PROJECT COSTS, BUDGETING
AND APPRAISAL
By
Jude Iheanacho, MNIM, FCA 1

Learning Objectives
At the end of this session, participants would be
able to:
• define project cost and its classifications;
• explain cost behaviour and how Managers use
this information in project cost management;
• generate budget forecasts;
• appraise projects to ascertain financial
viability
2

Introduction
• An important aspect of project management is
the cost/benefit analysis, which shows project
viability.
• This takes place at almost every stage in the
project lifecycle, though it is prominent at the
feasibility stage.
• For many government projects, other non-
financial factors weigh into the decision
process.
3

Meaning of Project Cost
• Project Costs are resources sacrificed or
foregone to achieve specific project
objectives, measured in monetary terms.
• Cost = resource usage x resource price.
4

Classifications of Project Cost
• Cost can be classified in the following ways:
– Natural Classification;
– Traceability Classification;
– Functional Classification;
– Controllability Classification; and
– Behavioural Classification.
5

Natural Classification (Cost elements)
• Materials and Components- Expenditure on
raw materials and supplies;
• Labour cost - Remuneration paid by project
owner to project executors;
• Overhead – Other operating expenses.
6

Traceability Classification
• Direct cost – Traceable to a
specific project or activity.
• Indirect cost – not readily
identified with a specific project
but grouped into common pools
and charged through an allocation
process. Cannot be easily or
efficiently traced to a specific cost
object.
7

Functional Classification
According to the functional areas / departments of the
business
• Production cost;
• Administrative cost;
• Marketing cost;
• Staff cost; and
• Finance cost;
8

Controllability Classification
• Controllable cost – can be affected by a
Manager at a given hierarchy.
• Uncontrollable cost – cannot be affected by a
Manager at a given hierarchy.
9

Behavioural Classification
• Fixed cost – the total cost does not change
with the level of activity (volume of business).
10

Behavioural Classification (cont)
• Variable cost – the total cost changes with the
level of activity.
11

Behavioural Classification (cont)
• Mixed cost –
partly fixed and
partly variable.
12

Cost Optimization Vs Cost Cutting
• Cost cutting is focussed on reducing
expenditure regardless of negative
consequences;
• Cost optimization is reducing cost while
considering impact on:
– revenue generation;
– Staff morale; and
– Long-term objectives.
13

Project Budgeting
• Budgeting stems from Strategic Financial Planning
(SFP), a formal process for establishing financial
goals and objectives over the long run;
• SFPs are implemented by developing short-term
action plans known as budgets.
14

Definition of Budget, Forecast, Plan
• ‘’A Budget is a quantitative statement for a
defined period of time, which may include
planned revenues, expenses, assets, liabilities
and cash flows’’ – CIMA
• A forecast is a prediction of future events
(business may have little or no control) and their
quantification for the purpose of planning;
• Whereas a forecast is simply a prediction, a plan
is similar to a budget as it shows what is to be
done with the forecast.
15

Forecasting Methods - Qualitative
• Opinion of a group of knowledgeable executives
Executive Committee Consensus
• A group of experts who eventually develop a consensus
Delphi Method
• Information from sales persons in the field
Sales Force Composite
• Asking customers their purchasing plans
Customer Surveys
16

Forecasting Methods - Quantitative
• Trends, Seasonal, Cyclical factors
Time Series Models
• Cause and effect, regression, y= a + bx
Causal Methods
• Averages
Smoothing Models
• Use of economic indicators, e.g. inflation, demand, GDP
Econometric Models
17

Benefits of Project Budgeting
• To establish project priorities,
provide direction and
promote forward thinking;
• Efficient planning on the use
of resources;
• To motivate managers and
other employees.
18

Benefits of Project Budgeting (cont)
• To communicate project
objectives and translate
strategy into action;
• Clarification of authority
and responsibility; and
• To facilitate management
by exception.
19

Project Appraisal Techniques or
Capital Budgeting
• This is the process of analyzing,
evaluating, and deciding whether
resources should be allocated to a project
or not.
• Involves allocating the firm's capital
resources between competing projects
and investments
20

Importance of Project Appraisal
• Involve massive investment of resources
• Are not easily reversible
• Have long-term implications for the firm
• Involve uncertainty and risk for the firm
21

Classification of Projects
• According to economic life:
–Short-term
–Long-term
• According to risk:
–Replacement projects
–Expansion projects
–New products and markets
–Mandated projects
22

>classification
• According to dependence on other projects:
– Independent projects
– Mutually exclusive projects
– Contingent projects
– Complementary projects
• According to cash flows:
– Normal cash flow projects
– Non normal cash flow projects
23

Steps in Project Appraisal
1. Estimate the CFs (inflows & outflows).
2. Assess the riskiness of the CFs.
3. Determine the appropriate discount rate
4. Evaluate the project viability.
5. Accept/Reject based on set criteria
24

Project Appraisal Techniques
• Payback Period Approach
• Accounting Rate of Return
• Net Present Value Approach
• Internal Rate of Return
• Profitability Index
25

Pay-Back Period
• The number of years it takes including a
fraction of the year to recover initial
investment is called payback period
• To compute payback period, keep adding the
cash flows till the sum equals initial
investment
26

Pay-Back Period Example
• Which of the following investments is preferred,
using the PBP Criterion?
27
YEAR CASH FLOW OF
PROJECT A (Nm)
CASH FLOW OF
PROJECT B (Nm)
0 (50) (50)
1 10 30
2 15 20
3 15 10
4 10 6
5 22 2

PBP strengths & weaknesses
• Strengths
– Provides an indication of a project’s risk.
– For companies facing liquidity problems, it
provides a good ranking of projects that would
return money early.
– Easy to calculate and understand.
• Weaknesses
– Ignores the Time Value Money.
– Ignores Cash Flows occurring after the payback
period.
28

Accounting Rate of Return (ARR)
• Accounting rate of return (also known as
simple rate of return) is the ratio of estimated
accounting profit of a project to the average
investment made in the project.
• ARR is used in investment appraisal.
29

• Accounting Rate of Return is calculated using
the following formula:
• ARR = Average Accounting Profit
Average Investment
30

• Average accounting profit is the arithmetic mean
of accounting income expected to be earned
during each year of the project's life time.
• Average investment may be calculated as the
sum of the beginning and ending book value of
the project divided by 2.
• Another variation of ARR formula uses initial
investment instead of average investment.
• Decision Rule: Accept the project only if its ARR is
equal to or greater than the required accounting
rate of return. In case of mutually exclusive
projects, accept the one with highest ARR.
31

ARR strengths and weaknesses
• Strengths
– Easy to calculate.
– It recognizes the profitability factor of investment.
• Weaknesses
– It ignores time value of money.
– It can be calculated in different ways. Thus there is
problem of consistency.
– It uses accounting income rather than cash flow
information.
32

Net Present Value
• Net present value is the present value of net
cash inflows generated by a project including
salvage value, if any, less the initial investment
on the project.
• It is one of the most reliable measures used in
capital budgeting because it accounts for time
value of money by using discounted cash
inflows.
• What is Time Value of Money (TVM)?
33

• Time value of money is the concept that the
value of a Naira to be received in future is less
than the value of a Naira on hand today due
to the following reasons:
1. Money received today can be invested thus
generating more money.
2. Inflation
3. Risk of default/changes in projections
34

• Thus, when a future payment or series of
payments are discounted at the given rate of
interest up to the present date to reflect the
time value of money, the resulting value is
called present value.
• The formula to calculate present value of a
future single sum of money is:
= Future Value (FV)/ (1 + i)n Where,
i is the interest rate per compounding period;
and
n are the number of compounding periods.
35

10 8060
0 1 2 3
10%
Cash Flows
-100.00
9.09
49.50
60.08
PV = 118.67 NPV = N18.67
0.909
0.826
0.751
36

Computation of NPV
• Before calculating NPV, a target rate of return
is set which is used to discount the net cash
inflows from a project.
• Net cash inflow equals total cash inflow during
a period less the expenses directly incurred on
generating the cash inflow.
• NPV = PV of cash inflows – Initial investment
37

• When cash inflows are uneven:
NPV = R1 + R2 + … − Initial Investment
--------- -------
(1 + i)1 (1 + i)2
Where,
i is the target rate of return per period;
R1 is the net cash inflow during the first period;
R2 is the net cash inflow during the second
period;
38

• When cash inflows are even:
• NPV = R × 1 − (1 + i) -n − Initial Investment
----------------
i
• Where,
R is the net cash inflow expected to be received
each period;
i is the required rate of return per period;
n are the number of periods during which the
project is expected to operate and generate cash
inflows.
39

Present Value Tables
Rate
Periods 10% 12% 14%
1 0.909 0.893 0.877
2 0.826 0.797 0.769
3 0.751 0.712 0.675
4 0.683 0.636 0.592
5 0.621 0.567 0.519
Periods 10% 12% 14%
1 0.909 0.893 0.877
2 1.736 1.690 1.647
3 2.487 2.402 2.322
4 3.170 3.037 2.914
5 3.791 3.605 3.433
Interest rate
per year
Annuity
40

NPV strengths and weaknesses
• Strengths
–Tells whether firm value is increased.
–Considers all cash flows.
–Considers the time value of money.
–Considers the riskiness of future cash flows.
• Weaknesses
–Requires estimate of cost of capital.
–Expressed in terms of Naira, not as a
percentage.
41

Capital Rationing
• Occurs when a limit is set on the amount of
funds available to a firm for investment.
• Firm must rank investments based on their
NPVs
• Those with positive NPVs greater than the cost
of capital are accepted until all funds are
exhausted
42

Illustration of Capital Rationing
PROJECT REQUIRED
INVESTMENT
NPV
A 800,000 (30,000)
B 1,000,000 100,000
C 2,000,000 400,000
D 1,000,000 150,000
E 2,000,000 380,000
F 800,000 40,000
If the company has a budget of N5m,
which projects will be accepted?
43

Factors that Affect Project Cost
• Armchair cost analysis
• Inadequate planning and coordination
• Design changes
• Unexpected ground conditions
• Inflation and Exchange rates
• Shortages of materials
• Inappropriate contractors
• Fund diversion
• Force Majeure
• etc
44

Imperatives of Project Cost
Management
• A WRITTEN ,NOT ORAL ,APPROACH TO PLANNING
• CLEARLY AND PROPERLY DEFINED AND VALIDATED PROJECT OBJECTIVES
• RIGOROUS PLANNING WHICH CLEARLY BRINGS OUT COSTS AND BENEFITS
• DOCUMENTATIONS OF ASSUMPTIONS WHICH UNDERPIN PLANS AND COSTINGS
• FORMAL COST AND BENEFIT ANALYSIS
• CLEAR LINES OF INTERNAL CONTROL AND ACCOUNTABILITY
• FORMAL CONTROL OF CHANGES TO PLANS AND THOROUGH DOCUMENTATION
45

Conclusion
• A manager must have good knowledge of costs
and their behaviour to enhance control of project
costs;
• Budgeting lies at the foundation of every financial
plan, failure to budget has grave consequences;
• Several methods are used to evaluate project/
investment proposals. The NPV method is
superior as it considers the amount and timing of
cash flows
46

Questions
47
THANK YOU