Profitability and Engineering Economics 9.1 INTRODUCTION — PROFIT GOAL A major decision point in process design is the selection of the most technically and economically feasible solution alternative. All companies set a profit goal. Most generally it is to maximize profit, i.e., maximize income above the cost of the capital which must be invested to generate the income. In addition, current governmental regulations require that processes must be safe and ecologically/environmentally sound. Others goals sometimes are used. For example: • Minimize loss • Minimize operating cost • Minimize environmental damage • Zero emissions • Produce a product that does not cost the company money Furthermore, companies usually have set a required rate of return on the invest- ment. In some cases such as with required environmental control equipment, the process must be built and operated even if it does not meet the rate of return that has been set. 9.2 PROFITABILITY ANALYSIS An analysis must be made to provide a measure of the attractiveness of a project for comparison to other possible courses of action. In some cases, the capital that would be invested in a process could earn more in some other investment or even in a savings account. For required environmental control processes there would be no other alternative investment allowed. It should be remembered, a profitability standard can only serve as a guide, and the profitability standard must be weighed against overall judgment and evaluation. 9.2.1 M ATHEMATICAL M ETHODS FOR P ROFITABILITY E VALUATION There are at least five reasonable methods to carry out a profitability evaluation. These methods are 1. Rate or incremental rate of return on investment 2. Discounted cash flow on full-life performance 9 9588ch09 frame Page 101 Wednesday, September 5, 2001 9:50 PM © 2002 by CRC Press LLC 3. Net present worth 4. Capitalized costs 5. Payout period Peters and Timmerhaus 1 present an excellent discussion of all these methods. Figure 9.1 illustrates the well-known concept in balancing fixed capital charges for a fabric filter against operating cost to find the minimum of the sum of the two. 9.2.2 I NCREMENTAL R ATE OF R ETURN ON I NVESTMENTS AS A M EASURE OF P ROFITABILITY One of the more simple methods of profitability analysis is based on rate of return and the incremental rate of return. It is assumed that there is a base case design that will provide the desired pollution control and meet the profitability objective set as the rate of return. As pointed out above, in some cases a pollution control apparatus must be built even if it does not meet a the profitability objective of a company. The base case should represent a system operating under nearly optimum conditions. All other designs are then compared against this base case. Defining the terms: ROI = percent return on investment IROI = incremental percent return on investment P = annual profit from invesment (income – expenses), or incremental profit or annual savings I = total investment or incremental investment (9.1) The process is as follows: FIGURE 9.1 Optimization of cost for a typical fabric filter or baghouse. ROI P I or IROI = 9588ch09 frame Page 102 Wednesday, September 5, 2001 9:50 PM © 2002 by CRC Press LLC • Set the base case — the alternative case that meets ROI at the least total initial cost. • Check IROI with base case compared to alternative case that meets the ROI and has the second lowest initial cost. • Accept the second alternative as base case if IROI is met. • With this new base case, check ROI compared to alternative that has the third lowest initial cost and then check the IROI. Set new base case if IROI is met. • Repeat process with all alternatives and select one that meets the ROI and the IROI by balancing the initial cost the ROI and the IROI. 9.2.2.1 An Example A chemical plant must install a new control system. Four alternatives are being considered. Each alternative will result in a reduction of emissions from the current 2000 T/year. The emissions fee is $35/T, and, therefore, the new equipment will reduce the annual emission fee. Furthermore, two of the processes will result in saving product for which an additional cost saving can be included. The company is demanding a 15% return on any investment. Which of the processes should be selected? Design A serves as the base case . A. Annual savings = 0 + 31,500 – 5,000 – 10,000 = $16,500 Meets ROI criteria. B. Annual savings = 6000 + 42,000 – 10,000 – 15,000 = $23,000 This ROI is acceptable. DESIGN A B C D Installed cost ($) 100,000 150,000 200,000 250,000 Operating cost ($) 5000 10,000 15,000 10,000 Fixed charges % of 10% 10% 10% 10% initial cost ($/yr) 10,000 15,000 20,000 25,000 Emission reduction 900 T 1200 T 1200 T 1500 T ($) 31,500 42,000 42,000 52,500 Product saved ($/yr) 0 6000 8000 21,000 ROI =×= 16 500 100 000 100 16 5 , , .% ROI =×= 23 000 150 000 100 15 3 , , .% 9588ch09 frame Page 103 Wednesday, September 5, 2001 9:50 PM © 2002 by CRC Press LLC This IROI is acceptable, therefore, this becomes the base case. C. Annual savings = 8000 + 42,000 – 15,000 – 20,000 = $15,000 This is an unacceptable ROI. Design C must be rejected. Design D is now compared to Design B which is the current base case. D. Annual savings = 21,000 + 52,500 – 10,000 – 25,000 = $38,500 This is an acceptable ROI. In this case, Design B produces nearly the same ROI and results in a better IROI. Select Design B and get a greater return on the incremental money. 9.3 THE EFFECT OF DEPRECIATION Depreciation is used to take into account the value of the equipment when it reaches obsolescence or must be replaced because of new technology. Assets before 1981 could be depreciated using the double declining balance method. From 1981 to 1986, the accelerated cost recovery system (ACRS) was used. Here all property was classified in 3-, 5-, 10-, 15-, or 20-year service life groups with no salvage value. The majority was in the 5-year group. A ½ full-year depreciation in the year placed in service was allowed; no deduction was granted in the year when property is disposed. From 1987 on, the modified accelerated cost recovery system (MACRS) has been used. This is the same as ACRS but also allows ½ of a full-year depreciation during the year of disposal. A 200% declining balance (i.e., double declining balance) for class lives of 3, 5, 7, and 10 years and a 150% depreciation for class lives of 15 and 20 years is allowed. A switch to straight-line depreciation at a time appro- priate to maximize deduction is permitted. Straight-line depreciation, although no longer permitted, can be used to illustrate the effect of depreciation. The following definitions apply. V R = initial cost V S = salvage value IROI =×= 23 000 50 000 100 46 0 , , .% ROI =×= 15 000 200 000 100 7 5 , , .% ROI =×= 38 500 250 000 100 15 4 , , .% IROI =×= 38 500 100 000 100 38 5 , , .% 9588ch09 frame Page 104 Wednesday, September 5, 2001 9:50 PM © 2002 by CRC Press LLC V A = asset value n = useful service life a = years in service d = annual depreciation (9.2) As a part of the example below, the declining balance method will be used. This method is somewhat similar to the ACRS and MACRS, but is easier to see in an example. Here equipment depreciates rapidly over the first few years to minimize taxes during the initial period. The annual depreciation is a fixed percentage at the beginning of the depreciation year. 9.3.1 A N E XAMPLE Companies P and Q bought identical Venturi scrubbers for $50,000. The service life of the scrubbers was eight years with no salvage value. The corporate tax rate is 34% for these companies. Company P uses the straight-line method of depreciation, and company Q uses the double declining-balance method. Compare the tax savings for these two companies for a period of 3 years. • Without depreciation, tax would be 0.34 × 50,000 = $17,000/year 3 × 17.000 = $51,000 over the 3 years d VV n Vnd V V da or d VV a RS R AR RA = − = =− =− = − annual depreciation V S f Vf VV f S n AR a = =− () =− () annual depreciation at a fixed percentage factor V R 1 1 V V n a R S = = = = initial cost = $50,000 salvage value = 0 useful service life = 8 years years in service = 3 years tax rate — applied at end of year34% 9588ch09 frame Page 105 Wednesday, September 5, 2001 9:50 PM © 2002 by CRC Press LLC • Company P — straight-line depreciation Tax Computation 1st year: 50,000 – 6250 = $43,750 Tax = $14,875 2nd year: 43,750 – 6250 = $37,500 Tax = 12,750 3rd year: 37,500 – 6250 = $31,250 Tax = 10,625 Total $38,250 Savings = 51,000 – 38,250 = $12,750 • Company Q — double declining-balance depreciation Tax Computation 1st year: V R (1 – f) = 50,000 × 0.7500 = $37,500 Tax = $12,750 2nd year: V R (1 – f) 2 = 50,000 × 0.5625 = $28,125 Tax = 9563 3rd year: V R (1 – f) 3 = 50,000 × 0.4219 = $21.094 Tax = 7172 Total $29,485 Savings = 51,000 – 29,485 = $20,515 Obviously a method like the double declining-balance is favorable when computing taxes. 9.4 CAPITAL INVESTMENT AND TOTAL PRODUCT COST Numerous costs are required to build and operate a chemical plant other than installed equipment costs and operating costs. However, the usual cost estimation technique is to relate these costs to the installed equipment costs. Guthrie 2 presents a capital cost-estimating technique which can be useful. Vatavuk 3 also discusses a method for estimating capital and operating costs. He presents a table of factors which should be roughly valid at this time. d year= − = 50 000 0 8 6250 , $ First year factor First year factor = −           = −           = =× = VV nV f RS R 1 50 000 0 8 1 50 000 0 1250 2 0 1250 0 2500 , , . 9588ch09 frame Page 106 Wednesday, September 5, 2001 9:50 PM © 2002 by CRC Press LLC 9.4.1 D ESIGN D EVELOPMENT In order to employ cost estimation and profitability analysis, it is suggested that the following process be used. 1. Select a process to develop from alternative processes. 2. Prepare the process flowsheet. 3. Calculate sizes of all equipment and estimate fixed capital cost. 4. Estimate installed cost. 5. Determine utilities usage and estimate cost. 6. Determine other costs — taxes, buildings, land, insurance. 7. Undertake a profitability analysis. In carrying out the design, it is recommended to set a budget for pollution control equipment. Then make as accurate a cost estimate as possible. Keep in mind main- taining a satisfactory profit structure if alternate choices are available. The following factors will affect equipment costs. • Company policies • Local and federal government regulations • Design standards • Union contracts and agreements • Agreements with fabricators REFERENCES 1. Peters, M. S. and Timmerhaus, K. D., Plant Design and Economics for Chemical Engineers , 4th ed., McGraw-Hill, Inc., New York, 1991. 2. Guthrie, K. M., Capital cost estimating, Chem. Eng. , pp. 114, March 24, 1969. 3. Vatavuk, W. M. and Neveril, R. B., Factors for estimating capital and operating costs, Chem. Eng. , pp. 157–162, November 3, 1980. 9588ch09 frame Page 107 Wednesday, September 5, 2001 9:50 PM © 2002 by CRC Press LLC . before 198 1 could be depreciated using the double declining balance method. From 198 1 to 198 6, the accelerated cost recovery system (ACRS) was used. Here all property was classified in 3-, 5-, 1 0-, . 50,000 × 0.42 19 = $21. 094 Tax = 7172 Total $ 29, 485 Savings = 51,000 – 29, 485 = $20,515 Obviously a method like the double declining-balance is favorable when computing taxes. 9. 4 CAPITAL INVESTMENT. rate of return on investment 2. Discounted cash flow on full-life performance 9 95 88ch 09 frame Page 101 Wednesday, September 5, 2001 9: 50 PM © 2002 by CRC Press LLC 3. Net present worth 4.