Table of Contents:-
- What is cost of project?
- Cost of Projects
- Estimation of Capital Cost of Project
What is cost of project?
Cost of Project estimation is one of the most important steps in project management. A cost estimate establishes the baseline of the project cost at various stages of project development. A cost estimate at a given stage of project development represents a prediction provided by the cost engineer or estimator based on available data.
Project cost estimating becomes a task of balancing the expectations of major stakeholders and the need for control while the project is implemented. Cost of project budgeting involves allocating the project cost estimate to individual work items over time. Cost estimation is the process of developing an estimated cost for the resources needed to complete project activities. It normally occurs in the planning process groups and is dependent on several of the outputs from the initiating and planning process groups.
Cost of Projects
Estimating project costs involves the estimation of the following types of costs, as shown in the image below:
- Estimation of Capital Cost
- Estimation of Cost of Production/Operating Cost of Project
- Estimation of Working Capital Requirement
1) Estimation of Capital Cost of Project: Capital costs are fixed and, as a result, are independent of the output level.
2) Estimation of Cost of Production/Operating Cost of Project: Operating costs (or manufacturing costs) are the expenses incurred during the regular operation of a facility or component, including labour, materials, utilities, and other related costs.
3) Estimation of Working Capital Requirement: Working capital is commonly used for the capital required for day-to-day working in a business concern, such as purchasing raw material, meeting everyday expenditures on salaries, wages, rent, rates, advertisement, etc.
Estimation of Capital Cost of Project
Capital costs refer to expenses incurred in acquiring buildings, land, construction, and equipment for use in producing goods or providing services. They represent the total cost necessary to bring a project to a commercially operable status. It’s important to note that capital costs extend beyond the initial construction of a factory or business.
For example, acquiring a new machine intended to enhance production and have a lasting impact over several years is considered a capital cost. Except for those associated with construction, labour costs are not part of capital costs. Unlike ongoing operating costs, capital costs are one-time expenses, though the payment may be distributed over several years in tax returns and financial reports. Additionally, capital costs are fixed and, therefore, remain independent of the output level.
Components of Capital Cost of Project
Conceptually, the project cost represents the total sum of all outlays associated with a project, supported by long-term funds. It is the sum of the outlays on the following: of the following:
1) Land and Site Development
Land and Site Development Costs include the following points:
- Essential land costs, including conveyance and other related charges,
- Premium payable on leasehold and conveyance charges,
- Cost of levelling and development,
- The cost of constructing approach roads and internal roads,
- Cost of gates,
- Cost of tube wells.
The land cost varies considerably from location to location, being very high in urban and semi-urban areas but relatively low in rural locations. Similarly, the expenditure on on-site development also varies widely based on the location and topography of the land.
2) Buildings and Civil Works
This category includes the following:
- Buildings for the main plant and equipment,
- Buildings for auxiliary services, such as steam supply, laboratories, workshops, water supply, etc.
- Godowns, warehouses, and open yard facilities,
- Non-factory buildings like canteen, time office, guest houses, excise house, etc.
- Quarters for essential staff,
- Silos, tanks, chests, wells, cisterns, basins, bins, hoopers, and other structures necessary for installation of the plant and equipment,
- Sewers, drainage, etc.,
- Other civil engineering works.
The cost of buildings and civil works depends on the types of structures required, which, in turn, are primarily dictated by the needs of the manufacturing process. Once the types of structures are specified, cost estimates are based on the plinth area and the rates for various structures. These rates, of course, may vary depending on the location.
3) Plant and Machinery
The cost of plant and machinery, generally the most significant component of the project cost, comprises the following:
i) Cost of Imported Machinery: This represents the total.
- FOB (Free on Board) value,
- Shipping, freight, and insurance costs,
- Import duty, and
- Clearing, loading, unloading, and transportation charges.
ii) Cost of Indigenous Machinery: This comprises the following:
- For (Free on Rail) cost,
- Sales tax, octroi, and other taxes, if any, and
- Railway freight and transport charges to the site.
iii) Cost of stores and spares.
iv) Foundation and installation charges.
The cost of the plant and machinery is determined based on the latest available quotation and adjusted for possible escalation. Generally, the escalation provision is calculated as the following product: (latest annual inflation rate applicable to the machinery and plant) x (length of the delivery period).
4)Technical Know-How and Engineering Fees
It is often necessary to engage technical consultants or collaborators from India and abroad for advice and assistance in various technical matters, such as preparing the project report, selection of plant and machinery, choice of technology, detailed engineering, and so on.
While the amount payable for obtaining the technical know-how and engineering services for setting up the projects is a component of the project cost, the royalty payable annually, which is typically a percentage of sales, is an operating expense taken into account in the preparation of the projected profitability statements
5) Expenses on Foreign Technicians and Training of Indian Technicians Abroad
The services of foreign technicians may be required in India to supervise the trial runs and set up the project. Expenses on their boarding, travel, lodging, salaries, and allowances must be accounted for in this category. Similarly, fees for Indian technicians who require training abroad must also be included here.
6) Miscellaneous Fixed Assets
Fixed machinery and assets not part of the direct manufacturing process may be miscellaneous fixed assets. These include furniture, office machinery and equipment, tools, vehicles, railway siding, diesel generating sets, transformers, boiler piping systems, laboratory equipment, workshop equipment, effluent treatment plants, fire-fighting equipment, etc. Expenses incurred for procuring or using licenses, patents, copyrights, trademarks, etc., and deposits made with the electricity board may also be included in this category.
7) Preliminary and Capital Issue Expenses
Expenses incurred for identifying the project, conducting the market survey, preparing the feasibility report, drafting the memorandum and articles of association, and incorporating the company are referred to as preliminary expenses.
Expenses related to raising capital from the public are termed capital issue expenses. The significant components of capital issue expenses include brokerage, underwriting commission, fees to managers and registrars, printing and postage expenses, listing fees, advertising and publicity expenses, and stamp duty.
8) Pre-Operative Expenses
Expenses of the following types incurred before the commencement of commercial production are referred to as pre-operative expenses:
- Establishment expenses,
- Rent, rates, and taxes,
- Travelling expenses,
- Interest and commitment charges on borrowings,
- Insurance charges,
- Mortgage expenses,
- Interest on deferred payments,
- Start-up expenses, and
- Miscellaneous expenses.
Pre-operative expenses are directly linked to the project implementation schedule. Consequently, delays in project implementation, which are relatively common, tend to increase these expenses. Recognizing this, financial institutions allow for some delay (20 to 25 per cent) in the project implementation schedule and permit a cushion in the estimate for pre-operative expenses.
Pre-operative expenses incurred up to the point the plant and machinery are set up may be capitalized by apportioning them to fixed assets on some acceptable basis. Revenue expenditures include pre-operative expenses incurred when the plant and machinery are set up. However, the firm may choose to track deferred revenue expenditures and write them off over some time.
9) Provision for Contingencies
A provision for contingencies accounts for unforeseen expenses and price increases beyond the average inflation rate already incorporated in the cost estimates.
To accurately estimate the provision for contingencies, it is recommended to follow the procedure outlined below:
i) Divide the project cost items into’ firm’ and ‘non-firm’ cost items (firm cost items are those that have already been acquired or for which definite arrangements have been made).
ii) Set the provision for contingencies at 5 to 10 per cent of the estimated cost of the non-firm items. Alternatively, make a provision of 10 per cent for all items (including the margin money for working capital) if the implementation period is one year or less. For every additional year, make a different provision of 5 per cent.
10) Margin Money for Working Capital
The primary support for working capital comes from commercial banks and trade creditors. However, a specific portion of the working capital requirement must be sourced from long-term financing options. Referred to as the ‘margin money for working capital,’ this is an essential element of the project cost.
11) Initial Cash Losses
Most projects experience financial losses during their initial years. However, promoters typically keep the initial cash losses private to present the project attractive to financial institutions and the investing public. Failure to provide such cash losses in the project plan can significantly impact liquidity and impair operations. Hence, prudence calls for making a provision, whether overt or covert, for the estimated initial cash losses.
Estimation of Operating Cost of Project
Operating costs (or manufacturing costs) are the expenses incurred during the normal operation of a facility, or component, including labour, materials, utilities, and other related costs.
Purpose of Operating Cost Estimates
Operating cost estimates are of utmost importance from various perspectives.
1) Operating costs are required to determine the potential profitability of a process or product and are very useful for screening alternative project possibilities.
3) They offer a tool for sensitivity analysis for individual components. It is important to remember to perform operating cost estimates at both full and reduced capacities for the operating system in question. It is not uncommon for a system to be highly efficient at total capacity but very inefficient when operating at less than designed capacity. The critical question is what range of operations a plant can cover and still make a profit. Such costs can be calculated as stand-alone estimates or incremental costs for specified projects. These different viewpoints could lead to other decisions depending on the situation.
Component of Operating Cost of Project
The accuracy of the cost estimate improves as one moves from the project’s conceptual phase to the point where individual items (work packages) are defined. Assuming work packages are limited, detailed cost estimates can be made. Given below are typical kinds of costs found in a project:
1) Direct Costs
These are chargeable to a specific work package. Direct costs can be influenced by the project team, the project manager, and individuals implementing the work package. Direct costs represent actual cash outflows that must be paid as the project progresses. Therefore, direct costs are typically separated from overhead costs. Lower-level project roll-ups often include only direct costs.
i) Labour: This section provides the estimated costs for various classifications of people expected to work on the project, such as painters, designers, and computer programmers. It might include the estimated hours and hourly rate for each person or classification.
ii) Materials: This section gives the cost of materials the contractor or project team needs to purchase for the project, such as paint, lumber, wallpaper, shrubbery, carpeting, paper, art supplies, food, computers, or software packages.
iii) Sub-contractors and Consultants: When contractors or project teams do not have the expertise or resources to do specific project tasks, they may hire sub-contractors or consultants to perform those tasks. Examples of such tasks include designing a brochure, developing a training manual, developing software, or catering for a reception.
iv) Equipment and Facilities Rental: Sometimes, the contractor may need special equipment, tools, or facilities solely for the project. The equipment may be too expensive to purchase if it will be used on only one or a few projects. In such cases, the contractor may rent the equipment for as long as needed on the project.
2) Direct Overhead Costs
Direct overhead rates more closely pinpoint which organisation resources are being used in the project. Direct overhead costs can be tied to work packages or project deliverables. Examples include the temporary rental space for the project team or the project manager’s salary.
While overhead may not require immediate out-of-pocket expenses, it is a tangible cost that must be accounted for in the long term to ensure the firm’s sustainability.
3) General and Administrative (G&A) Overhead Costs
These represent organizational costs that are not directly linked to a specific project but are carried out for the project’s duration. Examples include organization-wide costs across all products and projects, such as advertising, accounting, and senior management above the project level. The allocation of General and Administrative (G&A) costs varies from organization to organization. However, G&A costs are usually allocated as a percentage of the total direct cost or a percentage of the total of a specific direct cost, such as labour, materials, or equipment.
By summing up the direct and overhead costs of each work package, it becomes feasible to accumulate the expenses associated with any deliverable or the entire project.
Estimation of Working Capital Requirement
It is not easy to estimate the amount of working capital required by a firm to maintain a specific level of cash balance. Determining the working capital requirement is a practical and crucial problem, as inadequate working capital can lead to various issues. Similarly, having an amount of working capital beyond the necessary level, which could be utilized more efficiently and remain idle, can also increase costs. To avoid these difficulties, a forecast for the working capital requirement is prepared after scrutinizing and analyzing every aspect of a firm’s business activity.
The margin money for working capital is sometimes used to cover overruns in capital costs. When commissioned, the project can result in a working capital problem (and sometimes a crisis). To address this issue, financial institutions stipulate that a portion of the loan amount, equal to the margin money for working capital, be initially blocked and released when the project is completed.
The requirement of working capital can be explained in two ways:
1) Trading Concern
i) Where the balance sheet of the earlier period is available, the estimated working capital requirements for the budget period can be determined based on the data from the earlier or previous periods. Adjustments are made to current assets and liabilities during the budget period, and the working capital requirement can then be readily determined by subtracting the estimated total value of current liabilities from the estimated total value of existing assets.
ii) Where the Balance Sheet of the Earlier Period is not Available: In such a situation, the times of current liabilities for the budget period should be ascertained based on the given data. Then, the current liabilities must be deducted from existing assets.
2) Manufacturing Concern
The following factors are taken into account when ascertaining the requirement of working capital:
i) Total amount of units to be produced throughout the year.
ii) The cost of raw materials, wages, and overhead for each unit.
iii) The duration of raw materials in stock before issuance to production, as a more extended period increases the requirement for working capital.
iv) Processing time in the factory, with a more extended period leading to a more significant requirement of working capital.
v) Storage duration for finished products in the warehouse, with a more extended storage period increasing the working capital requirement.
vi) Credit period allowed to debtors, as a more extended period increases the working capital requirement.
vii) Credit period allowed by suppliers, with a more extended period decreasing the working capital requirement.
viii) Time lag in payment of wages and overheads, as a more extended period decreases the working capital requirement.
One must remember that facts based on estimates may not be entirely accurate, but it is possible to make a reasonable assessment through careful observation. The provision for contingency serves this purpose. The mathematical formula for this is:
Working capital Required = (Increase in accounts receivable + Increase in inventory + Cash inflows, i.e., cash in the bank, bank loan, other current assets) / (Increase in accounts payable + Cash outflows, i.e., prepaid expenses, payment to suppliers, other current liabilities).