MODULE IV SYLLABUS

Value Analysis and Value Engineering: Cost

Value, Exchange Value, Use Value, Esteem Value -
Aims, Advantages and Application areas of Value
Engineering - Value Engineering Procedure

Capital Budgeting: Time value of money - Net

Present Value Method - Benefit Cost Ratio –
Internal Rate of Return -– Payback – Accounting
Rate of Return.
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 Value
•

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 Value
Value is a measure of how well a product,
service, or process performs its intended
function relative to the resources expended to
achieve that performance.

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 Types of Value
Use Value
Value

Cost Value

Esteem Value

Exchange Value
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 Use Value
the measure of how well a product, service, or
system performs its intended function or fulfills its
primary purpose, independent of its cost or other
attributes.
- If a product does not successfully perform its
intended function, it has little or no use value,
regardless of how inexpensive it may be.

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 Use Value - Example
Water Bottle

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 Cost Value
Cost Value
- the cost required to produce or deliver the
product or service
- refers to the monetary expenditure incurred to
produce, deliver, or maintain a product, service,
or process through its lifecycle.
- It focuses solely on the actual cost required and
is critical in assessing economic efficiency
during value analysis and value engineering.
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 Cost Value - Example
Chair

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 Esteem Value
Esteem Value
- The perceived (observed) worth based on
brand, reputation, or aesthetic.
- Esteem value refers to the worth or
desirability a product gains due to features
such as brand reputation, appearance,
design, or perception among consumers,
beyond its basic functional use.
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Esteem Value - Example

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Esteem Value - Example

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 Exchange Value
Exchange value is the quantitative worth of a commodity
as determined by the proportion or rate at which it can be
traded for other goods or services in the market.

It reflects how much of one item must be given to obtain

another, serving as a measure in commercial
transactions, independent of the commodity's use or
personal significance.
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 Value Engineering Procedure
• The Value Engineering procedure is a structured, stepwise
process aimed at optimizing product or project value by improving
functionality and reducing unnecessary costs, without
compromising quality or performance.

The steps involved are:

• Step 1: Information gathering
• Step 2: Function Analysis
• Step 3: Creative Phase (Idea Generation)
• Step 4: Evaluation
• Step 5: Development
• Step 6: Presentation
• Step 7: Implementation

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Value Engineering Procedure

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 Value Engineering Procedure
• Step 1. Information Gathering
• This initial phase focuses on collecting
comprehensive data about the product, process,
or project under consideration. All aspects and
cost drivers (production, materials, logistics,
maintenance) are analyzed—including Bills of
Material and lifecycle costs—to identify where
most resources are spent.
• The aim is to clarify objectives, requirements,
and constraints.
• Techniques like Pareto analysis may be used for
prioritizing cost elements.
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 Value Engineering Procedure
• Step 2: Function Analysis
• Functions are identified and defined in clear,
measurable terms using active verb/noun
combinations such as “support load” or
“dispense water.” The team examines what
is essential for fulfilling project goals and
analyzes if functions can be improved,
eliminated, or consolidated.
• The cost associated with each function is
determined.
• Critical vs. secondary functions are
separated to focus on high-impact changes.
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 Value Engineering Procedure
• Step 3: Creative Phase (Idea Generation)
• An interdisciplinary team engages in guided
brainstorming to find alternative ways to
perform key functions and optimize value.
• Techniques include material substitution,
design changes, and process innovations.
• All potential solutions—no matter how
unconventional—are considered without
criticism.

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 Value Engineering Procedure
• Step 4: Evaluation
• The ideas generated are systematically
assessed for feasibility, cost-effectiveness,
potential risks, and alignment with objectives.
• Pros and cons of each alternative are
weighed; those with better advantages move
forward;
• Quantitative methods and ranking matrices
are often used.

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 Value Engineering Procedure
• Step 5: Development
• Selected ideas are further detailed, including
sketches, technical descriptions, ROI
calculations, and project plans.
• Detailed analyses forecast savings and
estimates the impact of change.
• Plans include schedules, budget allocation,
and resource needs.

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 Value Engineering Procedure
• Step 6: Presentation
• The most promising solutions are compiled
for presentation to decision-makers.
• Presentations include supporting data,
alternatives, and expected outcomes.
• Decision-makers review and provide
feedback or approval.

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 Value Engineering Procedure
• Step 7: Implementation
• Once approved, the solutions are executed
within the organization or project.
• Teams are assigned tasks, timelines are
established, and progress is tracked.
• Ongoing monitoring ensures intended
improvements are realized, and outcomes
are reviewed for continuous learning.

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 Value Engineering Procedure
Step Description Purpose
Analyse costs, functions, Identify improvement
Information Gathering
objectives potential
Define and evaluate
Focus on optimizing
Function Analysis necessary vs. secondary
core functions
functions
Brainstorm solutions, Generate maximum
Creative Phase
alternatives options
Screen alternatives, rank
Evaluation Select best-value ideas
by value and feasibility
Develop and detail Prepare for
Development
selected solutions implementation
Present proposals to
Presentation Secure approval
decision-makers
Execute changes, monitor Realize improvements,
Implementation
progress measure ROI
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 Value Engineering Procedure - Example
VE Step Description Example: Microscope
Manufacturing
Collect data on current Bill of Materials, cost, user
Information Gathering
design and costs feedback
Define essential functions "Support lens" identified as
Function Analysis
and costs critical
Brainstorm alternatives for Consider plastic supports
Creative Phase
functions instead of metal
Assess technical and Testing plastic for strength
Evaluation
economic feasibility and durability
Detail engineering and Updated drawings, cost
Development
implementation plans projections
Present proposals for Management reviews and
Presentation
approval approves changes
Apply changes and monitor Launch new microscope
Implementation
results version, track savings
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 Capital Budgeting
Capital budgeting is the process that
companies use to evaluate and select
long-term investment projects or expenditures
involving significant capital.
It involves analyzing the expected cash inflows
and outflows of a potential project to
determine if the project will generate returns
that meet a desired benchmark or financial
criteria.
The goal of capital budgeting is to allocate
limited capital resources efficiently to projects
that increase the company's value and
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profitability over time.
 Capital Budgeting – Time Value of Money

The Time Value of Money (TVM) is a fundamental financial

principle stating that a sum of money is worth more today
than the same sum in the future. This is because money
available now can be invested to earn interest or returns,
increasing its future value. Additionally, inflation reduces the
purchasing power of money over time, and there is
uncertainty about the receipt of future money.

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 Present value
•

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 Time Value of Money - Examples
Present Value Example:

If you expect to receive $5,000 one year from now,

and the annual discount rate is 7%, the present value
is:

This means $4,673 today is equivalent in value to

$5,000 a year from now.

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 Capital Budgeting Methods(Project
Evaluation Techniques)
Discounted Cash Flow Methods
• Net Present Value
• Internal Rate of Return
• Profitability Index or Benefit Cost Ratio
Non-Discounted Cash Flow Methods
• Accounting Rate of Return
• Payback Period

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 Net Present Value Method
Net Present Value (NPV) is a capital budgeting method used to
evaluate the profitability of an investment or project. It
calculates the difference between the present value of cash
inflows and the present value of cash outflows over the
project's lifetime.

The method accounts for the time value of money by

discounting future cash flows to their present values using a
discount rate, which is usually the required rate of return or cost
of capital.
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 Net Present Value Method
NPV helps in deciding whether to undertake a project:

If NPV > 0, the project is expected to generate value and is

considered profitable.

If NPV < 0, the project would result in a net loss and typically
should be rejected.

If NPV = 0, the project breaks even, yielding returns equal to

the discount rate.
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Net Present Value Method

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 NPV advantages and disadvantages
Advantage

•Considers time value of money.

•Includes all cash flows of the project.
•Shows true profitability in money terms.
•Objective decision rule – positive NPV means accept.
•Can adjust for risk using different discount rates.

disadvantage

•Difficult to choose the correct discount rate.

•Depends on accurate cash flow estimates.
•Not suitable for comparing projects of different sizes.
•Ignores non-financial factors.
•More complex than simpler methods.

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 Internal Rate of Return
Internal Rate of Return (IRR) is the discount rate that makes
the net present value (NPV) of all cash flows from a project or
investment equal to zero.

It represents the annualized effective compounded return rate

expected from a project.

In other words, IRR is the rate at which the present value of

future cash inflows equals the initial investment, indicating the
break-even point of the investment's profitability.

A higher IRR than the required rate of return or cost of capital

implies that the project is financially attractive.
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 IRR Decision Rule
• IRR > Cost of Capital (or Required Rate of
Return)- Accept the project
• IRR = Cost of Capital- Indifferent
• IRR < Cost of Capital- Reject the project

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Internal Rate of Return Method(IRR)

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 Advantages and Disadvantages
of IRR
Advantages of IRR

• Time value of money considered

• Easy comparison
• Simple interpretation
• Focus on profitability
• Independent of cost of capital (initially)

Disadvantages of IRR

• Multiple IRRs possible.

• Assumes reinvestment at IRR
• Ignores project scale
• Difficult for non-conventional cash flows
• May conflict with NPV

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 Internal Rate of Return - Applications
Capital Budgeting: To evaluate and compare the profitability of
investment projects.

Investment Decisions: Helps investors determine the expected

return and decide whether an investment meets required
thresholds.

Project Ranking: Used to prioritize projects based on their

return rates.

Risk Assessment: Assists in determining if a project

compensates adequately for its risk compared to the cost of
capital.

Financial Planning: Helps in long-term planning by estimating

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yields on investments.
Profitability Index(PI) or Benefit –
Cost Ratio

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 Decision rule- Profitability Index or
Benefit – Cost Ratio

• PI > 1 - Accept the project

• PI = 1 - Indifferent
• PI < 1 - Reject the project

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 Advantages and Disadvantages of
Profitability Index
Advantages of Profitability Index (PI)

• Considers time value of money

• Easy to interpret
• Helps rank projects
• Useful under capital rationing Consistent with NPV

Disadvantages of Profitability Index (PI)

• Ignores project size

• Difficult with mutually exclusive projects
• Requires accurate cash flow estimates
• Complex for long-term or uncertain projects

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 Benefit – Cost Ratio - Applications
•Project Evaluation: Assess financial feasibility of projects
by comparing benefits with costs.

•Public Sector: Used to analyze infrastructure projects like

highways, bridges, hospitals, where benefits and costs
occur over long periods.

•Resource Allocation: Helps prioritize projects by

comparing their BCRs to optimize investment.

•Risk Management: Provides a simple comparative

measure indicating the risk-return profile of investments.

This tool is especially useful alongside other financial

metrics to make sound investment decisions. 41
 Payback
The Payback Period is a financial metric that
measures the time required to recover the initial
investment cost from the net cash inflows generated
by a project or investment.

It indicates how long it takes for an investment to "pay

for itself" or reach the break-even point.

The shorter the payback period, the more attractive

the investment is considered because the invested
capital is recovered faster, reducing risk.

The method is popular for its simplicity but has

limitations as it ignores the time value of money and
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 Payback

This formula is applicable when cash inflows

are uniform over time.

If cash inflows vary, the payback period is

found by summing the cash inflows year by
year until the total equals the initial
investment.
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 Payback Period-Decision Rule

• Payback Period < Standard Payback Period -

Accept the project

• Payback Period > Standard Payback Period –

Reject the Project

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Payback

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Pay Back Period Method-Uneven cash
inflows
• The formula for the payback period method
with uneven cash flows is represented as
• P = N + (B/A)
• P = Payback Period
• N = the number of full years before full
recovery
• B = Balance amount to be recovered
• A =Annual cash inflow during the year of
recovery

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 Payback - Applications
Investment Decision Making: Helps investors or companies decide
whether to proceed with a project by evaluating how quickly the initial
outlay is recovered.

Risk Assessment: Shorter payback periods generally imply lower

risk.

Cash Flow Planning: Useful in liquidity management to know when

invested funds become available again.

Preliminary Screening: Often used as a quick screening tool to

evaluate multiple projects before applying more complex methods
like NPV or IRR.

Non-financial Investments: Used in other areas such as energy

efficiency to assess payback in terms of cost savings (e.g., solar
panel investment payback).
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 Accounting Rate of Return
The Accounting Rate of Return (ARR) is a financial
metric used in capital budgeting to measure the
expected profitability of an investment or project
based on accounting net income rather than cash
flows.

It expresses the average annual accounting profit

generated by the investment as a percentage of the
average investment cost or book value over the
asset’s life. ARR is also called the “simple rate of
return.”

ARR is useful for giving an intuitive percentage

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return based on accounting data but does not
Accounting Rate of Return

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 ARR Decision Rule
• ARR > Required Rate of Return (or Target ARR)
– Accept the project

• ARR < Required Rate of Return (or Target ARR)

– Reject the project

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 Accounting Rate of Return
Suppose a company buys equipment costing
$60,000 with an expected life of 5 years and a
salvage value of $20,000. The equipment generates
the following net incomes over 5 years:

Year 1: -$3,000 (loss), Year 2: $2,000, Year 3:

$7,000, Year 4: $12,000, Year 5: $17,000.

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 Accounting Rate of Return
Suppose a company buys equipment costing
$60,000 with an expected life of 5 years and a
salvage value of $20,000. The equipment generates
the following net incomes over 5 years:
Year 1: -$3,000 (loss), Year 2: $2,000, Year 3:
$7,000, Year 4: $12,000, Year 5: $17,000.

The project’s accounting rate of return is 17.5%, indicating the

average annual accounting profit is 17.5% of the investment 52
value.
 Accounting Rate of Return - Applications
Simple Profitability Measure: Offers a straightforward way for
management and investors to understand expected returns
in percentage terms.

Initial Screening: Used for quick evaluation of projects before

more complex analyses like NPV or IRR.

Comparing Projects: Helps compare profitability across

different projects or assets based on average accounting
profits.

Aligning with Accounting Reports: Since ARR uses

accounting profits, it aligns with income statements and is
easy to communicate within financial reporting frameworks.
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 Accounting Rate of Return
• Advantages

• Simple to calculate and understand.

• Uses readily available accounting data (profits).
• Focuses on overall profitability rather than cash flow.
• Useful for short-term decision-making.
• Provides a quick estimate of return on investment.

• Disadvantages

• Ignores time value of money.

• Based on accounting profits, not cash flows.
• Different accounting methods can affect results.
• Ignores project risk and timing of returns.
• May conflict with NPV or IRR decisions

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