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Lecture 13

The document discusses project risk and uncertainty, emphasizing the importance of cash flow estimations in capital investment decisions. It covers methods for analyzing project risk, including Break-Even Analysis and Sensitivity Analysis, which help determine minimum output for profitability and the impact of variable changes on economic decisions. Limitations of Break-Even Analysis are also highlighted, along with examples to illustrate the concepts.

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Salman hamad
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8 views21 pages

Lecture 13

The document discusses project risk and uncertainty, emphasizing the importance of cash flow estimations in capital investment decisions. It covers methods for analyzing project risk, including Break-Even Analysis and Sensitivity Analysis, which help determine minimum output for profitability and the impact of variable changes on economic decisions. Limitations of Break-Even Analysis are also highlighted, along with examples to illustrate the concepts.

Uploaded by

Salman hamad
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Project Planning, Management

& Engineering Economics

Course Code – CE407

Break Even Analysis


&
Sensitivity Analysis

Lecture # 13
1
Handling Project Uncertainty

• Origin of Project Risk

• Methods of Describing
Project Risk
Origins of Project Risk

• Risk is to describe investment


project where cash flows are
not known in advance with
certainty. Project risk on the
other hand refer to variability
in a project’s PW. In essence,
we can see that risk is the
potential for loss.

• Risk Analysis is the


assignment of probabilities
to the various outcomes of
an investment project.
Origins of Project Risk (Cont.)

• The decision to make a major capital investment such as introducing a


new product requires cash flow information over the life of a project.
• The profitability estimate of an investment depends on cash flow
estimations, which are generally uncertain.
• The factors to be estimated include
– the total market for the product;
– the growth in the market;
– the cost of producing the product, including labor and materials;
– the selling price;
– the life of a product;
– the cost and the life of equipment needed; and
– the effective tax rates.
• Many of these factors are subject to uncertainty.
Methods of Describing Project Risk

First, begin analyzing project risk by determining the


uncertainty inbuilt in a project cash flows. We can do this
analysis in a number of ways such as the following;
Break-Even Analysis
Sensitivity Analysis (SA)
Scenario Analysis
is a technique that does consider the sensitivity of NPW to
both changes in key variables and to the range of likely
variable values. The decision maker may consider two
extreme cases, a
– “worst-case” scenario (low unit sales, high variable cost
per unit, high fixed cost, and so on) / Pessimistic
– “best-case” scenario to identify the extreme /Optimistic
– and most likely project outcomes
Break Even Analysis

❑ Break-Even Analysis is used to predict future profit/


losses,
❑ The main purpose of the break-even analysis is to
determine the minimum output that must be
exceeded in order to make profit.
❑ How many units must be sold to achieve a target
profit?

6
Break Even Analysis (Cont.)

Fixed cost, FC — Costs not directly dependent on the variable, e.g.,


buildings, fixed overhead, insurance, minimum workforce cost
Variable cost, VC — Costs that change with parameters such as
production level and workforce size. These are labor, material and
marketing costs. Variable cost per unit is v
Total cost, TC = Sum of fixed and variable costs, TC = FC + VC

7
Break Even Analysis
Break Even Point
❑ Break-even point is the point at which total cost
and total revenue are equal.
– at this point no profit or loss is incurred
– the firm merely covers its total costs
– Revenues above the breakeven point result in profit
– Revenues below the breakeven point result in loss

Break Even Point


Total Revenue = Total
Cost
8
Break Even Analysis
Break Even Point (Cont.)
Let number of sales units = X, Sale Price = S,
Total Fixed cost = F, Variable cost per unit =
V,
Total variable Cost (TV) = X*V, Total Revenue (TR) = S*X
Total Cost (TC) = Total Fixed cost + Total Variable Cost
Total Cost (TC) = F + X*V, Break Even Point
In case of profit TR = TC
Total Revenue = Total Cost + Profit S*X = F + X*V
TR = TC + Profit
S*X = F + Profit + X*V

9
Break Even Analysis
Limitations
❑ It assumes that fixed costs (FC) are constant.
❑ It assumes average variable costs are constant per
unit of output (i.e. linearity).
❑ It assumes that the quantity of goods produced is
equal to the quantity of goods sold.
❑ The sales mix of products will remain constant – break
even charts cannot handle multi-product situations.
❑ Some costs cannot be identified as precisely Fixed or
Variable.
❑ Volume is the only factor affecting costs.

10
Break Even Analysis
Example
Given
Fixed factory overhead cost 60,000
Fixed selling overhead cost 12,000
Variable manufacturing cost per unit 12
Variable selling cost per unit 3
Selling price per unit 24

(i) Find the break even point in terms of sale & in terms of
units.
(ii) To earn a profit of Rs.90,000, how much units must be
sold.
11
Break Even Analysis
Example

12
Break Even Analysis
Example
Assignment # 3
A company has fixed cost of $20,000 in order to sell a product
that costs them $50 per unit. If a company sells the product
for $120 per unit,
a) Determine the break even point in terms of sales and in
terms of units
b) Determine the units required to produce $300,000 in
profit?

13
Sensitivity Analysis

❑ Engineering economy estimates of parameters such as


costs and other cash flow are only an approximation of
reality.
❑ The realized future value of a parameter will be generally
different from its estimated value.
❑ Sensitivity analysis attempts to measure the effect of this
uncertainty (variability) in parameters estimates.
❑ Sensitivity analysis identifies parameters that have the
most impact on an economic decision.
❑ That is, it identifies the parameters with the highest
sensitivity.
❑ Sensitivity of a parameter is the effect of changing the
parameter value on the economic criteria such as PW
value. 14
Sensitivity Analysis (Cont.)

❑ Sensitivity analysis is often done graphically by plotting


the economic criteria as a function of a parameter.
❑ The plot is over the range where the parameter is most
likely to vary.
❑ A flat plot indicates insensitivity, i.e. the parameter has
little effect on the economic decision. No need to get very
precise estimates for its value.
❑ A highly variable plot indicates high sensitivity, i.e. the
parameter has a significant impact on economic decision.
Estimating its value should be handled with care.
❑ Sensitivity analysis is some time called “what if Analysis”.
– What if incremental sales are only 1,000 units, rather than 2,00
units? Then, what will be the NPW?.
15
Sensitivity Analysis (Cont.)

❑ In this example, PW is highly sensitive to MARR 16


Sensitivity Analysis
with Several Parameters
❑ When several parameters
are being analyzed for
sensitivity,
❑ A spider plot can be used.
❑ This is a plot of the
economic criteria as a
function of percent.
❑ changes from the most
likely estimates of
parameters. (i.e. at base
price).

In this example, ROR is


• Insensitive to indirect cost (flat curve), and labor cost;
• Moderately sensitive to material cost and capital;
• Highly sensitive to sales volume and sales price. 17
THANK YOU!

18
Sensitivity Analysis - Example 1
• A machine is considered for immediate
installation. Because of the new technology
built in, we want to investigate its NPW over a
range of +/-40% in
a) capital investment, b) annual net cash flow,
c) market value, d) useful life.
• Use MARR = 10%
Example 1 - cont’d
• Base NPW =
-$11,500 + $3000 (P/A,10%,6) + $1000 (P/F,10%,6) = $2,130
• a) When capital invest. varies by +/- p%,
NPW = - (1 + p/100) ($11,500) + … (linear function)
• b) When revenues vary by +/- a%,
NPW = … + (1 + a/100) ($3000)(P/A,10%,6) + … (linear function)
• c) When market value varies by +/- s%,
NPW = … + (1 + s/100) ($1000) (P/F,10%,6) (linear function)
• d) When the useful life varies by +/- n%,
NPW = … + $3000(P/A,10%,(1 + n/100)(6))
+ $1000 (P/F,10%, (1 + n/100) (6)) (nonlinear function)
Example 1 - Spider Chart

• Sensitivity analysis is useful for identifying factors that need to be


estimated more carefully

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