Unit#2

CE-401:Construction Economics and

Management
Mahendra Kumar Pal, PhD
Assistant Professor
Department of Civil Engineering
IIT BHU Varanasi
 Syllabus
▪ Unit#1: Construction Planning and Management (6 Lectures): Elements of management, definition, history,
Taylor’s principles, Henri Fayol’s principles, project and construction management, process of management

▪ Unit#2: Engineering Economics (8 Lectures): Cash flow diagram, Tune value of money, Inflation, Interest,
Depreciation, Present worth and capitalized cost, Equivalent uniform annual cost and rate of return evaluations,
Benefit cost analysis, Analysis of variable costs, Types of capital financing, Valuation

▪ Unit#3: Application of CPM & PERT (6 Lectures): Time, Cost and research management of projects for
planning, Scheduling, Control and forecasting using networks with CPM/PERT.

▪ Unit#4: Construction Equipments (6 Lectures): Selection, planning and cost equipments, earthmoving,
excavating, hauling, compacting, drilling and blasting, grouting, conveying and dewatering equipments.
aggregate cement concrete equipments

CE-401: Construction Economics and Management 2

Recap of Previous Unit
▪ Construction Planning and Management

▪ Elements of management,

▪ Definition, history,

▪ Project and construction management,

▪ Process of management

▪ Organization Chart

▪ Management Principles
▪ Taylor’s Principles,
▪ Henri Fayol’s Principles,
▪ Toyota Way

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 Content of the Today’s Lecture
▪ Unit#1: Construction Planning and Management (6 Lectures): Elements of management, definition, history,
Taylor’s principles, Henri Fayol’s principles, project and construction management, process of management

▪ Unit#2: Engineering Economics (8 Lectures): Cash flow diagram, Time value of money, Inflation, Interest,
Depreciation, Present worth and capitalized cost, Equivalent uniform annual cost and rate of return evaluations,
Benefit cost analysis, Analysis of variable costs, Types of capital financing, Valuation

▪ Unit#3: Application of CPM & PERT (6 Lectures): Time, Cost and research management of projects for
planning, Scheduling, Control and forecasting using networks with CPM/PERT.

▪ Unit#4: Construction Equipments (6 Lectures): Selection, planning and cost equipments, earthmoving,
excavating, hauling, compacting, drilling and blasting, grouting, conveying and dewatering equipments.
aggregate cement concrete equipments

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Economic Decision Making
▪ Consider the situations
▪ Comparison of design or elimination of over-design
▪ Economical design of production/maintenance/transportation
▪ Economy of selection
▪ Economy of perfections
▪ Economy of relative size
▪ Economy and location
▪ etc

▪ These are reffered as “Problems of Present Economy”

▪ Methods of Evaluation
▪ Out-of-Pocket Committement
▪ Payback Period
▪ Average Annual Rate of Return

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Out-of-Pocket Commitment
▪ Out of pocket commitment is the total expenses required for alternatives.
▪ Let’s consider an example,
▪ Suppose a supplier has been awarded with work to supply 10,000 concrete pillars per month.
Given that labor cost of steel form work and wood form work are ₹10 and ₹9 per unit,
respectively. Cost of preparing one set of steel form work and wooden form work are ₹40,000
and ₹5000, respectively. Life of wooden formwork is one month and steel is one year. So,
which formwork shall the contractor use?
▪ Total expenses for wooden formwork would be =₹9*10,000*12+ ₹5000*12= ₹1,68,000
▪ Total expenses for steel formwork would be =₹10*10,000*12+ ₹40000= ₹1,60,000
▪ So, contractor shall go with steel formwork

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CE-401: Construction Economics and Management 7
Payback Period
▪ Numbers of years it requires to repay the original invested capital
▪ Lets take another example,
▪ A contractor plans to purchase a vehicle for transporting the concrete pillars of brands A and B
to choose from with down payment of 4 Lakhs. Given that both brands are useful for first five
years. Brand A is estimated to give a return of ₹100, 000/- year. However, Brand is expected
to give return of ₹50,000 in 1st year, ₹100,000 in 2nd and 3rd year and, ₹150,000 in last two
years. Now, which brand the contractor shall go with ?
▪ For brand A, payback period is 4 years as initial investment of 4 Lakh is recovered in 4 years
400000/100, 000=4 Years
▪ For brand B, payback period will be 4 years ₹50,000*1+₹100,000*2+₹150,000*1 =₹400,000
▪ He may choose either brand.

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Average Annual Return
▪ Average rate of return as expressed in percentage of the original capital
▪ This method does not distingush the period at which transcation take place, time of cash-flow,
it is not possible to account for time value of money
▪ In previous example, annual return of
▪ Brand A is ₹100, 000*5/5=₹100, 000
▪ Return in %= ₹100, 000/₹400, 000*100=25%
▪ Brand B is (₹50,000*1+₹100,000*2+₹150,000*2)/5=₹110, 000
▪ Return in %= ₹110, 000/₹400, 000*100=27.5%

▪ He may consider choosing Brand B.

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Time Value of Money
Real worth of a certain amount of money is not invariant on account of factors such as
▪ Inflation: Inflation is a rise in prices, which can be translated as the decline of purchasing power over
time.
▪ Interest : earning power of money (Riggs et al 2004)
▪ Dynamic Interaction between demand and supply
▪ Depreciation: reduction in the value of an asset over time

Calculation of compund interest:

▪ In general, given number of periods in a year to be taken for compounding (m) and nominal rate of
interest (inom), effective rate of interest (ieff), will be

𝑚
𝑖𝑛𝑜𝑚
𝑖𝑒𝑓𝑓 = 1+ − 1 × 100
𝑚 × 100

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Cash Flow Diagram
▪ Cashflow diagram is visual representation of inflow and outflow of money of any organization
▪ in cash-flow diagram, often time is drawn in horizontal axis with suitable scale, and amount in vertical axis -
inflow as positive and outflow as negative
▪ Lets take an example of a given balance sheet of a project is
▪ Date Description Amount (₹)
April, 5 Reciept of running account bill#1 150,000

April, 10 Salary disbursement 80,000

April 16 Payment for suuply for aggregate 20,000

April, 21 Payment for supply of stationary 5,000

May 7 Reciept of running account bill#2 190,000

May, 10 Salary disbursement 80,000

May 16 Payment for suuply for cement 50,000

June 7 Reciept of running account bill#3 170,000

June, 10 Salary disbursement 80,000

June 20 Payment for suuply for structural steel 100,000

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 Cash Flow Diagram
Month Reciept (₹) Expenditure (₹)

April 150,000 105,000

May 190,000 130,000
June 170,000 180,000
def cashflow(data, time):
x=np.linspace(1, len(time),len(time),endpoint=True);

for i in range(len(time)):
plt.arrow(x[i], 0, 0, data[i][0], head_width = 0.05, ec ='green')
plt.arrow(x[i], 0, 0, -data[i][1], head_width = 0.05, ec ='red')
plt.text(x[i], data[i][0], str(data[i][0]), fontsize=8);
plt.text(x[i], -(data[i][1]), str(data[i][1]), fontsize=8);
plt.text(x[i], 10000, time[i], fontsize=8);

plt.show();

CE-401: Construction Economics and Management 12

 Cash Flow Diagram
Month Reciept (₹) Expenditure (₹) Balance (₹)

April 150,000 105,000 45,000

May 190,000 130,000 60,000
June 170,000 180,000 -10,000
def cashflow2(data, time):
x=np.linspace(1, len(time),len(time),endpoint=True);

for i in range(len(time)):
balance=data[i][0]-data[i][1];
plt.arrow(x[i], 0, 0, balance, head_width = 0.05, ec =clr)
plt.text(x[i], balance, str(balance), fontsize=8);

plt.text(x[i], 1000, time[i], fontsize=8);

plt.show();

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Cash Flow Diagram
▪ Cost Dominated Cash Flow

▪ Revenue Dominated Cash Flow

▪ Cash Inflow Diagram

▪ Cash Outflow Digaram

▪ Project Cash-Flow Diagram: Inflow-Outflow Diagram

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Numerical Problem
▪ Suppose you have borrowed Rs. 10,000/- from your friend and agreed upon the repayment in
equal installment of Rs. 2000/- at the end of each month. Draw a cash-flow diagram from your
prospective as well as your friends’ prospective.

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Project Cash Flow Diagram
Details required
▪ Gross bill value and its time of submission
▪ Measurement period. It is usual for contractor to be paid on monthly basis. Such rules are
defined in “Terms of Payment”
▪ The certification time taken by owener: bill processing and time to release the fund
▪ Retention money deduction by owner and time to release the retention money
▪ Mobilazation advance and their terms of recovery
▪ Details of cost incurred- break-up of bills- labour cost, material cost, etc
▪ Credit Period- delay between cost incurred and actual time at which cost is reimbursed.

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Factors Affecting Cash Flow Diagrams
▪ Margin: The margin is excess over costs. Higher the margin, betterment for cashflow of contractor

▪ Retention: amount deducted by client. Higher the retention, bigger the cashflow problem

▪ Extra Claim: may rise on account of multiple reason such as extra work, change in quantity, etc

▪ Distribution of Margin: distributed across different items of project, either in uniform manner or it can
be front-or-back loading

▪ Certification Type:
▪ Overmeasurement: is a mechanism whereby the amount of work certified in the early months of contract is greater
than amount of work done.It has same impact as front-loading and helps contractor.
▪ Under-Measurement: is a mechanism whereby the amount of work certified in the early months of contract is
lesser than amount of work done. It works as back-loading and impacts cash-flow in negative.

▪ Delay in Recieving Payment from Client: time between interim measurement, issuing the certificate
and recieving payment

▪ Delay in paying labour, plant, material and subcontractor: time interval between recieving goods or
services and paying for these is credited

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Using Cash Flow Diagrams
▪ Determining Capital Lock-up
▪ In cash-flow diagram, one may notice that contracting company sometime faces negative cash flow in
early stages. These negative cash flow is either supplied from contractor’s reserve or loan
▪ The area under negative cash flow period is used to calculate the financing charges for the project by
contractor, which is known as captim (unit: Rs*months)
▪ In order to calculate the interest charges for financing the project, captim is used in following manner
(𝐶𝑎𝑚𝑝𝑡𝑖𝑚 𝑖𝑛 𝑅𝑠8𝑚𝑜𝑛𝑡ℎ ×𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑝𝑒𝑟 𝑎𝑛𝑛𝑢𝑚 %)
▪ Interest on the capital required for project=
12×100

▪ Determining the cash requirement of a project

▪ with understanding of cummulative cash inflow and outflow, one can determinet the maximum cash
requirement for a project

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Problem
Lets assume that contractor has been awarded a contract with following conditions
▪ Advance payment of 50Lakh, to be recovered in five equal installment from third running
account bill onward
▪ Total cost for contractor to execute a particular item is 90% of quoted rate
▪ The total cost of particular item consist of labour (20%), material (55%), plant and machinery
(10%), sub-contractor (10%), and project overhead (5%)
▪ Assume that there is no delay in payment towards labour cost and overhead cost but there
delay of one month occurs to sub-contractor, material supplier and plan and machinery
supplier
▪ Retention is 10% of the billed amount in every bill and 50% of retention amount is payable
after one month of practical completion.

CE-401: Construction Economics and Management 19

Computation of Interest
Lets look back to the problem of lending
▪ Suppose you have borrowed Rs. 10,000/- from your friend and agreed upon the repayment in
equal installment of Rs. 2000/- at the end of each month. Draw a cash-flow diagram from your
prospective as well as your friends’ prospective.

▪ What was mistake in last solution ??

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Formulation of Interest Computation
▪ Catergoy A with Single Payment
▪ Compound Amount Factor
▪ Present Worth Factor

▪ Category B: with Equal Payment Series

▪ Coumpount Amount Factor
▪ Present Worth Factor
▪ Sinking Fund Deposit Factor
▪ Capital Recovery Factor

▪ Category C with unequal Payment Series

▪ Arithmetic Gradient Factor
▪ Geometric Gradient Factor

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 Formulation of Interest Computation
▪ Single Payment Compound Amount Factor in one which single payment (P) is multiplied to find its
compound amount (F) at a specific time in future.
▪ Another way of representing this factor is (𝐹/𝑃, 𝑖, 𝑛), which reads as “𝐹 given 𝑃 at an interest rate of 𝑖 for a
period 𝑛”
(𝐹/𝑃, 𝑖, 𝑛) = (1 + 𝑖)𝑛

▪ Single Payment Present Worth Factor: When a single future payment (F) is multiplied by this
factor, the present worth (P) is obtained
▪ P given F at an interest of 𝑖 for a period 𝑛”
1
(𝑃/𝐹, 𝑖, 𝑛) =
(1 + 𝑖)𝑛

▪ Uniform Series Compound Amount Factor: This factor converts uniform series payment (A) to its
compound amount (𝐹), represented as (𝐹/𝐴, 𝑖, 𝑛), which reads as “𝐹 given 𝐴 at an interest rate of
𝑖 for a period 𝑛”
(1 + 𝑖)𝑛 −1
(𝐹/𝐴, 𝑖, 𝑛) =
𝑖

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Formulation of Interest Computation
▪ Uniform Series Present Worth Factor used to determine present worth (P) for uniform series
payment of A, represented as (𝑃/𝐴, 𝑖, 𝑛), which reads as “𝑃 given 𝐴 at an interest rate of 𝑖 for
a period 𝑛”
(1 + 𝑖)𝑛 −1
(𝑃/𝐴, 𝑖, 𝑛) =
𝑖(𝑖 + 1)𝑛

▪ Sinking Fund Deposit Factor by which future sum (F) is multiplied to find uniform sum (A) that
should be set regularly such that final value of funcs sets aside is F,
𝑖
(𝐴/𝐹, 𝑖, 𝑛) =
(1+𝑖)𝑛 −1

▪ Capital Recovery Factor to find uniform payment of A to exactly recover the present capital
sum with interest
𝑖(𝑖+1)𝑛
(𝐴/𝑃, 𝑖, 𝑛) =
(1+𝑖)𝑛 −1

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Evaluating Alternatives by Equivalence
▪ Cost Comparison between alternatives of different engineering, efficiency or cost such as
▪ one with high initial cost and low maintaince and operation cost
▪ another with low initial cost and high maintaince and operation cost

▪ Using time value of money and cash flow diagram illustration, one may study the better
alternative
▪ Some of commonly aplpied methods are
▪ Present Worth Comparison
▪ Future Worth Comparison
▪ Annual Cost and Worth Method
▪ Rate of Return Method

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Present Worth Comparison
▪ Present worth at t=0 of cash flow in term of equivalent single sum is determined using interest
rate and other known information on following assumptions
▪ Cash flow is known
▪ cash flow do not include the effect of inflation
▪ interest rates are known
▪ Comparison does not include the effect of tax, intangible consideration and consideration of fund
availability to implement the alternatives
Present Worth
Problems

Type 1: Type 2: Type 3:

Alternatives with Alternatives with Alternatives with
Equal Lives unequal lives infinite lives

Capitalized
Common Study Period
Equivalent
Multiple Method Method
Method

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Present Worth Comparison
▪ Type 1: Alternative with Equal Lives: Evaluating present worth of all competing alternatives and
alternative with maximum present worth is chosen
▪ Profitability Index (PI) is defined as ratio of net present value (NPA) and capital cost (CC) of investment

▪ Type 2: Alternative with Unequal Lives

▪ say, choosing with batching plants of lives of 5 years, 10 years and 15 years.
▪ Common Multiple Method
▪ Coterminous life period is chosen for alternatives using least common multiple of different life period
▪ In alternatives with life periods of 2, 3, 4, 6 years, coterminous time is 12 years
▪ Study Period Method
▪ A study period is chosen on the basis of length of project or service life of alternatives

▪ Type 3 Alternative with Infinite Lives

▪ Capitalized Equivalent (CE) Method
▪ based upon concept of capitalized equivalence which is present worth of cash flow and outflow
▪ CEis single amount determined at time zero, which at a given rate of interest will be equivalent to net difference of reciepts and
disbursement if the given cash flow pattern is to be looked upon as equal to present worth, with the added rider that cash flow
extended to forever.

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Evaluating Alternatives by Equivalence
▪ Future Worth Comparison
▪ Future worth of each component of cash-flow is evaluated and algebric sum of such future worth
becomes the basis of comparison
▪ there is no discounting each component of cash flow to the present, as it is done in present worth
method
▪ No major advantage over present worth comparison, but owners tend to adopt is incase of future
selling or liquidating

▪ Annual Cost and Worth Comparison

▪ Payment and disbursement are converted into an annualized cost series -annual cost is the cost
pattern of each alternative converted into an equivalent uniform series of annual cost at a given
interest rate.
▪ Alternative that yield to least cost is chosen
▪ Methods can be used for comparison of alternatives with equal and inequal life

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Rate of Return
▪ Minimum Attractive Rate of Return
▪ Minimum rate of return below which company would not be interested in proposed investment
alternatives

▪ Internal Rate of Return Method

▪ defined as interest rate that reduced the present worth of given cash flow to zero
▪ it represent the %age or rate of interest earned on the unrecovered balance of an investment, at any
point of time, and further earned recovered balance is reduced to zero at the end of the project

(𝑃𝑊)𝑏𝑒𝑛𝑖𝑓𝑖𝑡𝑠−(𝑃𝑊)𝑐𝑜𝑠𝑡= 0

▪ Incremental Rate of Return

▪ If an alternative requires a higher initial investment than other and evaluation is of the rate of return on
the increment of initial investment, the return yielded on this extra investment is called incremental
rate of return

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Effect on Cash-Flow
▪ Of Inflation
▪ General inflation results in price rise in all good, the relative price remains constant. Hence, it is
possible to disregard escalation
▪ As per IRC: SP 16-2004, where there is large difference between the rate of inflation and interest, the
discount rate is evaluated using
𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 (%)
1+ 100
Modified discount rate = 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 (%) × 100%
1+
100

▪ Of Taxation
▪ Prevaliling tax laws imposes tax on the basis of annual income generated through conduct of
bussiness,
▪ not only rates varies time to time,
▪ certain incentives and reliefs in tax are given

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Summary of the Lecture
▪ Construction Economics

▪ Time Value of Money

▪ Cash Flow Diagram

▪ Computation of Interest

▪ Method of Equivalence for evaluating alternatives

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