CHAPTER FOUR

COST ESTIMATES
The analysis of financial costs and benefits is a key step in the project
preparation process, which seeks to ascertain whether the proposed
project will be financially viable in the sense of being able to meet the
burden of servicing debt and satisfy the return expectations of the
promoters.

4.1 Project Life

A convenient starting point for establishing the period for financial analysis is
the technical life of the major investment item. In some projects, the
technical life (physical life) of the major investment item may be quite long.
However, the economic life of the same item might be shorter because of
expected technological obsolescence (as rapidly changing technology will
make a major investment obsolete in short period), frequently changing
tastes and preferences of customers, international competitiveness, and the
extent of natural resources or mineral deposits available.

A distinction may be made between the physical life and economic (or
optimal) life of an asset. The physical life of an asset represents the
number of years it can be used to produce a certain output by regular
maintenance and repair, which, of course, tends to cost more and more as
the years roll by. The economic life of an asset, however, refers to the
optimum number of years the asset should be used to produce a certain
output. In short:

⇒ Physical life is a period, often longer, over which a fixed asset can
continue to function, notwithstanding its acquired obsolescence, inefficiency
in operations, high costs of maintenance, or the obsolescence of its products.

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⇒ Economic life is the period during which a fixed asset is capable of
yielding service to the owner. The economic life of an asset is defined,
conceptually, as the period after which the asset should be replaced to
minimize the sum of operating and maintenance costs and capital costs
expressed on an annual basis.

4.2. Initial Investment Costs

Initial investment costs are defined as the sum of fixed assets (fixed
investment costs plus pre-production expenditures) and investment in
networking capital. Fixed assets constitute the resources required for
construction and equipping an investment project whereas the networking
capital corresponds to resources needed to operate the project totally or
partially. At the pre-investment stage, in this regard, the following two
mistakes are frequently made:

 Networking capital, meaning current assets minus current liabilities, is

either excluded at all or included in insufficient amount that, in turn,
might be causing liquidity problems for projects.
 Total investment costs are sometimes confused with total assets, the
latter constituting fixed assets plus pre-production expenditures plus
current assets.

The amount of total investment cost is, in fact, smaller than total assets,
since it is composed of fixed assets and net working capital, the latter being
the difference between current assets and current liabilities. The section
following discusses, in detail, the components of the total investment cost.

4.2.1. Fixed Investment Cost

The fixed investment cost represents the total of all items of outlay
associated with fixed assets in the project, which are supported by long-term
funds. It is the sum of the outlays on the following major components:

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A) Land and Site Development:

The cost of land & site development is the sum of broad range of costs, the
following being the major ones:
 Basic cost of land including conveyance (transfer) and other allied
charges,
 Premium payable on leasehold,
 Cost of leveling and site preparation,
 Cost of laying approach roads and internal roads,
 Cost of gate ways,
 Cost of tube wells, etc.
B) Buildings and Civil Works:

The cost of buildings & civil works depends on the following two basic
factors:
The kind of structures required, and
The specific requirements of the manufacturing process
It covers the costs of the following major items:
 Buildings for the main manufacturing plant;
 Buildings for auxiliary services like steam supply, workshops, etc;
 Laboratory, water supply, etc;
 Warehouses, open yard facilities, etc;
 Non-factory buildings (e.g. guesthouse, cafeteria, clinics, etc);
 Garages, sewage, drainage, and other civil engineering works.
C) Cost of Plant & Machinery:

It is fundamental component of the project cost.

 Costs of Imported Machineries and Equipments:
 CIF import value (including shipping, freight, and insurance
costs)
 Import duty (if any),
 Clearing, loading & unloading, and local transportation &
insurance charges

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  Costs of Indigenous Machineries and Equipments:
 FOR (Free on Rail ) costs (in other words, purchase price plus
freight charges),
 Sales taxes (if any),
 Rail way freights and transportation charges up to the site

 Cost of stores and spares acquired with machineries and

equipments
 Foundation & Installation charges (depending on the specific
requirements of the project)
The cost of plant equipments and machineries is based on the latest
available price quotations being adjusted for possible escalation.
[Latest rate of annual inflation applicable to the Plant Equipment
and Machinery) Multiplied by [Length of the delivery period]

D) Technical Know-how and Engineering Fees:

Technical consultants or collaborators, (local or foreign), may involve for
making:
 Project preparation report,
 Choice of technology,
 Selection of the plant machinery and equipments,
 Detailed engineering services, etc
The cost paid for these services in setting up the project is a component of
the project cost. However, any royalty payable (annually) on transfer of
technology, which is typically a percentage of sales, is an operating expense
and hence, accounted in the projected profitability statement.

E) Expenses on Foreign Technicians and Training of Local

Technicians Abroad
 Travel expenses of technicians to- and -from abroad,
 Boarding and lodging,
 Salaries and allowances, etc

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F) Miscellaneous Fixed Assets and Expenditures:
These are not parts of the direct manufacturing process but necessary to run
the organization as an entity. For instance, the following costs are classified
under this major group:
 Furniture and office equipments;
 Tools, vehicles, railway siding, diesel generators;
 Transformers, boilers, piping system;
 Laboratory and workshop equipments;
 Effluent treatment plants and firefighting equipment;
 Expenses for procurement (acquisition) of patents, licenses,
trademarks, and copyrights (for using a given technological package);
 Deposits made with the electricity board, and so on.

4.2 .2. Pre-Production Expenditures

Pre-production capital expenditures include the following:
A. Establishment and Capital Issue Expenses
 Establishment Expenses: These are expenditures incurred during
the registration and formation of the company, including:
 Legal fees for preparation of the memorandum & articles of
association, similar documents, and for capital issues as well
 Expenses for incorporating the company
 Capital Issue Expenses include:
Underwriting commission and brokerage fees,
Fees to managers and registrars,
Printing and postage expenses,
Advertising and public announcements,
Listing fees and stamp duty expenses for processing of share
applications and allotment, etc
B. Pre-Operative Expenses
i. Expenditures for Preparatory Studies
The major cost categories under this heading are the following:

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  Expenditures for pre-investment studies such as opportunity, pre-
feasibility, feasibility, and support or functional studies
 Consultant fees while project preparation
(Note also that preliminary expenses for identifying the project,
conducting the market survey, and preparing the feasibility report can be
presented under this heading as well.)
ii. Other Pre-Operative Expenditures are:
 Salaries, fringe benefits, and social security contributions for
personnel (i.e. for project implementation team);
 Travel expenses;
 Preparatory installation (workers camps, temporary houses, and
stores);
 Engineering services & supervision of plant erections and
constructions
 Pre-production marketing costs and promotional activities;
 Training costs (fees, travel, and living expenses);
 Interest and insurance during construction; and so on
o Costs incurred until the commencement of commercial
production include the following:
 Rent and taxes,
 Traveling expenses,
 Interest & commitment charges on borrowings,
 Start-up expenses, trial runs, and commissioning expenditures
(that include fees payable for supervision of start-up operations,
wages and salaries of workers, fringe benefits and contributions
for social security, wasted materials, supplies and utilities
consumed, etc).
iii. Initial Cash Losses
Most projects incur cash losses in the initial years. Promoters do not disclose
such losses because they want the project appear attractive to financial

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institutions. Failure to make a provision for such losses generally affects the
liquidity position & impairs the operations.

Remarks:
In general, one of the following two practices is followed when the pre
production expenditures are accounted for:
1. All pre-production expenditures may be capitalized and amortized
over a period of time that is usually shorter than the period over which
equipments are depreciated. [As deferred revenue expenditures,
which is capitalization of pre-production expenditures]
Part of the pre-production expenditures may initially be allocated, where
attributable, to the respective fixed assets [i.e. partial allocation of pre-
production expenditures]. However, pre-production expenditures that are not
attributable to fixed assets are, in total, capitalized and then, amortized over
years [i.e. partial capitalization of pre-production expenditures]

Note also that the magnitude of the pre-operative expenses is directly

related to the project implementation schedule. In this regard, delay in
implementation tends to push up these expenses. Often, financial
institutions allow for some delay (for instance, 20 - 25%) in the
implementation schedule and, thus, permit caution in estimating the pre-
operative expenses. Since the pre-operative expenses are incurred up to the
point of initial plant set-up, they are assets and hence, can be capitalized
either being apportioned to fixed assets or else the firm may treat them as
deferred revenue expenditures and subsequently write-off their value over a
period. Similar costs incurred after the point of time plant & machinery is
set-up and started commercial production, however, are treated as revenue
expenditures.

4. 2.3. Working Capital (WC) Requirements

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In estimating the working capital requirement and planning for its financing,
the following points have to be born in mind:
 The WC requirement consists of the following:
 Raw materials & components ( indigenous as well as imported)
 Stocks of goods in process (WIP)
 Stocks of finished goods
 Debtors (receivables)
 Operating expenses (prepaid insurances, prepaid rents, etc)
 Consumable stocks (supplies)
 The principal sources of WC finance are:
 WC advances provided by commercial banks (short term or
medium term WC loans)
 Trade credits (Account Payables)
 Accruals and provisions (such as salaries & wages payables, taxes
payable, interest payables, etc)
 Long-term sources of financing (long-term debts and equity)
In operational terms, there are limits to obtaining WC advances from
commercial banks. They are in two forms:
1. The aggregate permissible bank finance is specified as per the norms
of lending, followed by the lending bank; or else
2. Against each current asset, a certain amount of margin money (from
long-term sources) has to be provided by the firm.

Nowadays, banks are free to follow their own norms of lending. Yet, many of
them follow the second method suggested by the Tandon Committee
(Chandra, 2002). According to this method, the maximum permissible
bank finance is calculated as follows:
Current assets as per the norms laid _ Non-bank current liabilities
down by the Tandon Committee (0.75) like trade credits & provisions

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The implication of this norm is that at least 25% of current assets must
be supported by long-term source of finance. That is, certain part of the
working capital requirement has to come from long-term sources of finance,
which is referred to as “margin money for working capital”. In this
regard, the margin money for working capital is an important element of the
project cost, which constitutes the initial investment in networking capital.
However, it may sometimes be utilized for meeting over runs in capital cost,
which, in turn, leads to working capital problem (and sometimes a crisis)
when the project is commissioned.

To mitigate the working capital problems (or crisis), financial institutions

stipulate that a portion of the loan amount, equal to the margin money for
working capital, be blocked initially so that it can be released when the
project is completed.

[Note that the margin money for working capital is provided from
long-term sources.]

The margin requirement varies with the type of current asset. There is no
fixed formula for determining the margin amount. The range with in which
margin requirements for various current assets lie are as follows (Chandra,
2002):
 Raw materials 10 to 25%
 WIP 20 to 40%
 Finished goods 30 to 50%
 Debtors 30 to 50%

4.2.4. Provision for Contingencies

Provisions should also be made for physical contingencies as an allowance,
which is providing a safety factor to cover unforeseen or forgotten minor
costs. Contingency allowance is an amount included in a project account
to allow for adverse conditions that will add to baseline costs. These are:

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⇒ Physical Contingencies: Allow for physical events such as the effects of
adverse weather condition during construction, etc. (They are included in
both Financial and Economic analysis)
⇒ Price Contingencies: Allow for general inflation. In project analysis, they
are omitted both from financial and economic analysis when the analysis is
done in constant prices. Constant price is a value, most often a price, from
which the overall effect of general price increase (inflation) has been
removed.
By definition, a “constant price” is a price that has been deflated to real
terms by an appropriate “price index”, a price index being a series that
records changes in a group of prices relative to a given base period.

While physical contingency provides the basis to account for contingent

expenses, price contingency provides the basis to account for unforeseen
price increases over and above the normal inflation level during
implementation when the analysis is made in current (i.e. market) prices. As
normal inflation is already incorporated in the cost estimates, contingency
allowance is only provided to abnormal price rises.

In general, the following estimates for contingencies should be made:

 Physical Contingencies: 5 to 10% of fixed investment for
unexpected losses during construction
 Price Contingencies: 5 to 10% of fixed investment for price
escalation during construction period.
(Recall that increases in input prices in the operating period is assumed to
offset with proportionate increases in the prices of outputs)

4.3. Investment Required During Operations

The economic lifetime of the various investments such as buildings,

machineries and equipments, transport equipment, etc is often different. In
order to keep a plant in operation, therefore, each item must be replaced at

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the appropriate time. Hence, the replacement cost should be estimated and
included in the feasibility study.

The total investment cost includes investment in fixed assets and current
assets made initially and subsequently during operations. Fixed Assets
comprise fixed investments and pre-production capital costs. In this regard,
total fixed investments can be projected for each year of the construction
period until full production is reached. The estimate includes supplies
(stores), packing, transport, and installation charges. Exhibit 13.1 depicts the
components of the total fixed investment cost.

Exhibit 4.1: Total Fixed Investment Costs

No. Ite Ye
ms 0 1 2 n
1 Land purchase
2 Site preparation & development
3 Civil works, structures, and buildings
4 Plant machinery and equipment
5 Auxiliary and service plant equipment
6 Environmental protection
(requirements and standards):
Site preparation
Civil works
Plant machinery & equipment
7 Incorporated or allocated to fixed assets
(project overheads):
Technology related costs
Project implementation costs
Miscellaneous project overhead costs

8 Contingency Allowance
9 Total fixed investment
cost---------------
Foreign currency share (%)

4.4. Gross Working Capital

The gross working capital represents the amount of total investment made in
current assets, which is partly financed from current liabilities (both

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spontaneous liabilities and short-term borrowings from banks) and the rest
from long-term sources such as long-term debts and equity.

4.4.1. Current Assets

Current assets comprise:

 Receivables,
 Inventories (raw materials, auxiliary materials, supplies, packaging
materials, spare parts, and small tools),
 Work-in-progress,
 Finished products, and
 Cash
4.5. Networking Capital and Its Financing
4.5.1. Aspects of Networking Capital
Networking capital indicates the financial means required to operate the
project according to its production program. Networking capital is defined as
current assets minus current liabilities. In other words, it is gross working
capital minus current liabilities. It is very important to understand, in this
regard, that creditors related investments are to be excluded from the
computation of net working capital requirements. This is because, by
definition, investments are long-term commitments and, therefore, should be
financed by long-term resources (equity or long-term debt funds).

Networking capital forms an essential part of the initial capital outlays

required for an investment project because it is required to finance the
operations of the plant. Any change in current assets or liabilities such as an
increase or decrease of production volumes or inventories has an impact on
the financial requirements. Any net increase in the balance of working capital
corresponds to a cash flow to be financed and any net decrease would set
free financial resources (treated as cash inflow).

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4.6. Cost of Production

It is essential to make realistic forecasts of production or manufacturing

costs for a project proposal in order to determine the future viability of the
project. Deficiencies in the production process usually leads to unexpected
losses, which coupled with low capacity utilization caused by wrong sales
forecasts may quickly push a promising establishment out of operation. In
general, given estimated production, the cost of production will be
determined.

Production costs should be calculated as total annual costs and preferably as

cost per unit produced. The overall production costs should be broken down
at least into the main cost items, for instance, into the following four major
categories:
1. Factory costs,
2. Overhead costs,
3. Depreciation costs, and
4. Cost of financing
Production costs must be determined for the different levels of capacity
utilization and for an operational period. The sum of factory and
administrative overhead costs is defined as operating costs.
4.7. Factory Costs
Factory costs include the costs of the following:
 Materials, predominantly variable costs such as raw materials,
factory supplies, and spare parts;
 Labor, (production personnel), fixed or variable costs; and
 Overheads (utilities in the factory)
1. Materials Cost
It comprises the costs of raw materials, chemicals, components (parts), and
consumable stores. It is a function of quantities utilized and the prices

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payable. The considerations in estimating materials costs are indicated
below:
i. The requirements of various material inputs per unit of output may be
established on the basis of one or more of the following:
 Theoretical consumption norms,
 Experience of the industry
 Performance guarantees, or
 Specification of machinery suppliers
ii. The total requirement of various material inputs can be obtained as:
[Requirements Per Unit of Output] X [Expected Output During the
Year]
iii. The price of material inputs is defined in CIF terms
iv. The present cost of various material inputs is considered (the factor
of inflation is ignored). Recall that the factor of inflation is ignored in
estimating the sales revenue too.
v. If reasonable fluctuation in prices is regular, the same must be
considered in estimating the cost of material inputs.
2. Utilities
Utilities consist of power, water, and fuel. The requirements for power, water,
and fuel may be determined based on the norms specified by the
collaborators, consultants, etc or the consumption standards in the industry,
whichever is high.
 The cost of power would include only the cost of bought out power
 It may be estimated on the basis of power tariff structure of the
government
 The cost of captive power would naturally be reflected in the cost of
fuel
 The cost of water should be shown separately as:
i. Payable to local authorities, and
ii. Payable to some other firms for water and/or steam supply.

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  The cost of fuel that is comprised of the costs of furnace, oil, firewood,
biogases, etc is somewhat more difficult to estimate.

3. Labor Cost
It is the cost of all the labor employed and working in the factory floor
(production plant).
 Is a function of the number of employees and the rate of
remuneration
 The requirement of workers depends on the number of operations
and manning services required
 The number of supervisory personnel and administrative staff may be
calculated based on the general norms prevailing in the industry.
 In estimating remuneration rates, the prevailing rates in the industry
area should be taken in to account.
 The remuneration should include:
 Basic pay
 Desert allowance
 House rent
 Conveyance (for displacement of workers)
 Medical reimbursements
 Overtime work
 Night work
 Leave travel concession (for example, free flight tickets for
employees on vacation)
 Provident fund contribution
 Gratuity (or Privilege) contribution
 Bonus payments
 Vacation pays
 Work on holidays
Labor cost estimates may be raised at the rate of 5% per annum to allow for
annual increment. It may be calculated taking the year in which the

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maximum capacity utilization is first achieved. For earlier years, when the
capacity utilization tends to be low, somewhat lower labor cost, but not
proportionately lower in relation to capacity, may be assumed.

4.7.1. Overhead Costs

Overhead costs are frequently computed as a percentage charge on total
material and labor inputs or other reference items, a procedure that, in most
cases, is not sufficiently accurate. Overhead costs should be grouped as
outlined below:
1. Factory Overheads
Factory overheads are costs that accrue in conjunction with the
transformation, fabrication, and extraction of raw materials. Typical cost
items are:
 Wages and salaries (including benefits and social security
contributions) of manpower and employees not directly involved in
production.
 Factory supplies such as utilities (water, power, gas, and steam),
effluent disposal, and office repair maintenance expenses that depend
on the state of the machinery, which tends to be lower in the initial
years and higher in the later years.
 Rent, taxes, insurance, etc (these may be calculated at the existing
rates)
 A provision should be made for meeting miscellaneous factory
expenses
 Contingency margin may be provided on the items of factory
overheads
Note that the above cost items are part of the factory costs a plant incurs in
the manufacturing process, as they enhance production activities.

2. Administrative Overheads

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Administrative overheads should be calculated separately in cases where
they are of considerable importance; otherwise, they could be included
under factory overheads. Typical cost items are:
 Wages and salaries (including benefits and social security
contributions)
 Office supplies
 Utilities
 Communication
 Rents
 Insurance (property)
 Taxes (properties)
These cost elements should be estimated for administrative cost centers
such as management, bookkeeping and accounting, legal services and
patents, and public relations.
3. Marketing Overheads
Direct selling and distribution costs, such as special packaging and
forwarding costs and commissions and discounts, should be calculated
separately for each product. Indirect marketing costs that cannot be easily
linked directly with a product are usually treated as marketing overhead
costs. These costs are often included under administrative overheads.
However, marketing costs should be shown in the study as a separate cost
group if the total represents a significant share of the total costs of products
sold. Typical cost items are:
Wages and salaries (including benefits and social security
contributions) of employees involving in marketing activities
Office supplies, utilities, communications, indirect marketing costs,
advertising, training, etc.

4.7.3. Depreciation Costs

Depreciation is an accounting method used to distribute the initial
investment costs of fixed assets over the lifetime, usually the fiscal standard

17
lifetime, of the corresponding investment. Depreciation costs are charges
made in the annual net income statement, (profit/loss account), for the
productive use of fixed assets. Annual depreciation charges are frequently
included under overhead costs. However, since these costs are treated
separately for the discounted cash flow method, depreciation costs should be
shown separately from overhead costs.

In this way, it is still possible to include them for the calculation of factory
and unit costs, as well as for financial evaluation. Depreciation costs should
be calculated based on the original value of fixed investments, according to
the methods applicable, straight-line, declining balance, accelerated
depreciation methods, and so on, and rate adopted by management and
approved by the tax authorities. While depreciation costs have to be
considered in accounting for the computation of the balance sheet and net
income projections, they represent investment expenditure (cash outflows
during the investment phase) instead of production expenditure (cash
outflow during production).
Depreciation charges, therefore, must be added back if net cash flows are
calculated from the net profit.

Depreciation costs do have impacts on net cash flows, because the higher
the depreciation charges, the lower the taxable income and the lower the
cash outflow corresponding to the tax payable on income.

4.7.4. Financial Costs

Financial costs such as interest on term loans should be shown as a separate

item, because they have to be excluded when computing the discounted
cash flows of the project, but are to be included for financial planning.
Financial costs (interests) are sometimes considered as part of
administrative overheads. For the purposes of financial analysis and

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investment appraisal, however, it is necessary to determine financial costs
separately. With a declining amount of external finance, there is a
decreasing financial cost.

When forecasting overhead costs, attention should be given to the problem

of inflation. In view of the numerous cost items in overhead costs, it will not
be possible to estimate their growth individually, but only as a whole. A
sound judgment, therefore, has to be made as to the magnitude of the
overall inflation rate of overhead costs if the analysis is in constant prices.
Once estimates of sales revenue and overall production costs are made, the
next step is the projection of profits or estimation of working results.
Projection of profitability is important and often referred by term loan
providers. The profit/loss schedule is prepared as depicted in the Exhibit

below:

Exhibit 4.3: Total Annual Cost of Products

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 4.8. Profitability Projections
Once estimates of sales revenue and overall production costs are made, the
next step is the projection of profits or estimation of working results.
Projection of profitability is important and often referred by term loan
providers. The profit/loss schedule is prepared as depicted in the Exhibit
below:

Exhibit 4.4: Profit/Loss Schedule

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