
VP and VE are mainly applied in the concept and definition phases, and generally end when the design is
complete and construction started. However, VE can be applied at the construction stage to address
problems or opportunities which may arise. At a later stage a tendering constructor may be expected to
bring other value improvement ideas and techniques for consideration by the owner. Finally, the project
may run into practical, cost or time difficulties during construction, and here again solutions may be
developed using VM.
Value Analysis is based on the fundamental principle that the customer is always looking for the product,
which satisfies his requirement, at the least cost. Value is the connection between the customer
satisfaction and the price he is willing to pay. Value, then, is an essential parameter for improving a
process by reducing costs while always maintaining or increasing client satisfaction. Accordingly, the value
of a product, can be further divided into following categories:

(a)Basic Value: The properties and qualities, which accomplish a useful purpose or service.
(b)Esteem Value: The properties, features or attractiveness, which cause us a customer to want or own it.
(c)Cost value: The cost of labour, material and various other expenses required to produce it.
(d)Exchange Value: the properties or qualities that enable us to exchange it for something else we want.
Both Value Engineering and Cost Reduction aim at reducing costs but there is a basic difference between
these techniques. Value Engineering is functional oriented where as Cost Reduction is production oriented.
Value Engineering aims at functional cost effectiveness by avoiding unnecessary costs; it involves multi-
discipline team effort, and applies innovative and creative techniques to maximize value. On the other hand
Cost Reduction aims at changing the method of production to reduce the production cost of an item, it
involves usually an individual effort and generally its emphasis is on analysis of the past practices and
processes to reduce costs.
Value Analysis Job Plan

The Value Engineering job plan attempts to generate, identify and formulate the best value alternative for
making specific recommendations supported with proper data and identifying the actions necessary for its
implementation. Miles' system followed a rigorous six-step procedure, which he called the Value Analysis
Job Plan, for conducting the studies. Others have varied the Job Plan to fit their peculiar constraints. A
modern version has the following steps:
 Planning and Organization. The main aspects considered during the planning and organization
phase are the study objectives, the composition of the study team, information on which to base
the study and designing the organisation for the study.
 Information gathering. The information needed will vary widely depending on the type of objective
to be accomplished. The detailed information requirements for the project are identified and
distributed to team members.
 Functions and costs identification. After identification, these are tabulated in a matrix format.
 Development of ideas and means for solution. In this creative phase, alternative methods and
better ways of doing things are explored.
 Study and evaluation of solutions. A number of techniques are used to identify the best ideas and
prioritise them in terms of cost, time and practicality.
 Appraisal of proposed solutions. During this phase, developed initiatives are formally presented to
senior management along with alternatives and appropriate financial analysis where investment is
required.
 Implementation Phase. During this phase, selected proposals are implemented and new
approaches are brought into practice.
 Follow up after implementation. It is essential that implemented proposals are systematically
followed up to ensure that full benefits are achieved.
How is Function Analysed?

Value Engineering is unique in that its focus is on the analysis of functions of the product or a service or a
system with a view to finding alternative way to provide the prescribed function at a lower cost without
sacrificing the required performance standards. Heart of the Value Engineering is the Function Analysis.
Functional Analysis is a process, which involves identification of the functions, costing of functions and then
analysing the functions to achieve the required objective economically.
Identification of functions. Each product or process under study is identified in terms of the functions it
performed. Each function is designated using two words, that is, verb followed by noun. Each noun is
ideally a parameter or measurable quantity. For example, the functions of the components in a lead pencil
perform functions like Protect wood remove marks, erase writing, improve look, make marks, transmit
force, display information, support lead and protect wood.
In short, these two-word function statements are a total description of the product or process. The total
number of these functions could run from forty to eighty for even a simple product or process.
The functions are divided into two categories i.e. basic functions and secondary functions. The basic
functions mark the principle reasons for the existence of the product whereas the secondary functions
become necessary to support the primary function(s). In the example of the lead pencil, the primary

function is to make marks which can be erased and all other functions identified above are secondary
functions.
Costing of functions The next step is to cost these word-pairs functions. Take the example of production of
a Lead Pencil. The problem is to develop a new Lead Pencil at an acceptable cost for common use. The
market analysis reveals that the maximum retail price of such a pencil can be around Rs 10.00 and its
target production cost must not exceed Rs 5.00. The functions of a pencil identified with the function
category and the cost are tabulated in function–cost matrix given below:
Function–Cost matrix
Functions Remove Erase Improve Make Transmit Display Support Protect
marks writing look marks force info lead wood
Functions category Second. Second. Second. Basic Second. Second. Second. Second.
Cost Cost Cost Cost Cost Cost Cost Cost
Component Cost
(Rs.)
Lead 1.20 1.20
Body 1.00 0.50 0.10 0.4
Paint 1.00 0.50 0.5
Eraser 2.80 2.80
Metal band 1.00 0.50 0.25 0.25
Total Rs. 7.00 2.80 0.50 0.75 1.20 0.75 0.10 0.4 0.5
Total Cost % 40% 7.1% 10.6% 17.0% 10.6% 1.5% 6.0% 7.1%
In value analysis, the accent is on function a component is required to perform and not on the component
itself. Accordingly, the cost gets related to the functions rather than the product. When a component
serves one function, the cost of the component is equal to the cost of the function. However, in some the
cases, if a component serves more than one function, then the cost of the item is apportioned within the
related functions.
Analysing the functions. The functions in the order of their cost are then selected to analyse value. The
value analysis involves application of different techniques to achieve the required objective. It
includes qualitative questioning method and the analytical optimization techniques to achieve the function
economically. The qualitative function analysis method includes the option of elimination, modification,
substitution, combination, innovation etc, whereas analytical methods are mostly employed for minimisation
and optimisation of functions.
One of the technique often used in value analysis is the „Functional Analysis System Technique (FACT).
This technique identifies a basic function and models its relationships with higher and lower level functions
by asking „HOW‟ functions are performed and testing validity by asking „WHY‟ functions are performed.
The FACT methodology uses both structured and creative techniques, to develop alternative ways to
perform necessary functions at lowest overall cost without degrading quality or performance.
Services of a Value Engineering professional are invaluable for analyzing the functions.
Scope for Application of Value Engineering in Project Management

Construction projects face many challenges: budget constraints, safety issues, environmental impact. By
applying the value engineering methodology to construction projects, USA highway and transportation
departments claims to have saved U.S. taxpayers $750 million in 1998. In UK, there are examples ( not
publicized due to commercial reasons), where Value Engineering enabled:
Value Engineering Saving Potential. Value engineering can be applied in all the phases of a project,
however, the savings potential decreases as the project ages.

Scope Formulation Phase. . During this phase, the approved concepts are defined, outline specifications
are stated, and sufficient detailed information is developed. Designs, if subjected to value engineering, prior
to scope formulation, have the greatest potential for net cost saving. This is the most opportune time to
question functional performance characteristics.
Contracting Phase. During this phase, Value Engineering by the contractor or vendor can result
in reducing project construction costs resulting in saving in client‟s estimated costs and improving project
schedules,
Construction and Control Phase. Value Engineering can reducing waste, increasing material procurement
efficiency, using resources more effectively, extension of facility‟s life, reducing repair costs, improving
quality control systems and standing operating procedures.
Maintenance Phase. Value Engineering performed during the earlier phases can decrease operation and
maintenance costs.
How to Organise Value Engineering Function in a Major Project.
Value analysis as a staff function, can be entrusted to either technical manager or material manager or
planning manager. Since Value Analysis needs inter-departmental cooperation at all levels for the success,
Planning Chief, who performs the role of the project coordinator, can be perform the value analysis function
as he works in close conjunction with engineering, design, production and purchase departments. If the
project is large, it may be worth it to appoint an independent value engineer working directly under project
manager. Irrespective of the position or the type of organisation chosen, the Value Engineer must be a
part of the project management team.
Value Engineering / Value Analysis is a systematic and organised effort to identify the functions of a
product, system or procedure and to attain that function with minimum cost without jeopardising quality,
aesthetics, appearance etc. In general, Value Engineering:
 Enhances value for money.
 Effects improvements in function, performance and quality
 Enables people to pinpoint areas that need attention and improvement.
 Provides a method of generating ideas and alternatives for possible solution to a problem.
 Provides a vehicle for dialogue.
 Documents the rationale behind decisions.
 Improves the value of goods and services.
In conclusion, it must be re-emphasised that Value Engineering is an extremely powerful methodology for
cost effectiveness and value improvement. It is applicable in all phases of project life cycle.
Scope for application in the procurement of materials.

Value Engineering is an important tool of materials management. There is virtually no group of materials or
service which cannot be value-analysed. In project environments, where the designs are finalized before
the start of the project, there is great scope for value analysis in the materials procurement phase. Some of
the commonly used project materials, which can be value-analysed are:
Raw and semi-processed materials.
Parts, components, sub-assemblies, etc. (straight purchase).
Sub-contracted materials, parts, components, sub-assemblies, etc.
Finishing items e.g. tiles, paints, polishes etc.
Maintenance, repairs and operation items.

Transportation and materials handling processes.
Printing and stationary items.
Regular consumption materials.
Capital goods / plant, machinery, equipment, tools and appliances,
Utilities e.g. power and water supply.
Select the materials to be Value Analysed.
Select materials of A (High usage value) and B (Medium usage value) Categories. Even a small
percentage of reduction, after Value Analysis, for an A item will mean substantial reduction in over-all
costs.
Select materials whose quality, prices and deliveries are not favourable . Value Analysis can aid in finding
substitutes which can be obtained from other sources.
Select materials being imported . Value Analysis can assist in locating domestic substitutes.
Create value analysis awareness.
Value analysis awareness can be created by subjecting each material procurement order to the following
checklist:
Eliminate. If the function does not add anything desirable to the end product.
Alternate. Explore the better or cheaper alternatives.
Standardisation. If the component performing functions is a non-standard, locate a standard item that serve
the purpose at cheaper rates.
Modification. If the cost of the item is not reasonable in terms of its function to the end-product or end-
operation, try modification or substitution or combination of other functions to make it cheaper.
Consumption reduction. Analyse the process to explore if the consumption of the item can be cut down by
Value analysis.
Redesigning Component. If the specifications and tolerances are too complex.
Make decision. If the method of manufacturing is cheaper and trouble free. Does an analysis of reasonable
cost of material, labour, over-heads and reasonable profit roughly equal the price quoted? If not, further
investigation is needed. Also examine part buy or buy unfinished parts and finish at your works or vice-
versa.
Supply source. Locate another dependable source supply at a lesser price or better material at the same
price, if the present source of supply is not the best.
Imported components. Can you do without it? If not, is it possible to obtain it from indigenous sources
With practice, the value analysts will be able to draw up a questionnaire for the use of the procurement cell
in each project and revise it from time to time.
There are a number of techniques which are commonly used in the conduct of value management (VM)
studies. Some of these techniques are:
Function analysis.
Function analysis system technique (FAST).
Cost/worth.
SMART methodology (Simple Multi-Attribute Rating Technique).
Value drivers.
Value benchmarking (or value profiling).
Options selection.
Weighting techniques.
Creative techniques.
Evaluation techniques.
Scenarios technique.
Target costing.
Function performance specification (FPS).
Function analysis
Function analysis is a method for analysing the functions of the constituent parts of a project.
There are many approaches to function analysis, some very structured (such as the function system
analysis technique) and others less formal (such as value trees or mind maps). One of the key principles of

the VM process is that it focuses on achieving successful outcomes rather than on the process of getting
there. Functional analysis provides a very powerful tool to identify intended outcomes. In developing a
functional model, the team is forced to make a very clear definition of the project by considering key
questions such as:
What are we trying to achieve?
What must we get right if we are trying to achieve it?
What considerations do we need to bear in mind while designing it?
How do various design solutions contribute towards achieving the desired outcome?
The method relies on developing a function cost matrix in which the costs of performing each of the
identified functions can be determined by allocating elemental costs across the functions.
The value process

The value process generally involves putting a multi-disciplinary team through a structured and logical
sequence of tasks with the overall objective of ensuring that the optimum value to the business or
organization and its stakeholders is represented by the product, project or process under development.
The sequence of logical steps has remained broadly unchanged over the years since its initial development
by Larry Miles. It remains applicable today. The steps are as follows:
Step 1: Initiation
The initiation phase answers the questions „What?‟ „Who?‟ „Where?‟ and „When?‟ It is analytical and
involves the key stakeholders in the study exploring what is being studied and why, „What‟ they hope to get
out of the study, „Who‟ should be involved, „Where‟ it should take place and „When‟.
Step 2: Function Analysis
The formal analysis of function lies at the heart of the method and answers the question „Why?‟ Why
certain components are included and what contribution they make to the end purpose of the object of the
study; the mode of thinking during this stage is still analytical. It is important at this stage to achieve
consensus on functional requirements and to test that the requirements can be related to overall corporate
or organizational strategy.
Step 3: Speculation
The speculation stage poses the question „How?‟ How else can the function(s) be achieved? It is used to
generate alternative ideas and provides the innovative springboard of the method; here, the team will
employ creative thinking without evaluation.
Step 4: Evaluation
Generated ideas are evaluated to answer the question, „Is this better than what we had before?‟ During this
phase the team‟s thinking is judgemental. It will include consideration of opportunity and risk.
Step 5: Development
In step 5 the team answers the question, „Will it work?‟ Once more the team is back in analytical mode and
must validate the proposals that have been selected and appear to be better alternatives to the original.
Step 6: Implementation
It is in the implementation phase that the developed and validated proposals will be implemented.
Step 7: Audit
Audit is the final step and answers the question, „Did it work as well as we expected?‟ Again, this is
analytical and provides feedback for continuous improvement.
The application of value management
It is possible to apply the techniques in an ad hoc way, having workshops as and when deemed
appropriate and necessary by management. Many organizations adopt this approach and, indeed the
evidence suggests that generally the approach is positive and better projects, processes and products
result.
An alternative approach involves the creation of an organizational value culture to continuously improve all
aspects of business from corporate strategy through the management of operations. The techniques and
tools of value management can be used to underpin and make possible this culture. The general move
seems to be towards the adoption of this value culture; indeed similarities can be drawn between this
approach and the lean production processes used successfully in Japan over the last few decades.
However it should be remembered that culture develops and evolves over many years and for real benefit
the culture must be viewed and perceived as a permanent change necessary for the future success of the

organization and not simply as a passing management fad, that will be replaced by the next management
fad in a few years time.
With regard to involvement in the processes of value management the following three points are key to
success.
● Firstly, it is essential for senior management to demonstrate and express their support and commitment
to the use of value techniques – without this support it is often impossible to get the appropriate level of
commitment and buy-in from elsewhere in the organization to ensure success.
● Secondly, the facilitation and running of value programmes and workshops can either be undertaken
from within the organization or by the use of external facilitators – the decision is really down to available
resources and the frequency of value studies within the organization. It is however essential for those
facilitating to have the necessary skills and to demonstrate impartiality to the stakeholders involved.
● Thirdly, it is essential that all key stakeholders in the project, product or process under examination are
involved.
With regard to optimum timing for studies, it must be recognized that for developmental projects the
opportunity for a change and hence for a value improvement is considerably greater during the early
stages of development than at the later stages. Consequently, as a priority, value techniques should be
used to validate project need, project brief and initial design solutions.
However, where the techniques are used to support a value/ continuous improvement culture the timing
issues and strategy will be different.
Some value management case studies
The following case studies demonstrate how value management may be applied. A selection of case
studies is included to illustrate some of the issues and benefits outlined.
Case 1 – Implementing a value management programme

An international manufacturer of a wide range of consumer products spends over $500 million/annum on
capital projects to improve its manufacturing capabilities. Business analysts noticed that the productivity of
the assets was falling behind that of its competitors. They sought to implement a value management policy
to redress this balance and improve asset productivity by a target figure of 20% over a period of two years.
An individual within the central engineering department was made responsible for delivering this value
management programme, which included undertaking a value engineering study on every capital project
exceeding $5 m. During an 18-month period over thirty studies were carried out, achieving savings of
between 5 and 30%. The success of the programme was evidenced by the fact that it made a significant
impact on the company‟s market capitalization.
Case 2 – Optimizing the benefits of joint venture projects
Two major, non-competing, financial service organizations joined forces to develop a combined operations
centre. The rationale for the joint venture project was that a combined centre would lower operating costs
and hence create competitive advantage for both organizations. A joint brief had been developed by the
organizations and a sketch design solution evolved in response to this brief. The joint venture
commissioned a value management study involving all the major stakeholders to optimize the value of the
brief and design solutions to the benefit of the joint businesses. A one day workshop study was conducted
which identified that, far from reducing costs, the brief required a facility that met all the conflicting
corporate, process and security requirements of each organization – duplication and confusion abounded.
The workshop identified brief and design changes resulting in a re-design of the project representing a 30%
reduction in capital cost, a significant reduction in operating costs and the realization of competitive
advantage for both organizations. The study succeeded because the major stakeholders for the
businesses and the project were present at the workshop and consequently owned the solutions developed
during the workshop.
Case 3 – Re-engineering the procurement process
An oil and gas company desired to review the process by which it conducted its business of design,
procurement and contracting of off shore production facilities. Three areas of focus for reducing cost were
identified as follows:
● Functional performance specifications
● Reduction in procurement paperwork and
● Simplification of procurement related processes.

A value management study was instigated involving members from all key disciplines and including
representatives from most levels within management. The company prides itself on teamwork and this
contributed enormously to the effectiveness of the study. The study was a success and many proposals
were implemented quickly while others depended upon other changes taking place before their potential
could be fully exploited. In many cases improvement in performance exceeded 50%, dramatically reducing
man-hour requirements, delivery times and documentation but, at the same time, enhancing product
quality. With the help of the value techniques adopted the company enhanced its competitive edge.
Case 4 – Validating the project brief
This organization made it a condition of its headquarter relocation and consolidation project that a value
management programme be implemented to achieve optimum value for money and to ensure that the
project comprehensively addressed functional and performance requirements. The project involved
consolidating numerous business sectors on over fifty sites to less than ten carefully chosen new and
existing locations. There were strict budgetary limits and spend profiles for the project. A series of twenty
value workshops were conducted, using a single functional model for consistency, to validate that the
outline briefs and initial design concepts accurately reflected the organization‟s requirements. The results
of the workshops contributed significantly to the re-planning of several of the sites and provided the basis
for much improved definition of quality and functionality.
Case 5 – Building the team
A major organization, with a high public profile dealing with sensitive issues, wanted to ensure that its
buildings were developed to the highest standards and fully utilized the limited resources available. The
organization had formally incorporated value management into its procurement procedures.
One particular study was undertaken after the appointment of the building contractor and scheme design
but before the detailed design of a design, develop and construct contract. All parties were represented at
a value workshop, including the organization‟s design team who retained a „watching brief‟ over the design
development by the construction team. It soon became apparent that there was a difference in design
philosophy between the two teams; both were very experienced and put forward excellent and workable
proposals – the problem was that they were different. The atmosphere of the workshop proved to be the
ideal forum to explore both options in depth and understand the others viewpoint. By the end of the
workshop, the best parts of both schemes were adopted which far surpassed either original scheme. The
study started with two teams and two philosophies; it finished with one team and one far better scheme.
Case 6 – Achieving NPC savings
Many value engineering studies are concerned with obtaining better value for money often involving
reducing costs, preferably measured on a life cycle basis over the design life of an asset. This case
involved the examination of a proposed chemical packaging facility. The primary aim of the project was to
replace an existing, but worn out facility, with a modern one to comply with ever more stringent quality
control legislation and to improve competitiveness. To save capital costs, it was proposed to reuse and
extend the existing building to fill the available site but replace all the process plant within it with state of the
art equipment. To save running costs, it was proposed to automate the plant as much as possible,
particularly all handling equipment. The result of a two-day study workshop was a saving of 50% in the
NPC of the plant. The principal savings arose from just one proposal, namely to design the optimum
process-flow path and then provide a new building to house it. This enabled considerable simplification of
the entire facility reducing both capital and running costs.
The above case studies demonstrate that real benefits and cost savings can be secured by implementing a
VM approach.
The benefits of value management
The use of value management techniques and the establishment of a value culture encompassing the
techniques can deliver the following benefits
● The need for new investment is always verified and project goals are clearly defined.
● Objectives and decisions are openly discussed and explicitly stated.
● Evaluation frameworks are structured, rational and rigorous.
● Business decisions are supported by data and made on the basis of defined performance criteria aligned
with corporate strategy.
● Accountability is increased.
● Alternative solutions are always sought and considered.

● Business decisions can be made with greater confidence.
● There is enormous potential for increasing value for money.
● Communication, understanding and teamwork can be improved and disseminated throughout the
organization.
● Participation by all key stakeholders increases the likelihood of satisfaction with the end product.
● Opportunities for long-term profitability and continuous improvement are enhanced.
In summary some of the key opportunities of value management are
● To help optimize the balance between corporate strategy, market threats and opportunities and
investment decisions and to help prioritize capital investment.
● To validate and optimize the value of capital project briefs and design solutions and to help evolve the
design and construction of capital projects to meet functional requirements at lowest whole life cost.
● To help establish the optimum procurement and funding strategy for capital investment.
● To define, design and continuously improve business processes and the physical infrastructure
supporting these processes to deliver world-class solutions at the lowest whole life cost.
● To establish the strategies and relative economies associated with safeguarding for future change.
● To strike the optimum balance between capital and operating costs.
● To benchmark the performance of existing facilities and to identify potential value improvements that can
be applied to new facilities.
● To realize and maximize the value associated with business partnerships and strategic alliances.
● To support continuous improvement in operating processes through value analysis.
A function led value management approach can be used to identify and optimize investment for all types of
organizations and act as a basis for continuous improvement through improving revenues while reducing
operating costs.
Valuation & Construction Economics

Definitions
Assessee
Assessee means a person by whom Wealth-tax or any other sum of money is payable under Wealth Tax
Act, and includes ;
i) every person in respect of whom any proceeding under WT Act has been taken for the determination of
Wealth Tax payable by him or by any other person or the amount of refund due to him or such other
person;
ii) every person who is deemed to be an assessee under WT Act ;
iii) every person who is deemed to be an assessee in default under WT Act ;
Assets
Asset includes property of every description, movable or immovable, but does not include;
i) Agriculture land and growing crops, grass or standing trees on such land other than land comprised in
any tea, coffee, rubber or cardamom plantation;
ii) Any building owned or occupied by a cultivator of, or receiver of rent or revenue out of, agricultural land ;
Provided that the building is on or in the immediate vicinity of the land and is a building which the cultivator
or the receiver of rent or revenue by reason of his connection with the land requires as a welling house or
a store-house or an out-house.
iii) Animals ;
iv) A right to any annuity in any case where the terms and conditions relating thereto preclude the
commutation of any portion thereof into a lump sum grant
v) Any interest in property where the interest is available to an assessee for a period not exceeding six
years from the date the interest vests in the assesee ;
Property
It means any interest in property; movable or immovable. Immovable property means any land, building or
part of a building together with machinery, plant and other permanent fixtures.
Free Hold Land
A parcel of land is said to be free-hold when the owner has absolute right of enjoyment, possession and
ownership over it and it is free from any kind of encumbrance as to the transfer of title/occupancy/use.
Lease Hold Land

A parcel of land is said to be lease-hold when the right of enjoyment and possession is vested in a person
other than the owner for a definite period of time in consideration for a fixed sum of rent known as lease
(ground) rent. The owner of the land is known "Lessor" and the person holding the lease title is known as
"Lessee". Apart from the period of lease and the rate of lease rent, the lease agreement may stipulate
other restrictive covenants such as use of land, sharing of unearned profit, conversion of title into free hold,
renewal of lease, resumption of lease and right to sale / transfer of land. Long term leases having term of
99 years and above are considered leases in perpetuity.
Economic Life
Economic life of building means its life expectancy with normal repairs and maintenance. Economic life of
structure depends on the type of construction, the quality of construction materials, climatic conditions, use
of structure and the level of maintenance and upkeep. The expected economic life of different types of
structure depends on the type of construction, the quality of construction materials climatic conditions, use
of structure and the level of maintenance and upkeep.
Depreciation
Depreciation means the decline in the value of structure/asset due to its normal wear the tear on account of
its use and age.
FAR / FSI
Floor Area Ratio/Floor Space Index is the ratio of the total area of all floors of building including area of
walls as well as area of mezzanine floors but excluding staircase, passages elevators and other services
areas as permitted by local building bye-laws, to the area of plot.
Ground Rent
When land only is given on lease for construction buildings or any other use by the lessee, the periodic
payment the lessee under the covenants of the lease is called "ground rent". The ground rent is of two
kinds :
1) Secured ground rent : If under the lease agreement the lessee is required to construct a building on the
plot, the ground rent is said to be secured one.
2) Unsecured ground rent : When under the lease agreement the plot remains open without any
construction of building, the ground rent is said to be an unsecured one.
Standard Rent
Rent which can be lawfully charged from a tenant under relevant rent control act is known as standard rent.
Concessional Rent
When the property is let out at rent lower than the prevailing market rent, the rent is known as confessional
rent.
Annual Gross Rent
It is the total amount of the rent received from a property during the year.
Annual Net Rent
It is the net amount of the rent deducting the outgoings from the annual gross rent.
Out-Goings
The amount of taxes levied by local authority/state govt. and other recurring expenses in respect of a
house property such as repairs & maintenance, collection charges, insurance, ground rent, service charges
etc. is known as "outgoings".
Service Charges
It is the expenditure incurred by the owner for maintenance of common services like watch and ward,
operation of lifts and illumination of the common spaces, fire fighting arrangement, for proper enjoyment of
the properties by the users.
Annual Sinking Fund
Sinking fund is the notional fixed sum of money allocated annually at the prevailing rate of interest to create
the necessary capital for the replacement of an asset after the economic life span of the asset is over.
Year's Purchase
The multiplier of the net rent or net return to obtain capital value on material date of valuation is termed as
year's purchase. This multiplier depends upon the rate of return expected from the capital investment in the
property.

Rate of Capitalization
It is the rate of return which a prudent investor would expect from a particular kind of investment in an asset
or immovable property.
Value and Cost
The cost of an asset represents the actual amount spend in the construction of the asset while the value is
defined as the present worth of future rights in the property and depends to a great extent on demand and
supply. The cost relates to the past while the value relates to the future. With the inflationary trend in land
values and construction costs, it is inconceivable that the historic cost could ever represent the value of a
property on a specific date. In simple words the term value means the amount of money for which the asset
will exchange in the open market.
Market Value and Fair Market Value
"Market value" is the price that a willing purchaser would pay to a willing seller for a property, having due
regard to its existing conditions, with all its existing advantages and its potential possibilities when laid out
in its most advantageous manner.
"Fair Market Value" is the estimated price which any asset in the opinion of WTO/VO would fetch, if sold in
the open market on the valuation date.
The terms "Market Value" and "Fair Market Value" are synonym except the word "Fair" introduces an
element of a hypothetical market. The expression "if sold" does not contemplate actual sales or actual state
of market. The expression "Open Market" does not contemplate a purely hypothetical market exempt from
restriction imposed by law. The fair market value excludes sentimental value advertisement, brokerage,
stamp-duty, commission etc. for affecting the sale transaction.
Potential Value
This is the inherent value in the property which is realised when the property is developed in its most
advantageous manner. For example, land on outskirts of a town possesses building potential. Similarly, an
under-developed property possesses value which can be realised by fully developing the property.
Guideline Value
The value adopted for stamp duty is based on the land / building rates fixed by the local authorities for the
purpose of stamp duty charges.
Salvage Value
This term is mainly in case plant & machinery. It is the value of an asset realised on sale after it has
outlived its useful span of life but has not yet become useless. In other words, it is the amount realised over
and above the cost of its removal.
Scrap Value/Residual Value
It is the value which is realised when the property become absolutely useless except for sale as junk. In
other words, this is the value of old materials less cost of demolition and disposal. It is also known as
residual value. This value depends upon type of structure and quantities of useful materials which can be
obtained on its demolition.
Reversionary Value of Land
The valuation on yield basis (except for yield in perpetuity) has got two main components, namely (a)
Capitalised value of present rights to receive future income (b) Present worth of sale proceeds of an open
plot at the expiry of a specified period. Price paid for a property purchases not only the present rights to
receive future income but also purchases the reversion to free land. The capitalized value of net annual
income in case of a rented out property will be for a assumed future life of the building and thereafter the
owner will have the open plant of land without structure standing thereon. This is known as Reversion to
Land. Reversion means right to repossess the property at the end of term granted to the tenant or the
lessee or it can be said that the property comes back to the person who granted it to someone after the
specified term of grant is over.
Reversionary value of land should be considered in valuation of a property, where the remaining life period
of the structure is fifteen years or less.

METHODS OF VALUATION
Valuation should be realistic depending on the nature of property, its use, potential and all other
characteristics.
A valuer of land and buildings needs the knowledge of.
(i) Purpose, time and place of valuation.
(ii) Laws relating to valuation.
(iii) Building industry including method of construction, structural
arrangements, specifications, type of foundations finishing and services provided etc.
(iv) Plant and machineries installed.
The RICS Valuation – Professional Standards January 2014 (the Red Book) is a comprehensive set of
standards covering the key aspects of a valuer‟s work.
The principal purpose of the standards contained in the RICS Valuation – Professional Standards January
2014 (Red Book 2014) are clearly set out as the „Overall purpose‟ in paragraphs 1–6 of the Introduction:
„1 Consistency, objectivity and transparency are fundamental to building and sustaining public confidence
and trust in valuation. In turn their achievement depends crucially on possessing and deploying the
appropriate skills, knowledge, experience and ethical behaviour, both to form sound judgments and to
report opinions of value clearly and unambiguously to clients and other valuation users.
2 Globally recognised high level valuation principles and definitions are now embodied in the International
Valuation Standards (IVS) published by the International Valuation Standards Council (IVSC). RICS has
long been a supporter of the development of such universal standards, and not only fully embraces them
itself, but also proactively supports their adoption by others around the world.
3 But acceptance alone is not enough – effective implementation is the key. If confidence and public trust
in the valuation process is to be achieved, standards must not only be uniformly interpreted and
consistently applied but also actively monitored and enforced.
4 That is the rationale for this new global edition of RICS Valuation – Professional Standards 2014,
commonly referred to as the Red Book. This formally recognises and adopts the IVS by requiring members
to follow them. It also complements the IVS by providing detailed guidance and specific requirements
concerning their practical implementation.
5 This approach is reinforced by the RICS professional standards regarding ethics, skills and conduct; and
is assured by a well-established system of regulation and by progressive introduction of a system of
practising valuer registration. The whole ensures the positioning of RICS members and regulated firms as
the leading global providers of IVS-compliant valuations.
6 The aim is simply stated – it is to engender confidence in, and to provide assurance to, clients and
recognised users alike, that a valuation provided by an RICS-qualified valuer anywhere in the world will be
undertaken to the highest professional standards overall.‟
The standards set out procedural rules and guidance for valuers. They not only cover matters relating to
ethics and conduct, but also establish a framework for uniformity and best practice in the execution and
delivery of valuations. The Red Book is a procedural manual and not a valuation text book setting out
methodology.
Structure of the Red Book
The RICS global material has now been grouped under three distinct headings. The first two cover matters
relevant to valuation assignments generally, the third covers matters relating to particular applications. The
intention is to make clear to members what is mandatory and what is advisory – thus collected together
under the first two headings is the mandatory material and under the third the advisory material.
This signals a new approach to identifying and classifying valuation practice guidance. This will be issued
either in the form of Guidance Applications, covering specific asset types or situations that are closely
linked to one or more practice statements, or in the form of Guidance Notes, in all other cases. Guidance
Applications and Guidance Notes are of equal status – they contain advisory and not mandatory material.
Although the Guidance Applications are reproduced in full in Red Book 2014, only appropriate cross-
references are included in relation to Guidance Notes. The three distinct sections in the global edition are:
RICS professional standards (PS) These are mandatory and define the parameters for compliance with the
Red Book, including IVS requirements, set out associated RICS regulatory requirements and clarify the
detailed application of the RICS Rules of Conduct for members carrying out valuation work. They comprise:

PS 1 – Compliance with standards and practice statements where a written valuation is required
PS 2 – Ethics, competency, objectivity and disclosures
RICS global valuation practice statements (VPS)
These provide the mandatory requirements and related implementation guidance relating to providing an
IVS compliant valuation. They comprise:
VPS 1 Minimum terms of engagement
VPS 2 Inspections and investigations
VPS 3 Valuation reports
VPS 4 Bases of value, assumptions and special Assumptions
RICS global valuation practice guidance applications (VPGA)

These provide further implementation guidance in specific instances. They set out „best practice‟ and
should be followed wherever possible to ensure the highest standards of professional competence.
Although they are not mandatory they do represent what is regarded as best practice. In any litigation a
valuer would be at a disadvantage if it could be shown that he or she had not followed best practice as
indicated in a guidance application.
They comprise:
VPGA 1 – Valuation for inclusion in financial statements
VPGA 2 – Valuation for secured lending
VPGA 3 – Valuation of businesses and business interests
VPGA 4 – Valuation of individual trade related properties
VPGA 5 – Valuation of plant and equipment
VPGA 6 – Valuation of intangible assets
VPGA 7 – Valuation of personal property, including arts and antiques
VPGA 8 – Valuation of portfolios, collections and groups of properties
VPGA 9 – Valuation in markets susceptible to change: certainty and uncertainty
The following flowcharts are designed to provide practical assistance by providing an overview of the basic
requirements to enable you to comply with the standards contained in the Red Book relating to valuation
practice in the UK.
They are set out in the four stages you need to consider when carrying out a valuation:
A: Preliminary questions
Before commencing any valuation there are seven basic questions the valuer should ask. The answer to
some of the questions will be relevant to proper compliance with some of the standards.


B:Terms of engagement (ToE)

VPS 1 sets out and contains guidance on the minimum terms and states that terms of engagement must
be settled before the report is issued.The following methods are usually followed.



C:Valuation preparation
The chart below is a simplified valuation preparation procedure (found mainly in VPS 2). The aim is to
ensure that all relevant enquiries are made and uncertainties are resolved before proceeding to a valuation
calculation. Where information is obtained or verified, the file notes should clearly show the decisions made
or actions taken.

D: Reporting
The report must include all the matters agreed in the terms of engagement and not introduce any new
terms. VPS 3 contains further information on the minimum matters and this flowchart draws the valuer‟s
attention to valuation standards that need consideration. This is not an index to the valuation standards.


1 For determination of cost of construction of a building.
1.1 Accounts method.
1.2 Plinth Area Rate and Cost Index method.
1.3 Detailed or item wise method.
1.4 Material and labour contract method.
1.5 Comparable method.
2 For determination of Fair Market Value of the property.

2.1 Land and building method.
2.2 Rent capitalisation method
2.3 Development method.
2.4 Profit method.
2.5 Comparable method.
2.6 Combination of more than one method for partly owner occupied and partly tenanted property.
2.7 Guidelines rates issued by local Authorities for relevant period and location in respect of rates of land,
construction, flats commercial properties etc.
1.1 Accounts Method
If the assessee has maintained proper books of accounts wherein all details are correctly mentioned duly
supported by authentic vouchers and no defects are pointed out and the books are not rejected then the
figures shown therein have to be followed for determining the cost. If the assessee has produced less
vouchers for some of the materials, the same is estimated and added at the market rates.
Similarly, the quantum of labour payment is assessed and if the assessee has maintained proper account,
the total cost is worked out on the basis of detailed produced by him. We rarely come across such cases
where the assessee submits complete technical accounting alongwith justification statements of materials
and labour. Such cases appear where the assessee is a professional builder or has taken huge loans and
payments made through financial institutions. In such instances, the VOs should be more vigilant in
pointing out the items and specifications which may have got escaped from the assessee‟s submission of
facts. Such items can be valued and added separately. However this method yields to a near to perfect
valuation, if the accounts are correctly maintained.
1.2 Plinth Area Rates and Cost Index method
This is a commonly used method for determining the cost of a building by comparing with the known cost of
a building. The cost of a building interalia depends on the major factors - (i) the area and specification of
the building (ii) the cost of materials and labour. The first one is covered by the plinth area rate and the
second one cost index.
The known cost of a completed building (Standard building) is divided by its plinth area to arrive at the
Plinth Area Rate (PAR). For determining the basic cost of a similar building its plinth area is multiplied by
the PAR. The extra cost involved in providing richer specifications compared to the standard building,
whose plinth area rate was determined, is added to the basic cost to arrive at the completion cost. These
are usually termed as extra items. For instance, if PAR was determined for a building with a cement
concrete flooring then for determining the cost of a building with marble flooring, the additional cost
involved in flooring is to be added. There are instances where the additional cost due to richer
specifications is more than the basic cost arrived by multiplying the plinth area by the PAR.
In case of estimation of value of investment in construction where past years are involved it may not be
possible to work out Cost Indices for past years in respect of a place simply because it would not be
practicable to collect authentic data regarding prices of materials and labour (labour rates shall not be less
than statutory minimum wagers) required to determine Cost Indices of the place for past years. In such
cases it would be appropriate to adopt Cost Indices of places nearest to the place under consideration.
1.3 Detailed or item wise method
In this method the quantities of all items of work are separately calculated. Thereafter their rates are
determined and the cost is arrived at. Foundation for which construction drawings is not available, can be
taken as costing 10% to 15% of the cost of superstructure depending on the nature of the soil and type of
foundation. In case of specialised foundation techniques like raft deep bearing pipes etc. the authentic
certification on actual expenses and design of the consultant / construction agency can also be relied upon
as such work are executed through separate foundation experts an lump-sum contract basis etc. because

the element of foundations (other than normal) may not be within 10-15% range. In case reinforcement
drawings are not available the standard coefficients for slabs, beams and columns may be adopted. The
overall coefficient for framed and load bearing structures may be considered as 110 kg. & 70 kg. per cubic
meter of concrete respectively.
This method is applicable only when the detailed construction drawings or completion drawings are
available.
In case standard schedule of rates are followed then suitable cost index should be applied to make the
rates upto date.
Wherever possible with availability of working drawings and other details item wise method may be given
preference over other methods. Updated local authority Schedule of rates can be followed where
specification & mode of measurement of the schedule matches with the item of work.
1.4 Materials and labour contract method :
In this method the owner arranges for materials partly or fully. Work is executed by labour contract which
includes supply of material not supplied by the owner. Labour contract may include execution of all items of
work of separate contracts be given for main structure, water supply, sanitary, electrical wiring, electrical
fitting, flooring, wood work, steel work etc.
For adopting this method Valuation Officer should find out the cost of all required materials provided by the
assessee and the amount of work done by the labour contract, if contractor has provided any material then
its cost should be accounted for. Copies of the labour contract should be obtained. The standard
parameters like builder's effort, consultancy charges, supervision charges etc. may be considered.
1.5 Comparable method
For built up properties
(a) (Flats/Shops/Offices) In Apartments And M.S. Buildings :
The comparable method for valuation of properties like Flats/Shops/Offices in Apartments/ Multistoryed
buildings can be adopted. The sale instances should be noted and tabled in the same manner as that of
plots.
(b) Sale Instances For Built Up Properties :
For making the rates of built up properties most comparable with the property under consideration the
following factors should be adjusted.
1. Location.
2. Situation.
3. Area.
4. Floor Difference.
5. Specifications.
6. Facilities / Services.
7. Time-gap.
8. Status (Lease or Freehold).
9. Area of the Building.
10. Floor disposition.
Suitable and proper adjustment should be made to make the rate for built up properties fully comparable
with the property.
(c) Floor Disposition :
Fair Market Value of Residential flat/commercial premises should be determined by giving weightage for
floor disposition in multistory building as follows :
a) Basement
Used for storage purpose 0.50A
Used otherwise 0.75A to 0.90A
b) Ground floor / Ist & Mezzanine floors A
c) 2nd to 5th floor 0.95A
d) 6th to 9th floor 0.90A
e) 9th floor and above 0.85A
A is the average unit cost of a flat.
In cities like Mumbai, the position is quite reverse in case of flats and multistoried buildings as the rates of
upper floors go on increasing as compared to rate of G.F. and F.F. rates. The floors above G. floor and

Pent houses fetch the most, similarly location of flat in the same building is terms of seaface view also
plays as important role. Hence above factor should be carefully decided keeping in view the local trends
and situations. Help of local guidelines for the place may also be considered to decide the floor-wise
weightages.
For determination of Fair Market Value of the property.

2.1 Land and Building Method :
As the name indicates, in this method the value of land is added to the value of structure to arrive at the fair
market value of the property. The method is generally adopted in the following situations :-
(a) In the case of self occupied property.
(b) In the case of property partly self occupied (i.e. more than 60%) and balance tenanted.
(c) In the case where it is not possible to obtain fair and maintainable rent.
(d) In case where there is no direct evidence of rent such as schools and hospitals etc.
(e) In the case where the property is not fully developed, or the return from the property is not commercial.
Land Value :
The land value is to be determined by comparable sale instances which are to be identified and then
factors of adjustment / influence are to be applied.
Identification of Comparable Sales :
It should be genuine and should not be forced, accommodation and fancy sale. Auction sale instances or
the sales cleared by the Appropriate Authorities should be given preference. In the absence of above, the
local guidelines, auction / sale prices as fixed by local development authority. Improvement Trust, reputed
builder etc. may also be referred.
It should be proximate from situation angle. The order of preference should be given to :
(a) Sale of the adjacent land.
(b) Sale of the land in the same locality.
(c) Sale of the land in the neighborhood or adjoining localities.
(d) Guideline rates issued by Local Authorities for land & construction.
It should be proximate from time angle. Sale instances nearer to the valuation date should be preferred and
in no case sale instances older than 2 to 3 years should be adopted unless there is a justification for it.
The sale instances of the dates after the date of valuation can also be considered, provided there is no
sharp and speculative rise in the prices after the valuation date,. In this situation also the proximity of time
should be preferred.
The sale instances of allotment or sale of similar flats, bunglons, shops, banks etc. by the local
Development Authorities, Housing Boards, Nationalized Banks etc may also provide an authentic base for
FMV of land or building.
The sale instances of the period prior to and after the valuation date can also be considered together if they
are passage of time can be ascertained very accurately.
Thus for land value reliance has to be given to reliable and comparable contemporary sale instances and
these instances are to be analyzed with reference to various factors impinging on the land rate to arrive at
a figure representing the fair market rate as prevailing on the valuation date. Some of the important factors
affecting the land value are given below:
i) Size, ii) Shape, iii) Frontage, iv) Locality and surroundings, v) amenities and facilities vi) FAR or FSI, vii)
Connectivity, viii) Road width.
Date of transfer of sale instance property shall always be pre valuation date or the valuation date itself and
never post valuation date. Sale instances of a post valuation date that too only immediate one can be
considered for supporting the rate derived from other sale instances of pre or on date transfer. The number
of sale instances should preferably be three or more and average rate should be adopted.
Factors of Adjustment :
Two properties can not be identical. They may not possess similar advantage & disadvantage. All such
factors of adjustment / influence affecting land rates are to be considered. The main factors are :-
(a) Location & Situation : The lands rate increases with the degree of development and the situation of
the property like in commercial or residential zones, nearness to roads, proximity to civic amenities,
transport facilities, corner plots etc. As there is no fixed percentage for these factors so the (+) or (-)
percentage is to be decided judiciously. An allowance to the extent of + / - 15% may be made on this

account. For corner plots an additional adjustment upto 5% may be made depending upon the width of
return frontage. Factors adopted in the guidelines for land & construction by local relevant authorities may
also be seen.
(b) Time-gap : Generally the price of land increases with passage of time. To ascertain the price rise more
accurately sale instances of the dates prior to and after the date of valuation should be selected and should
be brought at par with property under valuation by applying all other factors of adjustment except for time
gap. The difference in rate so arrived divided by the time gap will give the rate of price increase around the
valuation date. Addition of this price rise to the rate of past sale will give the land rate on valuation date. If
no such sale instances are available then the price rise should be considered 18 to 24% P.A.. Earlier trend
may also be seen.
(c) Shape : A plot of rectangular shape fetches more value than the plot of irregular shape. An adjustment
factor + / - 5% can be applied depending upon the irregularity in shape and frontage of the plot that affect
the layout of the building and general architectural planning.
(d) Size : In general large plots fetch less unit price due to less number of buyers. Though there is no fixed
percentage or this factor, however due to availability of number of buyers for large size plots + / - 0.5% per
100 Sqm. can be considered reasonable. Sometimes it is not possible to have sale instances of larger size
of plots and the sale instances available are of very small size developed plot. In such a situation the price
of small developed plot can not be directly applied.
The value of large tracts of land can be determined from the sale instance of the small plot provided the
large tract of land is ripe for use for building purposes, that the building plots that could be laid out on the
land would be good selling propositions and that the valuation on the basis of hypothetical layout with
justification be adopted. In such a case necessary deduction for the cost of land required for the formation
of roads, drains, sewer water supply and electricity lines and the interest on outlays for a period of
deferment of realisation of the price, the profits on the venture etc. are to me made. The total cost of such
deductions vary from 25% to 50% and should be determined judiciously. For this purpose Development
method given in this chapter may be resorted to. Consideration should be given to local bye-laws. Where
multistoried building is admissible on a plot say having minimum 1500 Sqm. area, it may be more valuable
than smaller size plot due to higher FSI / FAR permissible.
(e) FAR : The market value of plot increases with the increase in the Floor Area Ratio (FAR) or Floor
Space Index (FSI). But this increase is not proportional. Effort should be made to adopt sale instances of
the same FAR/FSI or the sale instances of the FAR/FSI next above/below to the FAR of the plot under
valuation. In case if sale instances of same or next above/below FAR are not available the adjustment in
rates for FAR/FSI should be made as under :
FAR/FSI Rate
Additional 0.5 40% of basic rate.
Next 0.5 35%
Next 0.5 30%
Next 0.5 25%
Next 0.1 45%
In Mumbai there are provisions of transfer of unutilized FSI in same identified areas. This factor should be
carefully considered is view of prevailing land regulation Acts etc.
For figures of FAR/FSI in between, the variation in rates may be interpolated.
(f) Side Open : The plots having more sides open, fetch more rates. An adjustment of +5% for each
additional open side or vice-versa is considered reasonable.
(g) Co-ownership Undivided share, rights & Interest : The undivided share, rights & interest are less
attractive to the prudent buyers on account of absolute ownership, limited control, expenses of partition
suits, meeting of minds on a number of problems connected with maintenance, management and
development. As such a discount 5% to 12.5% depending upon the number of coowners and their
relationship can be given.
(h) Land Tenure : The leasehold land fetch less price as compared to free hold land due to the number of
restrictions imposed in lease deed. An adjustment fact + / - .25% is to be applied for working out the land
rate of free hold plot from the sale instance of lease hold plot and vice-versa.
(i) Encumbrance: Land which is encumbered by unauthorized occupation/encroachment will have
depressed value on account of litigation for eviction. Land value for the portion encumbered may be

deferred for reasonable period to allow for depressing effect to the extent of 30%. The bonfires of
unauthorized occupation/encroachment should, however, be checked by Valuation Officer before allowing
this adjustment.
(j) Unearned increase : If the property under valuation happens to be a lease hold plot then a certain
percentage, as specified in the lease deed of unearned increase (current market rate less premium paid) is
also to be deducted from the land value. In such cases, however, it should be ensured that if the sale
instance considered is also lease hold, then it should be first converted into free hold by applying at
adjustment factor of (+) 25%, in addition to other factors of adjustment.
(k) Impact of Statutory Restrictions: The main aim of statutory restrictions is to restrict the right of the
landlords to enjoy their properties and equitable distribution of land at nominal rates for mass scale housing
for urban poor.
Other Factors :
Apart from the adjustment factors described in the foregoing paragraphs, if there are other factors effecting
the price of property such as defect in title, mode of payment etc. these should also be considered.
Cost of Building :
The fair market value of the building on a valuation date is its cost of reproduction on that date minus the
depreciation from the date of completion of the building to the date of its valuation.
When an immovable property consisting of land and building is to be valued the above method is adopted
in certain circumstances viz. i) fully owner occupied, ii) untenanted or vacant.
Underlying concept for such valuation is the view that Fair Market Value of such property reflected in the
sum of the market value of vacant land as prevailing on the valuation date regarding valuation of land and
the reproduction cost of the building less depreciation as on the said date.
Reproduction cost is unaffected whether the building was constructed by the owner through his own efforts
or got it constructed through a contractor. Obviously in such case there is no question of making any
concession for any claim by the owner of constructing the building by the owner through self supervision.
No deduction whatsoever (7 ½ % or other wise), on this count shall be allowed in determining F.M.V. of an
immovable property.
Depreciation :
With the passage of time, the value of building decreases and after economic life of the building, its value
becomes equal to its salvage value.
Normally reproduction cost of building is worked out with the help of Plinth Area
After working out the cost of building as new on the situation date with the help of PAR a deduction termed
as depreciation is allowed to arrive at the reproduction cost of the building at its present form.
Deciding the quantum of depreciation to be allowed is a very important exercise to be undertaken by a
Valuation Officer. To estimate the value of depreciation a V.O. has to assess future life of the building (life
of a building is its economic life and not physical life) and this requires expertise of a Civil Engineer or an
Architect. Future life of a building depends on the following factors :
i) Date of commencement of construction, ii) Date of completion of construction, iii) Type and technique of
construction, iv) Type and quality of construction materials, v) Quality of workmanship, vi) Surroundings
and environment in which a building is situated, vii) Climatic conditions of the place, viii) Nature of use to
which the building was subjected in the past and likely nature to which the building will be put to use in
future, ix) Extent and quality of repair and maintenance, x) Present physical condition of the building with
special attention to critical components and its repairability in future, xi) Obsolescence.
Actual age of a building is one factor among may factors which influence future life of a building. One of the
most important factors is the factor of obsolescence which need to be further elaborated. Obsolescence
means going out of use or becoming out of date. Obsolescence of a building can be on account of either
aesthetic obsolescence or functional obsolescence or economic obsolescence or combination of any or all
of the three. If a building is obsolete the future life is NIL, though physical future life may be thirty years. A
building designed in the past say, an eighteenth century building is aesthetically obsolete and a new owner
will demolish the building and construct new designed in accordance with the aesthetic value and taste of
the twenty first century and therefore, value of the building will be the salvage value and nothing more
unless it has got huge heritage value. In this case life of the building has come to an end on account of
aesthetic obsolescence.

A building which was not built keeping in view the modern functional utilities and which can not be
economically altered to suit such functions will be demolished by the new owner and a new building will be
constructed in conformity with the present functional trend. For example a building with very high ceiling,
large doors and windows and without attached toilets is functionally obsolete building and this building will
have NIL future life, though physical future life may be considerable. In this case value of the building will
be its salvage value and nothing more.
A building, even if it is not aesthetically and functionally obsolete, is economically obsolete when it is
economically viable and lucrative to demolish the existing building and construct a new building. For
example, a building which has not developed the land to its full potential and it cannot be developed so
unless the existing building is demolished and a new building is constructed, then the existing building is
economically obsolete provided the new venture is economically viable and lucrative. In this case future life
of the building will be NIL even if it was constructed say, thirty years back and the value of existing building
will be the salvage value.
Considering all the factors mentioned above and after due deliberation a Valuation Officer has to assess
the future life of the building under valuation.
Having done so, equivalent spent life (le) of the of building will be life of the building (I) less assessed future
life of the build (If) i.e. le=I-If.
Lives of different categories of buildings (I) are given in enclosed Annexure ….. Normally salvage value
shall be taken as 10% of the reproduction cost but in certain cases it may go up to 15%. In case of old thick
walled load bearing buildings having extensive use of stone masonry, good quality marble, teak wood
doors, windows, beams and floors, brass fittings, cooper wirings etc. percentage may be taken as 15
instead of 10 for estimating salvage value.
In case of factory buildings having R.S. columns, beams, steel trusses and CGI sheet roofing in good
condition without rusting and flaking salvage value may be taken as 15% of the reproduction cost. Which is
generally taken as 10% of the value of the building. The economic life of the building depends upon its type
of construction. The depreciation can be worked out by any one of the three methods indicated below.
Generally the first method which is simplest among the three methods is followed.
In determining value of an immovable property by „Land and Building Method, another factor viz. Builder‟s
efforts is not considered. Builder‟s efforts as the name suggests is the monetary value assigned to the
efforts expected to be made by the owner of the property to get the buildingconstructed. This includes
expenses likely to be incurred by the owner for getting the building plan prepared and structural design
done, getting the building plan and other services sanctioned by the municipality, electricity board or other
local authorities etc. This may be taken as 3% of the reproduction cost of the buildings.
Therefore, value of a property by the Land and Building Method would be :
1) Value of land …………………….. A
2) Value of building :
2.1 Reproduction cost of the building
Based on CPWD-PAR ………… B
2.2 Amount of depreciation ………. (-) C
2.3 Builder‟s efforts @ 3% of B …… D
2.4 Value of building (B-C+D) …….. E
3. Value of the property ………….. A+E

B. Sinking Fund Method :

A sinking fund is an amount set aside every year and invested at compound interest so that on expiry of
economic life one gets the cost of building less salvage value Annual sinking fund to provide Re 1 in n
years.
C. Written down Value of Equal percentage or declining Balance Method:

In this method the rate of depreciation remains constant and it is given :-
2.2 Rent Capitalisation Method :

This method is generally resorted to in the following situations : -
(a) In case the land is fully developed i.e. it has been put to full use legally permissible and economically
justifiable and the income out the property is normal commercial and not a controlled return or a return
depreciated on account of special circumstances.
(b) In the case of fully tenanted property and statutory control of terms and conditions of tenancy.
(c) In the case of a property small portion of which is self occupied and balance large portion is tenanted.

(d) In the case of commercial establishment like cinemas and hotels, if the building is given on outright
lease / rental basis and rent fetched is reasonable.
The rent which is foundation ingredient of rent capitalization method is net maintainable Rent which is the
difference of Gross maintainable rent and out goings. The other ingredient of this method is year's
purchases or rate of capitalization. Thus to determine the fair market value of the property gross income
per annum is to be determined. From this income all the outgoings which are essential to be incurred for
maintenance are to be deducted to find out the net maintainable rent or annual letting value. The Annual
letting value multiplied by year's purchase gives the fair market value of the property.
Gross Maintainable Rent :
(a) In case of rented building attracted by Rent Control Act, the actual rent received or receivable should be
adopted.
(b) In case of a newly rented building, the actual rent if it is nearly equal to the fair and normal market rent
prevailing in the area be adopted.
(c) In case the rent fixed a lower level deliberately by collusion by letting out to near relations or subsidiary
concerned, the prevailing market rent should be adopted. The reasons should be recorded in the report.
(d) In case of partly self occupied building, where rent capitalisation method is resorted to, the rent for self
occupied should be equal to prevailing market rent.
(e) In case of commercial building, prevailing market rent in the locality should be adopted.
(f) In case the Rent Control Act is applicable, the rent should not exceed the standard Rent, whether fixed
or not.
(g) In case where the property is let throughout the year ending on the valuation date the gross annual
maintainable rent shall be the rent received or receivable as indicated in para (a) to (f) above in respect of
such year.
(h) In case where the property is let for only a part of the previous year (year ending valuation date), the
gross annual maintainable rent.
(1) In the gross annual rent the following amounts should also included :
(i) Interest on deposits not being advance payment towards the rent for a period of 3 months or less @
15% P.A. on the amounts of deposits outstanding from month to month basis for the period (excluding part
of a month) during which deposit was held by the owner in previous year. if the owner paid interest on such
deposit, the amount of interest paid by owner be deducted from the amount of interest calculated @ 15%
P.A.
(ii) The amount of premium divided by the number of years of lease period, if the owner received premium
for leasing out the property.
(iii) The value of benefits or perquisite whether convertible into money or not, desired by the owner as
consideration for leasing of the property or any modification of the terms of lease.
Out Goings :
Only those outgoings which are actually paid or payable by the assessee will qualify for deduction from the
gross main tenable annual rent.
1. Municipal Taxes : The amount of taxes as actually levied or leviable by the municipalities should be
considered for deduction.
2. Repairs and maintenance Charges : The yearly expenses incurred by the assessee for repairs and
maintenance or as per stipulated condition in the rent agreement should be deducted. Normally, 1/12 of
gross annual rent should be considered for deduction as outgoings for repairs and maintenance.
3. Ground Rent : Actual ground rent paid in the case of lease hold properties.
4. Insurance Cover : The actual amount paid by the assessee for the insurance for the safety of building
only limited to the scale laid down by Fire and General Insurance Rules.
5. Management & Collection charges : This will vary depending upon the number of tenants, types of
tenants, legal disputes in collecting the rent. If there is only one tenant or the building is under occupation

of the Govt. or Public Sector-25 undertaking only 2% should be adopted. In any case not more than 6%
deduction is to be made on this account.
6. Service Charges : Expenditure actually incurred by the assessee for sweeper, chowkidar, liftman,
pumpman, electrical energy for common light point etc. may be allowed subject to scrutiny of the
reasonableness of the claim.
7. Sinking Fund : Deductions for sinking fund for equipments and machinery installed in cinemas, hotels
and factories etc. may be allowed. No sinking fund is to be allowed for building.
8. In case of outgoings the expenditures for common securities, maintenance charges, fire fighting
charges, Rain water hawesting charges, maintenance on loan etc. may should also be considered.
Rate of Capitalisation :
Rates of Capitalisation :
Having determined the net maintainable annual rent and years purchase the F.M.V. of the property = Net
Maintainable Annual rent X year's purchase.
1.1 When a property is valued with reference to the income realized from it, the basic relationship is
expressed by
V = Present worth of future right to income.

I = Net operating income, before providing for interest on the investment and amortization payments on the
investment.
R = Rate of capitalisation, a summation of the rate of interest plus the rate of amortization (I + r).
Amortization means extinguishing debt, usually by means of sinking fund. The definition of "I" above
properly observed, will prevent the inclusion of interest on capital and sinking fund as 'outgoings' fro them
gross income.
1.2 "R", the Rate of Capitalisation represents the total property rate at which a fair return on and of the
investment is anticipated. The 'on' part (i) is the Interest on Capital, while the "of" part ® is the sinking
fund element. Land by itself is indestructible and does not call for the "of" part when it is considered along.
Improvements and land (structures) have finite lives, have to be replaced by new ones and, therefore, call
for the of part of sinking fund.
1.3 For a defined amount of sinking fund, R the Rate of Capitalisation will depend on 'r' and 'I' the Rate of
Interest. This rate is often the subject of dispute. It is, therefore, necessary to understand the background
of it.
Interest
Natural Resources (termed as and including "Land') and Human Labour are the Primary Factors of
Production. Production covers everything including properties. Capital goods produced by the economic
system itself constitute the Intermediate Factor. They are both outputs and inputs of the system. They can
be rented out. The rental yield derived from the capital goods in 'Interest – a percentage 9and hence a pure
number of the money value of these goods.
The Intermediate Factor is a product of the round about processes, which take time to get started and
completed and a mere productive than direct processes. The capital goods also depreciate. After allowing
for all depreciation requirements, capital has a net productivity 'the real interest yield'. However, no Society
can take unlimited advantage of the opportunity to get more production by round about processes because
it would have to cut down on present consumption to speed up capital's rate of growth and future
consumption.
Determination of Interest
Interest, the yield (or price) of capital, is subject to the laws of demand and supply. As Society transfers
more resources from current consumption, more capital (goods) becomes available projects with longer life
and lesser yield or lesser net-productivity come to be taken up.
This means that interest level is determined by interaction between two factors:
1. People's impatience to consume now rather than accumulate more capital goods for future consumption;
and,
2. Investment opportunities that exist to procure higher or lower net productive from such capital
accumulated.

The first factor limits the growth rates of capital and its attained size. The second tells what interest can be
earned as we have various amounts of diverse capital goods. The fundamental proposition is :
Society can exchange present consumption of goods for future consumption of good at a trade of rate
depicted by the rate of interest.
Interest Rate :
As capital goods are of diverse nature, at any time there is a whole spread of interest rates for ventures of
different risks and whole spread will move up or down. When the pure risk less rate of interest changes.
This takes up to the definition of Interest Rate.
The market rate of interest is that percentage return per year. Which has to be paid on any safe loan of
money, which has to be yielded by any safe bond or other security, and. Which has to be earned on the
value of any capital asset (such as a machine, a hotel building, a patent right). In any competitive market
where there are no risks or where all risk factors have already been taken care of by special premium
payments to protect against any risks.
Deciding factor of the interest rate
It is people in society that consume less today and save their earnings. The bulk of evidence suggests that
the level of interest rates tends to cancel out of consumption and saving decisions, even though a rise in
the rate paid by one savings bank may bring it more business because people will tend to transfer their
assets to it, without their having altered consumption one bit. Economic principles alone cannot given an
insight into the savings process.
Consumption lending is today less important than productive investment lending; therefore, productive
investment primarily determines the behavious of interest rates.
With the universal system of Centralised Banks, the Government is also an important determinant of
investment and interest rates. This, it does through its policies of supply of money in the market (money
measures) and taxation (fiscal measures).
All economic development induces a rise in prices. The 'real interest rate' is the 'money interest rate' minus
'the percentage price rise'. As people come to anticipate a steady rate of inflation, they build into the
interest rate, an allowance for the inflation.
Every asset is capitalised at the present discounted value of all its future net receipts. Decisions on the
wide-ranging investments would be made to maximise the present discounted value. This obviously is
governed by the type and durability of investment.
The Economic principles have been summarised from Nobel-laureate Paul Samuelson's Economics' 10th
Edition. We may see how they apply to immovable properties
Rates for properties ?
In "Valuation of Real Estate" Alfred Ring explains.
"The interest Rate as a composite annual return per dollar of investment isinfluence by the following market
forces.
1. Rate of government bonds on guaranteed bank deposits ;
2. Burden of management of cost of maintaining the investment, including book-keeping, collecting,
inspection etc.
3. Relative liquidity of the investment for conversion into cash.
4. Risk of loss of Income and investment due to competition or operation or economic forces.
"Although it is theoretically possible to build up a rate of interest by in depend consideration of the
economic forces which make up the rate as a composite whole in practice reliance must be placed on
market operations".
So, the sum and substance of it is that the rate of interest has to be based on the reality operating in the
concerned markets. At the same time, the componentsand factors affecting the interest rate have to be
given due consideration.
Compare immovable with other properties
As Mitra's Legal Dictionary' defines
'Capitalised value means the capital value of an asset based on its current earning power in relation to the
expected rate of return from that type of asset. It is clear that we have to select a rate which is applicable to
the given type of property and not the others which may be ruling in the market for other types of
properties, savings or investments. It will also be necessary to consider the nature of capital in the property
whether its purpose is consumption, earnings or mixed. It is easily seen that building properties occupy one

of lowest rungs on the ladder of investments. They more or less represent projects with lesser net
productivity. The reason is not far to see. Net to food, shelter is a primary need, to be satisfied irrespective
of what alternative gains can be had. This applies not only to residences but also to commercial and
industrial buildings which form the starting point of most business. This type of property, therefore,
occupies a borderline positionbetween consumption saving and investment. It cannot be expected to obey
the laws relating to any one of them. This also leads us to the corollary that the expected return, from
immovable properties would normally be in the minimum retunes range. There are other reasons for this
also.
Relation with long term securities of bank rates :
The rates of interest on Long term Government Securities (the so-called giltedged securities) are often the
lowest for the very reasons that they are longterm.
Short-term rises in interest rates of Bank deposits reflect temporary phases. When they are used as tools
for combating inflation they do not have direct relationship with the returns from investment. In fact their
use as tool is itself a means to secure an evening out of the fluctuation in the interest rates.
Built-up properties resemble the long term securities in the span of their lives. In spite of depreciation they
maintain their value to a great extent. Their security (based on their permanence) is as good as that of the
Long Term Government Loans.
The security or absence of risk in nationalised banks may be considered similar but in many other counts,
Deposits in Banks cannot be compared with immovable properties.
First : The security of the deposits. They are savings in simple and pure, and not investments. They do not
enable 'consumption' as building properties do. The distinction is fine but certain.
Second : The Bank rates are uniform all over the country. Not so the return from properties which may be
different in different localities.
Third : Long term deposits with banks have reduced liquidity. One cannot withdraw the amount without
foregoing part of the interest-non can one borrow a loan against the deposit without paying additional
interest. The most liquid deposits in Bank are the savings bank deposits and they carry a much lower rate
of interest.
Forth : Deposits with Banks do not provide any hedge against inflation. The 'real interest rate' is less than
the 'money interest rate' when prices rise, inflation grows and real money values go down. For properties,
the case is different. Their value, often grows with the rise in prices, in spite of depreciation. One of the
main incentives for investing in built up properties is their capacity to provide the hedge against inflation.
Expected Return
The motives behind putting up a property are of a mixed character. But one thing is certain when such a
property is put up, it is done with full knowledge of the fact that the returns are likely to below. One of the
indications is the Rent Control Acts. They specify the fair rents as percentage of the capital cost of the
building and land. These percentages are lower than the current rates on bank deposits. Further, these are
gross returns and if allowance is made for the outgoings, it would be lesser still. Those who argue for
adoption of high capitalisation rate also plead for adopting the low (legal) returns likely to be obtained from
the properties thus trying to take advantage both ways.
Compare the return from shares
Shares of an industrial or commercial concern an investment of a different type altogether ; therefore, their
returns, even if they were regular, could not be compared with returns from buildings properties. These
returns from shares do not follow a set pattern either depending on the general out look for business and
the fortunes of a particular industry, the returns may be high or low. Over a long period comparable to the
life of a building property, the average return may not be as high as it is shown over a small period.
Preference shares do carry a stipulation that dividend on them must be paid at specified rates.
Effect of constructions
There is a stock argument against a lower interest rate namely, that in the absence of a high return, there
will be no investment in properties. In valuation we deal with the state of affairs as it exist not as it should
be. But, even otherwise, there is no evidence to prove the point. On account of their special nature,
Building Properties do behave differently from the rest of the market. The Nobel laureate Kyznets has
shown that the 'Building Cycle' (periods of intense and poor building construction) has a length of 17 to 18
years or almost twice the major business cycle which affects all business. It is enough for us to see that

high activity in construction is not necessarily and directly dependent on the market conditions even in an
unfettered economy like that of America.
In a country like ours where Building properties are considered as one avenue for investments of unearned
income, the generalized argument about the interest rate affecting building construction, can be much less
effective.
 The rate of interest and so rate of Capitalisation depend on a number of factors tangible and
intangible.
 There is a whole array of investments and different types of investments will yield different rates of
interest.
 Immovable Properties are unique in many respects and have their own rate (s) of interest.
 The rate can be justifiably related to the yield from long term securities rather than to other savings
and investments. It does not necessarily affect the volume of construction. It can be reasoned out
figure based on the particular situation.
 Reversionary value of land should be added where the remaining life period of structure is 15 years
or less.
Reversionary Value of Land :
The capitalised value of net annual income in case of rented property will be for an assumed life of the
building and thereafter the owner will have the open plot of land without any structure standing thereon.
The present consideration of the full value of the vacant land available to the owner after the life of building
is over is know as "Reversionary value".
Normally the balance life of a building being less than 20 years the reversionary value should be added to
the capitalised value. The rate of deferring the value will depend upon the number of years of balance
useful life. Where reversionary value is added with capitalised value, the capitalisation should be obtained
using dual rate table i.e. capitalisation for a number of years together with redemption of capital for the
same number.
2.3 Development Method :
This method of valuation of large extent of land is adopted in the following situations.
(a) When the comparable sales of large tracts are not available but sales of small plot are available.
(b) When the land is ripe for use for building purpose it possess necessary potentialities for urban use.
The complete procedure to determine the fair market value of the large tracts of land, under this method
can divided into the following steps.
1. Ascertain the demand for small plots in the area.
2. Determine the area of land required for development work as per municipal bye laws. Deduct this area
from the total area of the plot so as to ascertain the area available for development of small size plots. By
rough estimation it works out to 20 to 25% of the total area.
3. Determine the number of small plots which can be legally carved out from the large tract of land with
necessary provisions for infrastructure facilities.
4. Determine the cost of development works such as cost in of construction of road as per municipal
specifications with street lights, cost of laying parks, underground drains, water supply lines, sewer lines,
electric lines & substation, earth fitting or cutting, cross drainage works and municipal taxes on open land.
As the total amount of development is not paid to the contractor at the commence mend of work so defer it
for half of the period of construction at certain rate of interest say to 12%. Let the deferred value be (A).
5. Ascertain the total sale price of all the small plots of scheme on the valuation date from the comparable
sales of small developed plots. As all these small plots can not be sold at one time, so estimate the time of
disposal of all the plots and defer the total sale price for half of the period of the sale @ 10% to 12%. Let it
be of (B).
6. From the deferred sale price (B) deduct the following.
(i) Present value of the cost of development deferred for half of the period of development (A) alongwith
architect or engineers fee for his supervision and getting the scheme approved.
(ii) Incidental charges such as cost of stamps, registration legal cost, cost of advertisement etc.. Normally it
is 8% to 10% of (B). If the cost of stamp, registration and legal cost is to be borne by the purchaser then
this percentage should be modifier accordingly.
(iii) Developer's profit and risk 15% of (B).

7. This amount available after above deductions from (B) will represent the fair market value of the large
undeveloped plot on the date of valuation.
Belting method of working out land value
The land value depends on frontage and depth of the plot. The frontage is the length of the land along the
road and the depth of the plot is perpendicular to the Road. As the depth increases, the land value
reduces. In urban areas, where commercial activities are predominant, the land value abutting the road will
be higher as compared to the land away from the road. The valuation of the land by considering different
strips is called Belting method. The depth of each belt varies from one locality to another locality in the
same city and naturally, it varies from one city to another city also. The depth of strip is generally
ascertained from the actual activities in similar areas. In some cities, the first belt may have the depth of
about 80 to 100 ft. Generally, the valuation of the first belt if taken as 100%, the second belt is taken as
50% and the third belt is taken as 25%. While valuing by belting method, the zoning restrictions made by
the Development Boards/Town Planning Authorities should be considered.
2.4 Profit method
In the case of Hotels, Motels, Cinemas, Public houses which falls under the category of the Licensed
premises, the F.M.V. depends primarily on the earning capacity of the property. The F.M.V. of such
properties is determined by applying profit method provided.
(i) The owner runs Hotel, Cinema himself.
(ii) The owner gives Hotel or Cinema on conducting agreement to a conductor.
The F.M.V. of the property is determined by capitalizing the net profits (70% tangible + 30% intangible) at
certain rate of expenses, owners risk and other outgoings from the gross income For example in the case
of Cinema the following steps are to be taken to determine its F.M.V.
Gross Income (Excluding entertainment tax) :
The gross income is estimated on the basis of full house capacity less normal vacancies multiplied by the
number of shows in a year. The vacancies can be determined either from the actual sale of tickets details
of which are available with the owner. Thus the source of gross income are :-
1. Regular and morning shows.
2. Regular and morning shows.
3. Soda fountains.
4. Advertisement slides/films.
5. Show cases.
6. Any other income.
As the gross income may not be consistent, so the gross income & expenses should be based on the
average of last 3 preceding years.
Expenses : Operating expenses can be broadly classified :-
1. Entertainment tax if included in gross income.
2. Total show tax.
3. Hire charges of new reels.
4. Other taxes pertaining to cinema business.
5. Octoroi, Freight charges.
6. Publicity.
7. Traveling expenses.
8. Printing & stationary.
9. Salaries & Bonus, gratuity, provident fund, Welfare fund of staff.
10. Carbon electrodes.
11. Telephone bills.
12. Electricity bills.
13. Postage & Telegrams.
14. Insurance for building as well as plant & machinery.
15. Repair & maintenance not exceeding 3% of building value
16. Ground rent, if any.
17. Property tax.
18. Sinking fund for furniture, equipment and plant & machinery.

(i) Owners risk & entrepreneurship : 15% of gross income in the case of owner runs the cinema himself
or 15% of conducting charges received by the owner form the conductor less the owner's liabilities such as
repairs & maintenance, ground rent, municipal taxes, collection charges etc., if any borne by the conductor.
(ii) Net Profit : The net income is worked out by deducting the expenses from the gross income.
(iii) Rate of capitalisation : The net profit is required to be divided into two parts.
(a) One due to land, building, furniture, equipment etc. called as tangible profit and generally taken as 30 to
25% and is capitalised at interest rate 2% higher than the rate of interest for tangible profits.
(b) Other due to good will management, licence called intangible profit and generally taken as 30 to 25%
and is capitalized at a interest rate 2% higher than the rate of interest for tangible profits.
Financial management:
Financial management involves planning, allocation and control of financial resources of a company.
Financial management is essential as it controls the financial operations of a company. For a construction
company, the decision to bid for a project will depend on its financial status which in turn will be governed
by financial management principles. The decision to bid for a project will depend on various factors namely
whether the company have enough funds or require outside financing, whether to acquire the equipment
through purchase or acquisition through renting or leasing, whether to carry out the entire work or
subcontract a portion of the work etc. If the company uses its own funds for the project, it may have an
adverse effect on its financial status as it will reduce the liquid asset thus affecting company‟s working
capital. The construction industry differs from other industries because of its unique characteristics and
accordingly the financial management principles are applied for using the financial resources of the
company. Generally the construction companies receive the payments from the owners at specified time
intervals as the construction work progresses and owners often retain certain amount subject to the
satisfactory completion of the project. Thus the terms and conditions for receipt of payments from owners
affect the cash flow of the construction companies and need the changes in allocation of financial
resources. Further construction companies often subcontract some portion of the work (as required) to the
subcontractors, which in turn affect the cash flow. The financial management decisions include the
decisions for investment, financing and distribution of earnings. For construction companies the investment
decisions relate to investment in the business i.e. investment of funds in acquiring the assets (both current
assts and long-term assets) to be utilized in the projects for the expected return along with the risk of cash
flows associated with uncertain future conditions. The financing decisions depend on decision to
investment the funds and the resources possessed by the construction companies. In addition the
financing decisions
are also controlled by other factors namely source of financing (from banks or other financial institutions),
cost of financing i.e. interest cost on the loan and the financing duration. The decision for distribution of
earnings or profits of the company depends on the dividends to be paid to the stockholders and the
retained earnings to be reinvested in the business to increase the return. Thus for any company or
organization, financial management has to ensure the supply of funds in acquiring the assets and their
effective utilization in business activities, to ensure the expected return on the investment considering the
risk associated and optimal distribution of the earnings. Construction accounting Construction
accounting involves collecting, organizing, recording and reporting the financial data of a construction firm.
It helps in identifying the problems encountered in effective management of financial resources of the firm
and taking the corrective measures in time. The accounting system allows for the systematic recording and
reporting the financial information form one period to another in accordance with the accounting principles.
Financial data relates to assets, liabilities, net worth, cost incurred, revenue earned etc. and is required for
preparing the financial statements of the construction firm. The most important financial statements which
are used to represent the financial status and evaluate the performance of the firm are balance sheet and
income statement. The financial statements are also used to communicate the financial status of the firm to
the shareholders and financial institutions. The shareholders and financial institutions can get the useful
information about the utilization of financial resources in the business activities, costs incurred, revenues
earned and other financial information of the firm from period to period. In addition the financial information
is also required for calculating the income tax to be paid by the firm. Construction firms use different types
of accounting methods for recognition of the revenues, costs and profit while preparing the financial
statements. These accounting methods are cash method, accrual method, percentage-of-completion

method and completed contract method. For obtaining the most accurate picture of financial status, the
construction firm has to use the best suitable accounting practice for recognition of the revenue and
expenses.
cash method, revenue is recognized when construction firm actually receives the payments from the
owner of the project for the services provided. Similarly the cost (expenses) is recognized when the
construction firm actually pays the bills (to subcontractors, material suppliers etc.). Normally the cash
method is not used for preparing the financial statements of the construction firm as the revenues or costs
are recognized when these are actually received or paid rather than the revenues billed to date or the costs
incurred to date. Due to this delay in the recognition of revenues and costs, this method does not provide
accurate financial status of the firm. In accrual method, revenue is recognized when construction firm bills
the owner of the project i.e. before the actual receipt of payments from the owner and expenses are
recognized as the construction firm receives the bills from subcontractors, material suppliers etc. i.e. before
the bills are actually paid. This method of accounting is used for preparing the financial statements of the
firm as it provides more accurate information about the financial status of the firm. In percentage-of-
completion method, the revenue and expenses are recognized as percentage of work that is complete
during the course of the project. This method of accounting normally used for long-term construction
projects. The revenue is recognized as the construction firm bills the owner of the project and expenses are
recognized as the construction firm receives the bills from subcontractors, material suppliers etc. The
percentage complete till date can be calculated by dividing the cost incurred to date by the total estimated
cost at completion. Corresponding to this percentage completion, the revenue and profit to date are
calculated. The percentage-of-completion method is used for preparing the financial statements and it
provides the most accurate picture of the firm‟s financial status.
In completed contract method, the revenue and expenses are recognized when the project is complete.
This method of accounting does not provide accurate information about the construction firm‟s financial
condition as the recognition of revenue and expenses are deferred till the completion project rather than in
the periods when the revenues are billed to date or the costs are incurred to date. The revenue recognized
to date for the project at any stage within the project duration is zero, as the project is not complete. This
method of accounting can be used for construction contracts having
higher uncertainty about the construction cost and revenue until the completion of the project, involving
higher financial risks in the business. Further completed contract method causes large fluctuations in the
profit as the cost and revenue are not recognized till the completion of the project. Example -1 The
following table presents the information about the financial data of a construction project.
Description of financial data Amount (Rs.)
Contract amount 3,85,00000
Original estimated cost of the 3,46,50,000
contract
Billed to date 2,57,95,000
Payments received to date 2,34,85,000
Costs incurred to date 2,07,90,000
Costs paid to date 1,84,03,000
Estimated or forecasted cost to 1,31,28,500
complete


Chart of accounts: Chart of accounts lists all the accounts which are required to organize the financial
information of a construction firm. The accounts mentioned in chart of accounts are used to prepare the
financial statements namely income statement and balance sheet of the firm. The accounts listed in chart
of accounts are assets, liabilities, net worth, revenue, expenses and tax. In chart of accounts the
components of balance sheet i.e. assets, liabilities and net worth are listed first followed by the components
of income statement i.e. revenue, expenses and tax. Each account in the chart is assigned by a reference
number for easy identification. Financial statements As already stated in Lecture 1 of this module,
financial statements are used to indicate the financial status and evaluate the performance of a firm. The
most important financial statements are income statement and balance sheet (already mentioned). Income
statement (or Profit and Loss statement)
Income statement is a summary of revenues, expenses and the resulting profit or loss of a firm for a stated
period of time, usually the fiscal year. The income statement is also referred as profit and loss statement. It
records the revenues and expenses in the interval between two balance sheets. It provides information
about net profit or loss of the firm, thus indicating whether the firm is running the business with profit or
loss. Profit is the excess of revenue over the expense. Through income statement, it is possible to track the
performance of the firm during the stated period of time by analyzing the revenues and the expenses.
Revenues represent the cash inflows earned in the exchange of services provided whereas the expenses
represent the cash outflows, the firm spent for providing the services. In income statement the operating
revenues and expenses represent the income and the expenditures those are associated with the core
operations of the firm whereas the nonoperating revenue and expenses represent the income and
expenditures from sources other than the core operations. For construction firms the operating revenues
represent the earnings against the services provided i.e. earnings against the completion of portion of work
or entire work of the projects. The operating expenses
represent the construction costs (both direct and indirect costs) i.e. material cost, equipment cost, labor
cost, cost of subcontracted work and the overhead cost. As already mentioned in Lecture 1 of Module 5,
the direct cost includes cost of materials, equipment and labor associated with each item of work, along
with subcontracted costs whereas the indirect cost (overhead costs) is calculated for the entire construction
project rather than allocating for each item of work in the project. In income statement, the nonoperating
revenues include the interest earned and the revenue earned from sources other than the core operations
(i.e. construction operations) of the firm. The nonoperating expenses include interest payments on loans
and other expenditures which are not associated with the construction operations of the firm. In the income
statement, the operating revenues and expenses are shown first. From these records, the gross profit from
operations is calculated. After that the net profit from operations is calculated by the subtracting the
overhead cost from the gross profit (from operations). The nonoperating revenue and expenses are then
recorded. The profit before tax is then equal to net profit from operations less the nonoperating revenue
and expenses. It may be noted here that the nonoperating revenue is added whereas nonoperating
expense is subtracted from net profit from operations. After that the net profit after tax is calculated by
subtracting the income tax (at an appropriate income tax rate) from profit before tax.


Balance sheet A balance sheet shows details about the financial status of a firm at a particular point in
time. A balance sheet is a summary of the firm‟s assets, liabilities and owners‟ equity or net worth (i.e.
worth that the firm owes to its owners i.e. stockholders or shareholders) at a given point in time. In other
words for a firm, a balance sheet provides details about the assets it owns, liabilities it owes and the equity
it owes to its owners. Balance sheet represents a snapshot of firm‟s financial position. It is commonly
prepared at the end of financial year (i.e. fiscal year). But it may also be prepared at other time intervals i.e.
quarterly, semiannually within a financial year or calendar year as required by the firm. The fundamental
relationship between assets, liabilities and owners‟ equity on the balance sheet is as follows; As observed
from above relationship, on the balance sheet the assets of a firm must be equal to the sum of its liabilities
and owners‟ equity. The categories of assets, liabilities and owners‟ equity are presented as follows.
Assets are the resources of monetary value those are owned by the firm. The assets of a typical
construction firm are cash, plant and equipment, land, buildings, construction materials, receivables etc.
Assets are classified into three categories namely current assets, long-term assets and other assets. equity
Owners'sLiabilitie Assets
Currents assets are defined as the assets which are likely to be converted into cash within one year. The
categories of current assets are cash, accounts receivable, notes receivable, costs and profits in excess of
billings, inventory, prepaid expenditures etc. Cash is the primary current asset. It includes cash in bank i.e.
bank deposits (savings, term deposits with maturity less than one year) and petty cash. Accounts
receivable include the amount that the owner of the project (i.e. client) owes to the firm for providing
service or for the job done. For example the monthly bill to be paid by the client of a project to the
construction firm is an account receivable till the payment against the bill is received. It also includes the
retentions receivable. The retentions receivable represent the amount that is held up by the client of the
project and is released
to the construction firm subject to fulfillment of requirements of the project. Notes receivable are the formal
written notes that represent the amount that is expected to be received by the firm within a year. The formal
note serves as written promise to receive the amount of money from the party obliged to make the
payment. It includes bill payments to be received through a formal written promise within a year. Costs
and profits in excess of billings are also known as underbillings and are recorded as current assets on
the balance sheet. Costs and profits in excess of billings occur when the firm bills the clients (project
owners) less than the sum of costs incurred and estimated profits for the portion of the work that is
complete. The firms using percentage-of-completion method of accounting are required to recognize the
revenues, expenses and estimated profits on the basis of percentage of project work that is complete and
costs and profits in excess of billings are accordingly recorded on the balance sheet. Percentage-of-
completion method is one of accounting methods that the construction firms use for preparing the financial
statements. Underbillings may occur due to more cost incurred than the estimated on the completed work
or due to non-proportionate distribution of profit. Inventory represents resources (mostly the materials) that
are with the firm and are likely to be used in the project within a short period of time and its monetary value
is entered in the balance sheet as current asset. For a construction firm, inventory includes the construction
materials to be used in a project. The material suppliers (subcontractors) generally carry inventory of the
construction materials which they supply to the construction firms. Prepaid expenditures represent the
amount of money paid for future services and include prepaid insurance premium, prepaid taxes, advance
rental payments etc. Long-term assets represent the resources which can not readily be converted into
money (cash) and these assets provide future benefits. Fixed or tangible assets (a category of long-term
assets) include land, building, plant and equipment and other tangible assets with longer service life. Fixed
assets are shown on the balance sheet at their original cost (i.e. purchase price) less the accumulated
depreciation (except for land). The recorded accumulated depreciation on the balance sheet represents the
loss in value of the fixed assets till date.
Other assets include other investments and equity in other enterprises.
Liabilities represent the obligations (i.e. debts) that the firm owes to other parties. Liabilities include bank
loans, debts to subcontractors, advances from project owners (i.e. clients), taxes payable both current and
deferred etc. Liabilities are classified into two categories namely current liabilities and long-term liabilities
and are according shown on the balance sheet. Current liabilities represent the obligations which are
likely to be paid within one year. The categories of current liabilities are accounts payable, billings in
excess of costs and profits, accrued payables, lease payments etc. Current liabilities are usually paid by

using current assets. Accounts payable include the debts that the firm owes to other parties for services
provided. For example the monthly bills received by the construction firm from subcontractors and suppliers
represent the accounts payable till the payment of the bills. It also includes the retentions payable which
represents the amount of money that is held up by the construction firm and is released to subcontractors
or suppliers subject to the fulfillment of the requirements. Billings in excess of costs and profits also
known as overbillings are recorded as current liabilities on the balance sheet. Billings in excess of costs
and profits occur when the firm bills the clients (project owners) more than the sum of costs incurred and
estimated profits. Overbillings may occur due to less cost incurred than the estimated on the completed
project work or due to non-proportionate distribution of profit. Accrued payables are the expenses which
the firm owe and include accrued wages, accrued taxes, accrued interest and accrued rents which are not
paid. Lease payments are recorded as a current liability on balance sheet and for construction firms it
represents rental payments for acquiring the construction equipment. In addition to these current liabilities,
notes payable (include the debts which are likely to be paid through a formal written promise within a year)
and dividends payable (portion of the profits or earnings that a firm pays to its stockholders) are also
recorded as current liabilities on the balance sheet. Long-term liabilities also known as non-current
liabilities are the debts which are not expected to be paid within a year and normally refer to loans from
banks or other financial institutions. Long-term liabilities include loans taken to purchase construction plant
and equipment and other assets, payment of mortgage for buildings etc.
Owners’ equity or net worth of the firm represents the excess of assets of a firm over its liabilities and is
recorded on the balance sheet. For the companies, the owners‟ equity consists of three components
namely common stock, preferred stock and retained earnings. Common stock represents the major source
of investment by the stockholders in the company and provides the stockholders with voting rights to
exercise in company decisions. Preferred stock that represents the ownership in a company usually do not
provide the stockholders the voting rights to exercise in company affairs, however it ensures a dividend to
be received by stockholders (holders of preferred stock) before any dividend is paid to holders of common
stock. Retained earnings represent the profits or earnings which are reinvested in the company rather than
being distributed as dividends to the stockholders. These earnings are retained by the company to reinvest
in the business to increase the income and thus to increase the value of stock. A typical balance sheet of a
construction firm is shown below. In the balance sheet the total assets of the construction firm is equal to
the sum of total liabilities and owners‟ equity.

Financial ratios Financial ratios are used to evaluate the financial status of a company. These ratios
provide information about the company‟s ability to meet the financial obligations (i.e. ability to pay the bills,
debt payment ability), profitability, liquidity and effective use of its assets. Financial ratios represent the
relationship between the financial data shown on the financial statements (i.e. balance sheet and income
statement). These ratios are calculated by dividing a category of financial data by another category shown
on financial statements and are then compared with other companies within the industry. Through financial
ratios, it is easy to identify the changes in the financial status of the company which are not evident, by only
referring to the values of different categories of assets, liabilities net worth, revenue and expenses shown
on the financial statements. The different financial ratios which are used to assess the financial status of a
company are presented below.
Current ratio Current ratio indicates the ability of a company to meet the short-term financial obligations. In
other words it is a measurement company‟s ability to pay the current liabilities by using the current assets
and is given by;

Current assets and current liabilities shown on balance sheet are used to calculate this ratio and the details
about the current assets and current liabilities are already stated in Lecture 3 (Balance sheet) of this
module. This ratio gives information about working capital status of a company. A current ratio of less than
1.0 to 1 (i.e. 1.0:1) indicates that the current assets of the company is not sufficient to pay its current
liabilities whereas a greater value of current ratio is a strong indicator of the ability of the company to pay
its current liabilities. However on the other hand a considerably higher value of current ratio indicates that
much of the assets of the company might have tied up in the current assets and can be invested in other
business to increase the earnings of the firm.
Quick ratio (or acid-test ratio)
Quick ratio measures the ability of a firm to pay current liabilities using cash or other assets that can be
readily converted into cash. Quick ratio is also referred as acid-test ratio. It is a measure of short-term
liquidity of a firm and provides information about its immediate financial status. This ratio is calculated by
dividing quick assets (categories of current asset) of a firm by its current liabilities. The quick assets include
cash and accounts receivable. Quick ratio is given by the following relationship.
Inventories and retentions receivable (of accounts receivable) are excluded from quick assets because
these assets can not be converted into cash quickly. A quick ratio equal to or greater than 1.0:1 indicates
the ability of a firm to pay the current liabilities with the quick assets. A quick ratio of less than 1.0:1
requires that the firm needs to convert inventories and other assets into cash for payment of current
liabilities.
Debt to worth ratio This ratio is calculated by dividing total liabilities of a company by its net worth or
owners‟ equity. It is also referred as debt to equity ratio and is given by;
This ratio is a measure of a company‟s leverage and the desired value of this ratio should be less than or
equal to 2.0:1. A debt to worth ratio less than 1.0:1 indicates that the firm is not utilizing the debt in the
business to increase the return on the investment. Further a lower value of this ratio indicates that there is
more protection to the creditors as the owners of the firm are contributing majority of the funds to the
business of the firm. A debt to worth ratio of greater than 2.0:1 may result in a greater risk for the
repayment of debt along with interest during recession in the construction industry.
Return on assets ratio The return on assets ratio is calculated by dividing the net profit after taxes by the
total assets of the company. This ratio is expressed as a percentage and is given by:
The net profit after tax from income statement and total assets from balance sheet of a company are used
to calculate this ratio. Return on assets ratio measures how efficiently a company uses its assets to earn
the return and indicates profitability of a company. For a company, the efficient use of assets earns a
higher return (higher value of this ratio) whereas there is low return on assets (lower value of this ratio) for
a poorly run company.
Return on sales ratio This ratio is calculated by dividing the net profit after taxes by the net sales revenue.
Return on sales ratio is expressed as a percentage. It is given by:

The operating revenues (net sales revenue) and net profit after tax from income statement are used to
calculate this ratio. This ratio indicates the profit margin for a company and measures how efficiently a
company can meet the adverse market conditions such as decline in demand, falling prices and increased
costs. An increasing value of this ratio (%) indicates higher profit margin due to increased revenue and
lowered company expenses. Similarly a lower value of this ratio (%) indicates lower profit margin due to
decline in revenue and increase in the costs. There are also other financial ratios such as current liabilities
to net worth ratio, fixed assets to net worth ratio, assets to revenues ratio etc. (calculated from data of
financial statements) can be used to assess the financial status of a company. The calculation of some of
the financial ratios is presented in the following example.
Example -2 Calculate the current ratio and debt to worth ratio for „AB Construction Firm‟ and return on
sales ratio for „XY Construction Firm‟
Solution:
From the balance sheet of „AB Construction Firm‟, the values of current assets and current liabilities are
Rs.1,60,98,000 and Rs.1,23,35,600 respectively. Further the values of total liabilities and net worth (or
owners‟ equity) are Rs.1,69,46,300 and Rs.1,51,91,540 respectively. The current ratio for „AB Construction
Firm‟ is given by;

Working capital management Working capital represents the excess of current assets over the current
liabilities. The details about current assets and current liabilities are already presented in Lecture 3 of this
module. Working capital includes the cash or near-cash assets which are required for the daily operations
in the business. Adequate working capital is required for ensuring regular supply of raw materials and other
consumables, timely payment of wages and for meeting other short-term expenses so as to have smooth
running of the operations in the business. Working capital measures the sort-term financial strength and a
company must have sufficient working capital to meet the short-term financial obligations. Insufficient
working capital may result in difficulty in meeting the cash requirement for the operations in the business.
On the other hand, much of assets tied up in working capital reduces the profit level of the company as
excessive working capital makes the funds idle. Thus working capital management aims at establishing the
optimum level of working capital for smooth running of the operations in the business by maintaining the
desired liquidity and profitability of the company. For a company, the main objective lies in increasing the
profit level so as to maximize the wealth of stockholders and increase the market value of stock and at the
same time maintaining the liquidity for meeting the short-term financial obligations. Liquidity and profitability
are inversely related as higher investment in current assets with lesser short-term borrowings increases the
liquidity and reduces the profitability of the company whereas, for a company lesser investment in current
assets with higher short-term borrowings decreases the liquidity and increases the profitability. Thus it is
essential to have a balance between liquidity and profitability by maintaining the satisfactory level of
working capital with the help of working capital management which assists in managing the desired level of
current assets and current liabilities of the company.
Working capital is represented in a continuous cycle known as operating cycle and a typical operating cycle
is shown in the following Fig. The operating cycle is also referred to as working capital cycle or current
assets and current liabilities cycle. The operating cycle starts with acquiring raw materials and
consumables using cash (or on credit), maintaining their inventory, use in production, obtaining finished
goods (or service)
followed by sales, receipt of payment against the bill and finally realizing the cash, which completes the
operating cycle and the same process is again continued. In other words in the operating cycle, there is
continuous flow from cash to suppliers, to inventory, to finished goods (or service), to accounts receivable
and then to cash again. The length of an operating cycle (i.e. duration) depends on the number of stages
involved (as mentioned above) and the average length (i.e. duration) of each stage. For a construction
company undertaking a project, the operating cycle begins with procurement of construction materials and
other consumables with cash (either available or from advance if any received from the owner of the
project) or on credit from the suppliers. The quantities of these items to be purchased depend on how
much to be used during a given period of time and how much to be kept in stock. Further cash is used for
payment of wages to labourers employed in the project and payment of equipment rental charges to the
equipment renting firm along with the payment of overhead expenses. If the equipment is owned by the
construction company, then cash is utilized for meting the operating cost of the equipment employed in the
project. The construction material suppliers and equipment renting firm are regarded as creditors if the
company acquires these items on credit. After completion of a portion of work, the construction company
raises the bill against the activities carried out during that period of time i.e. billing period which may be one
month or two months (i.e. as per conditions of contract between the owner and the construction company).
The billed amount becomes accounts receivable and owner of the project is regarded as debtor to the
construction company till the receipt of payment against the bill. The receipt of payment against the bill and
realization of cash completes the operating cycle and the process continues. The construction company
must have sufficient working capital to meet expenses of materials, equipment, labour and overhead till the
receipt of payment from the client (i.e. owner of the project). The estimation of working capital requirement
is an important aspect of working capital management. The factors those affect the working capital
requirement are nature and size of the business, type of raw materials, production process, credit policy,
duration of operating cycle, volume of production and sales etc.

Operating cycle
In the construction projects, there is usually a time lag between completion of a portion of work and the
receipt of payment from owner of the project and thus production (sales) is not converted into cash
instantaneously. Therefore working capital is required to meet the financial requirement in daily operations
in the project. Often material suppliers and the equipment renting firm also allow a credit period to the
construction company. Thus the credit period allowed by material suppliers and equipment renting firm to
the construction company and that allowed by the construction company to the owner of the project are to
be considered while calculating working capital requirement of the construction company. The calculation
of working capital requirement of a construction company is presented in the following example.
Example -3
The estimated annual revenue of a construction company from a project is Rs.51000000. In the project, the
proportions of material cost, labour cost, equipment cost, overhead cost and profit are 37%, 23%, 16%,
14% and 10% of the estimated annual revenue respectively. On an average two months‟ credit (i.e.
average time period between commencement of a portion of work and receipt of payment from owner of
the project) is allowed to the owner of the project. The materials are purchased from material suppliers and
equipment is hired on rental charges from the equipment renting company. The credit period allowed by
material suppliers and equipment renting firm to the construction company is one month. On average, two
and half months‟ supply of materials is kept in stock at all the times. Calculate the working capital
requirement of the construction company for the operations in the project.
Solution: The working capital requirement will be calculated for meting the expenses of material, labour,
equipment and overhead. The annual material cost, labour cost, equipment cost and overhead with the
corresponding percentages of annual revenue are Rs.18870000, Rs.11730000, Rs.8160000 and
Rs.7140000 respectively.
Materials Materials held in construction work (i.e. in work in progress) = 2 months (i.e. average time period
between the use of materials in the work and receipt of payment from owner of the project) Materials in
stock = 2.5 months Credit from suppliers = 1 month The construction company must have the working
capital to meet the expense of 4.5 (i.e. 2 + 2.5) months‟ materials requirement. However the material
suppliers allow 1 month credit to the company. Thus the construction company requires the working capital
to meet the expense of 3.5 (i.e. 4.5 - 1) months‟ materials requirement. The working capital requirement for
the materials is calculated as follows;
Similarly the working capital requirement for labour, equipment and overhead are calculated and are shown
below.
Labour In work in progress = 2 months (i.e. average time period between employment of labourers in the
work and receipt of payment from owner of the project)
Equipment In work in progress = 2 months (i.e. average time period between use of equipment in the work
and receipt of payment from owner of the project) Credit from renting company = 1 mon
Overhead In work in progress = 2 months (i.e. average time period between commencement of work and
receipt of payment from owner of the project)
The working capital requirement of the construction company in the project till the receipt of payment from
the owner of the project is given by;
Working capital= Rs.5503750++Rs.1955000+ Rs.680000+ Rs.1190000 =Rs.9328750
Working capital financing

Financing of working capital is an important aspect of working capital management. The different sources
of financing of working capital are short-term sources (bank financing such as loan facility, overdraft facility
etc., trade credit, short-term sources other than banks etc.) and long-term sources (retained earnings,
shares, debentures, long-term loans from banks and other sources, government development grants etc.).
One of the important aspects in working capital financing lies in determining the suitable mix of long-term
and short-term finances as this is likely to affect the balance between liquidity and profitability of the
company and the associated cost and risk of financing. The long-term finances are more costly as
compared to short-term finances. There are three basic approaches of financing working capital such as
matching or hedging approach, conservative approach and aggressive approach. In matching or hedging
approach, the permanent part of working capital requirement is financed by funds from long-term sources
whereas the variable component is financed through short-term sources. Thus in this approach, the source
of finance matches with the nature of the current assets. In conservative approach, the permanent part of
working capital requirement and part of variable working capital are financed from long-term sources and
short-term sources are used only to meet the emergency requirements. As majority of working capital
financing is from long-term sources, this approach makes the financing more costly, less risky and leading
to more liquidity and less profitability. In aggressive approach, the variable part of working capital
requirement and even part of permanent working capital requirement are financed from short-term sources.
As major sources of finances are short-term, this approach makes the financing less costly, more risky and
results in low liquidity and high profitability. It may be noted that, for further reading of various topics
presented in lectures of different modules, the texts mentioned in the list of references for this course can
be referred.

Unit 14. Valuation & Construction Economics

Uploaded by

Copyright:

Available Formats

Unit 14. Valuation & Construction Economics

Uploaded by

Document Information

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Unit 14. Valuation & Construction Economics

Uploaded by

Copyright:

Available Formats

Certificate Course in Quantity Surveying – Advanced Level

UNIT : VALUE MANAGEMENT , VALUATION & CONSTRUCTION ECONOMICS

Value = Worth / Cost

For the prospective producer:

Value = required function / cost

For the prospective customer:

Value = functional benefits / price

Chicago Institute For Management Training, UAE Page 1 of 52

The value management process as illustrated by ICE 1996)

Chicago Institute For Management Training, UAE Page 2 of 52

Chicago Institute For Management Training, UAE Page 3 of 52

Elements of Value (Kelly 1993)

Benefits of a Value Management Study are:

Advantage of Value Management

Chicago Institute For Management Training, UAE Page 4 of 52

Chicago Institute For Management Training, UAE Page 5 of 52

Source: Adapted based on Dallas, M., 1998.

Chicago Institute For Management Training, UAE Page 6 of 52

Timing is of the essence. Fig. illustrates the substantial scope to

Chicago Institute For Management Training, UAE Page 7 of 52

Value Analysis Job Plan

How is Function Analysed?

Chicago Institute For Management Training, UAE Page 8 of 52

Scope for Application of Value Engineering in Project Management

Chicago Institute For Management Training, UAE Page 9 of 52

Scope for application in the procurement of materials.

Chicago Institute For Management Training, UAE Page 10 of 52

Chicago Institute For Management Training, UAE Page 11 of 52

The value process

Chicago Institute For Management Training, UAE Page 12 of 52

Case 1 – Implementing a value management programme

Chicago Institute For Management Training, UAE Page 13 of 52

Chicago Institute For Management Training, UAE Page 14 of 52

Valuation & Construction Economics

Chicago Institute For Management Training, UAE Page 15 of 52

Chicago Institute For Management Training, UAE Page 16 of 52

Chicago Institute For Management Training, UAE Page 17 of 52

Chicago Institute For Management Training, UAE Page 18 of 52

RICS global valuation practice guidance applications (VPGA)

Chicago Institute For Management Training, UAE Page 19 of 52

Chicago Institute For Management Training, UAE Page 20 of 52

B:Terms of engagement (ToE)

Chicago Institute For Management Training, UAE Page 21 of 52

Chicago Institute For Management Training, UAE Page 22 of 52

Chicago Institute For Management Training, UAE Page 23 of 52

Chicago Institute For Management Training, UAE Page 24 of 52

Chicago Institute For Management Training, UAE Page 25 of 52

Chicago Institute For Management Training, UAE Page 26 of 52

2 For determination of Fair Market Value of the property.

Chicago Institute For Management Training, UAE Page 27 of 52

Chicago Institute For Management Training, UAE Page 28 of 52

For determination of Fair Market Value of the property.

Chicago Institute For Management Training, UAE Page 29 of 52

Chicago Institute For Management Training, UAE Page 30 of 52

Chicago Institute For Management Training, UAE Page 31 of 52

Chicago Institute For Management Training, UAE Page 32 of 52

B. Sinking Fund Method :

C. Written down Value of Equal percentage or declining Balance Method:

2.2 Rent Capitalisation Method :

Chicago Institute For Management Training, UAE Page 33 of 52