4Development of the training materials Content has been developed by:Tellus InstituteThe Illinois EPAThe Philippine Institute of CPAsThe Asian Institute of ManagementUNEP CP financing National Project Coordinators in Zimbabwe and GuatemalaUNEP Cleaner Production financing project team
5UNEP: Financing Cleaner Production — Support United Nations Environment Programme (UNEP); Division of Technology, Industry and Economics (DTIE)Course support is from the project:“Strategies and Mechanisms For Promoting Cleaner Production Investments In Developing Countries”Funding provided by the Government of Norway
6Introduction of Instructors Words of welcomeIntroduction of Instructors[15 min]
8Participant introductions Who is here today?What type of organization do you work for?e.g., industry, government, otherif from industry, which sector and what sizeWhat are your job responsibilities and areas of expertise?e.g., management, accounting, finance, engineering, production, environmentalWhat is your investment perspective?e.g., developer of investment proposals, one who funds investment proposals
9Why are you here? What work issues or concerns motivated you to come? What are your learning goals for this course?What are your expectations of this course?
11Focus of this course Cleaner Production Cost Identification & EstimationProject Profitability AssessmentAlso to incorporate your experiences, questions, and goals into the presentation, exercises, and discussionsCase studies of Cleaner Production at real facilities will be used
12Cleaner Production The cost of waste Profiting from Cleaner Production Small group exercise on classifying environmental management optionsCP implementation stepsWhere to go for more informationCP planning at your organization
13Cost identification and estimation Small group exercise on cost identificationProblematic accounting practicesPotential sources of cost dataSmall group exercise on cost estimationTools for data estimationCost identification and estimation at your organization
14Project profitability assessment Capital budgeting (of “environmental” projects)Project cash flows and simple paybackThe Time Value of Money (TVM) and Net Present Value (NPV)Two small group exercisesCapital budgeting with inflation and taxSensitivity analysisKey profitability indicators
15Conclusion Where to go for more information Brief review of what we learnedFinal questions and commentsCourse evaluation
19What is waste?Some proactive companies view waste as: “any material or energy that leaves a process or facility in any form other than product”A slightly less strict definition might be: “any material or energy that leaves a process or facility without first being used as efficiently as possible”Definitions vary — but all companies generate waste!
20Flow of materials & energy Air EmissionsMaterials,Energy,Water,Labour,CapitalProducts,By-ProductsSolid Waste, Waste Energy ,Wastewater
21Different types of waste There are many words for different types of waste:allowanceBODbrokecontaminated solidscore losscustomer returnsdamagedrainingsdusteffluentevaporationfurnace lossgreenhouse losshidden lossesleakagenon-conforming materialoverfillpackagingprocess lossreworksecond qualitystock losswashingsAdapted from: The Kaunas Institute of Technology, Kaunas, Lithuania
22The true cost of waste is often underestimated For every $1 of waste cost that companies actually measure, another $2-3 of cost are” hidden” in the accounting records, or are not on the books at allCompanies typically underestimate how much waste really costs them, sometimes by several orders of magnitudeThis applies even to big, well-managed companies
23The cost of waste ink at the Southwire Company The average disposal cost of a drum of hazardous waste ink was estimated as $50Upon closer inspection, the true cost was discovered to be $1300 per drum:$819 lost raw materials (ink, thinner)$369 corporate waste management activities$50 disposal$47 internal waste handling activities$16 hazardous waste tax
24The “Cost” IcebergThe true cost of waste can be like an iceberg, with only a small part visibleTHE HIDDEN COSTOF WASTEAdapted from: Bierma, TJ., F.L. Waterstaraat, and J. Ostrosky “Chapter 13: Shared Savings and Environmental Management Accounting,” from The Green Bottom Line. Greenleaf Publishing:England.
25So how do we melt the cost iceberg. through Cleaner Production So how do we melt the cost iceberg? ...through Cleaner Production! Stay tuned...
29Proactive environmental strategies: Cleaner Production Prevention of waste generation:Good housekeepingInput substitutionBetter process controlEquipment modificationTechnology changeOn-site recovery/reuseProduction of a useful by-productProduct modification
30Cleaner Production definition “The continuous application of an integrated preventive environmental strategy applied to processes, products, and services to increase overall efficiency and reduce risks to humans and the environment.”(UNITED NATIONS ENVIRONMENT PROGRAMME)
31Properly implemented CP: alwaysreduces long-term liabilities which companies can face many years after pollution has been generated or disposed at a given site
32Properly implemented CP: usuallyincreases profitabilitylowers production costsenhances productivityprovides a rapid return on any capital or operating investments requiredincreases product yieldleads to the more efficient use of energy and raw materials
33Properly implemented CP: oftenavoids regulatory compliance costsleads to insurance savingsprovides enhanced access to capital from financial institutions and lendersis fast and easy to implementrequires little capital investment
34CP versus End-of-Pipe approach CLEANER PRODUCTIONContinuous improvementtowards use of closed loop or continuous cycle processesPartnerships are essential: everyone has a role to play in the communityElimination of environmental problems at sourceInvolves new practices, attitudes and management techniques and stimulates technical advancesPOLLUTION CONTROL and WASTE MANAGEMENTOne-off solutions to single problemsProcesses result in waste materials for disposal Solutions are often developed by experts in isolationReactive responses to pollution and waste after they are generated (e.g. via waste treatment equipment and methods)Relies mainly on technical improvements to existing technologies
35What is not CP? Off-site recycling Transferring hazardous wastes Waste treatmentConcentrating hazardous or toxic constituents to reduce volumeDiluting constituents to reduce hazard or toxicity
36What are the benefits of Cleaner Production? Improving environmental situationContinuousenvironmentalimprovementIncreasing economical benefitsGaining competitive advantageIncreasing productivity
37CP motivators and drivers INTERNAL to the COMPANY:- Improvements inproductivity and competitiveness- Environmental management systems and continuous improvement- Environmental leadership- Corporate environmental reports and Environmental accounting
38CP motivators and drivers EXTERNAL to the COMPANY:- Innovative regulation- Economic incentives- Education and training- Buyer – supplier relations- Soft loans from Financial institutions- Community involvement- International trade incentives
39Team for CP successManagers, engineers and finance people in industry and commerce, in particular those responsible for business strategy, product development, plant operations and financeGovernment officials, both central and regional, who play an important role in promoting CPMedia representatives who play an important role in disseminating information on good environmental practice
40Small Group Exercise: Classifying Environmental Management Options [30 min]
41Exercise instructions Introduction (5 min.)Read and evaluate the two company cases detailed in your handout (10 min.)Discuss your answers with the other small groups and the instructor (10 min.)Lessons learned (5 min.)Refers to the handout “CP3Exercises” throughout the course
42Preview: Cleaner Production at a case study facility called “PLS” [5 minutes] A medium-sized company selling printed food packaging materials (such as potato-chip bags)They print product labels directly onto the film material, and then the customers make the final package
43Cleaner Production at the PLS Company PLS implemented two CP projects to reduce wasted solid scrap during print runsA quality control (QC) camera project to reduce waste from errors when printingAn on-site scrap recycling project to reduce waste from start-up runs
44CP projects’ profitability at the PLS Company The two CP projects in combination reduced solid scrap by about 45%Total initial investment:US $ 105,000The resulting annual savings:US $ 96,900More details to come later...
47Planning for Cleaner Production: Six steps to savingsStep 3Step 1Step 5Identify andevaluate CPalternativesGetorganizedImplementprojectsStep 2Step 4AnalyzeprocessesStep 6SecureprojectfinancingMeasureprogressAdapted from: A Guide to Pollution Prevention for New Hampshire Businesses.January N.H Department of Environmental Services.
48Step 1 — Get organized Get management support for Cleaner Production Form a planning teamSeek input from personnel at all levels30
49Step 2 — Analyze processes Take a close look at each production stepMap flows of materials, energy, waste, activitiesDetermine the true cost of waste generationPrioritise losses and target your CP efforts30
50Step 3 — Identify & evaluate CP options Get at the root cause of the problemBe creativeGenerate lots of ideasDetermine which alternatives are feasibleSelect best alternatives for implementation30
51Step 4 — Secure project financing Proceed to Step 5 for projects that need minimal up-front investmentDetermine availability of internal investment funds for bigger projectsObtain external financing for remaining projectsPrivate sectorGovernment sector30
52Step 5 — Implement projects Schedule projectsAssign responsibilitiesTalk to workers who will be affectedGet feedback from employeesSchedule financing payments30
53Step 6 — Measure progress Track waste generation, materials usage, and cost savingsTake into account variation in production levelDocument your results and your cost savingsCelebrate your successesNow go back to Step 230
54Teamwork is very important! Each person brings different,but vital, information
55Tools: The Cleaner Production Team CEOBoardAccounting & FinanceProductionSales & MarketingResearch & DevelopmentEnvironment, Health, & SafetyPurchasingMaterials ControlInventoryOperationsQuality ControlShippingMaintenanceEngineeringLegal
56Where to go for more information Click ‘Where to go for more information” on this CD-ROM orto the second last page of any of the UNEP/DTIE publicationsin the “Profiting from Cleaner Production” series
58Cleaner Production Review of what we have done The Cost of WasteProfiting from Cleaner ProductionSmall group exercise on Classifying Environmental Management OptionsCP implementation stepsWhere to go for more information
59CP Planning at your Organization [15 min] Take this time to write down some next steps for CP planning at your organizationWhat other quality, efficiency, or environmental initiatives already in place at your organization might fit well with CP?Who should be the members of your CP team?Would you go somewhere for external assistance? What kind? Where would you go?What might be some CP barriers at your organization, and how can you overcome them?
64The language of business Costs are an important aid in translating environmental needs to business needs. In addition, they already serve as an “official language” in the company.projectprofitabilityROIcapitalinvestmentmarketshareprofit centrecost allocationoverhead costsunit priceCDOincinerator banregulatorycompliancewastewaterenergyefficiencydioxinrecyclingWith the cost translation, the business and environmental manager can communicate and cooperate more effectively.Adapted from “Pilot programme for the promotion of environmental management in developing countries” (P3U). Environmental Cost Management. GTZ-P3U. Bonn, Germany
65Financial Analysis steps Cost identification & estimationProject profitability evaluationWe will discuss this nowWe will discuss these tomorrow
66Cost identification & estimation Initial investment costse.g., equipment, installation, trainingAnnual operating costs, savings,and revenuescurrent operations, before the projectafter project implementatione.g., materials, energy, labourNeed to identify, estimate and allocate all relevant and significant items impacted by the project
67Small group exercise: Cost Identification at the PLS Company [75 min]
68The PLS CompanyA medium-sized manufacturer of food packaging materialsMajor manufacturing steps are Printing, Laminating, and SlittingWaste management includes incineration and wastewater treatmentCleaner Production has reduced volume of solid scrap and annual operating costs
69Manufacturing Steps at the PLS Company — Materials flow mapplastic film, aluminium film, adhesivesolvent airemissionssolvent airemissionsINVENTORYprintedlaminatedfilmprintedfilmproductSLITTINGplastic film, inkPRINTINGLAMINATIONSolid scrapSolid scrapSolid scrapLiquid wasteinkto wastemanagementto wastemanagement
70Waste Management at the PLS Company — Materials flow map airemissionsairemissionswwtp chemicalsCleanerwater toa nearbystreamfresh waterdirty scrubberwaterfuel and fueladditiveWASTEWATER TREATMENTINCINERATORsolid scrapfrom printing,laminating,slitting stepsliquid inkwaste fromprinting stepsludgeashOFF-SITELANDFILL
71Exercise instructions Introduction (10 min.), detailed in your handoutReview the written description and flow maps for the PLS Company (10 min.)Question 1 (15 min.)Question 2 (15 min.)Discuss your answers with the other small groups and the instructor (20 min.)Lessons learned (5 min.)
72Three broad categories of costs The cost of manufacturing inputsMaterials, energy, labour, capital, etc.The cost of waste managementWaste handling, regulatory compliance, waste treatment and disposal, etc.Less tangible costsProduction throughput, product quality, company image, liability, etc.
73Checklist: “The Investment Decision Cost/Savings Checklist” Refers to the checklist handout3
74The cost of waste at the PLS Company The total cost of waste due to the generation of solid scrap during print runs was estimated to be US$213,000 per year, including:Cost of lost direct manufacturing inputs (e.g, plastic film, ink, energy, labour)Cost of waste management (e.g., incinerator operation, wastewater treatment plant operation, final waste disposal)
75Problematic accounting practices—what might make it difficult to estimate costs accurately (Particularly costs related to waste) Let’s brainstorm![30 min]
76Problematic accounting practices? Various costs at a facility might be...“Hidden” in the accounting recordsMisallocated from overhead accountsClassified as fixed when they are really variable, or semi-variableNot found in the accounting records at all(Can you think of others?)136
77“Hidden” costs of lost raw materials Manufacture of plastic rear panels for automobiles(As a percentage of input materials)Material loss perthe accounting recordsActualmaterial lossAdapted from: Rooney, Charles. “Economics of Pollution Prevention:How Waste Reduction Pays.” Pollution Prevention Review.Summer 1993.
78“Hidden” Costs of lost raw materials at the PLS company The PLS accounting records show:The amount of raw materials usedThe amount of final product shippedBut the records do not show:The amount of solid scrap waste generatedThe amount of any other lost raw materials136
79Direct vs. Indirect Costs (1) Direct Costs are costs that can be easily traced to a unit of producte.g., direct materials, direct labourIndirect Costs are costs that cannot be traced as easily to a unit of producte.g., facility energy use, insurance, maintenance, waste treatmentA cost considered “direct” at one firm may be considered “indirect” at another firm
80Direct vs. Indirect Costs (2) In general, direct costs within an industrial firm are assigned directly to the process, product, or project responsible for generating the costIndirect costs are assigned to facility, division, or company overhead accountsIt can be difficult to find costs “hidden” in overhead accounts131
81Environmental Management Costs “hidden” in an overhead account Product Manufacturing Cost StatementVariable CostsRaw MaterialsIntermediatesAdditivesUtilitiesDirect LabourPackagingWastewater Treatment$2.27/lb.$0.87/lb. $0.41/lb. $0.96/lb.$11.32/lb. $10.31/lb. $9.14/lb.$0.04/kW-h $0.07/kW-h$27.40/hr $31.43/hr.$0.60/pkg. $0.57/pkg$0.01/gal.legal expensesenvironmentally driven R&Dpermitting time and feesenvironmental trainingFixed CostsSupervisorFixed LabourDepreciationDivisional OverheadGeneral Services & AdministrationFixed CostsSupervisorFixed LabourDepreciationDivisional OverheadGeneral Services & Administration$4,600$57,800$1,227$13,662$1,294Total Variable CostTotal Fixed CostTotal Manufacturing CostTotal CostSource: Green Ledgers: Case Studies in Corporate Environmental Accounting. World Resources Institute. May 1995.135
82Survey of industry accountants in the US Findings:Environmental management costs such as waste handling, treatment, and disposal predominantly assigned to overhead accountsEven energy and water costs (manufacturing inputs) are usually assigned to overhead accountsSource: Environmental Capital Budgeting Survey . Tellus Institute, for U.S. EPA, June 1995131
83Cost assignment at the PLS Company The cost of direct materials, labour, and energy are assigned directly to the manufacturing stepsIn contrast, waste treatment and disposal costs are assigned to an overhead account in the Office of the Business Manager136
84Problematic accounting practices? Various costs at a facility might be...“Hidden” in the accounting recordsMisallocated from overhead accountsClassified as fixed when they are really variable, or semi-variableNot found in the accounting records at all(Can you think of others?)136
85Cost allocationCosts initially assigned to overhead accounts are usually allocated back to processes, products, or projects using an allocation basis such asQuantity of raw materials usedProduction volumeMachine hoursLabour hoursFloor space136
86Cost allocation at the PLS Company How would youallocate?On the basis of:# of set-up runs?raw materials use?machine hours?amount of scrap?some other basis?Allocated from overheadPrintingSolid scrap wasteTreatment and disposal costsLaminatingSlitting138
87Problematic accounting practices? Various costs at a facility might be...“Hidden” in the accounting recordsMisallocated from overhead accountsClassified as fixed when they are really variable, or semi-variableNot found in the accounting records at all(Can you think of others?)136
88Fixed vs. Variable Costs (1) Fixed Costs are costs that do not vary with production level or other factorse.g., equipment depreciation, labourVariable Costs are costs that do (or can) vary with production level or other factorse.g., raw materials use, energy useA cost considered “fixed” at one firm may be considered “variable” at another firm
89Fixed vs. Variable Costs (2) The goal of Cleaner Production is to reduce variable costsTherefore, it is important to correctly distinguish between fixed and variable costs when identifying and estimating costs to support CP effortsIf CP efforts will reduce a cost — then it is variable!131
90Fixed vs. Variable Costs at The PLS Company Incinerator operating costs at PLS include:Fuel, fuel additiveOperating labourTrucking ash to landfillEquipment depreciation costsPLS views these waste treatment costs as essentially fixed costs — do you agree?131
91It is important to remember: Future fixed costs are not fixed yet It is important to remember: Future fixed costs are not fixed yet! Cleaner Production now can reduce the size & cost of treatment equipment that you may have to purchase in the future29
92Problematic accounting practices? Various costs at a facility might be...“Hidden” in the accounting recordsMisallocated from overhead accountsClassified as fixed when they are really variable, or semi-variableNot found in the accounting records at all(Can you think of others?)136
93Costs missing from the accounting records In general, two types of costs may be entirely missing from the accounting records:Future costsFuture variable costs, e.g., landfill feesFuture fixed costs, e.g., future depreciation costs of new waste treatment equipmentLess tangible costse.g., lost profit from reduced production throughput131
94Costs missing from the accounting records at the PLS Company Lost profit from reduced productionFuture regulatory costs (e.g., stricter wastewater regulations)Potential liabilityNegative company image(Can you think of others?)131
95Problematic accounting practices? Various costs at a facility might be...“Hidden” in the accounting recordsMisallocated from overhead accountsClassified as fixed when they are really variable, or semi-variableNot found in the accounting records at all(Can you think of others?)136
96Ease of identifying and estimating costs Equipment purchase, direct materials, energy, labourIn general,as you godown this list, costs are more likely to be hidden or difficult to quantify(but every case is different!)LESSHIDDENMOREWaste disposalRecycle/rework, treatment, waste handlingRegulatory compliance,other indirect costsLess tangible costs
97Potential Sources of Cost Data Let’s brainstorm! [15 min]
98Potential sources of cost data Internal data sourcesThe accounting systemOriginal data records in different departmentsColleagues/employeesExternal data sourcesIndustry colleagues or trade associationsVendors and consultantsBusiness Partners (e.g., insurance firm)Government (e.g., environmental agency)National Cleaner Production Centre136
100Cleaner Production The cost of waste Profiting from Cleaner Production Usually underestimated!Profiting from Cleaner ProductionCleaner Production as waste prevention and on-site recyclingCleaner ProductionBenefitsImplementation steps
101Cost identification and estimation Introduction to PLS company (will see more of PLS tomorrow)Categories of costs (manufacturing inputs, waste management, less tangible costs)Problematic accounting practicesSources of cost data
102Tomorrow... Cost estimation tools Project profitability assessment Process mapping, material flowsProject profitability assessmentCash flows“Simple Payback” indicator“Time-value-of-money” concept“Net Present Value (NPV)” indicatorOther indicatorsOther profitability assessment issues
104Profiting from Cleaner Production: Day 2 For UNEPDivision of Technology, Industry, and EconomicsPrepared byTellus InstituteBoston, MA USA
105Small group exercise: Cost estimation at the PLS Company [60 min]
106Exercise instructions Introduction (5 min.), detailed in your exercise handoutQuestion 1 (20 min.)Question 2 (15 min.)Discuss your answers with the other small groups and the instructor (15 min.)Lessons learned (5 min.)
107Tools For Data Identification and Estimation [30 min]
108Tools: Original data records Purchase order/invoicesProduction recordsWaste shipment recordsEquipment logsEngineering estimatesRegulatory reportsStaff interviewsSource: Northeast Waste Management Officials’ Association67
111Tools: The Materials Balance Physical analogy to financial balance sheetCompares all material inputs and outputsIdentifies sources of waste and data gapsProvides basis for cost evaluationMANUFACTURINGPROCESSPRODUCTINPUTSNON-PRODUCTOUTPUT (WASTE)34
112Tools: Cost ChecklistConsider tailoring a generic checklist for routine use with specific industry sectors and/or for specific process/project typesDetermine if each item on the list is:Not relevantRelevant but quantitatively insignificantRelevant and quantitatively significantRelevant but not quantifiable128
113Checklist: “The Investment Decision Cost/Savings Checklist” — We used it yesterday 3
114Investment decision Costs & savings Initial investment costsAnnual operating costs and savingsThe cost of operating inputsThe cost of waste managementLess tangible costsRevenues
115Tools: Activity Based Costing (ABC) Under ABC, costs are allocated from overhead accountsTo the processes, products, or projects that actually generated the costsOn the basis of activities with a direct relationship to cost generationABC will not eliminate overhead accounts, but will ensure the availability of more accurate cost information for decision-making141
116Tools: External expertise for less tangible costs Examples:Insurance sector— liability estimationMarketing firms— value of company imageEnvironmental agencies — estimates of current and future regulatory compliance costs139
117Cost identification and estimation Summary of tools (1) Work as a team— talk to everyoneDo a facility walk-throughMap process steps, materials flows, employee activities, etc.Do materials and energy balancesUse a comprehensive cost/savings checklistExternal expertise for less tangible costs
118Cost identification and estimation Summary of tools (2) Do a check on data from the accounting recordsoverhead costs appropriately allocated?accurate characterisation of fixed vs. variable?Compare accounting record data to information from your maps, materials balances, staff interviewsGo back to the original data sourcesThink creatively
119To quantify or not to quantify? How do you know if a relevant cost or savings is quantitatively significant before you go ahead and quantify it?You don’t.Try to do at least a rough, first-cut estimate of all quantifiable costs — then decide whether or not refining the estimate is worth the effort.
120Do a balancing act...Don’t spend any more time than necessary collecting and analyzing databutMake sure you have really included all of the most significant costs & savings in the analysisMake sure that you are not neglecting other CP alternatives for the same waste stream that might be even more profitable!
121Cost Identification and Estimation Summary and Q&A [15 min]
122Cost identification & estimation Problematic accounting practicesPotential sources of cost dataSmall group exercise on cost estimationTools for data estimation
123Cost identification and estimation at your organization [15 min] Take this time to write down some next steps for cost identification & estimation at your organizationWhat accounting practices might you want to understand better?What other data sources might be the most valuable?What cost identification & estimation tools might be the most useful?
127Capital Budgeting The process by which an organization: Decides which investment projects are needed & possible, with a special focus on projects that require significant up-front investment (i.e., capital)Decides how to allocate available capital between different projectsDecides if additional capital is needed
128Capital budgeting practices Capital budgeting practices vary widely from company to companyLarger companies tend to have more formal practices than smaller companiesLarger companies tend to make more and larger capital investments than smaller companiesSome industry sectors require more capital investment than othersCapital budgeting practices may also vary from country to country
129Typical project types & goals (1) MaintenanceMaintain existing equipment and operationsImprovementModify existing equipment, processes, and management and information systems to improve efficiency, reduce costs, increase capacity, improve product quality, etc.ReplacementReplace outdated, worn-out, or damaged equipment or outdated/inefficient management and information systems
130Typical project types & goals (2) Expansione.g., obtain and install new process lines, initiate new product linesSafetymake worker safety improvementsEnvironmentale.g., reduce use of toxic materials, increase recycling, reduce waste generation, install waste treatmentOthers...
131The poor reputation of “environmental” investment projects Many people in industry view “environmental” projects as increasingly necessary to stay in business, but as automatic financial losers because:they associate “environmental projects” with pollution control systems such as wastewater treatment plants, which can be quite costly (end-of-pipe)they are unaware of the potential financial benefits of preventive environmental management practices
132We know better!We have learned that some environmental projects, i.e., Cleaner Production (CP) projects, can go hand in hand with:Production efficiency improvementsProduct quality improvementsProduction expansionSo, do not place your project idea into a single narrow category — think broadly about all the possible benefits
135The Cash Flow ConceptThe Cash Flow Concept is a common management planning tool.It distinguishes between: (a) costs -> cash outflows(b) revenues/savings -> cash inflows135
136Cash Flow Analysis Measures the difference between Relies on every day life principlesMeasures the difference betweenWhat we received, andWhat we paid outOnly cash receipts and cash payments are included in the analysisApplicable also to forecast cash available
139Working CapitalWorking Capital is: “the total value of goods and money necessary to maintain project operations”It includes items such as:Raw materials inventoryProduct inventoryAccounts payable/receivableCash-on-hand139
140Salvage ValueSalvage Value is the resale value of equipment or other materials at the end of the project140
141Cash Outflow Analysis (2) Direct costsInput costsOther costsLoan repaymentsInterest on loan application
148Cash Flow Analysis structure There are two basic ways to structure a project financial analysis:1) Stand-alone analysisConsiders only the cash flows of the proposed project2) Incremental analysisCompares the cash flows of the proposed project to the “business as usual” cash flows148
149Incremental analysis for CP For many CP projects, you will need to do an incremental analysis — compare the CP cash flows to the “business as usual” cash flowsYou only need to estimate the cash flows that change when you improve the “business as usual” operations149
150Profitability indicators A profitability indicator, or “financial indicator”, is: “a single number that is calculated for characterisation of project profitability in a concise, understandable form.”Common examples are:Simple PaybackReturn on Investment (ROI)Net Present Value (NPV)Internal Rate of Return (IRR)150
151Simple Payback (in years) This indicator incorporates:the initial investment costthe first year cash flow from the projectSimple Payback (in years)Initial InvestmentYear 1 Cash Flow=15124
152How to interpret Simple Payback The simple payback calculated for a project is usually compared to a company rule of thumb called a “hurdle” rate:e.g., if the payback period is less than 3 years, then the project is viewed as profitable152
153Small Group Exercise: Profitability Assessment at the PLS Company— Part I “Cash Flows & Simple Payback”[30 min]
154The PLS Company’s QC Camera Project PLS decided to purchase and install a camera system to monitor quality control (QC) of the print jobs as they actually occurAllows the operators to detect print errors earlier and halt the operations before too much solid scrap is generatedHas reduced generation of full-run solid scrap by about 40%143
155Costs and savings included in the QC camera analysis Initial investment costspurchase of the camera system, delivery, installation, start-upAnnual operating costs (and savings)Operating input — materials (plastic film, ink), energy, labourIncineration — fuel, fuel additive, labour, ash to landfillWastewater treatment — chemicals, electricity, labour, sludge to landfill155
156QC camera project Cash flows Annual savings = ???Year 1Year 2Year 3TIMEAnnual Tax Payments = 0 (PLS has tax holiday)Financing Payments = 0 (PLS paid cash)Time zero:Working Capital = 0 (not important for this project)Initial Investment = $105,000156
157The PLS Company’s QC camera project Initial InvestmentCostAnnual OperatingCostsBusiness As Usual???Annual Savings =???The QC Camera ProjectUS $ 105,000???157
158Exercise instructions Part I Introduction (5 min.), detailed in your handoutQuestion 1 (15 min.)Question 2 (5 min.)Discuss your answers with the other small groups and the instructor (5 min.)
159The Time Value of Money and Net Present Value (NPV) [30 min]
160Question: If we were giving away money, would you rather have: (A) $10,000 today, or (B) $10,000 3 years from now Explain your answer...
161Inflation costs $1.05 costs $1 inflation 5% Money loses purchasing power over time as product/service prices rise, so a dollar today can buy more than a dollar next year.inflation 5%costs $1.05costs $1next yearnow161
162Investment opportunity A dollar that you invest today will bring you more than a dollar next year — having the dollar now provides you with an investment opportunityGives you $1.10 a year from nowInvesting $1 nowInvestmentInterest, or “return on investment”162
163Time Value of Money (TVM) Money now is worth more than money in the future because of:a) inflationb) investment opportunityThe exact “time value” of your money depends on the magnitude of the:a) rate of inflation andb) rate of return on investment
164TVM and project profitability When you invest in a capital project, you have:(1) An initial investment happening NOW(2) A series of future cash inflows, over time, that pay back the initial investmentSo, it is important to take the Time Value of Money (TVM) into account when you are estimating project profitability
165The PLS Company’s QC camera project Initial InvestmentCostAnnual OperatingCostsBusiness As Usual$ 2,933,204Annual Savings =US$38,463The QC Camera Project$ 105,000$ 2,894,741(in US$)165
166Question: Is the annual savings of $38,463 per year for 3 years a sufficient return on the initial investment of $ 105,000?
167Answer?You might think about adding up the annual savings over the 3 years:Savings per year $38,463x 3 yearsTotal savings $115,389But: this ignores the Time Value of Money (the fact that $38,463 in year 1 is not the same as $38,463 in year 2 or year 3)
168Comparing cash flows from different years Before you can compare cash flows from different years, you need to convert them all to their equivalent values in a single yearIt is easiest to convert all project cash flows to their “present value” now, at the very beginning of the project168
169Converting the PLS cash flows to their “present value” Annual SavingsEnd of project= ??$38,463$38,463$38,463Year 1Year 2Year 3TIMETime zero:Initial Investment = $105,000169
170Converting cash flows to their present value You can convert future year cash flows to their present value using a “discount rate” that incorporates:Desired return on investmentInflationThe discount rate calculation is simple — mathematically, it is the reverse of an interest rate calculation170
171Interest rate calculation Invested at an interest rate of 20%, how much will $10,000 now be worth after 3 years?Afteryear$10,000 x = $12,000$10,000 x 1.20 x = $14,400$10,000 x 1.20 x 1.20 x = $17,280Note: these calculations are on a compound basis
172Discounting calculation The discounting calculation is essentially the opposite of the interest rate calculation.If you want to have $17,280 in 3 years, how much would you have to invest now?$17, = $10,0001.20 x 1.20 x needed nowIn other words, $17,280 in year 3 has a present value of $10,000
173Which discount Rate? (1)The discount rate a company chooses should be equal to the required rate of return for the project investmentThe required rate of return will usually incorporate three distinct elements:A basic return - pure compensation for deferring consumptionAny ‘risk premium’ for that project’s riskAny expected fall in the value of money over time through inflation
174Which discount Rate? (2)At a minimum, the chosen discount rate should cover the costs of raising the investment financing from investors or lenders (i.e. the company’s “cost of capital”)Often, rather than trying to identify the exact source of capital (and its associated cost) for each individual project, a firm will develop a single “Weighted Average Cost of Capital” (WACC) that characterises the sources and cost of capital to the company as a whole.
175Discounting (1) Present Value = Future Valuen (1 + d)n The value of the cash flow in year nPresent Value = Future Valuen(1 + d)nThe value of the cash flow at “Time Zero,” i.e., at project start-upn = the number of years after project start-upd = the discount rate175
176Discounting (2) Present Value = Future Valuen x (PV Factor) The value of the cash flow in year nPresent Value = Future Valuen x (PV Factor)Present Value (PV) Factors have been calculated for various values of d (discount rate) and n (number of years) and have been tabulated for easy use.(Also called discount factors)The value of the cash flow at “Time Zero,” i.e., at project start-up176
177Present value factors Value of $1 in the future, NOW Discount rate (d): 10% 20% 30% 40%Years into future (n)
178Net Present Value (NPV) If NPV > 0, the project is profitable Net Present Value (NPV) = the sum of the present values of all of a project’s cash flows, both negative (cash outflows) and positive (cash inflows)NPV characterises the present value of the project to the companyIf NPV > 0, the project is profitableIf NPV < 0, the project is not
179Estimating Net Present Value Expected Future Cash FlowsPresent Value of Cash Flows (at time zero)YearPVFactor=*123- $105,000+ $38,463- $???$??????Sum = the project’s Net Present Value =179
181Small Group Exercise: Profitability Assessment at the PLS Company— Part II “Net Present Value” [45 min]
182Located in your handout Also — you will need the handout: “Performing Net Present Value (NPV) Calculations”Located in your handout3
183Converting the PLS cash flows to their “present value” End of project= ??$38,463$38,463$38,463Year 1Year 2Year 3TIMETime zero:Initial Investment = $105,000183
184Exercise instructions Part II Introduction (5 min.), detailed in your handoutQuestion 3 (15 min.)Question 4 (5 min.)Discuss your answers with the other small groups and the instructor (15 min.)Lessons learned (5 min.)
186Discounting and inflation (1) even without inflation, money has a time value due to supply/demand for moneyinflation increases both:future cash flowsinterest rates (and discount rates)these offset each other
187Discounting and inflation (2) With 10% inflation (say), future cash flows will by 10% each yearInvestors & lenders will also require a higher rate to compensate for their loss in purchasing powerIf 15% was acceptable with no inflation, with 10% inflation they will now require115% x 110% = 126.5%
188Discounting and inflation (3) PLS Company, now assuming 10% inflation and 26.5% discount rate:Year Cash flow PV factor PV($) @ 26.5% ($)1 42, ,4662 46, ,0883 51, ,28987,843less: initial investment 105,000Net Present Value ,157i.e. same NPV* as with zero inflation, 15% discount rate* ignoring minor rounding difference
189What is the current rate of inflation in the economy? What return on their capital will the lender really earn on their money, after allowing for the erosion of their capital over time through inflation?
190Tax payments Taxes can be an important project cash flow Depending on a facility’s location, a firm may have to pay national and/or local income taxes on the revenues or savings generated by a projectOther types of taxes may also be relevant - sales taxes, pollution taxes, etc.190
191Tax deductions or credits Tax deductions or credits can also be importantOne example is the income tax deduction often given for equipment depreciation, which is the loss in value of a physical asset (e.g., a piece of equipment) as the asset agesSome “environmental” investments can receive special tax credits191
192Tax and project appraisal assume 30% rate of taxes of firms’ profitstax is based on accounting profits, not on cashflowsaccounting profits are after deducting depreciationtax is payable 1 year after the profits have been realised
193DepreciationA project needs $12,000 for a new machine which will last 3 yearsassume the machine has no residual value after 3 yearsdepreciation per year:initial cost = $12,000 = $4,000 per yearasset life 3 years
194Profit earned by project Profit earned by project in each year:cash inflow per year $6,000less: depreciation $4,000contribution to profit $2,00030% $600
195NPV of project, with tax time cash tax net PV PV factor now -12, , ,0001 +6, , ,0002 +6, , ,7503 +6, , ,125Net Present Value $414
196Project appraisal with inflation and tax depreciation (and accounting profits) are based on the asset’s original costthe asset’s original cost does not increase with inflation over the life of the projectproject analysis is then easier using nominal (not real) cashflows and discount rates
197Some good reasons to use a longer analysis time horizon Some out-year costs may be missed if the time horizon is too short, e.g., a required wastewater treatment plant upgrade in the futureSome annual operating costs may change significantly over time, e.g., disposal fees at landfillsShort time horizons neglect the impact of the time value of money, especially in times of significant inflation, deflation, changing cost of capital, etc.143
198Profitability assessment tips Be sure to:Include all relevant and significant costs/savings in the profitability analysisThink long-term (or at least medium-term!)Incorporate the time value of moneyUse multiple profitability indicatorsPerform sensitivity analyses for data estimates that are uncertain
201Sensitivity Analysis Introduction An important management tool questioning potential project benefit risks.Assumptions surrounding a project are computed to produce a base NPV and IRR.From the base case, changes in the original assumptions are made to gauge their effect on the NPV and IRR.Input variables varied adversely by 10%
202Sensitivity Analysis Example Input Variables Varied by 10%
203Sensitivity Analysis Summary Sensitivity Analysis permits project proposals to be evaluated simply.The model can evaluate sensitive variables without having to input any additional data.
204Sensitivity Analysis Conclusion By amending the original data, a variable whose change generates a negative NPV and /or an IRR lower than the firm’s cost of capital, is deemed to be sensitive.An investigation would need to be undertaken for a contingent plan. If results of the investigation are unfavourable, the project is unacceptable on economic grounds.However, development projects with social aspects may be treated differently.
206Profitability Indicators We have seen so far:Simple PaybackNet Present Value (NPV)But there are others, common examples are:Return on Investment (ROI)Internal Rate of Return (IRR)206
207Simple Payback and Return on Investment (ROI) These indicators incorporate:the initial investment costthe first year cash flowInitial InvestmentYear 1 Cash FlowSimple Payback (in years)=Year 1 Cash FlowInitial InvestmentROI (in %)=20724
208How to interpret Simple Payback and ROI The simple payback or ROI calculated for a project are usually compared to a company rule of thumb called a “hurdle” rate:e.g., if the project payback period is less than 3 years, then the project is viewed as profitablee.g., if the ROI is 33%, then the project is viewed as profitable208
209Net Present Value (NPV) NPV is a more reliable profitability indicator than Simple Payback or ROI as it considers both the time value of money and all future year cash flowsNPV = the sum of the discounted cash flows over the lifetime of the project, using the company’s cost of capital as the discount rate209
210Internal Rate of Return (IRR) IRR is similar to NPV in that it considers both the time value of money and all future year cash flowsIRR = the discount rate for which NPV = 0, over the project lifetime (calculated in an iterative fashion)It tells you exactly what “discount rate” makes the project just barely profitable210
211Profitability Indicator Summary (1) Advantage DisadvantageEasy to use Neglect TVMNeglect out-year costsDo not indicate project sizeConsiders TVM Needs firm’s discount rateIndicates project sizeConsiders TVM Requires iterationDoes not indicate project sizeSimplePayback& ROINPVIRR145
212Profitability Indicator Summary (2) NPV is generally the most valuable, problem-free indicatorOther indicators that consider the time value of money (e.g., IRR) are also usefulPayback and ROI are easy to understand and use, but of limited accuracyHowever, Simple Payback is particularly useful with uncertain or risky investment climates21226
213Interpret profitability indicators with caution... We have seen that Simple Payback has some limitations as a project profitability indicatorBe aware of the advantages and limitations of the indicators you useThe best approach is to use several indicators to give a balanced view of project profitability143
215Other IssuesThere are other issues that impact a project’s profitability, which we do not have time to address todaySource and cost of project financingCan you think of others?
216Project financingDifferent sources of project financing may have differing impacts on project profitabilityBe sure to take financing payments such as lease payments or payments on loan principal and interest into account appropriately when estimating profitability216
217Consider attending another UNEP course entitled: CP4: “The Cleaner Production Investment Process” 3
218Project Profitability Assessment Summary and Q&A [15 min]
219Project profitability assessment Capital budgeting (of “environmental” projects)Project cash flows and simple paybackThe Time Value of Money and Net Present Value (NPV)Two small group exercisesCapital budgeting : inflation and taxSensitivity analysisKey profitability indicators
222Review of what we have covered in this course [15 min]
223What we have learned today (1) The “Cost of Waste” has many components and can be much higher than companies assumeCleaner Production is a proven approach that uses preventive environmental management to reduce the cost of waste, enhance competitiveness, and reduce environmental impact simultaneously
224What we have learned today (2) Although data from the accounting records will be important for implementing CP, be aware of the potential limitations of accounting dataA number of very useful alternative cost identification and estimation approaches and tools exist - try them out!
225What we have learned today (3) When doing profitability assessment for more complex CP projects, be sure to do a comprehensive job of cost identification and estimationChoose longer analysis time horizons and multiple profitability indicators for assessing project profitabilityDon’t miss anything important!
226And don’t forget... Team up - multiply your brainpower! Learn about the manufacturing process - draw maps!Ask questions!Use the checklists!Start small and build on your successes!Get outside help if you need it!11