Project Analysis (Acct 422)

Project Analysis (Acct 422 )
TABLE OF CONTENT
Contents Page
Unit 1: Overview of Projects and Project Analysis 1
Unit 2: Project Life Cycle 12
Unit 3: Project Identification 23
Unit 4: Market and Demand Analysis 39
Unit 5: Technical Analysis 69
Unit 6: Project Organization and Management 93
Unit 7: Financial Evaluation 121
Unit 8: Economic Analysis 159
 References
UNIT 1: OVERVIEW OF PROJECTS AND PROJECT ANALYSIS
Contents
1.0 Aim and Objectives
1.1 Introduction
1.2 Project Concept/Definition
1.3 Types of Capital Investments
1.4 Importance of Capital Investments
1.5 Difficulties of Capital Investments
1.6 Objectives of Capital Investments
1.7 Phases of Capital Investments
1.8 Summary
1.9 Answers to Check Your Progress Questions
1.0 AIMS AND OBJECTIVES
After completing this unit successfully, you will be able to:

 define the term project;
 understand project as a conversion process;
 understand the relationship between projects and plans;
 describe the role of projects in national development;
 understand the importance, objectives and difficulties of capital investments;
 explain the types and phases of long-term investments; and
 describe the facets of project analysis.
1.1 INTRODUCTION
Project is a means of implementing the firm’s plans. As a means of plan implementation,

project involves a complex process. Before discussing the complex process of project, it
is reasonable to introduce basic concepts of projects. This unit highlights the nature of
project, types of projects, importance of projects, difficulties in projects, objectives of
projects, the phases of projects.
1.2 PROJECT CONCEPT/DEFINITION
The term ‘project’ may be defined as a complex of economic activities in which scarce
resources are committed in expectation of benefits that exceed the costs of resources
consumed. Projects require resources. They are also expected to derive benefits. Projects
are said to desirable if their benefits are greater than the costs incurred on them. A project
can also be referred to as a non-repetitive activity. A project is viewed as a conversion
process. This implies that a project involves a transformation of some form of inputs into
an output. (see the following diagram).
Constraints
Inputs Project Output
Mechanisms
In the above diagram, we observe that project is a conversion process which serves in
transforming inputs into outputs. Inputs represent want or need whereas outputs represent
satisfied need. Constraints consists of factors such as financial, legal, ethical,
environmental, time, and quality. Mechanisms include people, knowledge of expertise,
capital, tools and techniques, and technology.
Check Your Progress 1.1

a) Define the term project.
b) Discuss project as a conversion process.
c) What are the major constraints in projects?
d) What are the major mechanisms in projects?
e) What does “inputs:” and “output” represent in the conversion process?
1.3 TYPES OF CAPITAL INVESTMENTS/PROJECTS
The term capital refers to investments in fixed assets. Capital investments deal with the
whole process of identifying and analyzing which projects should be pursued. Capital
investments may be classified in different ways. Capital investments may be classified
into physical assets, monetary assets, and intangible assets. Capital investments in
physical assets include investments in building, machinery, equipment, vehicles, and
computers. Investments in monetary assets include investments in debt or equity
securities. Debt securities involve bonds, notes, deposits etc whereas equity securities
include equity shares (common stock and preferred stock), options, warrants and the like.
Projects may also be classified into cost reduction (replacement) investments, revenue
expansion projects, or mandatory investments. Replacement investments aim at replacing
the worn out equipment with new equipment to reduce operating costs (material, labor
and/or overhead costs), increase the yield (productivity), and/or improve quality. An
expansion investment is meant to increase the capacity to cater to a growing demand in
the form of entering new markets (market development), introducing new products to the
existing market (product development), operating with the same products in the existing
markets (penetration), or introducing the new product for new market (diversification). A
mandatory investment is a capital expenditure required to comply with statutory
requirements, such as pollution control, fire fighting, medical dispensary and so on.
Projects may also be classified into development projects and business projects. While
business (industrial) projects aim at profit or value maximization of the owners,
development projects aim at reducing poverty and are pursued by the government or
NGOs.
1. Differentiate investments in physical assets and monetary assets. Give at least two
examples for each.
2. What is the purpose of mandatory investments?
3. How do you think that expansion projects can be achieved?
4. Replacement investment primarily aims at increasing the revenue of the firm.
(True/False).
5. Business projects have profit as their basic motive. (True/False).
1.4 IMPORTANCE OF CAPITAL INVESTMENT
Capital investment decisions have several importance. Among them are:

1. They have long-term effects
Capital investments have the consequences that extend far in to the future. They
provide the framework for future activities and have a significant impact on the
basic character of a firm.
2. Irreversibility. A wrong capital investment decision often cannot be reversed
without incurring a substantial loss. This is due to the fact that the market for used
capital assets (equipment) in general is ill-organized i.e., the investment may be
sold below purchase price or the market for such as second hand investment may
be non-existent.
3. Substantial outlays
Capital investments require substantial outlays. This is especially the case with
investments in advanced technology.
1.5 DIFFICULTIES OF CAPITAL INVESTMENTS
What are the major difficulties in capital investments? What are the sources of these
difficulties?
Although capital investments are so important, they are not without difficulties. These
difficulties arise from three major sources; namely,
1. Measurement problems
It is difficult to identify and measure the costs and benefits of capital investment
proposals.
2. Uncertainty
The costs and benefits of capital investments are characterized by a great deal of
uncertainty. It is impossible to predict exactly what will happen in the future.
3. Temporal spread
The costs and benefits with a capital expenditure decision spread out over a long-period
of time, such as 10 – 20 years, or 20 – 40 years this creates problems in estimating the
discount rates and establishing equivalences.
1. Mention the importance of capital investments

2. List the difficulties of capital investments.
3. As costs and benefits of capital investments spread over a long period of time, so
do their risk. (True/False)
1.6 OBJECTIVES OF CAPITAL PROJECTS/INVESTMENTS
According to financial theory, the goal of financial management is to maximize the

present wealth of the firm’s stockholders’ equity. The wealth of equity stockholders is
reflected in the market value of the equity shares.
Wealth maximization, as objective of financial decision making, contributes to an

efficient allocation of capital. The expected return and risk serves as the bases for
allocation of capital. Since equity share prices are based on expected return and risk,
efforts to maximize equity share prices would result in an efficient allocation of
resources. Thus, the objective of capital investment decision is to maximize the value
(wealth) of equity shareholders.
Should firms solely act to further the shareholders’ welfare? In fact, firms may pursue
several goals at a time. Some of other goals the firms may pursue include:
- seek to achieve a high rate of growth
- increase market share
- attain product and technology leadership
- promote employee welfare
- further customer satisfaction
- improve community life and other societal problems
Most of the above goals are in congruence with the goal of maximizing the wealth of
equity shareholders. When they seem to conflict with wealth maximization, it is useful to
know the cost of pursuing these goals. However, it should be understood that wealth
maximization is regard as the normative goal from the financial point of view.
a) What are the possible goals of capital investment decisions?

b) Which of the goals you listed under (a) above is the normative goal from financial
point of view?
c) What is the role of wealth maximization as the goal of capital investments in
resource or capital allocation?
d) Mention the two bases of capital allocation.
1.7 PHASES OF CAPITAL INVESTMENTS/CAPITAL BUDGETING
What are the major phases of capital budgeting? As it involves a complex process, capital
budgeting process is divided in to six broad phases.
Planning
Analysis
Selection
Financing
Implementation
Review
Each of them is described below:

1. Planning
This phase is concerned with the articulation of the firm’s broad investment strategy and
the generation and preliminary screening of project proposals. The firm’s investment
strategy delineates the broad areas or types of investments the firm plans to undertake.
This provides the framework which shapes, guides, and circumscribes the identification
of individual project opportunities.
Followed by the identification of a project proposal, a preliminary project analysis is

done which is performed before the full blown feasibility study. The purpose of
preminary project analysis is:
a) to assess whether the project is prima facie (at first sight) worthwhile to justify a
feasibility study.
b) to assess what aspects of the project are critical to its viability and hence warrant
an in-depth investigation
2. Analysis
If the preliminary screening suggests that the project is prima facie worth while, a
detailed analysis of the project will be undertaken in terms of marketing, technical,
financial, economic, and ecological aspects. This phase involves the detailed analysis of
the project. It focuses on gathering, preparing, and summarizing relevant information
about various project proposals. The information developed in this analysis becomes the
basis for costs and benefits of the project.
3. Selection
The analysis of the project is followed by selection. Selection phase addresses the
question. “Is the project viable?” In order to select the project, a wide range of appraisal
techniques can be used. These techniques are classified into non-discounted criteria and
discounted cash flows techniques. These techniques will be discussed in detail in unit 7.
4. Financing
Once a project is selected, suitable financing arrangements have to be made. There are
two possible sources of financing the projects; namely, debt financing (loans, bonds etc)
and equity financing (common stock, preferred stock, retained earnings etc.)
The firm should decide on the optimal mix of debt and equity financing. The key
business considerations that influence the mix are flexibility, risk, income, control, and
taxes (FRICT) you can find a more detailed discussion on financing in unit 7.
5. Implementation
For industrial projects, the implementation phase involves setting up of manufacturing
facilities that consists of the following stages.
a) Project and engineering designs
b) Negotiations and contracting
c) Construction
d) Training
e) Plant commission (start the actual operation)
6. Review
Once the project is commissioned, the review phase has to be set in motion. Performance
review should be done periodically to compare actual performance with projected
performance. Review is helpful:
a) to throw light on how realistic were the assumptions underlying the
project
b) to provide a documented log of experience that is highly valuable in future
decision making
c) to take corrective action in light of actual performance
d) in uncovering judgmental biases
e) to induce a desired caution among project sponsors.
The phases of capital budgeting that are suggested by World Bank and United Nations
Industrial Development Organization (UNIDO) will be discussed at great length in unit 2.

From the following list of capital investment phases, match the appropriate phase with
the statements described below:
Planning Selection Implementation
Analysis Financing Review
1. Articulation of the project’s broad investment strategy
2. Generation of project ideas and preliminary screening of project proposal.
3. Focuses on gathering, preparing, and summarizing relevant information about
various project proposal
4. Deals with decision as to whether the project is worthwhile.
5. Uses discounted cash flow techniques and non discounted techniques.
6. Provides the framework which shapes, guides, and circumscribes the identification
of individual project opportunities.
7. The basis for defining project costs and benefits.
8. The detailed investigation of the project is undertaken in terms of marketing,
technical, financial, economic, and ecological aspects.
9. Deals with the decision on the optional mix of debt financing and equity financing.
10. Deals with assessing whether the project is prima facie worthwhile to justify a
feasibility study.
11. Involves setting up manufacturing facilities.
12. Deals with performance review of the project.
13. Plant commission.
14. Aims at taking corrective actions.
15. Negotiation and contracting.
1.8 SUMMARY
Project is a complex of economic activities in which scarce resources are committed in

expectation of benefits that are expected to be greater than the costs of resources
consumed. A project is viewed as a conversion process in which inputs (want or need) are
converted to outputs (satisfied need or want) using people, knowledge of expertise,
capital, tools, and technology under constraints such as financial, legal, ethical,
environmental, time, and quality.
Projects may be classified in various ways. They may be classified into cost reduction,
revenue expansion, and mandatory projects. On the other hand, projects may be classified
into physical monetary, and intangible. Projects may also be classified into industrial
projects and development projects.
The importances of project are their long-term effects, their irreversibility and their
requirement for huge investments. Some of the difficulties of projects are measurement
problems, uncertainty, and temporal spread.
The objective of capital investment decision is the maximization of the wealth of equity
shareholders. Projects involve six major phases; namely, planning, analysis, selection,
financing, implementation, and review.
1.9 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS
CYP 1.1
a. A project is a complex of economic activities that requires the commitment of
scarce resources in anticipation of future benefits that exceed the associated costs.
b. A project is considered as a conversion process, which is used to transform inputs
into outputs using different mechanisms under certain constraints.
c. The constraints in projects include financial factors, legal factors, ethical factors,
environmental factors, time factors and the like.
d. The mechanisms in projects include people, knowledge of expertise, capital, tools,
techniques, technologies etc.
e. Inputs represent wants or needs whereas outputs represents satisfied needs or
wants.
CYP 1.2
1. Physical assets include equipment, machinery, buildings, vehicles, computers and
similar assets. Monetary assets are investments in debt or equity securities such as
bonds, notes, common stock, preferred stock etc.
2. To comply with legal requirements
3. Through increase the capacity for the purpose of penetration, market
development, product development, or diversification
4. False. It aims primarily at reducing operating costs
5. True
CYP 1.3
1. Long-term effects, irreversibility, and substantial outlays.
2. Measurement problems, uncertainty, and temporal spread
3. True
CYP 1.4
a. Wealth maximization (maximize the equity share price), growth, increase market
share, attain product and technology leadership, promote employee welfare etc.
b. Maximize the wealth of the shareholders.
c. Enables to achieve efficient resource allocation.
d. Expected return and risk.
CYP 1.5
1. Planning 5. Selection 9. Financing 13. Implementation
2. Planning 6. Planning 10. Planning 14. Review
3. Analysis 7. Analysis 11. Implementation 15. Implementation
4. Selection 8. Analysis 12. Review
UNIT 2: PROJECT LIFE CYCLE
Contents
2.0 Aims and Objectives
2.1 Introduction
2.2. Definition of Project Cycle
2.3. Project Life cycle – Baum (World Bank) Approach
2.4. Project Life cycle – UNIDO Approach
2.4.1. Pre-investment Phase
2.4.2. Investment Phase
2.4.3. Operating Phase
2.5. Summary
After completing this chapter, you will be able to:

 discuss the term project cyclep;
 describe the various stages in project cycle according to Baum (World Bank);
 describe UNIDO’s project cycle; and
 understand the decision goal of each phase in the project cycle.
2.1. INTRODUCTION
Project passes through series of activities called stages. There are different approaches to
describing the project cycle. In the first chapter, we present one way of describing the
project cycle or stages in capital investments. This chapter highlights two other
approaches to project cycle; namely, the World Bank and United Nations Industrial
Development organizations (UNIDO).
2.2. DEFINITION OF PROJECT CYCLE
Project cycle refers to the various stages through which project planning proceeds from
the inception to implementation. In other words, it is the life cycle through which a
project advances from infancy to maturity. The main features of this cycle are
information gathering, analysis, and decision–making. What is the primary preoccupation
at each stage in the project cycle? Through out the project cycle, the primary
preoccupation of the analysis is to consider alternatives, evaluate them and to make
decisions on which of them should be advanced to the next stage.
2.3. PROJECT LIFE CYCLE – BAUM (WORLD BANK) APPROACH
According to World Bank, project cycle involves five stages; namely, project
identification, project preparation, project appraisal, project implementation, and project
evaluation. See the following diagram:
Project identification
Project preparation
Project Appraisal
Project Implementation
Project evaluation
Let’s highlight the major activities in each stage
1. Project identification
This stage is also called pre-feasibility studies. In this stage, projects that can contribute
towards achieving the specified objectives are identified (listed). Project ideas may come
from:
 New experiments from previous project failures
 New experiments from expansion
 Replication of successful project tested elsewhere
 New experiments from shortages or excess of resources
 External threats
 Opportunities
 Internal strengths and/or weaknesses
 Other sources
Project identification is also concerned with elimination of inferior alternatives (projects)

from the identified ones. The output of this stage is project that is prima-facie (at first
sight or based on first impression) promising and further work is justified. Chapter three
will present pre-feasibility study in more detail.
2. Project preparation
Project preparation is the most important stage in project planning. Project preparation
stage, also called feasibility study, is concerned with the detailed study of all aspects of
the projects. Project feasibility study is the center of this course and will be explored in
detail in chapter four to seven.
3. Project Appraisal
Appraisal is the comprehensive and systematic assessment of all aspects of the proposed
project. The project is reviewed (appraised) to confirm that it accords with the broad
objectives. It is to ensure that the project represents a high priority use of the firm’s
resources. What aspects of the project should be appraised? The project is appraised from
different perspectives: technical, commercial (market), financial, economic and
ecological.
4. Project implementation
It is the stage at which the conclusions are reached & decisions made are put into action.
What activities should be done during project implementation? Some of the major
activities in during project implementation phase include:
 Detailed designs and specifications are drawn;
 Tender documents are prepared;
 Bids are invited and evaluated,
 Orders for imputes are placed;
 Contracts are signed; workers are hired, trained and put to work;
 Materials are moved to sites etc.
5. Project Evaluation
What is the major focus of project evaluation phase? Where it begins? Implementation
phase is followed by supervision and follow up. The execution of the project should be
supervised closely and progress should be reported regularly to ensure that the
implementation is progressing without deviating from the envisaged path and the
objectives of the project have been reached. Project evaluation is a monitoring (checking)
activity in order to:
 Find out how things are going
 Encourage the project team
 Check that promised resources are in fact working on project tasks
 Rapidly learn about concerns and difficulties
 Show concern for the success of the project
 Take corrective action if things go wrong
Check Your Progress 2-1

1. Define the term project cycle
2. What are the main features of project cycle?
3. What are the primary preoccupations of the analysis in project cycle?
4. Mention the five stages in project cycle according to World Bank.
5. From the following stages of Baum project cycle, match the appropriate stage
with the statements described below:
Project identification Project appraisal Project evaluation
Project preparation Project implementation
a. Pre-feasibility study
b. Identify projects that are expected to contribute toward achieving firm objectives
c. Concerned with the detailed study of all aspects of the project.
d. Concerned with elimination of inferior projects
e. Results in projects that are prima-facie promising.
f. The comprehensive and systematic assessment of all aspects of the proposed
project.
g. Review the project to confirm that it is in line with the broad objectives.
h. Detailed designs and specifications are drawn
i. Ensure that project implementation is progressing without deviating from the
envisaged objectives
2.4. PROJECT LIFE CYCLE – UNIDO APPROACH
According to UNIDO, project cycle involves three major phases. These are:
1. Pre-investment phase
2. Investment phase (Implementation phase)
3. Operation phase (operation and ex-post evaluation)
Each of the above stages (phases) will be explained in the section that follows:
2.4.1 Pre-investment phase

The pre-investment phase includes four major activities; namely, project identification,
pre–selection, project preparation, and appraisal.
Project Identification / opportunity study/

Opportunity study is the main instrument used to quantity the parameters, information
and data required to develop a project idea in to a proposal. What aspects of the project
should be analyzed in opportunity study? In opportunity study, the firm is required to
analysis the following:
 Availability of resources
 Future demand for goods, increasing population and increasing purchasing
power.
 Import and export substitutions
 Environmental impact
 Success of similar projects elsewhere
 Possible inter-linkage with other industries
 Expansion through backward linkages (Backward integration) and forward
linkages (Forward integration)
 Industrial policies of the government
 General investment climate of the country
 Export potentials
 Availability and cost of production
 Etc
Generally, opportunity studies can be categorized in to Area studies, Industry studies, and
Resource based studies.
Pre-selection /pre-feasibility study/

This phase involves the analysis of the following factors:
1. Examination (investigation) of all possible project alternatives
2. Ensure that the detailed analysis of the project is justified.
3. In-depth investigation of critical areas of the project
4. Examine the attractiveness (viability) of the project
5. Investigate the stability of the environmental situation at the location site
The above analyses are based on guess-estimated data.
Preparation (feasibility study)

The projects justified by pre-feasibility study enter this phase for detailed analysis based
on investigated efforts than on guess-estimated. This stage provides all data, define, and
critically examine the commercial, technical, financial, economic, and environmental
aspects for each projects. In feasibility study phase, window dressing approach should be
avoided. What should be the major components of feasibility study?
The components of feasibility study are:

1. Project Background and history
 Name and address of the promoter
 Project Background
 Project objectives
 Outline of the proposed basic project strategies
 Project location
 Economic and industrial policies supporting the project
2. Summary of market analysis and marketing concepts (will be explored in detail in
Chapter four)
3. Raw materials and supplies (see chapter 5)
4. Location, site, and environment (see chapter 5)
5. Engineering and Technology (see chapter 5)
6. Organization and Management (see chapter 6)
7. Implementation planning & budgeting (see chapter 6)
8. Financial Analysis and investment appraisal (see chapter 7)
After the three phases (opportunity study, pre- feasibility, and feasibility study), the
supporting data should fulfill the following minimum reliability standards.
Feasibility study
Pre – feasibility study
Opportunity study
30% -20% 10% 0 10% 20% 30%
The above figure is interpreted as follows:

i. After opportunity studies, the project should be reliable about 70% for
implementation
ii. The project should be reliable about 80% for implementation after pre- feasibility
studies
iii. After feasibility studies, the project should be about 90% reliable for
implementation.
Project Appraisal
After feasibility studies are completed, the projects should be presented to the appraising
parties. The appraisal of project is based on the objectives set earlier, the expected risk,
costs, and gains. The quality of feasibility studies makes easier the appraisal work. If the
objective of the appraiser is Return on investment, the project is appraised on this base.
Types of decisions to be taken during each pre-investment phases
Decision Type of study Decision goal

Identification Opportunity studies  Identify opportunity
 Determine critical areas for support
studies
 Determine area for pre-feasibility or
feasibility study.
Pre-selection Support study Determine which of the possible choices
is the most viable
Pre- feasibility study  Determine provisional viability of
the project
 Appraise whether the feasibility
study should be launched.
Support studies Investigate in detail selected criteria
requiring in-depth study
Final analysis  Make the final choices of project
characteristics
Feasibility study  Determine the feasibility of the
project and selected criteria
Project evaluation Evaluation study Make final investment decision
Project Appraisal Appraisal report
2.4.2. Investment Phase

The investment phase, also called implementation phase, includes the following
activities:
1. Establish legal, financial and organizational basis
2. Technology acquisition and transfer
3. Detailed engineering, design, contracting, tending & negotiations.
4. Acquisition of land, construction works, and installations
5. Pre- production marketing, securing of supplies, and setting up administration.
6. Recruitment, training, and placement of workers.
7. Plant commissioning and startup
2.4.3. Operating phase

Once activities listed under investment phase are completed, the project will go in to
actual operation. The operation involves producing the envisaged goods, and sale to the
target market, or renders the envisaged service to the target market. The project also
requires evaluation, which deals with the review of whether the project is being
implemented as per expectation. The necessary corrective actions should also be taken if
deviation is identified.

1. Mention the three major phases in project cycle as per UNIDO
2. Mention at least five potential areas for opportunity study
3. Opportunity studies can be categorized into three. What are they?
4. What major things should be analyzed during UNIDO’s pre-feasibility studies?
5. What is the decision goal of UNIDO’s pre-feasibility study?
6. What is the decision goal of UNIDO’s feasibility study?
7. What is the reliability level of project for implementation after opportunity study?
After pre-feasibility study? After feasibility study?
8. What are the criteria against which the project is appraised according to UNIDO?
9. Which UNIDO’s project phase corresponds the implementation phase of Baum?
Check Your Progress 2 -3
Case Question
Assume that you have been working in a given private enterprise for the last l0 years.
Assume further that you have been saving Br. 1000 monthly from your salary over 10
years (a total of Br. 140,000). You are considering operating your own business.
a). Identify four possible investment projects.
b). Describe what you should do after you identified the projects until the project(s) is
(are) implemented?
2.5. SUMMARY
Project life cycle refers to the life cycle through which a project advances from infancy to
maturity. The main features of the project life cycle are information gathering, analysis,
and decision-making. There are several approaches to describing project life cycle.
The two common approaches are Baum project life cycle and UNIDO project life
cycle. According to Baum (World Bank, project life cycle involves five stages: Project
identification, project preparation, project appraisal, project implementation, and project
evaluation. On the other hand, UNIDO classifies project life cycle in to three main
phases. These are the pre-investment phase (project identification, pre-selection, project
preparation, and appraisal), investment phases (implementation phase0, and operation
phase.
CYP 2-1
1. Project cycle refers to the life cycle through which the project advances from
infancy to maturity
2. Information gathering, analysis, and decision-making
3. Consider the alternatives, evaluate the alternatives and making sound decisions
4. Identification, preparation, appraisal, implementation and evaluation.
5. a) Project identification
b) Project identification
c) Project preparation
d) Project identification
e) Project identification
f) Project Appraisal
g) Project Appraisal
h) Project implementation
i) Project evaluation
CYP 2-2
1. Pre-investment, investment, and operating phases
2. The possible potential areas for opportunity study include
 Resource availability
 Product/service demand
 Population increase
 Government investment policies and investment climate
 Cost of production
3. Area studies, industry studies, resource – based studies
4. Possible project alternatives
 Critical areas of the project
 Attractiveness of the project
 Suitability of environmental situation
 Whether the project can be further studied.
5. Determine provisional viability of the project and appraise whether the feasibility
study can be launched.
6. Make the final choices of project characteristics and determine the viability of the
project and selected criteria
7. After opportunity study - 70%
After pre-feasibility study – 80%
After feasibility study - 90%
8. The criteria against which the project is appraised include:
 Objectives originally set by the firm
 Expected risk
 Costs
 Gains
 Return on Investments (ROI)
9. Investment phase
UNIT 3: PROJECT IDENTIFICATION
Contents
3.1 Introduction
3.2 Generation of Project Ideas
3.3 Monitoring the Environment
3.4 Corporate Appraisal
3.5 Profit Potential of the Industry/Industry Analysis
3.6 Scouting for Project Ideas
3.7 Preliminary Screening
3.8 Project Rating Index
3.9 Being an Entrepreneur
3.10 Managing Risks
3.11 Summary
After completing this unit, you will be able to:

 describe the different stages in identifying and screening investments (projects);
 understand the need for generating project ideas;
 understand how to stimulate the flow of project ideas;
 explain the importance of monitoring the environment in generating project
ideas;
 list factors to be considered in environmental analysis, corporate analysis, and
industry analysis;
 explain the competitive forces that affect the profit potential of the industry;
 identify the possible sources of project ideas;
 understand the factors that are considered in projects’ preliminary screening; and
 use project-rating index to screen the project.
3.1 INTRODUCTION
The identification of promising project ideas is the first step towards establishing a
successful venture. It is also the beginning of the mobilization of investment funds.
The identification of opportunities for project (investments) requires an understand of the

environment in which one operates, sensitive to emerging investment possibilities,
imaginative analysis of tangible and intangible factors, and also an element of luck. The
task is partly structured and partly unstructured; partly dependent on convergent thinking
and partly on divergent thinking; partly requiring objective analysis of quantifiable
information, partly requiring subjective evaluation of qualitative factors; and partly
amenable to control, partly dependent on fortuitous circumstances.
The task (objective) of identification stage is to identify investment opportunities, which

are feasible and promising and which deserve further in-depth study and appraisal. To
briefly discuss the identification stage, the following points are explored.
 Generation of ideas  Preliminary screening
 Monitoring the environment  Project rating index
 Corporate appraisal  Being an entrepreneur
 Scouting for project ideas
3.2 GENERATION OF PROJECT IDEAS
‘Necessity is the mother of invention’ sounds rhythmic with projects, as they are roots of
needs and wants. These needs may be social, political, economic, commercial, technical
or environmental that drives the actions of entrepreneurs to pursue some creative actions.
That is project ideas are generated in order to satisfy the needs and wants. These actions
will impact both the macro and micro perspective of mankind.
Stimulating the flow of ideas:

Most organizations adopt a causal and haphazard approach to the generation of ideas. To
stimulate the flow of ideas, the following are helpful:
a. SWOT Analysis – SWOT stands for strength, weakness, opportunities and threats.
SWOT analysis represents a conscious, deliberate and systematic effort by an
organization to identify their internal strengths and weaknesses and the opportunities and
threats in the environment. This analysis helps to identify opportunities that can be
profitably exploited by the organization in light of its strength and weakness. Thus,
periodic SWOT analysis facilitates the generation of ideas.
b. Clear articulation of objectives – A clear articulation and prioritization of objectives

of an organization helps in canalizing the efforts of employees and helps them to think
more imaginatively.
The operational objectives of the firm may include

1. Cost reduction
2. Productivity improvements
3. Increase in capacity utilization
4. Improvement in contribution margin
5. Expansion into promising fields
c. Fostering a conductive climate – To tap the creativity of people and to harness their
entrepreneurial urges, a conducive organizational climate has to be fostered.
3.3 MONITORING THE ENVIRONMENT
Basically a provision investment idea enables a firm (or entrepreneur) to exploit

opportunities in the environment by drawing on its competitive strengths or to minimize
the external threats Hence, the firm must systematically monitor the environment and
assess its competitive abilities. The business environment consists of all those aspects and
forces in the surroundings of business enterprises under which business operations are to
be carried out effectively and efficiently. Business external environment can broadly be
divided in to two categories, namely:
1. Macro – external environment, and
2. Micro – external environment
Macro – external environment

The macro environment (which include the economic, political and legal, social and
cultural, and technological forces) and its important aspects studied in monitoring
consists of the following:
Economic sector - State of the economy
- Overall rate of growth
- The growth rate of primary, secondary and tertiary sectors.
- Projected national income trends, GNP trends
- Projected industry output, projected price movements
- Trends in fiscal, credit and monetary policies
- Cyclical fluctuation of the economy
- Corporate taxation and incentives
- Provisions of infrastructure
- Inflation rate, interest rate, exchange rate
- Unemployment level
- Linkage with the world economy
- Balance of payment (trade surplus/deficit)
- Budget deficit/surplus
Governmental (political - Manifestoes of party in power and the opposition
and legal) sector - Attitude towards investors
- Restrictions on areas of investment by private sector
- Restrictions on imports
- Industry policy
- Import and export policies
- International trade regulation
- Government programs and projects
- Tax framework
- Subsidies, incentives
- Financing norms
- Lending conditions of financial institutions and commercial
banks
- Environmental protection laws
- Control over prices and distribution of goods
Technological sector - Emergence of new technologies
- Access to technical know-how, foreign as well as indigenous
- Transport
- Product processing
- Use of computers and other automations
- Receptiveness on the part of the industry
Social and cultural - Population trends, shift in population among regions
sector - Age shifts in population
- Educational profile
- Employment of women
- Attitude towards consumption and investment
- Changes in ethnic composition
- Customs, beliefs and values
Micro – External environment

The micro external environment is also known as Task environment. The micro –
external environment is mainly concerned with industry, market, competitors, etc. and the
major factors to be studied consists of:
Competition sector (analysis of - Number of firms in the industry and the market
the industry and the market) share of the top few
- Degree of homogeneity and differentiation
among products
- Exit and Entry barriers
- Comparisons with substitutes in terms of quality,
price and functional performance
- Marketing policies and practices
- Capacity utilization
- Product life cycle
- Foreign opportunities
Supplier sector - Availability and cost of raw materials and sub-

assemblies
- Availability and cost of energy
- Availability and cost of money
- Exit and entry of suppliers
- Power of suppliers

1. Project ideas are generated in order to satisfy the needs and wants. (True/False)
2. What should entrepreneurs do to generate ideas?
3. Mention the major macro-environmental factors that may provide opportunities or
threats.
4. Indicate the major micro-external factors that may provide opportunities or threats
5. Mention at least three operational objectives of the firm that guide project ideas.
3.4 CORPORATE APPRAISAL
A realistic appraisal of corporate strengths and weakness is essential for identifying

investment opportunities, which can be profitably exploited. The broad areas of corporate
appraisal and the important aspects to be considered under them are as follows:
Corporate resource and personnel:

Market and distribution:
 Corporate image
 Market image
 Clout with governmental and regulatory
 Product line
agencies
 Market share
 Dynamism of top management
 Competence and commitment of employees
 State of industrial relations
 Distribution network
 Customer loyalty
 Marketing and distribution costs
Production and operations:
Finance and accounting:
 Conditions and capacity of plant and
 Financial leverage and
machinery
borrowing capacity
 Availability of raw materials,
 Cost of capital
sub-assemblies and power
 Tax situation
 Degree of vertical integration
 Relations with shareholders and
 Locational advantages
creditors
 Cost structure
 Accounting and control system
Research and development:
 Cash flow and liquidity
 Research capability of the firm
 Track record of new product development
 Laboratories and testing facilities
 Coordination between research and operation
3.5 PROFIT POTENTIAL OF THE INDUSTRY/INDUSTRY ANALYSIS
Michael porter has argued that the profit potential of an industry depends on the
combined strength of the following five basic competitive forces:
1. Threat of new entrants
2. Rivalry among existing firms
3. Pressure from substitute products
4. Bargaining power of buyers
5. Bargaining power of sellers/suppliers
These five forces are depicted in the following diagram.
Potential
Entrants
Threats of
new
entrants
Bargainin Bargainin
The Industry:
g power Rivalry among g power Buyers
Suppliers existing firms
of of Buyers
Threats of
substitute
products
Substitutes
Each of the above forces will be explained in the section that follows:
1. Threat of New Entrants

If an industry faces the threat of new entrants, its profit potential would be limited. New
entrants have the following effects on the industry:
- Add (increase) capacity
- Inflate costs
- Push prices down
- Reduce profitability
The entry barriers may limit the number of new entrants and the effect as well. If it is not
easier to entry an industry, the threat from new entrants is low. Entry barriers are high
when:
a) Entrance requires substantial resources to invest
b) Economies of scale are enjoyed by the industry
c) Control of the distribution channels by existing firms
d) Product differentiation by existing firms in the form of brand image and
customer loyalty
e) High switching costs
f) The government policy may limit or even prevent new entrants.
2. Rivalry between Existing Firms

There could be stiff competition among existing firms in terms of price, quality,
promotion, service, warranties, and so on. This is the case when one firm attempts to
improve its competitive position, other firm may take counter action. Strong completion
in the industry reduces the average profitability of the industry. The intensity of rivalry in
an industry tends to be high when:
 The number of competitors in the industry is large
 The level of fixed costs is high
 There is chronic over capacity in the industry
 The industry’s product is regarded as a commodity or near – commodity
 The industry confronts high exist barriers.
3. Pressure from substitute products

Substitute products are those products that perform the same function as the original
products. Substitute products may limit the profit potential of the industry by imposing a
ceiling on the prices that can be charged by the firms in the industry. The threat from
substitute products is high when:
- the price-performance trade-off offered by the substitute products is attractive
- the switching costs for prospective buyers are minimal
- the substitute products are being produced by industries earning superior profits
4. Bargaining power of buyers

Buyers, the competitive force, can bargain for price reduction, ask for superior quality
and better service, and induce rivalry among competitors. Buyers have high bargaining
power when:
- the purchase is large
- switching costs are low
- it poses a strong threat of backward integration.
5. Bargaining power of suppliers

Like buyers, suppliers can exert a competitive force in an industry because they can
increase material prices, lower quality and reduce the range of services that they provide.
Powerful suppliers can reduce the profitability of the buyer’s industry. Suppliers have
strong bargaining power when:
- few suppliers dominate
- the supplier group is more concentrated than the buyer group
- there are hardly any viable substitutes for the products supplied
- the switching costs for the buyers are high
- their strong threat for forward integration

1. What is the role of SWOT analysis in project idea generation?
2. What important aspects of the firm are appraised in order to identify internal
strengths and weaknesses?
3. What are the five basic competitive forces in the industry according to Porter?
4. The higher the threat of new entrants in to the industry, the greater the possibility
that industry’s profit margin increases. (True/False)
5. How new entrants affect the industry?
3.6 SCOUTING FOR PROJECT IDEAS
Good project ideas – the key to success – are elusive. So a wide variety of sources should
be tapped to identify them. Here are some suggestions in this regard.
 Analyze the performance of existing industries
 Examine the inputs and outputs of various industries
 Analyze possible extension of existing lines of manufacture by backward or
forward integration linking
 Analyze inter-linkage with other industries, indigenous or transnational
 Review import and exports
 Study plan outlays and governmental guidelines
 Look at the suggestions of financial institutions and developmental agencies
 Investigate local materials and resources
 Analyze economic and social trends
 Study new technological developments
 Draw clues from consumption abroad
 Analyze sectors successful in other countries with similar economic background
and levels of development, capital, labour and natural resources.
 Study new technological developments
 Explore the possibility of reviving sick units
 Identify unfulfilled psychological needs
 Attend trade fairs
 Hope that the chance factor will favor you
 Brain storming
3.7 PRELIMINARY SCREENING
By using the suggestions made in the preceding sections, it is possible to develop a long
list of project ideas. Some kind of preliminary screening is required to eliminate ideas
which are not promising. For this purpose, the following aspects may be looked in to:
 Compatibility with the promoter’s objectives
 Consistency with governmental priorities
 Availability of inputs
 Adequacy of market
 Reasonableness of cost
 Acceptability of risk level
Project preliminary screening is like pouring all the ideas into a filtering funnel. In the
first instance, all possible project ideas are listed (identified). Then some of them are
eliminated and few projects are screened for further analysis. After detailed study of few
limited projects, one project will be selected at the end.
3.8 PROJECT RATING INDEX
When a firm evaluates a large number of project ideas regularly, it may be helpful to
streamline the process of preliminary screening. For this purpose, a preliminary
evaluation may be translated into a project rating index. The steps involved in
determining the project rating index are as follows:
1. Identify factors relevant for the project rating
2. Assign weights to these factors (the weights are supposed to reflect their relative
importance)
3. Rate the project proposal on various factors, using a suitable rating scale.
(Typically a 5-point or a 7-point scale is used for this purpose.
4. For each factor, multiply the factor rating with the factor weight to get the factor
score.
5. Add all the factor scores to get the overall project rating index.
Example of project rating index
Assume that the following factors are identified to be relevant for project rating
Factors Factor weight
- Technical know-how 0.20
- Input availability 0.15
- Reasonableness of cost 0.20
- Adequacy of market 0.05
- Stability 0.10
- Dependence of firm’s strength 0.20
- Consistency with government priorities 0.10
If the firm uses five rating scale, determine the rating index for the project
Factor Factor Rating Factor
weight 5 4 3 2 Score
1
Technical know-how 0.20  0.80
Input Availability 0.15  0.45
Reasonableness of costs 0.20  1.00
Adequacy of market 0.05  0.20
Stability 0.10  0.50
Dependence of firm’s strength 0.20  0.40
Consistency with gov’t priorities 0.10  0.50
Rating index 3.85
What is the purpose of rating index? Project rating index enables to identify (from the
list) the project(s) that can be studied further in detail. If the policy of the firm is to
further study the projects whose rating index is 3.50 and above, the above project will
enter the next phase of the project.
3.9 BEING AN ENTREPRENEUR
What qualities and traits are required to be a successful entrepreneur? While it is difficult
to answer this question definitively, it appears that a successful entrepreneur has the
following qualities and traits:
 Willingness to make scarifies
 Leadership
 Decisiveness
 Confidence in the project
 Marketing orientation
 Strong ego

1. What major factors are considered in preliminary screening of project ideas?
2. What are the qualities of successful entrepreneurs?
3. Describe the procedures in project rating index?
3.10 MANAGING RISK
Risk is an inherent property of any change activity and is considered exclusively as a
future phenomenon. Risks may happen in project work but it is very difficult to write
down any specific universal rules for managing all risks. Risk management, however, is
important because it enables to minimize or even avoid the ‘show-stoppers’ that can cost
huge money to correct. Besides, risk management is important for the following:
 Predict the serious threats to the project before they happen

 Enable mitigation actions to be implemented immediately
 Enable contingency plans to be derived in advance
 Improve decision making in managing the project portfolio
 Help to create a ‘no surprise’ environment for the project
Risk management of a project is not a utility; it is a vital and fundamental part of the
project management process that impacts the probability of success.
3.10.1 Project Constraints and Risk

Constraints are those things that are imposed on the project knowingly or unknowingly.
The project has three major constraints; namely,
1. Cost. It refers to the overall cost of the work
2. Schedule. It refers to the time the project will take
3. Scope. It refers to the project deliverables or outputs and the quality of the work.
Project constraints and project risks are not the same. Constraints exist throughout the
project life. The project will be operated under these constraints.
3.10.2. The Risk Management Process

The identification and management of risk involves several phases. These phases are
described below:
1. Identifying Risk. Risk identification is the first step in risk management process.
The approaches to risk identification process include:
 Brainstorming session
 Checklists developed from data generated from past projects
2. Assessing the Risks. All projects have risks at the outset because of the many
unknown factors. Risks may disappear and new risks appear as the project
progresses. Risk assessment requires answers to the following questions:
o What exactly is the risk?
o How serious it is as a threat to the project?
o What could be done to minimize its impact on projects success?
For each risk an attempt should be made to establish the following two
characteristics:
a. What is the probability of it happening? The probability of occurrence is on a
scale of 1 to 9. 1 is low which means most unlikely to happen whereas 9 is
high which means very high probability it will happen.
b. What is the likely impact on the project if it happens? The impact on the
project could be high, medium or low. High impact means the risk has
significant effect on the schedule and project costs. If the impact is medium,
the risk has less serious effect on the schedule and some effect on costs. If the
impact is low, the risk has some effect on schedule and little effect on costs.
3. Ranking of Risks. The ranking of risk is based on the impact and probability of
occurrence. Risks can be ranked using either a qualitative or quantitative
approach. The approach used should rank the risk as high risk, medium risk, and
low risk.
4. Record the ranking on project risk log and derive action plan. All the risks
must be recorded in the project risk log. To derive action plan, the following
should be recorded:
 A Short description of the risk;
 When t is expected to occur;
 The probability assessed;
 What consequences are expected;
 What actions will be taken if it happens
 Who will take the actions
 Who is responsible for monitoring the risk
5. Monitoring Risks. Once risks to the project have been identified and action plans
derived, then these must be monitored to make sure that prompt action is taken
when appropriate. Risks change with time so careful monitoring is essential as the
project proceeds, achieving success is dependent on effective risk monitoring.
3.11 SUMMARY
The identification of promising project ideas is the first step towards establishing a
successful project. In order to generate ideas, the following are important. (1) Conduct
SWOT analysis (2) clear articulation of objectives (3) fostering a conducive environment.
SWOT analysis involves the study of internal strengths and weaknesses, on one hand,
and the study of external threats and opportunities. The internal analysis, also called
corporate appraisal, involves the study of the firm’s market and distribution, resources,
production and operations, research and developments, and accounting and finance.
SWOT analysis is also concerned with industry analysis, which is studied in terms of the
threats of new entrants, rivalry among existing firms, pressure from substitute products,
bargaining power of buyers, and bargaining power of sellers. SWOT analysis also deals
with monitoring of other external environments in terms of economic, legal and political,
social, cultural, and technological forces. The purpose of conducting SWOT analysis is to
generate new project ideas.
At first glance, all project ideas are listed down. Since all of them cannot be pursued,
preliminary screening should be performed to eliminate project ideas that are not
promising. Aspects that can be considered in preliminary screening are compatibility with
the promoter’s objectives, consistency with government priorities, availability of inputs,
adequacy of market, reasonableness of costs, and acceptability of risk level. In
preliminary screening of project ideas, project-rating index may be used.
CYP 3.1
1. True
2. Conduct SWOT analysis, clearly articulate the objectives, and foster a conducive
climate for people
3. Economic factors, political factors, legal factors, social and cultural factors,
technological factors etc.
4. Industry, market, competitors, suppliers etc.
5. Cost reduction, productivity improvements, increase in capacity utilization,
improve contribution margin, or expansion
CYP 3.2
1. SWOT analysis deals with identifying internal strengths and weaknesses and
external threats and opportunities. The strength, weaknesses, threats or
opportunities may be the sources of new project ideas
2. Market and distribution, production, research and development, resources and
personnel, and finance and accounting.
3. Rivalry among existing firms, threat of new entrants, bargaining power of buyers,
bargaining power of suppliers, and threat of substitute products.
4. False
5. By increasing capacity, inflate costs, decrease prices, and reduce profitability.
CYP 3.3
1. - Compatibility with the promoter
- Consistency with governmental priorities
- Availability of inputs
- Adequacy of market
- Reasonableness of costs
- Acceptability of risk level
2. - Willingness to make sacrifices
- Leadership
- Decisiveness
- Confidence in the project
- Marketing orientation
- Strong ego
3. - Identify factors that are most relevant
- Assign weight to each factor (Factor weight)
- Rate the project on factors identified earlier using the rating scale
- Multiply the factor weight by factor rating
- Determine the rating index by adding the product of factor weight and rating
scale.
UNIT 4: MARKET AND DEMAND ANALYSIS

Contents
4.1 Introduction
4.2 Objectives of Market Analysis
4.3 Marketing Elements
4.4 Situational Analysis and Specification of Objectives
4.5 Collection of Information
4.6 Characterization of the Market
4.7 Demand Forecasting Methods
4.8 Summary

 understand the objective of market analysis;
 explain the major elements of marketing;
 describe the dimensions of market strategy;
 explain the operating dimensions of marketing;
 understand the role of marketing research in demand analysis;
 apply the basic steps of marketing research in demand forecasting;
 list out the demand forecasting techniques; and
 forecast demand-using demand forecasting techniques, such as moving average
method, trend projection method, exponential smoothing and the like.
4.1 INTRODUCTION
Very often project analysis begins with the estimate of the potential size of the market for
the product proposed to be manufactured or service planned to be offered and get an idea
about the market share that is likely to be captured. These are very important issue in
project analysis. Market and demand analysis aims at determining the aggregate demand
for the product/service and the market share of the proposed project. Traditionally
entrepreneurs try to make the statement that “the market is attractive”. This is simply the
expectation of the investors, but it is misleading. Formal thorough market and demand
analysis increases the project’s probability for success if it is done in an orderly and
systematic manner. This unit deals with the practice of forecasting demand for the
proposed project. More specifically, it deals with:
- objectives of market analysis
- the marketing elements
- situational analysis
- collection of information
- characterization of the market
- demand forecasting techniques
4.2 OBJECTIVES OF MARKET ANALYSIS
Market and demand analysis is a key activity for determining the scope of an investment,
the possible production programme, the technology required, and the choice of location.
What are the objectives of market and demand analysis? The objectives of demand and
marketing analysis are:
i. To determine the effective demand for the envisaged (proposed) project
ii. To determine the characteristics of the corresponding market in terms of
unsatisfied demand, competition, imports, exports etc.
4.3 MARKETING ELEMENTS
What is marketing? What are the elements of marketing? Marketing is defined as a

managerial and social process by which individuals, and groups obtain what they need
and want through creating, offering and exchanging products of value with others.
Marketing is characterized by the following elements:
a) Business philosophy
Marketing puts the problems, needs, and desires of the existing or potential consumer
groups at the center of business activities of the firm.
b) Marketing research
Market orientation of project preparation considers both demand market and supply
market. Marketing research provides information to develop marketing strategies.
c) Marketing instruments
The successful implementation of marketing strategies requires shaping and influencing
the market in a well-planned manner, using the necessary combination or mix of
marketing instruments.
d) Marketing plan and budget

Based on the findings of market research, it is necessary to determine the required means
and to prepare plans of actions in achieving marketing objectives.

1. Why market and demand analysis is considered the key activity in project?
2. What are the objectives of market and demand analysis?
3. Mention the four elements of marketing
4. What is the role of marketing research in market and demand analysis?
4.4 SITUATIONAL ANALYSIS AND SPECIFICATION OF OBJECTIVES
The project analyst should be able to establish the relationship between the product and
its market. To do so, she/he may informally talk to the following parties:
- customers,
- competitors
- middlemen (wholesalers and retailers)
The purpose of contact with the above parties is to learn about the preferences and
purchasing power of customers, actions, and strategies of competitors, and practices of
middlemen. The main benefit of such informal contact is to avoid formal study of the
market if adequate and relevant information is obtained about project demand. If enough
data was not generated at this stage, formal market and demand analysis should be
carried.
4.5 COLLECTION OF INFORMATION
In order to achieve the market and demand analysis objectives, information should be
obtained from various sources. These sources are generally classified into primary
sources and secondary sources.
4.5.1 Sources of Secondary information

Secondary information is information that is gathered in some other context and is
already available. The important sources of secondary information are:
a) Census. The Central Statistical Authority (CSA) gathers and publishes data about
population, demographic characteristics, household size and composition and
other similar data
b) Economic survey
c) Annual reports on imports and exports
d) Industry specific sources
The reliability, accuracy and relevance of a secondary information should be examined
carefully in terms of:
- who gathered the information and the purpose (objective) for which it was
gathered
- the time of information gathering and publication
- the relevance of information gather for the period
- target population
- the means of choosing the sample
- the representativeness of the sample
4.5.2 Primary information/Market survey

Secondary sources may not provide a comprehensive data for market and demand
analysis. Information obtained through secondary sources should be supplemented with
primary information gathered through market survey.
The market survey may be a census, or a sample survey. In a census survey, the entire
population is covered. The term population refers to the totality of all units under
consideration in a specific study.
Example
- All higher private educational institutions
- All firms producing textile
Census survey may involve high cost and insensible. When census survey is impractical
(all elements of the population are not covered), sample survey is more useful.
What kind of information should be gathered through market survey? The following
types of information may be collected through market survey:
- Total demand and rate of growth of demand
- Motives for buying
- Demand in different segments of the market
- Income and price elasticity of demand
- Purchasing plans and intentions
- Satisfaction with existing products
- Unsatisfied needs
- Attitudes towards various products
- Distribution and price practices and preferences
- Socio-economic characteristics of buyers
The steps in sample market survey include:

1. Define the target population
2. selecting the sampling method and sample size
3. Develop the questionnaire
4. Recruit and train the field investigators
5. Obtain information as per the questionnaire from the sample of respondents
6. Secnitinize the information gathered
7. Analyze and interpret the information
4.6 CHARACTERIZATION OF THE MARKET
Market characterization involves describing the market for product/service in terms of the
following factors:
- effective demand in the past and present
- breakdown of demand/segmentation
- price
- methods of distribution
- promotion
- consumers
- supply and competition
- government policy
4.6.1 Effective Demand in the Past and Present

In order to gauge (measure) the effective demand in the past and present, apparent
consumption can serve as the starting point. Apparent consumption can be computed as
follows:
Consumption = P + I – E – CSL
where
P = production
I = Imports
E = Exports
CSL = Changes in stock level, usually increase in stock. The figure of apparent
consumption has to be adjusted for consumption of the product by the producers and the
effect of abnormal factors. After such adjustments, the consumption series may be
obtained for several years.
Generally, effective demand and apparent consumption are equal in a competitive

market. However, due to exchange restrictions and controls on production and
distributions, competitive markets do not existing in most developing countries. As a
result, the figure of apparent consumption should be adjusted for market imperfections,
but difficult to do so.
4.6.2 Breakdown of Demand/Market Segmentation

The total (aggregate) demand for the product may be broken down into demand for
segments of the market. What is market segment? What factors are considered in
segmenting the market? Why market is segmented?
Market segmentation is defined as the dividing of the target market into subgroups of
consumer population with identifiable, distinct and homogeneous characteristics. (Philip
Kotler, 1999). The main reasons of market segmentation are:
- efficient use of marketing resources
- better understanding of customer needs
- better understanding of the competitive situation
- accurate measurement of goals and performance
- formulate marketing programs and strategies
- Design marketing mix (i.e., product, price, place, and promotion).
- Pay proper attention to particular area
Market is segmented on varies bases. Some of the most common bases are:
- Geographic segmentation – divide the market into different geographic units such
as western, eastern, northern, southern, central etc.
- Demographic segmentation – divide the market on the basis of age, sex, family
size, marital status, language, religion and so on
- Socio-economic segmentation – divide the market on the basis of income levels,
consumption levels, caste level (exclusive social class), culture and the like
- Psychographics segmentation – divide the market based on how consumers think,
feel, and behave
- Buyer behavior segmentation – divide the market based on customers knowledge,
attitudes, rules, or responses to a product.
4.6.3 Price
Price represents the value of a good or service for both the buyer and the seller. Price is
the only element in the marketing mix which generates revenues. Price may also be
defined as the value of product attributes expressed in monetary terms which a consumer
pays or is expected to pay in exchange and anticipation of the expected utility.
What factors affect the firm’s pricing decisions? Factors which affect the pricing
decisions are both internal and external. External factors that affect pricing decisions
include:
- Demand for the product/service
- Competition
- Consumer’s quality perceptions
- Middlemen (distributors, detailers etc)
- Suppliers
- Government
- Economic conditions
- Ethical considerations
- Cost of materials and labor (or cost of inputs)
Internal factors that affect pricing decisions include:

- Organizational factors
- Marketing mix
- Product differentiation (different product attributes such as color, size, attractive
package, attractive uses, style etc).
- Cost of products
- Objective of the firm
What pricing strategy the firm may follow?

A firm that is planning to introduce new product may follow any one of the following
pricing strategy:
a) Market skimming pricing
It is the approach of setting a relatively high initial price for a new product.
b) Market penetration pricing

It is the strategy of setting a relatively low initial price for new product.
During market and demand analysis, the price statistics must be gathered along with
statistics concerning physical quantities. It may be helpful to distinguish the following
types of prices:
- manufacturer’s price quoted as FOB (Free-on-Board) price or CIF (Cost,
insurance, and freight) price
- Landed price for imported goods
- Average wholesale price
- Average Retail price
4.6.4 Distribution
The methods of distributing a product/service vary with the nature of the product. The
typical geographic separation of the manufacturer or producer from the ultimate
consumer requires some means for bridging the gap between the producer and the
customers: what are the major components of the distribution system? Distribution
system has two components; namely, channels of distribution, and physical distribution.
Channels of distribution refer to intermediaries or the process through which the products
are transferred from the producers to the ultimate users. Channels include wholesales,
retailers, dealers, agents and other parties involved in transferring the product or service
to the consumers.
On the other hand, physical distribution is concerned with the flow of goods to the
ultimate consumers. Physical distribution includes transportation, warehousing, and
inventory management.
Therefore, the methods of distribution (channels and physical distribution) employed

presently and their rationale must be specified during market and demand analysis. Such
a study may explain certain patterns of consumption and highlights and difficulties that
may be encountered in marketing the proposed products.
4.6.5 Promotion
In marketing, the word “promotion” is used in many ways. In general sense, promotion is
defined as “any identifiable activities (efforts) on the parts of the seller to persuade
buyers to accept the seller’s information and store it in retrievable form”. The
promotional function of any organization involves the transmission of message to
present, past, and potential customers.
Who is the target in promotion? How is promotion carried? What are the objectives of
promotion?
Personal
selling
Publicity Target
Advertising custome
r
Public relations Sales

promotion
The above diagram shows who the target for promotion is, and how promotion is carried
out. The target in promotion is customers. Customers may include industries, middlemen,
opinion leaders, and other consumers. The means of promotion are:
a) Personal selling – It involves face-to-face contact between seller’s representative
and the buyer
b) Advertising. It is paid form of non-personal mass media communication by an
identified sponsor. The media may include print media, direct mail, TV, radio,
billboard, Internet etc.
c) Sales Promotion. It includes activities that seek to indirectly induce or indirectly
serve as incentives to motivate a desired response on the part of target customers,
company sales people and middlemen, and their sales force.
d) Publicity. It involves the news carried in the mass media about a firm and its
products, policies, personnel or actions, such as news releases, press conference
etc.
e) Public relations. It is a planned effort by an organization to influence the attitudes
and opinions of a specific group.
The primary objectives of promotion are:
- to develop an awareness of, and an interest in, the organization and its products
and services
- to communicate the benefits of buying product or services
- To influence eventual purchase of the product or service
- To build the positive image of the organization
- To differentiate the product/service from its competitors
- To remind the people of the existence of the product/service and the organization
Therefore, during market and demand analysis, the project studying team should specify
the promotion methods employed presently and their rationale.
4.6.5 Supply and Competition

It is necessary to know the existing sources of supply. The existing sources may be
domestic or foreign. The following information should be gathered for domestic sources
of supply.
- Location
- Present production capacity
- Planned expansion
- Capacity utilization level
- Bottlenecks in production
- Cost structure
The study should also cover competition from substitutes and near-substitute products.
4.6.6 Government Policy

Government may have significant role in influencing the product’s demand and market.
How government affects the demand and market for the product? Governmental plans,
policies and legislations may have bearing on the market and demand of the product.
Some of the areas of influence are:
- production targets in national plans
- trade control on imports and exports
- import duties
- export and import incentives
- excise duties
- taxes
- industrial licensing
- credit controls
- financial regulations
- subsidies or penalties of any kind

1. What is the role of apparent consumption in determining the effective demand?
2. The dividing of the target market into sub groups of consumer population is
__________________.
3. Mention some of the bases of market segmentation.
4. What are the main objectives of market segmentation?
5. Mention at least five external factors that affect pricing decisions.
6. Mention at least four internal factors that affect pricing decisions.
7. What are the possible pricing strategy that can be used by firm considering to
launch new product/service?
8. What are the two major components of product/service distribution?
9. From the following lists, specify whether the item is related to channel of
distribution or physical distribution
a) Transportation
b) Wholesaler
c) Retailer
d) Inventory management
e) Sales agents
f) Consignee
g) Warehousing
10. The effort that involves the transmission of message to present, past, and potential
customers is ________________.
11. Mention the primary means of promotion.
12. In demand and market analysis, the analyst should identify the sources of supply.
What are the possible sources of supply?
13. How do you think the government influences the market and demand of the
product?
4.7 DEMAND FORECASTING METHODS
After gathering information about various aspects of the market and demand from
primary and secondary sources, an attempt is made to estimate future demand. The
market analyst has several methods of forecasting the demand. Generally, these methods
are classified in to qualitative and quantitative methods.
Qualitative methods include:

1. Jury of executive opinion method
2. Delphi method
Quantitative methods include:

1. Trend projection method
2. Exponential smoothing method
3. Moving average method
4. End use (consumption coefficient) method
Each of these methods is explained below:
4.7.1 Qualitative Methods

1. Jury of Executive Opinion Method
This method involves soliciting the opinions of a group of managers on expected future
sales and then combining them into a sales estimate. It is the most popular method used
in practice. Some of the advantages of Jury of Executive Opinion Method are:
- an expeditious method for developing a demand forecast
- enables to consider a variety of factors to be included in the subjective estimates
provided by the experts. These factors include economic climate, competitive
environment, consumer preferences, technological developments and the like.
- Immense appeal to managers who tend to prefer their judgment to mechanistic
forecasting procedures.
The jury of executive opinion method is not without limitations. Some of its limitations
are:
- It involves greater subjective
- Its reliability is questionable
2. Delphi Method
This method is used for eliciting the opinions of a group of experts with the help of a mail
survey. Delphi method involves the following steps:
a) Send a questionnaire to a group of experts by mail asking them to express their
views.
b) The responses received from the experts are summarized without disclosing the
identity of the experts. Then the summary is sent to the experts along with a
questionnaire that helps to probe further the reasons for the extreme views
expressed in the first round.
c) The process may be continued for one or more rounds till a reasonable agreement
emerges in the view of the experts.
Delphi method has got the following advantages:

i. It is intelligible to users
ii. It seems to be more accurate
iii. It seems to be less expensive than the tradition face-to-face group meetings
The limitations of Delphi method are:
- It is difficult to value the expert opinion
- It is not easy to measure the contribution of additional rounds and feedback to
accuracy.
4.7.2 Quantitative Methods

1. Trend projection method (regression analysis) – also called least square method
Demand forecasting by trend projection method involves interrelated steps: These are:
i. Obtain demand data for some past periods, such as 10 years. This involves
determine the trend of consumption by analyzing past consumption statistics
ii. Establish liner relationship using the following formula:
Yt = a + bT
where
Yt = Demand for year t
a = Intercept of the relationship
b = Slope of the relationship
T= Time variable
The values of a and b can be determined using the following formula:
Sxy
b=
Sxx
n
n(n  1) n
Sxy  n iDi   Di
i 1 2 i 1
where
n = No of observation
i = the ith observation
Di = the ith outcome
n 2 (n  1)(2n  1) n 2 (n  1) 2
Sxx  
6 4
b(n  1)
a= D
2
where D = the arithmetic average of the demands during periods 1, 2, … n.
To illustrate demand forecasting using simple regression analysis, consider the following
data concerning demand for product x during the last eight years.
Year Actual demand
1 200
2 250
3 175
4 186
5 225
6 285
7 305
8 190
The linear equation for the above data is formulated as follows: assuming that the base
line is the first five years:
Yt = a + bT
n
n(n  1) n
Sxy  n iDi   Di
i 1 2 i 1
= 5[(200 x 1) + (250 x 2) + (175 x 3) + (186 x 4) + (225 x 5) –

 5(5  1) 
 2  [200 + 250 + 175 + 186 + 225]
5(6)
= 5[200 + 500 + 525 + 744 + 1125] - [1,036]
2
= 5[3094] – 15[1036]
= 15470 – 15,540
= -70
n 2 (n  1)(2n  1) n 2 (n  1) 2
Sxx  
6 4
5 2 (5  1)(2(5)  1) 5 2 (5  1) 2
= 
6 4
25(6)(11) 25(36)
= 
6 4
= 275 – 225
= 50
After Sxy and Sxx are obtained, b can be computed as:
Sxy  70  7
b=  
Sxx 50 5
Then a is computed as:
b(n  1)
a= D
2
200  250  175  186  225
D  207.20
5
7
  5  1 
a = 207.20 -  5 
2
  42 
 
= 207.20 –  5 
 2 
 
 
21
= 207.20 +
5
= 211.40
It follows that the regression equation based on five periods of data is:
7
Yt = 211 .40  T
5
The above regression equation is used to forecast demand from period five to any period
into the future. For example, the demand forecast for period 7 (T = 7) is computed as
follows:
7
Yt = 211.40 - T
5
7
= 211.40 - (7 )
5
49
= 211.40 -
5
1075  49
=
5
1008
=
5
= 201.6
Similarly demand for year 10 (T = 10) is forecasted as follows:
7
Yt = 211.40 - (10)
5
= 211.40 – 14
= 197.4
Alternatively, the values of a and b can be computed as follows:
Yt = a + bT
n TY   T  Y
b= a=  Y  b T
n T    T 
2 2
n
Using the above data, the computations of a and b are as follows:

Year (T) Actual demand (Y) TY T2
1 200 200 1
2 250 500 4
3 175 525 9
4 186 744 16
5 225 1125 25
 = 15  = 1036  = 3094  = 55
n TY   T  Y
b=
n T 2    T 
2
5(3094)  (15 x1036)

=
5(55)  (15) 2
15470  15540
=
275  225
 70
=
50
7
=
5
a=  Y  b T
n
7
1036   15 
=  5 
5
1036    21
=
5
= 211.40
7
Yt = 211.40 - T
5
1. The following data shows monthly demand for the product of top company over the
past nine months.
Month Quantity demand

March 112
April 125
May 120
June 133
July 136
August 146
September 140
October 155
November 152
Required
a) Establish the regression equation
b) Forecast the demand using trend projection method for:
i. December
ii. January
iii. February
2. Assume that the demand for aircraft engines during the six months operations
(January – June) are summarized below:
Month No of engines Months No of engines

January 133 April 640
February 183 May 1876
March 285 June 2550
Required
a) Establish the regression equation
b) Forecast the demand using trend projection method for:
i. July
ii. August
iii. September
2. Exponential smoothing
Exponential smoothing is another very popular demand forecasting method. Under
exponential smoothing, the current forecast is the weighted average of the last forecast
and the current value of demand. That is:
New forecast:  (current observation of demand) + (1-) (last forecast)
In symbols,
Ft = Dt-1 + (1 - ) Ft-1
Where 0 <   1 is the smoothing constant. (alpha) determines the relative weight
placed on the current observation of demand. 1 -  is interpreted as the weight placed on
past observations of demand. D refers to the actual demand of current period (t-1). The
above formula can be rewritten as follows:
Ft = Ft-1 + (Dt-1 – Ft-1)
where
Ft-1 = previous forecast
 = smoothing constant
Ft = New forecast
Dt-1 = the demand for the current period.
From the above description, it is possible to conclude that exponential smoothing method
requires only three items of data: the last period’s forecast, the demand for the current
period, and the smoothing constant ().
To illustrate demand forecasting using exponential smoothing, assume that demand for
product X in April was forecasted to be 120 units (F t-1 = 120). Actual April demand was
140 units (Dt-1 = 140). If smoothing constant is 0.4 ( = 0.40), the forecast for May would
be:
FMay = Ft-1 + (Dt-1 – Ft-1)
= 120 + 0.40 (140 – 120)
= 120 + 8
= 128
Exponential smoothing applies a declining set of weights to all past data. If  is large,
more weight is placed on the current observation of demand and less weight on past
observations. On the other hand, if  is small, then more weight is placed on past data
and the forecasts are more stable. Thus, alpha () indicates the weight of importance
given for past forecasting inaccuracies in forecasting the next time period dictating how
much correction will be made.
To further illustrate exponential smoothing, assume that Grace company has the
following recorded demand for its product Y in the last 8 quarters: The smoothing
constant is 10%.
Quarter Actual demand (D) Forecast (F)
1 200 200 (By assumption)
2 250
3 175
4 186
5 225
6 285
7 305
8 190
The demand forecast for periods 2 – 5 are shown below:
Ft = Ft-1 +  (Dt-1 – Ft-1)
F2 = 200 + 0.10 (200 – 200) = 200
F3 = 200 + 0.10 (250 – 200) 205
F4 = 205 + 0.10 (175 – 205) = 202
F5 = 202 + 0.10 (186 – 202) = 200.4

1. Refer to Grace Company illustration, determine demand forecast from year 6-year 9.
2. Assume that the actual demand and forecast for the month of June 2005 were 100
units and 90 units respectively. The smoothing constant is 0.30. Forecast the demand
of July using exponential smoothing method.
3. Moving Average Method

According to this method, the forecast for the next period is equal to the average of
the sales for several preceding periods.
S t  S t 1  ...  S t b 1
Ft 1 
n
where:
Ft+1 = Forecast for the next period
St = Sales for period t
n = period over which averaging is done
To illustrate, consider the following data for the past 10 years.
Year Sales (Actual)
1 80
2 60
3 70
4 90
5 75
6 100
7 80
8 85
9 60
10 80
If the company uses a four-year moving average, sales forecast for year 5 is:
S1  S 2  S 3  S 4
4
80  60  70  90
F5 = = 75
4
If the company uses a nine-year moving average, sales forecast for the 10th year is:
S1  S 2  S 3  S 4  S 5  S 6  S 7  S 8  S 9
9
80  60  70  90  75  100  80  85  60
F10 =  77.78
9
If the company uses a five-year moving average, the sales forecast for year 11 is:
S 6  S 7  S 8  S 9  S10
5
100  80  85  60  80
F11 =  81
5
To elaborate the above answer (F11 = 81), the sales figure of the last five years (year 6, 7,
8, 9 and 10) are taken to forecast sales of year 11.
If the company uses a five year moving average, what will be sales forecast for year 12
and year 13?
S 7  S 8  S 9  S10  S11 80  85  60  80  81
F12 =   77.20
5 5
S 8  S 9  S10  S11  S12 85  60  80  81  77.20
F13 =   76.74
5 5
Bedassa enterprise uses a five-year moving average policy to forecast its sales. It wants to
forecast sales of 1998 E.C. The following data shows the enterprises actual sales data for
the past five years.
Year Sales (Actual) (in thousands)
1993 6000
1994 5500
1995 6500
1996 6800
1997 5800
Required
a) Compute the sales forecast for 1988.
b) If the company’s policy is to use three-year moving average, what is its sales
forecast for 1998?
c) Considering the enterprise’s forecasting policy, forecast sales for 1999, 2000,
2001, 2002, and 2003.
4. End use method

End use method, also called consumption coefficient method, is more suitable for
estimating the demand for intermediate products. Intermediate products are considered
output of one company and then input of another company. For example, chips are the
output to the chip manufacturer but input to computer producing company. The use of
end use method in demand forecasting involves the following steps.
Step 1. Identify the possible uses of the product

Step 2. Define the consumption coefficient (usage rate) of the product for various uses.
Step 3. Project the output levels for the consuming industries
Step 4. Derive the demand for the product.
To illustrate the application of end use method, let’s assume that four industries
(electronics industry, computer industry, electricity company, and telecommunication
company) use chips as input to their products. The chip manufacturer prefer to use End
Use Method to forecasting demand for chips in the upcoming year. The company
collected consumption coefficient and projected output of each industry and summarized
the data below:
Industry Consumption Projected output for
Coefficient each industry
Electronics 5 10,000
Computer 4 30,000
Electricity 6 15,000
Telecommunication 7 20,000
Required: Determine the total forecasted demand for chips

To give a solution to the above question, it is advisable to understand the data properly.
The consumption coefficient indicates the rate of input (chips) per unit of output. For
instance, the consumption coefficient of 5 for electronics industry implies that the
industry uses 5 chips to produce one unit of its output. The 3 rd column shows the planned
production for each industry. Accordingly, demand for chips in the coming year is
computed as follows:
Industry Consumption Projected Projected demand

coefficient output for chips
Electronics 5 10,000 50,000
Computer 4 30,000 120,000
Electricity 6 15,000 90,000
Telecommunication 7 20,000 140,000
Total forecasted chips 400,000

Assume that Kaliti Metal Factory produces various types of metal products, of these LTZ
metal is the major one. LTZ method is used by the following companies: French Door
Makers, table producers, and window makers. The consumption coefficient of each
company and their projected output are summarized below:
Company Consumption Projected

Coefficient output
French door makers 3 meters/door 3000 doors
Table producers 1.5 meters/table 2000 tables
Window makers 1.25 meters/window 4000 windows
Required: Determine the projected total quantity of LTZ metal
4.8 SUMMARY
Market and demand analysis is a key activity for determining the scope of investment, the
possible production programme, the technology required, and location choice. The
primary objective of market and demand analysis is to determine the effective demand
and the characteristics of the market for the proposed product/service.
In order to project the demand for the envisaged product/service, adequate and relevant
information should be gathered from primary as well as secondary sources. The market
for a product/service is characterized by, among other things, determining aggregate
demand, market segmentation, market mix (product, price, promotion, and distribution),
consumers, supply and competition, and government policy.
Several techniques may be used to forecast the demand for the product/service. They are
generally classified into qualitative methods and quantitative methods. Qualitative
techniques include jury of executive opinion method, and Delphi method. Quantitative
techniques include trend projection method, exponential smoothing, moving average
method, and end use method.
CYP 4.1
1. Market and demand analysis is considered a key activity because it is used to
determine:
- the scope of an investment
- the possible production programme
- technology required
- the choice of location
2. The objectives of market and demand analysis are to determine the effective demand
for the project and the characteristics of the corresponding market.
3. Business philosophy, marketing research, marketing instruments, and marketing
plan and budget.
4. Provides information about demand market and supply market to develop project
strategies
CYP 4.2
1. Since in a competitive market apparent consumption is equal to effective demand,
the successful determination of apparent consumption enables us to get effect
demand for the product or services
2. Market segmentation
3. Geographic segmentation, demographic segmentation, socio-economic
segmentation, psychographic segmentation, and buyer behavior segmentation.
4. The main objectives of market segmentation are:
- to pay proper attention to particular area
- for efficient use of marketing resources
- to better understand customer needs, and competitive situation
- to design marketing mix
- to formulate marketing programs and strategies
5. demand, competition, middleman, government, suppliers etc
6. marketing mix, product differentiation, cost of product, objective of the firm etc.
7. There are two possible pricing strategies; namely, price skimming (charge higher
price) and price penetration (charge lower price)
8. Channels of distribution and physical distribution
9. a) physical distribution
b) Channel of distribution
c) Channel of distribution
d) Physical distribution
e) Channel of distribution
f) Channel of distribution
g) Physical distribution
10. Promotion
11. Advertising, personal selling, sales promotion, publicity and public relations
12. Domestic sources and foreign sources
13. Though its plans, policies, and legislation
CYP 4.3
1. a) Yt = a + bT
n TY   T  Y
b=
n T 2    T 
2
Month Period (T) Y TY T2

March 1 112 112 1
April 2 125 250 4
May 3 120 360 9
June 4 133 532 16
July 5 136 680 25
August 6 146 876 36
September 7 140 980 49
October 8 155 1240 64
November 9 152 1368 81
45 1219 6398 285
9(6398)  ( 45 x1219)
b=
9( 285)  ( 45) 2
= 5.05
a=  Y  b T
n
1219  5.05(45)
=
9
= 110.19
Yt = 110.19 + 5.05T
b. (i) Forecast for December (T = 10)

Y10 = 110.19 + 5.05 (10) = 160.69 units
(ii) Forecast for January (T = 11)
Y11 = 110.19 + 5.05 (11) = 165.74 units
(iii) Forecast for February (T = 12)
Y12 = 110.19 + 5.05 (12) = 170.79 units
2. a) Yt = a + bT
n TY   T  Y
b=
n T 2    T 
2
Month Period (T) Y TY T2

January 1 133 133 1
February 2 183 366 4
March 3 285 855 9
April 4 640 2560 16
May 5 1876 9380 25
June 6 2550 15300 36
21 5667 28594 91
6( 28594)  ( 21x5667)
b=
6(91)  (21) 2
171,564  119 ,007
=
546  441
52.557
=
105
= 500.5
a=  Y  b T
n
5667  500.5( 21)
=
6
 4843.50
=  807.25
6
Yt = -807.25 + 500.5T
b. (i) Forecast for July (T = 7)

Y7 = -807.25 + 500.5(7) = 2696.25
(ii) Forecast for August (T = 8)
YB = -807.25 + 500.50 (8) = 3196.75
(iii) Forecast for September (T = 9)
Y9 = -807.25 + 500.50 (9) = 3697.25
CYP 4.4
1. Ft = Ft-1 + (Dt-1 – Ft-1)
F6 = F5 + (D5 – F5)
= 200.4 + 0.10 (225 – 200.40) = 203
F7 = F6 +  (D6 – F6)
= 203 + 0.10 (285 – 203) = 211.20
F8 = F7 +  (D7 – F7)
= 211.20 + 0.10 (305 – 211.20) = 220.58
F9 = F8 + (D8 – F8)
= 220.58 + 0.10 (190 – 220.58) = 217.52
2. FJuly = FJune +  (DJune – FJune)
= 90 + 0.30 (100 – 90)
= 93
CYP 4.5
6000  5500  6500  6800  5800
a) F1998 =  6120
5
6500  6800  5800
b) F1998 =  6366.67
3
5500  6500  6800  5800  6120
c) F1999 =  6144
5
6500  6800  5800  6120  6144
F2000 =  6272.80
5
6800  5800  6120  6144  6272.80
F2001 =  6227.36
5
5800  6120  6144  6272.80  6227.36
F2002 =  6112.83
5
CYP 4.6
Company Consumption Projected output
Projected
Coefficient (m) demand
French door makers 3/door 3000 9000
Table producers 1.5/table 2000 3000
Window makers 1.25/window 4000 5000
Total projected quantities of LTZ metal 17000
meters
UNIT 5: TECHNICAL ANALYSIS
Contents
5.1. Introduction
5.2. Manufacturing process/technology
5.3. Technical Arrangements
5.4. Material inputs and Utilities
5.5. Product Mix
5.6. Plant Capacity
5.7. Location
5.8. Site
5.9. Machineries and Equipment
5.10. Structure and Civil Works
5.11. Environmental Aspects
5.12. Project Charts and Layouts
5.13. Schedule of project implementation
5.14. Need for Considering Alternatives
5.15. Key Project Inter-linkages
5.16. Summary
5.17. Answers to Check Your Progress Questions
After completing this chapter, you will be able to:

 understand the aspects of projects that should be studied under technical analysis;
 enumerate the factors that should be considered in choosing the technology;
 evaluate the appropriateness of the technology for a particular project;
 identify the different types of materials required for the envisaged project;
 explain factors that affect plant capacity decisions, and the choice of location and
site;
 describe the different types of structures and civil works in project analysis;
 discuss the key issues that should be considered in environmental analysis; and
 explain the processes and techniques used in scheduling project implementation.
5.1. INTRODUCTION
Analysis of technical and engineering aspects is done continually when a project is being
examined and formulated. Other types of analysis are closely intertwined with technical
analysis. The broad purpose of technical analysis is (a) to ensure that the project is
technically feasible in the sense that all the inputs required to set up the project are
available, and (b) to facilitate the most optimal formulation of the project in terms of
technology, size, location, and so on.
While technical analysis is essentially the preserve of the technical expert, the financial
analyst participating in the project appraisal exercise should be able to raise basic issues
relating to technical analysis using common sense and economic logic. To this effect, this
chapter covers these issues very broadly in terms of:
 Manufacturing process/technology
 Technical arrangements
 Materials and inputs
 Product mix
 Plant capacity
 Location and site
 Machineries and equipments
 Structures and civil works
 Environmental aspects
 Project charts and layouts
 Project implementation schedule
 Need for considering alternatives
5.2. MANUFACTURING PROCESS/TECHNOLOGY
For manufacturing a product/service often two or more alternative technologies are

available. For example:
 Steel can be made either by the Bessemer process or the open-hearth process.
 Cement can be made either by the dry process or the wet process.
 Soda can be made by the electrolysis method or the chemical method.
 Paper, using bagasse as the raw material, can be manufactured by the Kraft
process or the soda process or the Simon Cusi process.
 Soap can be manufactured by the semi-boiled process or the fully boiled process.
5.2.1. Choice of Technology

The choice of technology is influenced by a variety of considerations. Some of these are:
1. Plant Capacity.
Capacity. Often, there is a close relationship between plant capacity and
production technology. To meet a given capacity requirement perhaps only a certain
production technology may be viable.
2. Principal Inputs The choice of technology depends on the principal inputs available
for the project. In some cases, the raw materials available influence the technology
chosen. For example, the quality of limestones determines whether the wet or dry process
should be used for a cement plant.
3. Investment Outlay and Production Cost.

Cost. The effect of alternative technologies on
investment outlay and production cost over a period of time should be carefully assessed.
4. Uses by Other Units. The technology adopted must be proven by successful use by
other units.
5. Product Mix. The technology chosen must be judged in terms of the total product mix
generated by it, including saleable byproducts.
6. Latest Developments.
Developments. The technology adopted must be based on the latest
developments in order to ensure that the likelihood of technological obsolescence in the
near future, at least, is minimized.
7. Ease of Absorption.
Absorption. The ease with which a particular technology can be absorbed can
influence the choice of technology. Sometimes a high – level technology may be beyond
the absorptive capacity of a developing country, which may lack trained personnel to
handle that technology.
5.2.2. Appropriateness of Technology

Appropriate technology refers to those methods of production, which are suitable to local
economic, social, and cultural conditions. The advocates of appropriate technology urge
that the technology should be evaluated in terms of the following questions:
 Whether the technology utilizes local raw materials?
 Whether the technology utilizes local manpower?
 Whether the goods and services produced cater to the basic needs?
 Whether the technology protects ecological balance?
 Whether the technology is harmonious with social and cultural conditions?
5.3. THCHNICAL ARRANGEMENTS
Satisfactory arrangements must be made to obtain the technical know-how needed for the
proposed manufacturing process. When collaboration is sought, inter alia (among other
things), the following aspects of the agreement must be worked out in detail:
 The nature of support to provided by the collaborators during the designing of the
project, selection and procurement of equipment, installation and erection of the
plant, operation and maintenance of the plant, and training of the project
personnel.
 Process and performance guarantees in terms of plant capacity, product quality,
and consumption of raw materials and utilities.
 The price of technology in terms of one-time licensing fee and periodic royalty
fee.
 The continuing benefit of research and development work being done by the
collaborator.
 The period of collaboration agreement.
 The assistance to be provided and the restrictions to be imposed by the
collaborator with respect to exports.
 The level of equity participation and the manner of sharing management control,
especially if the technical collaboration is backed by financial collaboration.
 Assignment of the agreement by either side in case of change of ownership.
 Termination of the agreement or other remedies when either party fails to meet its
obligation.
 Approach to be adopted in force majeure situations.
5.4. MATERIAL INPUTS AND UTILITIES
An important aspect of technical analysis is concerned with defining the materials and
utilities required, specifying their properties in some detail, and setting up their supply
programmes. There is an intimate relationship between the study of materials and utilities
and other aspects of project formulation, particularly those concerned with location,
technology, and equipments.
Material inputs and utilities may be classified into four broad categories: (i) raw
materials, (ii) processed industrial materials and components, (iii) auxiliary materials and
factory supplies, and (iv) Utilities.
5.4.1. Raw Materials

Raw materials (processed and/or semi-processed) may be classified into four types: (i)
agricultural products, (ii) mineral products, (iii) livestock and forest products, and (iv)
Marine products.
1. Agricultural products.
products. In studying agricultural products, the quality must first be
examined. Then, an assessment of the quantities available, currently and potentially, is
required. The questions that may be raised in this context are: What is the present
marketable surplus? What is the present area under cultivation? What is the likely
increase in yield per acre?
2. Mineral Products.
Products. In assessing mineral raw materials, information is required on the
quantum of exploitable deposits and the properties of the raw materials. The study should
provide details of the location, size, and depth of the deposits and the viability of open
cast or underground mining. In addition, information should be generated on the
composition of the ore, level of impurities, need for beneficiation, and physical, chemical
and other properties.
3. Livestock and Forest Products.

Products. Secondary sources of data on livestock and forest
products often do not provide a dependable basis for estimation. Hence, in general, a
specific survey may be required to obtain more reliable data on the quantum of livestock
product and forest products.
4. Marine Products. Assessing the potential availability of marine products and the cost
of collection is somewhat difficult. Preliminary marine operations, essential for this
purpose, have to be provided for in the feasibility study.
5.4.2. Processed Industrial Materials and Components

Processed industrial materials and components (base metals, semi-processed materials,
manufactured parts, components, and sub-assemblies) represent important inputs for a
number of industries. In studying them the following questions need to be answered: In
the case of industrial materials, what are their properties? What is the total requirement of
the project? What quantity would be available from domestic sources? What quantity can
be procured from foreign sources? How dependable are the supplies? What has been the
past trend in prices?
5.4.3. Auxiliary Materials and Factory Supplies

In addition to the basic raw materials and processed industrial materials and components,
a manufacturing project requires various auxiliary materials and factory supplies like
chemicals, additives, packaging materials, paint, varnishes, oils, grease, cleaning
materials, etc. The requirements of such auxiliary materials and supplies should be taken
into account in the feasibility study.
5.4.4. Utilities
A broad assessment of utilities (power, water, steam, fuel, etc.) may be made at the time
of the input study though a detailed assessment can be made only after formulating the
project with respect to location, technology, and plant capacity. Since the successful
operation of a project critically depends on the adequate availability of utilities, the
following questions should be raised while conducting the inputs study. What quantities
are required? What are the sources of supply? What would be the potential availability?
What are the likely shortages/ bottlenecks? What measures may be taken to augment
supplies?
Check Your Progress 5 – 1

1. The production of goods may involve two or more alternative technologies.
(True/False)
2. What factors should be considered in technology selection?
3. There should be a close relationship between plant capacity and production
technology. (True/False)
4. Those methods of production which are suitable to local economic, social, and
cultural conditions are referred to as: _______________________
5. What is the purpose of technical arrangement during technical analysis?
6. With whom technical arrangements are made?
7. What are the four broad categories of materials inputs and utilities?
5.5. PRODUCT MIX
The choice of product mix is guided by market requirements. In the production of most of
the items, variations in size and quality are aimed at satisfying a broad range of
customers. For example, a garment manufacturer may have a wide range in terms of size
and quality to cater to different customers. It may be noted that variation in quality can
enable company to expand its market and enjoy higher profitability. For example, a toilet
soap-manufacturing unit may, by variation in raw material, packaging, and sales
promotion, offer a high profit margin soap to consumers in the upper-income brackets.
While planning the production facilities of the firm, some flexibility with respect to the
product mix must be sought. Such flexibility enables the firm to alter its product mix in
response to changing market conditions and enhances the power of the firm to survive
and grow under different situations. The degree of flexibility chosen may be based on a
careful analysis of the additional investment requirement for different degrees of
flexibility.
5.6 PLANT CAPACITY
Plant capacity (also referred to as production capacity) refers to the volume or number of
units that can be manufactured during a given period. Plant capacity may be defined in
two ways: feasible normal capacity (FNC) and nominal maximum capacity (NMC). The
feasible normal capacity refers to the capacity attainable under normal working
conditions. This may be established on the basis of the installed capacity, technical
conditions of the plant, normal stoppages, and downtime for maintenance and tool
changes, holidays, and shift patterns. The nominal maximum capacity is the capacity,
which is technically attainable, and this often corresponds to the installed capacity
guaranteed by the supplier of the plant. Our discussion will focus on the feasible normal
capacity. Several factors have a bearing on the capacity decision. These are:
 Technological requirement
 Input constraints
 Investment cost
 Market conditions
 Resources of the firm
 Governmental policy
5.6.1. Technological Requirement

For many industrial projects, particularly in process type industries, there is a certain
minimum economic size determined by the technological factor. For example, a cement
plant should have a capacity of at least 300 tones per day in order to use the rotary kiln
method; otherwise, it has to employ the vertical shaft method, which is suitable for lower
capacity.
5.6.2. Input Constraints

In a developing country, there may be constraints on the availability of certain inputs.
Power supply may be limited; basic raw materials may be scarce; foreign exchange
available for imports may be inadequate. Constraints of these kinds should be borne in
mind while choosing the plant capacity.
5.6.3. Investment Cost

When serious input constraints do not exist, the relationship between capacity and
investment cost is an important consideration. Typically, the investment cost per unit of
capacity decreases as the plant capacity increases. This relationship may be expressed as
follows:
a
C1 = C 2 Q1
Q2
Where C1 = derived cost for Q1 units of capacity

C2 = known cost for Q2 units of capacity
A= a factor reflecting capacity – cost relationship. This is usually between 0.2 and
0.9.
Suppose the known investment cost for 7,000 units of capacity for the manufacturer of a
certain item is Br. 2,000,000. What will be the investment cost for 14,000 units of
capacity if the capacity-cost factor is 0.8? The derived investment cost for 14,000 units of
capacity may be obtained as follows:
0.8
C1 = 2,000,000 x 14,000 = Br. 3,482,202
7,000
5.6.4. Market Conditions
The anticipated market for the product /service has an important bearing on the plant
capacity. If the market for the product is likely to be very strong, a plant of higher
capacity is preferable. If the market is likely to be uncertain, it might be advantageous to
start with a smaller capacity. If the market, starting from a small base, is expected to
grow rapidly, the initial capacity may be higher than the initial level of demand and
further additions to capacity may be effected with the growth of the market.
5.6.5. Resources of the Firm

The resources, managerial and financial, available to a firm define a limit on its capacity
decision. Obviously, a firm cannot choose a scale of operations beyond its financial
resources and managerial capability.
5.6.6. Government policy

The capacity level may be influenced by the policy of the government. Traditionally, the
policy of the government was to distribute the additional capacity to be created in a
certain industry among several firms, regardless of economies of scale. This policy has
been substantially modified in recent years and the concept of ‘minimum economic
capacity’ has been adopted in several industries.
5.7. LOCATION AND SITE
The choice of location and site follows an assessment of demand, size, and input
requirement. Though often used synonymously, the terms ‘location’ and ‘site’ should be
distinguished. Location refers to a fairly broad area like a city, an industrial zone, or a
coastal area; site refers to a specific piece of land where the project would be set up.
The choice of location is influenced by a variety of considerations: proximity to raw

materials and markets, availability of infrastructure, labor situation, governmental
polices, and other factors.
5.7.1. Proximity to Raw Materials and Markets

An important consideration for location is the proximity to the sources of raw materials
and nearness to the market for the final products. In terms of a basic location model, the
optimal location is one where the total cost (raw material, transportation cost plus
production cost plus distribution cost for the final product) is minimized. This generally
implies that:
1. A resource- based project like a cement plant or a steel mill should be located
close to the source of the basic material (for example, limestone in the case of a
cement plant and iron – ore in the case of a steel plant);
2. A project based on imported material may be located near a port; and
3. A project manufacturing a perishable product should be close to the centre of
consumption.
However, for many industrial products proximity to the source of raw material or the
centre of consumption may not be very important. Petro-chemical units or refineries, for
example, may be located close to the source of raw material, or close to the centre of
consumption, or at some intermediate point.
5. 7.2. Availability of Infrastructure

Availability of power, transportation, water, and communications should be carefully
assessed before a location decision is made.
Adequate supply of power is a very important condition for location-insufficient power

can be a major constraint, particularly in the case of an electricity-intensive project like
an aluminum plant. In evaluating power supply the following should be looked into: the
quantum of power available, the stability of the power supply, the structure of the power
tariff, and the investment required by the project for a tie-up in the net work of the power
supplying agency.
For transporting the inputs of the project and distributing the outputs of the project,
adequate transport connections-whether by rail, road, sea inland water, or air-are
required. The availability, reliability, and cost of transportation for various alternative
locations should be assessed.
Given the plant capacity and the type of technology, the water requirement for the project
can be assessed. Once the required quantity is estimated, the amount to be drawn from
the public utility system and the amount to be provided by the project from surface or
sub-surface sources may be determined. For doing this the following factors may be
examined: relative costs, relative dependability, and relative qualities.
In addition to power, transport, and water, the project should have adequate
communication facilities like telephone and Internet.
5.7.3. Labor Situation

In labor-intensive projects, the labor situation in a particular location becomes important.
The key factors to be considered in evaluating the labor situation are:
 Availability of labor, skilled semi-skilled and unskilled
 Prevailing labor rates
 Labor productivity
 State of industrial relations judged in terms of the frequency and severity of
strikes and lockouts
 Degree of unionization
5.7.4. Government Policies

Government policies have bearing on location. In the case of public sector projects,
location is directly decided by the government. It may be based on a wider policy for
regional dispersion of industries.
In the case of private sector projects, location is influenced by certain governmental

restrictions and inducements. The government may prohibit the setting up of industrial
projects in certain areas, which suffer from urban congestion. More positively, the
government offers inducements for establishing industries in backward areas. These
inducements consist of subsidies, concessional finance, tax, loans, power subsidy, income
tax benefits, lower promoter contribution, and so on.
5.7.5. Other Factors

Several other factors have to be assessed as well before arriving at a location decision
These are:
 Climatic conditions
 General living conditions
 Proximity to ancillary units
 Ease in coping with pollution
Climate Conditions
The climatic conditions like temperature, humidity, wind, sunshine, rainfall, snowfall,
dust, flooding, and earthquakes have an important influence on location decision. They
have a bearing on the cost as they determine the extent of air-conditioning, de-
humidification, refrigeration, special drainage, and so on required for the project.
General Living Conditions

The general living conditions like the cost of living, housing situation, safety, and
facilities for education, health care, transportation and recreation need to be assessed
carefully.
Proximity to Ancillary Units

Most firms depend on ancillary units for components and parts. If the ancillary units are
located nearby, coordination becomes easy, transportation costs are lower, and inventory
requirements become considerably less.
Ease in Coping with Environmental Pollution

A project may cause environmental pollution in various ways: it may throw gaseous
emissions; it may produce liquid and solid discharges; it may cause noise, heat, and
vibrations. The location study should analyze the cost of mitigating environmental
pollution to tolerable levels at alternative locations.
5.8. SITE SELECTION
Once the broad location is chosen, attention needs to be focused on the selection of a
specific site. Two or three alternative sites must be considered and evaluated with respect
to cost of land and cost of site preparation and development.
The cost of land tends to differ from one site to another in the same broad location. Sites
close to a city cost more whereas sites away from the city cost less. Sites in an industrial
area developed by a governmental agency may be available at a concessional rate.
The cost of site preparation and development depends on the physical features of the site,
the need to demolish and relocate existing structures, and the work involved in obtaining
utility connections to the site. The last element, viz., the work involved in obtaining
utility connections and the cost associated with it should be carefully looked into. It may
be noted in this context that the cost of the following may vary significantly from site to
site: power transmission lines from the main grid, railway siding from the nearest rail
road, feeder road connecting with the main road, transport of water, and disposal of
effluents.
Check Your Progress 5- 2

1. What guides the choice of product mix?
2. The volume or number of units that can be manufactured during a given period is
referred to as _______________
3. Mention the two types of production capacity?
4. What factors determine the feasible normal capacity?
5. The capacity attainable under normal working conditions is _________________
6. The plant capacity that is technically attainable is ___________________
7. Mention factors that should be considered in capacity decisions.
8. What factors should be taken in to account in choosing the location?
5.9 MACHINERIES AND EQUIPMENT
The requirement of machineries and equipment is dependent on production technology

and plant capacity. It is also influenced by the type of project. For a process-oriented
industry like a petrochemical unit, machineries and equipment required should be such
that the various stages are matched well. The choice of machineries and equipment for a
manufacturing industry is somewhat wider as various machines can perform the same
function with varying degrees of accuracy. For example, the configuration of machines
required for the manufacture of refrigerators could take various forms. To determine the
kinds of machinery and equipment required for a manufacturing industry, the following
procedure may be followed: (i) Estimate the likely levels of production over time. (ii)
Define the various machining and other operations. (iii) Calculate the machine hours
required for each type of operation. (iv) Select machineries and equipment required for
each function.
The equipment required for the project may be classified into the following types:
(i) Plant (process) equipment,
(ii) Mechanical equipment,
(iii) Electrical equipment,
(iv) Instruments,
(v) Controls,
(vi) Internal transportation system, and others.
In addition to the machineries and equipment, a list should be prepared of spare parts and
tools required. This may be divided into: (i) spare parts and tools to be purchased with the
original equipment, and (ii) spare parts and tools required for operational wear and tear.
5.9.1. Constraints in Selecting Machineries and Equipment

In selecting the machineries and equipment, certain constraints should be borne in mind.
Some of these are:
(i) There may be a limited availability of power to set up an electricity-intensive
plant like, for example, a large electric furnace;
(ii) There may be difficulty in transporting heavy equipment to a remote location;
(iii) Workers may not be able to operate, at least in the initial periods, certain
sophisticated equipment such as numerically controlled machines;
(iv) The import policy of the government may preclude the import of certain
machineries and equipment.
5.9.2. Procurement of Plant and Machinery

For procuring the plant and machinery, orders for different items of the plant and
machinery may be placed with different suppliers of a turnkey contract may be given for
the entire plant and machinery to a single supplier. The factors to be considered in
selecting the supplier(s) of the plant and machinery are the desired quality of machinery,
the level of technological sophistication, the relative reputation of the various suppliers,
the expected delivery schedules, the preferred payment terms and the required
performance guarantees. Performance guarantees provided by machinery suppliers may
take three forms; namely, mechanical guarantee, input guarantee, and output guarantee.
If in-house technical expertise is inadequate, external consultant (s) may be employed to
select the plant and machinery and supervise the installation of the same
5.10. STRUCTURE AND CIVIL WORKS
Structure and civil works may be divided into three categories: (i) site preparation and
development, (ii) buildings and structures, and (iii) outdoor works.
5.10.1 Site Preparation and Development

This covers the following: i) grading and leveling of the site; (ii) demolition and removal
of existing structures; (iii) relocation of existing pipelines, cables, roads, power lines,
etc.; (iv) reclamation of swamps and draining and removal of standing water; (v)
connections for the following utilities from the site to the public network: electric power
(high tension and low tension), water for drinking and other purposes, communications
(telephone, telex, internet, etc.), roads, railway sidings; and (vi) other site preparation and
development work.
5.10.2 Buildings and Structures

Buildings and structures may be divided into: (i) factory or process buildings; (ii)
ancillary buildings required for stores, warehouses, laboratories, utility supply centers,
maintenance services, and others; (iii) administrative buildings; (iv) staff welfare
buildings, cafeteria, and medical service buildings; and (v) residential buildings.
5.10.3. Outdoor Works

Outdoor works cover (i) supply and distribution utilities (water, electric power,
communication, steam, and gas); (ii) handling and treatment of emission, wastages, and
effluents; (iii) transportation and traffic signals; (iv) outdoor lighting; v) landscaping; and
(vi) enclosure and supervision (boundary wall, fencing, barriers, gates, doors, security
posts, etc.)
5.11. ENVIRONMENTAL ASPECTS
A project may cause environmental pollution in various ways: it may throw gaseous
emissions; it may produce liquid and solid discharges; it may cause noise, heat, and
vibrations.
Projects that produce physical goods like cement, steel, paper, and chemicals by
converting natural resource endowments into saleable products are likely to cause more
environmental damage. Hence, the environmental aspects of the projects have to be
properly examined. The key issues that need to be considered in this respect are:
 What are the types of effluents and emissions generated?
 What needs to be done for proper disposal of effluents and treatment of
emissions?
 Will the project be able to secure all environmental clearances and comply with
all statutory requirements?
Check Your Progress 5 –3

1. What are the major constraints in selecting machineries & equipment?
2. Consider yourself the technical expert in procuring machinery and equipment.
What factors do you think you should consider in the procurement of plant and
machinery?
3. What are the three categories of structures and civil works in technical analysis?
4. What are the key issues that need to be considered in environmental analysis?
5.12 PROJECT CHARTS AND LAYOUTS
Once data is available on the principal dimensions of the project (market size, plant
capacity, production technology, machineries and equipment, buildings and civil works,
conditions obtaining at the plant site, and supply of inputs to the project) project charts
and layouts may be prepared. These define the scope of the project and provide the basis
for detailed project engineering and estimation of the investment and production costs.
The important charts and layout drawings are briefly described as follows:
1. General functional Layout.
Layout. this shows the general relationship between
equipment, buildings, and civil works. In preparing this layout, the primary
consideration is to facilitate smooth and economical movement of raw materials,
work-in-process, and finished goods. This means that:
a. The layout should seek to allow traffic flow in one direction to the extent
possible, with a minimum of crossing.
b. Godowns, workshops, and other services must be functionally situated with respect
to the main factory building.
2. Material flow diagram. This shows the flow of materials, utilities, intermediate
products, final products, by-products, and emissions. Along with the material flow
diagram, a quantity flow diagram showing the quantities of flow may be prepared.
3. Production Line diagrams.
diagrams. These show how the production would progress
along with the key information for the main equipment.
4. Transport Layout. This shows the distances and means of transport outside the
production line.
5. Utility Consumption Layout. This shows the principal consumption points of
utilities (power, water, gas, compressed air, etc.) and their required quantities.
These layouts provide the basis for developing specifications for utility supply
installations.
6. Communication Layout.
Layout. This shows how the various parts of the project will be
connected with telephone, intercom, etc.
7. Organizational Layout.
Layout. This shows the organizational set-up of the project along
with the information on personnel required for various departments and their
interactions (See Unit Six for detail)
8. Plant Layout.
Layout. The plant layout is concerned with the physical layout of the
factory. In certain industries, particularly process industries, the plant layout is
dictated by the production process adopted. In manufacturing industries, however,
there is much greater flexibility in defining the plant layout. The important
considerations in preparing the plant layout are:
 Consistency with production technology
 Smooth flow of goods from one stage to another
 Proper utilization of space
 Scope of expansion
 Safety of personnel
5.13. SCHEDULE OF PROJECT IMPLEMENTATION
As part of the technical analysis, a project implementation schedule is also usually

prepared. In order to prepare the project implementation schedule, the following
information is required:
 List of all possible activities from project planning to commencement of
production.
 The sequence in which various activities have to be performed.
 The time required for performing the various activities.
 The resources normally required for performing the various activities.
 The implications of putting more resources or less resources than are normally
required
The schedule of project implementation begins with the identification of key stages.
There are two ways of identifying the key stages. These are:
1. Top- down Approach
This involves the listing of all interim and final deliverables (outputs) of the
project as outcomes from a collection of activities that forms a key stage
2. Bottom up Approach
It involves identifying as many activities as possible and the grouping of related
activities together to form the key stage.
Once the key stages are identified, they are organized in a logical sequence to maximize
concurrency and to generate logical dependency (i.e. which key stage is dependent on
which). The next step is to derive the project logic diagram. The logic diagram contains
input dependency and output dependency. In this diagram, every key stage has at least
one arrow leaving an output dependency. The key to successful scheduling using this
logic diagram is to ensure you have well defined dependencies. Some of the project
Scheduling techniques are explained below:
1. The Work Breakdown Structure (WBS)
It is a convenient means of graphically presenting the work of the project in readily
understandable format. The project key stages form the highest level of the WBS, which
is then used to show the detail at the lower levels of the project. The WBS does not show
dependencies and is not time based (no time scale on the drawing).
The sample of WBS is shown bellow:
Project
1st level A B C D E F Key

Activities stages
A1
nd
2
Level
Activities A2
A3
A4
A4/1
3rd level
Activities
A4/2
A4/3
According to the above figure, each key stage is expanding to show 2 nd level activities.
Each 2nd level activities is further expanded to the 3rd level and lower levels as
appropriate. The WBS is the basis for budget derivation when all activities are identified.
2. Gantt chart. It is a convenient graphical means of picturing a schedule. Gantt

chart, developed by Henry L. Gantt, is a useful project scheduling method for
small projects with few activities. Gantt chart is also called bar chart. It does not
show the precedence constraints.
3. Critical path method (CPM). Critical path method is useful for purely
deterministic problems in which each activity has definite time of completion. In
order to apply CPM, the project is first represented as a network. Network
explicitly shows the precedence constraints. A network is a collection of nodes
and direct arcs. A node represents an event and an arc represents an activity.
4. Project Evaluation & Review Technique (PERT)

(PERT)
PERT is a generalization of CPM to allow uncertainty in the activity times. It
allows randomness in the activity times. PERT is useful for more complex
projects having many activities.
5.14. NEED FOR CONSIDERING ALTERNATIVES
Although the need for considering alternatives has been touched upon earlier, this point
needs to be emphasized. There are alternative ways of transforming an idea into a
concrete project. These alternatives may differ in one or more of the following aspects:
 Nature of project
 Production process
 Product quality
 Scale of operation and time phasing
 Location
1. Nature of Project. The project may envisage the manufacture of all the parts and
components in a vertically integrated unit or it may consist of an assembly type unit,
which obtains the bulk of the parts and components from outside suppliers. The project
may consist of processing up to the finished stage or may stop at a semi-finished stage.
These alternatives are available with respect to the nature of the project.
2. Production Process. There may be several alternatives with respect to the production
process. The availability and characteristics of raw materials, the cost structure, and the
nature of markets served are factors that have to be borne in mind while deciding about
the process.
3. Product Quality. Barring a few products where a certain standard has to be
maintained, the choice with respect to quality is fairly wide. This is particularly true in
the case of consumer products like textiles, footwear, etc. The quality and product range
decisions would depend on the characteristics of the market, the elasticity of demand,
consumer preferences, and the nature of competition.
4. Scale of Operation and Time phasing. In many cases several scales of operation are
feasible technically and financially. The choice of a particular scale would depend on the
financial resources available, the nature of competition, the nature of demand, and the
economics of scale. Further, a given capacity may be installed in one stage or in phases.
The capital cost of capacity installation is usually lower when it is done in one stage. The
cost of idle capacity, however, is higher when it is built in a single stage. The trade-off
between these costs would determine the optimal pattern of time phasing.
5. Location. Location and size are closely interrelated. Perhaps the same demand could
be satisfied by: (i) a single plant for the entire market; or (ii) one large plant for the bulk
of the market with a few smaller plants for the remaining market; or (iii) several plants of
a similar size spread over the market areas. The choice would depend mainly on the
trade-off between economies of scale in manufacturing and economies of distribution.
5.15. KEY PROJECT INTER-LINKAGES
While evaluating various alternatives, the inter-linkages among key facets of the project
like product (or service), demand, plant capacity, production technology, location,
investment outlay, financial resources, production costs, selling price, and profitability
must be borne in mind.

1. What are the principal project dimensions that define the scope of the project?
2. The following are lists of project charts and layouts drawings:
a. General Functional layout e. Utility consumption layout
b. Material flow diagram f. Communication layout
c. Production line diagram g. Organizational layout
d. Transport layout h. Plant layout
Match the each of the above charts and layouts with the following descriptions
i. It is concerned with the layout of the factory

ii. It shows the general relationship equipment, buildings, and civil works
iii. It shows the organizational setup of the project
iv. It shows the flow of materials, utilities, intermediaries, final products, by-products, and emissions
v. It shows how the various parts of the project will be connected with telephone, fax, Internet etc.
vi. It shows how the production progresses along with the key information for the main equipment.
vii. It provides the basis for developing specifications for utility supply installations
viii. It shows the distances and means of transport outside the production line.
3. Mention some of the principal project implementation techniques

4. The promoter of the project has several alternatives of transforming ideas in to a
concrete project. What are the different aspects in which these alternatives differ?
5.16 SUMMARY
For manufacturing a product or a service often two or more alternative technologies are
available. The choice of technology is influenced by a variety of considerations: plant
capacity, principal units, investment outlay, production cost, use by other units, product
mix, latest developments, and ease of absorption. Satisfactory arrangements have to be
made to obtain the technical know-how needed for the proposed manufacturing process.
An important aspect of technical analysis is concerned with defining the materials and
inputs required, specifying their properties in some detail, and setting up their supply
programmes.
Materials may be classified into four broad categories; namely, raw materials, processed
industrial materials and components, auxiliary materials and factory supplies, and
utilities.
The acquisition of technology from some other enterprise may be by way of technology
licensing, outright purchase, or joint venture arrangement. Appropriate technology refers
to those methods of production, which are suitable to local, economic, social, and cultural
conditions. Several factors have a bearing on the plant capacity decision: technological
requirements, input constraint, investment cost, market conditions, resources of the firm,
and governmental policy.
The choice of location is influenced by a variety of considerations such as proximity to

raw materials and markets, availability of infrastructure facilities, and other factors. Once
a broad location is chosen, the attention needs to be focused on the selection of a site, a
specific piece of land where the project would be set up.
The requirements of machinery and equipment are dependent on production technology

and plant capacity. Further, it is influenced by the type of product. Structures and civil
works may be divided into three categories: These are site preparation development,
buildings and structures, and outdoor works. A project may cause environmental
pollution in various ways. Hence the environmental aspects have to be properly
examined. Once data is available on the principal dimensions of the project, project
charts and layout may be prepared. The important charts and layout drawings are general
functional layout, material flow diagram, production line diagram, transport layout, utility
consumption layout, communication layout, organizational layout, and plant layout. As
part of the technical analysis, a project implementation is also prepared using techniques
like Work break down structure, Gantt chart, CPM, and PERT. There are alternative
ways of transforming an idea into a concrete project. These alternatives may differ in one
or more of the following aspects: nature of project, production process, quality of
products, scale of operation, time phasing, and location
5.17 ANSWER TO SELF-TEST QUESTIONS
CYP 5 -1
1. True
2. Plant capacity, principal inputs, investment outlays, production costs, product
mix, last technology developments, ease of absorption etc
3. True
4. Appropriate technology
5. Collaborators
6. To obtain the technical know – how needed for the proposed manufacturing
process.
7. Raw materials, processed industrial materials and components, auxiliary materials
and factory supplies, and utilities.
CYP 5 – 2
1. Market requirements
2. Plant capacity (or production capacity)
3. Feasible normal capacity and nominal maximum capacity.
4. Installed capacity, technical considerations of the plant, normal stoppages, down
time for maintenance and tool changes, holidays, and shift patterns.
5. Feasible normal capacity.
6. Nominal Maximum capacity.
7. Technological requirement, input constraints, investment costs, market
conditions, resources of the firm, and government policy.
8. Proximity to raw materials, proximity to market, availability of infrastructures,
labor market, government policy & others
CYP 5 -3
1. a. Availability of power to set up and operate the machineries
b. Difficulty in transporting heavy machinery and equipment
c. Inability to operate them by the workers
d. Import policy of the government.
2. Desired quality, technological sophisification, relative reputation of the suppliers,
the expected delivery schedule, payment terms, and performance guarantees.
3. Site preparation and development, buildings & structures, & outdoor works.
4. Types of effluents and emissions generated, the manner of effluent disposal,
methods of emission treatment, statutory requirements with respect to
environmental issues etc.
CYP 5-4
1. Market size, plant capacity, production technology, machineries and equipment,
buildings and civil works, conditions obtaining at the plant site, and supply of inputs
to the project.
2. i. H ii. A iii. G iv. B v. F vi. C
vii. E viii. D
3. Work break down structure, CPM, PERT, and Gantt chart
4. Nature of the project, production progress, product quality, location, and scale of
operation and time phasing.
UNIT 6: PROJECT ORGANIZATION AND MANAGEMENT
Contents
6.1 Introduction
6.2 Project Organization Structure
6.3. Project Management
6.4. Organizing and Staffing Projects
6.5. Project Environment
6.6. Selection of Project Manager
6.7. Skill Requirements of Project Manager
6.8. The Organization Staffing Process
6.9. Project Office
6.10. Functional Team
6.11. Project Management Functions
6.12. Motivating Project Staff
6.13. Project Authority
6.14. Project Team Development
6.15. Leadership in Project Environment
6.16. Role of Communication in Project Environment
6.17. Summary

 understand the ways in which a project organization can be structured;
 explain the criteria for selecting a project manager;
 explain the selection of project staff and building an effective project team;
 understand the establishment of project authority and the delegation of authority;
 understand the importance of communications, review meetings, policies and
procedures; and
 describe the project management concepts.
6.1 INTRODUCTION
What type of organization structure will be appropriate for managing projects? Before we
seek an answer to this question, we should know the various types of organization
structures.
6.2. PROJECT ORGANIZATION STRUCTURE
6.2.1 Traditional Organization Structure

The traditional or classical organization is also referred to as the functional organization.
In this type of organization structure, the chief executive has beneath him all of the
functional entities necessary to either perform Research & Development, Manufacturing
and Operations, Administration, Marketing, and so on. All activities are performed within
the functional groups and are headed by a divisional/departmental manager as shown in
Fig. 6.1 each department maintains a strong concentration of technical expertise.
Chief
Executive
Division
Engineering Operations Financial Administration Marketing
Department
Functional
Responsibility
Fig. 6.1 Traditional Organization Structure
In a classical organization, the levels of authority and responsibility are clearly defined.
Because each person reports to only one individual, communication channels are well
structured. It facilitates better technical control, since specialists can be grouped to share
knowledge and responsibility and they can also be used on may different projects.
The major drawback of the classical organization structure is that there is no strong
control authority or individual responsible for the total project. Consequently, integration
of activities that cross functional lines become a difficult chore. Conflicts occur as each
functional group struggles to assert their position. The strongest functional group
dominates the decision making process. Functional managers tend to favor what is best
for their group, rather than what is best for the project.
Recognizing that traditional organization structure lacked a focal pointer for the project to
ensure that all activities are properly integrated, an attempt is made to develop project
leaders or coordinators within each functional department. Section-level personnel are
assigned the role of project leaders, who returned to their former position after the project
is completed. While this arrangement proved effective for coordinating and integrating
work within one department, the project leader failed. Leader in one department did not
have the authority for coordinating the activities in another department. Further, the
creation of project leader position caused internal conflicts within each department.
An alternative arrangement is to identify a manager responsible for the project, and

placing him as a staff assistant to the Chief Executive. The project manager virtually has
no authority, does not make any decisions relating to the project, and does not provide
any staff service to the functional departments who make all the decisions relating to the
project. The project manager simply collects information and communicates the same to
the chief executive. This arrangement may be chosen by a chief executive who wants to
directly control the project. This may work for small projects, but cannot work for large
projects.
6.2.2. Task Force Oriented Organization Structure

Under this approach, the task force drawn from various departments is put under a project
manager. The staff assigned continues to receive administrative support from their parent
departments but they will respond only to project manager.
Manager’s directions violate the policies and procedures of the functional departments;
the task force will bring it to the attention of the functional head and the project manager.
If the matter is not settled between the functional manager and the project manager, the
matter is taken to the higher management for resolution. If the project manager takes the
task the task staff into confidence when making decisions, the need to bring to the
attention of the functional manager or higher management can be avoided.
The organization structure based on task force concept is shown in Fig 6.2
Chief
Executive
Engineering Operations Construction Procurement
Cent. Cent. Cent.

Engineering Construction Procurement
Task force
engineering Task force Task force
construction Procurement
Project
Fig. 6.2 Task Force Organization Structure
The project manager’s authority is indicated and the dotted lines show the relationship
between the task force staff and the functional manager. The dotted lines enable
communication between the task force staff with their respective functional departments
for obtaining technical support or additional staff support, but not decisions relating to the
project. All communication between the task force and their respective functional
departments is routed through project manager. In the task force organization structure,
the loyalty of the functional staff is with the project, and the functional department’s
influence is virtually non-existent.
Under this arrangement, the project department assumes dominant line role, while the
functional departments are relegated to the staff position. It is therefore natural that the
time and cost objective of the project are given maximum attention, but one cannot be too
sure about the quality. The project moves very fast and for this reason, many people tend
to prefer task force organization structure.
6.2.3 Product Type Organization Structure

Product type organization structure consists of divisions within divisions. Under this
structure, one individual, the project manager, maintains complete line authority over the
entire project. The project manager’s responsibilities are entirely new, and he derives
authority from the senior management. The project manager can maintain strong
communication channel with the people under him, since the project participants work
directly for the project manager. Staff can maintain expertise on a given project without
sharing key personnel. Further, the staffs have loyalty to the project, showing better
morale and satisfaction. As the project manager handles all conflicts, interface
management becomes easier rendering senior management concentrate on decision
making rather than on conflict resolution.
The major drawback of the product form of organization is the cost of maintaining the
organization due to duplication of effort, facilities, and personnel. There is no chance for
sharing an individual with another project or order to reduce cost.
6.2.4 Project Management as a Staff Function

A project management division under the chief executive may render special staff service
function to all other functions in relation to a project. The project manager in this role
provides schedules, budgets and information to the various functional departments who
will execute the project. The project manager in this case, will be a specialist in project
management tools and techniques, and in view of his superior knowledge relating to
scheduling, budgeting and information systems, he is in a better position to advice other
functions. A project manager also performs certain service other functions. A project
manger also performs certain service activities like collection and transmission of data,
follow-up of one functional group to serve another group, measure progress and prepare
progress reports. He also acts as a single focal point for communication between
participating functions.
The organization structure with project management as a specialized staff function is

shown in Fig 6.3
Chief
Executive
Commercial Technical & Project

Engineering Management
Project
Instrumentati Civil Mechanical A
on & Control Engineering Engineering
Project
B
Design Electrical
Engineering Project
C
Fig. 6.3 Organization Structure with Project Management as staff function
When an organization uses project management for the first time, this type of
organization structure is followed since it does not require much change in the working of
the organization. Whether the objective of project management are achieved by this
structure is another issue but a focal point for a project is recognized and provided under
this structure.
The project manager under this arrangement fully identifies himself with the project and
considers himself responsible for the successful completion. But at times of advertisity
the project manager is liable to throw up his arms and declare that he could not be held
responsible for achieving project goals, as he had no voice in its execution.
6.2.5 Matrix Organization

Although the project manager is not formally granted any authority under the type of
organization structure discussed in 6.4, a competent project manager will succeed
eventually in acquiring some authority due to his identification with the project and
working for its success. To the extent a project manager is able to acquire the authority,
the functional managers will be forced to dispense with the same. When there is a sharing
of authority between a project manager and other functional managers, formalizing such
an arrangement is what is known as the matrix form of organization. The concept of
matrix organization can be shown as in Table 6.1
Table 6.1: Matrix Concept

Functional Functional Functional Functional Functional
Managers Manager(Civil) Manager Manager Manager
(Electrical) (Mechanical) (Instrumentation
& Control)
A C1 E1 M1 |C1
B C2 E2 M2 |C2
C C3 E3 M3 |C3
FLOW OF
D C4
PROJECT E4 M4 |C4
AUTHORITY
FLOW OF
FUNCTINAL
AUTHORITY
A matrix is a concept where an individual will abide by the decisions made by two
superiors-one belonging to the project and the other to the specialized function. Both are
responsible for the successful completion of the project and, therefore, both ought to have
authority over the working force through whom the project is being executed. The matrix
organization is shown in Fig. 6.4.
Chief
Executive
Project Civil Electrical Mechanical Instrumentati

Management Engineering Engineering Engineering on Engg.
Project 'A' Civil Project Electrical Mechanical Instrumentation

Manager 'A' Project 'A' Project 'A' Product 'A'
Civil Project Electrical Mechanical Instrumentati

'B' Project 'B' Project 'B' on Project 'B'
Project 'B'
Manager
Fig. 6.4. Matrix Organization
Those who are used to single reporting relationship may find this arrangement confusing.
But, all people since childhood are used to dual reporting relationship. But industrial
organizations are different, no matter how much the family concept is propagated. Still,
the dual reporting relationship can work satisfactorily if the roles are clearly defined. A
mutually supportive relationship should exist between the partners in a matrix set up for
the successful execution of project.
6.2.6 Project-Oriented Organization Structure
A totally project-oriented organization structure is an arrangement in which the project
manager has total authority even regarding functional policies and procedures. There are
no constraints with respect to any function. The function specialists have no one to report
to, and they will be carrying out the instructions of the project manager and do what the
project demands.
Project-oriented structure is completely autonomous organization in which the project

manager is the chief executive. Such an organization will have several
departments/divisions needed by senior functional specialists who can function
independently. They will be functioning on behalf of the project manger and will have
authority delegated to them by the project manager for taking decisions in their area of
competence.
Project-oriented organization becomes necessary when a project is too large and complex
or geographically so located that here is no way of managing it without granting
autonomy to the team handling the project. The project manager for such a project will
obviously be a senior person to justify delegation of so much authority by the company.
Under this arrangement, the project manager will have to perform a lot of administrative
functions, besides carrying out the main project activities.
Fig. 6.5 represents a typical project-oriented organization. It differs from the task force
organization structure in the not only the dotted line relationship is eliminated, but not-
technical departments like personnel, finance and accounts, etc., are included and which
come under the direct purview of the project manager.
Chief
Executive
Engineering Finance & Personnel Materials

Accounts
Project ‘A’ Project ‘B’
Engineering Finance & Personnel Commercial Administration

Accounts
Engineering Finance & Personnel Commercial Administration
Accounts
Fig. 6.5 Project-oriented organization structure
Check Your Progress Questions 6-1

1. In classical organization structure,
a. Chief executive controls beneath him all functional entities
b. All activities are performed within the functional group
c. Each functional department maintains a strong concentration of technical
expertise
d. All of the above
e. B and c
2. Which of the following is true about functional organization structure?
a. Authorities and responsibilities are clearly defined
b. It facilitates better technical control
c. Each person reports to only one superior
d. Integration of activities that cross functional lines become a difficult task
e. All of the above
3. Which of the following is not true about task force organization structure?
a. The project manager manages task forces drawn from various departments
b. The task assigned to the project receives administrative support from
project manager.
c. Manager’s direction violates the policies and procedures of the functional
departments
d. The project department assumes dominant line role
e. a and b
4. Which of the following organization structure contains division within the
division?
a. Classical d. Matrix
b. Task-force e. Project oriented
c. Product type
5. The organization structure in which a project manager and other functional
managers share authority is:
a. a. Classical d. Matrix
b. Task-force e. Project oriented
c. Product type
6. The organization structure in which a project manager has total authority even
regarding functional policies and procedures is:
a. a. Classical d. Matrix
b. Task-force e. Project-oriented
c. Product type
6.3 PROJECT MANAGEMENT
Project management is an exciting managerial activity. Wherever there is a need for a

specified time-bound work, project management is called for – whether it is a publishing
house, a university, agricultural rural development, social work or industrial construction
projects. A project is not a physical objective nor is it the end result, it is concerned with
the going-on in-between, which must be the same, whether a high technology process
plant is involved or an election is held. A project initiated for achieving a mission gets
completed as soon as the mission is fulfilled. In other words, it lies between these two out
off points, which time span, is known as project life cycle.
The traditional forms of organization with functional divisions of management and a

well-defined hierarchical relationship are suitable only for established operations,
characterized by a continuous flow of repetitive work with each department attending to
specific functions. This is because a project is characterized by certain distinctive
features, such as:
- A non-routine and non-repetitive undertaking, often plagued with uncertainties,
- Requirement of coordinated efforts of persons drawn from different departments
and disciplines as also contributions from external agencies and
- Relationships in a project, which are dynamic, temporary and flexible.
These make management of a project different from management of operations, as the
former calls for sharper tools of planning and control and improved ways of coping with
human problems caused in a project setting. Project management involves issues, like
forms of project organization, project planning, project control and human aspects of
project management. The following aspects are to be studied in the understanding of
project management, along with the application of quantitative/network techniques.
i. Scope of management, its types and objectives.
ii. The project phase concept.
iii. The feasibility study involving detailed project report preparations and
project selection
iv. Financial evaluation, cost and time overruns
v. Implementation phase in project management.
vi. Other aspects like specifications and contracts, foreign exchange and
import controls, power shortage, labor and tax incentives etc.
Work in the context of a project is not mere processing or conversion of input to output.
The concern for the ultimate objective is the motivating force for the project management
approach. Project management means dedicating us to the end objective and keeping
totality in focus all the time. The emphasis in project management is on results and on the
holistic approach. This approach ensures delivery of goods. A good project management
seeks to remove, amongst other things delays in execution, avoid cause of delays and
identification of technical flaws on difficulties in executing projects.
In a project management, all work has interdependence and inter-relationship with others.
To practice project management requires the distinguishing between what is part and
what is whole, what is motion and what is work. Project management approach differs
from the functional management approach in that the later does not hold responsible any
one individual for a work from A to Z. This crates problems of communications,
coordination, commitment and control. No good decision could be taken without
considering all inter-related things and no useful things can be achieved without
completing the whole. The importance of any work depends on how it stands in relation
to others and to the whole. The inter-relationships and even the work to be performed is
liable to be changed, but the objective does not change. In project environment the future
is uncertain unlike in a routine functional management. In project management it is
necessary to keep an eye on the future and adapt to very fast changed needs of the future.
Quick responses and flexibility are essential for dealing with ever-changing dynamic
saturations which pervade the project management.
6.3.1. Aims and Objectives of Project Management

Peculiarities of the nature and category of projects call for a special approach to ensure
the success of project. This is called Project Management. Success of a project refers to
the following:
1. The project must get completed
2. It must be completed within the allocated funds
3. It must be completed within the allocated time
4. It must be completed to the satisfaction of users.
The aims and objectives of a project management are therefore timely completion,
avoidance of delay, technical flaws and drawings defects, proper fund flow, control over
chain reaction activities, and proper tooling and techniques
6.3.2. Systems
The main thrust in the implementation stage is the evolution or designing of systems and
their operations. Systems are the only means that bring the people and projects ideas
together. A project team leader manages his projects through systems. A system consists
of men machinery and materials and interaction between them in implementation.
Procedures are part of systems. They are planned sequence of operations to do a work
which is part of a system.
The characteristics of a system are

 It is a set of elements organized systematically
 The elements are inter-related
 It is a self-sufficient organic whole
 It has a behavior characteristic of its own
 It has a hierarchy
Human system is a natural system and is a perfect system. By study of natural systems,
ingredients of a successful system are evolved. In a project management system the two
main systems are the project work and project control systems. Project work systems
design, calls for visualizing the total system so that inter-related elements are created in a
way as to lead to their self-regulation without external intervention. Work breakdown
structure (WBS) technique enables the integration of people with the machinery and
material. To inter-relate executing agencies with the soft and hardware of a project, a
project execution plan is conceived. This consists of contracting plans, work packaging
plans, organization plan and system and procedure plan.
6.3.3 Manual
A project procedure manual is the right answer to achieve the required coordination. This
manual is prepared in such a way that the interacting agencies are able to see their roles
and mutual relationships in pursuance of the common goal. The preparation of this
manual commences right with each sub-system. A system analysis, element wise, is
carried out with each sub-system to identify the need for procedure write-ups. In doing
this analysis, the aspects, the system or sub-system seeks to achieve, is developed and a
complete picture about the system is available. It may however be cautioned that while a
project procedure manual would meet the day-to-day transaction-need, it may not be an
end in itself. Procedures are only guidelines and not laws.
6.4. ORGANIZING AND STAFFING PROJECTS
Whatever organization structure is chosen for a project, its successful management is

only as good as the individuals and leaders who manage the key functions. Project
management requires a group of dedicated individuals for achieving the specific project
goals. Project management includes a project manager, project office, and project team.
There may not be any need for a project office for small projects, and just one person
may perform all project office functions. But when a company, for its continuous growth
undertakes a stream of projects extending over several years, there is need for
establishing a project office.
6.5. PROJECT ENVIRONMENT
The project management process cannot be isolated from the project environment. An
appreciation or an awareness of the project environment is necessary to understand fully
the problems of staffing, Personnel performance problems and personnel policy problems
are the two major kinds of problems related to project environment. Personnel
performance is difficult for many individuals because it represents a change in the way of
doing things. Some individuals, however, competent they are find it difficult to adapt
continuously to a changing situation in which they report to multiple managers. Most
individuals prefer stable situations; but projects, by definition, are temporary
assignments. On the other hand, there are some other individuals who thrive in temporary
assignments. These are usually highly creative and challenging work; they resent stable
repetitive jobs. The second major performance problem lines in the project/functional
interface where a person finds himself reporting to two bosses, the project manager and
the functional manager. If the two managers are in total agreement with the work to be
accomplished, then performance at the interface may not be affected. But if conflicting
directions are received, then the individual at the interface, regardless of his capabilities
and experience, may allow his performance to suffer because of his compromising
situation.
Project management is successful only if the project manager and his team are totally
dedicated to the successful completion of the project. The project team, therefore, should
have a good understanding of the fundamental project requirements, viz., project
planning, project control, project evaluation, and project reporting. Since these
requirements cannot generally be fulfilled by single individuals, members of the project
of office as well as functional representatives, must work together as a team. Teamwork
concept is vital to the success of a project.
The person with the maximum influence during the staffing phase is the project manager.
The personal attributes and abilities of project managers will either attract or deter highly
desirable individuals. A project manager should not hesitate to face trouble: on the other
hand he should welcome them. Besides having the capability to evaluate risk and
uncertainty, a project manager’s characteristics should include honesty and integrity
sympathetic understanding of personnel problems, understanding of project technology,
managerial competence and communication skills, alertness and quickness, versatility,
energy and toughness, and the ability to take decisions. The project manager’s objectives
during staffing are to acquire the best available people and try to improve them, provide a
good working environment for all personnel, and make sure that all resources are applied
effectively and efficiently so that all constrains are met, if possible.
6.6 SELECTION OF PROJECT MANAGER
Probably the most difficult the senior management faces is the section of the project
manager. Some managers work best on long-duration projects where decision-making
can be slow; others may do well on short-duration projects that can result in constant
pressure environment. Senior management must know the capabilities and weaknesses of
their project managers.
The project manager must learn from his own mistakes so that they will not be repeated
again. The responsibilities of the project manager include:
 to produce the end item with the available resources and within the constraints of
time, cost and performance/technology
 to meet contractual profit objectives
 to make all required decisions whether they be for alternatives or termination
 to act as the customer (external) and upper-level and functional management
(internal) communications focal point
 to “negotiate” with all functional disciplines for accomplishment of the necessary
work packages within time, cost and performance/technology.
 To resolve all conflicts as far possible
In order for project managers to fulfill their responsibilities successfully, they are
constantly required to demonstrate their skills in interface, resource, and planning and
control management. These implicit responsibilities are:
1. Interface management, which includes project interface including performance of
parts or subsections and physical connection of parts or subsections;
2. Project interfaces that include customer, management (functional and senior level),
and change of responsibilities information flow material interfaces (inventory
control);
3. Resources management covering time (schedule), manpower, money facilities,
equipment, material, information/technology; and planning and control
management
4. Increased equipment utilization. This includes increased performance efficiency,
reduced risks, and identification of alternatives to problems, identification of
alternative resolutions to conflicts.
Finding a suitable person is not easy task because the selection of project manager is
based more on personal characteristics than on the job description. Many companies
prefer to find project managers from within. However, this is easier said than done. On
this point, Robert Fluor, in his keynote address to Project Management Institute’s Ninth
International Seminar, remarked that on-the-job training is probably the most important
aspect in the development of a project manager. This includes assignments to
progressively more responsible positions in engineering and constructing management
and project management. It also includes several rotational assignments in several
engineering department disciplines, constructing, procurement, cost and scheduling,
construct administration and others. There are great advantages to developing project
managers from within the company. There are three good reasons for selecting a project
manager from within.
i) They know the organization, policies, procedures, and they key people. This
allows them to give quality performance.
ii) They have an established performance record which permits placing them at the
maximum level of responsibility and authority.
iii) Clients prefer a proven track record within the project manager’s present
organization.
There is also good case for selecting project manager from outside. A project manager
from outside is less likely to have strong informal ties to any one line organization and
therefore could show impartiality on the project. A good project manager, whether from
inside or outside, must show ability to understand and know both themselves and their
employees in terms of strengths and weaknesses.
6.7 SKILL REQUIREMENTS OF PROJECT MANAGERS
The implementation phase of a project is the most important activity in the life of a
project. A substantial portion of work is done during this phase and calls for the
application of all techniques of project management. It is in this phase that several
activities require to be done parallel to each other, simultaneous and complimentary to
other activities mutually. Time is the essence of this phase. The time over-runs so far
occurred are to be made good, besides ensuring the timely completion of the project
within the targeted time schedule. This calls for crashing of activities attendant with
additional cost and other management problems.
A high degree of coordination and control not only inter with activities of this phase but
also with those of earlier phases is required. The personnel involved in this phase of
activity are normally those not associated with the earlier phases of project management.
A project manager, therefore, has the important task of bringing together the goal
congruence of the project and the participants. This calls for identification and
developing systems to ensure proper implementation of the activities envisaged so that
the goals set are attained.
Projects are often complex and multifaceted. Managing complex projects is a challenge
requiring skills in team building, leadership, conflict resolution, technical expertise,
planning, organization, entrepreneurship, administration, management support, and the
allocation of resources. A key factor to good project performance is the project manager’s
ability to integrate personnel from many disciplines into an effective work team.
6.8 THE ORGANIZATION STAFFING PROCESS
Once the project manager is selected and put in place, the immediate task facing him is
staffing the project organization. In large complex projects, this task can be long and
tedious. The task involves determining people resources required and the source from
which people can be hired.
To determine the people resources required, the types of individuals (possibly job
descriptions) as well as the number of individuals for each job category, and when these
people are needed must be decided.
The project manager, at times, may remain content with second best: this is not a bad
arrangement as long as the people continue with the project till the end. The project
manger may therefore, prefer continuity to highly efficient, since there is always the risk
of the highly efficient being withdrawn and put on some of the more complex project. So,
the project manager may have to compromise with functional managers in accepting
some people who may not be the best. Mutual trust between project manager and
functional manager is crucial, especially during staffing sessions. Once a project manager
has developed good working relationship with employees, the project manager would like
to keep those individuals assigned to his activities.
Once the people resource are defined, the next question will be whether the staffing will
be from within the organization, or from outside sources, such as new hirer or
consultants. Outside consultants are advisable, if internal manpower resources are being
fully utilized on other projects, or if the company does not possess the required project
skills.
The final step in the staffing of the project office is a meeting between the senior
management, the project manager on whose project the requested individuals are
currently assigned, and managers of the projects. Project managers, generally, are
reluctant to give up qualified and experienced personnel to the staff of other project
offices. The presence of senior management shows to all negotiating parties that top
management is concerned with maintaining the best possible mix of individuals from
available resources and to help resolve staffing conflicts. Staffing from within is a
negotiation process in which senior management establishes the ground rules and
priorities.
6.9 PROJECT OFFICE

The project team is a combination of the project office and functional employees. The
project office is intended to support the project manager in carrying out his duties. Project
office personnel must have the same dedication towards the project as the project
manager and must have good working relationships with both the project and functional
manager. The responsibilities of the project office include: (i) acting as the focal point of
information for both in-house control and customer reporting, (ii) controlling time, cost,
and performance to adhere to contractual requirements, (iii) ensuring that all work
required is documented and distributed to all key personnel, and (iv) ensuring that all
work performed is both authorized and funded. The major responsibility of the project
office personnel and the project manager is the integration of work across functional lines
of the organization. Functional units, such as engineering, manufacturing, research and
development, together with subcontractors, must work toward the same specifications,
design, and objectives.
6.10 FUNCTIONAL TEAM
The functional personnel, who report horizontally as well as vertically for information
flow, are part of the project team; the other members of the project team being the project
manager and the project office personnel. Senior management may have a say in the
selection of functional team members, as in the case of project office personnel. It may be
desirable for the senior executive not to take an active role unless the project and
functional managers cannot come to an agreement.
Functional team members can be full-time either during of the project of only for specific
phases. In the selection of functional team members, any special requirements of the
project must be taken into account. The special requirements may develop from changes
in technical specifications, special customer requests, organizational restructuring
because of deviation from existing policies, and compatibility with the customer’s project
office.
For large complex projects, it is desirable to have full-time functional representative from
each major department or division assigned permanently to the project. Such
representation might include program management, project engineering, engineering
operations, manufacturing operations, procurement, quality control, cost accounting,
marketing and sales. The project manager and the functional team members must
understand fully the responsibilities and functions of each other team member, so that
total integration can be achieved as effectively as possible.
6.11. PROJECT MANAGEMENT FUNCTIONS
As discussed earlier, the project manager’s success is measured by how well he can
negotiate with his senior management and functional management for the resources
necessary to achieve the project objective. The project manager may have a great deal of
delegated authority but very little power. Hence, the managerial skills he requires for
successful performance may be drastically different from those of his counterparts in
functional management. The difficult part of the project management environment is that
the individuals at the project-fictional interface must report to two bosses. Functional
managers and project mangers, by virtue of their different authority levels and
responsibilities, treat their people
differently, according to the management project philosophy believe in.
6.12 MOTIVATING PROJECT STAFF
A project manager, as part of controlling and directing, has to motivate his employees so
that they feel secure on the job. Since project managers cannot motivate by promising
material gains, they must appeal to each person’s pride. The guidelines for proper
motivation are: (i) adopt a positive attitude, (ii) refrain from criticizing management, (iii)
avoid making promises that cannot be kept, (iv) circulate customer reports, (v) give each
person the attention he requires. Some effective ways of motivating project personnel are
giving assignments that provide challenges, clearly defining performance expectations,
giving proper criticism as well as credit, giving honest appraisals, providing a good
working atmosphere, developing a team attitude, and providing a proper direction.
6.13 PROJECT AUTHORITY

Project management structures create a web of relations that can cause chaos in the
delegation of authority and the internal authority structure. One form of the project
manager’s authority can be defined as the legal rightful power to command, act, or direct
the activities of others. Authority can be delegated from one’s superiors. Power, on the
other land, is granted to an individual by his subordinates and is a measure of their
respect for him. A manager’s authority is a combination of his power and influence such
that subordinates, peers, and associates willingly accept this judgment. In the project
structure, power comes from credibility, expertise, or being a sound decision maker.
The key to project management process is authority. Project authority provides the way
of thinking required to unify all organizational activities towards accomplishment of the
project regardless of where they are located. The amount of authority given to a project
manager depends upon the project size, management philosophy, and management
interpretation of potential conflicts with functional managers. There are, however, certain
fundamental elements over which the project manager must have authority in order to
maintain effective control. The project manger should have broad authority over all
elements of the project. His authority should be sufficient to permit him to engage all
necessary managerial and technical actions required to complete the project successfully.
He sould have appropriate authority in design and making technical decisions in
development. He should be able to control funds, schedule production activities and
ensure quality of product. If subcontractors are used, he should have maximum authority
in their selection. Generally speaking, the authority of project manger must be
commensurate with the risk he undertakes; the greater the risk, the greater the amount of
authority. The most common sources of power and authority problems in a project
environment are poorly documented or no formal authority, power and authority
perceived in correctly, dual accountability of personnel, two bosses who often disagree
with each other, project organization encouraging individualism, sub-ordinate relations
stronger than peer or superior relationships, shifting of personnel loyalties from vertical
to horizontal lines, group decision-making based upon the strongest group, ability to
influence or administer rewards and punishment, and sharing resource with several
projects.
The authority relationship must be clearly established and they must exist for the duration
of the project. The responsibility matrix or the Linear Responsibility chart attempts to
clarify the authority relationship that can exist when the functional units share common
work. Fig. 6.6 shows a typical Linear Responsibility Chart (LRC). The rows, which
indicate the activities, responsibilities, or functions required, can be all of the tasks in the
work breakdown structure. The columns identify positions, titles, or the people
themselves. The symbols indicate the degrees or responsibility existing between the rows
and columns.
Project Manager
Project Office
Team Member
Managerial Procurement Department Manager
Division manager
D
B
C E
Prepare bill of materials B E
C E
Contact suppliers B
B
Visit suppliers F D
B
Prepare purchase order E
F B
Authorize expenditure A C
B
Place Purchase orders C
E B
Inspect materials C
F B
Quality Control testing D
D B
Inventory update C
Prepare inventory report B
F
Withdraw material
Fig. 6.6 Linear Responsibility
Chart
Legend: A: General Management responsibility.
B: Specialized responsibility.
C: Must be consulted.
D: May be consulted.
E: Must be notified
F: Must approve.
The LRC attempts to answer such question as:

(a) Who has the signature authority?
(b) Who must be notified?
(c) Who can approve?
These questions can be answered by clearly defining the term authority, responsibility,
and accountability.
Authority is the right of an individual to make the necessary decisions required to
achieve his objectives or responsibilities.
Responsibility is the assignment for completion of a specific activity or event.
Accountability is the acceptance for success or failure.
The LRC is no doubt a valuable tool for management, but it has a weakness in that it does
now describe how people interact with each other.
6.14. PROJECT TEAM DEVELOPMENT
Most people within project-oriented and non-project oriented organizations have

differing views on project management. These differing vies can create severe barriers to
successful project management operations. The understanding of barriers to project team
building can help in developing an environment conducive to effective teamwork. The
barriers to team building typical in many project environments are:
(a) Team members outlooks, priorities and interests are different from project
objectives
(b) Role conflicts among team members
(c) Lack of clarity in project objectives and outcomes
(d) Project environment in which the project scope, objectives, resource base, client
needs, etc., keep changing continuously
(e) Competition over team leadership
(f) Lack of clearly defined task responsibilities and reporting structures
(g) Improper selection of team personnel
(h) Poor credibility of project leader
(i) Lack of commitment on the part of team members
(j) Poor Communication among team members, between project team and top
management, between the project leader and team members, and between the
project leaders and the client.
(k) Lack of senior management support.
While proper attention of team building and development is critical during the early
phases of a project, it is a never-ending process. The project manager is continuously
monitoring team functioning and performance to see what corrective action may be
needed to prevent to correct various team problems. Several barometers provide good
clues of potential team disfunctioning. First, noticeable changes in performance levels for
the team and/or for individual team members should always be investigated. Second, the
project leader and team members must be aware of the changing energy levels of team
members. Third, verbal and non-verbal clues from team members may be a source of
information on team functioning. And finally detrimental behavior of one team member
toward another can be a signal that a problem within the team warrants attention. It is
highly recommended that all the project leaders, hold regular meetings to evaluate overall
team performance and deal with team functioning problems. The purpose of these review
meetings is to focus on actual or potential problem areas.
6.15. LEADERSHIP IN PROJECT ENVIRONMENT
Leadership can be defined as a style of behavior designed to integrate both the

organizational requirement and one’s personal interests into the pursuit of some
objective. All managers have some sort of leadership styles. Project managers prove to be
ineffective leaders if they show their inability to balance the technical and managerial
project functions. The greater the project manager’s technical expertise, the higher his
propensity to over involves himself in the technical details of the project. The greater the
project manager’s interest in the technical details of the project, the more likely it is that
he will defend on the project manager’s role as one of the technical specialist. The lower
the project manager’s technical expertise, the more likely it is that he will overstress the
non-technical project functions.
The literature on leadership techniques in organizations deals with two most desirable
leadership techniques human-relations-oriented, and formal authority-oriented. Under
human relations-oriented leadership technique, the project manager must make all the
team members feel that their efforts are important and have a direct effect t on the
outcome of the project. The project manager must educate the team concerning what is to
be done and how important its role is. Project manager should make the team members
feel and believe that they play a vital part in the success of failure of the team. By
working closely with members of the team, the project manager can win their loyalty to
the project. By knowing the project team members individually, the project manager can
increase their motivation level by making them understand that they are an indispensable
part of the team. The most effective way of overcoming the authority-gap is by
understanding as much as possible the needs of the individuals with whom the project
manager deals, and over whom he has no direct authority.
Using formal authority-oriented leadership technique, the project manager can point out
how great the loss will be if co-operation is not forthcoming. He can put all his authority
in functional statements. Further, he can apply pressure beginning with a tactful approach
and minimum application warranted by the situation and then increase it. If the
performance of some team members continue to be unsatisfactory, the project manager
may threaten high-level intervention and do so, if necessary. He can convince the team
members that what is good for the organization is also good for them. The project may
place authority to full-time assigned people in the operating division to get the necessary
work done. The project manager should maintain control expenditure. It is most
important that the team members recognize that the project manager has the mandate to
direct the project.
6.16. ROLE OF COMMUNICATION IN PROJECT ENVIRONMENT
Both written and oral communications, formal as well as informal, are vital for the
success of a project. The communication process is more than simply conveying
message; it is also source control. Communication must convey both information and
motivation. Knowing how to communicate does not guarantee that clear message will be
generated. The various techniques used to improve communications include:
a) Obtaining feedback, possibly in more than one form
b) Establishing multiple communications channels
c) Using face-to-face communications if possible
d) Determining how sensitive the receiver is to communication
e) Being aware of symbolic meanings such as expressions on people’s faces
f) Communicating at appropriate time
g) Reinforcing words with actions
h) Using a simple language
i) Using redundancy whenever possible (i.e., saying it in two different ways)
The actual use of techniques can vary from project to project. With every effort to
communicate, there are always barriers. Some of the barriers of effective communication
are:
b) Receive hearing what he wants to hear. This results from people doing the same
job so long that they no longer listen
c) Sender and receiver having different perceptions. This is vitally important in
contractual requirements, statements of work, and proposal information requests.
d) Receiver evaluating the source before accepting the communications
e) Receiver ignoring conflicting information and doing as he pleases
f) Words meaning different things to different people
g) Communications ignoring non-verbal cues
h) Receiver being emotionally upset.
Three important conclusions can be drawn from communications techniques and barriers;
a) Not to assume that the message sent by the sender will be received in the form in
which it is sent.
b) The swiftest and most effective communications take place among people with
common points of view. The manager who fosters good relationship with his
associates will have little difficulty in communicating with them.
c) Communications must be established early in the project.
In a project environment, communications are often filtered. There are several reasons for
the filtering of upward communications, such as unpleasantness for the sender: receiver
cannot obtain information from any other source, embarrass a superior: lack of status or
mobility for the sender; insecurity; or mistrust.
Team meetings are supposed to be meetings of the mind where information giving,
receiving, and listening take place. It is the responsibility of the project manager to ensure
that meetings are valuable and necessary for the exchange of information. Team meetings
quite often provide individuals with mean of exhibiting suppressed ideas.
Project review meetings are necessary to convince key personnel that orderly progress is
being made on a project. There are three types of project review meetings; (i) project
team review meetings, (ii) executive management review meetings, and (iii) customer
project review meetings. Periodical meetings weekly and monthly-are held in order to
keep the project manager and his team informed about the project’s status. These
meetings are flexible and should be called only if positive benefit will result. Executive
management has the right to require monthly status review meetings. Customer review
meetings are the most critical and most inflexibly scheduled. Project managers often
overlook the fact that their project is simply one of several interrelated project for the
customer. Project managers must allow time to prepare the necessary materials well in
advance for the meeting.
Check Your Progress Questions 6-2

1. Who are the components of project management?
2. What are the major problems related to project environment?
3. Mention the fundamental project requirements.
4. List some of the responsibilities of project manager
5. What kinds of skills are required of the project manager?
6.17. SUMMARY
Appropriate organization and management is essential for the success of a given project.
Some of the organization structures that can be used in managing a project include
classical (functional) organization structure, task force organization structure, product
type organization structure, project management as a staff function, matrix organization,
and project type organization structure.
Project management is composed of project manager, project office, and project team.
The project management process cannot be isolated from the project environment. The
major type of problems related to project environment are personnel performance
problems, and personnel policy problems. Project management is only successful only if
the project manager and his team are totally dedicated to the successful completion of the
project. The project team should have an understanding of the fundamental project
requirements, such as project planning, project control, project evaluation, and project
reporting.
Some of the responsibilities of project manager are Meet contractual profit obligations,
make the necessary decisions, act as communication focal point of customers, upper-level
management, and functional management, negotiation, and conflict resolution. In order to
successfully manage the project, the project manager should possess the following skills:
Team building, leadership, conflict resolution, technical expertise, administration,
management support, and resource allocation.
6.18. ANSWERS TO CHECK YOUR PROGRESS QUESTIONS
C-Y 6-1
1. D 2. E 3. B 4. C 5. D 6. E
C-Y 6-2
1. Project manager, project office, and project team
2. Personnel performance problems, and personnel policy problems
3. Project planning, project control, project evaluation, and project reporting
4. Meet contractual profit obligations, make the necessary decisions, act as
communication focal point of customers, upper-level management, and functional
management, negotiation, and conflict resolution
5. Team building, leadership, conflict resolution, technical expertise, administration,
management support, and resource allocation
UNIT 7: FINANCIAL EVALUATION
Contents
7.0. Aims and Objectives
7.1. Introduction
7.2. Cost of Project
7.3. Means of Financing the Project
7.4. Production costs
7.5. Estimation of Sales and Production
7.6. Estimation of Material s Costs
7.7. Estimation of Labour Costs
7.8. Estimation of Factory Overhead costs
7.9. Computation of Unit Costs
7.10. Estimating Administrative, Selling and Other Costs
7.11. Estimating Project Cash Flows for Revenue Expansion Projects
7.12. Estimating Project Cash Flows for Replacement Projects
7.13. Project Evaluation Techniques
7.14. Summary
7.0. AIMS AND OBJECTIVES

 explain and determine the costs of projects;
 estimate sales, production, material costs, labor costs, factory overhead costs, and
other expenses associated with the project;
 prepare projected income statement for a project;
 estimate project cash flows for revenue expansion and cost reduction projects; and
 evaluate the project using various project evaluation techniques.
7.1. INTRODUCTION
Project is evaluated (or analyzed) from financial point of view and economic point of
view. Financial analysis of the project is concerned with the analysis of the profitability
of the project based on monetary costs and benefits. On the other hand, economic
analysis of the project deals with project analysis based on social costs and benefits.
Economic analysis of the project will be dealt with in unit eight. This unit deals with
financial analysis of the project. Financial analysis requires the determination of project
costs, the estimation of cost of production and other expenses, the estimation of project
net cash flows, and the evaluation of the desirability of the project using various criteria.
7.2. COST OF PROJECT
Conceptually, the cost of project represents the total of all items of outlay associated with
a project which are supported by long-term funds. It is the sum of the outlays on the
following: Land and site development, Building and civil works, Plant and machinery,
Technical know-how and engineering fees, Expenses on foreign technicians and training
local technicians abroad, Miscellaneous fixed assets, Pre-operative expenses, Margin
money for working capital and Initial cash losses.
7.2.1. Land and Site Development

The cost of land and site development is the sum of the following:
 Basic cost of land including conveyance and other allied charges
 Premium payable on leasehold and conveyance charges
 Cost of leveling and development
 Cost of laying approach roads and internal roads
 Cost of gates
 Cost of tube wells
The cost of land varies considerably from one location to another. While it is very high in
urban and even semi-urban locations, it is relatively low in rural locations. The
expenditure on site development, too, varies widely depending on the location and
topography of the land.
7.2.2. Buildings and Civil Works

Buildings and civil works cover the following:
 Buildings for the main plant and equipment
 Buildings for auxiliary services like steam supply, workshops, laboratory, water
supply, etc.
 Godowns, warehouses, and open yard facilities
 Non-factory buildings like canteen, guesthouses, time office, excise house, etc.
 Quarters for essential staff
 Silos, tanks, wells, chests, basins, cisterns, hoopers, bins, and other structures
necessary for installation of the plant and equipment
 Garages
 Sewers, drainage, etc.
 Other civil engineering works.
The cost of the buildings and civil works depends on the kinds of structures required
which, in turn, are dictated largely by the requirements of the manufacturing process.
Once the kinds of structures required are specified, cost estimates are based on the plinth
area and the rates for various types of structures. These rates, of course, vary with the
location to some extent.
7.2.3. Plant and Machinery

The cost of the plant and machinery, typically the most significant component of the
project cost, consists of the following:
 Cost of imported machinery: This is the sum of (i) FOB (free on board) value, (ii)
shipping, freight, and insurance cost, (iii) import duty, and (iv) clearing, loading,
unloading, and transportation charges.
 Cost of indigenous machinery: This consists of (i) FOR (free on rail) cost, (ii)
taxes, if any, and (iii) railway freight and transport charges to the site.
 Cost of stores and spares
 Foundation and installation charges
The cost of plant and machinery is based on the latest available quotation adjusted for
possible escalation. Generally, the provision for escalation is equal to the following
product: (latest rate of annual inflation applicable to the plant and machinery) x (length of
the delivery period).
7.2.4. Technical Know-how and Engineering Fees

Often it is necessary to engage technical consultants of collaborators from local and /or
abroad for advice and help in various technical matters like preparation of the project
report, choice of technology, selection of the plant and machinery, detailed engineering,
and so on. While the amount payable for setting up the project 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.
7.2.5. Expenses on Foreign Technicians and Training of Local Technicians

Abroad
Services of foreign technicians may be required for setting up the project and supervising
the trial runs. Expenses on their travel, boarding, and lodging along with their salaries
and allowances must be shown here. Likewise, expenses on local technicians who require
training abroad must also be included here.
7.2.6. MISCELLANEOUS FIXED ASSETS

Fixed assets and machinery which are not part of the direct manufacturing process may
be referred to as miscellaneous fixed assets. They include items like furniture, office
machinery and equipment, tools, vehicles, railway siding, diesel generating sets,
transformers, boilers, piping systems, laboratory equipment, workshop equipment,
effluent treatment plants, fire fighting equipment, and so on. Expenses incurred for the
procurement or use of patents, licenses, trademarks, copyrights, etc. and deposits made
with the electricity authority may also be included here.
7.2.7. 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 borne in connection with the raising of capital from the public are referred to as
capital issue expenses. The major components of capital issue expenses are underwriting
commission, brokerage, fees to managers and registrars, printing and postage expenses,
advertising and publicity expenses, listing fees, and stamp duty.
7.2.8. Pre-operative Expenses

Expenses of the following types incurred till the commencement of commercial
production are referred to as pre-operative expenses these include (i) establishment
expenses, (ii) rent, and taxes, (iii) traveling expenses, (iv) interest and commitment
charges on borrowings, (v) insurance charges, (vi) mortgage expenses, (vii) interest on
deferred payments, (viii) start-up expenses, and (ix) miscellaneous expenses.
Pre-operative expenses are directly related to the project implementation schedule. So,
delays in project implementation, which are fairly common, tend to push up these
expenses. Pre-operative expenses incurred up to the point of time the plant and machinery
are set up may be capitalized by apportioning them to fixed assets on some acceptable
basis. Pre-operative expenses incurred from the point of time the plant and machinery are
set up are treated as revenue expenditure. The firm may, however, treat them as deferred
revenue expenditure and write them off over a period of time.
7.2.9. Provision for Contingencies

A provision for contingencies is made to provide for certain unforeseen expenses and
price increase over and above the normal inflation rate which is already incorporated in
the cost estimates.
To estimate the provision for contingencies, the following procedure may be followed:
(i) Divide the project cost items into two categories, viz, ‘firm’ cost items and ‘non-firm’
cost items (firm cost items are those which have already been acquired or for which
definite arrangements have been made). (ii) Set the provision for contingencies at 5 to 10
percent of the estimated cost of non-firm cost items. Alternatively, make a provision of
10 percent for all items (including the margin money for working capital) if the
implementation period is one year or less. For every additional one-year, make an
additional provision of 5 percent.
7.2.10 Margin Money for Working Capital

The principal support for working capital is provided by commercial banks and trade
creditors. However, a certain part of the working capital requirement has to come from
long-term sources of finance. Referred to as the ‘margin money for working capital’ this
is an important element of the project cost.
The margin money for working capital is sometimes utilized for meeting over-runs in
capital cost. This leads to a working capital problem (and sometimes a crisis) when the
project is commissioned. To mitigate this problem, 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.
7.2.11. Initial Cash Losses

Most of the projects incur cash losses in the initial years. Yet, promoters typically do not
disclose the initial cash losses because they want the project to appear attractive to the
financial institutions and the investing public. Failure to make a provision for such cash
losses in the project cost generally effects the liquidity position and impairs the
operations. Hence prudence calls for making a provision, overt or covert, for the
estimated initial cash losses.
7.3 MEANS OF FINANCE
To meet the cost of the project, the means of finance that are available include Share
capital, Term loans, Bonds, Deferred credit, Incentive sources, and Miscellaneous
sources.
1.Share Capital. There are two types of share capital; namely, equity capital (through
the issuance of common stock) and preference capital (through the issuance of preferred
stock). Equity capital represents the contribution made by the owners of the business, the
equity shareholders, who enjoy the rewards and bear the risks of ownership. Equity
capital being a risk capital carries no fixed rate of dividend. Preference capital represents
the contribution made by preference shareholders and the dividend paid on it is generally
fixed.
2. Term Loans. They are provided by financial institutions and commercial banks. Term
loans represent secured borrowings which are a very important source (and often the
major source) for financing new projects as well as for the expansion, modernization, and
renovation schemes of existing firms.
3. Bond capital. Bonds are instruments for raising debt capital. The typical example of
bonds is debentures. There are two broad types of debentures; namely, non-convertible
debentures and convertible debentures. Non-convertible debentures are straight debt
instruments. Typically they carry a fixed rate of interest. Convertible debentures, as the
name implies, are debentures, which are convertible, wholly or partly, into equity shares.
The conversion period and price are announced in advance.
4. Deferred Credit. Many a time the suppliers of the plant and machinery offer a
deferred credit facility under which payment for the purchase of the plant and machinery
can be made over a period of time.
5. Incentive Sources. The government and its agencies may provide financial support as
an incentive to certain types of promoters or for setting up industrial units in certain
locations. These incentives may take the form of seed capital assistance (provided at a
nominal rate of interest to enable the promoter to meet his contribution to the project), or
capital subsidy (to attract industries to certain locations), or tax deferment or exemption
for a certain period.
6. Miscellaneous Sources. A small portion of the project finance may come from
miscellaneous sources like unsecured loans, public deposits, and leasing and hire
purchase finance. Unsecured loans are typically provided by the promoters to bridge the
gap between the promoters’ contribution (as required by the financial institutions) and the
equity capital the promoters can subscribe to. Public deposits represent unsecured
borrowings from the public at large. Leasing and hire purchase finance represent a form
of borrowing different from the conventional term loans and debenture capital.
Planning the Means of Finance

The various means of finance that can be tapped for a project have been descried above.
How should you go about determining the specific means of finance for a given project?
The guidelines and considerations that should be borne in mind for this purpose are as
follows:
1. Norms of Regulatory Bodies and Financial Institutions. In some countries, the

proposed means of finance for a project must either be approved by a regulatory agency
or conform to certain norms laid down by the government or financial institutions in this
regard. The primary purpose of such regulations is to impart prudence to project
financing decisions and provide a measure of protection to investors. In addition, the
norms of financial institutions, which often provide substantial assistance to projects
significantly shape and circumscribe project financing decisions.
2. Key Business Considerations. The key business considerations which are relevant
for the project financing decision are cost, risk, control, and flexibility.
a. Cost. In general, the cost of debt funds is lower than the cost of equity funds. Why?
The primary reason is that the interest payable on debt capital is a tax-deductible expense
whereas the dividend payable on equity capital is not.
b. Risk. The two main sources of risk for a firm (or project) are business risk and
financial risk. Business risk refers to the variability of earnings before interest and taxes
and arises mainly from fluctuations in demand and variability of prices and costs.
Financial risk represents the risk arising from financial leverage. It must be emphasized
that while debt capital is cheap it is also risky because of the fixed financial burden
associated with it.
Generally the affairs of the firm are, or should be, managed in such a way that the total
risk borne by equity shareholders, which consists of business risk and financial risk, is
not unduly high. This implies that if the firm is exposed to a high degree of business risk,
its financial risk should be kept low. On the other hand, if the firm has a low business risk
profile, it can assume a high degree of financial risk.
c. Control. From the point of view of the promoters of the project, the issue of control is
important. They would ordinarily prefer a scheme of financing which enables them to
maximize their control, current as well as potential, over the affairs of the firm, given
their commitment of funds to the project.
d. Flexibility. This refers to the ability of a firm (or project) to raise further capital from
any source it wishes to tap to meet the future financing needs. This provides
maneuverability to the firm. In most practical situations, flexibility means that the firm
does not fully exhaust its debt capacity. Put differently, it maintains reserve-borrowing
powers to enable it to raise debt capital to meet largely unforeseen future needs.
7.4. PRODUCTION COSTS
There are three major categories of manufacturing costs. These are
1. Direct materials cost: - The acquisition costs of all materials that are identified as
part of the cost object and that may be traced to the cost object in an economically
feasible way. Acquisition costs of direct materials include inward delivery charges,
tax, and custom duties. Direct material often does not include minor items such as
glue or tacks. Why? because the cost of tracing insignificant items do not seem worth
the possible benefits of having more accurate product costs. Such items are called
supplies or indirect materials and are classified as part of the indirect manufacturing
costs.
2. Direct labour. The compensation of all labour that can be identified in an
economically feasible way with a cost object. Examples are the labour of machine
operators and assembler. Indirect labour costs are all factory labour compensation
other than direct labour compensation. These are labour costs that are impossible or
impractical to trace to a specific product. They are classified as part of the indirect
manufacturing cost. Examples include wages of janitors, and plant guards.
3. Indirect manufacturing costs (manufacturing overhead). All manufacturing costs
that cannot be identified specifically with or traced to the cost object in an
economically feasible way. Other terms used are factory overhead, factory burden,
manufacturing overhead, and manufacturing expenses. Examples of factory overhead
(when products are cost object) include power, supplies, indirect labour, factory rent,
insurance, property taxes, and depreciation.
7.5. ESTIMATES OF SALES AND PRODUCTION
7.5.1. Estimating Sales

The sales forecast is the starting point for the projections of profitability. In estimating
sales revenues, the following should be taken into account:
1. Economic level (activities)
2. The project’s probable market share in each distribution territory
3. Competitor’s and their capacities
4. Pricing strategies
5. The effect of inflation on prices
6. Advertising campaigns, promotional discounts, and credit terms.
7.5.2. ESTIMATING PRODUCTION

Once sales projections are made, the next step is production estimates. Production may be
estimated as follows:
Production = sales + Desired ending Inventory – Beginning finished goods
inventory
For the first year of operation, there is no beginning inventory. To illustrate, assume that
the sales are projected to be 100,000 units in the first year although the capacity is
180,000 units. It is estimated that there should be finished goods inventory of 5000 units
on hand at the end of the first year. Estimated production would be:
Production = 100,000 + 5000 – 0 = 105,000 units
Similar approach can be followed for a period of more than one year. Production can also
be estimated in another way. To illustrate, assume that Addis Company has set the policy
of maintaining finished goods inventory of 10,000 units at the end of each year. The
installed plant capacity is estimated to be 300,000 per year. It is estimated that the project
will operate at 50% and 60% in year 1 and year 2 and full capacity from year 3 to year 5.
Annual production is computed as follows:

Year 1 Year 2 Year 3 Year 5 Year 6
Installed capacity 300,000 300,000 300,000 300,000 300,000
Capacity utilization 50% 60% 100% 100% 100%
Production 150,000 180,000 300,000 300,000 300,000
Based on production estimates and ending finished goods inventory policy, sales revenue
projections can be that a unit of out put is expected to be gold at Br. 160. Revenue budget
is prepared as follows:
TABLE 7-1 ESTIMATION OF TOTAL REVENUE

Year
1 2 3 4 5
Production 150,000 180,000 300,000 300,00 300,000
Desired ending inventory 10,000 10,000 10,000 10,000 10,000
Sold 140,000 170,000 290,000 290,00 290,000
Expected selling price/unit 160 160 160 160 160
Total sales revenue 22,400,000 27,200,000 46,400,000 46,400,000 46,400,000
7.6 ESTIMATION OF MATERIAL COSTS
The costs of materials include the cost of raw materials, chemicals, components, and
consumable stores required for production. The following should be considered in
estimating the cost of materials:
1. The requirements of various material inputs per unit of output.
When materials inputs requirements are established, it is necessary to consider:
- Theoretical consumption norms
- Experience of the industry
- Performance guarantees
- Specification of machinery suppliers
2. The total requirements of various inputs
Total requirements = Requirements per unit X Expected Production
3. The prices of material inputs
The prices of material inputs are defined in cost, insurance, and freight (CIF)
4. The present costs of various material inputs
5. The seasonal fluctuations in prices
To exemplify, refer to the above example, suppose that each unit of output requires two
types of materials: three units of input x and 2 units of material y. The estimated costs of
one unit of material x and one unit of material y are Br. 5 and Br. 10 respectively. To
adjust for estimation error the company allows a 2% contingency on the costs of
materials. The total requirement of each material type is computed as follows:
TABLE 7-2 ESTIMATED COST OF MATERIAL X
Year
1 2 3 4 5
Production 150,000 180,000 300,000 300,000 300,000
Material x /unit of 3 3 3 3 3
output
Total requirements 450,000 540,000 900,000 900,000 900,000
Unit cost 5 5 5 5 5
Total cost of material x 2,250,000 2,700,000 4,500,000 4,500,000 4,500,000
before contingency
Contingency (2%) 45,000 54,000 90,000 90,000 90,000
Total cost of material x 2,295,000 2,754,000 4,590,000 4,590,000 4,590,000
TABLE 7- 3 ESTIMATED COST OF MATERIAL Y
Year
1 2 3 4 5
Production 150,000 180,000 300,000 300,000 300,000
Material y/unit of 2 2 2 2 2
output
Total requirements 300,000 360,000 600,000 600,000 600,000
Unit cost 10 10 10 10 10
Cost before contingency 3,000,000 3,600,000 6,000,000 6,000,000 6,600,000
Contingency (2%) 60,000 72,000 120,000 120,000 120,000
Total cost of material y 3,060,000 3,672,000 6,120,000 6,120,000 6,120,000
Total material costs are summarized below:
YEAR MATERIAL X MATERIAL Y
TOTAL
1 2,295,000 3,060,000 5,355,000
2 2,754,000 3,672,000 6,426,000
3 4,590,000 6,120,000 10,710,000
4 4,590,000 6,120,000 10,710,000
5 4,590,000 6,120,000 10,710,000
7.7. ESTIMATING LABOR COSTS
Labor cost includes the cost of all the manpower employed in the factory. Labor cost is a
function of the number of employees and the rate of payment. Refer to Addis Company’s
example; assume that 3 hours of direct labor are required to produce one unit of output. It
is estimated that direct labor cost per hour is Br. 20 and is expected to increase at the rate
of 5% every year. Accordingly, direct labor cost is estimated as follows:
TABLE 7- 4 ESTIMATED DIRECT LABOR COST
Year
1 2 3 4 5
Production 150,000 180,000 300,000 300,000 300,000
Labor hour/unit of 3 3 3 3 3
output
Total labor hours 450,000 540,000 900,000 900,000 900,000
required
Labor rate/hour 20 21 22.05 23.15 24.31
Total cost of labor 9,000,000 11,340,000 19,845,000 20,835,000 21,879,000
Note that direct labor rate increases at 5% per year.
7.8. ESTIMATING OVERHEAD COSTS

Overhead costs are costs other than direct material costs and direct labor costs. Certain
bases should be used to estimate overhead costs. Some of the bases could be direct labor
hours, direct labor costs, material costs etc. To illustrate, suppose that (refer to Addis
Company’s example) factory overhead costs are estimated to be 60% of direct labor
costs. Then factory overhead costs are estimated as follows:
Table 7- 5Estimates of Factory overhead
Year
1 2 3 4 5
Estimated labor costs 9,000,000 11,340,000 19,845,000 20,835,000 21,879,000
Overhead rate 60% 60% 60% 60% 60%
Estimated Factory 5,400,000 6,804,000 11,907,000 12,501,000 13,127,400
Overhead
7.9. Computation of Unit Costs
The computation of unit cost is based on manufacturing costs which is composed of

Direct materials, direct labor, and overhead costs
Unit Cost = Manufacturing costs
Units produced
The unit cost is computed for each of the five years as shows below:
Table 7- 6 Computation of unit cost

Direct Direct Factory
Year Material labor cost overhead Total Production Unit cost
Costs costs
1 5,355,000 9,000,000 5,400,000 19,755,000 150,000 131.70
2 6,426,000 11,340,000 6,804,000 24,570,000 180,000 136.50
3 10,710,000 19,845,000 11,907,000 42,462,000 300,000 141.54
4 10,710,000 20,835,000 12,501,000 44,046,000 300,000 146.82
5 10,710,000 21,879,000 13,127,400 45,716,400 300,000 152.39
Once unit cost is determined, the cost of ending inventory and cost of goods sold can be
computed. The following table shows the cost of ending finished goods inventory
assuming that FIFO method is used:
TABLE 7- 7 ESTIMATED COST OF ENDING INVENTORY
Year
Cost of ending inventory = Desired ending inventory X Unit cost
Based on the above data, the cost of goods sold can also be computed as follows:
TABLE 7- 8 ESTIMATED COST OF GOODS SOLD
Year
1 2 3 4 5
Cost of production 19,755,000 24,570,000 42,462,000 44,046,000 45,716,400
Add: Beg. Finished - 1,317,000 1,365,000 1,415,400 1,468,200
Goods inventory
Available for sale 19,755,000 25,887,000 43,827,000 45,461,400 47,184,400
Ded: Ending Finished 1,317,000 1,365,000 1,415,400 1,468,200 1,523,900
Goods inventory
Cost of goods sold 18,438,000 24,522,000 42,411,600 43,993,200 45,660,500
7.10. ESTIMATING ADMINISTRATIVE, SELLING, AND OTHER COSTS
Administrative, general, selling and other costs should be estimated in order to prepare
projected income statements. To prepare the projected income statement, based on the
foregoing illustration, assume the following additional data:
a) Administrative and general expenses, including depreciation of Br. 100,000 per
year are estimated at Br. 500,000 in year 1 and expected to increase by Br. 10,000
thereafter.
b) Selling expenses, including depreciation of Br. 60,000 per year are estimated at
Br. 400,000 in year 1 and year 2 and are expected to be Br. 420,000 thereafter.
c) The project will be financed fully by equity.
d) Income tax rate is 30% after two years
Accordingly, the projected income statement is prepared as follows:

Addis Company
Projected Income Statement
For the year ended Dec. 31, years 1 – 5
Year
1 2 3 4 5
Sales 22,400,000 27,200,000 46,400,000 46,400,000 46,400,000
Gross profit 3,962,000 2,678,000 3,988,400 2,406,800 739,500
Expenses:
Administrative & 500,000 510,000 520,000 530,000 540,000
General
Selling 400,000 400,000 420,000 420,000 420,000
Total expenses 900,000 910,000 940,000 950,000 960,000
Earning before taxes 3,062,000 1,768,000 3,048,400 1,456,800 (220,500)
Taxes (30%) - - 914,520 437,040 -
Net income 3062,000 1,768,000 2,133,880 1,019,760 (220,500)
It is also possible to prepare balance sheet and statement of cash flows, had the
information is complete.
7.11. ESTIMATIING PROJECT CASH FLOWS FOR REVENUE EXPANSION
The estimation of project cash flows is a key element in investment evaluation but also
the most difficult step in capital budgeting. Forecasting project cash flows involves
numerous variables and many parties participate in this exercise.
These parties include:
1. Engineers – estimate capital outlays
2. Marketing group – projects revenues
3. Production people – forecast operating costs.
The forecasting of operating costs also involves cost accountants, purchase managers,
personnel executives, tax experts, and so on.
What is the role of finance manager in forecasting project cash flows? The role of finance
manager is to coordinate the efforts of various departments and obtain information from
them, ensure that the forecasts are based on a set of consistent economic assumptions,
keep the exercise focused on relevant variables, and minimize the biases inherent in cash
flow forecasting.
THE ELEMENTS OF PROJECT CASH FLOWS

Project cash flows comprises of three basic components.
These are:
1. Initial investment. The initial investment, also called net investment, is the cash
outlay on capital expenditures. In revenue expansion projects, initial investments
include the purchase price, installation costs, taxes, transportation costs, increase
in networking capital etc.
2. The operating cash flows. These include the after-tax cash flows resulting from
the operations of the project during its economic life.
3. Terminal cash flow. These are cash flows that occur at the end of the life of the
project. Terminal cash flows involve mainly salvage value (net of tax) and
recovery in networking capital.
To illustrate how project cash flows are forecasted, suppose that the project requires gross
investment of Br. 900,000. Besides, it is forecasted that additional costs will be incurred
at the beginning of the life of the project.
Transportation costs 60,000
Assembling & installation costs 20,000
Increase in networking capital 200,000
Based on the above data, initial investment can be computed as follows:
Gross investment 900,000
Transportation costs 50,000
Assembly and installation costs 20,000
Increase in networking capital 200,000
Initial Investment 1,170,000
Let’s use Addis Company’s project to illustrate how operating cash flows are forecasted.
Project after-tax cash flows (or net cash flows) can be determined using the following
formula:
After tax cash = Net income + Non-cash expenses + Interest (1-tax rate)
In Addis Company’s project, depreciation is considered the only non-cash expense.

Assuming that the project required increase in networking capital of Br. 100,000 at the
beginning of year 1 and is expected to be recovered at the end of year 5. Besides, the
project has salvage value of Br. 80,000 at the end of year 5. Straight-line method of
depreciation will be used.
After-tax cash flows of Addis Company are computed below:
TABLE 7- 9 DETERMINATION OF PROJECT NET CASH FLOWS
Year
Items 1 2 3 4 5
Net income 3,062,000 1,768,000 2,133,880 1,019,760 (220,500)
Add: Depreciation 160,000a 160,000 160,000 160,000 160,000
Salvage proceeds - - - - 80,000
Recovery in NWCb - - - - 100,000
After tax cash flows 3,220,000 1,928,000 2,293,880 1,179,760 119,500
a Obtained by adding Depreciation related to administrative and general expense (Br. 100,000)
and selling expense (Br. 60,000)
b Net working capital
Check Your Progress Questions 7.1

Suppose that the company has identified a project that is expected to have useful life of
six years. The project’s gross investment and increase in networking capital are estimated
at Br. 800,000 and Br. 50,000 respectively. It is estimated that it will have annual income
before depreciation and taxes of Br. 250,000. The project’s salvage value will be Br.
20,000 at the end of the year 6. The amount of net working capital is expected to be
recovered fully at the end of year 6. The project will depreciate using straight-line
method. Income taxes rate is 40%.
Required: Determine
a) Initial investment
b) After tax cash flows for each year
7.12. ESTIMATING PROJECT CASH FLOWS FOR REPLACEMENT

PROJECTS
In replacement projects, old asset is replaced by new one. The old asset is sold. As a
result, the initial investment can be determined using the following components:
1. Purchase price of new asset
2. Salvage proceed (net of tax) of old asset
The primary benefits from replacement projects is cost saving. Similarly, the manner in
which net cash flows for replacement projects is different from that of revenue expansion
projects.
Net cash flows = After-tax cost saving + Tax saving on incremental depreciation
To illustrate the determination of initial investment for replacement projects, suppose that
the firm is contemplating to replace old equipment with new equipment, which has a cost
of Br. 900,000. The original cost and accumulated depreciation of old equipment are Br.
400,000 and Br. 280,000 respectively. Income tax rate and capital gain tax rate are 40%
& 20% respectively. Old equipment is sold for Br. 150,000.
In replacement project, gain or loss on disposal of old equipment should be computed

before initial investment is determined. This is due to the fact that any gain or loss on
disposal has tax implication. Gain results in additional tax payment to taxing authority
and loss results in tax saving (shield). Thus, gain or loss on disposal is computed as:
Gain/loss = Selling price of old equipment – Book value of old equipment
Book value = Original cost – Accumulated depreciation
= 400,000 – 280,000
= 120,000
Gain = 150,000 – 120,000
= 30,000
Tax increase = Gain X Income tax rate
= 30,000 X 40% = 12,000
Then initial investment is determined as follows:
Original cost of new equipment 900,000
Tax increase (12,000)
Selling price of old equipment (30,000)
Initial investment 882,000
Let’s modify the assumption in that the selling price of old equipment is Br. 100,000.
Book value of old equipment is Br. 120,000
Loss on disposal is Br. 20,000 (i.e., 120,000 – 100,000 = 20,000).
Tax saving on loss is Br. 8,000 (i.e. 20,000 x 40% = 8,000). Then initial investment is
computed below:
Proceed from sales of old equipment (100,000)
Tax selling (8,000)
Old equipment may be sold above its original cost. In the illustration under consideration,
let’s assume that the old equipment is sold for Br. 480,000. When old asset is sold above
its original cost, two types of gains result.
i. Ordinary gain = Original cost – Book value
= 400,000 – 120,000
= 280,000
ii. Capital gain = Selling price – Original cost
= 480,000 – 400,000
= 80,000
Ordinary gain is taxed at normal income tax rate.
Tax on ordinary gain = ordinary gain X normal income tax rate
= 280,000 X 40%
= 112,000
Similarly, tax is also paid on capital gain
Tax on capital gain = Capital gain X Capital gain tax rate
= 80,000 x 20%
=16,000
Total tax increase = Ordinary tax + Capital gain tax
= 112,000 + 16,000
= 128,000
Then, initial investment is computed as follows:
Proceed from sale of old equipment (480,000)
Tax increase 128,000
The evaluation of replacement project also requires the determination of net cash flows.
To illustrate the estimation of net cash flows, assume that the company is planning to
replace old equipment by new one. The old equipment had original cost of Br. 100,000,
salvage value of Br. 5000 and useful life of ten years, but remaining life of five years.
The new equipment has original cost, salvage value and useful life of Br. 150,000, Br.
10,000 and five years respectively. The company uses straight-line method. If old
equipment is replaced, the company can have cost saving (before tax) of Br. 30,000 per
year over five years. Income tax rate is 30%.
Net cash flow for replacement project is computed as follows:

Net cash flows = After-tax cost saving + tax saving on incremental depreciation
Depreciation on:
Old equipment = 100,000 – 5000 = 9500
10
New equipment = 150,000 – 10,000 = 28,000
5
Incremental depreciation = 28000 – 9500 = 18500
Net cash flows (year 1 – year 4) = 30,000 (1 – 0.30) + 18500(0.30)
= 21,000 + 5550
= 26,550
Net cash flows (year 5) = Operating cash flows + Terminal cash flows
Terminal cash flows = Salvage value of new equipment
Net cash flows (year 5) = 26,550 + 10,000 = 36,550
ARS Company purchased a machine five years ago at a cost of Br. 100,000. The machine
had an expected life of 10 years at the time of purchase, and an expected salvage value of
Br. 10,000 at the end of the 10 years. It has been depreciated by the straight-line method.
A new machine can be purchased for Br. 180,000, including installation costs. During its
five-year life, the new machine will reduce cash operating costs by Br. 50,000 per year.
The new machine will be depreciated using straight-line method. The salvage value of
new machine is Br. 5000. The old machine can be sold for Br. 70,000 today. The income
tax rate is 30%.
Required:
a) Compute the initial investment.
b) Determine annual net cash flows over the life of the project.
7.13. PROJECT EVALUATION TECHNIQUES/CRITERIA
The key steps involved in determining whether a project is worthwhile or not are:
- Estimate the cost and benefits (revenues) of the project
- Calculate the cost of capital,( also called the Required Rate of Return)
- Compute the criterion of merit and judge whether the project is good or bad.
The estimation of the costs and revenues was the concern of the preceding sections. The
cost of capital is dealt with in your financial management courses. Similarly, risk
assessment was discussed at the end of unit three and you can also refer to your earlier
accounting courses (financial management) and management courses.
This section is concerned with the project’s evaluation techniques, (also called capital
budgeting techniques). There are several project evaluation criteria that have been
suggested by economists, accountants, and others to judge the worthwhileness of capital
projects. However, only few of them and the most common ones are presented in this
section. They are classified into two categories. These are:
1. Non-discounting (traditional) criteria
a) Payback Period (PBP)
b) Accounting Rate of Return (ARR)
2. Discounted Cash Flows (DCF) criteria
a) Net Present Value (NPV)
b) Internal Rate of Return (IRR)
c) Profitability Index (Benefit-cost ratio)
Each of the above methods is discussed in the following sections:
7.13.1. Payback Period (PBP)

Payback period refers to the length of time it takes to recover initial investment of the
project. Depending on the nature of net cash flows, payback period may be computed in
two ways.
a) When cash flow is in annuity form
Annuity refers to equal amount of cash flows that occur every period over the life
of the project
Initial Investment
PBP = Annual Net Cash Flows
To illustrate the computation of payback period, assume that a project requires an initial
investment of Br. 24,000 and annual after tax cash flows of Br. 6000 for five years. How
long it takes the company to recover its initial investment?
24,000
PBP = = 4 years
6000
It is expected to take the company four years to recover the project’s initial investment of
Br. 24,000
b) When cash flows are not in annuity form
When net cash flows are not annuity, payback period is obtained by adding net cash
flows for successful years until the total is equal to initial investment. To exemplify,
assume that a project requires an initial investment of Br. 60,000. The after tax cash flows
(or net cash flows) are as follows:
Year 1 = 8000 Year 4 = 20,000
Year 2 = 15,000 Year 5 = 20,000
Year 3 = 22,000
The payback period is computed as follows:
15,000
PBP = 3 years + 20,000 = 3.75 years
In the above example, if the 1st three years’ net cash flows are added, the sum is equal to
Br. 45,000. But the initial investment is Br. 60,000. If the fourth year net cash flows (Br.
20,000) is added to Br. 45,000, the sum is Br. 65,000 which is greater than the initial
investment. Thus, the payback period is between year 3 and year 4. To find the exact
payback period, we take the three years and divide the remaining cash flows by the fourth
year net cash flows. If the exact payback period is needed in months the fraction can be
computed as follows:
15,000
PBP = 3 years + 20,000 (12 months)
= 3 years and 9 months
Decision Rule for Payback Period

i. Accept the project if its payback period is less than or equal to the required
payback period (standard)
ii. Reject the project if its payback period exceeds the required payback period. The
shorter the payback period, the more desirable the project.
Advantages of Payback Period
1. It is simple both in concept and application
2. It is a rough and ready made method for dealing with risk
3. It may be a sensible criterion when the firm is pressed with problems of liquidity
Disadvantages of Payback Period
1. It fails to consider time value of money
2. It ignores cash flows beyond the payback period
3. It is a measure of the project’s capital recovery, not profitability.
4. It does not indicate the liquidity position of the firm as a whole.
7.13.2. Accounting Rate of Return (ARR)

Also called the average rate of return on investment, the accounting rate of return is a
measure of profitability which relates net income to investment. Both net income and
investment are measured in accounting terms. Although there are several methods of
computing ARR, the most common method is shown below:
Average annual net income
ARR = Average investment
Original cos ts  salvage value

Average Investment =
2
To illustrate, assume that a project has original investment of Br. 70,000, life of 4 years,
and salvage value of Br. 6000. Straight-line method of depreciation is used. Income
before depreciation and taxes for each of the four years are as follows: year1, Br. 40,000;
year 2, Br. 42,000; year 3, Br. 36,000; and year 4, Br. 50,000. Income tax rate is 40%.
Depreciation = 70,000 – 6000 = 16,000
4
Before ARR is determined, it is necessary to compute net income for each of the four
years as follows:
Year 1 Year 2 Year 3 Year 4
Income before depreciation tax 40,000 42,000 36,000 50,000
Less: Depreciation 16,000 16,000 16,000 16,000
Income before taxes 24,000 26,000 20,000 34,000
Less: Taxes (40%) 9600 10,400 8000 13,600
Net income 14,400 15,600 12,000 20,400
14,400  15,600  12,000  20,400
Average Net income =  15,600
4
70,000  6000
Average Investment =  38,000
2
Average Annual Net Income
ARR = Average Investment
15600
=  41%
38000
Decision Rule for Accounting Rate of Return

i. Accept the project if ARR exceeds the required rate of return.
ii. Reject the project if ARR is less than the required rate of return.
Advantages of ARR
1. It is simple to calculate
2. It is based on accounting information, which is readily available and familiar to
businessmen.
3. It considers benefits over the entire life of the project.
4. It facilitates post-auditing of capital expenditures.
Limitations of ARR
1. It is based upon accounting profit, not cash flow.
2. It does not take into account the time value of money.
3. Since there are numerous measures of accounting rate of return, this may create
controversy, confusion, and problems in interpretation.
4. Accounting income is not uniquely defined because it is influenced by various
methods, such as depreciation methods, inventory costing method etc.
7.13.3. Net Present Value Method

The net present value of project is the difference between the present value of net cash
inflows and present value of initial investment. In formula,
n
Ct
NPV =  1  r 
i 1
t
 I0
Where:
NPV = Net present value
Ct = Net cash flows at the end of year t
n = Life of the project
r = Discount rate
I0 = Initial investment
Net present value can also be determined as follows:
NPV = PV of NCF – I0
where: PV = Present value
NCF = Net cash flows
To illustrate, assume that a project is expected to have initial investment and life of Br.
40,000 and five years respectively. The annual after tax net cash flow is estimated at Br.
12,000 for each of the five years. The required rate of return is 10%. Net present value is
determined as follows:
NPV = PV of NCF – I0
 1 
1 
  1  0 .10 
5
  40,000
= 12,000  0.10 
 
 
= 12,000 (3.791) – 40,000

= 45,492 – 40,000
= 5492
1
1
In the above formula, 1  0.10  5 represents the discount factor and its value is equal
0.10
to 3.791. This discount factor can be taken from the present value of annuity of 1 table
from the intersection of i = 10% and n = 5. It can also be determined using your
calculator.
In the above example, net cash flows are annuity. The same procedure can be followed if
net cash flows are not in annuity form. To illustrate the computation of NPV when net
cash flows are not annuity, suppose the project has initial investment and useful life of
Br. 30,000 and four years respectively. Its annual cash flows are as follows: Year 1, Br.
10000; Year 2, Br. 8000; year 3, Br. 15000; and year 4, Br. 12,000. If the required rate of
return is 10%, NPV is determined as follows:
Year Net cash flows Discount factor (10%) Present value
1 10,000 0.909 9090
2 8000 0.826 6608
3 15,000 0.751 11,265
4 12,000 0.683 8196
Present value of NCF 35,159
Less: Initial investment 30,000
NPV + 5159
What does NPV represent? NPV represents the amount by which the value of (wealth of)
the firm will increase if the project is accepted.
Decision Rule for NPV

1. If NPV is greater than zero (NPV > 0), the project is considered desirable.
2. If NPV is less than 0, the project is considered undesirable.
7.13.4. Internal Rate of Return (IRR)
Internal Rate of Return is the discount rate which equates the project NPV equal to zero.
It is the discount rate at which the present value of Net cash flows is equal to the present
value of initial investment. In other words, IRR is the rate of return on investments in the
project. The determination of IRR is purely based on project cash flows. Mathematically,
at IRR,
n
Ct
i 1 (1  r ) t
= Initial investment
IRR is determined using trial and error: the complexity of determining IRR is greater if
net cash flows are not in annuity form. This section illustrates the determination of net
cash flows when cash flows are annuity as well as non-annuity.
a) Determination IRR when NCFs are annuity.

Assume that the project has initial investment of Br. 40,000, and useful life of five years.
the annual net cash flows is estimated at Br. 12000 for five years. The required rate of
return is 10%. The following steps can be followed to determine IRR.
Step1: Compute the leading discount factor (payback period)

Initial Investment 40,000
PBP = Annual net cash flows  12,000 = 3.333
Step 2. From the present value of annuity table, find two discount factors and their
corresponding interest rates closest to the computed leading discount factor. If we look in
the PV of annuity table on n = 5 years row (horizontally), the leading discount factor
(3.333) is found between 15% and 16%.
Interest rate 15% 16%
Discount factor 3.352 3.274
Step 3: Compute the actual IRR using the following formula

 PBP  DFr 
IRR = r –  
 DFrL  DFrH 
Where:
r = Either of the two interest rates (15% or 16%)
DFr = Discount factor for the taken interest rate
DFrL = Discount factor for the lower interest rate
DFrH = Discount factor for the higher interest rate
Let's take r = 15%, IRR is determined as follows:
 3.333  3.352 
IRR = 15% -  
 3.352  3.274 
= 15% - (-0.24)
= 15.24%
If we take r = 16%, the computation of IRR looks like the following:
 3.333  3.274 
IRR = 16% -  
 3.352  3.274 
= 15.24%
b) Determination of IRR when net cash flows are non-annuity

The steps followed in the preceding section are equally applicable for non-annuity cash
flows. However, one step is added at the beginning to determine the weighted average net
cash flow, which will be used to determine the leading discount factor. To illustrate,
assume that a project has initial investment of Br. 40,000 and the following net cash
flows: year 1, Br. 15,000; year 2, Br. 10,000; year 3, Br. 10,000; year 4, Br. 15000; and
year 5, Br. 15,000. The discount rate is 15%. The following steps can be used to compute
IRR:
Step 1. Compute the weighted average net cash flows.

Year Net cash flows Weight NCF X weight
1 15,000 5 25,000
2 10,000 4 40,000
3 10,000 3 30,000
4 15,000 2 30,000
5 15,000 1 15,000
Total 15 190,000
Note that the weight is assigned in the reverse order of the project's useful life.
190,000
Weighted average NCF =
15
= 12,667
Step 2: Compute the leading discount factor (PBP)
Initial Investment
PBP = Weighted average NCF
40,000
= 12,667
= 3.158
Step 3: From the present value of annuity table, find the starting rate (a good first guess)
by looking for the closest interest rate and discount factor. In this case, the nearest rate is
18% (i.e., first guess = 18%)
Step 4: Compute NPV at the 1st guess (18%)

NPV (18%)
Year NCF Discount factor (18%) Present value
1 15,000 0.847 12,705
2 10,000 0.718 7180
3 10,000 0.609 6090
4 15,000 0.516 7740
5 15,000 0.437 6555
Present value of net cash flows 40,270
Less: Initial Investment 40,000
NPV + 270
Since, at IRR, NPV is equal to zero, 18% is not the exact IRR. Thus, another rate should
be tried. Which rate should be tried next? Generally as we go down (in rate decreasing
direction), discount factor increases. Now we need to find a rate at which NPV = 0. Thus,
we should try a higher rate. The next (2nd) guess could be 19%. Then NPV should be
computed at 19% using the above procedure.
NPV at 19%:
Year NCF Discount factor (19%) Present value
1 15,000 0.840 12,600
2 10,000 0.706 7060
3 10,000 0.593 5930
4 15,000 0.499 7485
5 15,000 0.419 6285
Present value of net cash flows 39,360
Less: Initial investment 40,000
NPV -640
At 19% NPV is negative, this implies that IRR lies between 18% and 19%. Thus, such
iteration process ends when two neighboring rates, at lower rate NPV is positive and at
higher rate is negative. To find the exact IRR, steps 4 and 5 will be followed:
Step 4: Obtain the absolute sum of the two present values

Sum = |+270| + |-640|
= 270 + 640
= 910
Step 5: Divided the NPV of the smaller rate by the absolute sum and add to the smaller
rate
270
IRR = 18% +
910
= 18.30%
Decision Rule for IRR

Accept: If the IRR is greater than the discount rate
Reject: If the IRR is less than the discount rate
7.13.5. Profitability Index (PI)

The profitability index, also called benefit - cost ratio, is the ratio of the present value of
net cash flows and initial investment.
Pr esent value of NCF
PI = Initial investment
To illustrate, assume that a project is expected to have initial investment and useful life of
Br. 90,000 and four years respectively. Annual net cash flows amounted to Br. 40,000.
The discount rate is 10%. Profitability index can be computed as follow:
Pr esent value of NCF
PI = Initial investment
40,000(3.170)
=
90,000
126,800
= 90,000
= 1.41
Decision rule for profitability Index

i. Accept if the project's profitability index is grater than 1
ii. Reject if the project's profitability index is less than 1

A. Assume that a project has original costs of Br. 400,000, salvage value of Br. 50,000
and useful life of five years. The project has the following estimated Revenues,
operating expenses, cost of goods sold:
Year Revenues Cost of goods sold operating expenses, including

Depreciation
1 800,000 450,000 150,000
2 900,000 500,000 120,000
3 1,000,000 450,000 200,000
4 1,200,000 550,000 300,000
5 1,400,000 600,000 350,000
Straight line depreciation method is used. The required rate of return is 10%. Income tax
rate is 30%. All revenues are collected in cash and all operating expenses (except
depreciation) are paid in cash in the year. The project requires increase in net working
capital of Br. 80,000 which will be recovered fully at the end of year 5.
Requires
a) Determine net income each year
b) Compute net cash flows for each year over the life of the project.
c) Evaluate the feasibility of the project using:
1) Payback period if the required payback period is 2.5 years
2) Accounting rate of return
3) NPV
4) Profitability index
B. Suppose that a project has initial investment of Br. 42,204 and annual net cash flows
of Br. 12,000 for five years. The required rate of return is 8%. Evaluate the
desirability of the project using IRR.
7.14. SUMMARY
Cost of the project is the sum of the outlays on Land and site development, Building and
civil works, Plant and machinery, Technical know-how and engineering fees, Expenses
on foreign technicians and training local technicians abroad, Miscellaneous fixed assets,
Pre-operative expenses, Margin money for working capital and Initial cash losses.
The project may be financed from share capital, term loans, bonds, deferred credits,
incentive sources and others. The guidelines that can be used to determine the specific
source of finance are norms of regulatory bodies and financial institutions, and key
business considerations such as costs, risk, control, and flexibility.
The sales forecast is the starting point for the project of profitability, followed by
estimation of production, cost of production, administrative and selling expenses, project
net income, and project net cash flows. Once project cash flows are determined, the
project can be evaluated using various techniques such as Payback period, accounting
rate of return, net present value, IRR, and benefit-cost ratio.
7.15. ANSWERS TO CHECK YOUR PROGRESS QUESTIONS
CYP 7.1
a) Initial investment = 800,000 + 50,000 = 850,00
b) After tax cash flows:
800,000  20,000
Annual depreciation = = 130,000
6
1 2 3 4 5
6
Income before depreciation
and taxes 250,000 250,000 250,000 250,000 250,000
250,000
Ded: Depreciation 130,000 130,000 130,000 130,000 130,000 130,00
Income before tax 120,00 120,000 120,000 120,000 120,000
120,000
Ded: Taxes (40%) 48,000 48,000 48,000 48,000 48,000 48,000
Net income 72,000 72,000 72,000 72,000 72,000 72,000
Add: Salvage Proceeds __ __ __ __ __ 20,000
Recovery in NWC __ __ __ __ __ 50,000
Net cash flows 72,000 72,000 72,000 72,000 72,000 72,000
CYP 7.2
a) Initial investment
100,000  10,000
Annual depreciation on old machine = = 9000
10
Accumulated depreciation on old machine = 900 x 5 = 45,000
Book value on old machine =- 100,000 - 45,000 = 55,000
Gain on disposal of old machine = 70,000 - 55,000 = 15,000
Tax increase = 15,000 x 30% = 4500
Initial investment:
Original cost of new machine 180,000
Proceed from sale of old machine (70,000)
Tax increase 4500
b) Net Cash Flows (NCF)

NCF = After tax cost saving + Tax saving on incremental depreciation
180,000  5000
Depreciation on New machine = = 35,000
5
100,000  10,000
Old machine = = 9000
10
Incremental depreciation = 35,000 - 9000 = 26,000
NCF (Years 1-4) = 50,000 (1-0.30) + 26,000 (0.30)
= 35,000 + 7800
= 42,800
NCF (Year 5) = 42,800 + 5000 = 47,800
CYP 7.3
Original cos t  Salvage value
A. a) Annual depreciation = Useful life
900,000  50,000
=
5
= 70,000
Year
___________________________________________________
1 2 3 4
5
Revenues 800,000 900,000 1,000,000 1,200,000 1,400,000
Cost of goods sold (450,000) (500,000) (450,000) (550,000) (600,000)
Gross profit 350,000 400,000 550,000 650,000 800,000
Operating expenses (150,000) (120,000) (200,000) (300,000) (350,000)
Income before taxes 200,000 280,000 350,000 350,000) 450,000
Taxes (30%) (60,000) (84,000) (105,000) (105,000) (135,000)
Net income 140,000 196,000 245,000 245,000 315,000
b) Net Cash Flows (NCFs)
NCFs = Net cash + Non-cash expenses
Year
1 2 3 4 5
Net income 140,000 196,000 245,000 245,000
315,000
Add: Depreciation 70,000 70,000 70,000 70,000 70,000
Recovery in NWC - - - - 80,000
Net cash flows 210,000 266,000 315,000 315,000 515,000
190,000
c) 1) PBP = 1 year + 266,000 = 1.71 years
Average Annual net income

2) ARR = Average Investment
Average Annual net income =
140,000  196,000  245,000  245,000  315,000

5
= 228,200
400,000  50,000
Average investment = = 225,000
2
228,200
ARR = 225,000 = 101%
3) NPV = PV of NCF - I0
NPV = 210,000 (0.909) + 266,000 (0.826) + 315,000 (0.751)
+ 315,000 (0.683) + 515,000 (0.621) - 400,000
= 1,182,131 - 400,000
= 782,131
PV of NCF
4) Profitability Index = I0
1,182,131
= 400,000
= 2.96
B. IRR
42,204
 Leading discount factor = 12,000 = 3.517
 In the present value of annuity table, the leading discount factor (3.517) is found
exactly on 13%. Thus, IRR is 13%
Comprehensive Problem
A project having a life of 5 years requires a gross investment of Br. 1,250,000 in fixed
assets and Br. 300,000 in net working capital. Net working capital will be recovered in
the final year.
1. An annual depreciation on all fixed assets is Br. 250,000 per year (60% factory
overhead) and at the end of year 5 the salvage value of building, and machinery
and equipment will be Br. 220,000.
2. 50% of initial investment is borrowed from a bank at the beginning of the first
year for four years with a grace period of one year at the rate of 10% to be repaid
in three equal annual equal installments. The required rate of return is 10%.
3. The income tax rate is 40% and to be paid after two years' tax holiday.
4. The plant has an installed capacity to produce 100 units per hour for 24 hours on
each working day. Presently the plant will be working only one shift of 8 hours
per day. The annual working days are assumed to be 300. Considering market
demand, the plant works at 80% of its capacity in the first two years and at 100%
capacity from 3rd year thereafter. There are no beginning and ending inventory of
finished goods.
5. Two raw materials are used in the production process. Each unit produced
consumes 2 kgs of material x and 1 kg of material y. The average purchase price
of material x is Br. 3 per kg and that of material y is Br. 2 per kg. Packing
material costs Br. 0.50 per unit of output.
6. The electricity and water charges are at Br. 1 per unit produced plus Br. 5000
annual rent.
7. Fixed factory overhead costs, except depreciation are estimated to be Br. 768,000
with 5% annual increase.
8. The direct labor costs in the first two years are estimated at Br. 614,000 per year
with a 2% annual increase thereafter.
9. Selling and administrative expenses, except depreciation amounted to Br. 450,000
with annual increase of Br. 10000 therafter.
10. The average selling price of a product is Br. 22 per unit. All sales are for cash
11. The required rate of return is 8%.
Required
Determine: (Round figures to the nearest birr)
1. Production in units for each year
2. The raw materials requirements in kg.
3. The cost of raw materials and packaging
4. The annual revenue of the project
5. The annual total production costs
6. The loan amortization schedule
7. The projected income statement for each year
8. The projected net cash flow
9. Evaluate the project using:
a) Payback period
b) Accounting rate of return
c) Net present value
d) Internal rate of return
e) Benefit-cost ratio
(See the answers to this problem at the end of this material)
UNIT 8: ECONOMIC ANALYSIS OF A PROJECT
Contents
8.1 Introduction
8.2 Economic Analysis vs. Financial Analysis
8.3 Approaches to Economic Analysis
8.3.1 UNIDO Approach to Economic Analysis
8.3.2 Little-Mirrlees Approach to Economic Analysis
8.4. Summary

 describe the difference between financial analysis (evaluation) and economic
analysis of the project;
 list the principal sources of discrepancy between financial evaluation and
economic evaluation of the project;
 discuss the different approaches to economic analysis of the project;
 explain the basic concepts and issues of shadow pricing;
 mention the sources of shadow pricing;
 measure the impact of project on savings and income distribution;
 understanding how the shadow prices of goods, labour, and capital can be
determined; and
 determine the social costs and benefits of the project.
8.1 INTRODUCTION
The economic analysis, also called social cost-benefit analysis (SCBA), is a methodology
developed for evaluating investment projects from the point of view of the society or
economy as a whole. Although economic analysis can be applied to both profit oriented
(private) projects and public investments, it is primarily used for evaluating public
investments.
Since private investments get approval from the government and quasi-governmental
agencies, economic analysis is applied to private investments. Economic analysis helps in
evaluating individual projects within the planning framework, which indicates national
economic objectives and broad allocation of resources to various sectors. In other words,
economic analysis is concerned with tactical decision-making within the framework of
broad strategic choices defined by planning at the macro level. The perspectives and
parameters provided by the macro level plans serve as the basis of economic analysis.
These perspectives and parameters are considered as tools for analyzing and appraising
individual projects. To this effect, this unit is concerned with the following:
- Economic analysis Vs financial analysis
- Approaches to economic analysis
8.2 ECONOMIC ANALYSIS VS FINANCIAL ANALYSIS
Financial analysis focuses on monetary costs and benefits of the project (see unit 7)
whereas economic analysis focuses on the social costs and benefits of the project. What
are the principal sources of discrepancies between financial analysis and economic
analysis? The major sources of discrepancies are:
1. Market imperfections
In computing the monetary costs and benefits, market prices are the base. Market prices
show social values only under conditions of perfect competition. However, in developing
countries, markets are not perfect and as a result imperfections occur. When
imperfections exist, market prices do not show social values. The common market
imperfections are:
a) Rationing – The control of the prices and distribution of commodities. The price
paid by the consumer is less than the market price that would prevail in
a competitive market.
b) Prescription of minimum wage rates
c) Foreign exchange regulation – the official exchange rate is less than the rate that
would prevail in the absence of foreign regulations.
2. Externalities
Externalities refer to the external benefits or costs that the project creates and for which
the users do not pay or get compensation. For example, a project may create
infrastructure facilities like roads. These roads benefit the neighboring areas. Financial
analysis ignores such benefits in assessing the project because the owners of the project
do not receive any monetary compensation from those who enjoy this external benefits
created by the project. Similarly, a project may have a harmful effect such as pollution of
the environment. Financial analysis does not take into account such harmful effect of the
project. However, in economic analysis, all costs and benefits of the project are relevant
irrespective of whom they accrue and whether they are paid for or not.
3. Taxes and Subsidies

From financial analysis point of view, taxes are definite monetary costs and subsidies are
definite monetary gains. An example of subsidy is tax exemption (holiday) granted by the
government. From the social point of view, taxes and subsidies are generally regarded as
transfer payments. Thus, taxes and subsidies are irrelevant for economic analysis.
4. Concern for savings

In evaluation of private investments, the division of benefits between consumption and
savings is not made. In other words, private investments do not put differential valuation
on savings and consumption. From social point of view, it is relevant to divide the
benefits between consumption and savings. It is generally believed that a Birr benefit
saved is deemed to have more value than a Birr benefit saved. This means a higher
valuation is placed on savings and a lower valuation is put on consumption. Thus,
economic analysis of the project reflects the concern of the society for savings as well as
investments.
5. Concern for Redistribution

Different groups in the society get benefits from the project. A private firm does not
bother how its benefits are distributed across various groups. However, the society is
concerned about the distribution of benefits across different groups. This is based on the
assumption that a Birr of benefit going to an economically poor section is considered
more valuable than a Birr of benefit going to an affluent (rich) section of the society.
Thus, economic analysis of the project is concerned with the redistribution of the benefits
from the project.
6. Merit wants
Merit wants refer to goals and preferences that are not expressed in the market place.
These goals and preferences are believed by policymakers to be in the larger interest. For
example, the government may prefer to promote girls education. This is not sought by
consumers in the market place. Merit wants are not relevant from the private point of
view. But they are important from the social point of view.
Check Your Progress Question 8.1

1. ____________ focuses on monetary costs and benefits of the project where as
___________ focuses on the social costs and benefits of the project.
2. What are the principal sources of discrepancies between financial analysis and
economic analysis?
3. What is the base in computing monetary costs and benefits?
4. What is the base in computing social costs and benefits?
5. Mention the common market imperfections that result in differences between market
prices and social values of goods and services.
6. What are the two external effects of the project?
8.3 APPROACHES TO ECONOMIC ANALYSIS
There are two approaches to economic analysis. These are:

1. UNIDO Approach
2. Little-Mirrlees (L–M) Approach
8.3.1 UNIDO Approach

The United Nations Industrial Development Organization (UNIDO) method of the
project appraisal involves five stages. These are:
1. Calculation of the financial feasibility of the project measured at market prices
(Financial Analysis of the Project). This was discussed in the previous unit of this
material. (unit 7)
2. Obtaining the net benefits of the project in terms of economic (efficiency) prices.
3. Adjustment for the impact of the project on savings and investments.
4. Adjustment for the impact of the project on income redistribution.
5. Adjustment for the impact of the project on merit goods and demerit goods whose
social values differ from their economic values.
Each stage of project appraisal measures the desirability of the project from a different
angle. Except the first stage, the remaining are described in the section that follows:
8.3.1.1 Net Benefit in terms of Economic (Efficiency) Prices

The second stage of UNIDO approach is concerned with the determination of the net
benefits of the project in terms of economic, efficiency, or shadow prices. In perfect
markets, market prices represent shadow prices. But when there is market imperfection,
market prices do not represent shadow prices and hence there is a need to develop
shadow prices that is used to determine net economic benefits of the project.
Before dealing with shadow pricing of specific resources, it is desirable to discuss the
basic concepts and issues. Some of the basic issues include:
a) Choice of Numeraire
Numeraire refers to the unit of account in which the value of inputs or outputs is
expressed. To define numeraire, the following questions have to be answered.
- what unit of currency (domestic or foreign) should be used to express benefits and
costs?
- should costs and benefits be measured in current values or constant values?
- with references to which point (present or future) should costs and benefits be
evaluated?
- what use (consumption or investment) will be made of the income from the
project?
- should income of the project be measured in terms of consumption or investment?
- with reference to which group should the income of the project be measured?
The specification of the UNIDO Numeraire in terms of the above questions is: “Net
present consumption in the hands of people at the base level of consumption in the
private sector in terms of constant price in domestic accounting Birr.”
b) Concepts of Tradability
Whether a good is tradable or not is the key issue in shadow pricing. The international
price is a measure of its opportunity cost to the country for tradable goods. For tradable
goods, it is possible to substitute import for domestic production and vice versa.
Likewise, it is possible to substitute export for domestic consumption and vice versa.
Thus, the international price (also called the border price) represents the real value of the
goods in terms of economic efficiency.
c) Sources of shadow prices

A project uses and produces resources. A project may for any given input or output:
i. Increase or decrease the total consumption in the economy
ii. Increase or decrease production in the economy
iii.Increase or decrease imports, or
iv. Increase or decrease exports
According to UNIDO, there are three sources of shadowing pricing; namely,
1. Consumer willingness to pay – used if the impact of the project is on consumption
in the economy
2. Cost of production – used if the impact of the project is on production in the
economy.
3. Foreign exchange value – used if the impact of the project is on international
trade. How project affects international trade? The project may increase/decrease
imports or exports.
d) Taxes
When shadow prices are being calculated, taxes usually pose difficulties. With respect to
taxes, UNIDO’s guidelines are as follows:
1. Include taxes in shadow pricing – when a project results in diversion of non-traded
inputs, which are in fixed, supply from other producers or addition to non-traded
consumer goods.
2. Exclude taxes from shadow pricing – when a project augments domestic production
by other producers. Taxes should also be excluded from shadow pricing for fully
traded goods.
Shadow Pricing of Specific Resources

1. Shadow pricing for tradable inputs and outputs
A good is fully traded when an increase in its consumption results in a corresponding
increase in import or decrease in export or when an increase production results in a
corresponding increase in export or decrease in import. For such goods, shadow pricing is
the border (international) price translated into domestic currency at the market exchange
rate.
For fully traded goods, domestic changes in demand or supply affect just the level of
imports or exports. The following conditions should be met for imported goods to be
traded.
a) If there is an import quota, goods are not restrictive
b) The import supply is perfectly elastic over the relevant range of import volume
c) There is no surplus domestic capacity, it cannot be utilized for want of necessary
inputs.
d) If the additional demand exists in land, the imported goods cost less than the
marginal cost of production.
e) The imported input costs less than the domestic marginal cost of purchase.
When the above conditions are met, additional demands are satisfied by external trade.
Similar conditions must be satisfied for importable outputs, exportable inputs, and
exportable outputs. If a good is not tradable if it is tradable but does not fulfill conditions
(a) though (d).
2. Shadow pricing for non-tradable inputs and outputs

For non-tradable goods, the border price does not reflect its economic value. More
specifically, a good is said to be non tradable when the following conditions are satisfied:
a) Its import price (cost-Insurance-Freight) is greater than its domestic cost of
production.
b) Its export price (Free-on-board price) is less than its domestic cost of production.
What then is the value of non-tradable goods?
i. On the output side

If the impact of the project is to increase the consumption of the product in the economy,
the measure of value is the marginal consumers’ willingness to pay. On the other hand, if
the impact of the project is to substitute other production of the same non-tradable in the
economy, the measure of value is the saving in cost of production.
ii. On the input side

If the impact of the project is to reduce the availability of inputs to other users, their
willingness to pay for that input represents social value. If the projects input requirement
is met by additional production of it, the production cost of it is the measure of social
value.
3. Shadow pricing for externalities

Externalities are special classes of goods. Externalities have the following characteristics:
i. They are not deliberately created by the project owners but are incidental outcome of
the economic activity.
ii. They are beyond the control of the persons who are affected by them, for better or for
worse.
iii.They are not traded in the market and thus have no market price. Externalities may
be beneficial or harmful. They are intangible in nature.
So how should the value of externalities be determined?

The values of externalities are estimated by indirect means. For example,
a. Assume that the company designed a training project that helps upgrade the skills of
its workers thereby enhancing their earning power in subsequent employments. From
this description of the project, the beneficial external effect is the enhancement of
employees earning power in subsequency employment. What is the value of this
benefit? The benefit from the training programme may be estimated in terms of
increased earning power of workers.
b. Assume that a highway company is considering the construction of highway that cuts
the holding of a farmer in two, separating his grazing land and his cowsheds, thereby
adversely affecting his physical output. Does the project have beneficial external effect
or harmful external effect on the farmer? Since the project affects the farmer
adversely, it will have harmful external effect. What should be the value of this effect?
The value of harmful external effect of the highway may be measured by the consumer
willingness to pay for the output of the farmer, which has been reduced due to the
highway.
Generally, it is not easier to measure external effects (or externalities). Due to this, some
argue that these external effects should be ignored. Other suggested that external effects
should be taken into consideration whenever it is possible to do so. Although these
effects cannot be measured in monetary terms, some qualitative evaluation must be
attempted.
4. Shadow pricing for labour inputs

Labour is considered to be a service. The principles of shadow pricing for goods may be
applied to labor as well.
When a project lives a labour, it could have three possible impacts on the rest of the
economy.
i. It may take labour away from other employment
ii. It may induce the production of new workers
iii. It may involve import of workers
When a project takes labor away from other, the shadow price of labour is equal to what
other users of labor are willing to pay for this labor. This will be equal to the marginal
product of such labor in a relatively free market.
The social cost associated with inducing ‘additional’ production of workers consists of
the following:
a) the marginal product of the worker in the previous employment. For unemployed
worker, marginal product is equal to zero.
b) The value assigned by the worker on the leisure that he may have to forgo as a
result of employment in the project. The value of this leisure is reflected in his
reservation wage which depends on:
- the income she/he already enjoys through transfer payments
- his/her idea of what job is acceptable to him.
- His/her preference for work and leisure.
c) The additional consumption of food when a worker is fully employed as opposed to
when he/she is idle or only partly employed.
d) The cost of transport and rehabilitation when a worker is moved from one location
to another.
e) The increased consumption by the worker and its negative impact on savings and
investments.
f) The cost of training a worker to upgrade his/her skills.
The social cost associated with the import of foreign workers is the wage they command.
5. Shadow pricing for capital inputs

Capital inputs refer to investments in machinery, building, and other similar physical
assets. Two things happen when a capital investment is made in a project. There are:
a) Financial resources are converted into physical assets

What is the value of physical assets? The value (shadow price) of physical assets is
calculated the way the value of other resources is calculated. If it is a fully traded good,
its shadow price is equal to its international price. The cost of production or consumer
willingness to pay becomes the basis of shadow price for non-traded goods.
b) Financial resources are withdrawn from the national pool of savings and hence
alternative investments are foregone
These financial resources involve opportunity cost. The opportunity cost of capital
depends on how the capital required for the project is generated. To the extent that it
comes from additional savings, its opportunity cost is measured by the consumption rate
of interest. The consumption rate of interest reflects the price the saver must be paid to
sacrifice present consumption. To the extent that it comes from the denial of capital to
alternative projects, its opportunity cost is the rate of return that would be earned from
those alternative projects (also called the investment rate of interest).
6. Shadow pricing for foreign exchange

According to UNIDO, the Numeraire is the domestic currency (Birr). Thus, the foreign
exchange input of the project must be identified and adjusted by an appropriate premium.
The valuation of inputs and outputs that was measured in international price (Birr) has to
be adjusted upward to reflect the shadow price of foreign exchange.
The shadow price of foreign exchange is determined on the basis of marginal social
value. The marginal social value is revealed by the consumer willingness to pay for the
goods that are allowed to be imported at the margin. The shadow price (value of unit of
foreign exchange is equal to:
n
F
i 1
i Qi Pi
where:
Fi = Fraction of foreign exchange, at the margin, spent on importing commodity i.
Qi = Quantity of commodity i that can be bought with one unit of foreign
exchange
1
Qi =
CIF
CIF = Cost, Insurance, Freight
Pi = Domestic market clearing price of commodity i.
To illustrate, the computation of the value of a unit of foreign exchange, assume that
commodity 1, commodity 2 and commodity 3 are imported at margin. The proportion of
foreign exchange spent on them, the quantities that can be bought per unit of foreign
exchange, and the domestic market clearing prices are as follows:
F1 = 0.4 F2 = 0.3 F3 = 0.3
Q1 = 0.8 Q2 = 1.2 Q3 = 4
P1 = 20 P2 = 10 P3 = 15
The value of a unit of foreign exchange is computed as follows:
Value = (0.40 x 0.8 x 20) + (0.3 x 1.2 x 10) + (0.3 x 4 x 15) = Br. 28
The above computation of shadow price is in terms of consumer willingness to pay and is
based on the assumption that the foreign exchange requirements of the project are met
from the sacrifice of others. However, the use of foreign exchange by a project may also
induce the production of foreign exchange through additional exports or import
substitution.
In such a case, the shadow price of foreign exchange would be based on the cost of
producing foreign exchange and not consumer willingness to pay for foreign exchange.
To exemplify the computation of net economic benefit, assume that presently a ferry
service (operated privately) is being used to cross a river of Gannale. The ferry operator
charges Br. 4 per person. It costs the ferry operator Br. 3 per person. Assume further that
about 60,000 persons use the ferry service throughout the year.
The Bale zone of Oromia Regional state is considering the construction of a bride over
the river. It is estimated that after the bridge is constructed, about 400,000 persons will
cross the river on the bridge. The bridge is expected to cost Br. 2.5 million initially and
Br. 20,000 annual maintenance costs. After the bridge is in operation, the ferry operator
will close down the ferry service and the boats will be sold for Br. 150,000. The bridge is
expected to have an indefinite life and the monetary figures indicated in the problem
represent economic value. There is no payment for the use of bridge. The social costs and
benefits of constructing the bridge are summarized below:
Costs Benefits
1. A one shot construction cost of Br. 2,500,.000 1. A one-shot benefit of Br. 150,000 from the sale of
2. Annual maintenance cost of Br. 20,000 boats
2. The annual benefit in the form of saving in the
cost of ferry operation of Br. 180,000 (i.e., Br.
3/person x 60,000 persons)
3. Increase in consumer satisfaction that is equal to
willingness to pay of 340,000 additional persons
(400,000 – 60,000) who are expected to use the
bridge. The average willingness to pay of
4 0
additional person is Br. 2 (i.e. 2 = 2).
Assuming that demand schedule is linear. The

willingness to pay of 340,000 additional persons
is Br. 680,000 (i.e., 340,000 persons x 2)
Additional examples
1. Suppose the project requires indigenous power equipment costing Br. 900,000
(estimated by project promoter). The power equipment produced indigenously is a
tradable item whose FOB value is $100,000. The shadow price per dollar is Br. 9.5,
though the official price is Br. 8.925. What is the cost of power equipment from:
a) the private point of view.
b) the economic point of view.
Solution
a) From private point of view, the cost of power equipment is Br. 900,000.
b) The indigenous power equipment is a tradable item for which international price
should be used. The FOB value of this equipment is converted to the birr by
applying the shadow price of foreign exchange to obtain the cost from the
economic point of view. i.e., the cost of the power equipment is Br. 950,000 (9.5 x
$100,000)
2. Assume that the project requires power equipment that will be imported at a cost of
$150,000. The equipment will be financed by a gift of $150,000 from a foreign
donor. However, the gift of $150,000 is not related to the project. The shadow price
of a dollar is Br. 9.520, though the official price is Br. 9.00. What is the cost of
imported power equipment from:
a) Private point of view?
b) Economic point of view?
Solution
a) From private point of view, the imported power equipment is not considered
project resources. Thus, no cost is considered.
b) From economic point of view, the cost of power equipment is Br. 1,428,000 (i.e,
$150,000 x 9.520).
3. Assume the construction of a road requires 300,000 tons of cement produced by
Muger Cement factory. The production cost per ton is Br. 60. Assume further that
cement is not tradable and 2/3 of the cement required for the project will come from
additional domestic production which has a cost of Br. 60 per ton and the remaining
will come from diversion from other consumers who are willing to pay, on average,
Br. 80 per ton. What is the cost of cement from:
SOLUTION
a. From private point of view
Cost of cement = Br. 60 x 300,000 tons = Br. 1,800,000
b. From Economic point of view
Cement is non-tradable. The quantity of additional production is 200,000 tons (i.e.2/3 x
300,000 = 200,000 tons). The cost of additional production will be Br. 12,000,000 (i.e.
200,000 tons x Br. 60/ton = 12,000,000). Besides, quantities of cement that will come
through diversion are 100,000 tons and the cost of these will be Br. 8,000,000 (i.e., Br. 80
x 100,000 tons = 8,000,000). Thus, the total costs of cement from economic point of view
are Br. 20,000,000 (i.e., 12,000,000 + 8,000,000 = 20,000,000).
4. Assume that the project requires 10,000 unskilled labours for which the project
control board (project promoter) has decided to pay a Br. 10 daily wage rate. The
shadow price of unskilled labour is Br. 6 per day. What is the cost of unskilled
labour from:
Solution
a) From private point of view
Cost of unskilled labour = 10,000 x Br. 10 per day = Br. 100,000
b) From economic point of view
Cost of unskilled labour = 10,000 x Br. 6 per day = Br. 60,000
5. Assume that project that involves the protection of food is expected to have annual
saving of Br. 800,000 due to flood damages. What is the benefit of this project
from:
a) Private point of view
b) Economic point of view
Solution
Financial analysis does not consider such benefit of the project because it does not
accrue to the firm in the form of cash flow.

The value of savings due to flood relief is Br. 800,000.
6. Suppose that a private agricultural firm is considering the construction of irrigation

on Awash River. The irrigation will be used by the farmers for which they will pay
to the agricultural firm per acre. The firm decided that the water charge would be
Br. 20 per acre per season. It is estimated that 500,000 acres of land will be
irrigated per season. However, the value of additional output per acre, attributable
to the water supplied by the irrigation project, will be Br. 30 per season. A year has
got three seasons. What is the yearly benefit from irrigation project from:
a) Private firm point of view?
Solution
Benefit = charge per acre x Irrigated land per season x No of seasons
= Br. 20 x 500,000 acres x 3 seasons
= Br. 30,000,000

The value of additional agricultural output attributable to the water supplied by the
project is considered. Accordingly, the economic benefit is computed as follows:
Benefit = Irrigated land per season X value of additional output per acre X number of seasons
= 500,000 acres X Br. 30 X 3 = Br. 45,000,000

1. What are the two approaches to social cost benefit analysis of the project?
2. The unit of account in which the value of inputs or outputs is expressed is
_______.
3. _________ is measure of the opportunity cost for tradable goods to the country.
4. According to UNIDO, what are the three major sources of shadow pricing?
5. According to UNIDO, when are taxes excluded from shadow pricing?
8.3.1.2 Measurement of the Impact of Distribution

This is concerned with measuring the value of the project in terms of its contribution to
income redistribution among various groups. For the purpose of income distribution
analysis, the society may be divided into various groups, such as project, government,
workers, consumers, external sector, and other private business.
Within the society, the project results in a gain or loss to an individual group. The gain or
loss is computed in terms of whether the input/output is physical resources and financial
transactions.
Gain or loss to an individual group on physical resources is the difference between the
shadow price and the market price of each input or output. For financial transactions, gain
or loss is the difference between the price paid and the value received. To illustrate the
computation of gain or loss, assume that Residents of certain area use 600,000 cubic
meter water provided by water project. The benefit derived by the residents, measured in
terms of the willingness to pay, is equal to Br. 20 per cubic meter. The tariff paid by the
residents to the water authority is Br. 15 per cubic meter. What is the gain or loss by the
residents due to the project?
Gain = (20 – 15) x 600,000 = Br. 3,000,000
The shadow price is Br. 20 and the market price is Br. 15. Since the residents are required
to pay less than the shadow price, thus gain from the project.
Check Your Progress Question 8. 3

a) Farmers in a certain area use 2 million KWH of electricity generated by a
hydroelectric project. Measured in terms of the willingness to pay, the benefit
derived by them is equal to Br. 900,000. The tariff paid by the farmers to the electric
power authority is Br. 700,000. Have the farmers gained or lost? By how much?
b) Agar Mining firm is considering establishing as query project near Dukem Town.
The project requires 500 laborers. Dukem town is characterized by high level of
youth unemployment. As a result, they are willing to work at a daily wage rate of Br.
5, which represents their supply price. However, Agar mining firm agreed to pay
them Br. 8 per day. From income redistribution point of view, have the labors in
Dukem Town gained or lost from the project? By how much?
8.3.1.3 The saving impact of the project

The scarcity of capital characterizes most of the developing countries which are
concerned with the impact of a project on savings and its value thereof. The following
questions should be answered?
- What is the impact of the project, given the income distribution impact?
- What is the value of such saving to the society?
The saving impact of the project is determined as follows:
Saving =  y i MPS i
where:
y i = Chang in income of group i as a result of the project
MPSi = Marginal propensity to save of group i.

To illustrate the computation of saving impact of the project, assume that the income
gained or lost by three groups of the society as a result of the project is shown below:
Group 1 = Br. 600,000, Group 2 = Br. (200,000), Group 3 = Br. 400,000
The marginal propensity to save (MPS) of the three groups is as follows =
MPS1 = 0.20 MPS2 = 0.15 MPS = 0.30
What is the impact of the project on saving?
The saving impact of the project is determined as follows:
Saving = (600,000 x 0.20) + (-200,000 x 0.15) + (400,000 x 0.30)
= 120,000 – 30,000 + 120,000
= 210,000
8.3.1.4 Adjustment for Merit and Demerit Goods

What are merit goods? Demerit goods? A merit good is one for which the social value
exceeds the economic value. The best example of merit good could be oil, and creation of
employment. A higher social value may be placed over economic value on production of
oil by the country because it reduces dependence on foreign suppliers.
Demerit good is a good whose economic value exceeds social value. Some of the best
examples of demerit goods are tobacco products, and alcoholic products
In order to adjust for merit or demerit goods, the following steps may be used:
1. Estimate the economic value of the project
2. Calculate the adjustment factor
Social value
Adjustment factor = Economic value  1
For merit goods, the ratio of social value to economic value is greater than 1 and
adjustment factor becomes positive. On the other hand, the ratio of social value to
economic value is less than 1 for demerit goods and the adjustment factor becomes
negative.
3. Multiply the economic value by the adjustment factor to obtain adjustment

Adjustment = Economic value x adjustment factor
4. Compute the social value by adding adjustment to the economic value
Social value = Economic value  Adjustment
To illustrate the adjustment for the difference between social value and economic value
of the project, assume that the present economic value of the project is Br. 5,000,000. The
output of the project is merit good and its social value exceeds its economic value by
30%.
Based on the above information, the adjustment factor is computed as follows:

130%
Adjustment factor = 1
100%
= 1.30 - 1
= 30%
Adjustment for merit good is computed as follows:
Adjustment = Economic value X adjustment factor
= 5,000,000 X 0.30
= 1,500,000
Then social value is equal to the sum of economic value and adjustment
Social value = 5,000,000 + 1,500,000 = 6,500,000

Suppose that tobacco manufacturer is considering to introduce a new tobacco brand. It is
estimated that the present economic value of the project is Br. 4,000,000 per year. The
economic value of the new tobacco product is greater than its social value by 20%
Required
a) Is the new tobacco brand merit good or demerit good?
b) Determine the adjustment factor.
c) Compute adjustment to economic value of the product.
d) Compute the social value of the new tobacco product.
8.3.2 Little-Mirrlees (L – M) Approach

I.M.D. Little and J.A Mirrlees have developed an approach to social cost benefit analysis
of the project. The UNIDO and L-M approaches have considerable similarities between
them. Some of the similarities are:
1. The calculation of shadow (Accounting) prices
2. The consideration the factor of equity
3. the use of Discounted Cash Flow (DCF) analysis
Although L-M approach and UNIDO approach are similar in some aspects, they are not
without differences.
There differences are:

UNIDO Approach L-M approach
1. Measures costs and benefits in terms of 1. Measures costs and benefits in terms of
domestic Birr international (border) prices
2. Measures costs and benefits in terms of 2. Measures costs and benefits in terms of
consumption uncommitted social income.
3. The analysis focuses on, efficiency, savings, 3. Tends to view efficiency, savings, and
and redistribution considerations in redistribution considerations together.
different stages
8.3.2.1 Shadow Pricing under L-M Approach

L-M approach classified the inputs and outputs of the project into three categories. These
are
a. Tradable goods and services

The border price is considered the shadow price for a traded good or service. Assume that
foreign demand and supply are perfectly elastic, the shadow price of exportable goods is
Free-on-Board (FOB) price. On the other hand, the shadow price of importable good is its
Cost Insurance Freight (CIF) price.
b. Non-tradable goods and services

Certain goods are not amenable to foreign trade, such as land, building, electricity, water,
and transportation. Since there is no observable border price for such goods and services,
their shadow (accounting) prices are defined in terms of marginal social cost and
marginal social benefits.
The marginal social cost of a good is the value in terms of accounting prices of the
resources required to produce an extra unit of the good. Similarly, the marginal social
benefit is the value of an extra unit of the good from the social point of view.
c. Labour
According to L-M, the shadow wage rate is the function of several factors, some of which
include:
- the marginal productivity of labour
- the cost associated with urbanization such as cost of transport, urban overheads
etc.
- the cost of having an additional amount committed to consumption (when the
consumption of the worker increases as a result of the higher income he/she
enjoys in urban employment).
1. What are the similarities between UNIDO approach and L-M approach in social cost
benefit analysis of the project?
2. What are the principal differences between UNIDO and L-M approaches in social
cost benefit analysis of the project?
3. What are three categories of inputs and outputs of the project according to L-M
approach?
4. According to L-M approach, the shadow price of a tradable good or service is
_________
5. According to L-M approach, if the good is exported, its shadow price is _______,
and if the good is imported its shadow price is __________.
6. How the shadow price of non-tradable good/services defined?
8.4. SUMMARY
Economic (social cost benefit) analysis is a methodology for evaluating projects from the
social point of view. Economic analysis aids in evaluating individual projects with in the
planning framework. In economic analysis, the focus is on social costs and benefits of a
project which tends to differ from financial analysis. The principal reasons for
discrepancy are market imperfections, externalities, taxes, concern for saving and income
redistribution, and merit and demerit goods.
There are two principal approaches for economic analysis of projects; namely, UNIDO
approach and Little-Mirrlees (L-M) Approach. The UNIDO approach involves five
stages
(1) Calculation of the financial profitability measured at market prices. (2) Obtain the net
benefit of the project measured in terms of shadow prices (3) Adjustment for the impact
of savings and investment (4) Adjustment for the impact of the project on merit and
demerit goods.
A key issue shadow pricing is whether a good is tradable or not. For a traded good, the
shadow price is the border price, translated in domestic currency at market exchange rate.
The shadow price of a non traded good is measured in terms of consumer willingness to
pay, or cost of production depending on the impact of the project on the rest of the
economy.
Since economic analysis seeks to consider all costs and benefits to whomsoever they may
accrue, external effects (harmful or beneficial) also need to be considered. The valuation
of these external effects is rather difficult because they are often intangible in nature and
there is no market and there is no market price, which can be used as a starting point.
The principles of shadow pricing for goods may be applied to labour as well although
labour is considered a service. When the project takes labour away from other
employments, the shadow price of labour is equal to what other users of labour are
willing to pay. The shadow price associated with inducing “additional” production of
workers consists of the marginal product of labour in previous employment plus certain
other costs.
The opportunity cost of capital goods depends on how the capital required for the project
is generated. To the extent that the capital comes from additional savings, its opportunity
cost is measured by the consumption rate of interest. To the extent that it comes from the
denial of capital to alternative projects, its opportunity cost is the rate of return that would
be earned from those alternative projects.
The UNIDO approach uses domestic currency as the Numeraire. The foreign exchange
impact of the project must be identified and valued. The UNIDO approach determines the
shadow price of foreign exchange on the basis of marginal social value as revealed by the
consumer willingness to pay for the goods that are allowed to be imported at the margin.
On the other hand, the L-M approach has considerable similarity with the UNIDO
approach through there are certain important differences. According to L-M approach,
the inputs and outputs of a project are classified into tradable goods and services, non-
tradable goods and services, and labour. The shadow price of a traded good is simply its
border price. If a good is imported, its shadow price is its CIF price. The shadow prices of
a non traded goods are defined in terms of marginal social cost and marginal social
benefit.
8.5. ANSWERS TO CHECK YOUR PROGRESS QUESTION
CYP 8.1
1. Financial Analysis, economic analysis or social cost benefits analysis.
2. Market imperfections, externalities, taxes and subsidies, concern for savings and
income redistribution, and merit wants.
3. Market prices of goods and services.
4. Social values.
5. Rationing, prescription of minimum wage rates, and foreign exchange regulations.
6. External beneficial effect and external harmful effect.
CYP 8.2
1. UNIDO approach and Little-Mirrlees approach
2. Numeraire
3. International price
4. Consumers’ willingness to pay, cost of production, and foreign exchange value.
5. When the project augments domestic production by other producers and for fully
traded goods.
CYP 8.3
a) The farmers have gained. The gain is equal to Br. 200,000 (i.e., 900,000 –
700,000 = 200,000).
b) The laborers in the town gain from the project. The gain is equal to Br. 1500
(i.e., (8-5) x 500 = 1500)
CYP 8.4
1a) It is demerit good because its economic value exceeds its social value.
Social Value
b) Adjustment factor = Economic value  1
0.80
= 1
1.00
= 0.80 – 1
= -20%
c) Adjustment = Economic value X adjustment factor
= 4,000,000 X -20%
= (800,000)
d) Social value = Economic value  Adjustment
= 4,000,000 – 800,000
= 3,200,000
CYP 8.5
1. The similarities between L-M approach and UNIDO approach are in computing
shadow prices, the factor of equity and the use of discounted cash flows analysis.
2. While under UNIDO approach, costs and benefits are measured in terms of
domestic Birr and consumption, costs and benefits are measured under L-M
approach in terms of international prices and uncommitted social income.
3. Tradable goods and services, non-tradable goods and services, & labour.
4. The border/international price
5. FOB price, CIF price
6. In terms of marginal social cost and marginal social benefits.
SOLUTION TO UNIT 7 PROBLEM
1) Production in units/year
Production = No of hours/day X capacity per hour X capacity X No. of effective
Utilization working
days/year
Year No of hours Capacity Capacity No of effective Estimated

per day per hour utilization working days/year production (units)
1 8 100 80% 300 192,000
2 8 100 80% 300 192,000
3 8 100 80% 300 240,000
4 8 100 80% 300 240,000
5 8 100 80% 300 240,000
2. Raw materials Requirements

Requirements = Estimated production X materials required per unit of output
Year
1 2 3 4 5
Production 192,000 192,000 240,000 240,000 240,000
Material x (2kg/unit) 384,000 384,000 480,000 480,000 480,000
Material y (1kg/unit) 192,000 192,000 240,000 240,000 240,000
3. Cost of raw materials and packaging

Raw material cost = Requirements in units X Cost/unit
Packaging cost = Estimated production (units) X Packaging cost per unit of output
The cost of raw materials and packaging is computed as follows:
4. Annual Revenue of the Project

Annual sales = Sales in units x selling price per unit
Year 1 = 192,000 x 22 = 4,224,000
Year 2 = 192,000 x 22 = 4,224,000
Year 3 = 240,000 x 22 = 5,280,000
Year 4 = 240,000 x 22 = 5,280,000
Year 5 = 240,000 x 22 = 5,280,000
5. Annual total production costs
Total production costs = Direct materials used + Direct labour cost + Factory overhead
costs
In the question under consideration, factory overhead is composed of electricity and
water charges (variable costs), fixed factory overhead, and depreciation (60% of annual
depreciation of Br. 250,000). Accordingly, factory overhead costs are computed below:
Year
1 2 3 4 5
Depreciation (60%) 150,000 150,000 150,000 150,000 150,000
Electricity and water* 197,000 197,000 245,000 245,000 245,000
Other fixed factory overhead 768,000 806,400 846,720 889,056 933,509
Total factory overhead 1,115,000 1,153,400 1,241,720 1,284,056 1,328,509
* Electricity and water charges = (Estimated production x 1) + 5000

Then direct labor cost can also be calculated as follows:
Year 1 = 614,400 Year 4 = 626,688 x 1.02 = 639,222
2 = 614,400 Year 5 = 639,222 x 1.02 = 652,006
3 = 614,400 x 1.02 = 626,688
Finally, total production costs are computed below:

Year Raw material Direct labour Factory Total
costs costs overhead production
costs costs
1 1,632,000 614,400 1,115,000 3,361,400
2 1,632,000 614,400 1,153,400 3,399,800
3 2,040,000 626,688 1,241,720 3,908,408
4 2,040,000 639,222 1,284,056 3,963,278
5 2,040,000 652,006 1,328,509 4,020,515
6. Loan Repayment Schedule
Initial investment = Gross investments + Increase in NWC
= 1,250,000 + 300,000 = 1,550,000
Amount of loan = 1,550,000 x 50% = 775,000 (50% of initial investment is
financed
by debt)
Annual loan repayment (A):
 1 
1 
(1  i ) n
PVA = A 
 i 
 
 
where;
PVA = Present value of annuity
A = Periodic payment
i = The required rate of return
n = No of periods to maturity
 1 
1 
 (1  0.10) 3 
775,000 = A
 0.10 
 
 
775,000 = A (2.487)
775,000
A=
2.487
= 311,620
Loan repayment schedule
Year Amount Unpaid balance Interest Principal
unpaid
Installment at beg. of year Repayment
balance at
End of
year
1 __ 755,000 __ __
775,000
2 311,620 755,000 77,500 234,120 540,880
3 311,620 540,880 54,088 257,532 283,348
4 311,620 283,348 28,272 283,348 __
7. Projected Income Statement

Since there are no beginning and ending finished goods inventory, total production costs
is equal to cost of goods sold. Operating expenses are computed as follows:
Year
1 2 3 4 5
Depreciation 100,000 100,000 100,000 100,000 100,000
Selling and administrative
expenses 450,000 450,000 460,000 470,000 480,000
Total factory overhead 550,000 550,000 560,000 570,000 580,000
Projected Income Statement for five years:

Year
1 2 3 4 5
Sales 4, 224,000 4,224,000 5,280,000 5,280,000 5,280,000
Gross profit 862,600 824,200 1,371,592 1,316,722 1,259,485
Operating expenses 550,000 550,000 560,000 570,000 580,000
Operating Income 312,600 274,200 811,592 746,722 679,485
Interest expense - 77,500 54,088 28,272 -
Income before tax 312,600 196,700 757,504 718,450 679,485
Tax (40%) - - 303,002 287,380 271,794
Net income 312,600 196,700 454,502 431,070 407,691
8. Net cash flows:

Year
1 2 3 4 5
Net Income 312,600 196,700 454,502 431,070 407,691
Add: Depreciation 100,000 100,000 100,000 100,000 100,000
Recovery in NWC - - - - 300,000
Interest - 46500 a 32453 b 16963 c -
Net cash flows 412,600 343200 586955 548033 1007691
a) Interest (1 – Tax rate) = 77500(1-0.40) = 46500

b) 54088 (1-0.40) = 32453
c) 28272 (1 – 0.40) = 16963
9. Project evaluation
a) Payback period (PBP)
Initial investment = 1,250,000 + 300,000 = 1,550,000
207245
PBP = 3 years + = 3.38years
548033
b) ARR =
312,600  196,700  454,502  431,070  409,691
Average Net income =
5
1,802,563
=
5
= 306,513
1,550,000  220,000
Average investment =
2
= 885,000
360,513
ARR = 885,000 = 41%
c) Net present value

Year NCF Discount Factor Present value
1 412,600 0.926 382,068
2 343200 0.857 294122
3 586955 0.794 466042
4 548033 0.735 402804
5 1007691 0.681 686238
Present value of NCF 2,231,274
Less: Initial Investment 1,550,000
NPV +681274
d) IRR = 21.03%
e) Benefit-Cost ratio (Profitability index)
PV of NCF
Benefit-Cost ratio = Initial Investment
2231274
= 1,550,000
= 1.44
 REFERENCES
1. Prasana Chandra (2002), Projects: Planning, Analysis, Financing,

Review, 5th edition, Tata McGraw-Hill Publishing
Implementation, and Review,
Company Ltd
2. Behrens, W. and Hawranek, P.M (1991), Manual for the preparation of

Industrial feasibility studies,
studies, UNIDO, Vienna.
3. UNIDO (1999), Manual for Project Evaluation,
4. Brigham, Eugene F. and Houston. Joel F. (1999), Fundamentals of financial

Management, 2nd edition, The Dryden Press, New York.
Management,
5. Ethiopian Business Development Services Network (2004), start and improve
your business,
business, German Technical Cooperation (GTZ), Addis Ababa.
Analysis, 3rd edition,

6. Nahmias, Steven (1997), production and operations Analysis,
McGraw – Hill, New York. And in

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Project Analysis (Acct 422 )

Unit 1: Overview of Projects and Project Analysis 1

Unit 2: Project Life Cycle 12

Unit 3: Project Identification 23

Unit 4: Market and Demand Analysis 39

Unit 5: Technical Analysis 69

Unit 6: Project Organization and Management 93

Unit 7: Financial Evaluation 121

Unit 8: Economic Analysis 159

1.0 AIMS AND OBJECTIVES

After completing this unit successfully, you will be able to:

Project is a means of implementing the firm’s plans. As a means of plan implementation,

Inputs Project Output

Check Your Progress 1.1

1.3 TYPES OF CAPITAL INVESTMENTS/PROJECTS

Check Your Progress 1.2

Capital investment decisions have several importance. Among them are:

1.5 DIFFICULTIES OF CAPITAL INVESTMENTS

Check Your Progress 1.3

1. Mention the importance of capital investments

1.6 OBJECTIVES OF CAPITAL PROJECTS/INVESTMENTS

According to financial theory, the goal of financial management is to maximize the

Wealth maximization, as objective of financial decision making, contributes to an

Check Your Progress 1.4

a) What are the possible goals of capital investment decisions?

1.7 PHASES OF CAPITAL INVESTMENTS/CAPITAL BUDGETING

Each of them is described below:

Followed by the identification of a project proposal, a preliminary project analysis is

Check Your Progress 1.5

Project is a complex of economic activities in which scarce resources are committed in

1.9 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

2.0 Aims and Objectives

After completing this chapter, you will be able to:

2.2. DEFINITION OF PROJECT CYCLE

2.3. PROJECT LIFE CYCLE – BAUM (WORLD BANK) APPROACH

Let’s highlight the major activities in each stage

Project identification is also concerned with elimination of inferior alternatives (projects)

Check Your Progress 2-1

2.4. PROJECT LIFE CYCLE – UNIDO APPROACH

2.4.1 Pre-investment phase

Project Identification / opportunity study/

Pre-selection /pre-feasibility study/

The above analyses are based on guess-estimated data.

Preparation (feasibility study)

The components of feasibility study are:

Pre – feasibility study

30% -20% 10% 0 10% 20% 30%

The above figure is interpreted as follows:

Types of decisions to be taken during each pre-investment phases

Decision Type of study Decision goal

2.4.2. Investment Phase

2.4.3. Operating phase

Check Your Progress 2-2

2.6 ANSWERS TO CHECK YOUR PROGRESS QUESTIONS

UNIT 3: PROJECT IDENTIFICATION

3.0 AIMS AND OBJECTIVES

After completing this unit, you will be able to:

The identification of opportunities for project (investments) requires an understand of the

The task (objective) of identification stage is to identify investment opportunities, which

3.2 GENERATION OF PROJECT IDEAS

Stimulating the flow of ideas:

b. Clear articulation of objectives – A clear articulation and prioritization of objectives

The operational objectives of the firm may include