Cost Estimation

Dr. Suverna Trivedi

Assistant Professor
Department of Chemical Engineering
IIT Kharagpur
Cost Estimation & Economic Analysis

 Project cost estimation

 Cost indexes
 Net earning
 Interest and investment costs
 Income tax
 Depreciation
 Income tax & Depreciation
 The profits generated by most chemical plants are subject to taxation.
 Taxes can have a significant impact on the cash flows from a project.
 The design engineer needs to have a basic understanding of taxation and tax
allowances such as depreciation in order to make an economic evaluation of the
project.
 The details of tax law can be complicated, and governments enact changes
almost every year.
 Specialized knowledge about tax rules is not required for engineering design
projects, which are usually compared on a relatively simple after-tax basis.
 The design engineer may occasionally need to consult a tax expert though,
particularly when comparing projects in different countries with different tax law.
 Various types of tax allowance are permitted in the tax laws, the most common of
which is depreciation.
Taxable income
 The taxable income of a plant = Total Gross Profit - Tax allowances

 Total Gross Profit = Total Revenue – Total Product Cost

 Payable Tax = Gross Profit * Tax rate

 Total Revenue is income from all sources

 Product sales
 Sales of assets and supplies
 Royalties
 Other revenue
Capital Gains Tax

 A capital gains tax is levied on profits made from the sale of

capital assets, such as land, buildings, and equipment.
 Land is not depreciable.
 Profit on the sale of land = (Selling price) - (Purchase price) –
(Costs of selling) –(Costs of improvements)
 For depreciable assets, such as buildings and equipment
 Profit = Selling price –– (Costs of selling) - (Cost of Purchase - Depreciation).

 Consider an equipment: Purchase cost is $80,000 which has

already had $50,000 of depreciation charged as an expense, and
is sold for $45,000 with $2000 in selling expense—advertising
and removal from service
 Capital gain = $45,000 — (80,000 — 50,000) — 2000 =
= $13,000
 Losses
 Offsetting Gains: If a company makes a loss in a year, it can use that loss to
reduce its profits (gains) for that same year. This helps lower the amount of tax
the company needs to pay, because taxes are based on profits.

 Carrying Losses:
•If a company has a total loss in a year (like losing money in its business), it
can either:
• Carry the loss back: The company can use the loss to reduce profits
from the previous 3 years. This means it can get a refund of some
taxes paid in those past years.
• Carry the loss forward: The company can also use the loss to reduce
profits in the next 5 years. This helps lower future tax bills.
 Losses
 Project-Specific Losses: A project or business might be profitable overall, but
it could show a loss in some individual years. In these cases, the company can
decide whether to:
Depreciation
 The value of physical assets decrease with time and a business is allowed to take
this into consideration when analysing costs and profits for a particular
operation.

 The decrease in the value of assets.

 It may be due to several factors such as physical depreciation, technological

advances, and economic changes, etc.,

 Depreciation, however, has a significant effect on corporate cash flow.

 Depreciation: Classification
Physical Depreciation
 Wear and tear
 Corrosion
 Accidents,
 Deterioration due to age
Functional Depreciation
 Obsolescence due to technological advances
 Decrease in demand for the service rendered by the property
 Shifts in population
 Changes in requirements of public authority
 Inadequacy or insufficient capacity
 Abandonment of the enterprise
 Depreciation: a Hypothetical expense
 In computing income taxes on the profits of an operation, Governments allow a
deduction for a fraction of the initial cost of the plant as a “hypothetical
expanse” to be subtracted from the actual gross profit for income tax
calculations. This deduction is called Depreciation.

 The depreciation may be considered as a fund flow to allow eventual

replacement of the plant or equipment of acknowledging that the plant has
worn or becoming somewhat obsolete or less competitive with passage of time.

 Companies can calculate yearly depreciation for assets and deduct the
depreciation from their gross income.

 Land is not allowed for depreciation.

 Depreciation is only calculated on business assets not personal assets.

Annual cash flow

where the subscript j indicates an annual

value in year j,
A the annual cash flow,
s the annual sales revenue,
c0 the operating cost (all of total product
cost except depreciation),
∅ the fractional income tax rate, and
d the annual depreciation.
 Depreciable Investments
Depreciable investments Non-depreciable investments
All property with a limited useful life of more Working capital and start-up
than 1 year that is used in a trade or business, costs
or held for the production of income
Improvements to the land such as grading and Land
adding utility services
Physical facilities, including such costs as Inventories held for sale
design and engineering, shipping, and field
erection
The fixed-capital investment, not including The costs of maintenance and
land repairs
,
.
 The total amount of depreciation that may be charged is equal to the
amount of the original investment in a property—no more and no less.
 Depreciation does not inflate or deflate.
 Terms in Depreciation

 Current value: The current value of an asset is the value of the asset in its
condition at the time of valuation.

 Book value: is the difference between the original cost of a property and all the
depreciation charged up to a time.

 Over a period of time, the book value of the asset decreases until it is fully paid
off or written off at which point depreciation can no longer be charged.

 Market value: The price that could be obtained for an asset if it were sold on
the open market is designated the market value.

 It may be quite different from the book value and clearly is important for
determining the true asset value of the company.
Terms in Depreciation
Salvage value refers to the estimated amount an asset is worth at
the end of its useful life. This is the price you expect to get for the
asset after it has been fully used or depreciated.

Scrap value: If the property is not useful, it can often be sold for
material recovery. Income obtainable from this type of disposal is
known as scrap value.

Service life: The period over which the use of a property is

economically feasible is known as the service life of the property.

.
 Methods for Calculating Depreciation

There are several methods for calculating depreciation

 Straight-line method

 Double-declining balance method

 Sum of digits method

 Modified accelerated cost recovery system (MACRS)

Straight-line method
 In the straight-line method, the property value is assumed to
decrease linearly with time over the recovery period.
 Thus the amount of depreciation in each year of the recovery
period is
𝑉−𝑉𝑠
d=
𝑁
d = Annual depreciation, Rs./Year
V= Original investment in the property at the start of recovery
period (Rs.)
Vs = Salvage value at the end of depreciable life (Rs.)
N = Length of the straight line recovery period (year)
 Straight-line method

 For chemical plants the salvage value is often taken as zero, as

the plant continues to operate for many years beyond the end of
the depreciable life.

 Book value of the asset after m years of depreciation is

 Bm = V- σ𝑚
𝑖=1 𝑑𝑖

 When the book value is equal to the salvage value (or zero) then
the asset is fully depreciated and no further depreciation charge
can be taken.
Example 1: Straight line method
The cost of a heat exchange is Rs. 100,000. It has a useful life of 9
years. Its salvage value is 10000. Assuming straight line
depreciation, what is the book value of the heat exchanger at the
end of 5 th year.

Solution:

The annual depreciation is

𝑉−𝑉𝑠 100000−10000
d= 𝑁
= 9
= Rs. 10,000 /year

The book value of the heat exchanger after 5 years of depreciation,

B5 = V- σ5𝑖=1 𝑑𝑖 = 1,00,000 – 5(10,000) = Rs. 50, 000

Straight-line method

End of year Depreciation charged Book value (Rs)

0 - 1,00,000
1 10,000 90,000
2 10,000 80,000
3 10,000 70,000
4 10,000 60,000
5 10,000 50,000
6 10,000 40,000
7 10,000 30,000
8 10,000 20,000
9 10,000 10,000
10 10,000 0

Value of depreciation is constant in straight line method

 Declining Balance Method
 The Declining Balance Method is a way to calculate depreciation where
the asset loses a larger portion of its value in the earlier years of its life
and a smaller portion in the later years. This method assumes that the
asset loses its value faster in the beginning.
 In this method, depreciation is calculated by multiplying the book value
of the asset at the start of the year by a fixed percentage (called the
depreciation rate).
Limitation:
 Unlike the straight-line method, the declining-balance method does not
automatically take account of the salvage value of the asset.
 The book value at the end of the life of the asset may not be exactly
equal to the salvage value of the asset.
 Declining Balance Method
 Declining-balance depreciation (also called as fixed percentage
method) models the loss in value of an asset over a period as a
constant fraction of the asset’s current book value.
 The fixed percentage factor remains constant throughout the
service life of the asset.
 Therefore, the annual depreciated amount is different for each
year.
 Depreciation = Book value at the beginning of the year x Depreciation rate
 Book value = Original Cost- Accumulated depreciation
 Bm = V- σ𝑚
𝑖=1 𝑑𝑖

 The most common rate of depreciation is double the straight line

rate. For this reason, this method is also referred as double-
declining balance method.
Declining Balance Method
 In the declining-balance method, the annual depreciation charge is a fixed
fraction (fd) of the book value:

 Depreciation at the end of first year, d1 = V fd

 Book value at the end of first year, B1 = V – d1 = V- Vfd = V(1- fd )

 Depreciation at the end of second year, d 2= B1 fd = V(1- fd )fd

 Book value at the end of second t year, B1 = B1 – d2 = V(1- fd )-V(1- fd )fd = V(1-
f d )2

Similarly,

 Book value at the end of n th year, Bn = V(1- fd )n

 Depreciation at the end of n th year, dn= V(1- fd )n-1f d

 The fraction fd must be equal to or less than 2/N, where N is the depreciable life
in years.
Double Declining Balance Method

 Book value at the end of n years, Bn = V(1- fd )n

 Depreciation at the end of n years, dn= V(1- fd )n-1f d

2
 Admissible value for fd ≤
𝑁
2
 When fd = , this method is known as Double Declining-
𝑁
Balance (DDB) depreciation.
 The DDB depreciation rate will be 200% (twice) of the straight-
line rate.
 The book value for the DB method never goes to zero because the
book value is always decreased by a fixed percentage.
 Since the DB depreciation may not reduce the book value to the
salvage value at year N, it may be necessary to switch to
straight-line depreciation in later years
 It is not allowed to depreciate the asset below their salvage
value.

BN
Vs
Example 1: A company has purchased an equipment at a cost of Rs.
1,00,000 with an estimated life of 8 years. The estimated salvage
value of the equipment at the end of its lifetime is Rs. 20,000. Using
declining balance method find its book value and depreciated amount
for its service life at 20 % depreciation rate.
Solution:
End of the Depreciated amount, Book Value, Bn
Bn = V(1- fd ) n
year dn ,(Rs)
0 0 100000
dn= V(1- fd )n-1f d 1 20000 80000
2 16000 64000
f d = 0.2 3 12800 51200
4 10240 40960
For 8 th year
5 8192 32768
20971.52−20000 6 6553.6 26214.4
d8 = 7 5242.88 20971.52
1
=971.52 4194.304 16777.22
8 971.52 20000
Example 2: A pump has an installed cost of Rs. 40,000 and a 10 year
estimated life. The salvage value of the pump is zero at the end of
10 years. What is the pump value (in Rupees) after depreciation by
the double declining balance method, at the end of 6 years? GATE
2007

Solution:
Double Declining-Balance depreciation method: fd= 2/N = 2/10 = 0.2

Bn = V(1- fd )n B6 = 40000(1- 0.2 )6 = 10485.76 INR

dn= V(1- fd )n-1f ; d = 40000(1-0.2)5 x 0.2 =

Example 3: A process plant has a life of 7 years and its salvage value is 30%. For
what minimum fixed- percentage factor will the depreciation amount for the second
year, calculated by declining balance method be equal to that calculated by the
straight line depreciation method? (GATE 2011)
Solution:

𝑉−𝑉𝑠 𝑉−0.3𝑉
Straight line method, d = = = 0.1 V
𝑁 7

Declining balance method, d2 = V(1- fd) fd

Therefore

V(1- fd) fd = 0.1V

𝑓 2 -f+0.1 =0
Solving for f
F = 0.887 or 0.113
2
fd ≤ 𝑁 ≤ 2/7 ≤ 0.27 → f =0.113
Sum-of-Years-Digits Method
 Sum-of-the-years digits (SOYD) depreciation is another accelerated cost
recovery method for calculating depreciation that allows for more depreciation
in the earlier years during the life of an asset.
 The rate of depreciation charge for the first year is assumed as the highest and
then it decreases.
 The annual depreciation rate is computed by adding up all of the integers from
1 to N (depreciable life of plant/asset) and then taking a fraction of that each
year.
 For example, if the plant’s depreciable life is N = 5 years, then
the sum-of-years digits is: 1 + 2 + 3 + 4 + 5 = 15.

Sum of 1 2 ....N = N(N+1)/2

The rates of depreciation for all the years are as follows:
 First Year: 5/15
 Second Year = 4/15
 Third Year = 3/15
 Fourth Year = 2/15
 Fifth Year = 1/15
Sum-of-Years-Digits Method

For any year, the depreciation is calculated by multiplying the corresponding rate of
depreciation with (V– Vs)

𝑌𝑒𝑎𝑟𝑠 𝑅𝑒𝑚𝑎𝑖𝑛𝑖𝑛𝑔
SOYD Depreciation = x (V - 𝑉𝑠 )
𝑆𝑢𝑚 𝑜𝑓 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟𝑠 𝑑𝑖𝑔𝑖𝑡𝑠

Depreciation in the m th year

𝑁−𝑚+1 (𝑁−𝑚+1)
Dm = 𝑁(𝑁+1) (V- 𝑉𝑠 ) = 2 𝑁(𝑁+1)
(V - 𝑉𝑠 )
2

Book Value in m-th year

(𝑁−𝑚)(𝑁−𝑚+1)
Bm = (V- 𝑉𝑠 ) + 𝑉𝑠
𝑁(𝑁+1)
 Sum-of-Years-Digits Method
 The sum-of-years-digits (SOYD) depreciation method also
assumes that the book value of the asset decreases at a decreasing
rate.
 This method is an arbitrary method for determining depreciation,
but larger amounts are allowed to depreciate during the early life
of the property.
 This method does allow the purchase price to decrease to zero at
the end of the service life.
Example 1: A company has purchased an equipment at a cost of Rs.
1,00,000 with an estimated life of 8 years. The estimated salvage
value of the equipment at the end of its lifetime is Rs. 20,000. Using
Soyd method find its book value and depreciated amount for its
service life at 20 % depreciation rate.
Solution:
End of the d Depreciated Book Value
SOYD = N(N+1)/2 year amount (Rs)
= 8*9/2 = 36
0 0 100000
𝑁−𝑚+1 1 8/36 17,777 82222.23
Dm = 𝑁(𝑁+1) (V-Vs) 2 7/36 15555.55 66666.68
2
3 6/36 13333.33 53333.35
8 4 5/36 11111.11 42222.24
D1 = 36 𝑥 (80000)
5 4/36 8888.88 33333.36
= 17777.77 6 3/36 6666.66 26666.70
7
D2= 36 𝑥 (80000) 7 2/36 4444.44 22222.26
= 15555.55 8 1/36 2222.22 20000
 Modified accelerated cost recovery system (MACRS)
 The Modified Accelerated Cost Recovery System (MACRS) is
the primary method used in the United States for depreciating
assets for tax purposes. It allows businesses to recover the cost of
capital investments over a specified lifespan using accelerated
depreciation methods.

Key Features of MACRS:

1. Accelerated Depreciation:
•Assets depreciate faster in the early years, reducing taxable income
sooner.
•Uses Declining Balance (DB) methods, often 200% (Double
Declining) or 150% DB, and switches to Straight-Line (SL) when
beneficial.
 Modified accelerated cost recovery system (MACRS)

Asset Classifications:

Assets under MACRS are grouped into different property classes based on their expected
useful life. These classifications determine the recovery period (how long the asset can be
depreciated) for each type of asset.

Depreciation Methods:
•General Depreciation System (GDS): The most common method under MACRS.
Typically uses accelerated depreciation, specifically the Double Declining Balance
(DDB) method, but switches to Straight-Line once the depreciation slows down.
•Alternative Depreciation System (ADS): This method is used for specific types of
property (e.g., certain properties used in farming or long-term property) and usually
applies the Straight-Line method over a longer period than GDS.
 Modified accelerated cost recovery system (MACRS)

Property Classes & Useful Life:

Under GDS, assets are classified into property classes based on their useful life,
and each class has its own depreciation schedule. Common classes include:
•3-year property: Certain property like racehorses or special equipment.
•5-year property: Computers, office equipment, cars, and trucks.
•7-year property: Office furniture, industrial equipment, etc.
•27.5-year property: Residential rental property.
•39-year property: Non-residential real property (commercial buildings).
 Modified accelerated cost recovery system (MACRS)
Example: Company XYZ purchases a piece of machinery for Rs. 1,50,000.
The machinery has a useful life of 5 years and a salvage value of Rs. 15,000.
The company will use MACRS for tax purposes. We will assume that the
machinery falls under the 5-year property class for depreciation, and the IRS
depreciation table for a 5-year asset using the General Depreciation System
(GDS) applies.

1. Depreciable Amount:
The depreciable amount is the cost of the machinery minus its estimated
salvage value.
Depreciable Amount=Cost of Machinery−Salvage Value
Depreciable Amount=1,50,000−15,000=1,35,000
 Modified accelerated cost recovery system (MACRS)

2. MACRS Depreciation Rates for 5-Year Property:

For a 5-year property, the MACRS depreciation rates using the half-
year convention (which is the standard method) are as follows:
4. Calculate Book Value at the End of Each Year:
We will subtract the depreciation for each year from the initial cost of Rs. 1,50,000
to find the book value at the end of each year.
Other methods:

Units of Production method: Units-of-Production Depreciation

is based on the number of units of production (output) and the useful
life of an asset in terms of production ( units, tons, feet, meters, cubic
yards, cubic meters, hours, or mileage)
𝑵𝒐.𝒐𝒇 𝒖𝒏𝒊𝒕𝒔 𝒄𝒐𝒏𝒔𝒖𝒎𝒆𝒅 𝒐𝒓 𝒑𝒓𝒐𝒅𝒖𝒄𝒆𝒅 𝒊𝒏 𝒏 𝒕𝒉 𝒚𝒆𝒂𝒓
Depreciation = (V- VS)
𝑻𝒐𝒕𝒂𝒍 𝒖𝒏𝒊𝒕𝒔 (𝒊𝒏 𝒍𝒊𝒇𝒆)

 Assume a Rs. 2,000,000 asset with neglegible salvage value.

 In its Lifetime it produces 2,400,000 units. For a monthly
production of 12,000.
 Monthly depreciation = (12,000/2,400,000)*2,000,000 = Rs 10,000
 The depreciation calculation will fluctuate as the monthly
production changes over the life of the asset.
Home work
A car is bought for Rs. 10,000,000 in 2020 and its salvage value is
1,00,000 in 2030. Tabulate the depreciation amount of the car for
its useful life of 10 years using

1. Straight line method

2. Double declining method
3. Sum of digits methods.
References

1. Max S. Peters, Klaus D. Timmerhaus, Ronald E. West,

Plant Design and Economics for Chemical Engineers, 5th Ed,
Mc Graw hill (2003).

2. G. Towler, R. Sinnot, Chemical Engineering Design, Principles,

Practice and economics of plant and process design, Elsevier
(2009).
Thank you

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