PRODUCTION COSTS

To determine the financial attractiveness of a process, management requires both the total capital
requirements and the production cost of a product. Operating cost and manufacturing cost have
also been used synonymously with production cost. Figure below lists the various costs that
contribute to the production cost. It divides the total production cost into three main categories
direct costs, indirect costs, and general costs. Direct costs, also called variable costs, tend to be
proportional to the production rate, whereas the indirect costs, composed of fixed cost and plant
overhead cost, tend to remain constant regardless of the production rate. General costs include
the costs of managing the firm, marketing the product, research and development on new and old
products, and financing the operation.
Estimation of Capital Requirements
A company that manufactures a product has funds invested in land, buildings, and equipment.
Some industries require very large capital investments as reflected in their assets per employee.
These industries have a high degree of large, expensive equipment and automatic control
equipment and are said to be “capital intensive”. Examples of such industries are crude-oil
production, energy, petroleum refining, chemicals, and pharmaceuticals. Other industries that
require a large amount of labor to manufacture or sell a product are said to be “labor intensive.”
Examples are merchandising, textiles, and food consumer products. National magazines
occasionally publish information listing the assets and the number of employees so that the
capital or labor intensiveness may be determined.
Total capital investment includes funds required to purchase land, design, purchase, and install
equipment and buildings, as well as to bring the facility into operation.
A list of these items includes:
 Land
 Fixed capital investment
 Offsite capital
 Allocated capital
 Working capital
 Other capital items
 Interest on borrowed funds prior to startup
 Catalyst and chemicals
 Patents, licenses, and royalties

LAND
Although land is a small part of the total capital investment, it should be included. Companies
will frequently purchase a tract of land for a future plant location and will allocate a parcel of this
land at cost to a project when the project is authorized. Other companies consider land as a sunk
cost and since it is small will eliminate it from economic evaluation considerations. Land costs
may be obtained by checking with the firm’s real estate department (if it has one). Local
chambers of commerce or real estate agents may be able to give information on land costs. In the
absence of such data, and for preliminary estimates only, about 3% of the fixed capital
investment may be used to estimate land costs.
FIXED CAPITAL INVESTMENT
The fixed capital investment for a plant includes the manufacturing equipment, piping, ductwork,
automatic control equipment, structures, insulation, painting, site preparation, and environmental
control equipment, as well as engineering and contractor’s costs. One may think of it as that part
of the total investment pertinent to the manufacturing of a product; it is “fixed” to the land. It is
the depreciable part of the total capital investment. Land is not a part of the fixed capital
investment and is not depreciable. Numerous techniques are available for estimating the fixed
capital investment.
Capital Cost Estimates
When a firm considers a project to manufacture a product, a capital cost estimate is prepared. An
in-house engineering staff may develop the estimate, if the staff is large enough, or the estimate
may be outsourced to an engineering or consulting company.
Classification of Estimates
There are two broad classes of cost estimates: grass-roots and battery-limits estimates. The
former, also called a green-field estimate, is a descriptive term. It means the entire facility is
estimated starting with site preparation and includes building and structures, processing
equipment, utilities, service facilities, storage facilities, railroad yards, and docks. A battery-
limits estimate is one in which there is an imaginary boundary drawn around the facility to be
estimated. It is assumed that all raw materials, utilities, services, etc. are available at the
boundary in the proper quantity and with the desired quality to manufacture the product in
question. Only costs within this boundary are estimated—hence the name battery-limits estimate.
Quality of an Estimate
Capital cost estimation is more an art than a science. An estimator must use a great deal of
judgment in the preparation of an estimate. As the estimator gains experience, the accuracy of
the estimate improves. Estimates may be classified further based upon the quality and the
amount of required information. In an attempt to bring order to the types of estimates, the
American Association of Cost Engineers has proposed the following:
Estimate type Accuracy range
Order of magnitude -30% to +50%
Budget -15% to +30%
Definitive -5% to +15%
Many companies have a fourth type between the budget and the definitive type called an
authorization estimate which has an accuracy range of -10% to +20%. Still other companies may
have a fifth category called detailed estimate that has a purported accuracy range of -5% to
+10%. The five-category breakdown is as follows:
Estimate type Accuracy range
Order of magnitude -30% to +50%
Study -25% to +30%
Preliminary -20% to +25%
Definitive -10% to +20%
Detailed -5% to +10%
During inflationary periods, there is an overlap in the accuracy range and therefore the
distinction between estimates may be blurred. Figure 4.1 shows the relationship between the two
estimating procedures.
Cash flow model