The most important aspect of this is that profits can be increased by either an increase in revenues or a decrease in expenses. Water treatment operations are by and large end-of-pipe treatment technologies, and hence from the standpoint industry applications that must treat water, the investments required increase expenditures and decrease profit. Municipal facilities view their roles differently, because their end-product is clean water which is saleable, plus they may have addon revenues when biosolids are developed and sold into local markets. There are different categories of revenues and expenses, and it is important to distinguish between them.
Obviously, revenue is money coming into the company; from the sale of goods or services, from rental fees, from interest income, etc. The profit equation shows that an increase in revenue leads to a direct increase in profit, and vice versa if all other revenues and expenses are held constant. Note that we are going to assume that the condition of other expenses/revenues are held constant in the discussions below.
Revenue impacts must be closely examined. For example, companies often can cut wastewater treatment costs if water use (and, in turn, the resulting wastewater flow) is limited to nonpeak times at the wastewater treatment facility. However, this limitation on water use could hamper production. Consequently, even though the company's actions to regulate water use could reduce wastewater charges, revenue could also be decreased, unless alternative methods could be found to maintain total production. Conversely, a change in a production procedure as a result of a technology change could increase revenue. For example, moving from liquid to dry paint stripping can not only reduce water consumption, but also affect production output. Because clean-up time from dry paint-stripping operations (such as bead blasting) is generally much shorter than from using a hazardous, liquid based stripper, it could mean not only the elimination of the liquid waste stream (this is a pollution prevention example), but also less employee time spent in the cleanup operation. In this case, production is enhanced and revenues are increased by the practice. Another potential revenue effect is the generation of marketable byproducts such as biosolids. Such opportunities bring new, incremental revenues to the overall operation of the plant. The point to remember is that the project has the potential to either increase or decrease revenues and profits - and that's the reason for doing a financial analysis.
Expenses are monies that leave the company to cover the costs of operations, maintenance, insurance, etc. There are several major cost categories:
• Insurance expenses
• Depreciation expenses
• Interest expenses
• Labor expenses
• Training expenses
• Auditing and demo expenses
• Floor-space expenses
Each of these should be carefully considered in your analysis. Insurance Expenses. Depending upon the project, insurance expenses could either increase or decrease. Insurance premiums can be increased depending on the technology option chosen for a plant design.
Depreciation Expenses. By purchasing capital equipment with a limited life the entire cost is not charged against the current year. Instead, depreciation expense calculations spread the equipment's procurement costs (including delivery charges, installation, start-up expenses, etc.) over a period of time by taking a percentage of the cost each year over the life of the equipment. For example, if the expect life of a piece of equipment is 10 years, each year the enterprise would charge an accounting expense of 10 percent of the procurement cost of the equipment. This is known as the method of straight-line depreciation. Although there are other methods available, all investment projects under consideration at any given time should use a single depreciation method to accurately compare alternative projects' expense and revenue effects. Because straight-line depreciation is easy to compute, it is the preferred method. Note that even though a company must use a different depreciation system for tax purposes (e.g., the Accelerated Cost Recovery System, or ACRS), it is acceptable to use other methods for bookkeeping and analysis. In any event, any capital equipment must be expensed through depreciation. Interest Expense. Investment in equipment implies that one of two things must occur: Either a company must pay for the project out of its own cash, or it must finance the cost by borrowing money from a bank, by issuing bonds, or by some other means. When a firm pays for a project out of its own cash reserves, the action is sometimes called an opportunity cost. If you must borrow the cash, there is an interest charge associated with using someone else's money. It is important to recognize that interest is a true expense and must be treated, like insurance expense, as an offset to the project's benefits. The magnitude of the expense will vary with bank lending rates, the interest rate offered on the corporate notes issued, etc. In any case, there will be an expense. The reason companies account for equipment purchases as a cost is this: If cash is used for the purpose of pollution control, it is unavailable to use for other opportunities or investments. Revenues that could have been generated by the cash (for example, interest from a certificate of deposit at a bank) are treated as an expense and thus reduce the value of the project. But again - we may not have a choice if the project is driven by legal requirments such as the CWA.
Although the reasoning seems sound, opportunity costs are not really expenses. Though it is true that the cash will be unavailable for other investments, opportunity cost should be thought of as a comparison criteria and not an expense. The opportunity forgone by using the cash is considered when the project competes for funds and is expressed by one of the financial analysis factors discussed earlier (net value of present worth, pay back period, etc.). It is this competition for company funds that encompasses opportunity cost, so opportunity cost should not be accounted directly against the project's benefits.
Many companies apply a minimum rate of return, or hurdle rate, to express the opportunity-cost competition between investments. For example, if a firm can draw 10 percent interest on cash in the bank, then 10 percent would be a valid choice for the hurdle rate as it represents the company's cash opportunity cost. Then, in analyzing investment options under a retum-on-investment criteria, not only would the highest returns be selected, but any project that pays the firm a return of less than the 10 percent hurdle rate would not be considered.
Labor Expenses. In the majority of situations, projects will cause a company's labor requirements to change. This change could be a positive effect that increases available productive time, or there could be a decrease in employees' production time depending upon the practice. When computing labor expenses, the Tier 1 costs could be significant. Labor expense calculations can be simplistic or comprehensive. The most direct and basic approach is to multiply the wage rate by the hours of labor. More comprehensive calculations include the associated costs of payroll taxes, administration, and benefits. Many companies routinely track these costs and establish an internal 'burdened' labor rate to use in financial analysis.
Training Expenses. Your project may also involve the purchase of equipment that requires additional operator training. In computing the total training costs, the enterprise must consider as an expense both the direct costs and the staff time spent in training. Remember that some of the technologies discussed require more extensive worker training than others. In addition, any other costs for refresher training, or for training for new employees, that is above the level currently needed must be included in the analysis. Computing direct costs is simply a matter of adding the costs of tuition, travel, per diem, etc., for the employees. Similarly, to compute the labor costs, simply multiply the employees' wage rates by the number of hours spent away from the job in training.
Auditing and Demo Expenses. Labor and other expenses associated with defining the engineering project are often overlooked. Although these tend to be small for low-investment projects, some contemplated operations may require pilot testing, or sending personnel off-site to work with vendors in their shops. This can happen when dealing with exotic sludge or unique waste waters that require treatment. Pilot or plant trials can incur significant up-front costs from production down times, personnel, monitoring equipment, and laboratory measurements, as well as engineering design time and consultant-time charges. Some enterprises may prefer to absorb these costs as part of their R&D budget - for organizations these expenses simply are a part of the baseline cost of operations. Floor Space Expenses. As with any costs, the floor-space costs must be based on the value of alternative uses. Unfortunately, computing floor-space opportunity cost is not always straightforward, as it is in the case of training costs. In instances where little square footage is required, there may be no other use for the floor space, which implies a zero cost. Alternatively, as the square footage required increases, calculating floor-space costs becomes more straightforward. For example, if a new building is needed to house the water treatment equipment, it's easy to compute a cost. The average-square-foot cost for a new or used warehouse (or administrative or production space) that would be charged to procure the space on the local market is the average market worth of a square foot of floor space. Unless there is a specific alternative proposal for the floor space, this market analysis should work as a proxy.
Though cash flow does not have a direct effect on a company's revenues or expenses, the concept must be considered. If the project involves procurement costs, they often must be paid upon delivery of the equipment - yet cash recovery could take many months or even years. Three things about any project can affect a firm's available cash. First, cash is used at the time of purchase. Second, it takes time to realize financial returns from the project, through either enhanced revenues or decreased expenses. Finally, depreciation expense is calculated at a much slower rate than the cash was spent. As a result of the investment, a company could find itself cash-poor. Even though cash flow does not directly affect revenues and expenses, it may be necessary to consider when analyzing your project.
Though most companies use only revenue and expense figures when comparing investment projects, income-tax effects can enter into each calculation if either revenues or expenses change from the baseline values. More expenses mean lower profits and less taxes, and vice versa. If an company needs to know the effect of income taxes on profit, the computations are simple and can be done during or after the analysis. As with expenses and revenues, you do not need to compute the total tax liability for each option. Instead, you only need to look at the options' effect on revenues and/or expenses, and the difference in tax liability resulting from deviations from the baseline. The profit equation reflects gross or pretax profits. Income tax is based on the gross profit figure from this equation and cannot be computed until you know what effect the options will have on revenues and/or
We have introduced some concepts above as they relate to total-cost accounting and the total-cost assessment. Total-cost accounting is applied in management accounting to represent the allocation of all direct and indirect costs to specific products, the lives of products, or to operations as we have considered in this volume. It should be thought of as a long-term, comprehensive analysis of the entire range of costs and savings associated with the investment. Life-cycle cost assessment represents a methodical process of evaluating the life-cycle costs of a product, product line, process, system, or facility - starting with raw-material acquisition such as the chemical additives used in water conditioning, and going all the way to disposal of the sludge - by identifying the environmental consequences and assigning monetary value. A more detailed discussion of this subject is beyond our scope, but you will find some good references to refer to below. The references provided below are organized by general subject category. I have looked at all of these and relied on quite a few in y own consulting practice. The last section provides you with some challenging exercises that you can work
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