SHRI K J POLYTECHNIC, BHARUCH
CHEMICAL ENGINEERING DEPARTMENT
CHEMICAL ENGINEERING PLANT ECONOMICS (3360502)
Economic Evaluation of Projects
Topic: PROFITABILITY ANALYSIS:
- The word profitability is used as the general term for the measure of the amount of profit
that can be obtained from a given situation. Profitability, therefore, is the common
denominator for all business activities.
- Profit is defined as the difference between income and expense.
- Therefore, profit is a function of the quantity of goods or services produced and the
selling price.
- The amount of profit is also affected by the economic efficiency of the operation, and
increased profits can be obtained by use of effective methods which reduce operating
expenses.
- To obtain reliable estimates of investment returns, it is necessary to make accurate
predictions of profits and the required investment.
- Profits may be expressed on a before-tax or after-tax basis:
Gross earning (Gross profit):
Gross Profit = Total Income – Total Product Cost
GP = TI – TPC
- Total Income is obtained from selling product and by-product.
- Total Product Cost (TPC) = Manufacturing costs + General expenses
(a) Manufacturing costs = Direct Production cost
+ Fixed charges
+ Plant over head cost
(b) General expenses = Administrative cost
+ Distribution & selling cost
+ Research & Development cost
Net earning (Net profit):
Net Profit = Gross Profit – Income tax
NP = GP – IT
Mathematical Methods for Profitability Evaluation:
The most commonly used methods for profitability evaluation can be categorized under the
following headings:
1. Rate of return on investment (ROR)
2. Payout period (PP)
3. Turn over ratio (TR)
4. Net present worth (NPW)
5. Discounted cash flow based on full-life performance
6. Capitalized costs
Rate of Return (ROR):
- The rate of return on investment is ordinarily expressed on an annual percentage basis.
- The yearly profit divided by the total initial investment necessary represents the fractional
return, and this fraction times 100 is the standard percent return on investment.
% ROR = (Annual Profit/ Total Capital Investment)*100
- Annual profit may be Gross profit (i.e. profit before income taxes) or Net profit (i.e.
profit after income taxes).
- Most probably, the annual profit can be considered in terms of Net profit.
% Rate of Return = (Net Profit / Total Capital Investment) * 100
% ROR = (NP / TCI) * 100
- The methods for determining rate of return, as presented in the preceding sections, give
“point values” which are either applicable for one particular year.
Pay Out Period (POP):
- Payout period or Payout time or Payback period is defined as the minimum length of time
theoretically necessary to recover the original capital investment (in the form of cash
flow to the project based on total income minus all costs except depreciation).
- Generally, for this method, original capital investment means only the original,
depreciable, fixed-capital investment, and interest effects are neglected.
POP = FCI/(NP+ Depreciation)
Turn over Ratio:
- Turnover ratio is defined as the ratio of gross annual sales to the fixed-capital investment,
where the product of the annual production rate and the average selling price of the
commodities is the gross annual sales figures.
- The reciprocal of the turnover ratio is sometimes defined as the capital ratio or the
investment ratio.
- Turnover ratios of up to 5 are common for some business establishments and some are as
low as 0.2. For the chemical industry, as a very rough rule of thumb, the ratio can be
approximated as 1.
- It is a rapid evaluation method suitable for order-of-magnitude estimates known as the
“turnover ratio” method.
Net Present Worth:
- A related approach, known as the method of net present worth (or net present value or
venture worth), substitutes the cost of capital at an interest rate (i ) for the discounted-
cash-flow rate of return.
- The cost of capital can be taken as the average rate of return the company earns on its
capital, or it can be designated as the minimum acceptable return for the project.
- The net present worth of the project is then the difference between the present value of
the annual cash flows and the initial required investment.
- For example : The value of capital to the company is at an interest rate of 15 percent. And
if the present value of the cash flows is $127,000 and the initial investment is $110,000.
Thus, the net present worth of the project = $127,000 - $110,000 = $17,000.
