Thursday 17 February 2022

Peculiarities of determining costs in project calculations

Let's consider an example of determining costs for company A. Suppose that the company has areas at plant X that do not use a workshop that produces industrial control systems. In the next 10 years, it is planned to install new equipment in the workshop in such a way that with the expansion of production, the "extra" areas at the end of the tenth year will be fully occupied. A new, rather profitable investment project is proposed in the shop for the production of consumer electronics. Based on the needs of the new production line for the manufacture of plastic pressed components and integrated circuits, as well as due to the lack of space at the plant U, it is envisaged to place a line at the plant X. At the same time, the plant X has enough space for the installation of the line, but the control shop of industrial control systems indicates that the areas that are not occupied now, in ten years will be fully involved in production. 


The question is: how much does the consumer electronics shop have to pay (that is, include as "costs" in the analysis of the project) for the use of unoccupied capacities?

Sometimes it is proposed to calculate as follows: to translate the total value of the house into the cost per square meter of area (of course, with adjustments to inflation). Then, from the area used in the project, you can "demand" this additional amount on the basis of the meter. The advantage of this approach of distributive costs is the simplicity and understanding of calculations. 


The disadvantages are that this approach is based on initial information (the cost of a house at the time of its construction), and not on forecasts for the future; it does not cite the real economic costs incurred by the company. The house has already been bought, money has been paid for it, so in this case it will be more profitable to use the already purchased and paid areas for income than to leave them empty for several years. Such a decision requires determining the real economic costs caused by the project and the use of the area now, and not in the future.

If the project is rejected, the industrial management systems workshop will not require new construction for another ten years. Permission of the consumer electronics shop to use part of the available area will force later to build a new room for the "absorption" of the expected expansion of the workshop of industrial control systems. 


In economics, this approach is called the principle of transfer to an earlier period - the cost of building a new house is transferred from the tenth (for example) year to the sixth. Thus, it is possible to determine the correct amount of "costs" of using unused capacities by calculating according to the value of the current cost of building a new house, which is planned in six years, and removing the difference between them. 


Changes in today's corresponding cost of moving construction from the tenth to the sixth year are due to the adoption of the project. Thus, they meet the requirements of conditioning, have a growing nature, and, in addition, are really economic costs. These costs should certainly be included in the project analysis.

The principle of transfer to an earlier period implies future capacity growth. If it is projected that all available capacities will never be involved in current activities, then there is no transfer to an earlier period. When new areas are never needed for current activities, but new investments finally have to apply "surplus" capacity and require expansion to serve the intended market, the total costs of such expansion should be included in the analysis of projects. If the extension is unnecessary, then additional costs have no place. If a new project is completed before the year in which there was a need for expansion, and the capacities are returned to the original user (in our example, to the workshop of industrial control systems), then there is no transfer to an earlier period and there are also no additional costs.

The next problem in determining costs in project analysis is the problem of using assets that are still owned by the company, but no longer needed for production. What costs fall on the share of idle assets if they are expected to be attracted to a new project? The obvious answer would be "none," but that's not always true. Alternative uses of such assets should also be taken into account. To explain, let's turn to a specific example.

Suppose a milling machine with software management and a book (accounting) cost of 8000 Dollar. takes a place at the plant X, but is not used by the workshop of the industrial control system (or other division). A certain company offers to buy this machine for 10000 Dollar. on the terms of the "Franco-wagon". The terms of the "Franco-wagon" mean that the buyer company will pay 10,000 Dollar. after the machine is dismantled from the previous workplace, prepared for departure and loaded into the car. If these transactions are not made, payment will not take place. Dismantling of the machine costs 500 Dollar, preparation for departure — 300 Dollar, transportation to the station and loading to the railway platform — 200 Dollar. After all this, the company receives 10,000 Dollar. The outflow of funds is a total of 500(dismantling) + 300 (preparation for departure) + 200 (delivery to the station and loading) = 1000 Dollar. Thus, net receipts will be equal to 10,000 – 1000 = 9000 Dollar, which is 1000 more than the carrying amount of the machine (8000 Dollar). 

So, previously, depreciation deductions were too large, which protected income from taxes. Let's assume that the tax rate is 40%. 

Excess of 1000 Dollar. 

above the net price is taxed, the amount of tax is 0.4H1000==400 Dollar. Having withdrawn this amount from 9000 Dollar, we get 8600 Dollar. — net proceeds after tax.

Now suppose that the consumer electronics shop realized that it can use this machine on a new production line. The machine should remain in the previous workplace, but will be used to produce new products. What costs reflecting the use of the machine by the consumer electronics shop should be noted in the new project analysis? The answer will be correct "net receipts of 8600 Dollar", since this is the best option for using the machine. In other words, if the company uses the machine in the new project, it refuses to receive 8600 Dollar, which could be obtained by selling the machine.

However, this situation can be considered from the other side: if the value created by the new project is less than 8600 Dollar. In this case, we are dealing with two alternatives that exclude each other: in case A - to sell the machine and get 8600 Dollar., in case B - to use the machine in the new project. Alternative B is preferred only if the project brings more value than in case A, that is, 8600 Dollar.

Let's change the terms of the task. 


The consumer electronics shop wants to use the machine, but in order for it to become a component of the production line, it must be moved to another place and re-installed. Dismantling costs 500 Dollar,transportation to another workplace — 50 Dollar,re-installation and adjustment — 750 Dollar. 


What costs reflecting the operation of the machine in this case, it is necessary to note during the analysis of the project? Outflow of funds is: 500+50+750=1300Dollar.

In addition, leaving the machine at home, the company refuses to receive 8600 Dollar. revenue in the case of the sale of the machine to another company, so this value of the alternative value should be added to cash costs. Thus, the total cost of using the machine will be 9900 Dollar, and this figure should be indicated in the project analysis.

However, we constantly emphasize that the calculation twice includes the cost of dismantling the machine: the first time in the calculation of the alternative cost of 8600 Dollar. Therefore, the correct figure should be 9400 Dollar. 


The logical error of such an argument is that the calculation is in the amount of 8600 Dollar. (maximum revenue from the sale of the machine) is not provided that anyone has already taken measures to dismantle the equipment. This is just one of the alternatives that exclude each other, and which should be taken into account. 


The costs of 500 Dollar associated with the physical movement of the machine to a new installation site only characterize the dismantling process for another alternative. Obviously, in this case, the required costs will be only 1300 Dollar. It should also be clear that this procedure deprives any possibility of obtaining 8600 Dollar. from the sale of the machine (another possible alternative), and this figure is the true value of the alternative value.

 Thus, the cost in the amount of 9900 Dollar. are monetary costs when using the second alternative plus income that was not received due to the rejection of the first option. That is why the amount is 9900 Dollar. it is true and should be used in economic analysis.

The cost of the project is defined as the difference between positive results (benefits - B) and negative results (costs - C). Since the purpose of the project analysis is to establish the amount of excess of additional benefits from the project over the additional costs necessary for its implementation, it is necessary to determine the methodology for calculating additional benefits and additional costs.

The concept of alternative value is central to project analysis because each cost used for financial (from a firm's point of view) or economic analysis (taking into account the impact on national income) is an alternative cost. An alternative cost is the lost benefit of using limited resources to achieve one goal instead of another, the best remaining option. Since the alternative value is expressed by any measure, it is sometimes called "shadow price", "the price of a missed chance", "the price of economic efficiency".

In the project analysis, there are obvious and implicit benefits and costs. 


Obvious are the material benefits (costs) due to a decrease (increase) in costs or the receipt of additional income (expenses), the value of which is largely obvious, which makes it quite easy to determine their financial value. Implicit benefits (costs) include the side benefits (costs) that accompany the project. They are usually associated with the economic or social consequences of the project and are indirect in nature. Implicit benefits (costs) are necessarily reflected in the economic assessment of the project, when its attractiveness is assessed from the standpoint of society as a whole.

Obvious benefits from the project arise from: an increase in output, which helps to reduce the cost of production; the possibility of increasing the price of manufactured products; changes in the qualifications of employees, which makes it possible to improve the quality of products; changes in implementation time; changes in the place of implementation, etc.

Expenses can be classified according to the following grounds: 

  • The possibility of reflection in the accounting statements (accounting and economic); 
  • the degree of dynamism depending on the increase or decrease in production volumes (constant, variable); 
  • implementation period (long-term, short-term); 
  • method of attribution per unit of production (average, marginal); 
  • origin (operational, financial); 
  • the degree of coverage of the real cost; 
  • possibility of distribution. In the project analysis, 
  • there are features of taking into account some costs. 

The main originality of these calculations is the consideration of planned costs in terms of alternative cost.

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