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

1

Profiting fromCleaner Production:

Day 1

For UNEPDivision of Technology,

Industry, and Economics

Prepared byTellus Institute

Boston, MA USA

TELLUS INSTITUTE

2

Introduction

3

Course Background

[15 min]

4

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

5

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

6

Words of welcome

[15 min]

Introduction of Instructors

7

Participant Introductions

[30 min]

8

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

Participant introductions

9

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?

10

Course Overview

[15 min]

11

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

12

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

13

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

14

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

15

Conclusion

Where to go for more information

Brief review of what we learned Final questions and comments Course evaluation

16

Time for a break! [15 min]


17

Cleaner Production

18

The Cost of Waste

[15 min]

19

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!

20

Flow of materials & energy

Materials,

Energy,

Water,

Labour,

Capital

Products,By-Products

Solid Waste, Waste Energy ,Wastewater

Air Emissions

21

Different types of waste

There are many words for different types of waste:

• greenhouse loss• hidden losses• leakage• non-conforming

material• overfill• packaging• process loss• rework• second quality• stock loss• washings

• allowance• BOD• broke• contaminated

solids• core loss• customer

returns• damage• drainings• dust• effluent• evaporation• furnace lossAdapted from: The Kaunas Institute of Technology, Kaunas, Lithuania

22

The true cost of wasteis 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

23

The cost of waste inkat 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

24

THE HIDDEN COSTOF WASTE

The “Cost” Iceberg

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.

The true cost of waste can be like an iceberg, with only a small part visible

25

So how do we meltthe cost iceberg?

...throughCleaner Production!

Stay tuned...

26

Profiting from Cleaner Production

[30 min]

27

Passive environmental strategies

Dilute & disperse

28

Reactive environmental strategies

end-of-pipe approaches

29

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

30

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)

31

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:

32


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

33

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


34

CP versus End-of-Pipe approach

CLEANER PRODUCTION

• Continuous improvementtowards 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

35

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

36

What are the benefits of Cleaner Production?

Improving environmental situation

Increasing economical benefits

Increasing productivity

Gaining competitive advantage

Continuous environmental improvement

37

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

38

CP motivators and driversEXTERNAL to the COMPANY:

-Innovative regulation

- Economic incentives

- Education and training

- Buyer – supplier relations

- Soft loans from Financial institutions

- Community involvement

-

International trade incentives

39

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

40

Small Group Exercise:Classifying Environmental

Management Options

[30 min]

41

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

42

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

43

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

44

CP projects’ profitabilityat the PLS Company

CP projects’ profitabilityat 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...

45

Time for lunch! [60 min]


46

CP Implementation Steps

[30 min]

47

Step 1

Step 2

Step 3

Step 4

Step 5

Step 6

Get organized

Analyzeprocesses

Identify andevaluate CPalternatives

Secureprojectfinancing

Implement projects

Measureprogress

Planning for Cleaner Production: Six steps to savings

Adapted from: A Guide to Pollution Prevention for New Hampshire Businesses. January 1999. N.H Department of Environmental Services.

48

Step 1 — Get organized

Get management support for Cleaner Production

Form a planning team Seek input from personnel at all

levels

49

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

50

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

51

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

52

Step 5 — Implement projects

Schedule projects Assign responsibilities Talk to workers who will be

affected Get feedback from employees Schedule financing payments

53

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

54

Teamwork is very important!

Each person brings different,but vital, information

55

Tools:The Cleaner Production

Team

PurchasingMaterials ControlInventoryOperationsQuality ControlShippingMaintenanceEngineering

PurchasingMaterials ControlInventoryOperationsQuality ControlShippingMaintenanceEngineering

Environment, Health, &

Safety

Environment, Health, &

Safety

BoardBoard

LegalLegal

Research & Development

Research & Development

CEOCEO

ProductionProduction Accounting & Finance

Accounting & Finance

Sales & Marketing

Sales & Marketing

56

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

57

Cleaner ProductionSummary and Q&A

[15 min]

58

Cleaner ProductionReview 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

59

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?

60



61

Cost Identificationand Estimation

62

Introduction to Cost Identification and

Estimation

[15 minutes]

63

Decision-making factors

Project selection

Technical

Organizational

FinancialRegulatory

Today’s focus

64

Costs are an important aid in translating environmental needs to business needs. In addition, they already serve as an “official language” in the company.

The language of business

Adapted from “Pilot programme for the promotion of environmental management in developing countries” (P3U). Environmental Cost Management. GTZ-P3U. Bonn, Germany

project profitability market

share

capital investment overhead costs

profit centre

unit pricecost allocation

ROI

regulatory compliance

incinerator banCDO

wastewaterdioxin energy

efficiencyrecycling

With the cost translation, the business and environmental manager can communicate and cooperate more effectively.

65

Financial Analysis steps

Cost identification & estimation

Project profitability evaluation

We will discuss this now

We will discuss these tomorrow

66


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

67

Small group exercise:Cost Identification at

the PLS Company

[75 min]

68

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

69

INVENTORY

SLITTING

Manufacturing Steps at the PLS Company

— Materials flow map

solvent airemissions


printed laminated

filmplastic film, inkproduct

plastic film, aluminium film, adhesive

PRINTING LAMINATION

Liquid wasteink

Solid scrap

to waste management

to waste management

Solid scrapSolid scrap

printed

film

70

Waste Management at the PLS Company — Materials flow map

air emissions

dirty scrubber water

OFF-SITELANDFILL

INCINERATOR WASTEWATER TREATMENTsolid scrapfrom printing,laminating,slitting steps

fuel and fueladditive

fresh water

wwtp chemicals air

emissions

Cleanerwater to a nearbystream

ash sludgeliquid inkwaste from printing step

71


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.)

72

Three broad categoriesof 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.

73

Checklist:

“The Investment Decision Cost/Savings Checklist”

Checklist:


Refers to the checklist handout

74

The cost of wasteat 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)

75

Problematic accounting practices—what might

make it difficult to estimate costs accurately

(Particularly costs related to waste)

Let’s brainstorm![30 min]

76

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?)

77

2%

Material loss perthe accounting

records

52%

Actualmaterial

loss

“Hidden” costs of lost raw materials

Manufacture of plastic rear panels for automobiles

(As a percentage of input materials)

Adapted 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 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

79

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

80

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

81Source: Green Ledgers: Case Studies in Corporate Environmental Accounting. World Resources

Institute. May 1995.

Environmental Management Costs

“hidden” in an overhead account

Product Manufacturing Cost Statement

Variable 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.

Fixed CostsSupervisorFixed LabourDepreciationDivisional OverheadGeneral Services &

Administration

$4,600$57,800$1,227

$13,662

$1,294

Total Variable CostTotal Fixed Cost

Total Manufacturing CostTotal Cost

• legal expenses• environmentally

driven R&D• permitting time and

fees• environmental

training

Fixed CostsSupervisorFixed LabourDepreciationDivisional OverheadGeneral Services & Administration

82

Survey of industry accountants

in the US

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

83

Cost assignmentat the PLS Company

Cost assignmentat 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

84





85

Cost allocationCost 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

86

Cost allocationat the PLS Company

Cost allocationat the PLS Company

Solid scrap waste

Treatment and disposal costs

Printing

Laminating

Slitting

How would youallocate?

On the basis of:• # of set-up runs?• raw materials use?• machine hours?• amount of scrap?• some other basis?

Allocated from overhead

87





88

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

89



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!

90

Fixed vs. Variable Costsat 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?

91

It is important to remember:

Future fixed costsare not fixed yet!

Cleaner Production nowcan reduce the size & cost of

treatment equipment thatyou may have to purchase

in the future

It is important to remember:

Future fixed costsare not fixed yet!

Cleaner Production nowcan reduce the size & cost of

treatment equipment thatyou may have to purchase

in the future

92





93

Costs missing fromthe 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

94


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?)

95





96

Ease of identifyingand estimating costs

In general,as you go down this list, costs are more likely to be hidden or difficult to quantify(but every case is different!)

LESSHIDDEN

MOREHIDDEN

Equipment purchase,direct materials, energy, labour

Waste disposal

Recycle/rework, treatment, waste handling

Regulatory compliance, other indirect costs

Less tangible costs

97

Potential Sourcesof Cost Data

Let’s brainstorm!

[15 min]

98

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

99

Review of What We have Covered Today

[15 min]

100

Cleaner Production

The cost of waste – Usually underestimated!

Profiting from Cleaner Production– Cleaner Production as waste prevention

and on-site recycling Cleaner Production

– Benefits– Implementation steps

101


Cost identification– 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

102

Tomorrow... Cost estimation tools

– 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

103

Final questions or comments?

104

Profiting fromCleaner Production:

Day 2

For UNEPDivision of Technology,

Industry, and Economics

Prepared byTellus Institute

Boston, MA USA

TELLUS INSTITUTE

105

Small group exercise:Cost estimation at the

PLS Company

[60 min]

106


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.)

107

Tools For Data Identification and

Estimation

[30 min]

108

Tools:Original data records

Tools:Original data records

Source: Northeast Waste Management Officials’ Association

Purchase order/invoices Production records Waste shipment records Equipment logs Engineering estimates Regulatory reports Staff interviews

109

Checklist:

“Cleaner Production Data Sources”

Checklist:

“Cleaner Production Data Sources”

110

Tools: Materials flow map

INVENTORY

SLITTING



printed laminated

filmplastic film, inkproduct

plastic film, aluminium film, adhesive

PRINTING LAMINATION

Liquid wasteink

Solid scrap

to waste management

to waste management

Solid scrapSolid scrap

printed

film

111

MANUFACTURINGPROCESSINPUTS

PRODUCT

NON-PRODUCT OUTPUT (WASTE)

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

112

Tools:Cost Checklist

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

113

Checklist:


— We used it yesterday

Checklist:


— We used it yesterday

114

Investment decisionCosts & savings

Initial investment costs Annual operating costs and

savings– The cost of operating inputs– The cost of waste management– Less tangible costs– Revenues

115

Tools:Activity Based Costing

(ABC)

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

116

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

117


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

118


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

119

To quantify or not to quantify?

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.

120

Do a balancing act...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!

121

Cost Identification and Estimation

Summary and Q&A

[15 min]

122


Problematic accounting practices Potential sources of cost data Small group exercise on cost

estimation Tools for data estimation

123

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?

124



125

Project Profitability Assessment

126

Capital Budgeting(of “Environmental”

Projects)[15 min]

127

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

128

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

129

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

130

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...

131

The poor reputation of “environmental” investment

projects

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

132

We know better!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

133

Decision-making factors

Project selection

Technical

Organizational

FinancialRegulatory

Today’s focus

134

Project Cash Flowsand

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

136

Cash Flow Analysis

• 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

Inflow

Equipment salvage

value

Operating revenues & savings

Working capital

Outflow

Initial investment

cost

Operating costs &

taxes

Working capital

137

138

Cash Outflow Analysis (1)

• Planning/

Engineering

• Permitting

• Site Preparation

• Purchased

Equipment

• Working Capital

• Utility Systems &

Connections

• Start-up/Training

• Contingency

• (Salvage Value)

INITIAL INVESTMENT

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

141

•Direct costs

•Input costs

•Other costs

•Loan repayments

•Interest on loan application

Cash Outflow Analysis (2)

142

•Sales

•Savings

•Salvage value

•Cash shortfall / surplus

Cash Inflow Analysis

143

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 .

144

Cash Flow Forecast/Projection (2)

Make assumptions about likely outcomes regarding:

– Inflation– Market size – Demand for goods and services– Interest Rates

145

I nvestment Year 0 1 2 3

I NI TI AL I NVESTMENTTotal I nvestment Costs

OPERATI NG COSTSTotal Operating Costs

OPERATI NG AND MAI NTENANCETotal Operating and Maintenance Costs

WASTE MANAGEMENTTotal Waste Management Costs

COMPLI ANCE AND REG. (LessTangibles)

Total Compliance Costs

REVENUES AND SAVI NGSREVENUESOperating CostsLess DepreciationTaxable I ncomeTax payableNet I ncome af ter Depreciation and Tax

Cashflow Projection Worksheet

146

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 & Savings

(see also Cleaner Production Investment Decision: Costs and Savings Checklist)

Timing of cash flows

Workingcapital

Annual Operating CostsAnnual Tax Payments

Annual Financing Payments

Salvage Value

End of project:

Time zero:

Initial InvestmentWorking Capital

TIMEYear 1 Year 2 Year 3

Annual Revenues/Savings

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 analysisCompares 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 indicatorsA 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

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

How to interpretSimple 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

153

Small Group Exercise:Profitability Assessment

at the PLS Company— Part I

“Cash Flows & Simple Payback”

[30 min]

154

The PLS Company’sQC 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%

Costs and savingsincluded 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 projectCash flows

Annual Tax Payments = 0 (PLS has tax holiday)Financing Payments = 0 (PLS paid cash)

Initial Investment = $105,000Working Capital = 0 (not important for this project)


Annual savings = ???

Time zero:

156

The PLS Company’sQC camera project

Initial Investment

Cost

Annual Operating

Costs

BusinessAs

Usual Annual Savings =

???The QC Camera Project

0

US $ 105,000

???

???

157

158

Exercise instructionsPart I


Question 1 (15 min.) Question 2 (5 min.) Discuss your answers with

the other small groups and the instructor (5 min.)

159

The Time Value of Moneyand

Net Present Value (NPV)

[30 min]

160

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

Money loses purchasing power over time as product/service prices rise, so a dollar today can buy more than a dollar next year.

costs $1 costs $1.05

inflation 5%

nownow next yearnext year161

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

Interest, or “return on investment”

Investing $1 now

InvestmentGives you

$1.10 a year from now

162

163

Time Value of Money (TVM)

Money now is worth more than money in the future because of:a) inflationb) investment opportunity

The exact “time value” of your money depends on the magnitude of the:a) rate of inflation andb) rate of return on investment

164

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’sQC camera project

Initial Investment

Cost

Annual Operating

Costs

BusinessAs

Usual Annual Savings =

US$38,463The QC Camera Project

0

$ 105,000

$ 2,933,204

$ 2,894,741

(in US$)165

166

Question:

Is the annual savings of$38,463 per year for 3 years

a sufficient returnon the initial investment of

$ 105,000?

167

You might think about adding up the annual savings over the 3 years:

Savings per year $38,463x 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)

Answer?

Comparing cash flowsfrom 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 flowsto their “present value”

End of project

Time zero:

Initial Investment = $105,000


$38,463 $38,463 $38,463

= ??= ??= ??

Annual Savings

169

Converting cash flowsto 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

171

Invested at an interest rate of 20%, how much will $10,000 now be worth after 3 years?

Afteryear

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

Interest rate calculation

172

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

Discounting calculation

173

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

174

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

The value of the cash flow at

“Time Zero,” i.e., at project start-up

d = the discount rate

n = the number of years after

project start-up

175

Discounting (2)

Present Value = Future Valuen x (PV Factor)

The value of the cash flow in year n

The value of the cash flow at

“Time Zero,” i.e., at project start-up

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)176

177

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

178


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

EstimatingNet Present Value

Expected Future Cash

Flows

- $105,000

+ $38,463

+ $38,463

+ $38,463

PVFactor

Present Value of Cash Flows (at time zero)

- $???

$???

$???

$???

$???

Year

0

1

2

3

* =

???

???

???

???

Sum = the project’s Net Present Value = 179

180



181

Small Group Exercise:Profitability Assessment

at the PLS Company— Part II

“Net Present Value”

[45 min]

182

Also — you will need the handout:

“Performing Net Present Value (NPV) Calculations”

Also — you will need the handout:

“Performing Net Present Value (NPV) Calculations”

Located in your handout

Converting the PLS cash flowsto their “present value”

End of project

Time zero:

Initial Investment = $105,000


$38,463 $38,463 $38,463

= ??= ??= ??

183

184

Exercise instructionsPart II


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.)

185

Capital Budgeting: inflation & tax

[30 min]

186

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

187


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%

188


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

87,843less: initial investment 105,000

Net Present Value -17,157

i.e. same NPV* as with zero inflation, 15% discount rate

* ignoring minor rounding difference

189

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

192

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

193

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

yearasset life 3 years

194

Profit earned by project

Profit earned by project in each year:

cash inflow per year $6,000less: depreciation $4,000

contribution to profit $2,000

tax @ 30% $600

195

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

196

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

197

Some good reasons to use a longer analysis

time horizon

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.

198

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

199



200

Sensitivity Analysis

[15 min]

201

Sensitivity AnalysisIntroduction

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%

202

Sensitivity Analysis Example

Input Variables Varied by 10%

OriginalData

10% increasein Cost of

Capital

10% increasein I nvestment

cost

10% decreasein cashflows

Year 0 - 2735000 - 11323650 - 12456015 - 2735000Year 1 - 14978753 12951647 - 14978753 - 14828965Year 2 17122990 2592375 17122990 16951760Year 3 8022274 5151626 8022274 7942051Year 4 376354 117364 376354 372590.5Year 5 8203865 374538 8203865 8121826Year 6 76133 5142598 76133 75371.67DiscountRate

35% 48,5% 35% 35%

Project Life 5 years 5 years 5 years 5 yearsNPV 7810 - $2,741,092 - $8,940,009 $745,846I RR 39% 54% 9% 39%

203

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.

204

Sensitivity AnalysisConclusion

•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.

205

KeyProfitability 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 andReturn on Investment

(ROI)

These indicators incorporate:– the initial investment cost – the first year cash flow

Simple Payback (in years)

Initial Investment

Year 1 Cash Flow=

ROI (in %)Year 1 Cash Flow

Initial Investment=

207

How to interpretSimple 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


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

211

Profitability Indicator Summary (1)


Advantage Disadvantage

Easy to use Neglect TVMNeglect out-year costsDo not indicate project size

Considers TVM Needs firm’s discount rateIndicates project size

Considers TVM Requires iterationDoes not indicate project size

SimplePayback& ROI

NPV

IRR


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

213

Interpret profitability indicators with

caution...

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

214

Other Profitability Assessment Issues

[15 min]

215

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

217

Consider attending anotherUNEP course entitled:

CP4: “The Cleaner Production Investment Process”

Consider attending anotherUNEP course entitled:

CP4: “The Cleaner Production Investment Process”

218

Project Profitability Assessment

Summary and Q&A[15 min]

219

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

220

Conclusion

221

Where to gofor more information

222

Review ofwhat we have covered

in this course[15 min]

223

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

224

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!



225

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!



226

And don’t forget...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!

227

Final questions and comments?[15 minutes]

228

Course Evaluation

[15 min]

229

Thank you for attending!

Please keep in touch with us regarding your Cleaner

Production efforts.

Documents

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