Tuesday, May 12, 2009

9/09/08
Importance of building economics
• Economics are introduced in early design stage
• Time is an important factor / aspect in building industry
• Initial stage design concept should be planned with sufficient time
• The related pertaining working drawings etc can be submitted
• FINANCE
• ATTITUDE
• MAGNITUDE
• Lifetime investment
• lease an apartment = 15 – 25% of income
• Own an apartment = 50% of family income
COST OF PROJECT
• Land Survey & Registry
• Plan sanction fees
• Architects fees
• Contractors profit
• Construction cost
• Clearances from various authorities
• Operation & maintenance – 3 to 4 times the cost of building
• Debt service
• Furnishings etc
OPTIONS
• BUILD & SELL
• BUILD & RETAIN – SELF USE / LEASE

ECONOMY IN DESIGN
Working pattern, the flow charts, reduction in work force = results in reduction of 50 times or more cost pf project (in 20 yrs)

CHALLENGES TO THE ARCHITECT
Pressure to speed up the design solution
Accepting the role of financial advisor
12/09/08

FINANCIAL ADVISORS

• Reduction in initial cost
• Reduction in operation & maintenance cost
• Reduction in personnel cost, if possible
OR
• Sit back & renegotiate the fees downwards
OR
Become part of clients advisory team
• Economics
• Aesthetics
• User needs
• Environment

BUILDING ECONOMICS
Related fields
1. Engineering economics structural
Equipments
Methodology of construction
2. Real Estate Economics Value of built environment
3. Urban Economics town & its surroundings
4. Energy economics
5. Environment economics
MACRO & MICRO ECONOMICS ANALYSIS
Micro – problems of individuals
Macro – laws of governing the economics
Building industry , national economics – relative to each other micro & macro

Microeconomics is the study of decisions that people and businesses make regarding the allocation of resources and prices of goods and services. This means also taking into account taxes and regulations created by governments. Microeconomics focuses on supply and demand and other forces that determine the price levels seen in the economy. For example, microeconomics would look at how a specific company could maximize it's production and capacity so it could lower prices and better compete in its industry

Macroeconomics, on the other hand, is the field of economics that studies the behavior of the economy as a whole and not just on specific companies, but entire industries and economies. This looks at economy-wide phenomena, such as Gross National Product (GDP) and how it is affected by changes in unemployment, national income, rate of growth, and price levels. For example, macroeconomics would look at how an increase/decrease in net exports would affect a nation's capital account or how GDP would be affected by unemployment rate


While these two studies of economics appear to be different, they are actually interdependent and complement one another since there are many overlapping issues between the two fields. For example, increased inflation (macro effect) would cause the price of raw materials to increase for companies and in turn affect the end product's price charged to the public.

The bottom line is that microeconomics takes a bottoms-up approach to analyzing the economy while macroeconomics takes a top-down approach. Regardless, both micro- and macroeconomics provide fundamental tools for any finance professional and should be studied together in order to fully understand how companies operate and earn revenues and thus, how an entire economy is managed and sustained.




• Construction
• Estimation
• Project management
• Construction finances
• Real estate financing
• Production processes ( material related to construction)
• Transportation processes
• Marketing studies – minimizes the gap between user needs and products offered

16/09/08
PROJECT COSTING
• REQUIREMENTS design according to needs & estimate it
• BUDGETS estimate could be more than the budget or vice versa
Resultant solution
Increase budget
Reframe requirements
Change specifications
Fine tuning the project requirement & budget
INITIAL PROJECT COST
Total amount paid for planning & construction of a building project upto its completion & occupancy. This also includes cost of borrowing funds.
VARIOUS COMPONENTS OF INITIAL PROJECT COST
A. CONSTRUCTION COST
1. CONSTRUCTION COST
• Building construction cost
• Site works cost initial preparation cost
Improving ,landscaping, leveling, surface parking, driveways, providing measures for rainwater run off, providing retention ponds, clearing site of trees, re moving old construction, fencing, signage, outdoor furniture, lighting, fountains, pools, etc.
• Overheads & profits
2. SITE ACQUISITION COST land purchase
3. DEVELOPMENT COST roads, utilities, playgrounds, water tanks, sewer lines,
substations
4. PROFESSIONAL FEES Architects, Engineers, Consultant, Management
5. PERMITS Plan sanctioning, building permit, development plan,
Sewer & water works, signage permit, NOC, PCB, etc.
6. CARRYING CHARGES maintenance of the site, property tax payment, site security,
insurance, fencing, temporary lighting
7. CONTINGENCY FUNDS allowances for unforeseen expenditure at building level &
overall project level
8. FURNITURE & EQUIPMENT COST fixed & movable ( to be used at site)
9. MOVING COST client belongings & operation shifting, loss of income
during transition
B. CONSTRUCTION FINANCING COST loan fee
Fee associated with arranging the finance
C. PERMANENT FINANCING COST
19/09/08

INITIAL BUILDING CONSTRUCTION COST

COST = AREA X UNIT PRICE

COST = AMOUNT OR QUANTITY / UNIT PRICE

PRICE – governed by the market , not the designer

METHODS OF CALCULATING IBCC

1. WHOLE UNIT METHOD also called the building method
Eg – colony , schools, etc
1 BR unit x qty x rate
2 BR unit x qty x rate
2. UNIT OF USE METHOD number of people staying / using the building
Eg – hospital (beds), auditorium( seats) ,Cinema/ multiplexes (seats), offices ( work stations), schools ( number of students), Airport ( number of entry gates)
3. AREA METHOD Standard of the building = rate of unit price
Cost = area x unit price
4. VOLUME METHOD larger volume of spaces
Cost = volume x unit price
5. ENCLOSURE METHOD non regular spaces
Calculated on basis of surface area of the walls, roof, floor etc.
6. SYSTEMS METHOD structural system
Mechanical equipment
Foundation
Façade , etc
Add up the above
7. TRADE BREAKDOWN SYSTEM civil work
Electrical work
Mechanical work
Share of work done by different trades working for the construction of the building
8. QUANTITY SURVEY BASED METHOD after design stage
Estimation of items
9. OWNERS & ARCHITECTS ESTIMATE V CONTRACTORS ESTIMATE


BASIS OF UNIT PRICE
1. Building type & Quality
2. Building size
3. Location
4. Height of building

16/10/08

ELEMENTARY CONCEPTS OF ECONOMICS Bk ref : economics for engineers by Dr. Mansoor Ali

UTILITY
DEMAND & SUPPLY
WANTS
COST
VALUE
PRICE
MICRO ECONOMICS
MACRO ECONOMICS

UTILITY It is defined as the power in the article or service to satisfy a want
It depends upon the intensity for an individual; the degree of want
It has no moral or ethical significance
It declines as we get more units of commodity
(law of diminishing utility)
There are 3 types of utilities
1. Average utility
2. Marginal utility
3. Total utility

UNITS CONSUMED MARGINAL TOTAL AVERAGE
UTILITY UTILITY UTILITY

1 20 20 20
2 15 35 17.5
3 10 45 15
4 5 50 12.5
5 0 50 10
6 -5 45 7.5
7 -10 35 5

With a Fall in marginal utility an increase in units consumed

DEMAND & SUPPLY
Supply is the amount of goods offered for sale at a given price
Demand is the quantity the consumer is willing to buy at that price
Both vary with price
These 2 forces can be balanced by adjustment of the price
The higher the price more will be the supply & vice versa
The gap between the 2 can be met with varying the price
DEMAND PRICE SUPPLY
40 Apts 30 lacs 30 apts
35 apts 40 lacs 35 apts
25 apts 50 lacs 50 apts

















Increase in demand increase in price
Decrease in supply increase in demand
Increase in price decreases in demand


VALUE & PRICE
Value of a commodity is the power it has to command other goods or services in exchange
It also satisfies want
Value in exchange
Value in use
Value in exchange has 2 characteristics 1.Value in use
2.Short in supply or scarcity
More the scarcity more the value of commodity
Goods are of 2 types
i. Free these are solar energy , air etc

ii. Economic goods which have value in exchange, are transferable, visible, or invisible like goodwill
Wealth personal own
Collective society
Natural
International global
WANTS & NECESSITIES
Dire needs or wants are essential part of life. Want is the mother of all inventions. When desire becomes more effective and one is able to fulfill it, it gets converted to want
Criteria for want
i) Desires
ii) Reasons to fulfill the desire
iii) Willingness to spend on that desire
Classification of Want
1) Necessities – daily needs
(a) For existence – food, shelter & clothing
(b) For efficiency – better balanced diet , food, clothing, furniture, education for children, medical facilities, etc
(c) For conventional necessity- social obligations, performing various rites, events like birth , death, marriage etc
2) Comforts to live in an environment which enhances productivity & efficiency in an healthy environment, eg ; good ventilated home , having a vehicle, etc, other gadgets & conveniences
3) Luxury – lead a luxurious life

Characteristics of Want

1) Unlimited
2) One by one fulfillment as per priorities
3) Recur again & again
4) Listed in order of priority
5) Immediate or present wants are more important than future want
6) Some wants are complimentary
7) Knowledge increases wants
8) Wants maybe a matter of habit

Standard of living
Index of the economic progress of a person
Definition as per Engles – Law of Consumption
“As income of a person increases his expenditure on food & clothing decreases and expenditure on education , entertainment & comforts increases”

21/10/08

Future costing
Cost of Project after building completion. Initial cost of the project is miniscule portion of the total cost. Energy cost plays a major role in costing of the project. At designing stage like planning for energy efficiency is done

Elements Of Future Cost
i) Operating expenses cost towards maintenance & , heating, cooling and their respective billing
which includes lifts, escalators, servicing & running, salary of operating staff,
payment to the owner or tenant
ii) Utilities Water taxes average usage
Gas charges average usage per person / unit
Garbage collection or per apartment unit or
Sewage tax per sq mtrs of floor area
Detailed understanding required of energy implication , climate, orientation,
construction methodology, mechanical equipment etc
For eg ; insulation saves energy, wrong selection of material to be avoided
iii) maintenance cost it includes janitorial services, cleaning crews, window washers, painting
of building, relampers, fixture cleaners
dependence of cost burden on the promoter & user
servicing & monitoring of mechanical equipment
ground maintenance – cleaning of outdoor premises, weeding, trimming of
plants , landscape maintenance, trash collection
cost implication is on basis of prior data available
iv) administrative cost depends upon the type of building residential or commercial
management cost tenant turnover rate
type of lease & rental agreement
computed in Rs/ sqmtrs for apartments, Rs/ unit for hotels
a) management cost
b) security cost
electronic security system
services of security guard
computed in Rs / sqmtrs or Rs / unit
depend on location of building
crime rate is directly proportion to rate of security cost
c) Insurance cost depends upon the type of building ( nature of use)
Kind of hazards covered
Level of risk associated and level of competition among Insurance companies
Distance from fire hydrants & number of burglaries in the area
Insurance from natural disaster
Computed from existing data

d) Telephone & communication charges
Charges will be borne by the lessee or the promoter
v) debt service payback of mortgage loan , payment periodic
CRF = mortgage interest rate (1 + MINT )
{ (1 + MINT) 1}

Where , CRF = capital recovery factor
MINT = interest amount
-m = term
CRF = monthly payment
Total loan amount

vi) Taxes real estate tax
Sales tax on Services & rental
Income tax
Capital gain tax sale of property
All taxes as applicable
vii) repairs & replacement cost replacement reserve for building
30 yrs life of building – to be replaced
Initial cost = 10,00,000
Life of building = 30 yrs
Inflation @ 5% pa = depreciation
Single compound = 4.3218
Amount factor
Cost after 30 yrs = 43,218,000 (replacement cost)
Loan against above cost
80 % =
20% = equity contribution = 8,64,360 to be paid by owner
Accumulate in bank @ 6% in SB a/c = 10,934 pa for 30 yrs
Sinking fund factor = 0.01265 – to keep aside for future as fixed amount , interest return maybe less in a nationalized bank but return is assured
viii) renovation , alteration & additions cost eg : office building
space rented to company individual for 10 yrs , after vacating new work carried out for new tenant
addition of space = vertical / horizontal
ix) miscl cost & expenses a) vacancy & bad debts
b)contingency funds – for unforeseen expenditure
eg – legal bills, etc
computed as per sq mtr rate
% age of rental income
x) sale cost a) realtor fee
b) own efforts
advertising cost
time spent in showing the building to prospective tenants/ buyers & negotiating
sales tax
transfer fees
xi) demolition cost cost of tearing down the building , carrying away the waste


NONMONETARY COSTs intangible cost that are imposed by a project on the neighborhood
or other members of the society

Aesthetic value pleasing
Environment approved
Neighborhood improved
Parking congestion’
Nuisance value
Loss of vegetation
Cut the view, sunlight of the neighborhood
Increase of traffic
Architectural qualities
Space
Change in neighborhood scales
Property value



Benefits of building 2 categories
1) monetary benefits
2) nonmonetary benefits
1) monetary benefits from sale
from rental ( income from lease)
sale price or profit
a) cost approach cost of construction = land cost & profit
cost of construction = 1,00,000
profit = 20%
sale cost = 12,00,000
profit = 2,00,000
developers equity = 20% = 2,00,000
mean loan value = 80%
sale price profit = 20% = 2,40,000
profit = 40,000
b) market approach after 2 yrs - sale price n = sale price (1+ INFL)
where INFL = inflation rate
for longer period –
sale price n = building value o (s-n/s) + land value ( 1 + appreciation rate)
where s = expected life of the building
other factors effecting building
1. supply of similar buildings in the market
2. average occupancy rate for similar building
3. how desirable is the area of locality
4. cost of operating & maintaining the building
5. projection of sale price
6. distance from downtown CBD
7. distance to school, shopping center, recreational area, parks etc , distance from industrial area
8. age of the neighbourhood
9. style of surrounding area
10. mix of population
11. condition of neighborhood buildings
12. economic demographics effect the price value
13. social activities, crime rate etc

c) income approach how much income one can generate from building

income capitalization approach
expected rental income
requirement = prevailing market rate
rent (n) =rent (o) (1 + INFL) n
consideration for vacancy & bad debts
net rent (n) = Rent (n) ( 1 – VRn)
VRn = vacancy rate for the nth year
Occupancy rate
1st year = 60% VRn = 40%
2nd year = 80% VRn = 20%
3rd year = 90% VRn = 10%
Non monetary benefits
Prestige value
Economic
Non economic or intangible
These benefits are derived from architectural quality of the building
1. a building constructed by an architect has more nonmonetary value , for eg – placement of cupboards, bedrooms with attached toilet, view from the house
2. architectural design decision creates value
3. how the building needs functional , emotional, practical and aesthetical
4. architect having knowledge of climate , circulation, easy maintenance etc
5. design advertising value / recognized names of the architects
6. building design by renowned architects increases value
7. the visibility fashion aspect of corporate image architect
8. architectural value is the economical value of the building






7/11/08

economic performance of a business

client objectives
shelter
getting proceeds from sale
long or short term gains (performance)
keep the cost down & sell it after construction
cost is the performance measure
getting a large income from rent
monthly net income is the measure of performance

various types of performance measures
1) costs not bothered about initial cost or future cost but about its running cost
ie the energy cost
a comparison should be made between the cost in using energy efficient free system to keep the operational cost down & energy consumed will be less
2) benefits
(a) net benefits
• potential gross income (PGI)
• effective gross income (EGI)
EGI = PGI – Vacancy
• net operating income (NOI)
NOI = EGI – expenditure ( net annual expenditure)
• cash throw off (CTO)
CTO = NOI – DS ( debt service)
• taxable income
tax income = CTO – replacement services
• spendable cash after taxes (SCAT)
SCAT = Tax income – income tax
(b)building sold after completion
• sale value – at a specified time is the estimated amount the investor could obtain by selling his property also known as reversion
• net sale value = sale value – sale cost
• project net worth = net sale value (n) - mortgage balance
• capital gain tax @ 10%


3) rates & ratios
A B
COST 10,00,000 1,000
GROSS BENEFIT ( sale price) 10,01,000 2,000
NET BENEFIT 1,000 1,000
BCR 10,01,000 = 1.001 2,000 = 2.00
10,00,000 1,000
BCR = benefit cost ratio = ratio of benefit over cost
If BCR < 1 , PROJECT IS IN LOSS
Incremental analysis = difference or increment – B/W benefits / cost


4) periods or time frame
how soon the person will get his money back
a) payment period or break even period cash equity contribution
simple payback = CEQC / CTO
discounted payback = CEQC / CTO (n)
b) amortization period – say 20 yrs , payback time


decision theory & game theory
decision conditions & expectation value
decision point expectation outcome 1 net benefits say 5,00,000
outcome 2 net benefits say 6,00,000

game theory
(a) number of competitions are finite
(b) each player has a limited number of strategies
(c) each player may not have same number of strategies
(d) when all players select their strategies simultaneously & play starts
(e) the outcome of play depends upon the strategies of the player

objective to develop a criteria for the selection of strategies by each player till optical solution in selecting. No further improvement is possible
expectation value
minimum / maximum or maximum / minimum rule
bayers rule
hurwel alpha


11/11/08

Life cycle cost analysis
One of the techniques to study economics of a building

Assumption of cost of life cycle of a building
1) study period
i) span of building ( life span ) – projected useful life - 45 yrs – as per tax laws & IIA
ii) starting date – inception, structural or commissioning
2) discount rate money worth after 45 yrs
conversions from future worth to present worth . no general rate at which discount could be made . it reflects investors average expected rate of return and it includes inflation
eg ; expected rate of return by investor = 10%
rate of inflation = 6%
nominal discount rate = 16%
say 10,000 , for 5 yrs later
= 5 X 16% x 10,000
= value
3) present worth or equivalent uniform annual cost
uniform present worth - recurring cost of survey
single present worth – one time investment
present worth is useful when owner wants to see how the total cost relates to the ability of the project to generate the income needed to pay them on an annual basis
present worth method analyses the relationship of exchange possibilities between initial cost and long term cost
4) current money value regarding dealing with the inflation when future cost are quoted in actual value
we should be able to predict the current actual value of building
5) comprehensiveness life cycle cost analysis can be applied to the building or its component
objective of the exercise is important
6) data escalation rates are taken into consideration

7) replacement period frequency of various sub system must be known selection between higher initial
cost & higher replacement period
8) resale & salvage value capital gain


example of life cycle cost analysis

energy system
A B
COST 1,20,000 2,00,000
ANNUAL ENERGY COST 20,000 5,000
REPLACEMENT COST 60,000
(after 10 yrs)
Assumptions
i) all the funds for A & B are to be borrowed @10% pa
ii) owner will own the facility for 15 yrs
iii) other costs are equal
iv) energy cost will not escalate
most economical of the above systems by using life cycle cost analysis

alt A
purchase P = 1,20,000 present worth = 1,20,000
replacement = 60,000 single present worth
for 10 yrs @ 10% pa = 0.386 x 60,000
= 23,160
Annual energy = 20,000 uniform present worth
For 15 yrs @ 10 % pa = 20,000 x 7.706
= 1,52,120

Total expense borne in 15 yrs for ALT A = 2,95, 280
Alt B
purchase P = 2,00,000 present worth = 2,00,000
replacement = nil single present worth
for 10 yrs @ 10% pa = nil
Annual energy = 5,000 uniform present worth
For 15 yrs @ 10 % pa = 5,000 x 7.706
= 38,030

Total expense borne in 15 yrs for ALT A = 2,38,036



rate of return analysis
income generated by the building

14/11/08


Value engineering proper value of money is availed
Proper identification of problem & solution with least amount of expense in design solution & monetary value
This is an attempt at reducing cost of either building , component or element
It deals with manipulating or improving the relationship between the value & cost of the product
Its main aim is to identify the function of various parts of a building , machine and systematically look for substitute material & design solution , function at less cost & using less expensive material
HOW TO Identify & analyze the function of a building or a component
Function can be of 2 types
a) USE FUNCTION columns cannot be avoided as they transfer the load to ground
b) AESTHETIC FUNCTION pleasant view of building, façade, elevation, entrance & general landscape

BASIC FUNCTION air conditioning , electrical supply are primary & essential functions
SECONDARY FUNCTION Insulation for that air conditioning stops the noise & loss of heat ,
it is the secondary function
example of value engineering waste disposal single stack vs multi stack
hollow vertical elevation column can carry the rain water pipes
TYPES OF VALUES IN VEC
i) USE VALUE
ii) ESTEEM VALUE
iii) COST VALUE
iv) EXCHANGE VALUE
Determination of value of a function
i) Worth of a function – maximum
ii) Cost of a function – minimum
WORTH > 1 Good functional value
COST < 1 Poor functional value requires value engineering

Application in architectural building
Searching for ways of achieving the same purpose cheaper or better option



18/11/08

Real estate Performa analysis
Performance analysis is done in the initial stages
4 essential parts of performing analysis
a) income and expense generated from project
expenditure for the project

SPENDABLE CASH AFTER TAX yield
INCOME TAX taxable income
REPLACEMENT RESERVES cash throw off
DEBT SERVICES net operating income
OPERATING EXPENSES effective annual income
VACANCY & BAD DEBTS potential gross income

Not being handsome(?) one can repay the loan , take care of Debt service & pay the taxes – ie project should pay for itself

b) project value & loan capitalized value = value of project
CAP VALUE - NOI / CAPR
Where CAPR = capitalization rate – rate at which one can repay the loan
Loan value = loan value ratio x CAP value
c) cash equity contribution CAEC = project cost - loan
d) tax implication & yield yield = spendable cash after tax ( SCAT) / CEQC
= 2,00,000 / 20,00,000
= 10 %
Potential gross income = net leasable area x market rental rate
To increase the PGI managing debt services & operating expenses to a low / reduction is important




21/11/08

Feasibility analysis
The concept of feasibility is to know whether the project is possible without violating rules & principles
Feasibility ranges from logical aspects ,physical aspect goals and objectives of a builder
There are various types of feasibility
i) financial
ii) logical or physical
iii) technical – building should be confined to technology
iv) political – no political conflict
v) code or zonal regulation (building should confine to all laws and regulation)
vi) environmental ----------------

preview of the business plan with the cogent issues

need to verify the enterprise is viable before
you spend the time and money into doing a full-blown business plan
• Is there sufficient demand for the product or service?
• Can the product or service be provided on a profitable basis?


A brief overview of what the business is about
Overview of the market for the product or service and the results of the market analysis
Competitive advantage of your product or service over the competitor, and the strengths
and weaknesses of your competitors
Rough proformas, including the income statement, which should show the expected level
of profit over the next five years

the first step is to draft a brief description of the business.
next step in the Feasibility Analysis is to do the market analysis
A market analysis is simply the act of ascertaining if there is the demand for the product or
service. This is the heart of both the Feasibility Analysis and the business plan. You must show on an
empirical level, that people want to buy your products or services.
how do you do this
marketing analysis? Well like most things there are two parts:
1) Looking at the health of the industry.
2) Quantifying the demand for the product or service.
1) looking at the industry you are going to be operating in
and assessing its viability and future growth
to ascertain the future growth of the industry.
2) quantifying the demand for the product or service is the most critical. It is this portion of the Feasibility Analysis
that states what people will pay to buy your product
to do a survey of at least 20 people who are randomly selected

Competitive Advantages-
This next section of the Feasibility Analysis is divided into two parts.
A) Competitive Advantages
B) Strength and weaknesses of your major competitors
With competitive advantages it is important to lay out what really differentiates your product from
your competitors. Some of these ideas could be:
A) Quality
B) Features
C) Location
D) Price (Not a good idea)
E) Service
F) New Application
Price is not a very good competitive advantage for most entrepreneurs as it does not generate repeat
business. Most entrepreneurs want and need to have repeat business. By selling on a price basis you do not
generate repeat business. Customers are only interested in price and are not loyal to the business – this is
not the type of customers an entrepreneur should be after.
The strengths and weaknesses of the competition portion of the Feasibility Analysis is where you
need to list each competitor and their critical attributes on how they relate to your product. SWOT analysis
looks at the Strengths, Weaknesses, Opportunities and Threats which surround your business. This helps
the entrepreneur to asses the viability of their options and determine a competive advantage.

The last section (finally we get to this) of the Feasibility Analysis is the financials. In this section
we need to determine the firm’s breakeven point and a proforma or forecasted income statement. The
purpose of this section is to quantify if we can generate a profit off the product or service. While having a
demand for the product or service is great, the litmus test of the entire Feasibility Analysis rests on the
financials. We want to know does it look reasonably promising that the business will make adequate money

Breakeven Analysis
(Here we go into some simple math so hang on). The breakeven point is the dollars of revenue or
units of sales that will be necessary to cover both the fixed and variable expenses.
In order to find the breakeven point, we need to find where
TR = VC + FC
Where, TR = Total Revenue,
VC = Variable Costs, and
FC = Fixed Costs.
At the point where TR = VC + FC this is the breakeven point and this can be shown in the graph below
(first equations and now graphs!):


The breakeven value can be ascertained by solving for Q.

Suppose a firm is going to introduce a new product. They hope to wholesale the new
product at $12. Their fixed costs are expected to be $50,000 (rent, utilities, etc.) and the
variable coat of their product is expected to be $2 per unit, which is composed mainly of
labor expenses.
The breakeven point is:
Q = $50,000 / ($12-$2)
Q = 5000 units
Okay, so what does this mean? It means that if we expect have sales higher than 5000 units, we
will make a profit. So if we are considering the project, we would to be darn sure that our sales are going to
exceed this number, before we do a full-blown business plan


Proforma Statement
A proforma income statement is just fancy buzzwords for a forecasted income statement. The
proforma income statement is just a statement of future profitability of the business broken down into
revenue and expenses. The revenue will be a function of the market research you have done, adjusted for
growth rate in sales. For example, if you forecast that you will generate sales of $1,000,000 in the first year
of operations then estimate (we will refine this growth rate in the business plan) the expected growth in
sales. So if we anticipated sales in year 1 to be $1,000,000 and then grow at the 10% growth rate, the
resulting sales levels are shown below.
Year 1 2 3 4 5
Sales $1,000,000.00 $1,100,000.00 $1,221,000.00 $1,343,000.00 $1,475,000.00
Remember in the Feasibility Analysis that we are not trying to get these sales estimates exact, but
rather we just need to have numbers that are in the ballpark.
The next step in the proforma income statement development is to estimate what various expenses
per year will be. Some of the typical major expenses will be:
1. Cost of Goods Sold (COGS).
2. Rent.
3. Labor.
4. Utilities.
5. Office supplies.
6. Advertising.
7. Administrative.
8. Miscellaneous.
Then we apply these costs to the sales estimates to produce a proforma income statement that is
similar to one shown below:
Year 1 2 3 4 5 NOTES
Sales $1,000,000 $1,100,000 $1,210,000 $1,331,000 $1,464,100 10% Increase
COGS $600,000 $660,000 $726,000 $798,600 $878,460 60% of sales
Gross Profit $400,000 $440,000 $484,000 $532,400 $585,640 Sales - COGS
Operating Expenses (O.E.)
Rent $20,000 $21,000 $22,050 $23,153 $24,310 5% Increase
Labor $125,000 $131,250 $137,813 $144,703 $151,938 5% Increase
Utilities $15,000 $16,050 $17,174 $18,376 $19,662 7% Increase
Advertising $40,000 $44,000 $48,400 $53,240 $58,564 4% of Sales
Administrative $25,000 $26,250 $27,563 $28,941 $30,388 5% Increase
Misc. $3,000 $3,150 $3,308 $3,473 $3,647 5% Increase
Total O.E. $228,000 $241,700 $256,306 $271,885 $288,509
PBT $172,000 $198,300 $227,694 $260,515 $297,131 Profit Before Tax
Tax $51,600 $59,490 $68,308 $78,155 $89,139 Assume 30%
PAT $120,400 $138,810 $159,386 $182,361 $207,992 Profit After Tax
Notice that there is profit attained in every year (but this is not necessarily a requirement),
therefore, we can move on to the full-blown business plan. If the PAT resembles the following example:
Year 1 2 3 4 5
PAT -$50,000 -$90,000 -$100,000 -$200,000 -$250,000
We should then reject this idea and move to a more profitable and viable business venture.
A Complete Feasibility Analysis
Shown below is a complete Feasibility Analysis for our baby bottle temperature indicator
business.
SAFE-TEMP Baby Bottle Temperature Indicator
I. Overview
This new business venture will develop a plastic temperature device to measure
the temperature of the liquid in a baby bottle. The device will be a spiral spring looking
device (which is patent pending) that fits down the center of an existing baby bottle to
indicate to the parent the current temperature of the liquid inside the bottle.
The product currently has superficial competition form the XYZ company which
produces a bottle with a device attached to the outside of the bottle and therefore can not
measure the temperature of the liquid in the middle of the bottle.
The manufacturing of this product will be out-sourced and the firm will
concentrate on sales as an operating expense for the other plastic baby bottle sellers by
hiring a sales manager who has the necessary contacts to get the product sold.
The distribution will be done by the contracts with the manufacturer to inventory
and ship the products as needed.
II. Market
After peaking in 1990 at 4.16 million births in the United States (U.S.), the
number of newborn children has stabilized at 4 million, and is not expected to deviate
from this number much. The current baby bottle market in the U.S. is estimated at $154
million, or 73 million units, per year.
Year 1 2 3 4 5
Revenue $4,620,000 $5,544,000 $6,652,800 $7,983,360 $9,580,000
III. Competitive Advantages
All though there are several major competitors in this industry, none of them has
attempted to market a temperature indicator.
However, XYZ Bottle manufactured a similar product where the gauge
(temperature indicator) is on the outside of the bottle. This product was withdrawn from
the market as it was an inaccurate indicator of temperature.
Survey-
An empirical survey was done of women who had recently given birth to a
child. A sample of 30 women surveyed, where 50% said they would be willing to pay an
extra $.50 a bottle for the temperature gauge. Many of these women said they were
willing to buy the product right now!
If we assume that we can get 3% of the market the first year (reduced a whole bunch from our
sample) and the market growth is estimated to be 20%. The 20% growth rate is not the market (?),
rather we are capturing a greater share of the market. Shown below are revenue estimates for our
company.
Year 1 2 3 4 5
Revenue $4,620,000 $5,544,000 $6,652,800 $7,983,360 $9,580,000
IV. Proformas
Year 1 2 3 4 5 NOTES
Sales $4,620,000 $5,544,000 $6,652,800 $7,983,360 $9,580,032 20% Increase
COGS $2,310,000 $2,772,000 $3,326,400 $3,991,680 $4,790,016 50% of Revenue
Gross Profit $2,310,000 $2,772,000 $3,326,400 $3,991,680 $4,790,016 Sales-COGS
Operating Expenses (O.E.)
Rent $ 50,000 $ 52,500 $ 55,125 $ 57,881 $ 60,775 5% Increase
Labor $1,000,000 $1,100,000 $1,210,000 $1,331,000 $1,464,100 10% Increase
Utilities $ 84,000 $ 88,200 $ 92,610 $ 97,241 $ 102,103 5% Increase
Advertising $ 500,000 $ 525,000 $ 551,250 $ 578,813 $ 607,753 5% Increase
Admin. $ 150,000 $ 157,500 $ 165,375 $ 173,644 $ 182,326 5% Increase
Misc. $ 50,000 $ 52,500 $ 55,125 $ 57,881 $ 60,775 5% Increase
Total O.E. $1,834,000 $1,975,700 $2,129,485 $2,296,459 $2,477,832
Interest on Debt $ 200,000 $ 200,000 $ 200,000 $ 200,000 $ 200,000 $2,000,000
EBT $ 276,000 $ 596,300 $ 996,915 $1,495,221 $2,112,184
Taxes $ 82,800 $ 178,890 $ 299,075 $ 448,566 $ 633,655 Assume 30%
EAT $ 193,200 $ 417,410 $ 697,841 $1,046,655 $1,478,529
The financials in this case look great and given the large response we received
from our market survey, we need to proceed into the full-blown business plan.
However, if the financials would have been negative (a lot of losses), we would
disregard this alternative, and find a more attractive venture.
Summary
This chapter addressed the Feasibility Analysis as a screening device before a complete business
plan is done.
The two critical sections of the business plan are the marketing section and the financial section.
With the marketing section of the business plan you need to ascertain if there is a demand for the product
and the price people would be willing to pay for the product or service. With the financial section, the
purpose is to forecast the financial viability of the business.
The Feasibility Analysis is a great way to do a preliminary test of a new venture.

3 comments:

  1. Excellent appraisal of the condition respecting future building.

    ReplyDelete
  2. Are you a student of architecture? I am from Hyderabad, India - an academician & an architect. I am familiar with the curriculum in the B.Arch program here, & am quite amazed at the grip & interest you have of this subject. Over here, building economics is more of a qualitative appraisal of the factors in this field, while your understanding also includes the quantitative aspects - which is actually the core of this field.
    I am interested in the pedagogy used for facilitating this subject.

    ReplyDelete