Profiting from Cleaner Production: Day 1 For UNEP Division of Technology, Industry, and Economics Prepared by Tellus Institute Boston, MA USA

Introduction

Course Background [15 min]

Development of the training materials Content has been developed by: Tellus Institute The Illinois EPA The Philippine Institute of CPAs The Asian Institute of Management UNEP CP financing National Project Coordinators in Zimbabwe and Guatemala UNEP Cleaner Production financing project team

UNEP: 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

Introduction of Instructors Words of welcome Introduction of Instructors [15 min]

Participant Introductions [30 min]

Participant introductions Who is here today? What type of organization do you work for? e.g., industry, government, other if from industry, which sector and what size What are your job responsibilities and areas of expertise? e.g., management, accounting, finance, engineering, production, environmental What is your investment perspective? e.g., developer of investment proposals, one who funds investment proposals

Why 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?

Course Overview [15 min]

Focus of this course Cleaner Production Cost Identification & Estimation Project Profitability Assessment Also to incorporate your experiences, questions, and goals into the presentation, exercises, and discussions Case studies of Cleaner Production at real facilities will be used

Cleaner Production The cost of waste Profiting from Cleaner Production Small group exercise on classifying environmental management options CP implementation steps Where to go for more information CP planning at your organization

Cost identification and estimation Small group exercise on cost identification Problematic accounting practices Potential sources of cost data Small group exercise on cost estimation Tools for data estimation Cost identification and estimation at your organization

Project profitability assessment Capital budgeting (of “environmental” projects) Project cash flows and simple payback The Time Value of Money (TVM) and Net Present Value (NPV) Two small group exercises Capital budgeting with inflation and tax Sensitivity analysis Key profitability indicators

Conclusion Where to go for more information Brief review of what we learned Final questions and comments Course evaluation

Time for a break! [15 min]

Cleaner Production

The Cost of Waste [15 min]

What 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!

Flow of materials & energy Air Emissions Materials, Energy, Water, Labour, Capital Products, By-Products Solid Waste, Waste Energy , Wastewater

Different types of waste There are many words for different types of waste: allowance BOD broke contaminated solids core loss customer returns damage drainings dust effluent evaporation furnace loss greenhouse loss hidden losses leakage non-conforming material overfill packaging process loss rework second quality stock loss washings Adapted from: The Kaunas Institute of Technology, Kaunas, Lithuania

The 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 all Companies typically underestimate how much waste really costs them, sometimes by several orders of magnitude This applies even to big, well-managed companies

The cost of waste ink at the Southwire Company The average disposal cost of a drum of hazardous waste ink was estimated as $50 Upon 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

The “Cost” Iceberg The true cost of waste can be like an iceberg, with only a small part visible THE HIDDEN COST OF WASTE Adapted from: Bierma, TJ., F.L. Waterstaraat, and J. Ostrosky. 1998. “Chapter 13: Shared Savings and Environmental Management Accounting,” from The Green Bottom Line. Greenleaf Publishing:England.

So how do we melt the cost iceberg. through Cleaner Production So how do we melt the cost iceberg? ...through Cleaner Production! Stay tuned...

Profiting from Cleaner Production [30 min]

Passive environmental strategies Dilute & disperse

Reactive environmental strategies end-of-pipe approaches

Proactive environmental strategies: Cleaner Production Prevention of waste generation: Good housekeeping Input substitution Better process control Equipment modification Technology change On-site recovery/reuse Production of a useful by-product Product modification

Cleaner 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)

Properly implemented CP: always reduces long-term liabilities which companies can face many years after pollution has been generated or disposed at a given site

Properly implemented CP: usually increases profitability lowers production costs enhances productivity provides a rapid return on any capital or operating investments required increases product yield leads to the more efficient use of energy and raw materials

Properly implemented CP: often avoids regulatory compliance costs leads to insurance savings provides enhanced access to capital from financial institutions and lenders is fast and easy to implement requires little capital investment

CP versus End-of-Pipe approach CLEANER PRODUCTION Continuous improvement towards use of closed loop or continuous cycle processes Partnerships are essential: everyone has a role to play in the community Elimination of environmental problems at source Involves new practices, attitudes and management techniques and stimulates technical advances POLLUTION CONTROL and WASTE MANAGEMENT One-off solutions to single problems Processes result in waste materials for disposal Solutions are often developed by experts in isolation Reactive 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

What is not CP? Off-site recycling Transferring hazardous wastes Waste treatment Concentrating hazardous or toxic constituents to reduce volume Diluting constituents to reduce hazard or toxicity

What are the benefits of Cleaner Production? Improving environmental situation Continuous environmental improvement Increasing economical benefits Gaining competitive advantage Increasing productivity

CP motivators and drivers INTERNAL to the COMPANY: - Improvements in productivity and competitiveness - Environmental management systems and continuous improvement - Environmental leadership - Corporate environmental reports and Environmental accounting

CP 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

Team for CP success Managers, engineers and finance people in industry and commerce, in particular those responsible for business strategy, product development, plant operations and finance Government officials, both central and regional, who play an important role in promoting CP Media representatives who play an important role in disseminating information on good environmental practice

Small Group Exercise: Classifying Environmental Management Options [30 min]

Exercise 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

Preview: 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

Cleaner Production at the PLS Company PLS implemented two CP projects to reduce wasted solid scrap during print runs A quality control (QC) camera project to reduce waste from errors when printing An on-site scrap recycling project to reduce waste from start-up runs

CP projects’ profitability at the PLS Company The two CP projects in combination reduced solid scrap by about 45% Total initial investment: US $ 105,000 The resulting annual savings: US $ 96,900 More details to come later...

Time for lunch! [60 min]

CP Implementation Steps [30 min]

Planning for Cleaner Production: Six steps to savings Step 3 Step 1 Step 5 Identify and evaluate CP alternatives Get organized Implement projects Step 2 Step 4 Analyze processes Step 6 Secure project financing Measure progress Adapted from: A Guide to Pollution Prevention for New Hampshire Businesses. January 1999. N.H Department of Environmental Services.

Step 1 — Get organized Get management support for Cleaner Production Form a planning team Seek input from personnel at all levels 30

Step 2 — Analyze processes Take a close look at each production step Map flows of materials, energy, waste, activities Determine the true cost of waste generation Prioritise losses and target your CP efforts 30

Step 3 — Identify & evaluate CP options Get at the root cause of the problem Be creative Generate lots of ideas Determine which alternatives are feasible Select best alternatives for implementation 30

Step 4 — Secure project financing Proceed to Step 5 for projects that need minimal up-front investment Determine availability of internal investment funds for bigger projects Obtain external financing for remaining projects Private sector Government sector 30

Step 5 — Implement projects Schedule projects Assign responsibilities Talk to workers who will be affected Get feedback from employees Schedule financing payments 30

Step 6 — Measure progress Track waste generation, materials usage, and cost savings Take into account variation in production level Document your results and your cost savings Celebrate your successes Now go back to Step 2 30

Teamwork is very important! Each person brings different, but vital, information

Tools: The Cleaner Production Team CEO Board Accounting & Finance Production Sales & Marketing Research & Development Environment, Health, & Safety Purchasing Materials Control Inventory Operations Quality Control Shipping Maintenance Engineering Legal

Where to go for more information Click ‘Where to go for more information” on this CD-ROM or to the second last page of any of the UNEP/DTIE publications in the “Profiting from Cleaner Production” series

Cleaner Production Summary and Q&A [15 min]

Cleaner Production Review of what we have done The Cost of Waste Profiting from Cleaner Production Small group exercise on Classifying Environmental Management Options CP implementation steps Where to go for more information

CP Planning at your Organization [15 min] Take this time to write down some next steps for CP planning at your organization What 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?

Time for a break! [15 min]

Cost Identification and Estimation

Introduction to Cost Identification and Estimation [15 minutes]

Decision-making factors Today’s focus Technical Project selection Regulatory Financial Organizational

The 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. project profitability ROI capital investment market share profit centre cost allocation overhead costs unit price CDO incinerator ban regulatory compliance wastewater energy efficiency dioxin recycling With 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

Financial Analysis steps Cost identification & estimation Project profitability evaluation We will discuss this now We will discuss these tomorrow

Cost identification & estimation Initial investment costs e.g., equipment, installation, training Annual operating costs, savings,and revenues current operations, before the project after project implementation e.g., materials, energy, labour Need to identify, estimate and allocate all relevant and significant items impacted by the project

Small group exercise: Cost Identification at the PLS Company [75 min]

The PLS Company A medium-sized manufacturer of food packaging materials Major manufacturing steps are Printing, Laminating, and Slitting Waste management includes incineration and wastewater treatment Cleaner Production has reduced volume of solid scrap and annual operating costs

Manufacturing Steps at the PLS Company — Materials flow map plastic film, aluminium film, adhesive solvent air emissions solvent air emissions INVENTORY printed laminated film printed film product SLITTING plastic film, ink PRINTING LAMINATION Solid scrap Solid scrap Solid scrap Liquid waste ink to waste management to waste management

Waste Management at the PLS Company — Materials flow map air emissions air emissions wwtp chemicals Cleaner water to a nearby stream fresh water dirty scrubber water fuel and fuel additive WASTEWATER TREATMENT INCINERATOR solid scrap from printing, laminating, slitting steps liquid ink waste from printing step sludge ash OFF-SITE LANDFILL

Exercise instructions Introduction (10 min.), detailed in your handout Review 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.)

Three broad categories of costs The cost of manufacturing inputs Materials, energy, labour, capital, etc. The cost of waste management Waste handling, regulatory compliance, waste treatment and disposal, etc. Less tangible costs Production throughput, product quality, company image, liability, etc.

Checklist: “The Investment Decision Cost/Savings Checklist” Refers to the checklist handout 3

The 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)

Problematic accounting practices—what might make it difficult to estimate costs accurately (Particularly costs related to waste) Let’s brainstorm! [30 min]

Problematic accounting practices? Various costs at a facility might be... “Hidden” in the accounting records Misallocated from overhead accounts Classified as fixed when they are really variable, or semi-variable Not found in the accounting records at all (Can you think of others?) 136

“Hidden” costs of lost raw materials Manufacture of plastic rear panels for automobiles (As a percentage of input materials) Material loss per the accounting records Actual material loss Adapted from: Rooney, Charles. “Economics of Pollution Prevention: How Waste Reduction Pays.” Pollution Prevention Review.Summer 1993.

“Hidden” Costs of lost raw materials at the PLS company The PLS accounting records show: The amount of raw materials used The amount of final product shipped But the records do not show: The amount of solid scrap waste generated The amount of any other lost raw materials 136

Direct vs. Indirect Costs (1) Direct Costs are costs that can be easily traced to a unit of product e.g., direct materials, direct labour Indirect Costs are costs that cannot be traced as easily to a unit of product e.g., facility energy use, insurance, maintenance, waste treatment A cost considered “direct” at one firm may be considered “indirect” at another firm

Direct 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 cost Indirect costs are assigned to facility, division, or company overhead accounts It can be difficult to find costs “hidden” in overhead accounts 131

Environmental Management Costs “hidden” in an overhead account Product Manufacturing Cost Statement Variable Costs Raw Materials Intermediates Additives Utilities Direct Labour Packaging Wastewater 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 expenses environmentally driven R&D permitting time and fees environmental training Fixed Costs Supervisor Fixed Labour Depreciation Divisional Overhead General Services & Administration Fixed Costs Supervisor Fixed Labour Depreciation Divisional Overhead General Services & Administration $4,600 $57,800 $1,227 $13,662 $1,294 Total Variable Cost Total Fixed Cost Total Manufacturing Cost Total Cost Source: Green Ledgers: Case Studies in Corporate Environmental Accounting. World Resources Institute. May 1995. 135

Survey of industry accountants in the US Findings: Environmental management costs such as waste handling, treatment, and disposal predominantly assigned to overhead accounts Even energy and water costs (manufacturing inputs) are usually assigned to overhead accounts Source: Environmental Capital Budgeting Survey . Tellus Institute, for U.S. EPA, June 1995 131

Cost assignment at the PLS Company The cost of direct materials, labour, and energy are assigned directly to the manufacturing steps In contrast, waste treatment and disposal costs are assigned to an overhead account in the Office of the Business Manager 136

Problematic accounting practices? Various costs at a facility might be... “Hidden” in the accounting records Misallocated from overhead accounts Classified as fixed when they are really variable, or semi-variable Not found in the accounting records at all (Can you think of others?) 136

Cost allocation Costs initially assigned to overhead accounts are usually allocated back to processes, products, or projects using an allocation basis such as Quantity of raw materials used Production volume Machine hours Labour hours Floor space 136

Cost allocation at the PLS Company How would you allocate? On the basis of: # of set-up runs? raw materials use? machine hours? amount of scrap? some other basis? Allocated from overhead Printing Solid scrap waste Treatment and disposal costs Laminating Slitting 138

Problematic accounting practices? Various costs at a facility might be... “Hidden” in the accounting records Misallocated from overhead accounts Classified as fixed when they are really variable, or semi-variable Not found in the accounting records at all (Can you think of others?) 136

Fixed vs. Variable Costs (1) Fixed Costs are costs that do not vary with production level or other factors e.g., equipment depreciation, labour Variable Costs are costs that do (or can) vary with production level or other factors e.g., raw materials use, energy use A cost considered “fixed” at one firm may be considered “variable” at another firm

Fixed vs. Variable Costs (2) The goal of Cleaner Production is to reduce variable costs Therefore, it is important to correctly distinguish between fixed and variable costs when identifying and estimating costs to support CP efforts If CP efforts will reduce a cost — then it is variable! 131

Fixed vs. Variable Costs at The PLS Company Incinerator operating costs at PLS include: Fuel, fuel additive Operating labour Trucking ash to landfill Equipment depreciation costs PLS views these waste treatment costs as essentially fixed costs — do you agree? 131

It 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 future 29

Problematic accounting practices? Various costs at a facility might be... “Hidden” in the accounting records Misallocated from overhead accounts Classified as fixed when they are really variable, or semi-variable Not found in the accounting records at all (Can you think of others?) 136

Costs missing from the accounting records In general, two types of costs may be entirely missing from the accounting records: Future costs Future variable costs, e.g., landfill fees Future fixed costs, e.g., future depreciation costs of new waste treatment equipment Less tangible costs e.g., lost profit from reduced production throughput 131

Costs missing from the accounting records at the PLS Company Lost profit from reduced production Future regulatory costs (e.g., stricter wastewater regulations) Potential liability Negative company image (Can you think of others?) 131

Problematic accounting practices? Various costs at a facility might be... “Hidden” in the accounting records Misallocated from overhead accounts Classified as fixed when they are really variable, or semi-variable Not found in the accounting records at all (Can you think of others?) 136

Ease of identifying and estimating costs Equipment purchase, direct materials, energy, labour In general, as you go down this list, costs are more likely to be hidden or difficult to quantify (but every case is different!) LESS HIDDEN MORE Waste disposal Recycle/rework, treatment, waste handling Regulatory compliance, other indirect costs Less tangible costs

Potential Sources of Cost Data Let’s brainstorm! [15 min]

Potential sources of cost data Internal data sources The accounting system Original data records in different departments Colleagues/employees External data sources Industry colleagues or trade associations Vendors and consultants Business Partners (e.g., insurance firm) Government (e.g., environmental agency) National Cleaner Production Centre 136

Review of What We have Covered Today [15 min]

Cleaner Production The cost of waste Profiting from Cleaner Production Usually underestimated! Profiting from Cleaner Production Cleaner Production as waste prevention and on-site recycling Cleaner Production Benefits Implementation steps

Cost 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 practices Sources of cost data

Tomorrow... Cost estimation tools Project profitability assessment Process mapping, material flows Project profitability assessment Cash flows “Simple Payback” indicator “Time-value-of-money” concept “Net Present Value (NPV)” indicator Other indicators Other profitability assessment issues

Final questions or comments?

Profiting from Cleaner Production: Day 2 For UNEP Division of Technology, Industry, and Economics Prepared by Tellus Institute Boston, MA USA

Small group exercise: Cost estimation at the PLS Company [60 min]

Exercise instructions Introduction (5 min.), detailed in your exercise handout Question 1 (20 min.) Question 2 (15 min.) Discuss your answers with the other small groups and the instructor (15 min.) Lessons learned (5 min.)

Tools For Data Identification and Estimation [30 min]

Tools: Original data records Purchase order/invoices Production records Waste shipment records Equipment logs Engineering estimates Regulatory reports Staff interviews Source: Northeast Waste Management Officials’ Association 67

Checklist: “Cleaner Production Data Sources” 3

Tools: Materials flow map plastic film, aluminium film, adhesive solvent air emissions solvent air emissions INVENTORY printed laminated film printed film product SLITTING plastic film, ink PRINTING LAMINATION Solid scrap Solid scrap Solid scrap Liquid waste ink to waste management to waste management

Tools: The Materials Balance Physical analogy to financial balance sheet Compares all material inputs and outputs Identifies sources of waste and data gaps Provides basis for cost evaluation MANUFACTURING PROCESS PRODUCT INPUTS NON-PRODUCT OUTPUT (WASTE) 34

Tools: Cost Checklist Consider tailoring a generic checklist for routine use with specific industry sectors and/or for specific process/project types Determine if each item on the list is: Not relevant Relevant but quantitatively insignificant Relevant and quantitatively significant Relevant but not quantifiable 128

Checklist: “The Investment Decision Cost/Savings Checklist” — We used it yesterday 3

Investment decision Costs & savings Initial investment costs Annual operating costs and savings The cost of operating inputs The cost of waste management Less tangible costs Revenues

Tools: Activity Based Costing (ABC) Under ABC, costs are allocated from overhead accounts To the processes, products, or projects that actually generated the costs On the basis of activities with a direct relationship to cost generation ABC will not eliminate overhead accounts, but will ensure the availability of more accurate cost information for decision-making 141

Tools: External expertise for less tangible costs Examples: Insurance sector— liability estimation Marketing firms— value of company image Environmental agencies — estimates of current and future regulatory compliance costs 139

Cost identification and estimation Summary of tools (1) Work as a team— talk to everyone Do a facility walk-through Map process steps, materials flows, employee activities, etc. Do materials and energy balances Use a comprehensive cost/savings checklist External expertise for less tangible costs

Cost identification and estimation Summary of tools (2) Do a check on data from the accounting records overhead costs appropriately allocated? accurate characterisation of fixed vs. variable? Compare accounting record data to information from your maps, materials balances, staff interviews Go back to the original data sources Think creatively

To 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.

Do a balancing act... Don’t spend any more time than necessary collecting and analyzing data but Make sure you have really included all of the most significant costs & savings in the analysis Make sure that you are not neglecting other CP alternatives for the same waste stream that might be even more profitable!

Cost Identification and Estimation Summary and Q&A [15 min]

Cost identification & estimation Problematic accounting practices Potential sources of cost data Small group exercise on cost estimation Tools for data estimation

Cost identification and estimation at your organization [15 min] Take this time to write down some next steps for cost identification & estimation at your organization What 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?

Time for a break! [15 min]

Project Profitability Assessment

Capital Budgeting (of “Environmental” Projects) [15 min]

Capital 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 projects Decides if additional capital is needed

Capital budgeting practices Capital budgeting practices vary widely from company to company Larger companies tend to have more formal practices than smaller companies Larger companies tend to make more and larger capital investments than smaller companies Some industry sectors require more capital investment than others Capital budgeting practices may also vary from country to country

Typical project types & goals (1) Maintenance Maintain existing equipment and operations Improvement Modify existing equipment, processes, and management and information systems to improve efficiency, reduce costs, increase capacity, improve product quality, etc. Replacement Replace outdated, worn-out, or damaged equipment or outdated/inefficient management and information systems

Typical project types & goals (2) Expansion e.g., obtain and install new process lines, initiate new product lines Safety make worker safety improvements Environmental e.g., reduce use of toxic materials, increase recycling, reduce waste generation, install waste treatment Others...

The 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

We know better! We have learned that some environmental projects, i.e., Cleaner Production (CP) projects, can go hand in hand with: Production efficiency improvements Product quality improvements Production expansion So, do not place your project idea into a single narrow category — think broadly about all the possible benefits

Decision-making factors Today’s focus Technical Project selection Regulatory Financial Organizational

Project Cash Flows and Simple Payback [15 min]

The Cash Flow Concept The Cash Flow Concept is a common management planning tool. It distinguishes between: (a) costs -> cash outflows (b) revenues/savings -> cash inflows 135

Cash Flow Analysis Measures the difference between Relies on every day life principles Measures the difference between What we received, and What we paid out Only cash receipts and cash payments are included in the analysis Applicable also to forecast cash available

Types of cash flows One-time Annual Other Outflow Initial investment cost Operating costs & taxes Working capital Inflow Equipment salvage value Operating revenues & savings Working capital 137

Cash Outflow Analysis (1) INITIAL INVESTMENT Planning/ Engineering Permitting Site Preparation Purchased Equipment Working Capital Utility Systems & Connections Start-up/Training Contingency (Salvage Value)

Working Capital Working Capital is: “the total value of goods and money necessary to maintain project operations” It includes items such as: Raw materials inventory Product inventory Accounts payable/receivable Cash-on-hand 139

Salvage Value Salvage Value is the resale value of equipment or other materials at the end of the project 140

Cash Outflow Analysis (2) Direct costs Input costs Other costs Loan repayments Interest on loan application

Cash Inflow Analysis Sales Savings Salvage value Cash shortfall / surplus

Cash Flow Forecast/Projection (1) We are looking at the likely future cash position. We examine the possible effects of changes in the cash flow components .

Cash Flow Forecast/Projection (2) Make assumptions about likely outcomes regarding: Inflation Market size Demand for goods and services Interest Rates

Cashflow Projection Worksheet

Annual Operating Costs & Savings (see also Cleaner Production Investment Decision: Costs and Savings Checklist) Operating inputs Materials Energy Labour Floor space Taxes Depreciation Cost of capital Waste management includes waste handling, recycling, treatment, disposal, and regulatory compliance Materials Energy Labour Floor space Fees Taxes & depreciation Cost of capital Less tangibles Productivity Future regulation Potential liability Insurance Company image Revenues Product sales By-product sales Pollution credits

Annual Operating Costs Annual Financing Payments Timing of cash flows End of project: Salvage Value Annual Revenues/Savings Working capital Year 1 Year 2 Year 3 TIME Annual Operating Costs Annual Tax Payments Annual Financing Payments Time zero: Working Capital Initial Investment 147

Cash Flow Analysis structure There are two basic ways to structure a project financial analysis: 1) Stand-alone analysis Considers only the cash flows of the proposed project 2) Incremental analysis Compares the cash flows of the proposed project to the “business as usual” cash flows 148

Incremental 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 flows You only need to estimate the cash flows that change when you improve the “business as usual” operations 149

Profitability 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 Payback Return on Investment (ROI) Net Present Value (NPV) Internal Rate of Return (IRR) 150

Simple Payback (in years) This indicator incorporates: the initial investment cost the first year cash flow from the project Simple Payback (in years) Initial Investment Year 1 Cash Flow = 151 24

How 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 profitable 152

Small Group Exercise: Profitability Assessment at the PLS Company— Part I “Cash Flows & Simple Payback” [30 min]

The 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 occur Allows the operators to detect print errors earlier and halt the operations before too much solid scrap is generated Has reduced generation of full-run solid scrap by about 40% 143

Costs and savings included in the QC camera analysis Initial investment costs purchase of the camera system, delivery, installation, start-up Annual operating costs (and savings) Operating input — materials (plastic film, ink), energy, labour Incineration — fuel, fuel additive, labour, ash to landfill Wastewater treatment — chemicals, electricity, labour, sludge to landfill 155

QC camera project Cash flows Annual savings = ??? Year 1 Year 2 Year 3 TIME Annual 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 = $105,000 156

The PLS Company’s QC camera project Initial Investment Cost Annual Operating Costs Business As Usual ??? Annual Savings = ??? The QC Camera Project US $ 105,000 ??? 157

Exercise instructions Part I Introduction (5 min.), detailed in your handout Question 1 (15 min.) Question 2 (5 min.) Discuss your answers with the other small groups and the instructor (5 min.)

The Time Value of Money and Net Present Value (NPV) [30 min]

Question: 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...

Inflation 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 $1.05 costs $1 next year now 161

Investment 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 opportunity Gives you $1.10 a year from now Investing $1 now Investment Interest, or “return on investment” 162

Time Value of Money (TVM) Money now is worth more than money in the future because of: a) inflation b) investment opportunity The exact “time value” of your money depends on the magnitude of the: a) rate of inflation and b) rate of return on investment

TVM 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 investment So, it is important to take the Time Value of Money (TVM) into account when you are estimating project profitability

The PLS Company’s QC camera project Initial Investment Cost Annual Operating Costs Business As Usual $ 2,933,204 Annual Savings = US$38,463 The QC Camera Project $ 105,000 $ 2,894,741 (in US$) 165

Question: Is the annual savings of $38,463 per year for 3 years a sufficient return on the initial investment of $ 105,000?

Answer? You might think about adding up the annual savings over the 3 years: Savings per year $38,463 x 3 years Total savings $115,389 But: 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)

Comparing 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 year It is easiest to convert all project cash flows to their “present value” now, at the very beginning of the project 168

Converting the PLS cash flows to their “present value” Annual Savings End of project = ?? $38,463 $38,463 $38,463 Year 1 Year 2 Year 3 TIME Time zero: Initial Investment = $105,000 169

Converting 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 investment Inflation The discount rate calculation is simple — mathematically, it is the reverse of an interest rate calculation 170

Interest rate calculation Invested at an interest rate of 20%, how much will $10,000 now be worth after 3 years? After year 1 $10,000 x 1.20 = $12,000 2 $10,000 x 1.20 x 1.20 = $14,400 3 $10,000 x 1.20 x 1.20 x 1.20 = $17,280 Note: these calculations are on a compound basis

Discounting 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? $17,280 = $10,000 1.20 x 1.20 x 1.20 needed now In other words, $17,280 in year 3 has a present value of $10,000

Which discount Rate? (1) The discount rate a company chooses should be equal to the required rate of return for the project investment The required rate of return will usually incorporate three distinct elements: A basic return - pure compensation for deferring consumption Any ‘risk premium’ for that project’s risk Any expected fall in the value of money over time through inflation

Which 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.

Discounting (1) Present Value = Future Valuen (1 + d)n The value of the cash flow in year n Present Value = Future Valuen (1 + d)n The value of the cash flow at “Time Zero,” i.e., at project start-up n = the number of years after project start-up d = the discount rate 175

Discounting (2) Present Value = Future Valuen x (PV Factor) The value of the cash flow in year n Present 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-up 176

Present value factors Value of $1 in the future, NOW Discount rate (d): 10% 20% 30% 40% Years into future (n) 1 .9091 .8333 .7692 .7142 2 .8264 .6944 .5917 .5102 3 .7513 .5787 .4552 .3644 4 .6830 .4823 .3501 .2603 5 .6209 .4019 .2693 .1859 10 .3855 .1615 .0725 .0346 20 .1486 .0261 .0053 .0012 30 .0573 .0042 .0004 .0000

Net 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 company If NPV > 0, the project is profitable If NPV < 0, the project is not

Estimating Net Present Value Expected Future Cash Flows Present Value of Cash Flows (at time zero) Year PV Factor = * 1 2 3 - $105,000 + $38,463 - $??? $??? ??? Sum = the project’s Net Present Value = 179

Time for lunch! [60 min]

Small Group Exercise: Profitability Assessment at the PLS Company— Part II “Net Present Value” [45 min]

Located in your handout Also — you will need the handout: “Performing Net Present Value (NPV) Calculations” Located in your handout 3

Converting the PLS cash flows to their “present value” End of project = ?? $38,463 $38,463 $38,463 Year 1 Year 2 Year 3 TIME Time zero: Initial Investment = $105,000 183

Exercise instructions Part II Introduction (5 min.), detailed in your handout Question 3 (15 min.) Question 4 (5 min.) Discuss your answers with the other small groups and the instructor (15 min.) Lessons learned (5 min.)

Capital Budgeting: inflation & tax [30 min]

Discounting and inflation (1) even without inflation, money has a time value due to supply/demand for money inflation increases both: future cash flows interest rates (and  discount rates) these offset each other

Discounting and inflation (2) With 10% inflation (say), future cash flows will  by 10% each year Investors & lenders will also require a higher rate to compensate for their loss in purchasing power If 15% was acceptable with no inflation, with 10% inflation they will now require 115% x 110% = 126.5%

Discounting and inflation (3) PLS Company, now assuming 10% inflation and 26.5% discount rate: Year Cash flow PV factor PV ($) @ 26.5% ($) 1 42,309 0.791 33,466 2 46,540 0.625 29,088 3 51,194 0.494 25,289 87,843 less: initial investment 105,000 Net Present Value -17,157 i.e. same NPV* as with zero inflation, 15% discount rate * ignoring minor rounding difference

What 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?

Tax 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 project Other types of taxes may also be relevant - sales taxes, pollution taxes, etc. 190

Tax deductions or credits Tax deductions or credits can also be important One 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 ages Some “environmental” investments can receive special tax credits 191

Tax and project appraisal assume 30% rate of taxes of firms’ profits tax is based on accounting profits, not on cashflows accounting profits are after deducting depreciation tax is payable 1 year after the profits have been realised

Depreciation A project needs $12,000 for a new machine which will last 3 years assume the machine has no residual value after 3 years depreciation per year: initial cost = $12,000 = $4,000 per year asset life 3 years

Profit earned by project Profit earned by project in each year: cash inflow per year $6,000 less: depreciation $4,000 contribution to profit $2,000 tax @ 30% $600

NPV of project, with tax time cash tax net PV PV factor now -12,000 -12,000 1.000 -12,000 1 +6,000 +6,000 0.833 +5,000 2 +6,000 -600 +5,400 0.694 +3,750 3 +6,000 -600 +5,400 0.579 +3,125 4 -600 -600 0.482 -289 Net Present Value - $414

Project appraisal with inflation and tax depreciation (and accounting profits) are based on the asset’s original cost the asset’s original cost does not increase with inflation over the life of the project project analysis is then easier using nominal (not real) cashflows and discount rates

Some 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 future Some annual operating costs may change significantly over time, e.g., disposal fees at landfills Short time horizons neglect the impact of the time value of money, especially in times of significant inflation, deflation, changing cost of capital, etc. 143

Profitability assessment tips Be sure to: Include all relevant and significant costs/savings in the profitability analysis Think long-term (or at least medium-term!) Incorporate the time value of money Use multiple profitability indicators Perform sensitivity analyses for data estimates that are uncertain

Time for a break! [15 min]

Sensitivity Analysis [15 min]

Sensitivity 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%

Sensitivity Analysis Example Input Variables Varied by 10%

Sensitivity Analysis Summary Sensitivity Analysis permits project proposals to be evaluated simply. The model can evaluate sensitive variables without having to input any additional data.

Sensitivity 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.

Key Profitability Indicators [15 min]

Profitability Indicators We have seen so far: Simple Payback Net Present Value (NPV) But there are others, common examples are: Return on Investment (ROI) Internal Rate of Return (IRR) 206

Simple Payback and Return on Investment (ROI) These indicators incorporate: the initial investment cost the first year cash flow Initial Investment Year 1 Cash Flow Simple Payback (in years) = Year 1 Cash Flow Initial Investment ROI (in %) = 207 24

How 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 profitable e.g., if the ROI is 33%, then the project is viewed as profitable 208

Net 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 flows NPV = the sum of the discounted cash flows over the lifetime of the project, using the company’s cost of capital as the discount rate 209

Internal Rate of Return (IRR) IRR is similar to NPV in that it considers both the time value of money and all future year cash flows IRR = 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 profitable 210

Profitability Indicator Summary (1) Advantage Disadvantage Easy to use Neglect TVM Neglect out-year costs Do not indicate project size Considers TVM Needs firm’s discount rate Indicates project size Considers TVM Requires iteration Does not indicate project size Simple Payback & ROI NPV IRR 145

Profitability Indicator Summary (2) NPV is generally the most valuable, problem-free indicator Other indicators that consider the time value of money (e.g., IRR) are also useful Payback and ROI are easy to understand and use, but of limited accuracy However, Simple Payback is particularly useful with uncertain or risky investment climates 212 26

Interpret profitability indicators with caution... We have seen that Simple Payback has some limitations as a project profitability indicator Be aware of the advantages and limitations of the indicators you use The best approach is to use several indicators to give a balanced view of project profitability 143

Other Profitability Assessment Issues [15 min]

Other Issues There are other issues that impact a project’s profitability, which we do not have time to address today Source and cost of project financing Can you think of others?

Project financing Different sources of project financing may have differing impacts on project profitability Be sure to take financing payments such as lease payments or payments on loan principal and interest into account appropriately when estimating profitability 216

Consider attending another UNEP course entitled: CP4: “The Cleaner Production Investment Process” 3

Project Profitability Assessment Summary and Q&A [15 min]

Project profitability assessment Capital budgeting (of “environmental” projects) Project cash flows and simple payback The Time Value of Money and Net Present Value (NPV) Two small group exercises Capital budgeting : inflation and tax Sensitivity analysis Key profitability indicators

Conclusion

Where to go for more information

Review of what we have covered in this course [15 min]

What we have learned today (1) The “Cost of Waste” has many components and can be much higher than companies assume Cleaner Production is a proven approach that uses preventive environmental management to reduce the cost of waste, enhance competitiveness, and reduce environmental impact simultaneously

What 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 data A number of very useful alternative cost identification and estimation approaches and tools exist - try them out!

What 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 estimation Choose longer analysis time horizons and multiple profitability indicators for assessing project profitability Don’t miss anything important!

And 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

Final questions and comments? [15 minutes]

Course Evaluation [15 min]

Thank you for attending Thank you for attending! Please keep in touch with us regarding your Cleaner Production efforts.