February 23 Topics

1. February 23 Topics • Discussion of Economic Analysis approach • Assignments • HW6-team feedback due 2/23 • HW7-revised draft due 2/28

2. Economic Analysis • Purpose: to present a cost/benefit analysis of your proposed solution to the client’s problem • Requires: Examination of all pertinent costs, gains, timing of expenses & income

3. What kind of analysis to do? • Return on investment using Net Present Value • Payback period • Comparative cost/benefit • Market analysis • Meet client expectations!

4. Common errors in 440 • Consider only initial investment cost (no operating costs) • Calculate payback period without considering time value of money • No consideration of alternative use of funds

5. Expectations • Identify cost of or losses under current system • Estimate both initial investment and operating costs, and the time when they occur • Estimate gains anticipated and time occurring

6. Steps to Economic Analysis • Know all the requirements of the solution and how they can be implemented • Determine the costs of the current situation • Real costs • Opportunity costs

7. Steps to Economic Analysis • Determine sequence of steps to implement solution, costs for and timing of each step (total gives installation cost) • Determine operating expenses and time incurred (depreciation, interest, etc.)

8. Steps to Economic Analysis • Determine cost savings or income and time occurring • Create time series of expenses and income extending over the entire evaluation period

9. Steps to Economic Analysis • Calculate Net Present Value and Internal Rate of Return for the cash flow series • Compare IRR to client policy on investments or alternative uses of funds

10. Partial Budget • Partial budget examines only those costs/benefits that will change. Provides change in profit, not total profit • May be most appropriate for some projects, but not all

11. Useful tool • Excel has Net Present Value and Internal Rate of Return calculators that can be used • Use Excel Formulas and Financial for the functions or go to Excel Help

12. Example • Nursery pruner disinfection system • Evaluate costs and benefits for profitability analysis • Use partial budget analysis

13. Example - Solution • Solution is addition of pressurized solution sprayer to existing pruners • Safety equipment limited to respirators for workers mixing solution and operating pruner

14. Example – Current costs • Real costs • Average plant cost - $1 • Loss due to disease transfer – uncertain, client suggests 1% • Plants produced - 435,600/6 months • Opportunity costs • Profit per plant - $1.50

15. Example – Install costs • Train workers - $500 for trainer, 12 hrs @ $10/hr unproductive time + fringe benefits of 20% = $644, occurs at time = 0 • Install one sprayer system - $3075, occurs at time = 0 • Total install cost = $3719

16. Example – Operating costs • Solution - $45, monthly • System prep time – 6 hr@ $10/hr + 20% fringes each month - $72 • Tip and seal replacement – every 6 months - $175 • Depreciation – none, not a capital expense • Interest – none, paid from cash flow

17. Example - Gains • Cost savings (monthly) • 72,600 potential sales/month • 1% loss, $1/plant • Real loss - $726 • Income gains (monthly) • Lost plants * $1.50 profit/plant = $1089 • $726 + $1089 = $1815

18. Example – time series

19. Example – NPV & IRR • See Excel file • Need to determine interest rate for calculation of net present value – assume 6% annual, or 0.5% per month • Evaluate over 6 months

22. HW6 In-class Activity • As a team, discus the strengths and weaknesses of the reports that you each read • Look for common factors. If the same weakness appeared in all reports, tell them • Prepare the team document to be submitted

23. Report Format • Project title • Common points communicated • Points that differ • Strengths of reports • Weaknesses of reports