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Management of large capital projects Fromson, Douglas Arthur 1969

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MANAGEMENT OF LARGE CAPITAL PROJECTS • by DOUGLAS ARTHUR FROMSON •B.A.Sc.,-University, of -Bri t i sh . Columbia, 1959 A THESIS SUBMITTED IN PARTIAL FULFILMENT OF .-. THE REQUIREMENTS FOR THE. DEGREE.. OF , . .-MASTER OF BUSINESS ADMINISTRATION i n the Department Commerce and Business Administration Yle accept this . thesis as conforming to the required standard THE UNIVERSITY OF BRITISH COLUMBIA A p r i l , 1969 In p r e s e n t i n g t h i s t h e s i s i n p a r t i a l f u l f i l m e n t o f t h e r e q u i r e m e n t s f o r a n a d v a n c e d d e g r e e a t t h e U n i v e r s i t y o f B r i t i s h C o l u m b i a , I a g r e e t h a t t h e L i b r a r y s h a l l m a k e i t f r e e l y a v a i l a b l e f o r r e f e r e n c e a n d S t u d y . I f u r t h e r a g r e e t h a t p e r m i s s i o n f o r e x t e n s i v e c o p y i n g o f t h i s t h e s i s f o r s c h o l a r l y p u r p o s e s may b e g r a n t e d b y t h e H e a d o f my D e p a r t m e n t o r b y h i s r e p r e s e n t a t i v e s . I t i s u n d e r s t o o d t h a t c o p y i n g o r p u b l i c a t i o n o f t h i s t h e s . i s f o r f i n a n c i a l g a i n s h a l l n o t b e a l l o w e d w i t h o u t my w r i t t e n p e r m i s s i o n . D e p a r t m e n t o f CO'flvlKRCE T h e U n i v e r s i t y o f B r i t i s h C o l u m b i a V a n c o u v e r 8, - C a n a d a D a t e APRIL, 1969  i i ABSTRACT The value of an investment project is a. function of the magnitude •'and the dis tr ibut ion over time of the current capital outlay and future ' cash benefits pertaining to the project. Three basic problems must be resolved in capital budgeting and decision-making during project imple-mentation:' l ) It is d i f f i c u l t to estimate capital costs and cash benefits. 2) The real izat ion of future benefits i s uncertain. 3) Future benefits must be compared with current capita l costs. Generally, r i sk and uncertainty associated with an investment project are given implic i t consideration by basing decisions on the most l i k e l y single-valued estimates of capital cost and cash flow. However, recent developments in investment management techniques enable r i s k and uncertainty to be given expl ic i t consideration by assignment of a p r i o r i probabi l i ty distributions to capital cost and cash flow estimates. These methods are enabled by the introduction of Monte Carlo computer simulation. d"he problem of comparing current capita l costs with future benefits can be resolved by discounted cash flow (dcf) or net present value (npv) analysis . Both methods enable the distr ibut ion over time of the cash flow-to be e x p l i c i t l y taken into account. The minimum acceptable y ie ld for a project is'dependent upon the firm's cost of capi ta l . The decision to undertake a project included in the set of viable projects available to the firm is constrained by the a v a i l a b i l i t y of resources, part icu lar ly f inancial and managerial resources. i i i A normative model of a large industr ia l capita l project can be divided into seven reasonably d i s t inct phases: l ) Idea Generation, 2) Preliminary Analysis , 3) Comprehensive F e a s i b i l i t y Study, ll) Project Development, £) Project Implementation, 6) Start-Up, and 7) ,Post-Completion Audit . A decision to proceed with a project is gener-a l l y made at the completion of the f e a s i b i l i t y study phase; however, the decision can reasonably be reviewed and revoked at the completion of the .project, development phase. Beyond this point the implementation process '• is essential ly irrevers ible , , as cash outlays accelerate for fixed and intangible assets which have l i t t l e or no salvage value. To ensure optimization of the project's value to the f irm, a competent and sufficient management team must be provided to direct the implementation. For a large single undertaking, definable in terms of a specif ic end result which is unique, complex and involves a high degree of interdependence of task accomplishment, a project or task force organ-izat ion i s invariably u t i l i z e d . The uniqueness, frequency, and c r i t i c a l importance of project decision-points demand a high degree of senior executive attention and control . Modern network methods (PSRT/CPM) enable the separation of the planning and scheduling functions and aid i n the establishment of an ' e f f ic ient , coordinated work flow. Network diagrams provide an expl ic i t means of considering dependencies between events, even for large projects which include several thousand or more signif icant a c t i v i t i e s . Network analysis enables c r i t i c a l ac t iv i t i e s to be distinguished from non-cr i t i ca l a c t i v i t i e s , and.thus project durations can be controlled or minimized by application of resources to specific key areas. Established computer routines are available to systematically 'crash' projects and to aid in iv schedule formulation -which fac i l i ta tes s tabi l izat ion of resource input levels . A case study of a hypothetical industr ia l project is used to i l l u s t r a t e the comprehensive f e a s i b i l i t y study, project development, and project implementation phases. Although confidential requirements pre-vented the use of a specif ic project, the case is r e a l i s t i c in that the data base was synthesized from several actual projects of corresponding scope.'. Examination of the methodology of capita l project management on an overal l basis indicates that the integrated systems concept approach is required for maximum efficiency of resource u t i l i z a t i o n . The future w i l l undoubtedly see rat ional izat ion of the fragmented approach to problems in economics, finance, engineering and administration; as well as more widespread application of modern techniques in data processing, management science and information system design. v TABLE OF CONTENTS CHAPTER I . INTRODUCTION . . 1 Scope of Management ' 1 Preview . . . 2 Methodology . . h • • CHAPTER TI.'.,- IWSSTLHKT-ENVIRONMENT AND- ANALYSIS. . •.'.••'. .. .-Investment A n a l y s i s . . . . . . . . . . . . . . . . . . . . 8 Trends i n Investment A n a l y s i s . . . . TO Cost o f C a p i t a l . 12 In d u s t r y P r a c t i c e 15 Investment Models f o r P r o j e c t A n a l y s i s and Management . . . 1? CHAPTER I I I . . PROJECT PHASES 22 Idea Generation . 2h P r e l i m i n a r y A n a l y s i s 25 Comprehensive F e a s i b i l i t y Study . . . 27 P r o j e c t Development 36 P r o j e c t Implementation' ' h i Start-Up 1*8 Post-Completion A u d i t . h9 CHAPTER IV. PROJECT MANAGEMENT 52 Or g a n i z a t i o n 5k Leadership 58 Summary . 62 CHAPTER V. PLANNING, SCHEDULING AMD CONTROL 63 Project. Implementation Duration 6I4. System Requirements 63 Network-Based Management Systems (PERT/CPM) 70 Planning . 72 Scheduling . . . . . . . . . 78 Implementing P.ERT/CPM 83 Summary 38 vi CHAPTER VI." CASS STUDY 9 0 F e a s i b i l i t y Study 92 Project Development 97 Project Implementation 100 Start-Up 10U Summary 105> CHAPTER VII.' CONCLUSIONS AND RECO?;MSNDATIONS .". . . . . . . . . ' 106 SELECTED BIBLIOGRAPHY . 112 • APPENDIX' A. '•' TYP ICA L PROJECT DOCtftlENTA TION' .' .' ." .'-.'V. ."''119 ' APPENDIX B. SCOPS OF SERVICES OFFERED BY SAWDY/ELL 126 APPENDIX C. COMPARISON OF dcf AND npv METHODS OF ANALYSIS ..... 129 v i i LIST OF ILLUSTRATIONS Figure Page •1. Flovr of Funds In the Firm '. . . .' .'•'•. .• . . . . . . • 7 2. ' Typical Calculation f o r Cost of Capital . . lU 3. Internal Rate of Return (dcf) Model . . . . . 19 '••'•' i i . Net Present-'Value '(npv) Model. . ;. '. .'...•.'•;••'»•'.' ..•....•'...'•.'•.•• ;.: •'/• 21 £. Example of Project L i f e Cycle Model 23 6, System Diagram of Cost Relationships for Process Plants . . . 30 7a. Alternate Forms of Construction Contracts . LU 7b. Alternate Forms of Construction Contracts Ii5 . 8. Project Cost as a Function of Implementation Duration 66 9. Optimal F i e l d Construction" Duration . . . . . . . . . . . . . 69 10. Simple. (PERT/CPM) Net-work f o r a New House Project 73 11. A c t i v i t y Cost as a Function of Duration 82 12. (PERT/CPM) Planning, Scheduling and Operating Cycle 8u 13. Example '.York Breakdown Structure 101 v i i i AC KTTOV/LSDGMSNT' The cooperation of. Sandwell and Company Limited in allowing the inclusion of the case study is gratefully acknowledged. ix CHAPTER I INTRODUCTION The t i t l e Management of Large Capital Projects has a number of ' s igni f icant ly different connotations. We w i l l consider large capital projects to be investments .in.'industrial plants. In the western world, . such plants are almost invariably owned and operated by private enterprise, and the prime function of the plant is to earn a prof i t for the owner, "•whether he be a private individual or a diverse col lect ion of common stockholders. Construction of a new plant or purchase of an existing plant i s an investment to a business man, in that a current outlay of funds is made to provide a future stream of benefits. To an economist, only the construction of a new plant adds to the nation's stock of cap i ta l , and hence qualif ies as an investment - the foregoing of present consumption in order to enable greater consumption in the future. In this thesis, the aspect of investment which w i l l be examined in some de ta i l is the process by which industr ia l plants are conceived and born. Scope of Management The management scope for capital projects i s broad. The major portion of the l i terature surveyed focuses on the analysis of investment proposals and the capital budgeting process by which management allocates i t ' s scarce funds. The generation of investment proposals, the planning and control of construction and the start-up of the new.plants are treated less extensively - 1 -in business l i t era ture . Only occasionally in the l i terature consulted is an attempt made to treat capital project management on an integrated systems concept basis . Technical competence in the diverse disc ipl ines of economics, finance, law, engineering, and administration and management is required for various facets of the implementation.of a capita l project. As is typica l in modern complex business situations, successful execution is contingent on a high degree, of integration and coordination to prevent sub-optimization. The difficult?/, in e f f i c i ent ly managing large undertakings and groups of prof-essionals is recognized. Caddis writes that we must optimize management knowledge in order to transform management from an art to a profession. It i s necessary to-organize more effectively for massive engineering.^" Preview The investment environment and principals of f inancial analyses are examined very br i e f l y in Chapter I I . This section i s not intended as a br i e f treatment of these cruc ia l aspects of investment, but rather i t i s included to establish the terms of reference under which a large capital project is implemented. Rational decision-making.for the planning and control of a capita l project is contingent on a basic understanding of investment goals and the investment environment. Cost/time/value^ are the variables which determine the benefit of an investment project to the firm. The''investment models developed in Chapter I I provide a basis for capital project management. ^•P. 0. Caddis., "The Age of Massive Engineering", Harvard Business  Review, (January - February, l°6l), pp. 138 - ll>5. ^The cost/time/value skeleton is used by John Hackney in Management  and Control of Capital Projects, (New York: John T.'7iley and Sons, 1965), one of the few books which considers management of capital projects on an integrated systems concept basis . - 3 -The project b i r t h process i s examined i n Chapter I I I . This thesis i s p r i m a r i l y concerned with the construction of large m u l t i - m i l l i o n d o l l a r plants i n the chemical, pulp and paper, mining or simi l a r process indus-t r i e s , where large plant construction i s a r e l a t i v e l y common occurrence, but where each project presents varied...and unique problems.. There i s , . of . . course, much common ground with projects undertaken by u t i l i t y companies where large-scale construction may be almost continuous; with projects carried out-by government or agencies where the p r o f i t motive i s absent; • and with large b u i l d i n g or c i v i l engineering projects which are comparable i n magnitude, but which do not have, complexities i n planning and design, a t t r i b u t a b l e to complex production equipment. The descriptive model presented i n Chapter I I I i s normative. While i t i s u n l i k e l y that any sp e c i f i c project would follow the modus operandi presented, the model does i l l u s t r a t e the process and scope.of a t y p i c a l large i n d u s t r i a l c a p i t a l project from idea generation to start-up. Scope and methodology of project management are examined i n Chapter IV. The optimal organizational form and management method f o r accomplishing a s p e c i f i c , unique and complex task w i t h i n established cdst/time/value constraints differ.from that applicable to normal corporate a c t i v i t y . The systems approach, where objectives take precedence over organizational form, i s indicated. Predominance of professionals, time constraints and l i m i t e d a v a i l a b i l i t y of personnel c a l l f o r substitution of human resources management i n l i e u of t r a d i t i o n a l hierarchal methods. Planning and scheduling of a project requires consideration of a large number of interdependent a c t i v i t i e s . Conventional C-antt bar chart arrays can be used. V/ith t r a d i t i o n a l methods,'however, i t i s d i f f i c u l t - ll -to take expl ic i t account of dependencies and to establish the effects of deviations from established schedules as the project progresses. Network methods (PERT/CPM) are considered' in Chapter V. A case study of a hypothetical project i s presented in Chapter VI to i l l u s t r a t e the project process. Although hypothetical, the case i s r e a l i s t i c i n that the data base was synthesized from several actual projects of corresoonding scope. Confidential requirements prevented the use of a single project• for the case study.' • • . ' . ?.fethodolopy Chapter II i s based ent ire ly on a survey of current books and > periodical ar t ic les on investment analysis and the investment environment. The remaining chapters are based to a large extent on the writer's indus-t r i a l experience in the implementation of engineering projects, supple-mented by l i terature studies, part icular ly for the chapters on project management and network (PERT/CPM) methods. The data base for the case study includes project documentation from a number of pulp and paper industry projects on which Sandwell and Company Limited, Consultants, have, been engaged since 1963. CHAPTER II INVESTMENT ENVIRONMENT AND ANALYSIS Basic Problems Three basic problems must be resolved to enable evaluation of a capital investment project: 1. It is difficult to estimate the magnitude of future benefits and the capital cost of obtaining these benefits. 2. Benefits from an investment occur in the future; hence the realization of the benefits is uncertain, and the degree of uncertainty must be recognized. 3. The value of future benefits must be compared with required capital investment.^-Expected future benefits are determined from estimates of future revenues and operating costs. Varied factors - total product demand, expected market share, selling price and so forth - must be considered when estimating future revenues. Revenue forecasts, whether based on relatively crude surveys of buyer or sales force opinion or more sophis-ticated time series or statistical demand analysis, are generally d i f f i -cult to prepare. Operating costs are developed from analysis of the proposed manufacturing and marketing operations and on estimated costs of required inputs. Expected operating costs can typically be estimated with somewhat more confidence than expected revenues. David Quirin, The Capital Expenditure Decision (Homewood, Illinois: Richard D. Irwin, 1967), p. 3. - 5 -- 6 -It i s generally less d i f f i c u l t to estimate capital costs than future benefits. I n i t i a l estimates for preliminary investment evalua-tion can often be derived from capital costs for existing plants of similar design published in industry or corporate l i t erature . F i n a l capi ta l cost estimates based on reasonably complete basic engineering are generally expected to be accurate within £ to 10 per cent. I^he certainty of investment benefits is a function of the predict-a b i l i t y of the input and output market environment, and of technological development. . The major portion of investment required for large Indus-t r i a l plant projects i s in fixed assets. Obsolescence of specialized equipment due to unforeseen developments can result in rapid erosion of expected benefits. In rapidly changing, yet highly capital- intensive industries , uncertainty due to dynamic change is part icular ly s ignif icant . The third problem of equating future benefits with present cost can be resolved quite sa t i s fac tor i ly by the concept of present value -discounting of future benefits or cash flows. Assuming annual year-end compounding and a constant rate of interest , the present value of future benefits can be determined as follows: n E(PV) = S~ 3(CBt) ( t B i , 2, 3 . . . n) •Where S(PV) is the Expected Present Value of Future Benefits, S(OBt) is the Expected Value of the Cash Benefit for Year t , and r i s the Discount Rate The flow of funds in the firm is i l lus tra ted on Figure 1. Interest on debt and non-cash expenses, such as depreciation and depletion, are not deducted from profits when determining annual cash benefits or cash flow. The cash benefits real izable from an investment are not equivalent to the net earnings determined for f inancial reporting. Cross Income (Sales Revenue) Gross Earnings Cash Operating Expenses Taxable Income 3r iaxe Cash Flow dx dx co cf a S-H 3 CD 3 CO a - c+-CD 1 c+ CD 01 O (U O CD -—- ca pJ ca * d c+ a CD • d H-c+ O S> 3 CD a • Cs.sh Benefits (For dcf Calculations) <! H* P. CD <:+ 3 13 M P CD <-J c+ 3 P p . p . 3 3 •jq co co O. !" f-3 H 9 3 O O a. ^) O M CD O O Q, a O CD • ' • 'a O |_l fu 3 Q , » co O C+ -V) O CD 4 O i-i O 3 <* • rr 3 H* o (T) 3 M 3 O P . c+ Mr CD CO fU >~t \-> ca t-3 O a-O ' ~ ,t> CU hij CO M-. CO. J—1 CQ P> c+ a 4 CO t- 1 CD CD o oi o rr (i> co CD t-3 O a CD a*-P-CD CO P CO i-3 3 £ O p . >d ' d M CO M CD H-^d 4 CD I-" < M o H- 01 O CD O ID CO l-*3 01 Q P> 6 3 O. P . p. CO - 8 -Investment Analysis Three basic methods for determining Investment acceptability or ranking are in common usage: 1. Return on Investment 2. Payback Period 3. Discounted Cash Flow or Net Present Value Return on investment is the ratio of the annual net or gross income to the total investment. If the magnitude of the annual income varies over time, a weighted average is used. In comparing return on investment calculations, i t is imperative that the exact definitions of income and investment are known. An exhibit in a study by the National Industrial Conference Board illustrates how the calculated return on investment for a particular project could range from 16-2/3 per cent to 6 0 per cent, depending on the definitions used for income and investment.^ The rationale of the return on investment method is conceptually faulty, in that i t does not take into account the timing of future benefits. Profit received in twenty years is given the same weighting as profit received in the next year. The payback period is the length of time required to equate the future profits to the capital investment. This method has a distinct advantage over the return on investment method, in that i t recognizes that profits received in the immediate future are more valuable than • profits received at a later date. However, used alone, the payback method is deficient in assigning zero weight to profits received after the pay-back period. Two projects with equal payback periods would be given the N^orman E. Pflomm, Managing Capital Expenditures: Studies in Business Policy, No. 1 0 7 , National Industrial Conference Board (New York, 1 9 6 3 ) , p. W . - 9 -same ranking, even though the benefit stream of one project terminated at the end of the payback period, while the benefit stream of the other continued. The payback period i s , however, useful in assessing the relative risks, of projects with comparable returns. Forecasts of. revenues in the . distant future are more susceptible to error than forecasts of those in the near future. The payback period is often used to aid in the assess-ment, of risk, along with the. return on investment, or discounted cash-flow method of ranking. The concept of present value, introduced on page -6, provides the basis for the discounted cash flow (dcf) and net present value (npv) methods of investment analysis. The discounted cash flow method involves finding the interest rate - commonly known as the internal rate of return -by which the present value of the future benefits is made equal to the current investment. Inthe net present value method, future benefits are discounted at a specific interest rate, and the present value of the future benefits is compared to the capital cost. Eoth the dcf and npv methods are concept-ually correct, in recognizing the time distribution of the cash flow. The internal rate of return must be determined by t r i a l and error. For large projects, the time and expense for calculation is insignificant, and standard computer programs are available. Occasionally i f negative cash flows are incurred in the latter stages of the project l i f e , there may be multiple solutions for the internal rate of return. This is more an abstract problem than a practical one.'1 A modification of the .. . 3 l b i d , p. 1+2. • ^For example, see P. S. Kirshenbaum, "A Resolution of the Multiple Rate of Return Paradox", The Engineering Economist, October - November, 196U. p. 11 - 16. discounted cash flow methods known as the MAPI system has been developed by the Machinery and Allied Products Institute. This system is intended primarily for analysis of equipment replacements, rather than for the evaluation of large projects.^ Application of dcf or npv analysis provides a reasonable and opera-tional solution to the third problem of investment evaluation - the comparison of future benefits with present capital cost - but i t does not provide a solution to the fir s t two basic problems - the uncertainty • of receiving future benefits and the difficulty in estimating the benefits and the capital cost. Operational techniques by which explicit account can be taken of uncertainty and risk are currently being used to a limited extent; and i t is expected that in the not-too-distant future their use will be quite widespread, at least for large projects. Trends in Investment Analysis Uncertainty and risk can be treated in one of three ways: 1. Decisions can be based on the most likely single-valued estimates of capital cost and cash flow. This is the basis on which the majority of capital expenditure decisions are made. 2. Decisions can be based on multivalued estimates for capital cost and cash flow associated with a priori, discrete or continuous probability distributions. In '. the discrete case, outcome possibilities can be calculated directly. With continuous distributions, Monte Carlo simulation techniques can be employed. ^Pflomm, on. c i t . , p. l;7. - 11 -3. Decisions can be based on multivalued estimates of future outcome under circumstances -where estimates of the. prob-a b i l i t y of outcomes cannot be made with even remote confidence. Proposals i n this sort f a l l into the category .'of 'speculations' rather than investments, and as. such do not concern us here.^ For small investment projects, analysis based on single-valued .. estimates, i s probably the most practical, unless a s u f f i c i e n t l y low-cost and easy-to-use computer program i s available. "Where more sophisticated analysis i s warranted, models employing multivalued estimates are opera-tional and are currently being u t i l i z e d . A good example is a Monte Carlo simulation model being used by the Weyerhaeuser Company, which enables a probability distribution for the expected internal rate of return to be determined. Inputs for this model are assigned subjectively-determined beta distributions.7 David B. Hertz, a director of McKinsey and Co., reports that the results of simulation studies indicate the follovriLng: 1. There i s a wide gap i n financial performance between some commonly-used investment policies and the best poli c i e s . 2. Policies which take explicit account of risk consist-ently give better results than single-point determinate decision rules. ^Gerald 7f. Smith, Engineering Economy: Analysis of Capital Expen-ditures (Ames, Iowa: Iowa State University Press, 1968), p. 331. ?R. M. Curley, R. L. Schock and B. E. Wynne, "Simulation Applied to Project Risk Analysis", i n Operations Research and Design of Management  Information Systems, ed. by J. F. Pierce, Special Technical Association Publication No. k, Technical Association of the Pulp and Paper Industry (New York, 1967), pp. 228 - 2l$. 3» Long-run financial results are highly dependent on the r i s k accepted for a given return or on the return achieved for a given level of risk. l i . npv and dcf methods give better results than such commonly used methods as average annual return, •which do not take o into account the time value of money. • • Cost of Capital The maximization of long-run wealth i s generally accepted as the principal goal of the firm's stockholders. Equity funds w i l l be provided to the firm by stockholders, who expect that the all - i n c l u s i v e return w i l l be as good or better than that of any alternate available to them. The al l - i n c l u s i v e return includes both dividends and capital gain or loss from later sale of stock. Retained earnings, which are i n effect the present stockholders' funds, should be employed by the firm i f they are worth more to the stockholders when used by the firm, than i f handed over as cash to the stockholders.^ Borrowed funds should be used only to the extent that they do not detract from the market value of the stockholders' holdings.^ Under conditions of certainty, borrowed funds could be used to finance any asset which had a guaranteed return larger than the cost of borrowing. Under the real-world conditions of uncertainty, the use of borrowed funds SDavid B. Hertz, "Investment Policies that Pay Off", Harvard Business  Review, January - February 1968, p. 105. ^Quirin, o p > c i t . , p. 97. lOlbid, p. 97 is optimized when the ratio of debt to equity is such that the value placed on the equity by stockholders is maximized. At this point-the financial risk due to any greater use of debt would be considered excessive, and the leverage considered prudent would be fully exploited. While such an optimum debt - equity ratio is conceptually obtainable.; in practice its determination is quite subjective, and i t can only be approximated. A specific asset or group of assets can be financed in some optimum manner to maximize the stockholders' equity. Similarly, given a particular . financial structure, an optimum group of assets can be purchased to maximize the value of equity. The capital-budgeting or investment-decision process is basically an attempt to achieve this latter maximization. Helliwell defines the cost of capital as "the minimum return that wil l obtain its use".''"''" Given a particular financial structure and the estimated minimum return required for each category in the structure, the weighted average cost can be estimated. The cost of debt capital can be estimated quite readily. The cost is adjusted for the tax deductibility of interest. Kd = (1 .+ T)R where K<j is Cost of Debt Capital, T is the Marginal Tax Rate, and R is the Rate of Interest - actual for an existing debt, or estimated for a potential debt.^ The cost of equity capital is dependent on a complex relationship between the earnings per share and dividend payout, and the manner in •'-•'-John F. Helliwell, Public Policies and Private Investment, (Oxford: Clarendon Press, 1968), p. Iu IP Quirin, op. cit., p. 100. - Hi -which the market evaluates these earnings and dividends. A number of models have been developed for evaluation of market value of common stock, and hence the implicit cost of equity capital. Since no one of the models i s theoretically pure or universally accepted, we shall assume that K e - the Cost of Equity Capital - i s subjectively determined, pos-sibly with the aid of one of the valuation models. We shall also make the simplifying assumption that the cost of subscribed capital and retained earnings are equal.. Other forms of capital such as preferred stocks, convertible deben-tures, and so forth, which are intermediate between pure debt and pure equity, may be considered to have intermediate costs. On this basis the cost of capital for a simple hypothetical firm may be estimated as follows: Portion of Capital Estimated Cost Weight Current L i a b i l i t i e s .20 - -7% Bonds- .30 .07 (1- .50) .010 $% Preferred .0$ .08 .00U Capital Stock ,2$ .18 ,0U$ Retained Earnings .20 .18 .036 Cost of Capital, «K' .095 • FIGURE 2 TYPICAL CALCULATION FOR COST OF CAPITAL It must be recognized that the cost of capital calculated i n this manner i s quite subjective, and should be used as a guideline rather than as an absolute measure. Firms which do attempt to determine their cost of capital set a minimum standard for capital projects which i s greater than their estimated ~ 15 -cost of capital. This is in recognition of the fact that not a l l capital projects are expected to earn a profit, and that some will f a i l . - ^ A large new plant or expansion includes a certain portion of dis-cretionary and required investment for services, safety requirements, pollution abatement, and so forth. Thus the minimum required return for . a major new fa c i l i t y may be somewhat lower than for specific cost reduc-tion, quality improvement, or small incremental projects. In the limiting •case where.a proposed investment project is to be the. sole, asset of a new company, the cost of capital is by definition the investment yield. In this case the cost of equity capital is the residual after determina-tion of the expected return on the investment and the cost of debt financ-ing. The minimum cost at which capital can be obtained will determine whether a specific plant will be constructed by a new company. The decision to build a major new plant by an existing company will be gov-erned by more complex factors; including the firm's existing cost of capital, the incremental cost of financing the new plant, and the long-range effect on the firm's cost of capital as a result of the incremental financing. Industry Practice Surveys of the investment-decision practices of Canadian industry, conducted during recent years, indicate that the level of sophistication is perhaps somswhat lower than might be expected. Nicholson and Ffolliot of the University of Western Ontario mailed questionnaires on capital 13pfiomm, op. cit . , p. Ul. - 16 -expenditure evaluation procedures to approximately 300 Canadian firms, and received replies from approximately 100,^ In the order of 20 per cent of the respondents used the theoretically preferred discounted cash flow (dcf) method as a prime indicator of investment profitability, although use.of dcf as a secondary measure increased the number who employed dcf to some extent to 1+2 per cent. Less than one-third had attempted to compute their cost of capital. In a significant number of cases, apparent inconsistencies, such as deduction of depreciation-in payback or dcf calculations, were indicated. Helliwell reports that approximately the same portion of Canadian 15 firms employ dcf, but that its use appears to be increasing. Similar patterns are indicated by the findings of earlier studies conducted in the United States by Istvan^ and the National Industrial Conference Board.17 •While accuracy of a mathematical nature is obviously not possible, sensitivity analysis and simulation permits' explicit consideration of the effect on the rate of return due to variations of investment analysis ^ J . T. Nicholson and J. D. Ffolliot, "Are Investment Practices Inadequate?", The Business Quarterly of Western Ontario (Winter, 1965), p. 83 - 93; and J. T. Nicholson and J. D. Ffolliott, "Investment Evaluation Criteria of Canadian Companies", The Business Quarterly of Yfestern Ontario, (Summer, 1966), p. 5U - £27 ! ~ ~ " l5Helliwell, op. cit., pp. 77, 79. ^Donald F. Istvan, Capital Expenditure Decisions: Now They-are  Made in Large Corporations, (Bloomington: Bureau of Business Research, Indiana University, 1961). Pflomm, op. c i t . -17 -inputs. Considering the crucial nature of the investment decision, these modern techniques will undoubtedly become more widely used in evaluating large projects. Precision of measurement is not possible, -I Q but results can be checked for range and r e l i a b i l i t y . 1 Currently, the dispersion of the net returns of projects is frequently considered by the use of range estimates, by the use of risk classes, or sometimes merely by the listing of events which would cause the cash flow from the project ' to be different from that estimated.^ . A surprising practice of firms in evaluating investment proposals is to place considerably more emphasis on the accuracy of capital cost PC) estimates than on estimates of future cash flow. This apparent incon-sistency probably stems from the fact that even though capital cost estimates are often crude, the capital outlays will at least be made in the immediate, and hence, more predictable future. Investment Models for Project Analysis  and Management In order to establish parameters for the analysis and management of capital investment projects, i t is desirable to construct a model of the investment process. The present value concept permits future benefits to be compared with current capital costs. Two alternate models will be ^Nicholson and Ffolliot, "Are Investment Practices Inadequate?'} op. c i t . , p. 85. 19HeIliwell, op. cit., p. 68. 2°ibid, p > 68. - 18 -presented - one intended principally as a basis for the determination of the viability of investment projects, and the other principally as a basis for decision-making during project implementation. Both models are based on the assumption that the objective of an investment project is the maximization of long-term •wealth. The models w i l l be based on the simplifying premise that a l l dis-bursements and receipts occur in a lump sum at the end of a year. The actual cash flows will,, of course, have a wide range.of frequency, uni-formity and regularity. The year-end approximation is almost invariably used in economic analysis, as the accuracy of analysis inputs does not warrant more accurate timing. To maintain consistency with commonly-used evaluation methods, year-end compounding wil l be assumed. Negative cash flows - capital expenditures - typically take plr.ce over a significant period for large projects of the class with which we are mainly concerned. It is common for the project implementation to take place over two, three or more years. When analyzing small invest-ment proposals, such as equipment replacements or minor additions or modifications, i t is generally assumed that investment occurs as a lump sum at the completion of the project implementation. For large projects, however, the time distribution of the capital expenditure should be taken into account in analysis. The model intended primarily for investment analysis is illustrated as follows: where r is the Internal Rate of Return, K is the Estimated Cost of Capital, I^ c is the Capital Expenditure made in Year t e , and CBt is the Cash Benefit in Year t. - 19 -Find: n \ t c J2 7-here: I t c ( l + r ) — ° B t ( l + r ) 1 t = 1 . t.= 1 c " • • ( t c - 1, 2 , 3 • . . n ; and t = 1, 2 , 3 . . . m) k + Cash Flows CE3 CBU CB^ CB6 CB7 CB8 CB2 CBif 12 0 1 2 3 U 5 6 7 8 Cash Flows FIGURE 3 INTERNAL RATS OF RETURN (dcf) MODEL - 20 -The above model must be solved by t r i a l and error. Manual calcula-tions are re la t ive ly simple and computer programs for solution are readi ly avai lable , so this does not present a procedural problem. The measure of p r o f i t a b i l i t y which i s produced - the internal rate of return - fac i l i ta tes •ranking'of investments, and is analogous to commonly held concepts of investment y i e l d . The model Is based on the assumption that cash receipts are reinvested at a y ie ld equal to the internal rate of return. This assumption generally, does not present a-.problem, when using the model to evaluate proposals, which arc not mutually exclusive. However, a more r e a l i s t i c measure of reinvestment yie ld is desirable for decision-making during project implementation, where decisions must frequently be made between alternate ways of accomplishing the same objective ( i . e . mutually exclusive opportunities) .^! A simple i l l u s t r a t i o n comparing the results of the dcf and npv methods is included in Appendix C. The present value of past or future disbursements or receipts is determined at a uniform point in time by compounding or discounting. The rate of return which a firm considers as the minimum acceptable for an investment project can be considered as the firm's opportunity cost. If this opportunity cost is used as the compounding or discount rate, the value of disbursements or receipts so calculated represents the ir present value to the f irm. ^ F o r determining project v i a b i l i t y , the dcf method provides a measure of p r o f i t a b i l i t y which can be thought of as being compatible with a corporat goal of maximizing return on investment. 7/hen comparing mutually exclusive 'proposals, unreal i s t ic results can be generated by using an unreal is t ic reinvestment rate; and hence, the present value method "is preferred. The reinvestment assumption is the subject of confl ict ing discussion in cap i ta l -budgeting l i t era ture . For a synopsis, see G. A. Pollack, "The Capital Budgeting Controversy: Present Value vs Discounted Cash Flow Method", selected reading included in Robert 0. Murdick and Donald D. Deming, The Management of Capital Expenditures, (New York: McGraw-Hill, 1968), pp. 2J6 2 W ! - 21 -Decision-making during project implementation frequently involves consideration of alternate cash flow d i s t r i b u t i o n s . The d e s i r a b i l i t y of a p a r t i c u l a r d i s t r i b u t i o n i s a function of i t s net present value, deter-mined by discounting at the firm's opportunity cost. The net present value model i s i l l u s t r a t e d as. follows: . .. . . . Where: NPV i s the Net Present Value, and r D i s the firm's Opportunity • • Cost.. ; n Maximize: NPV =r J> I t ( l + r 0 ) c V " 1 Subject to: r Q ^  K FIGURE k . m NET.PRESENT' VALUE (npv) MODEL CHAPTER III PROJECT PHASES A normative model of a large capital project from the i n i t i a l idea to completion can be divided into seven reasonably distinct phases: 1. ..Idea Generation. ... . • ' 2. Preliminary Analysis 3. Comprehensive Feasibility Study U» Project Development Project Implementation 6. Start-Up 7. Post-Completion Audit The phases listed above are similar to those proposed by Magyar, illustrated on Figure The Post-Completion Audit, a specific project activity, has been substituted for the more general operations phase. Except for the exploitation of natural resources with a limited l i f e , such as mineral or petroleum deposits, or in the case where a reasonably vrell-defined product-life-cycle is anticipated, the abandonment phase included by Magyar is an unplanned activity arising out of the operating environment. Since the abandonment phase is not part of the project's planned progress, i t is not included. The inevitability of operations being terminated must, however, be considered in the determination of - 22 -RECOMMENDED STAGE-WISE APPROACH TO ECONOMIC EVALUATION N A T U R E O f T H E DECISION REJECT. OR PROCEED f i n FURTHER STI/DIFS •EJECT, n mmt un OETAIIEO STUDIES. PIAHIIHC I OESIII IEIECT 01 III01 F10JECT TO COMPETE F0» AVAIIAIIE CAPITAL D t F i i . c n AOTHOIIIE I W I I I EIPEAOITURE E V A L U A T I O N S T A G E IDEA EVALUATION PRELIMINARY F E A S I B I L I T Y S C O P E O F ECONOMIC E V A L U A T I O N • UUITEI IICNT] • TECHHICAL SO0I0RESS • OHIO CEIEISl USEISIEIT • tUllTATIIE IEIIEI •tEfl l t SPOISOA'S OSJECTItEl • o l fn i PROJECT score -CtYELOP U T t l l l T I Y t l .LITEAATIJAE SEARCHES • r t E i n n m f i o i SHEETS I DESICA • ROl'CH ESTIMATES Or nVESTKEIT. 0PEP.ITIIC COSTS. IEIER0ES I U l ! 0E IETUI I •ESTKATE SCOPE E0« HOKE RESEARCH I OEVELOPIEIT . AOTAITACES I OlSAmiTACEJ • ASSESS m i l COMPREHENSIVE F E A S I B I L I T Y S DESIGN •OEEIHE SPOISM'S ETUUATI0» CRITERIA. • KARAEI RESEARCH • SrtCIET PROJECT LIFE •KTMLEO EIOI SHEETS I EUCItEEtiKC OESIil EOI SPECiflCAIIOIS •PHEPAKE COIIIACTS • CASH F10I EI7IIATES TESTS Or lEASOIAItEIESS SEISIMITT AIAITSIS ItOJECT HIE Of R.EI0A1 • ELATE T) SPOISOI'S ASSET IASE 'SHOT I INI TEH IHH.ICITICM P L A N S , N O a BUDOETIKO • H O S E EITEPIIL l»r iCTM!I - I ICS FPC< COIKACTOIS I SUITIIIRS • DEVEICP I'.'DCETS A P L U S Ell i«riE«[«TATio<, O P E A I N O I , PAHAEEUC. CORTPOL t HAmEMEAT • AECOTlATE C0I1IACTS • ASSESS FIRIACIIC AllEKATKES PIOFCRHA CASH EtOtS. OPERA Tl SIATEME HIS I IALA1CE (KECIS IAI1 IIS IRVESTHEIT TOATH. iOITAASI IIIH OTHER OPKATIIIIIIES 101 AVAILABLE fllRDS CONSTRUCTION ' EITEI C0ATI1CIS PAOCIESi IEPOATS ' PERIODIC UPOATIIC Of COSTS . C0MP1AIS0HS f ITH OflUECTIVES 1 PIIOI EST IK AT ES ' REVISED FWECASIS ' JUSIIFICAMIS F M HAKES STAR r - UP . PIOCAESS REPORTS COHPtHISOHS » I U OBJECTIVES I. PRIOR ESTIMATES •ARAET IESEAACH CORSiOEl IIPIDVE. tOISIDlR A l U O C K r i T HEPUCE, 01 RET 10[A AIF.ACOI OPERATIONS PROCRESS REPORTS tPEIAIIOHS AIAITSIS • IITCCET AEVIUS ' PERFORMAHCf REVIEIS , CMPAIISOHS III* OIJECIIVES REEP FOP. MIKES II SCOPE ABANDONMENT ISASOHS rOI AIIIDOIIEIf ' FITEIII!. IREIOEICES ' ASSESS ALIflHJIIFS ' OEVE10P I0RIFT | FURS F N AIIIOOnllT ro I TD II HDITKS H t l T H T RODTIIE I S , H O • l » , 0 0 I ISI.OII - l iOD . I I l 110,000 • 110,011 I D .111 - tSO.001 FIGURE $ EXAMPLE CF PROJECT LIFE-CYCLE MODEL Source: William B. Magyar, "Economic Evaluation of Engineering Projects", The jfrigineering Economist, (Winter .1968), p. 8I4. -2k-project viability. The timing of abandonment on project worth becomes less significant, the greater the discount rate and the longer the opera-tional l i f e . At a discount rate of 10 per cent, a uniform stream of benefits of $ 1 per annum to infinity is worth $ 1 0 ; while a fifteen-year stream is worth $ 7 » 6 0 . At a discount rate of.20 per.cent, the value of . the uniform benefit stream is decreased to and f?U.70 for an infinite and a fifteen-year l i f e , respectively. • Hackney describes phases in project conception similar to those listed above, and draws an apt analogy between engineering construction projects and the flight of a rocket. Modern engineering projects are big, complicated and expensive. Things happen so fast there is l i t t l e chance for second guessing . . . condition reporting instruments and control systems for capital ventures must be sensitive and responsive, they, must indicate promptly and clearly any deviations from good performance and make i t possible to take effective and timely action. Good control can substantially improve the chance of success. It can a l l but eliminate the possi-b i l i t y that a project wi l l have to be destroyed in flight because of a malfunction.1 The project process described in this chapter is a normative model. A l l steps may not always be carried out or required, and preferred methods may not always be used. For example, i f the firm is very fortunate, the profit potential indicated by the preliminary-analysis stage may be so large that a comprehensive feasibility study •will be skipped, and the firjh will proceed directly to the project development stage. Idea Generation The activities in this stage are more diverse and less amenable to definition than the activities of the other stages. The history and •Hackney, op. ci t . , p. h. - 25 -organizational structure of the 07/ner or promoter will determine when and how ideas for projects are germinated. Some projects such as new plants or expansions to serve growing markets, or projects developed to enable exploitation of company-controlled resources may be the result of systematic corporate planning activities. Research;and development may . provide the impetus for new product projects. The inspiration for other new products may be based on perceived customer needs. Preliminary Analysis The f i r s t step in evaluating an investment project.is to perform sufficient analysis to determine i f more detailed and comprehensive analysis in the form of a full-scale feasibility study is warranted. Data which is available free or at l i t t l e cost provides the bulk of the inputs for the preliminary analysis. Government and industry publica-tions are consulted. Relevant firm and personal data and experience are incorporated. It is due to the factors involved in this stage that there is a tendency for firms to concentrate in particular fields or areas. Since the outsider's investigation usually costs more and takes longer, the insider has an advantage both in cost and in speed of decision in those 2 industries where changes in products or technology are frequent. The possibility of using specialized consultants at this point may also be limited; as the scope of investigation is probably not yet well defined, arid management may not yet be prepared to allocate specific funds for specific analysis. 2Helliwell, op. cit . , p. 92. - 26 -A primary objective at this phase is to prepare preliminary estimates of revenue, operating costs and capital costs, to permit preliminary estimation of the internal rate of return. Preliminary investigation of major variables such as the product specifications, basic production process and key input and product market structure, is required. Wherever possible, costs are based on readily available industry and firm data. Approximate estimating methods consistent with the accuracy of the. data are employed. For example,, plant capital costs may be. lump- .... sum estimates derived from scaled costs of existing plants, after adjust-ment for inflation and varied conditions. Accuracy expected for estimates of this sort would generally not be better than "t 25 per cent. Alternatives which are significantly different in major concept are considered at this stage. The emphasis, however, is on proving or disproving the viability of the basic idea, rather than on development of the idea. If.an acceptable return on investment is indicated by the preliminary investigations, the terms of reference must be defined, and the cost of a full-scale feasibility study estimated. The decision to proceed with a feasibility study for a major project may entail a considerable investment. Magyar indicates a cost of from $50,000 to $500,000 for a comprehensive feasibility study.3 The return on this investment wil l be zero i f the feasibility study results are unfavourable. On the other hand, failure to undertake feasibility analysis and to proceed with good projects may be fatal to the firm's long-run future. ^William B. Magyar, "Economic Evaluation of Engineering Projects", The Engineering Economist, (Winter 1968), p. 7 8 . - 27 -Comprehensive Feasibility Study At the beginning of the feasibility study phase a project begins to take on a definite form. It assumes a name, and gains the recognition of the firm's executives. Investigations are commenced under the terms of reference, which are formulated at the conclusion of the preliminary analysis. As comprehensive studies progress, the objectives and scope are periodically reviewed, and revised i f required. .. The focus of the feasibility study is the preparation of: 1. Revenue Forecasts 2. Operating Cost Forecasts 3. Capital Cost Estimates The above data enables the estimation of the internal rate of return. It is assumed that dcf analysis would be used, and that the internal rate of return would be the key measure of project viability. If any of the other less-conceptually desirable measures of investment profitability were used, the scope and objectives of the feasibility study would not be significantly affected. Formulation of a Monte Carlo model of the project facilitates explicit consideration of risk and uncertainty, and enables determination of the project's sensitivity to changes in key variables. A mathematical model also aids in the consideration of alternates and permits rapid updating. Revenue Forecasts. The investigation and analysis required for the preparation of revenue 'forecasts varies considerably with the product. The output from large-scale process plants will very likely be sold in - 28 -relatively'well-defined industrial or commercial markets. Since there are typically relatively few suppliers and purchasers in such markets, the reactions of competitors and customers to a new source of supply w i l l have a significant effect on sales and prices. Thus while the methodology of preparing the. sales forecast may be. relatively simple and straight-, forward, considerable subjective judgment may be required in correctly evaluating data. . It is. imperative that the sales forecast be as realistic as possible, as the production rate established from the sales forecast is the key to engineering analysis and estimation of plant and manufacturing costs. Due to time constraints, i t is likely that preliminary plant process design will be based on sales estimates produced in the preliminary analysis phase. Revision may be required i f the sales forecast is significantly altered as a result of more intensive investigation. In many process industries, economic production cannot be achieved in plants of less than a certain minimum size. In such cases, the decision to proceed to even the feasibility study phase may hinge on the probability of a market of sufficient size to support the minimum economically-sized plant. Alternate channels of distribution are considered, particularly i f marketing costs are great or i f marketing will be a key factor in the project's success. Estimated marketing costs will probably be determined in conjunction with the preparation of sales forecasts, or will be based on common industry ratios to sales. Preliminary Plant Design. To enable estimation of plant capital and operating costs, preliminary basic design of the plant is required. - 29 -Preliminary flow diagrams and plant layouts, which take into account major components, are prepared. For existing products, good preliminary designs can be based on existing industry knowledge. For new products, extensive research and development, including pilot plant tests, may be required to formulate realistic preliminary designs. The emphasis at this stage is on preparation of good workable designs, rather than on refinements. Alternates are considered where major cost or operational differences are expected. The objective is to complete preliminary engineering for a good . plant which will work, but not necessarily the best plant or the plant which wil l actually be constructed. Plant Capital Costs. The purchase of major process equipment com-prises the bulk of the capital cost for a process plant. For example, in the pulp and paper industry, purchase of mechanical and electrical equip-ment and materials typically represents 1;0 to 5>0 per cent of the total plant cost.k The requirements for major process equipment are determined from the preliminary process flow diagrams. Purchase costs for these items are then estimated, based on preliminary quotations from suppliers or from historic cost data, adjusted as required. Occasionally more detailed and fundamental cost estimating may be required for major unique equipment. The cost of the major process equipment forms the basis for estimating costs of minor equipment, piping, electrical equipment and installation labour. Ratios of costs for these items to the cost of major process equipment are determined from analysis of historic costs for similar D^. F. Williamson and I. C. Innes, "Site Evaluation and Selection", Journal of the Technical Association of the Pulp and Paper Industry, (April 1968), p. 57A. : ' - 30 -E Q U I P M E N T M A T E R I A L Major Proceu Equipment AUJ. Process Cqutpment (pumps Com*., out. £ eont.) L A B O R labor tor Major Equipment bill »Hi lion i l I ftoject Design I Conditicfli I I | " Enjinterinj I I Unit C«ti field Eipense Total Plant Engineering (super., admin., Coits temp. fac. etc.) Cost FIGURE 6 SYSTEM DIAGRAM OF COST REIATI0M5HIPS FOR PROCESS PLANTS Source: J . V.'. Hackney, Control and Management of Capital Projects, (New York: John Wiley and Sons, 1 9 6 5 ) , p. 33^  - 31 -projects.' A formal model for cost estimating in this manner is i l l u s -trated on Figure 6. Site preparation and building costs may be estimated with suffic-ient accuracy based on the above ratio method, or approximate unit cost methods may be employed.. Building costs are often based on typical costs per unit of area or volume. Costs for service and transportation f a c i l -ities may be based on approximate unit costs and assumed designs. Adjustments for current business conditions in the capital goods manufacturing industry, local construction labour productivity and costs, competitive climate in the construction industry, inflationary trend and so forth may significantly influence the total estimated cost. Hence, the quality of the capital cost estimate is very directly related to the quality of the technical personnel employed on the feasibility study. Rapidly changing economic environment may limit the period during which the capital costs are applicable. The accuracy of capital cost estimates for feasibility studies is typically expected to be in the order of i 1$ per cent. Total Investment. Pre-start-up expenses, such as for organizing and training the operating staff, marketing and promotional expenses, legal expenses and so forth are considered as capital costs when calculat-ing the return on investment. Similarly, start-up expenses and working-capital requirements are included. Although some of these items will be treated as expenses in company accounts, for financial analysis they should be considered as capital outlays, since they represent the purchase of a future•stream of benefits. Deductibility for tax purposes is con-sidered, however, when estimating cash flow. - 32 -Operating Cost Forecasts. Material, power and fuel balances are derived from the preliminary process flow diagrams. Raw material and energy costs may be determined from prevailing ratesj or for key items tentative negotiations may be entered into with suppliers. Allowances for costs of miscellaneous operating supplies may be estimated on the basis of industry experience. Labour costs are based on estimated manning requirements; rates are .based on industry and local conditions. It is necessary, of course, to allow for a l l required indirect as well as direct labour, and to provide for fringe benefits and supervision. Plant and head office administrative costs can be estimated on the basis of industry experience. It is often desirable for operating costs to be tabulated or shOYm graphically to illustrate annual and per-unit costs at various production rates. This facilitates break-even analysis and consideration of changes in sales forecasts. For consistency, revenue and operating cost forecasts, particularly for the early years of the project operation, should be comparable in accuracy to capital cost estimates. It i s , however, not uncommon for considerably more emphasis to be placed on capital cost estimates than on cash flow estimates.^ Alternates. In the early stages of the feasibility study, i t may be necessary to consider a large number of alternatives. For example, in the case of a $1% million petroleum pipeline and refinery project, forty alternates were considered, twenty analyzed in detail, and two more ^Helliwell, op. ci t . , p. 93. - 33 -subsequently added.^ To reduce computational effort, capital and operat-ing cost estimates are built up in blocks, which may be utilized in a number of alternates. Mathematical modelling and computer calculations facilitates analysis of a large number of alternates. Those responsible for technical analysis weed out the obviously unsuitable cases, and make recommendations for the best alternatives; but the final decision on the best alternate rests with top management. Failure to consider a l l reason-able alternatives may result in an erroneous decision.? General Considerations. While determination of the internal rate of return as the measure of project profitability is the prime objective of the comprehensive feasibility study; in a firm vrith existing operations, consideration must be given to the effect on the overall performance. The incremental cash flow of the project, both negative and positive por-tions, must be considered in conjunction with projections of the firm's overall flow of funds. The effect of the project on the overall company accounts may be evaluated by preparation of pro forma financial statements covering the years during the project's implementation and the i n i t i a l years of operation. If heavy start-up expenses and incremental debt charges result in a significant short-term drop in the firm's reported earnings per share, i t is likely that common stock market prices will be adversely affected.^ Even though the goal of the firm's o\mers - the share-holders - is generally assumed to be long-term rather than short-term ^Milton F. Usry, Capital-Expenditure Planning and Control, (Austin, Texas: Bureau of Business Research, The University of Texas, 1966), p. 1870 7lbid, p. 18^. % o r a discussion which presents the hypothesis that the optimum capital expenditure program should be based on maintaining a continuous growth in earnings, rather than simply wealth or long-run profit maxim-ization, see E. M. Lerner and A. Rappaport, "Limit DCF in Capital Budgeting", Harvard Business Review, (September - October, 1963), p. 133 - 139. - 3U -wealth maximization, management is likely to give some consideration to detrimental short-term effects.^ By the same token, management must consider the short-term effects on the firm's human resources due to heavy requirements for managerial and technical staff to implement and operate a large new project. Project, go-ahead is as contingent on the availability of the required human resources, as i t is on the availability of financial resources. Consideration may be given, to anticipated reactions of government, the general public, and the firm's major customers and suppliers. It is difficult to evaluate these factors quantitatively; nevertheless, they must be given some weight. In some cases, significant implications of this sort may not have been detected at the preliminary analysis stage, and may only be brought to light when the scope of the project is more accurately defined during the feasibility study. Project engineering undertaken in the feasibility study stage includesthe formulation of preliminary basic plans for the project design and construction activities, and the preparation of outline sched-ules showing the expected duration of major sections of the work. Summary. The results of a comprehensive feasibility study are generally summarized in a report which would typically include the following: 1. Feasibility Study Objectives 2. Summary of Principal Environmental Factors 3. Description of Alternates Considered ^Helliwell, op. cit., p. 8£. 9 - 35 -Uo For Each A l t e r n a t e Considered i n D e t a i l - Revenue Foreca s t - Operating Cost Forecast - C a p i t a l Cost Estimates - . I n t e r n a l Rate o f Return Forecast 5. D e s c r i p t i o n o f Study Methodology and Data Sources 6. D i s c u s s i o n o f E f f e c t on O v e r a l l Operations of the Firm 7. .Discussion on U n q u a n t i f i e d and I n t a n g i b l e Considerations 8. Conclusions of Study 9. Recommendations f o r Management Based on the f i n d i n g s o f the f e a s i b i l i t y study, the company manage-ment, probably a t the e x e c u t i v e committee or board of d i r e c t o r s l e v e l , •would then decide on whether or not t o proceed t o the p r o j e c t development phase. Although f o r m a l and f i n a l a p p roval of the p r o j e c t may not be confirmed u n t i l the completion o f the p r o j e c t development phase, the key d e c i s i o n - p o i n t i s a t the completion o f the comprehensive f e a s i b i l i t y study. At t h i s p o i n t , the r e l e v a n t key v a r i a b l e s a f f e c t i n g the p r o j e c t ' s p r o f i t a b i l i t y and d e s i r a b i l i t y to the company have been determined and a n a l y z e d , t o the extent c o n s i s t e n t w i t h the a v a i l a b l e data and the o b j e c -t i v e s o f the f i r m . I f a d e c i s i o n made to*proceed w i t h a p r o j e c t i s revoked a t a l a t e r date, or i f a p r o j e c t terminated a t t h i s p o i n t i s l a t e r r e v i v e d , i t w i l l l i k e l y be due t o s i g n i f i c a n t environmental or t e c h n o l o g i c a l changes or r e v i s i o n s i n the proposed method of f i n a n c i n g the p r o j e c t . - 36 -Project Development "Work i n this phase i s usually undertaken on the assumption that the project w i l l proceed, even though authorization to spend or commit funds may be limited to that required for the project development work. In specific instances, special authorizations may be made for purchase of land or key items of equipment with long delivery or c r i t i c a l supply, or sales cohtracts may be negotiated. However, such purchases or con-tracts are frequently made with provision for cancellation. The objectives of this stage are to: 1. Complete basic engineering. 2. Develop comprehensive plans and schedules for detailed design, equipment purchasing, construction, staffing and i n i t i a l plant operation and marketing, 3. Formulate detailed budgets for the project implementation and i n i t i a l plant operation and marketing. l i . Obtain firm tenders for major equipment and contracts. Finalize project financing. During the carrying out of this work the conclusions, recommenda-tions and decisions of the f e a s i b i l i t y study w i l l be periodically reviewed, particularly for the effects of any environmental changes or for the implications of any new data or analysis. Engineering. Basic process engineering and plant layouts are completed, using as a starting-point the preliminary process flow diagrams and equipment layouts developed during the f e a s i b i l i t y study phase. Alternate process methods and equipment arrangements are considered. - 37 -Investigations of a l t e r n a t e s i t e s and transp o r t a t i o n and ser v i c e f a c i l i t i e s are concluded, and optimum choices made. The objective i s to 'freeze', as f a r as p o s s i b l e , the b a s i c plant design. S p e c i f i c a t i o n s are prepared f o r major items of equipment, and enquiries are issued to prospective s u p p l i e r s . A l t e r n a t e s t r u c t u r a l systems and b u i l d i n g materials are inv e s t i g a t e d , and best s e l e c t i o n s made. Plant e l e c t r i c a l , instrumentation and ser v i c e systems are analyzed and defined. P r o v i s i o n to be made f o r a i r and water p o l l u t i o n abatement are discussed with governing a u t h o r i t i e s , and approvals obtained. On completion o f a n a l y s i s of a l t e r n a t e s , the basic design i s f i n a l -i z e d . Preliminary requirements f o r minor equipment items such as pumps, compressors, heat exchanges, e l e c t r i c a l controls and motors, instrumenta-t i o n and so f o r t h are determined. Basic s i t e , equipment and b u i l d i n g layouts are completed, and preliminary s t r u c t u r a l designs are made. Major p i p i n g and e l e c t r i c a l s e rvice requirements, p a r t i c u l a r l y between plant u n i t s , are determined. Minor p i p i n g and service requirements are determined l a t e r i n the d e t a i l e d design phase. The b a s i c engineering described above i s used as a basis f o r prep-a r a t i o n of a d e t a i l e d construction budget. This budget, which i s broken down by a d e t a i l e d code of accounts, provides a d e t a i l e d d e l i n e a t i o n of the p r o j e c t f a c i l i t i e s , and forms the p r i n c i p a l c o n t r o l document f o r cost c o n t r o l during plant construction. Costs f o r major items of equipment are based on f i r m quotations. Costs f o r minor equipment and materials are based on h i s t o r i c cost records or estimated p r i c e s provided by s u p p l i e r s . B u i l d i n g material requirements are determined from rough take-offs from preliminary designs. B u i l d i n g m a t e r i a l u n i t costs are determined from cost records and discussions with experienced contractors. Labour costs are determined p a r t i a l l y by fundamental -•38 -estimating of time required, and partially from historic ratios to material costs or equipment weights. Minor piping and services costs are estimated, based on ratios to basic equipment costs. In addition to the direct costs, allowances are made for indirect costs - construction plant and equipment, purchasing and expediting, supervision and management, and so forth. It is important that a l l cost estimates reflect current and applicable site conditions. Factors such as climate, local labour productivity, .hours worked per week and job sche-dule may have significant bearing on cost. An allowance for contingencies is provided. This is not intended to provide for a change in scope, but rather to provide for unforeseen requirements which arise during the detailed design stage. The construction budget is generally expected to have a i 10 per cent accuracy. The principal justification for preparation of a detailed construction budget is not for the improvement in accuracy over the estimates prepared in the feasibility study stage, but rather for its function as a source-control document. A detailed delineation of the plant equipment, along with estimates broken down by a detailed code of accounts, enables management to control the project scope and cost. Basic planning and scheduling of design and construction activities is carried out in conjunction with the completion of the basic engineering and the preparation of the construction budget. The project completion date, as well as target dates for key milestones, are established. Modern network methods for planning and scheduling will be discussed in some detail in Chapter V. Contract Negotiations. Negotiation of major contracts for.supply of raw materials, power and fuel, and for sale of production wi l l be commenced during the project development stage. Successful negotiation of acceptable supply and sales contracts may be the key factor in deter-mining i f the project is to proceed. Considerable delays, attributable to the bargaining tactics of the participating parties, may be encountered. An example is a delay of over seven months attributable to a delayed letter.of intent for purchase of plant output,: encountered during the implementation cf a relatively small S2.1+3 million petrochemical plant project.-1-0 As far as possible, contracts for supply of process equipment and plant construction wi l l be negotiated during this phase. Initial negotia-tions may be based on preliminary specifications, with provision for revision when final engineering is complete. Construction drawings, which will not be completed until detail design is well advanced, are required to enable lump-sum price tendering for structural/and mechanical-electrical erection contracts. When con-struction schedules are tight, cost plus or unit price contracts may be negotiated before detailed design is completed. Operating Plans. Dates for commencement of plant operations are generally determined by the length of time required to construct the phy-sical facilities. It is necessary, however, to plan and schedule operat-ing staff employment and training to coincide with plant construction. Similarly, the distribution and marketing operations must be analyzed, *°Usry, op. cit., p. 139. - ho -planned and scheduled, to enable a well co-ordinated start-up and efficient i n i t i a l operations. Financing. Finalization of arrangements can now be made for outside financing i f required, or in the firm's flow of funds budgeting to provide for the negative cash flows during the construction and start-up period. Estimates of quarterly funds requirements are generally prepared at this stage. • . As:with contracts for the supply of other resources, contracts for financing can be brought to the point where they are ready for approval and ratification by the firm's board of directors. Organization. During the feasibility study phase, personnel required can be essentially confined to a relatively small group of technical analysts. With the commencement of the project development phase, partic-ipation is required from functional departments within the firm, and extensive use may be made of one or more groups of outside consultants, or contractors. The co-ordination and decision-making functions involved require that the owner appoint a senior•executive to act as the project manager at the commencement of the project development phase. Point of No Return. Referring back to Hackney's rocket analogy, the project is now on the launching pad, the count-down is complete, and the 'fire' button is presented to the firm's board of directors. Consid-erable money has been spent to date - almost certainly a minimum of several hundred thousand dollars for a multi-million dollar project - but this is a sunk cost and has no influence on the decision to proceed. To proceed from this point, major firm commitments must be made for raw materials - h l -and other plant inputs, for costly process equipment, and possibly for delivery of a product. Assuming that the key contracts discussed above have been essential ly f inal ized and that the decision to proceed i s given shortly after the completion of the project development phase, firm commitments for major expenditures would be entered into immediately after the decision is made.to proceed. Since project v iab i l i t y , i s now a function of the cost to complete rather than of to ta i investment, the point df no. return i s very quickly reached. Project Implementation The ' c r i t i c a l path' from the decision to proceed to plant start-up w i l l almost certainly be comprised of detailed design, structural con-struction, and fabrication and erection of equipment a c t i v i t i e s . At the beginning of this phase the emphasis i s on engineering design and equip-ment procurement, and as construction ac t iv i t i e s get r o l l i n g the emphasis shifts to f i e l d construction. It is assumed that the project scope remains essential ly as deter-mined in the project development phase. If major changes of scope are authorized after the decision to proceed, a certain amount of back-tracking and redoing of project development engineering w i l l be required. In short order after authority to commit funds has been confirmed, contracts for major process equipment, which were negotiated in the project development phase, arc f ina l i zed . Purchase of major equipment - !42 -with c r i t i c a l ^ - delivery or for which engineering information is immed-iately required is of prime importance. Initial detailed engineering is focused on the preparation of drawings and specifications for structures and buildings, and for spec-ialized custom equipment. Final completion of structural design is contingent on receipt of engineering data and drawings from equipment suppliers, and on completion of equipment layouts and design. To allow both design and construction work to. proceed, assumptions: on equipment layout and dimensions based on preliminary data and experience must often be made. Specifications for auxiliary equipment such as pumps, compressors, heat exchangers, instrumentation, motors and electrical equipment are prepared as soon as possible after the finalization of major process equip-ment requirements. Purchase orders for this equipment must be placed promptly to obtain the required engineering data., and to ensure that the equipment is delivered to the field in accordance with the requirements of the construction schedule; The detailed design phase is concluded with the finalization of drawings and specifications for piping, instrumentation, and electrical work. As well as the technical aspects of design, project engineering includes planning and scheduling of construction. Responsibilities for various aspects of the work must be determined, and contracts negotiated for the execution of these sectors according to the schedules established. •^Events or activities referred to as 'critical' include not only those items which would be on the critical path of a planning network (PERT/CPM), but also events or activities for which there is l i t t l e slack or float. - U3 -A -wide variety of organizational arrangements are used i n implement-ing a project. At one polar extreme, the owner's staff may undertake a l l of the a c t i v i t i e s i n d e t a i l . At the other extreme, the owner may contract with an integrated engineering-construction company to perform and be responsible for a l l aspects of design, as well as the construction and start-up of the plant on a turn-key basis. Between these two extremes there are a large number of p o s s i b i l i t i e s . Consultants may be u t i l i z e d for process design, detailed design, construction management, or start-up assistance. Segments of the plant may be purchased as complete packages from specialized contractors. A general contractor responsible for a l l aspects of construction may be engaged by the owner; or alternately specialized contractors may be employed for specific sections. The optimum arrangement i s dependent on the nature of the plant, the resources of the owner, and the capability of available engineering and construction companies. The characteristics of the major forms of contracts for engineering construction are il l u s t r a t e d on Figure 7. Control of the three key elements of a major capital project i s most c r i t i c a l during the design and construction phase. Successful execution hinges on good measurement and control of: Capital Cost - How much is the project going to cost? Time - How soon w i l l i t start earning money? Value - "What is the relationship between capital cost and future b e n e f i t s ? ^ 12Hackney, op. c i t . , p. 7 Contract For-r;; Project Definition (PD) COST-PLUS PO: Minimal. (Scope of work docs not have to be clearly defined.) Primary Advantages 1. Eliminates entailed scope-definition and propos j I-prepa-ration time. 2. Eliminates costly extra negotiations if many changes ,ire contemplated. • 3. Allows client complete flexibility to supervise design and.'or construction. Primary Disadvantages 1. Client must exercise tight cost control over project expenditures. 2. Project cost is usually not optimized. Typical Applications 1. Major revamping of exist-ing facilities. 2. Development projects where technology is not well defined. 3. Confidential piojects where minimum industry, exposure is desired. 4. Piojects where minimum tine schedule is critical. Comments • Cost-plus contracts should be used only where client has suf-ficient engineering staff to Supervise work. COST-PLUS WITH GUARAN-TEED MAXIMUM PD; General specifications and preliminary layout drawings. ' 1. Maximum price is estab-lished without preparation of detailed design drawings. 2. Clrent retains option to approve ' a l l * major project decisions. ' '3.'An savings under maxi-iiium price remaui with client. 1. Contractor has little in-centive to reduce cost. 2. Contractor's fee and con-tingency is relatively higher than for other fixed-price con' tracts, because price is fixed : on prehminary'design data. 3. Chen; must exercise-tight cost control over project expenditures. Where client desires fast time schedule with a guaranteed limit on maximum project cost. COST-PLUS WITH GUARAN-T E E D MAXIMUM AND INCENTIVE PD: General specifications and preliminary layout drawings. 1. Maximum price is estab-lished without preparation of detailed design drawings. 2. Client retains Cf<t'on to approve .alt major project decisions. 3. Contractor hjs incentive to improve performance since tie shares in savings. Contactor's fee and con- -tmgency is relatively higher than other fixed-pr ice con-tracts, because price is fixed on preliminary design data. Where client desires fast time schedule with a guaranteed limit on maximum cost, and assurance that the contractor will be motivated to try for cost savings. Incentive may be provided to optimize - features other than .capital cost - e.g., operating cost. COST-PLUS WITH GUARAN-T E E D MAXIMUM AMD PROVISION FOR E S C A L A H O N PD: General specifications and preliminary layout drawings. 1. Maximum price is estab-lished without preparation of detailed oesign drawings. 2. Client retains option to approve alt major project decisions. 3. Piotects contractor against Inflationary periods. 1. Contractor has little in-centive to reduce cost. 2. Contractor's fee and con-tingency is relatively higher than ether fixed-p:ice con-tracts, because price is fixed on preliminary design data. 3. Client must exercise tight COSt Cont ro l Over project expenditures. 1. Pioject involving financ-. ing in semi-industr ialized cou.itr ies. 2. Projects requiring long time schedules. 1. Escalation cost-reimburse-ment terms should be based on recognized industrial index. 2. Escalation clause should be negotiated prior to contract Signing. BONUS ' P E N A L T Y , TIME AND COMPLETION PD: Variable, depending- cn Other aspects of contract. 1. Extreme pressure is ex-erted on contractor to complete project ahead of schedule. 2. Under carefully controlled conditions, will result :n mini-mum design and construction time. 1. Defining the cause for de-lays during project execution nay involve considerable dis-cussion and disagreement be-tween client and contractor. 2. Application cf penalty under certain conditions may result in considerable loss to contractor. 3. Piessure for early com-pletion may result in I ewer Quality of work. Usually applied to lump-sum contracts where, completion of project is absolute necessity to client in order to fulfill customer commitments. 1. Pioject execution should be carefully documented to minimize disagreements cn reasons for'delay. 2. The power to apply pen-alties should not be used lightly; mar.im-jm penalty sh:uld not exceed total expected con-tractor profit. B O N U S ' P E N A L T Y . OPERA-TION AND P E R F O R M A N C E PD: Variable, depending on Other aspects of contract. Directs contractor's peak per-(ormance toward area of par-ticular importance to client. 1. Application cf penalty under certain conditions may lesult in consider a hie loss to contractai. 2. Difficult to cbtan exact operating conditions needed to verify performance guarantee. Where client desires maxi-mum production o' a particular . byprod'j:t in a new process plant, to meet market require-ments. -Power to as'ply penalty should not be used lightly. FIGURE 7a ALTERKATE FORIIS 0 ? CONSTRUCTION CONTRACTS Source: John T. Gallagher, "A Fresh Look at Engineering Construction. Contracts'^ Chemical Engineering, (September 1 1 , 1 9 6 7 ) , p.' 2 2 0 . - h$ -Contract Form; and Project Definition (PD) LUMP SUM. BASED ON DEFINITIVE SPECIFICATIONS P P : General s p e c i f i c a t i o n s . d e -s i gn , d r a w i n g , jut ! layout - o i l complete. Primary 1. U s u a l l y resu l ts in maxi-mum c O J I s t f u c t i e f f i c i e n c y . 2. D c t . H f e d p io ject def in i t ion a s s u r e 5 c l ien t of desi red quality. • Primary Disadvantages 1. Sepaiate des ign * l n ^ Ccf l -St iuc t icn cent; acts increase over-a l l project schedu le . 2. Noi tcc:n?-t t t )ve design may result in use of c v e r c o n s e i v a -l i ve design b a s i s . . 3 . - R e s p o n s i b i l i t y is d iv ided between designer and con-st ructor . Typical Applications Where c l ient s o l i c i t s con-struct icn bids on a d is t i nc t i ve bui ld ing des igned by an archi -tectural firm, oi where a feder.il government bureau so l i c i t s con-struct i,ou bids on pio ject de-s i g n e d by an outside f ier i . . Comments C l i e n t s ate caut ioned against use of th is type of c o n t a c t if project is not we l l de f ined . LUMP SUM. 6 A S E 0 OM P R E L I M I N A R Y S P E C I F I C A T I O N S P D : Complete general s p e c i f i -ca t ions , prel iminary layout, and ' ' v te l l -de f ined-des isn ; . 1. Compet i t ive engineer ing des ign often resul ts in cost re-duc ing features. . 2. Reduces over -a l l project ti:;!.e by over lapp ing des ign and .const ruc t ion . -3. Single-party r e s p o n s i b i l i t y . ' leads to e f f i c ien t p io ject execu t ion . 4. A l l o w s contractor to in-crease prof i t by superior per-formance. 1. Cont rac tor 's proposal cos t is 'high. 2. F i x e d pr ice is b j s e d on prel iminary d r a w i n g s . . 3. Contract and proposal re-.quire carefu l and lengthy c l ien t review.' -1. Turnkey contract to des ign and construct fer t i l iser p l jn t . 2. Turnkey contract to des ign .ind construct foreign powei-£ener,it ion p lant . 1. B ids shou ld be s o l i c i t e d only f ioci contractors exper i -enced in part icu lar f i e ld . 2. C l i e n t shou ld review proj-ec t team proposed by contractor. U N I T - P R I C E CONTRACTS, F L A T R A T E P D : Scope of work we l l def ined qua l i t a t i ve ly , -.vita approximate quanti ty known. 1. Const ruc t ion woik can com-mence without knowing exact quant i t ies invo lved. 2. Reimbursement terms are c lea r l y def ined. 1. Large quant i ty-est imate e r - , rors may resul t in c l i e n t ' s pay-ing unnecessar i l y high unit cos ts or contract extra. 2. Ex tens i ve c l i en t f ie ld su-perv is ion is required to measure ins ta l led quant i t i es . 1. Gas- t ransmiss ion p ip ing project. 2. Highv/ay bu i ld ing . 3. Insulat ion work in process p lan ts . Contractor shou ld define the methods of f ie ld measurement before the 'cont rac t is awarded. U N I T - P R I C E CONTRACTS, S L I D I N G R A T E P D : Scope of work we l l def ined qua l i t a t i ve l y . 1. Const ruc t ion v/o:k can com-mence without knowing quanti ty requirements. 2. Reimbursement terms ate Clear ly de f ined . Ex tens ive c l ien t f ie ld surer-v i s i on is required to measure in-s ta l l ed quan t i t i es . 1. Gas t ransmiss ion p ip ing project. 2. H ighway b u i l d i n g . 3. Insulat ion work in process p lan ts . Contractor shou ld c lear ly de-fine the methods of f ie ld meas-urement before the contract is awarded. C O N V E R T I B L E CONTRACTS P D : Va r i ab l e : depends on type of contract conve rs ion . 1. Des ign work can commence without delay of s o l i c i t i n g com-pet i t ive b ids . . 2. Cons t ruc t ion price is f i xed at time of contract convers ion , Vihen project is reasonably we l l -de f i ned . 3. Over -a l l des ign and con-st ruct ion schedule is minimum, w i th reasonable cos t . 1. Des ign may not be optimum. 2. D i f f i cu l t to obtain competi-t ive b ids , s ince ether c o n t a c t o r s are reluctant to bid aga ins tcon -tractor who performed des ign work. . 1. Where c l ient has conf iden-t ial project requir ing a balance of minimum project-t ime wi th reasonable cos t . • 2. '.'/here c l ient se lec t s part ic-ular contractor based on superior past performance. Contractors se lec ted on this bas is should be we l l known to c l i en t . T IME A N D M A T E R I A L S . P D : Genera l scope of pro ject . 1. C l i e n t may exerc ise c l ose control over cont ractor 's execu-t ion methods. 2 Contracto i is assured rea-sonable prof i t . 3 . Reimbursement • terms are c lea r l y de f ined . 1. Pro jec t cos t may not bo min imized. 2. Ex tens i ve c l i en t superv i -s ion is requ i jed . Management engineer ing serv-i ces suppl ied by consu l t i ng en-gineering fir:;:. E l im ina tes lengt'ay scope def in i t ion and proposal-prepare t ion t ime. FIGURE 7b ALTERNATE FORMS OF CONSTRUCTION CONTRACTS Source: John T. Gallagher, "A Fresh Look at Engineering Construction Contracts", Chemical Engineering, (September 11, 1967), p. 221. - U6 -The standard for measurement of each of these three elements i s established during the project development phase. Capital cost and value of the project are determined by the basic plant design. The optimum plant design minimizes capital cost and maximizes present value of future benefits. The composition of the plant and the estimated cost of the plant are defined by the construction budget. The project control system i s based on the assumption that the plant defined by the construction budget i s optimal. • ' ' ' .' • If the control system functions properly, deviations from the con-' struction budget are permitted only i f i t i s shown that the value of the plant can i n fact be increased as a result of the deviation. In many cases the determination of value i s quite.subjective. Since i n general deviations from the budget w i l l tend to disrupt and delay design and construction, changes should be limited to those cases where increased 13 value i s defi n i t e l y indicated by objective analysis. J The construction budget is a source-control document for control of design. Both design costs and plant scope are constrained by limiting design to the basic design established i n the project development phase, unless approval for a change i s obtained from project management. Design costs are also controlled by comparison to an engineering cost budget, also established during the project development phase.^ 13This system of instituting design constraints founded on an established baseline is used by the Apollo Spacecraft Project Office (ASPO) of the National Aeronautics and Space Administration (NASA) to control costs and schedules for the Apollo project. Deviations from approved plans require explic i t review and approval by ASPO. A description of the "Configuration Management and Control" system used on the Apollo project i s Included i n Richard M. Hodgetts, "An Interindustry Analysis of Certain Aspects of Project Management" (unpublished Ph.D. dissertation, Management Department, University of Oklahoma, University Microfilms, 1968). l^-For a discussion on control of engineering costs, see A. L. Spaet, "Controlling Engineering Costs", Consulting Engineer, (August 1963) 9p. 110. - U7 -Purchases of materials and equipment or finalization of contracts are reconciled with the construction budget. Special approvals should be required where items are not included in the defined scope of the pro-ject. Periodic reports are issued comparing expenditures plus estimates to complete with construction budget allocations. Estimates to complete : are based on actual status, not on.the balance remaining in the budget. J. H. Lutz notes, however, that cost reporting is not cost controlling. Where periodic cost reports, indicate significant deviations from the bud-get, appropriate corrective action must be initiated. If overruns cannot be avoided, the implications on project value must be evaluated. For construction work carried out under cost-plus or unit-cost arrangements rather than on a fixed price basis, i t is essential that comprehensive up-to-date cost records be maintained, and that the work be closely controlled to ensure compliance with the scope defined by drawings and specifications. In essence, primary cost control on a cost-plus arrangement reverts back from the contractor to the owner, unless contracts include bonus incentives to the contractor for reducing costs. Capital cost and value are also functions of the duration of design and construction activities. The value of the project varies inversely as the length of time over which negative cash flows take place. During the project development phase, a detailed schedule estab-lishing start and completion dates for major activities is prepared. Modern network (PERT/CPM) control methods are generally used for large complex projects. H. Lutz, "Estimating Project Completion Costs", Chemical  Engineering, (January 30, 1967)^p. l6h. - 1*8 -Very l i t t l e of the design and construction process is reversible or slavageable. Hence, i t is essential that status reporting and control procedures enable prompt and effective corrections of deviations from established standards. Start-Up During the early stages of the project implementation phase, plant organization and manning are finalized. As the construction of the plant nears completion, the plant supervisory staff must be engaged and pro-vision made for employing and training the operating and maintenance crews. In a company with existing operations, the nucleous for the operating organization is frequently obtained from existing plants. With new companies, key supervisory and operating staff must be enticed from firms with similar operations. Formal training sessions for area supervisors, foremen and operators are generally required to establish sufficient familiarity and competance to enable a complex plant to be put safely into operation within an acceptable time period, and at an acceptable cost. Training sessions may be guided or conducted by the engineering personnel who were respon-sible for the plant process design. Comprehensive operating and mainten-ance manuals, prepared specifically for the new plant, are used as source material for training sessions. As specific sections of the plant are completed they are accepted by the company, and the responsibility for these sections is assumed by the plant management. Operating personnel are often utilized to aid in the check-out and commissioning of equipment. -h9 -•Wherever practical, dry-run tests utilizing water and air are carried out before i n i t i a l manufacturing operations. Additional technical staff from the contractors or other company plants is usually provided to assist the plant operating staff during the start-up. Normal mill maintenance staff is also frequently not of sufficient size to cope with start-up repairs and modifications, and must be augmented with outside crews. Particularly v/here new products are being produced or new process methods are being initiated 1, start-up problems maybe extensive. : Finlayson and Gans cite planning as the key to a successful start-up. Preparation of detailed schedules, thorough training of operators, and rigorous plant testing are recommended.-^ Planning, scheduling and control of pre-start-up and start-up activities should be carried out in a manner consistent with those used for design and construction activities. Irrespective of their treatment for company account and taxation purposes, pre-start-up and start-up costs can be considered as part of the capital cost for profitability analysis and project management decisions. These activities have a significant effect on determining when negative cash flows cease and positive cash flows commence. Post-Completion Audit The post-completion audit is included in the project process because it arises directly out of the preceeding project activities, and because i t can be planned and scheduled in advance. The studies on corporate i^K. Finlayson and M. Gans, "Planning the Successful Start-Up", Chemical Engineering Progress, (December, 1967), pp. 33-39. - SO -investment policies by Helliwell, 1? Istvan, 1 8 Nicholson and F f o l l i o t 1 9 and Pfloraro20 indicate that while a significant number of firms do have established procedures for reviewing the results of investment decisions, the practice is by no means universal. It would seem irrational, however, to neglect to make an overall comprehensive review of such a unique and important corporate activity as a large investment project. The purposes of the post-completion audit cited by the National Industrial Conference Board study are: 1. To verify the resulting savings or profit. 2. To reveal reasons for project failure. 3. To check on soundness of management's proposals. U. To aid in assessing future capital expenditure proposals. 2 1 An objective analysis of a new plant's performance in reference to the perceived environment and parameters on which the decision to under-take the project was based, may reveal flaws in the original analysis. The detection of errors in the analysis may not be of much help in improv-ing the performance of the project in question, but i t may prevent errors of a similar nature from being made in the future. Analysis on a project basis may uncover specific areas where planned objectives are not being met.22 The failure in these areas may be due to •^Helliwell, op. cit. •^Istvan, op. c i t . •^Nicholson and Ffolliot, "Are Investment Practices Inadequate?", op. cit.j and "Investment Criteria of Canadian Companies", op. c i t . 20Pflomm, op. c i t . 2 1 I b i d , p. 8 0 . 2 2Ibid, p. 8 1 . - £L -sub-standard operating performance or to changes in environment. When • changes in environment can be identified, i t may be possible to improve profitability by revising operating plans and standards. To facilitate comparison with expected project performance, the plant must achieve normal' operating standards before the post-completion audit is taken. With a complex process plant, normal operations may not be attained for several months or more after start-up. The post-completion audit completes the last of the project phases introduced at the beginning of this chapter. CHAPTER IV PROJECT MANAGEMENT As the project proceeds, from the preliminary analysis phase into the comprehensive f e a s i b i l i t y study phase, the rate of expenditure by the firm on the project begins to accelerate, and the impact of the project on the firm's future becomes ever more s ignif icant . Eff ic ient use.of resources applied to the project and optimization of the future benefit of the project to the firm are largely contingent on the direct ion given by the firm's top management. Project objectives and constraints must be in accordance v<lth the firm's long-term goals. In establishing the scope for f e a s i b i l i t y analysis , management must ensure that objectives and constraints are adequately defined, but that definitions are not so res tr ic t ive that profitable opportunities w i l l be overlooked or prematurely discarded. Recognition must be taken of the influence of the new project on the firm' existing operations. However, care must be taken to prevent reactions of affected interests from causing biased analysis . The goals of a.comprehensive f e a s i b i l i t y study are to objectively analyze an investment opportunity, or a number of related alternate investment opportunities, to correlate the data forming the basis of the analysis into a form which can readily be perceived and reviewed by the firm's management, and to formulate conclusions and recommendations in a manner which w i l l permit the firm's management to make objective decisions - 52 -Decision-making by those involved in the technical analysis is l imited to determining what information T r i l l be directed to management, and how i t w i l l be presented. Technical analysis includes the elimination of obviously and c lear ly in fer ior and spurious alternates. Conclusions and recommendations, are drawn to aid management decision-making. Considering that the results of a major f e a s i b i l i t y study may have a cruc ia l influence on a firm's future, and that complex considerations involving .existing operations and the long-term pol icy of. the firm..may. d i rec t ly and s igni f icant ly influence the f e a s i b i l i t y study scope and resul ts , i t is essential that a major f e a s i b i l i t y study be closely directed and coordinated by a senior executive. A major f e a s i b i l i t y study may cost several hundred thousand dol lars . I f the goals and constraints of the f e a s i b i l i t y stud;/ are not compatible with the pol icy of the firm, the benefits derived from the study w i l l be greatly reduced. In some cases, outside consulting groups may be engaged to undertake specific, sections of the f e a s i b i l i t y study. Generally where outside groups are employed, part icular attention is given to establishing the ir terms of reference. However, to ensure optimum advantage of the consultant's output, periodic reviews and appraisals should be carried out by senior executives of the f irm. If several different groups of consultants are employed, their work must be coordinated. At the end of the f e a s i b i l i t y study stage, assuming that the decision i s made to proceed with the project, the emphasis for senior management responsibi l i ty shifts from considerations pertaining to the f irm's-long-term future to the measurement and control of capital cost, time and value.-- <k -Key decision points in the c r i t i c a l project development and implementation phases frequently bear extreme rewards and penalties, and once many major decisions are made they are irreversible. The firm must apply managerial resources which are consistent with the importance of project decision-making and.control. •' . As the scope of work being carried out i n relation to the project is enlarged, increasing contributions w i l l be required, from functional . groups• within the firm, and there, w i l l be increased . requirements', for . . . employing outside consultants and contractors. Managerial control must be compatible with the organizational levels within the firm at which . work i s being carried out, and with the requirements to commit the firm to contracture! agreements with outside parties. Organization :"' To meet these managerial requirements, for a major undertaking, the firm w i l l almost invariably establish a project group. The control of cost, time and value for the project w i l l be assigned to a special project group, rather than to functional departments. Hodgetts defines project management as . . the gathering of the best available talent to accom-plish a specific and complex undertaking within time, cost and/or quality parameters, followed by disbanding of the team upon completion of the undertaking".-1- Tnis organizational form is applicable under the following conditions: '1. The project is a large single undertaking, definable in terms of a specific end result. ^Hodgetts, op. c i t . , p. 7. - K -2. The attainment of the specific end result can be easily-recognized. 3 . The project is somewhat unique, infrequent, and not famil iar to functional management. In .The implementation of the project is complex, involving a high degree of interdependence and detailed and specific task accomplishment. 5. The. successful execution of the project is of c r i t i c a l o importance to the company. The construction of a large mult i -mil l ion dol lar plant would, essen-t i a l l y meet a l l of these conditions applicable to the project organiza-t ional form. Organization of tasks and personnel on a project basis i s typ ica l of consulting and construction companies which are continually engaged in this type of work. The centralized control of a project organization enables more effective and faster decision-making. Functional groups tend to be con-cerned mainly with their related a c t i v i t i e s ; they may frequently be over-zealous in guarding their own perogatives within the project; and they lack the f l e x i b i l i t y to change with rapidly changing project requirements. Project organization f a c i l i t a t e s maintenance of an overal l project perspec-t ive , and aids in the prevention of sub-optimization by participating functional groups.^ ^John M. Stewart, "Makine Project Management Work", Business Horizons, ( F a l l , 1 9 6 5 ) , pp. 56 - $7. ' A). J . Middleton, "How to Set-Up a Project Organization", Harvard  Business Review, (:.!arch - A p r i l , 1967), p. 75>. •• ^David I . Cleland, "Why Project Management", Business Horizons, (Winter, 1 9 6 U ) , p. 8 3 . - *6 -Projects are typically implemented under stringent time constraints. Thus, although key decisions bear major rewards or penalties, in general they must be made promptly and expeditiously. Delays can be tolerated only to the extent that they are l i k e l y to increase the value of the pro-ject. . Participating groups and.individuals working toward specific objectives at a predetermined pace to meet specific deadlines build up 'a momentum which can be destroyed by failure of project management to make .prompt decisions.. Since a project i s by nature somewhat.unique, the problems which . arise during i t s implementation w i l l tend to be somewhat unique. The use of operational rules and procedures i s limited in comparison to decision-making for more repetitive operations, and hence a relatively large number of 'decision points' w i l l require management attention. Project-type organization f a c i l i t a t e s prompt and effective decision-making. The quality of the managerial resources assigned to project .group determines i f the decisions made are correct. If preliminary analysis indicates that the likelihood of the project proceeding i s very high, selection of the project manager and key project personnel at. the start of the f e a s i b i l i t y study stage w i l l enable the earliest possible familiarization with environmental, inter-firm and technical parameters pertinent to the project. In the early stages, the project manager and some personnel may be u t i l i z e d on a part-time basis for project duties. Alternatively, the formation of the project group may be delayed u n t i l the commencement of the project development phase. Although f i n a l approval of the project may not be formalized at the start of the project development phase, this work is generally carried out on the assumption that the project w i l l proceed. To fac i l i ta te . compat ib i l i ty and coordination of a l l aspects of the .implementation of the project, the project manager's scope should include responsibi l i ty for pre-start-up ac t iv i t i e s such as organization and t r a i n -ing of operating and marketing personnel, as well as for design and con-struction of the physical f a c i l i t i e s . Planning and scheduling of start-up ac t iv i t i e s must be closely coordinated'with the f ina l stages of construc-t ion and operator tra in ing . Division of responsibi l i ty for directing s tart -up-act iv i t ies between project and plant" operating, personnel.will" vary, depending on the organization of the firm and the personnel involved. At some point during the start-up phase, however, responsibi l i ty for the plant is shifted ent ire ly to the functional operating group, and the project group is disbanded. The above discussion is centered on the project organizational requirements of the plant owner. A number of essential ly autonomous units , such as engineering consultants, equipment manufacturers and con-struction companies, w i l l almost certainly provide essential contributions toward the implementation of a large project. In any one of these p a r t i c -ipating units the respective undertaking may be of suff ic ient magnitude and complexity to ' jus t i fy project status. Within the autonomous unit the project group's function is to f u l f i l l the owner's requirements, subject to-the constraints imposed by the unit 's management and the contractural agreement between the owner and the autonomous unit . The project organi-zation within an autonomous unit w i l l be similar in scope and character to that of the owner, and this discussion is applicable to sub-projects, as well as to the overal l project. - 58 -Leadership Few major projects are ever successfully managed on a part-time bas i s . ' It is invariably desirable for the company to appoint a senior executive to act as the ful l - t ime project manager for a major undertaking.. Middleton suggests that an executive who already has a high position of responsibi l i ty be selected, or that the chosen executive be placed in a senior posit ion -within the firm's organization;.and that the project . manager be assigned as important a sounding t i t l e as those of functional unit managers.^ The requirements for a certain position and level of the project manager within the organization are dictated to a large extent by the need to direct and coordinate the work of functional groups toward the project goals. In projects included in a survey conducted by Hodgetts, the project manager was within two echelons of the vice-presidential leve l in a l l cases.? The firm's top management can prevent conf l ict by delineat-ing the extent of the project manager's authority over the project, and 8 by supporting him in his dealings with functional managers. The project.manager's responsibi l i ty is to complete the project within the cost and time l imitations established by the budget and the schedule. In general, the project manager w i l l delegate by task, so that the subordinate managers within the firm's project group and within auton-q omous units w i l l have essential ly equivalent responsibi l i ty for sub-projects.' ^Stewart, op. c i t . , p. 6 0 . ^Middleton, op. c i t . , p. ?8. ^Hodgetts, op. c i t . , p. 105. %iddleton, op. c i t . , p. 78. 9 P . 0. Gaddis, "The Project Manager",- Harvard Business Review (May -June, 1959), p. 91. • . - $9 --Personnel within the project groups may formally report to super-visors who are not actively engaged on work pertaining to the project. The project manager, as well as supervisors of sub-projects, must somehow obtain the f u l l support of these functional people who are responsible to someone else for pay raises,,promotion, and other.expected line superior-subordinate relationships.^ To enable accomplishment of the specified tasks, project managers and supervisors must often rely on persuasive ability, maintenance'of rapport with functional supervisors and staff, influence inherent with rank or technical standing, and informal bilateral agreements negotiated on an ad hoc basis.^ The traditional vertical functional organization is com-bined with the horizontal project organization to form a matrix structure across such functions as engineering, production, marketing, procurement and accounting. Within project groups, even where organizational structures are established along traditional superior-subordinate lines, work methods frequently differ markedly from the traditional authoritative model. Project management and engineering groups are composed principally of professionals and near-professionals. Project leadership must include explanations of the rational of the effort, as well as the more obvious functions of planning, organizing, directing and controlling. Effective management in this environment calls for the abandonment of the traditional 1 3 authoritative model in favour of a human resources model, where f u l l participation is solicited in.an effort to maximize individual contribution. 1 0Cleland, "Why Project Management", op. cit., p. 8h. n I b i d , p. 8U. •^ D. I. Cleland, "Understanding Project Authority", Business Horizons (Spring 1967), p. 6 9 . l^For an exposition on the Human Resources Model, see Raymond E. Miles, "Human Relations or Human Resources", Harvard Business Review', (July -August, 1965), pp. HB - 163. - 60 -The human resources approach i s founded on the assumption tha t p e o p l e , p a r t i c u l a r l y p r o f e s s i o n a l s , a re w i l l i n g and a b l e t o c o n t r i b u t e i n excess o f u s u a l and t r a d i t i o n a l demands. The environment o f a l a r g e c a p i t a l p r o j e c t p rov ides the i d e a l s tage f o r the e f f e c t i v e u t i l i z a t i o n o f the human resources model . M i l e s e s t a b l i s h e s - t h e s u i t a b i l i t y o f t h i s approach f o r p r o j e c t management i n the f o l l o w i n g passage.: .The human resources approach r e q u i r e s the manager to r e c o g n i z e , . .develop, and appl;/ - the f u l l range of r e s o u r c e s . o f h i s s u b o r d i n a t e s . One .of the major problems w i t h t h i s approach i s t h a t i t . . .works . [ People deve lop and grow - t hey grow r i g h t out of t h e i r i n i t i a l a s s ignments . This problem tends to s o l v e i t s e l f when a p a r t i c u l a r u n i t i s faced w i t h a l a r g e and c h a l l e n g i n g se t o f t a s k s to pe r fo rm. The members s i m p l y grow i n t o more demanding jobs w i t h added c h a l -lenge and added ' r e w a r d . " - ^ The t y p i c a l l y s t r i n g e n t t ime c o n s t r a i n t s and l i m i t e d a v a i l a b i l i t y o f t r a i n e d and competent pe r sonne l f o r l a r g e c a p i t a l p r o j e c t s v i r t u a l l y render e f f e c t i v e p r o j e c t management con t ingen t on the human resources approach . The method o f accomplishment f o r p r o j e c t t a sks must.accommodate t ime and c o s t c o n s t r a i n t s , and e x t e n s i v e interdependence between sub-groups . Many s p e c i f i c t a sks a re c r i t i c a l to the success o f the p r o j e c t , and a re o f ten unique and h i g h l y t e c h n i c a l l y complex. E f f e c t i v e communica-t i o n s w i t h i n the p r o j e c t group and between a s s o c i a t e d f u n c t i o n a l u n i t s i s e s s e n t i a l . I n the p r o j e c t o r g a n i z a t i o n , elements o f the h i e r a r c h a l v e r t i c a l c h a i n e x i s t , but prime emphasis i s p l aced on h o r i z o n t a l and d i a g o n a l communications and work f l o w . 1 ^ aymond E. M i l e s , "The A f f l u e n t O r g a n i z a t i o n " , Harvard Business  Review, (May - June 1966) , p . 112. l ^ C l e l a n d , "Unders tanding P r o j e c t A u t h o r i t y " , op. c i t . , p . 6 6 . - 6 1 -Particular leadership techniques are indicated for the project manager and supervisors to overcome 'authority-gaps', v;here personnel and functional groups are not d i rec t ly and formally responsible to the project management; and to effectively operate in a professional environ-ment, where communication and.authority-flow i s mult i -direct ional rather . than.vert ica l . Investigation carried out by Hodgetts into project leader-ship techniques in the aerospace, construction and miscellaneous industries indicates that prime importance is placed on negotiation, personality and persuasive a b i l i t y , competance and reciprocal favours. However, i t was found that where projects were very large, the 'authority gap' was eliminated, and personnel and functional groups were made d i rec t ly respon-sible to project management, to reduce the' necessity for unwieldy and time-consuming human relations methods.^ Successful project implementation is dependent upon effective leader-ship by the project manager, and by the supervisors of sub-projects. In the project environment, the optimal organizational and leadership model-is f lu id and mult i -direct ional; dependent upon compstance, part ic ipat ion, negotiation, persuasion and eff ic ient communications, rather than on the hierarchy of t radi t iona l pyramidal organization. In consideration of the constraints imposed by the l imited a v a i l a b i l i t y of human resources with respect both to quantity and qual i ty , the* ideal of project leadership i s . to develop a project tea-n which can 'play over i t s head' during the r e l a -t ive ly br ie f and f in i t e project duration. R. M. Hodgetts, "Leadership Techniques In the Project Organization", Academy of Ifenagement Journal, (June 1963), pp. 211 - 219. - 62 -Summary A major capita l project invariably has a significant influence on the future of a company. During the implementation of the project key decision points, which are essential ly irrevers ible and which must be handled with dispatch, regularly require attention. To e f f i c i ent ly administer a major capital expenditure, a competent and sufficient pro-ject group under a capable project leader is a necessity. The organiza-• . t ional methods and leadership tact ics required for project management' ' • 1 are more f lex ible and complex than tradi t ional arrangements. CHAPTER V PLANNING, SCHEDULING & CONTROL The cr i t er ion in implementing a capital project i s maximization of the project's benefit to the f irm. Achievement of this maximization •requires the control-of cost, tir,;e and value. Tne-foundation for control . of any undertaking i s the establishment of standards i n the form of budgets, schedules and specifications, which are based on sound plans founded on comprehensive and objective analysis . I n i t i a l planning i s carried out during the f e a s i b i l i t y study phase. This might be denoted as 'preplanning'. Based on preliminary market, engineering and economic analysis, preliminary flow diagrams and plant layouts which form a basic def ini t ion of the plant f a c i l i t i e s are pre-pared. -This preliminary plant specification' establishes the framework for plant capita l cost and future operating costs and revenues. The value of the project is also dependent oh the timing of cash outflows for plant construction and of cash inflows result ing from profitable operations. Tentative schedules for both negative and positive cash flows are prepared during the f e a s i b i l i t y study phase. During the project development phase, firm and re la t ive ly detailed standards for control of cost, time and value are established. Schedules and basic plant specifications are reviewed and amplified during the detailed design and. construction stages. However, the basic parameters - 63 -- 6U -are e s t a b l i s h e d as f a r as p o s s i b l e before i n t e n s i v e d e t a i l e d work i s commenced. This o r d e r l y development i s , o f c o u r s e , con t ingen t on t he r e be ing no major changes i n p r o j e c t scope once the p r o j e c t development phase i s comple te . ..••The compos i t i on o f the p l a n t i s the. prime de terminate o f . c a p i t a l . c o s t . The major d e c i s i o n s govern ing b a s i c p l a n t de s ign a re made d u r i n g the p r o j e c t development phase. I n a d d i t i o n t o p r o d u c t i o n process r e q u i r e -ments, . d e s i g n c o n s i d e r a t i o n must be g i v e n to f l e x i b i l i t y , r e l i a b i l i t y and e f f i c i e n c y . A good d e a l of d i s c r e t i o n and s u b j e c t i v i t y a re i n v o l v e d i n d e s i g n i n g f o r these l a t t e r t h ree r equ i remen t s . The key to c o n t r o l o f c a p i t a l c o s t i s the c o n t r o l o f b a s i c p l an t design.^- The c o n s t r u c t i o n budget , which was d i s c u s s e d i n some d e t a i l i n Chapter I I I , p rov ides a comprehensive d e f i n i t i o n o f the scope and compos i t ion o f the p l a n t and a d e t a i l e d accoun t ing o f es t imated c a p i t a l c o s t . The p r i n c i p a l o p p o r t u n i t y f o r c a p i t a l cos t c o n t r o l i s d u r i n g the f o r m u l a t i o n o f the c o n s t r u c t i o n budget . ^ A f t e r the budget i s f i n a l i z e d and approved, i t becomes the s tandard f o r measurement and c o n t r o l o f cos t and v a l u e . The major sub jec t o f t h i s chap te r i s p l a n n i n g , s c h e d u l i n g , and c o n t r o l o f the t ime f a c t o r o f p r o j e c t implemen ta t ion . P a r t i c u l a r a t t e n t i o n * i s focused on network-based systems (PSRT/CPM) as an a i d t o p r o j e c t management. P r o j e c t Implementat ion D u r a t i o n The investment model i n t r o d u c e d on page 19 i n d i c a t e d t h a t . a p r o j e c t ' s v a l u e cou ld be i n c r e a s e d by r educ ing the c a p i t a l cos t and /or the p e r i o d . P . S t u r g i s , "For B i g Savings - C o n t r o l C o s t s ' W h i l e D e f i n i n g Scope", Chemica l E n g i n e e r i n g , (August l b , 19&7), pp . I S 8 - 190. - 65 -over which project cash flows are negative. Capital costs can be broken down into two components - direct costs for labour and materials; and indirect costs for project management, construction f a c i l i t i e s , and so forth . Both direct and indirect costs are influenced by the project duration. .• • ; . Direct cost for materials - structural steel , cement, equipment, piping - generally does not vary according to the construction schedule, unless normal deliver;/- time is inadequate and more prompt delivery entai l greater cost.' Direct cost of labour - engineers, draftsmen, equipment operators and welders - is essential ly an inverse function of the time period over which the work is carried out. If ten days are required to erect one hundred tons of structural steel using a crew of ten men, i t does not follow that the steel can be erected in five days by increasing the size of the crew to twenty men. Due to ineff iciencies in working with the larger than optimum-sized crew, doubling the crew might only reduce the erection time from ten days to six days. This is based on the assumption that constraints of the job would not enable two ten-man crews to be u t i l i z e d . I f a man-day costs *75> the labour cost for erect-ing the structural steel would be increased from *75 per ton to S°0 -per ton as a result of. reducing the erection period from ten days to six days In keeping with this concept of diminishing marginal productivity as the work duration is shortened, the plot .of project direct-cost vs duration may be expected to be concave from above. Indirect cost may generally be assumed to vary as the project duration on a l inear basis . In many cases a specif ic indirect cost would be a step function of project duration; however, a l inear approximation for to ta l indirect costs is a reasonable s impl i f icat ion. - 66 -The typical form of direct, indirect and total cost as functions of project duration is shown in Figure 8. Scheduling a project duration longer than the period at which total cost is. minimized is irrational, as both duration and cost are greater than at the minimum point. Cost A FIGURE 8 PROJECT COST AS A FUNCTION 0? IMPLEMENTATION 'DURATION t 0 is the Implementation Time for minimum project cost. The minimum feasible duration, t c , is called the 'Crash Time'. Beyond this point, the productivity of additional resources applied to the project is assumed to be negligible. The curves are based on the assumption that resources are utilized at normal efficiency. Any point which lies above the curves is feasible, but represents an inefficient utilization of resources. - 6 7 -Conceptually, project c a p i t a l cost can be expressed as a function-of the project duration and the investment model, revised to include optimization of the project duration. Maximize: n m . . \ - t c N P V - T V £2t . - y j ( 1 + r D ) t - 1 t c ~ 1 (t S 1 , 2 , 3 . . . . n) ( t c =. 1 , 2 , 3 . . . T I I ) m Where: y~ I t c - f(Max-tc)' t c " l t c * l Subject to: r Q ^ K Where NPV i s Project Net Present Value, CB^ i s the Cash Benefit i n Year t , I t c i s the Investment i n Year t c , r 0 is-the firm's Opportunity Cost, and K i s the firm's Cost of C a p i t a l . Meaningful estimation of a c a p i t a l cost-duration function i s contin-gent on e s s e n t i a l l y complete plans f o r plant construction. Formulation of planning to the required degree of d e t a i l i s not possible u n t i l vrell into the detailed design stage. However, due-to lead time required for.major engineering and equipment f a b r i c a t i o n a c t i v i t i e s , tentative completion dates for key events, including project completion, must be established early i n the project development phase. Thus, optimization of project duration according to the above model i s generally not p r a c t i c a l . Key completion dates can be established on the basis of judgment and experience. A l t e r n a t i v e l y , crude analysis could be carried out, based on rou.ph estimations of c a p i t a l cost at the extreme minimum cost - 68 -and crash durations. • I f project p r o f i t a b i l i t y is high and incremental costs for expediting project completion are not excessive, i t is feasible that the crash duration may be optimum. The time required for f i e l d construction i s generally the pr inc ipal determinate of the to ta l implementation duration of the project. The duration of f i e l d construction i s d i f f i c u l t to estimate. Figure 9 i s an example of a rough guide suitable for establishing key completion dates. System Requirements Control of the time factor of project implementation i s accomplished by measuring the actual progress of the project against established schedules. Before schedules can be prepared, i t i s necessary to establish basic c r i t e r i a for planning, and then to plan the project implementation. Kackney defines planning and scheduling as follows: Planning is the determination of the individual operations or ac t iv i t i e s which must be performed in order to carry out a project, and the establishment of the sequential and dependency relationships between them. Scheduling i s the development of time requirements for each operation or ac t i v i ty .and the relat ing of each to calendar.time.2 Good planning hinges on a clear def in i t ion of the objectives and constraints which govern the manner i n which- the project can be implemented. The major problems .which impinge on basic planning are: 1. What are the major segments of the undertaking and how are these major segments related to one another? 2. What resources are available to complete various sections of the work? 2Kackney, op. c i t . , p. 106. - 69 -100 80 60 £ 40 20 1 1 1 1 1 11 1 1 1 1 1 11 1 1 1 1 1 1 I I I I 1 1 1 1 111 1 1 1 I I 1 I I 100,000 1,000,000 Field force man-hours Optimum time in field, from start of foundations till ready for commissioning. 80 90 100 110 120 130 140 150 160 Job duration, % of optimum (see also Figure 8) Job duration, effect on labor productivity. FIGURE 9 OPTIMAL FIELD CONSTRUCTION DURATION Source: J. Vi. Hackney, Control and Management of Capital Projects, (New York: John Wiley and Sons, 1 9 6 5 ) , p. 6 3 . - 70 -3. How w i l l the available and viable resources be organized and which ac t iv i t i e s w i l l be assigned to which resources? Unt i l the .early l°60 ' s > planning and scheduling were generally based on the u t i l i z a t i o n of Gantt bar charts. With bar charts i t i s d i f -f i c u l t to account for dependencies, between ac t iv i t i e s and to separate the planning and scheduling functions. Control points are established by assigning target dates to milestones which are key or major events, based on planned work accomplishment. The establishment of target dates is to a large extent arbi trary , based on subjective judgment and past experience on similar projects. In the late 1950's, two similar network-based systems for project management were developed in an attempt to overcome, the faults of t rad-i t i o n a l systems and to enable better control of project cost, schedule and performance. The f i r s t system, known as the c r i t i c a l path method (CPM) was developed in 1957 - 1958 by M. R. Walker of DuPont and J. E. Kelley of Remington Rand. The other system was developed for the U.S. Navy in 1958 - 1959 by the consulting firm of Booz, Al len and Hamilton, and is known as the Program Evaluation and Review Technique (PERT). 3 Network-Based Management Systems (PERT/CP?.!) CPM was developed primarily for the planning, scheduling and control of maintenance and construction projects. CPM is act ivi ty-oriented and deterministic. Specific duration's'are assigned to each ac t iv i ty , and a single expected occurrence date is calculated for each event. PERT was 3 C e c i l E . Law and David C. Lach, Handbook of C r i t i c a l Path, (Montreal, 1965), p. 2. (Handbook for CPM Course-at McGill University) . - 71 -developed for controlling vast and sprawling weapons system projects and R&D programs. The f i r s t use of PERT was for the Polaris Missile pro-ject. PERT is event-oriented and probabilistic. Multiple estimates may be made for activity durations, and a probability distribution gen-erated for the expected occurrence time of each event. Generally, CPM is more amenable to construction projects where resources are essentially unlimited and a time constraint is imposed; while PERT is applied to military and.'R & D projects where resources are limited and there is no time constraint.^ The use of multiple-time estimates in PERT is diminishing, and PERT is also tending to become more activity-oriented. PERT tends to be organized from the point of view of the man at the top, who is interested in reviewing and controlling progress, and in the completion of major sections of the work. CPM is organized more from the point of view of the man at the bottom - the man who must actually see that the work is performed.^ The separate systems are now tending to be merged into an overall and general system which is both activity- and event-oriented, and which can be tailored to suit the specific project requirements.^ The following discussion is intended to apply to the more general PERT/CRM network' concept, rather than to a particular system.''' ^J . p.. i . Tyas.,- Pertaining to PERT, (Ottawa: Queen's Printer, 1966), p. 60. ' *La w and Lach, op. cit . , p. 25>2. ^Russell D. Archibald and Richard L. Villoria, Network-Based Management Systems (PERT/CPM), (New York: John Wiley and Sons, 1966), p. It. " ^In the early 1960's, a number of other less-well known acronyms including HEPP, ICON, IMPACT, LESS, PAR, PEP, PRISM, SPSRT and TOPS* were promoted. These have now generally given way to PERT and CPM. For a listing and synopsis, see Robert W. Miller, Schedule, Cost and Profit  Control with PERT (New York: McGraw K i l l , 1963),Appendix 3, pp. 207 - 2 l £ . - 72 -The "relatively rapid recognition and acceptance of network systems in the bui lding and engineering construction industry is i l lus trated by the following conclusion to a 1962 ed i tor ia l in the highly pragmatical Engineering News Record; CPM • . ..marks, a major breakthrough for sc ient i f ic management into construction - comparable in i t s impact to a major advance in £ p h y s i c a l ] technology. It forces builders to substitute expl ic i t knowledge, rigorous analysis and clear understanding for mental calculat ion, rough estimation and in tu i t ion . In the intensively competative f i e ld of construction, progress in management techniques as well as in ^physical] technology may well be a condition of survival ." Planning The detailed rules and methods for constructing networks and for calculating expected completion dates for a c t i v i t i e s , slack or float times and so forth are well covered i n a large number of good and readi ly available books and monographs, and w i l l not be discussed in d e t a i l . The thesis bibliography l is ts , several recent publications which provide this information. A simple example of a network system w i l l , however, be presented br i e f l y to i l l u s t r a t e the system attr ibutes . This example may be somewhat d i f f i c u l t to follow for anyone who has not had some prior experience with PERT/CPM. However, the basic logic of a network diagram is quite simple and self-evident. Arrows are used to represent a c t i v i t i e s . Nodes are used to represent events, which are the starting and completion points of each a c t i v i t y . A network (or arrow diagram) is prepared to show the log i ca l sequence and dependency of ac t iv i t i e s and events. Figure 10 shows a simple network which i l lus trates the plan for construction of a- house. Q °Anonymous, Editorial,"CPM and Survival", Engineering News Record, (July 19, 1962), p. 116. - 7 h -For example, referring to Figure 1 0 , the arrow 7 - 9 represents the a c t i v i t y , f ina l ize financing. The node, 9 , represents the event, f ina l i za t ion of financing. Dotted arrows such as 6 - 7 are dummy ac t iv i t i e s which take no time and consume no resources. They are used to show network log ic . The network is simply .a. diagram, showing the log ica l sequence and-.dependency of the major a c t i v i t i e s . Only eighteen ac t iv i t i e s are shown. The number of ac t iv i t i es could be expanded many times to show more d e t a i l . Act iv i ty 10 - 1 1 , for example, could.be broken down to show detailed ac t iv i t i e s such as purchase lumber, form basement, pour concrete and so forth, which the contractor must undertake i n order to bui ld the house. The contractor may prepare his own network to plan his part icular respons ib i l i t i e s . Each a c t i v i t y which leads into an event must be completed before any a c t i v i t y which starts at that event can be started. For example, before the owner, can move into his house - ac t iv i ty 15 - 16 - each of the three ac t iv i t i e s leading into ..event l £ must be completed. If in fact the owner i s able to move into his house with one or more of these three ac t iv i t i e s not complete, the logic shown is incorrect . Different ac t i v i t i e s shown on the network are the responsibi l i ty of different parties - owner, architect , contractor, furniture store, '. The network shows the dependency between the efforts of the various par-t ic ipants , and enables the manager to establish the effects of delay by one participant on the ac t iv i t i e s of other participants. With a re la t ive ly simple project l ike the.construction of a new house, an experienced manager could visual ize the dependencies and act to control the project without the a id of a formal logic network. In - IS -effect, he would u t i l i z e an impl ic i t logic network contained in his head, rather than an expl ic i t logic network drawn on paper. Since the imple-mentation of a large engineering construction project involves several thousand readily-definable a c t i v i t i e s , even a sk i l l ed and experienced manager or project management team can visual ize only very roughly the implementation logic without expl ic i t and thorough analysis . A network diagram provides an operational framework for analysis and fac i l i ta te s display of the log ica l sequence and dependency of project a c t i v i t i e s . The network logic does not have expl ic i t s c i en t i f i c , behavorial, or empirical basis . At no point is the network self-generating or corrective. The logic of the network can be no better than the logic of the planners who prepare i t . The network shown on Figure 10 was prepared without any considera-t ion being given to the time required to complete specific a c t i v i t i e s , or to the to ta l duration of the project. The network concept allows i n i t i a l planning to be completed before scheduling is commenced. After completion of the network diagram, the expected duration of each a c t i v i t y can be estimated independently. Considering each a c t i v i t y independently in this manner prevents fudging and biasing estimates to meet previously established milestone-dates, .as is inevitable when Gantt bar charts are u t i l i z e d in planning. The estimated time for each a c t i v i t y is shown below the arrow. Starting at the f i r s t event in the network, the earl iest occurrence time for each event can be calculated by determining the time required for the longest series of ac t iv i t i e s leading up to each respective event. The earl iest occurrence date for the f i n a l event in the project is the earl iest date oh which the project can be completed. The earl iest occurrence date - 76 -for each event, Tg, i s shown in the upper left-hand corner of the event c i r c l e . The calculation of the earl iest expected occurrence date for each event i s known as the forward pass. A target date for completion of the project can now be assigned. , In our example, we w i l l assume, that the target date,for project comple-t ion is to be day 220.. This is noted as the latest allowable occurrence time, T^, for event 16 . Working backward, the latest allowable completion time for each event which w i l l permit the project to be completed by day 220 can now be calculated. This is known as the backward pass. I f we now look at an a c t i v i t y , for example, 8 - 10, we see that the earl iest possible start for this ac t iv i ty is. day 60, and the latest possible f in ish which w i l l not delay the project completion beyond the target date is day 90. The maximum allowable duration for this a c t i v i t y i s thus 90 minus 60, or 30 days; which is 20 days more than the estimated required time of 10 days. The 20 days is known as the to ta l f l o a t 9 for a c t i v i t y 8 - 10. This is the maximum number of days that ac t iv i ty 8 - 1 0 may s l i p without delaying project completion beyond the target date, assuming that a l l ac t iv i t i e s preceeding event 8 are started as early as possible, and that a l l succeeding ac t iv i t i e s after event 10 are started as la te .as possible. • The path through the network which is comprised of events having the minimum amount of f loat is known as the ' c r i t i c a l path' . Tne c r i t i c a l path on the example network i s shown as a heavy l ine . If the tota l s l i p -page of events along this path exceeds 20 days, the project completion w i l l be delayed beyond the target date. .9 'Float ' is synonomous with ' s lack' . - 77 -Events not on the c r i t i c a l path can be allowed more slippage without delaying the completion date. For example, ac t i v i ty 8 - 1 2 requires only 3 0 days and the ear l ies t start is day 60, and the latest f inish i s day 2 1 0 . Hence, tota l f loat for a c t i v i t y ( 8 - 1 2 ^ = ( 2 1 0 - 6 0 ) - 3 0 = 1 2 0 days. /That is., i f a l l preceeding ac t iv i t i e s are started as soon as possible and a l l succeeding ac t iv i t i e s are started at their latest feasible date, the •duration of this ac t i v i ty is permitted to be 1 2 0 days longer than estimated without, delaying the project. In the example, the target completion date for the project was established later than the earl iest possible completion date. It is more usual to set the target date as the earl iest completion date, and hence the c r i t i c a l path w i l l have zero f loat . The target completion date could have been set ear l ier than the earl iest completion date, and i n this case t h e . c r i t i c a l path would have had negative f loat . The path with the least posit ive f loat , or alternately with the greatest negative f loat , is the c r i t i c a l path. Free f loat , which is the excess time allowed for an ac t i v i ty when a l l preceeding ac t iv i t i e s are completed as soon as possible and a l l succeeding ac t iv i t i e s start as soon as possible, can be calculated in a similar manner. Independent f loat is the excess time allowed for.an a c t i v i t y when a l l preceeding ac t iv i t i e s are started as late as possible, and a l l succeeding ac t iv i t i e s start as soon as p o s s i b l e . ^ The network - enables the planner to distinguish between those ac t iv -i t i e s which are cr i t i c? . ! to the.attainment of target completion dates from those non-cr i t i ca l ac t iv i t i e s which can be allowed to s l i p . Typical ly , i ° A r c h i b a l d and V i l l o r i a , op. c i t . , p. 1.02. - 78 -no more than 5 to 15 per cent of the project activities v a i l be on the critical path. The functions and attributes of the network diagram may be summar-ized as follows: b) It shows the sequence and interrelationship of activities. c) It clearly defines responsibilities. d) It separates planning and scheduling, and aids in the production of a coordinated schedule. e) It aids in the identification of specific problems early in the project. f) It separates urgent things from important things. g) It is a simple and clear communication tool. h) It allows management by exception. i ) It measures achievement against plan. j) It enables the simulation of alternate^plans, so that they can be tested before using them. The planning summarized by the network diagram indicates when things can be done; scheduling determines when they should be done for best" a l l -around project effectiveness. ^  The resources which must be scheduled are manpower, materials, equipment, and money. Scheduling of industrial projects is generally centered on manpower, materials and equipment. a) It is'the basis for consideration and' construction of a Scheduling ' 11Law and Lach, op. cit., p. 162. •*-2Tyas, op. cit., p. 6. •^Kackney, op. cit., p. 12U. - 79 -Money is generally made available to suit the required schedule, although i n some case, projects may be stretched out due to financing l imitat ions . Ac t iv i t i e s on t h e . c r i t i c a l path are given f i r s t p r i o r i t y in estab-l i sh ing schedules. If the c r i t i c a l path has zero float for the given project logic and a c t i v i t y durations, the schedule for. c r i t i c a l ac t iv i t i e s i s f ixed. 'Schedule constraints are also imposed by equipment del iveries and imposed dates for key milestones. For example, when plants are con-structed .in northern regions, i t i s usual to require that buildings be closed in before the onset of. cold weather in the f a l l to permit equipment erection to continue in closed and heated buildings. There may be more than one c r i t i c a l path and some c r i t i c a l paths may terminate at milestones. The i n i t i a l network logic i s generally based on the assumption that there are no constraints on the a v a i l a b i l i t y of manpower or equipment resources. A possible exception might be where i t is known that specific resources w i l l be required for several a c t i v i t i e s . In cases of this sort, the constraint would be taken into account in the network. Non-cr i t ica l ac t iv i t i e s could be simply scheduled to commence at the earl iest possible time. This would provide the maximum available margin to accommodate slippage. It is desirable, however, to avoid excessive fluctuations in the level of manpower and equipment inputs, .and to minimize peaks. This applies both to to ta l input as wel l as to specif ic resources. The f loat available on non-cr i t i ca l ac t iv i t i e s i s u t i l i z e d to prepare a schedule which enables manpower and equipment l eve l l ing . Delaying the start of ac t iv i t i e s to accommodate l eve l l ing reduces the available f loat , and .more ac t iv i t i e s tend to the c r i t i c a l state. - 80 -F a i r l y reasonable schedules can be prepared by t r i a l and error, but i t is desirable, of course, to use a more formalized and rat ional method.""^ Unfortunately, a r ig id mathematical solution is beyond current technique.-^ Operational but somewhat tedious and cumbersome manual .methods, which aid in formulation of good i f not r i g i d l y optimum schedules, are ava i lab le . 1 ^ Considering that the network logic w i l l almost certainly not be"optimum, that estimated ac t i v i t y durations may be s igni f icant ly . in error, and that the schedule w i l l generally be revised as the project progresses, such' sub-optimization cannot be considered a- serious handicap. Resource l eve l l ing operations must take into account a c t i v i t y p r i o r i t i e s and desired resource levels . Even though manual methods are slow, cumbersome and prone to error,, programming resource scheduling and al locat ion for computor solution has had limited application due to the 17 complexity of the problem. ' One of the most sophisticated programs, RAMPS, developed by du Pont and C-E-I-R Inc . , has not been widely used 18 due to the d i f f i c u l t y in setting up the required input data. v I f the earl ies t project completion date determined by the i n i t i a l network analysis is not acceptable to management, a number of techniques for 'shortening' the c r i t i c a l path are available: •^ •'R. L . Martino, Project Management and Control, V o l . I l l , Al locating and Scheduling Resources^ (New York: American Management Association, 1 9 6 5 ) , p. 12. — ^ I b i d , -p. 1U. l 6 F o r example., see Ibid; or Law and lach, op. c i t . . Chapter X. A good description of the heuristic programming technique for project scheduling is Included in J . D. F i e s t , "Heuristic Programs for Decision-Making", Harvard. Business Review, (September - October, 1966), pp. li|0 - II4.3-• 17 18 Law and Lach, op. c i t . , p. 238. Archibald and V i l l o r i a , op. c i t . , p. 228. - 81 -1. Revision of network log ic . 2. Placing preliminary equipment orders. 3. Providing temporary f a c i l i t i e s . l i . Elimination of non-essential components. '•5'. ' Crashing c r i t i c a l a c t i v i t i e s . . ^ ' In describing the preparation of a logic diagram, i t was stressed that the diagram was merely an expl ic i t presentation of a particular method of. implementing the project. I f the i n i t i a l plan i s : n o t accept-, able, i t can be reviewed and revised. In part icular , c r i t i c a l ac t iv i t i e s can be closely scrutinized to see i f more ac t iv i t i e s can be overlapped, and to see i f a l l preceeding ac t iv i t i e s must be 100 per cent complete. Design ac t iv i t i e s may be started ear l ier by basing i n i t i a l design on sound assumptions, where more exact datais not yet avai lable . Construc-t ion activit ies ,may be started ear l ier by placing preliminary blanket orders, and by provision of temporary f a c i l i t i e s . Non-essential ac t iv i t i e s may often_be delayed u n t i l after 'project completion', although extra cost might be involved. It was shown ear l ier that to ta l project cost yras an inverse function of project duration; that i s , project completion time could be shortened at the sacri f ice of increased cost. To demonstrate this fact , an example •was given of a specific a c t i v i t y - erecting structural s teel . Estimation of a cost-duration function for an entire project is d i f f i c u l t . However, i t i s feasible to estimate such a function for a particular ac t i v i ty . A reasonable representation is enabled by estimating the normal cost and 19See Law and Iach, op. c i t . , p. l £ 6 . - 82 -duration and the crash cost and duration, and assuming a l inear re la t ion-ship. This i s shown in Figure 11. FIGURE 11 ACTIVITY COST AS A FUNCTION OF DURATION The slope of the l inear approximation gives a cost per unit of time for crashing the particular a c t i v i t y . To shorten the c r i t i c a l path, c r i t i c a l ac t iv i t i e s can be selectively crashed, commencing 'with the act iv -i t i e s which have the lowest oost per unit of time gained. As c r i t i c a l ac t iv i t i e s are crashed, ac t i v i t i e s which were not on the c r i t i c a l path, but which had small slacks, w i l l tend to become c r i t i c a l . Manual methods, as well as computer programs, are available for systematically crashing . . 20 projects. ^ u For a detailed procedure for manual calculation, see John Y/. Fondahl, A Non-Computer Approach to the C r i t i c a l Path Method for the Construction  Industry, Technical Report No. 9, Second Edit ion, (Stanford, Cal i fornia: Department of C i v i l Engineering, Stanford University, 1962), Several standard computer programs are cited by law and Lach, op. c i t . , p. 167. - 83 -Implementing PZRT/CPM Optimization of the benefits of network-based management systems i s contingent on systematic planning and implementation of the system. The .-following questions must be answered in the preplanning stage: • 1. What are the project objectives?. 2. What are the major elements of the vrork to be performed and how are these elements related to one another? 3. What organizations are available to perform the work and how can they be organized? l l . Who w i l l be assigned responsibi l i ty for various sections of the work? 5 . What w i l l be the information requirements of various 21 levels of management? The planning, scheduling and operating cycle is shown on Figure 12. A useable def ini t ion of project objectives for planning must be considerably more def ini t ive than the broad concept - to maximize the firm's wealth - that we introduced in Chapter 2. Project objectives are developed into i n i t i a l useable form during the f e a s i b i l i t y study phase. The project specifications, which we now c a l l the project objectives, are determined by the interaction of the market, product, and production process variables . Project objectives in this sense are work packages referring to specific physical f a c i l i t i e s or to tangible services and systems. Construction of a chlorine dioxide plant and the employment, organization and training' of a sales force are examples of such def ini t ive project objectives. ^Arch iba ld and V i l l o r i a , op. c i t . , p. 23. - 8U -Define Objectives X I Establish Work Breakdown Structure Revise i f Necessarv Define and List Tasks Construct Networks I — -Recycle i f Necessary Management Review Analyze • Plans' and Schedules Estimate Activity Durations JL Develop Schedules ± Approve Plans and Schedule Planning & Scheduling Phase Authorize Y/ork Accumulate Actual Time Data Revise Program, Plans and Schedule When Necessary Decide on Action Process Prepare Incut Reports Data . • r . Evaluate Analyze Project Reports Status •4-Control Phase FIGURE 12 (PERT/CPM) PLANNING, SCHEDULING AND OPERATING CYCLE References: J . P. I. Tyas, Pertaining to PERT, (Ottawa: Queen's Printer, August 1 9 6 6 ) , p. 1 0 ; R. D. Archibald and R. L. Villoria, Network:. Rased Management S:/stems, (New York: John Wilev and Sohs, 1 9 6 5 ) , p. 1 U 3 . - 8 5 - , The major elements of the work are defined by a work breakdown structure, which i s a detailed l i s t i n g of project objectives. Packages in the work breakdown structure aire summarized in levels or t i ers of increasing d e t a i l . The level of maximum deta i l may vary according to the character of the. work package. For example, re la t ive ly minor items of equipment might be l i s t ed in the detailed accounts of the construction budget, while work packages pertaining to sales force operations might be summarized in less d e t a i l . ' The work breakdown structure: a) Defines the project tasks to be performed. b) Establishes the task's relationship to the project end items and project objectives. c) Establishes the framework for planning and scheduling . d) Establishes a framework for summarizing the schedule status of the project for progressively higher levels of management. e) Establishes the basis for constructing the . . . network of project c of d e t a i l . 2 2 t , ,activit ies and events at the desired leve l Ideally, network formulation would be commenced at the maximum level of d e t a i l , and less detailed summaries would be prepared from the bottom up. For. an engineering-construction project, detailed def ini t ion of construction ac t iv i t i e s is not possible u n t i l detailed design is well advanced. Since i n i t i a l planning must be undertaken before detailed data i s avai lable , less detailed networks must be prepared i n i t i a l l y . As detai ls become avai lable , these networks may be 'exploded' to show the reouired degree of de ta i l . 22 Tyas, op. c i t . , p. 13. - 8 6 -The level of f i n a l de ta i l w i l l , of course, depend on the circum-stance. Law and Lach suggest that no ac t i v i ty should be longer than one or two reporting- periods, should be no longer than 5 per cent of the to ta l project duration, and should not involve more than 5 per cent of the to ta l 23 •project resource input.. J At the maximum level of d e t a i l , i t is not feasible on a large pro-ject to represent a l l ac t iv i t i e s on a single network. 'Subnets' or 'fragnets', .which show specific- portions of. the project, are prepared. , The. fragnets are linked by common, interface events, and may be summarized by less detailed master networks. The act ivi ty-oriented approach of CPM fac i l i ta tes analysis at the maximum leve l of d e t a i l , while the event-orientation of PERT fac i l i ta tes network summarization. A key influence on the development of PERT was the necessity for summarization at several levels of d e t a i l . Systems which are activity-based at the maximum leve l of de ta i l and which are summarized by events are convenient where summary networks must be pre-p a r e d . ^ As the project progresses, actual completion dates are accumulated and compared.with the scheduled dates. Where deviations occur, the effect i s assessed and corrective action Ini t iated as required. Period-i c a l l y the network is up-dated by substitution of actual data for the estimated data for completed a c t i v i t i e s . Recalculation may indicate the need' for a change in plans. Ac t iv i t i e s which were' c r i t i c a l may become n o n - c r i t i c a l , and non-cr i t i ca l ac t iv i t i e s c r i t i c a l . Where the need i s indicated, plans and schedules are revised. 2 3 Law and Lach, op. c i t . , p. 35. 2 k l b i d , pp. 199 - 205. It is inevitable that flaws will be revealed in Initial plans, and that expectations will not be realized. Revisions to plans and schedules are necessary in every project, so i t is essential that plans and sche-dules be updated to current conditions. Replanning and rescheduling at every reporting period is not.likely to be practical, but revision should not be postponed until there are major changes. The network logic facilitates simulation of proposed plans. As the project develops and problems are encountered, alternate methods of attack-ing the problem may be tested. As a typical engineering project approaches start-up, i t is usual for schedules to break down to a large extent, and construction work may be monitored on a punch-list basis. Completion of final activities is governed not so much by sequence and dependency constraints as by resource limitations and priorities. As start-up approaches i t may be desirable to curtail network-based reporting and control, at least on a detailed-activity basis. If a network has more than a few hundred activities, manual computa-tions are slow, prone to errors, and likely to be expensive. Computers, in general, are used where manual methods are more expensive, or where manual methods are too slow-and inaccurate to provide useful results. Network calculations for a large project qualify on both counts. In selecting a computer and computer program, factors which must be con-sidered include: accessibility, simplicity of use (node number rules, input requirements, error checking, report layouts, calendar dating, sorting techniques), program capacity, and crashing and resource alloca-tion capabilities. ^ Law and Lach, pp. 255 - 265. - 88 -Summary Network-based management systems (PERT/CPM) are powerful tools, enabling improvement in the efficiency of project management. Hackney reports that a 1965 survey/ by the Cost Control Committee, Metropolitan Section,' American Association of Cost Engineers, indicated that 86 ' per cent of engineer-contractors were using some form of-network-activity OA scheduling. A questionnaire distributed by Schoderbek at about the same time to 200 firms Included in Fortune's list.of the top 5Q0 indicated that approximately one-half were using PSRT/CPM.^ ' Improved control, ability to stay on top of the job, and ability to compare progress with scheduled goals were the major advantages cited by respondents. The mot-ivation and training of personnel rather than technical problems were generally considered to be the most difficult areas in application. Schoderbek concluded that: Despite its limitations . . . (PFRT/CPM^is a tested and workable tool for providing management with a maximum of planning and control for complex projects of a non-repetitive nature.2^ R. L. Martino, Y.>ho participated in the earliest commercial utilization of network systems, suggests that a 'new breed' of management is imminent: • . . project management is the function of judiciously allocating resources to accomplish pre-selected objectives according to a plan and-schedule, and reacting to deviations between predicted and actual results to forestall the development of unfavorable situations. Being a manager requires a balance 'between subjective ability and objective (or scientific) method. . ^Hackney, op. cit., p. 129. 27p eter P. Schoderbek, "A Study of the Applications of PERT /CPM ',' Academy of Management Journal, (September 1965), pp. 199 - 210. 2 3Ibid, p. 206. - 89 -We are members of a new breed of management. This new breed cannot "afford to operate on its wits alone as management in the past was able to do. Whether we like i t or not, as members of this new breed, we ?.re compelled to understand and to use, a l l the new manage-ment techniques at our disposal. We cannot launch a new product (whether i t be a toy or a missile), we cannot erect a structure (whether a house, a bridge, or a gigantic industrial complex), and, indeed, we cannot successfully complete any project unless we plan and schedule the work and then control its completion. It is no longer a question of will we use new techniques,' but rather of when.. The when is nowi 2 9 2 9R. L.. Martino, Project Management and Control, Vo. II, Applied  Operational Planning, (New York: American Management Association, 196U), p. 162. . CHAPTER VI CASE STUDY . A case study of a hypothetical project m i l be used in th to i l l u s t r a t e the comprehensive f e a s i b i l i t y study, project development, and project implementation phases discussed in Chapter I I I . The case w i l l be based on actual projects, for which Sandwell and Company Limited has been responsible for the engineering analysis and design and a major portion of the project management a c t i v i t i e s . Sandwell is a major consultant special-iz ing in the forest products industry. An excerpt from a compan?/- brochure, included in Appensix B, i l lus trates the range of services offered by Sandwell. It is necessary to use a hypothetical rather than an actual project, as work carried out by Sandwell is confidential between the company and i t s respective c l i en t . Nevertheless, the case i s r e a l i s t i c . Actual data from several completed projects was used to synthesize the data for the hypothetical project. The data base includes Sandwell project f i l e s and first-hand observations by the author, who has been employed by Sandwell since' 1°63« Typical examples of key items of project documentation are included in Appendix A. In the Canadian pulp and paper industry, operating firms frequently employ engineering consultants'to carry out major comprehensive f e a s i b i l i t y studies, td perform engineering and design for major capital projects, and - 90 -- 91 -and to assist in project management. Physical facilities are generally erected by construction firms, under direct contracts with the owner. The "turn-key" arrangement, which' is common in some other areas - partic-ularly in the petroleum refining and chemical process industries - has not-/been widely.used in the Canadian pulp and paper industry. With a... turn-key arrangement, the owner contracts with' a 'combined engineering-construction firm to design and construct the facility and' to put i t into operational condition. .'.'•' •' To enable use of the turn-key arrangement, the owner must be able to prepare relatively accurate specificationsof plant inputs and outputs, and of the intent and scope of the desired plant facilities. The relatively limited use of turn-key contracts for pulp and paper plants is attributable to the difficulty in specifying, requirements at the beginning of the project development phase with sufficient accuracy to permit competitive bidding by engineering-construction firms. The owner-consultant, relationship presented in this case is typical of more than a dozen projects of similar function and scope, on which Sandwell has been engaged since 1963. On the basis of industry literature and intelligence, the case is very likely typical of a large number of major pulp and paper projects which have been undertaken in North America in the last decade. An outline schedule showing duration of major phases of the work is shown in Exhibit A.^ •Ali exhibits referred to in this chapter are included in Appendix-A.. - 92 -F e a s i b i l i t y Study The Hypothetical Forest Products Company (HFPC) had held rights to an extensive block of timber in an undeveloped region of Canada for a number of years. Pulpwood in l imited quantities was harvested from this area and shipped by r a i l to existing HFPC mi l l s . Periodical ly the company had studied the v i a b i l i t y of constructing a major.new f a c i l i t y in the area to-enable better u t i l i z a t i o n of the controlled resource. The long-range company plan's were to provide a processing plant in the- area, • although the timing and product were not f ina l i zed . In early 19X0 HFPC reviewed their long-range plans in l ight of federal government l eg i s la t ion , which provided tax incentives for industries located in depressed areas. Preliminary analysis indicated that the.tax incentives were suff ic ient ly attractive to warrant serious consideration of the construction of a plant to produce kraft pulp, newsprint or l i n e r -board. Prompt action was required. To receive the benefits of the tax incentive', the plant was required to be i n operation by the end of 19X3. In June HFPC entered into discussion with and engaged Sandwell to undertake a major portion of a comprehensive f e a s i b i l i t y study according to the following terms of reference: 1. The following cases were to be considered: Case Product . Capacity  1 Bleached Kraft Pulp 750 Tons/Day 2A Newsprint £00 Tons/Day 23 Newsprint 1000 Tons/Day 3 Linerboard 600 Tons/Day - 93 -• 2. Sandwell was t o develop preliminary engineering plans and estimate capita l costs for each case. Capital cost estimates were to have an expected r e l i a b i l i t y of - V~> per cent. 3. A l l cases were to be based on a specific s i te .location • which had been tentatively selected by K F P C . Sandwell was to develop a manufacturing cost estimate for each case, based on operating at maximum m i l l capacity. 5. The cost of pulpwood delivered to the m i l l was to be pro-vided by HFPC. The cost of a l l other raw materials, as well as the cost of labour, fue l , power and so forth was to be estimated by Sandwell. 6. Sandwell was to develop an estimate of annual gross prof i t for each case, based on m i l l net prices provided by HFPC and operating.at maximum m i l l capacity. 7« Sandwell's work was to be completed by 30 December 19X0. The following discussion b r i e f l y describes the work carried out by Sandwell to achieve the f e a s i b i l i t y study objectives. Preliminary process design was carried out for each case. Rough specifications were developed for each major item of eqiiipment, and prelim-inary' material and energy balances were prepared. An outline process flow diagram was prepared for each m i l l department. In a l l cases, process.design was based on most common and accepted industry practice. Cost saving or qual i ty improvement alternates which were not thoroughly proven were not considered. - 9h -Upon completion of basic process design, preliminary m i l l and building layouts were prepared. Service and e l e c t r i c a l d is tr ibut ion and instrumentation requirements veere'determined. As the study proceeded, i t became evident that addition of 350 tons per day of newsprint capacity to Case 1, a 750 ton per day kraft m i l l , was an additional feasible'alternate. Following discussion, Sandwell was instructed to consider th is additional case. • A re la t ive ly detai led capital cost estimate vrais prepared for each case. Suppliers for major items of equipment - paper machines, bo i l ers , digesters, ki lns - were contacted and in some cases requested to submit preliminary proposals. Tn other cases the cost of major equipment was estimated, based on purchases of similar items for recently-completed projects. Lump-sum estimates wer^ made for minor equipment requirements and piping, based on similar projocts. E l e c t r i c a l costs and building costs were based on estimated costs per instal led horsepower and per cubic foot of building volume, respectively. ITherever possible, capital cost estimates were grouped in modules which were applicable to several cases. Manufacturing cost estimates were grouped into the following.cate-gories: 1 . Pulpwood 2. Other Raw Materials 3. Fuel k. Power 5. labour 6. Administration and Overhead 7i Miscellaneous and Other - 95 -Pulpwood was by far the most significant single manufacturing cost, comprising over 2 5 per cent of the to ta l manufacturing cost in the kraft pulp and linerboard cases. Requirements for raw materials, fuel and power were based on the preliminary material and energy balances developed for each case. Major suppliers were contacted and requested to. make preliminary -proposals. Several meetings were conducted with the hydro-electric company to establish conditions of power supply and tentative rates . Labour cost estimates, s imilar to that shown in Exhibit 2 , were developed for each m i l l department. Whenever possible, departments were defined in a manner which allowed a specific department estimate to be used for several cases. A tentative m i l l supervision roster was used as a basis for estimation of administration costs. Lump-sum estimates established on the basis of general industry experience were used for associated se l l ing and head office expense. A l l communication with HFPC was channeled through the company's vice-president in charge of planning, who kept technical , marketing and f inancia l personnel advised on developments of work being carried out by Sandwell. Concurrent with Sandwell's work, HFPC functional personnel were preparing sales forecasts and estimates of start-up costs and working-capital requirements relat ive to each of the cases. Trie pulpwood costs provided to Sandwell during the early stages of the f e a s i b i l i t y study were based on existing company operations in the area, and on'open-market pulpwood costs. When i t became evident that there was a s ignif icant poss ib i l i ty that pulpwood-harvesting operations would be expanded, the HFPC forest d iv is ion in i t ia ted a study of their operations to determine optimum methods for larger-scale production, and to establish requirements for capital for expanded operations. - 96 -Since the site was in a remote underdeveloped area, i t was necessary for HFPC to develop preliminary plans for the provision of extensive new housing f a c i l i t i e s at a small v i l lage near.the proposed m i l l s i t e . It was contemplated that a suitable arrangement could be negotiated with a rea l estate development company to provide the bulk of the required capita l for l i v i n g accommodation and. services. Nevertheless', some capita l outlay would be required to ass ist in housing development, and to'provide recrea-t iona l f a c i l i t i e s essential for attraction of m i l l staff . • A rough draft of Sandwell's f e a s i b i l i t y study report was turned over to HFPC early in December. Several minor contentious points were reviewed and discussed, and the f ina l report was completed shortly before Christmas. Plants of this nature are extremely capital- intensive. The estimated plant capi ta l cost for each of the alternate cases was in excess of $60 mi l l i on . After the inclusion of capital requirements for woods opera-tions, townsite, start-up expenses, working capital and so forth, the to ta l investment required was in the order of $100 mi l l ion for any of the cases considered. In no case did annual m i l l net sales exceed 5>0 per cent of the tota l capita l investment. During January and February 19X1 a f inancial analysis and review of the alternate cases was carried out by S T C . A decision to proceed with Case 1, a 75>0 ton per day bleached kraft pulp m i l l , was confirmed at a board of directors meeting late in February. To ensure that the m i l l could be put into operation by the end of 19X3 as required to receive tax bene-f i t s , Sandwell was instructed to proceed Immediately with project develop-ment wo rk . Project Development Sandwell commenced detailed process design, using the preliminary-plans previously prepared as a starting-point. The preliminary process design had been based e s s e n t i a l l y on most common industry practice, with o n l y a minimal consideration being given to possible a l t e r n a t i v e s , p a r t i c -u l a r l y where- technology was not w e l l .proven. I t was now necessary.to consider i n d e t a i l alternate process arrange-ments.' For' example, the f e a s i b i l i t y study had been based on the use of • o batch digesters, although continuous digesters -were r e l a t i v e l y common i n the industry. An extensive analysis was now carried out, comparing c a p i t a l and operating costs and expected operating c h a r a c t e r i s t i c s between the t/ro systems. This detailed analysis indicated that the continuous unit was a better choice, and a decision was made to design the plant on th i s b a s i s . The results of major design analyses were presented i n r e l a t i v e l y formal memoranda, to f a c i l i t a t e decision-making by Sandwell and HFPC management, and to provide a record of basic design c r i t e r i a . Specifications were prepared f o r a l l major Items of equipment, and enquiries were issued to prospective suppliers requesting firm proposals. Representative s p e c i f i c a t i o n s were prepared f o r standard items such as ".pumps, motors, controls, and so forth,-where exact requirements could not be determined u n t i l the detailed design stage. Purchase enquiries were • issued and proposals analyzed on the basis of these tentative s p e c i f i c a -t i o n s , to enable selection of standard m i l l equipment and to aid i n c a p i t a l cost estimating. • > 2A digester Is a pressure vessel i n which wood chips are chemically cooked to separate the cell u l o s e f i b r e s from the lisrnin and resi n s . - 93 -The t e n t a t i v e m i l l s i t e which was used as a b a s i s f o r the f e a s i b i l i t y -study was a c t u a l l y o n l y one of f o u r s u i t a b l e l o c a t i o n s . Each of these s i t e s was now examined i n d e t a i l . Factors considered i n c l u d e d : s o i l c o n d i t i o n s and n a t u r a l drainage and r e l a t i v e c o s t s of s i t e p r e p a r a t i o n , s e r v i c e s , and e f f l u e n t d i s p o s a l f a c i l i t i e s , P r o v i s i o n f o r e f f l u e n t d i s p o s a l was.a major c o n s i d e r a t i o n i n choosing the optimum s i t e . Once the b a s i c process had been e s t a b l i s h e d and the s i t e l o c a t i o n confirmed, l a y o u t of the m i l l equipment and b u i l d i n g s was completed. . B u i l d i n g s f o r pulp m i l l s are e s s e n t i a l l y equipment en c l o s u r e s , and l a y o u t p r i o r i t y i s given t o the equipment arrangement. A l t e r n a t e s t r u c t u r a l systems and m a t e r i a l s were now comparedj and b e s t s e l e c t i o n s made. S t r u c -t u r a l d esign c r i t e r i a was e s t a b l i s h e d , and b a s i c design commenced. A c a p i t a l c o s t estimate broken down by a d e t a i l e d code of accounts was prepared. Purchase costs of a l l major items of equipment were based on f i r m quotations r e c e i v e d from s u p p l i e r s . A u x i l i a r y equipment cos t s were based on v e r b a l q u o t a t i o n s c r Sandwell current cost records. Pur-chased equipment comprised almost $0 per cent of the t o t a l estimated c a p i t a l c o s t . Estimated p i p i n g , w i r i n g , i n s t a l l a t i o n l a b o u r , e t c . , c o s t s were based on Sandwell experience and records from other s i m i l a r p r o j e c t s . S t r u c t u r a l estimates were based on p r e l i m i n a r y designs from-which r e q u i r e d q u a n t i t i e s of m a t e r i a l s were developed. The u n i t costs f o r s t r u c t u r a l c o n s t r u c t i o n were based on recent b i d s f o r s i m i l a r work,- adjusted f o r c u r r e n t c o n d i t i o n s . An example page from a c a p i t a l c o s t estimate i s shown i n E x h i b i t 3 . C a p i t a l cost estimates were compiled on Sendwell's IBM 360 -hO computer. R e l a t i v e l y comprehensive plans f o r d e t a i l e d design a c t i v i t i e s and f i e l d c o n s t r u c t i o n were developed during t h i s phase. An example of an - 99 -outline CPM network is shown i n Exhibit Lu The objectives of the design development phase carried out by Sand-well were to: 1. Make comprehensive studies of alternate process systems, ...... s i te -locations, m i l l arrangements, structural materials and so forth, to enable an eff ic ient plant'design. 2. Complete basic engineering and establish a firm, and complete, def in i t ion of the plant f a c i l i t i e s . 3. Prepare a detailed estimate of plant capital cost, broken down by a detailed code of accounts to fac i l i t a t e cost control . Lu Develop a basic plan and schedule for implementing the project. Tne design development work established a baseline for the project implementation. The results of this phase were summarized in a report known as the Construction Budget, which included the following: 1. Summary of Estimates 2. Description of Plant 3. Basis Of Estimates Lu Construction Schedule 5. Time-Money Schedule 6. Detailed Estimates 7. Basic Process Flow Diagrams 3. Drawings of Basic Plant layout - 1 0 0 -Project Implementation The detailed capital cost estimate of the Construction Budget compared closely with the estimate prepared for Case 1 of the f e a s i b i l i t y -study.. The capi ta l required for the m i l l was in excess of §60 mi l l ion , and the to ta l capital ,required for the project, approached $100 mi l l i on . The total cost of vrork carried out by Sandwell to this point exceeded . $Uop,ooo. The project status was given a second review by HFPC top management, and in late August 19X1 the HFPC board of directors authorized the capital expenditure required to implement the project. The work breakdown structure for the complete project is shown in Figure 1 3 . Items which were the prime responsibi l i ty of Sandwell are indicated. Only those particular Items w i l l be discussed in d e t a i l . The organization established by Sandwell to accomplish i t s section of the work Is i l lus tra ted in Exhibit 5>. Immediately on receiving direction, to proceed, f i n a l specifications were prepared for major items of equipment for which delivery was c r i t i c a l or. for which engineering data was urgently required. Requisitions were prepared and issued to HFPC for approval and issuance of purchase orders. A l l purchase orders were reconciled with the Construction Budget, and jus t i f i ca t ion and approval was obtained for a l l items where budgeted cost •was exceeded or for which provision had not been made. Required delivery dates were stipulated with a l l purchase orders, and an expediting program was established to review progress and to ensure that required delivery dates would be maintained. I n i t i a l design ac t iv i t i e s were concentrated on the completion of equipment and builiin.?. layouts to enable detailed structural design. A - 101 -HFPC' MILL PROJECT Site & Services Power Supply & Distr ibution! Pulp Drying & Handling • Effluent Treatment Woods Onerations Road System Pulpwood Harvesting Pulpwood. Transportation Woods Management Staff Procurement Staff Training j M i l l "I Start-Up M i l l Administration Sandwell Prime Responsibil ity Administrative k. Sales Operations Information Systems '. Sales Operations Product Transportation Corporate Organization Townsite F a c i l i t i e s FIGURE 13 WORK BRSAKDO'TN STRUCTURE - 102 -target of early January 19X2 had been established for issuance of bid specifications and drawings for c i v i l construction. For the purposes of this bid i t was not required that drawings be complete in every d e t a i l , but the intent and scope of the work was required to be well defined. Discussions were, held with a number of general contractors who were experienced in industr ia l plant construction. After a review with HFPC, i t was agreed that tenders for the c i v i l work would be l imited to four contractors. Bid documents were issued to the selected contractors early in January 19X2, and tenders were received in mid February. After review of the proposals, meetings were held with each of the contractors to recon-c i l e any apparent conf l ic ts . A contract requiring immediate start of construction and essential completion of a l l main structures by November 19X2 was negotiated with the chosen contractor. To enable commencement of general c i v i l construction as early as possible in the spring of 19X2, a separate contract had been let in Sept-ember of 19X1 for general s i te preparation and the construction of temporary services. . This work was completed in December 19X1. As equipment layouts were f inal ized and engineering data became available on process equipment, detailed design of piping, e l ec tr i ca l and instrumentation systems was commenced. A target date of the end of June 19X2 had been established for the issuance of bid specifications and drawings for a general mechanical-electrical contract. A general mechanical-electrical contract was negotiated in a similar manner to the c i v i l contract. Several major process units were purchased on a supply and erect basis . These items were excluded from the mechanical-electrical contract. - 103 -The general contractor ?ras responsible, however, for providing certain stipulated site services to independent contractors employed d irect ly by the owner. At the peak of construction in the summer of 19X3, the to ta l f i e l d force numbered over 1300. men, To enable adherence to.schedule and.to a id .. contractors In enticing men to the remote location, a l l contractors worked a f i f t y to sixty hour week. . A f i e l d construction camp was established for the common use of a l l contractors. • Sandwell prepared a master CPM network for overal l plant construction. Each of the prime contractors engaged by the owner was responsible for preparing and maintaining a detailed CPM fragnet covering his own a c t i v i t i e s . The detailed networks were based on exploding ac t iv i t i e s from the master network, subject to established Interface and milestone constraints. Shortly after the start of c i v i l construction, the contractors' detailed fragnets were integrated, with the master network. Each contractor was s t i l l responsible for reporting, on and maintaining his own fragnet; however, master reports were also prepared on a project basis.under the direction of the Sandwell f i e l d staff . CPM reports 'were prepared monthly, except for a four-month period in early 19X3 at the height of mechanical construction, when reports were prepared every two weeks. In June 19X3 when construction was approaching completion, CPM reporting was discontinued, and from this point the project was monitored on a punch-list basis . The Sandwell f i e l d staff also prepared concise weekly reports on construction progress. These reports served a dual function of keeping' HFPC and Sandwell management informed of progress, and constituted an' - lOli -outline project diary v/hich could be used in event of any l i t i g a t i o n ar i s ing on project completion. Each month the f i e l d staff estimated the percentage completion on each contract. Tnese estimates formed the basis for progress payments to the contractors. The HFPC head office f inancial group had overal l responsibi l i ty for project cost accounting and control of disbursements. The f i e l d staff . assisted by recording receivals , freight charges, extra work authorizations and. so forth . Monthly statements were .issued showing expenditures, e s t i -mates to complete, and expected over- or underruns for each account. The f i e l d staff was responsible for checking out a l l f a c i l i t i e s to ensure adherence to drawings and specifications. Personnel from the m i l l operating-maintenance staff were used to assist in detailed chsck-out of mechanical and e l ec t r i ca l equipment. A systematic procedure was imple-mented, u t i l i z i n g cards attached to each piece of. equipment, which were then signed by inspectors responsible for specif ic areas and functions. As individual sections of the plant were completed, they were accepted from the contractors and responsibi l i ty for the area was assumed by the m i l l operating personnel, Where possible,, dry runs were- in i t ia ted in these areas, using water-and air . in l i eu of process f lu ids . Start-Up During the late summer of 19X3, HFPC completed h ir ing of the m i l l operating staff , and conducted classroom training sessions. Operating manuals had previously been prepared by the m i l l supervisors, assisted by Sandwell process engineers. Tnsse manuals were used as. texts for the classroom training sessions. - 105 -Start-up operations'were under the direct ion of the HFPC m i l l manager. Additional technical s taff to ass ist supervisors and foremen during the d i f f i c u l t start-up phase was obtained from other HFPC mi l l s and from Sandwell. Supplementary mechanical and e l ec tr i ca l crews, from the contractor were •retained'to a id m i l l maintenance' staff in making' required modifications. Approximately one month was required to produce the f i r s t saleable product. During the next two months, equipment .was debugged and crews gained operating experience, u n t i l by the end ofDecember 19X3 the m i l l . was. operating at 70 per cent of maximum design capacity. Operating e f f i c -iency was further improved over the next several months, and by mid 19Xii., approximately four years after the commencement of the f e a s i b i l i t y study phase, the m i l l was f u l l y operational at maximum design capacity. This •was the approximate turning-point from negative to positive cash flows. Summary The above description, while hypothetical, is i l l u s t r a t i v e of the scope.and timing of ac t iv i t i e s required to implement a large capital project in the pulp ana paper industry. CHAPTER VII • CONCLUSIONS & RECOMMENDATIONS In this thesis , capital investment in large industr ia l plants has •been-considered in a highly pragmatic manner. As far as possible within the l imited scope of...the thesis, the approach has been on .an i n t e r d i s c i p l i n -ary or systems-concept basis . The intention has been to develop a br ie f overal l analysis , rather than to focus on specific aspects. An outline overview of investment goals and principles of investment analysis has been included to enable development of simple dcf and npv investment process models. These models, which take into account the time dis tr ibut ion of both negative and positive cash flows, provide an opera-t ional basis for capital budgeting.and decision-making during capital project implementation. The internal rate of return derived from the dcf model is a useable parameter for determining project v i a b i l i t y for capita l budgeting purposes. However, the assumption which is inherent in the dcf model that cash benefits are reinvested at a y i e ld equal to the internal rate of return, can result in erroneous decisions -when mutually exclusive proposals are considered. I f cash benefits from an investment are used to purchase assets -either current or fixed - which are productive, a return on investment w i l l be rea l ized . This' return is the reinvestment y i e l d . Clearly the reinvest-ment y i e ld bears no direct relationship with the internal rate of return. - 106 -- 107 -Only i f the' internal rate of return is representative of the p r o f i t a b i l i t y of investment projects available to the f irm, w i l l the internal rate of return and the reinvestment y ie ld be equal. The rate of return on available projects i s the firm's opportunity cost (of cap i ta l ) . . . I f the internal rate of return i s less., than the opportunity cost, a project is hot v iable . I f the internal rate of return is greater than the opportunity cost, a project is v iable . However, in choosing between mutually exclusive proposals, the best alternate does riot necessarily have the greatest internal rate of return. Selection between mutually exclusive proposals should be based on maximization of npv. Investment decision during project implementation generally involve consideration of alternates; hence the npv model is preferred. In the l i terature on capital budgeting consulted, the only significant constraint on the set of viable investment projects, generally considered, is the a v a i l a b i l i t y of funds. V/hen the capital investment process is examined on an integrated basis, i t becomes clear that the a v a i l a b i l i t y of human resources to manage and implement projects is a comparable con-straint to the a v a i l a b i l i t y of cap i ta l . S imilarly , non-financial considera-tions and considerations which cannot be quantified w i l l impinge to a s ignif icant degree on capital-investment decisions. 'Modern techniques such as Monte Carlo simulation, by which expl ic i t account can be taken of r i s k and uncertainty, are essential to thorough and rat ional analysis of major investment opportunities. Hertz writes: . . . The less certainty there is in an average estimate, the more important i t is to consider the possible variations in that estimate. Further, an estimate of the variation possible in a factor, no matter how judgmental i t may be, is always better than a simple average estimate, since i t includes more information about what i s known and what is not known. It is in fact , this very lack of - 108 -knowledge which may distinguish one investment po s s i b i l i t y from another, so that for rational decision-making i t must be taken into account. This lack of knowledge is in i t s e l f important information about the proposed investment. To threw any information away . simply because i t is highly uncertain i s a serious error in analysis 'which .the new approach £Monte Carlo Simulation^ is designed to correct.1 ; ••''••'; /Implementation of•simulation techniques is dependent on the systems approach to the management of capital investment. Marketing analysis, • engineering analysis, and .financial .analysis. cannot be. .carried out by separate functional groups with minimal inter-communication. The trad-i t i o n a l f e a s i b i l i t y study approach illustrated by the case study in Chapter VI requires revision. The project organizational form is an example of the systems approach. Personnel are obtained and organized to accomplish a specific task. Tne organization i s tailored to suit the task, rather than the task moulded to suit the organization. Mockler defines a system as follows: . . .-an orderly grouping of separate but interdependent components for the purpose of obtaining some predetermined objective. Three important aspects of systems are implied by this definition. - The arrangements of components must be orderly and hierarchical no matter how complex i t i s . - Since the components of the system are interdependent, there must • be communication among them. - Since a system is oriented toward an objective, any interaction among the components must be designed to achieve that objective. 2 ipavid B. Hertz,. "Risk Adversion in Capital Investment", Harvard .' Business Review, (January - February 196h), p. 101~. Robert J. Mockler, "The Systems Approach to Business Organization and Decision Making", California Management Review, (Winter 1968), p. 5>3. - 109 -Presently the systems approach i s generally confined to the project development and implementation phases, and frequently only to selected sectors of these phases. To achieve overal l capital project optimization, an expansion of the systems approach to encompass the whole of the capital investment process from idea generation to start-up i s indicated. The. systems concept is required to avoid suboptimization and fragmented develop-ment. The organization of tasks and personnel are structured around project objectives and information flows, rather than authority and responsibi l i ty uni ts . Network (PERT/CP") planning, scheduling and information system methods are an example of the application of modern management science techniques to capital project management. Application of network methods is re la t ive ly recent - the f i r s t commercial applications were made in the early 1960's. In the short interval since the ir introduction, network methods have under-gone considerable development and have come into widespread use. However, there are areas, part icu lar ly in improving resource al location methods, where operational improvements are required and expected. For pract ica l rather than fundamental reasons, the application of advanced techniques l ike PSRT/CPM and Monte Carlo simulation is dependent on the use of high-speed, high-capacity d i g i t a l computers. Without computers large-scale u t i l i z a t i o n of such methods would be infeasible due to the cost and time required for manual calculations. The advent of high-speed, hi<?h-capacity computers has made pract ica l a number of management-science techniques, which are or could, be used in management and implementation of capital investment projects. A study conducted in England during 1967 indicates that management science techniques - 110 -a r e be ing a p p l i e d i n the c o n s t r u c t i o n i n d u s t r y by c o n s u l t a n t s and c o n -t r a c t o r s i n the fo i lovd .ng a r e a s : 1. S t a t i s t i c a l a n a l y s i s and f o r e c a s t i n g . 2 . Resource u t i l i z a t i o n and s c h e d u l i n g . 3. L o c a t i o n p l a n n i n g and v e h i c l e r o u t i n g . h . P r o d u c t i o n p l a n n i n g . P r o d u c t i v i t y a n a l y s i s . S i m u l a t i o n o f dynamic systems. 6. Cos t a n a l y s i s . 7» Economic e v a l u a t i o n . 8. Stock C o n t r o l 9. Eng inee r ing de s ign o p t i m i z a t i o n . Process c o n t r o l . 10. I n fo rma t ion r e t r e i v a l and s o r t i n g . 11. . Replacement and maintenance' p l a n n i n g .3 ' I n . t h e f i e l d o f eng inee r ing d e s i g n , computer programs a re b e i n g • u t i l i z e d i n areas such as s t r e s s a n a l y s i s of s t r u c t u r e s and p i p i n g systems, •where t he re i s s u f f i c i e n t r e p e t i t i v e work to enable a m o r t i z a t i o n o f the h igh c o s t o f programming problems f o r computer s o l u t i o n . P r o j e c t eng inee r -i n g I n v o l v e s a c o n s i d e r a b l e volume o f da ta p r o c e s s i n g . Computers a re be ing u t i l i z e d i n p r o c e s s i n g of budgets , r e p o r t s and schedu les . The fu tu re w i l l undoubtedly see g rea te r mechan isa t ion o f r o u t i n e c a l c u l a t i o n and data p r o c e s s i n g . This v r i l l a l l oy / more r e sources to be devoted to eng inee r ing a n a l y s i s , thus r a i s i n g the e f f i c i e n c y o f c a p i t a l investment through reduced c a p i t a l cos t and i n c r e a s e d v a l u e . Research i n t o the methodology of s e l e c t i n g and implementing l a r g e c a p i t a l p r o j e c t s i s i n d i c a t e d i n the f o l l o w i n g two a r e a s : 1. F u r t h e r a n a l y s i s i s r e q u i r e d i n t o the e f f e c t i v e n e s s o f the f u l l y - i n t e g r a t e d systems concept approach to c a p i t a l inves tment management} i n comparison to the c u r r e n t • f r equen t ly - f ragmented approach t o problems i n economics, f i n a n c e , e n g i n e e r i n g and a d m i n i s t r a t i o n . ^ C o n s t r u c t i o n I n d u s t r y Study Croup, "Review and E v a l u a t i o n of Cur ren t O o e r a t i o n a l Research. Work i n the C o n s t r u c t i o n I n d u s t r y " , O p e r a t i o n a l  Research Q u a r t e r l y , V o l . 19, No. 2 , (June 1963) , pp . -1W, - I l l -•2. Further evaluation is required of the scope for eff ic ient application of modern techniques in management science, information system design and data processing to the selection and implementation of large c a p i t a l projects. Considering the increasing- size and complexity of Industrial i n s t a l -lations, and the trend to more capital- intensive production processes, economic growth w i l l be ever more dependent on eff icient use of scarce resources; devoted, to capital investment.. There is .obviously scope for. improving on current methodolo.gy, and the future w i l l see more eff ic ient Management of Large Capital Projects. SELECTED BIBLIOGRAPHY INVESTMENT ENVIRONMENT AND ANALYSIS Books IMge, C. 0. 'MThe Economic Justification of Mew Equipment". Conference ..Pacer, The Economic Council of Canada.- Ottawa: Queen's Printer, -• .... • 1966. -v , - '. , '. .: Kelliwell, John F. Public Policies and Private Investment. Oxford: Clarendon Press, 1968.-Istvan, Donald F. Capital Expenditure Decisions, How They Are Made in large Corporations. Bloomington: Bureau of Business Research, Indiana University, 196l. Kendrick, D. A. Programming Investment in the Process Industries. Boston: Massachusetts Institute of Technology Press, 196?. Murdick, Robert 0., and-Deming, Donald D. The Management of Capital Expenditures. New York: McGraw-Hill, 1963. Quirin, G. David. The Capital Expenditure Decision. Homewood, Illinois: Richard D. Irwin, 1967-Smith, Gerald "r. -Engineering Economy: Analysis of Capital Expenditures. •Ames, Iowa: Iowa State University Press, 1963. Usry, Milton F. Capital-Expenditure Planning and Control. Austin, Texas Bureau of Business Research, The University of Texas, 1966. Periodical Articles Hertz, David B. "Investment Policies That Pay Off". Harvard Business Review, January - February 1968, pp. 96 - 108. - 112 -- 113 -Hertz, David B. "Risk Analysis i n Capital Investment". Harvard Business Review, January - February 196ii, pp. 95 - 1C6. H i l l i e r , F. S. and Heebink, D. V. "Evaluating Risky Capital Investments". C a l i f o r n i a Management Review, Winter 1965, pp. 71 - 80. o Kirsbenbaum, P. S. .• "A .Resolution of the Multiple Rate,of Return Paradox". . The Engineering Economist, October - November,.196h. pp. .11.- 16. Lerner, E. M. and Rappaport, A. "Limit DCF i n Capital Budgeting". Harvard •Business Review,.September - October, 1963, pp..113 - 139.. Magee, John F. "Decision Trees for Decision. Making", Harvard Business Review, J u l y - August, 1961;, pp. 126 - 138. . "How to Use Decision Trees". Harvard Business Review, September '"October 196U, pp. 79 - 96. Mathews, J . B. "How to Administer Capital Spending" (Capital Budgeting and Decision-Making). Harvard Business Review, March - A p r i l 1959, pp. 87 - 99. Nicholson, J . T. and F f o l l i o t , J . D. "Are Investment Practices Inadequate". Business Quarterly of the University of Western Ontario, Winter 1965, pp. 83 - 93. . "Investment C r i t e r i a of Canadian Companies". Business Quarterly of Western Ontario, Summer 1966, pp. 5h - 62. Perdunn, R. F. "Capital Investment and large Projects". F i n a n c i a l Execu-t i v e , June 1965, pp. 1 1 - 1 8 . - l l h -PROJECT ENGINEERING AND MANAGEMENT Books Hackney, John ¥. Control and Management of C a p i t a l Projects. New York: John Wiley and Sons, 196j>. ' Johnson, Richard A.-, Kast,'F.. E., and Rosenzwei'g, J . E. Theory -and •' Management of Systems. 2nd ed. New York: McGraw-Hill., 1967. •..Pflomm, .'Norman-.E.. -Managing. C a p i t a l Expenditures.. Studies i n . Business .. P o l i c y No. 107. New York: National I n d u s t r i a l Conference Board, 1963." Pierce, J . F., ed. Operations Research and the Design of Management Information Systems. -Special Technical A s s o c i a t i o n P u b l i c a t i o n , -STAP No. h. New York: Technical A s s o c i a t i o n of the Pulp and Paper Industry, 1967. Rase, H. F. and Farrow, M. H. Project Engineering of Process Plants. New York: Wiley and Sons, 1957. Di s s e r t a t i o n s Hodgetts, Richard Michael. An Interindustry Analysis of Certain Aspects of Project Management. Unpublished D o c t o r i a l D i s s e r t a t i o n . Management Department, U n i v e r s i t y of Oklahoma. U n i v e r s i t y Microfilms, 1968. P e r i o d i c a l A r t i c l e s Chamberlain, C. J . "Coming Era i n Engineering Management". Harvard Business Review, September - October 1961, pp. 87-92. Cleland, David I. "Ideational Items; The Deliberate C o n f l i c t " . Business Horizons, February 1963, pp. 78 - 80. -115 -Cleland, David I . "Understanding Project Authority". Business Horizons, Spring 1967, pp. 63 - 70. . "Why Project Management". Business Horizons, Winter 196H, pp. 31 - 88. Doctors, S. I . ' ."Project Management in Urban, Redevelopment" ... MSU Business . . . . Topics, ..Summer. 1963,. ... Finlayson, K. and Gans, M. "Planning the Successful Start-Up". Chemical . Engineering Progress, December 1967, pp. 33 - 39. . Gaddis, P. 0. "The Age of Massive Engineering". Harvard Business Review. January - February 196l. pp. 138 - lh5. . "The Project Manager". Harvard Business Review, May - June 1959, pp. 89 - 97. Gallagher, John T. "A Fresh Look at Engineering Construction Contracts". Chemical Engineering, 11 September 1967, pp. 218 - 22h. Goodman, R. A. "Ambiguous Authority in Project Management". Academy of Management Journal, December 1967> pp. 395 - h00. Hodgetts, R. M. "Leadership Techniques in the Project Organization". Academy of Management Journal, June 1968, pp. 211 - 219. Howell, R. A. "Multiproject Control". Harvard Business Review, March -A p r i l 1968, pp". 62 - 7 0 . Lawrence, P. R. and Lorsch, J . W. "New Management Job, the Integrator" Harvard Business Review, November - December I 9 6 7 , pp. Ih2 - 151. Lutz, J . H. "Estimating Project Completion Costs". Chemical Engineering, 3 0 January 1 9 6 7 , pp. l 6 h - 1 6 5 . McLellan, J . M. "Manaeinc- Engineering Projects". Chemical Engineering, May 13, 1963, pp.' 157 -167. - 116 -Magyar, W. 0. "Economic Evaluation of Engineering Projects". The Engineering Economist, Winter 1963, pp. 6? - 85. Meinhart, W. A. and Delionback, L. M. . "Project Management: An Incentive Contracting Decision Model". Academy of Management Journal, December 1963, pp. U27 - b3b. Middleton, C. J'. "How to Set Up a. Project Organization". Harvard Business RevieTf, March - Ap r i l 1967,' pp.' 73 - 32. .'. Miles, Raymond E. "Human Relations .or Human Resources". . Harvard Business •Review, J u l y , - August 19.65, pp. Ih8 - 163... . "The Affluent Organization". Harvard Business Review, May -June, 1966. pp. 106 - l l l i . Spaet, A. L. "Controlling Engineering Cost". The Consulting Engineer, August 1 9 6 3 , pp. 1 1 0 - " 1 1 2 . S p i t z , P. H. "Handling Your Process Engineering-Staff or Outside Consultants". Chemical Engineering, 13 December 1967, pp. 173 - 173. Stewart, John M. "Making- Project Management Work". Business Horizons, Fall 1965, pp. 5U- - 68. Sturgis, R. P. "For Big Savings - Control Costs While Defining Scope". Chemical Engineering, lh August 1967, pp. 188 - 190. Wickensburg, A. K. and Cronin, T. C. "Management by Task Force". Harvard Business Review, November - December 1962, pp. I l l - 118. Williamson, D. F. and Innes, I. C. "Site Evaluation and Selection". Journal of the Technical Association of the Pulo and Paper Industry, A p r i l 1968, pp. 55A - 59A. - 117 -PLANNING, SCHEDULING AND CONTROL Books A n t i l l , James "." and Woodhead, Ronald M. C r i t i c a l Path Methods i n C o n s t r u c t i o n P r a c t i c e . ' New Y o r k : John W i l e y and Sons, 196$. A r c h i b a l d , R u s s e l D . and V i l l o r i a , R i c h a r d L . Network'.'Based Management Systems (BSRT/CPM). New Y o r k : John W i l e y and Sons, 1966. Fondah l , John W.' 'A Non-Computer Approach to the C r i t i c a l Path Method ' ; • F o r the C o n s t r u c t i o n ' I n d u s t r y . ' • •Technica l Report No. 9,' 2nd ed.. •••'• S t a n f o r d , C a l i f o r n i a : Department of C i v i l Engineering, S tanford U n i v e r s i t y , 1962. . Methods f o r Extend ing the Range o f Non-Computer C r i t i c a l Pa th A p p l i c a t i o n s . T e c h n i c a l Report No. 1;7. S t a n f o r d , C a l i f o r n i a : Department o f C i v i l E n g i n e e r i n g , S tanford U n i v e r s i t y , 1961;. Law, C e c i l E . and L a c h , David. C . Handbook o f C r i t i c a l P a t h . (Handbook f o r CPM course a t M c G i l l U n i v e r s i t y ) . M o n t r e a l , 196.5. A v a i l a b l e a t Vancouver P u b l i c L i b r a r y . M a r t i n o , R . L . P r o j e c t Management and C o n t r o l . Volume I . F i n d i n g the C r i t i c a l P a t h . New Y o r k : American ?v?anagem.ent A s s o c i a t i o n , 196U. . P r o j e c t Management and C o n t r o l . Volume I I , A p p l i e d O p e r a t i o n a l Planning. New York : American Management A s s o c i a t i o n , 196U. . P r o j e c t Management and C o n t r o l . Volume I I I , A l l o c a t i n g and S c h e d u l i n g ' R e s o u r c e s . New Y o r k : American Management A s s o c i a t i o n , 1965. M i l l e r , Robert W. Schedule , Cos t and P r o f i t C o n t r o l w i t h PERT. New York : M c G r a w - H i l l , 1 9 6 3 . Moder, Joseoh J . and P h i l l i p s , C e c i l R. P r o j e c t Management w i t h CPM and PERT." New Y o r k : R e i n h o l d , 1961;. - 118 -Riggs, James L. and Heath, Charles 0. Guide to Cost Reduction Through C r i t i c a l Path Scheduling. Englewood C l i f f s , New Jersey: Prentice H a l l , 1966. s Tyas, J . P. E. Pertaining to PERT. 0ttar;a: Queen's Pr i n t e r , 1966. P e r i o d i c a l A r t i c l e s . Dooley, k. R. "Interpretations of PERT". Harvard Business Review, ."March - A p r i l .1961+, -pp. 160 - 172.. Peterson, Rein. " C r i t i c a l Path Scheduling: A Comprehensive Look". Business Quarterly of Western Ontario, Summer 1965, pp. 70 - 85. Saitow, Arnold R. "CSPC: Reporting Project Progress to the Top". Harvard Business Review, January - February 1969, pp. 88 - 97. Schoderbek, Peter ?. "A Study, of the Application of PERT'-'. Academy of Management Journal, September 1965, PP. 199 - 210. Wiest, J . D. "A. Heuristic Model for Scheduling Large Projects with Limited Resources". Management Science B,. February 1967, pp. B359 - 377. APPENDIX A TYPICAL PROJECT DOCUMENTATION •..Exhibit' ••• \ " '•" •'-•'•••Page. 1. Outline Project Schedule 120 2. Labour Cost Estimate . . . ; . . . . ... '.. ... . .••.-. . •". -121 3. Capital Cost Estimate 122 • U. CPM Summary Network 123 5. Project Organization Chart . 12h ' 6. Cost Control Schedule . 125 - 119 -PROGRESS SCHEDULE I T E M 19 X o 19 x. 1 A N M A J J A S 0 D 19 X 2 J F 1M I A M J S 0 J M A JSJL3_ M A N D 19 X 4 FEASIBILITY STUDY FINANCIAL ANALYSIS & REVIEW PROJECT DEVELOPMENT DETAILED DESIGN SITE PREPARATION CIVIL CONSTRUCTION MECHANICAL-ELECTRICAL CONSTRUCTION OPERATOR TRAINING START-UP PHASE MILESTONES _1_ _2_ 3 FEASIBILITY REPORT ISSUED DECISION TO PROCEED WITH PROJECT PROJECT DEFINITION COMPLETE AND GO-AHEAD CONFIRMED 6 CIVIL CONTRACTOR SELECTED MECH- "ELECT CONTRACTOR SELECTED MILL STRUCTURES ESSENTIALLY COMPLET'E 8 MECH-ELECT WORK ESSENTIALLY COMPLETE MILL OPERATIONAL REVISION A P P R O V E D B O R D E R D A T E A D E L I V E R Y D A T E ^ S E C O N D L I N E A C T U A L P R O G R E S S F I R S T L I N E • S C H E D U L E D T I M E D A T E DAF B S H E E T NUMBER N U M B E R OF S H E E T S 62 OUTLINE SCHEDULE FEASIBILITY STUDY, PROJECT DEVELOPMENT & IMPLEMENTATION PHASES THIS DRAWING IS T H E PROPERTY OF S A N D W E L L AND MUST BE R E T U R N E D ' TO S A N D W E L L ON R E Q U E S T . ITS C O N T E N T S ARE S E C R E T AND C O N F I D E N T I A L . ANY INFORMATION OBTAINED BY INSPECTION OF THIS DRAWING S H A L L NOT BE USED FOR ANY OTHER T H A N T H E SPECIFIC PURPOSE FOR WHICH ITS INSPECTION IS AUTHORIZED BY S A N D W E L L S A N D W E L L HYPOTHETICAL PROJECT' DWG. EXHIBIT 1 REV - 121 -SULPHATE PULP MILL Position Tour Foremen Pulping Group Co-ordinator Senior Operator 1 s t Asst. Operator 2 n d Asst. Operator 3 r d Asst. Operator Recausticizing, K i l n & Water Plant Operator Recausticizing, K i l n & Water Plant Assistant' Night.Shift D i f f e r e n t i a l Total . Labour -' 3 5 0 Days Additional f o r Sunday Operation Salaries Total Labour PULP DRYING PLANT Rate $ 1 , 0 0 0 1+.10 3 - 7 0 3 . 6 0 3 . 1 0 2 . 7 5 : 3 . 1 6 Total MH/D Cost/Day Men/Tour Employees 2k 2k 2k 2k 2k 2k 4 2 . 8 6 2k ( 0 . 1 3 5 ) ( 1 1 2 ) 98.1+0 8 8 . 8 0 8 6 . ko 7I+.I+0 6 6 . 0 0 7 5 . 8 U .68.61+ 1 5 . 1 2 1 6 8 . $ 5 7 3 . 6 0 . Labour - 350 Days Additional .for Sunday Operation Salaries Total Labour 1 k 1 1+ 1 k 1 k 1 5 1 ^ 1 . . k 1 k. 8 . 33 "•' - $ 2 0 1 , 0 0 0 1 5 , 0 0 0 1+8,000 $ 261+,000 MH/A 5 8 , 8 0 0 Machine Tender $ 3 - 8 8 2k $ 9 3 - 1 2 1 5 Back Tender 3 - 3 3 2k 7 9 - 9 2 1 k Scale Man/Tyer • 2 . 7 3 ka 131.01+ . 2 8 U t i l i t y Man 2 . 5 0 2k 6 0 . 0 0 1 . 1+ Car Loader/Shipper 2 . 7 5 1+8 1 3 2 . 0 0 2 9 Warehouse Man 2 . 5 0 21+ 6 0 . 0 0 1 1+ Night S h i f t D i f f e r e n t i a l ( 0 . 1 3 5 ) ( 1 2 8 ) 1 7 . 2 8 — _ Total 192 $ 5 7 3 . 3 6 8 3k $ 2 0 0 , 7 0 0 1 5 , 3 0 0 $ 2 1 6 , 0 0 0 M H / A 6 7 , 2 0 0 EXHIBIT 2 LABOUR COST ESTIMATE C O M P U T E R R E P O R T A C C O U N T D E S C R I P T I O N - — R U N I T E M N O I T E M . 0 0 F E D E R A L M A T E R I A L S A L E S C O S T D U T Y T A X - F R E I G H T . 0 1 . 0 2 s_Oj . 0 4 ~\tz~ P R O V I N G . S U B S A L E S T O T A L S U N D R Y T O T A L T A X H A T E R I A L M A T E R I A L - M A T E R J A L — L A B O R T O T A L ^Lfl 4 2 1 . 0 0 . 0 0 0 W A S H I N G A N D S C R E E N I N G ( C O N T I N U E D ) 4 2 1 . 3 5 . 0 0 0 I N S U L A T I O N ( C O N T I N U E D ) . 9 0 0 E X T R A WORK T O T A L A C C O U N T 1 8 0 0 0 2 1 0 0 1 0 0 0 2 1 1 0 0 4 0 0 2 1 5 0 0 A 4 2 1 . 3 7 . 0 0 0 M A T E R I A L H A N D L I N G . 0 0 1 K N O T T B L O W E R F E E D C O N V E Y O R 1 0 0 0 I N C L 1 0 0 1 0 0 1 0 0 1 3 0 0 1 3 0 0 . 0 0 2 K N O T T B L O W E R , C Y C L O N E A N D D U C T I N G 1 0 0 0 0 1 2 0 0 I N C L . 6 0 0 1 1 8 0 0 2 0 0 1 2 0 0 0 . 9 0 0 E X T R A WORK T O T A L A C C O U N T 1 1 0 0 0 1 3 0 0 TOO 7 0 0 1 3 1 0 0 2 0 0 3 . 3300 A 4 2 1 . 3 8 . 0 0 0 P R O C E S S C O N T R O L S . 0 0 1 I N S T R U M E N T S , C O N T R O L V A L V E S , P A N E S , T U B I N G 9 5 0 0 0 7 6 0 0 1 0 3 0 0 4 P 0 O 5 9 0 0 1 2 3 6 0 0 1 9 0 0 1 2 5 5 0 0 . 9 0 0 E X T R A WORK. T O T A L A C C O U N T 9 5 0 0 0 7 6 0 0 1 0 3 0 0 4R00 5 9 0 0 1 2 3 6 0 0 1 9 0 0 1 2 5 5 0 0 A 4 2 1 . 4 1 . 0 0 0 M O T O R S 0 0 1 U N B L E A C H E D P R I M A R Y K N O T T E R N O 1 4 0 X 7 2 0 1 1 0 0 2 0 0 1 0 0 1 0 0 1 5 0 0 15 0 0 . 0 0 2 U N B L E A C H E D P R I M A R Y K N O T T E R NO 2 4 0 X 7 2 0 1 1 0 0 2 0 0 1 0 0 1 0 0 15 -00 1 5 0 0 0 0 3 U N B L E A C H E D P R I M A R Y K N O T T E R NO 3 4 0 X 7 2 0 1 1 0 0 2 0 0 1 0 0 1 0 0 1 5 0 0 1 5 0 0 . 0 0 4 U N B L E A C H E D P R I M A R Y K N O T T E R N O 4 4 0 X 7 2 0 -1 1 0 0 2 0 0 1 0 0 1 0 0 1 5 0 0 1 5 0 0 8 1 0 0 2 0 0 1 5 0 0 1 7 0 0 1 4 3 0 0 1 4 3 0 0 2 9 6 0 0 1 5 0 0 1 3 5 0 0 1 5 0 0 0 1 3 ^ 8 0 0 1 3 9 6 0 0 1 5 0 0 1 5 0 0 1 5 0 0 1 5 0 0 S A N D W E L L T Y P I C A L P U L P S P A P E R C O . L T D . , V A N C O U V E R C A N A D A A P P R O V E D p j S A M P L E M I L L C O N S T R U C T I O N B U D G E T ! F O I J J P M E N T - DF T A I L S ' A C C O U N T S 4 2 1 . 3 5 - 4 2 1 . 4 1 L A S T I S S U E » 1 4 J A N 6 8 T H I S R E P O R T I S T H E P R O P E R T Y O F S A N D W E L L A N D M U S T B E R E T U R N E D T O S A N D W E L L O N R E Q U E S T . I T S C O N T E N T S A R E S E C R E T A N D C O N F I D E N T I A L . A N Y ( N f O R M A T I O N O B T A I N E D B Y I N S P E C T I O N O F T H I S R E P O R T S H A L L N O T B E U S E D F O R A N Y O T H E R T H A N T H E S P E C I F I C P U R P O S E F O R W H I C H I T S I N S P E C T I O N I S A U T H O R 1 Z E D B Y ' i A N D.W E L i. T H I S I S S U E W T E E B 6 8 V 5 0 0 0 1 7 EXHIBIT 3 B S A N D W E L L N O S H E E T C L I E N T N O . R U N | J ~ I' t i r r oct M M c t t JAW'- M4< ' A M * r CA/.W ' r '<^ un«*Jtot^  ctfwcT* . w t WIT*I*« 4 w f M W i PW - Ft* MM Krwii. "' MAY JtfW* f • P M H U fry T 1 . ' ^ I J * 1 1 I ! ! i -i.jt.wr MitittMit<a.tmtwit«4 iMiTfax . »»*^ » mmwt 4 wm<» <N<«MJ ^ i m i i a T i H TO i n . I C - ) I I 4««X- »*P M K T I : \ ! ! I-mtMcr I, I I J . . V t A P f FOB M — r , \ , . | l : r - J . T I I I I ' l l I TfcWO**,*!^*^ • I ****** I •Ijl.l i I I I 31 J « M»'V I i i 5s its i ' I I 1/ lift, <pmm/n« fco*.tp Kt,Cii«H I • I « n t u / n > P W H t o n . * * EXHIBIT U on 3 A N D W E L L DWG. DL)U0--1U IREVJ - 12U -0 H E A D O F F I C E REGIONAL MANAGER CHIEF ENGINEER ACCOUNTING PROCUREMENT. EXPEDITING CLERICAL CHIEF DRAFTSMAN FIELD ENGINEER PROJECT ENGINEER ASSISTANT PROJECT ENGINEERS DESIGN SPECI AL 1ST FIELD STAFF DEPARTMENT PESIGN ENGINEERS ASSISTANT DESIGN ENGINEERS TECHNICIANS DRAFTSMEN EXHIBIT 5" PROJECT ORGANIZATION CHART ER COPY - 1 C O M P U T E R R E P O R T v • ACCOUNT-—— DESCRIPTION-— -R ITEM ' DESCRIPTION- — —TOTAL COMMITMENTS — ESTIMATEO TOTAL VARIANT.E U ALLOCATED COST TO ESTIMATED OVER(+) N SUB ITEM-—•—.. DESCRIPTION-^  ^ — — • TO--- AMOUNT - AMOUNT P.O. NO.— AMOUNT -COMPLETE ——COST -UNDER(-) . 421.38.000.00 PROCESS CONTROLS (CONTINUED) 421.38.001.00 INSTRUMENTS« CONTROL VALVES. PANES * -TUBING (CONT T NUFO) A 09 LABOR 14250 14250 14250 A 10 TOTAL 139640 139^40 139640 — A 421.3,8.900.00 EXTRA WORK, A 06 5UIR-T0TA1 MATERIAL — — -A 07 SUNDRY MATERIAL - • -A. 09 LABOR - - -A 10 TOTAL — — 421 .38 .000 .00 TOTAL ACCOUNT • -06 SUB-TOTAL MATERIAL 123490 123490 1P3490 07 SUNDRY MATERIAL 1900 1900 1900 -09 LABOR 14250 14250 142 50 -10 TOTAL 139640 139640 139640 -. . . _ . . _ . . _ „ . „ * 6 *421 .41.000.00 *HOTORS •. -•B *421.41 .001.00 *UN BL E AC HE'D P R IM A R Y KNOTTER NO 1 8 06 SUB-TOTAL MATERIAL 421.51 .001* - 2 0 * 400-A* ! B 900-01 i-A* i S: 1010* B 1050* | 8 TOTAL.06 -20* 1500* 172i0* 1500* 3220* 1720+* B 07 SUNDRY MATERIAL 421.41.800* -20* - i 20 20* ?0+* A 09 LABOR - - - -• B 10 TOTAL. -40 1500* 172f>* 1520* 3240* B *421 .41 .002 .00 * UN BlE ACHED PR IWARY KNOTTER NO 2 i i 1 B. 06 SUB-TOTAL MATERIAL 1520 1010* 147|0* 50* . 1520 -fi 07 SUNDRY MATERIAL 421.41.800* -20* - i 20 20* 20+* A 09 LABQ8 - - -B 10 TOTAL -20 152 0* 147;0* 70* 1540* 20+* ft *423..41.003.O0 *UNBL£A C HE 0 P R I MA R Y KNOTTER NO 3 1 B 06 SUB-TOTAL MATERIAL 1520 1 010* 1470* 50* 1520 -& 07 SUNDRY MATERIAL . 42:1.41 .800* -20* - 20 20* 20+* A 09 LABOR - - - - ' 8 10 TOTAL -20 1520* 1470* 70* 1540* 20 + * 8 *421,41.004.00 nJH BLEACHED PR I MAR Y KNOTTER NO 4 • B 06 SUB-TOTAL MATERIAL 1520 1010* 1470* 50* 1520 -B 07 SUNDRY MATERIAL 421.41.800* -20* - : 20 20* 20+* A. 09 LABOR - - • - -B 10 TOTAL -20 152 0* 1470* 70* 1540* ?0 + * S A N D W E L L TYPICAL PULP f> PAPER CO. LTD. VANCOUVER CANADA APPROVED » SAHPLfc MILL COST RECORDING AND FORECASTING EOUIPMENT-DETA ILS ACCOUNT 421.38-421.41 LAST ISSUE • 4MAY68 T H I S R E P O R T I S T H E P R O P E R T Y O F S A N D W E L L A N D M U S T B E R E T U R N E D T O S A N D W E L L O N R E G U £ S T I T S C O N T E N T S A R E S E C R E T A N D C O N F I D E N T I A L . A N Y I N F O R M A T I O N O B T A I N E D B Y I N S P E C T I O N O F T H I S R E P O R T S H A L L N O T B L U S E D F O R A N Y O T H E R 1 T H A N T H E S P E C I F I C P U R P O S E F O R W H I C H I T S I N S P E C T I O N I S A U T H O R I Z E D B Y . S A N D W E L i THIS ISSUE »31JUL68 V5000 _ - 22 ET)(VA\B'tT (o B S A N D W E L L N O S H E E T C L I C K T N O APPENDIX B SCOPE OF SERVICES OFFERED BY SANDWELL - 126 -SCOPE OF SERVICES Flexibi l i ty and divers i f ied exper i -ence enable Sandwe l l eng ineers and staff to provide the fo l lowing pro fess iona l engineer ing se rv i ces on a regional and w o r l d - w i d e bas is . . ; S e n i o r personnel with w ide prac-t ical exper ience are avai lab le to adv ise upon : • P lann ing of new deve lopments or plant improvements for pulp and paper mi l ls, sawmi l ls , ply-w o o d and part ic le board plants, thermal and hydro-e lect r ic in-stal lat ions, industr ial and c h e m -ica l plants, and environmental pol lut ion prob lems • Management aspec ts of inte-grat ion, the des ign , cons t ruc -t ion and econom ic operat ion of p lants and their ma in tenance Over the years an increas ing n u m b e r of c l ients have cont inued to retain Sandwe l l to study and report on the techn ica l and eco -nomic feasibi l i ty of a w ide range of industr ial and util it ies projects. Usual ly such feasibi l i ty studies inc lude al l , or some of the fol low-ing typ ica l a reas : • Management and f ield surveys • Integration of operat ions • Appra isa l of forest or other raw mater ia ls resources • S i te se lec t ion , geo log ica l c o n -di t ions and water supp l ies , po l -lut ion studies and effluent c o n -trol • Power s tud ies • Superv is ion of research , pulp test ing and pilot plant work • Pre l iminary, p rocess and plant des igns • Est imates of capi ta l require-ments, labour, operat ing costs and profits • F inanc ia l ana lyses Sandwe l l feasibi l i ty reports are usual ly prepared in suff icient de-tail to serve as the bas is for d is-cuss ing the f inancing of a project and are recogn ized by leading internat ional and nat ional f inan-c ia l o rgan izat ions. Sandwe l l eng ineers provide all des ign and engineer ing serv ices required for the construct ion of industr ial and util it ies deve lop-ments. S u c h serv ices normal ly inc lude: • Detai led p rocess flow d iagrams • Gene ra l site and plant ar range-ment d rawings • Estab l ishment of plant and equipment spec i f ica t ions, c o m -par ison of tenders and recom-mendat ions for purchase • Detai led structural eng ineer ing, mechan ica l and e lectr ica l draw-ings; bi l ls of mater ia ls and spe -c i f icat ions for const ruct ion In addi t ion to car ry ing out eng in-eer ing for major projects and de-velopments Sandwe l l eng ineers undertake des ign engineer ing and engineer ing for minor pro-jects, frequently in co l laborat ion with a c l ient 's own organizat ion. - 128 -The Purchas ing G r o u p is staffed by exper ts with many years of expe r i ence in all phases of ma-ter ials and equipment purchas-ing , inspect ion and exped i t ing , wh i ch inc lude : • Prepara t ion of p rospect ive ven-dor l ists, pu rchase enqui r ies, ana lys is of tenders. Preparat ion of pu rchase requis i t ions or or-de rs • Exped i t ing and inspect ion of mater ia ls , plant and equipment in al l parts of the wor ld • Traff ic and routing by the most sat is factory and economic me-thod • P r e p a r a t i o n of data for import l i cences app l ica t ions and as -s is tance in negot iat ing cus toms dut ies and sa les tax levels in al l parts of the wor ld • Rece iv ing and warehous ing of mater ia ls, plant and equipment . Sandwe l l staff inc ludes personnel with w ide exper ience in the man-agement and superv is ion of c o n -struct ion work such a s : • Deta i led const ruct ion schedu l -ing and progress • Co-ord ina t ion of cont ractors work • Inspect ion and accep tance of cont rac t work • Con t inuous cos t ana lys is and budgetary contro l • Cer t i f icat ion of accounts for payment. Sandwe l l ' s evaluat ion of current techn ica l and econom ics deve l -opments in the pulp and paper, forestry and forest products in-dustr ies is not conf ined to as-s ignments undertaken for c l ients. Qual i f ied members of the staff maintain a wor ld-wide review of f ibre resources , technology and e c o n o m i c s . Repor ts on these sub jec ts are embod ied in S a n d -wel l deve lopment memoranda and research papers wh ich are pub l ished at frequent intervals. Sandwe l l staff, exper ienced pr in-c ipa l ly in the management and operat ion of pulp and paper mil ls and plants in the forest industr ies are avai lable to provide manage-ment and techn ica l serv ices de-s igned to br ing projects into full operat ion and up to capac i t y qu ick ly . These serv ices inc lude: • Se lec t ion and training of key superv isory and operat ing per-sonnel • Management ass is tance to im-prove ef f ic iencies of ex ist ing mi l ls and plants or part icular sec t ions and departments • Deve lopment and integration of ei ther manual or compute r i zed sys tems for product ion cont ro l , main tenance cont ro l , cost c o n -t r o l and s tock cont ro l . Expe r i enced personnel are avai l -able to conduc t market surveys for c l ients throughout the wor ld , typ ica l projects be ing : • B a c k g r o u n d s tud ies for a pre-l iminary market assessment • Deta i led surveys of market po-tential, compet i t ion, p r ices and consumer accep tance • Stat is t ica l ana lyses and long term forecast ing. APPENDIX C COMPARISON OF dcf AND npv METHODS OF ANALYSIS The -following simple i l l u s t r a t i o n is intended to show how the assumption that investment benefits are reinvested at a y ie ld equal to the internal rate of return'can. lead to an erroneous-decision... Consider two simple projects with the following cash flow d i s t r ibu-t ions . Project 'B - A' i s an a r t i f i c i a l project representing the d i f f e r -ence between Project A and Project B. Year 0 Project A - 1000 2 0 0 0 0 Project B - 1000 0 3 0 0 0 Project *B - A' 0 2 0 0 0 3 0 0 0 The internal rate of return and the net present value of these pro-jects can readi ly be calculated, and the results are shown.as follows. A discount rate'of 12 per cent, assumed to be representative of a firm's after-tax opportunity cost, was used to calculate npv. Internal Rate Net Present of Return Value (12%) Project A 100% 790 Project B 733 1380 Proj ect 'D - A' $0% 680 - 129 -- 130 -If the projects are not mutually exclusive and i f the firm's oppor-tunity cost is 12 per cent, both projects should be undertaken, assuming that sufficient financial and other resources are available. However, i f the projects are mutually exclusive (i.e. represent different ways'of accomplishing the same objective), or i f sufficient .. resources are not available to undertake both projects, the 'best1 project must be selected. If the decision were based solely on the internal rate of return, (irr), Project A with an i r r of 100.per cent, as opposed to. Project B with an i r r of 73 per cent, would be selected. The a r t i f i c i a l Project 'B - A' has an acceptable i r r of 5*0 per cent, indicating that the increment in going from Project A to Project B is desirable. When the cash flows are evaluated using the firm's opportunity cost - the npv is calculated Project B is also shown to be more desirable than Project A. Clearly Project B is the better project, and a decision based solely on the i r r would be erroneous. In order for the same benefits to be obtained from Project A as from Project B, the $ 2 0 0 0 received in Year 1 must be reinvested to yield $ 3 0 0 0 in Year 2 . A reinvestment yield of $0 per cent is required. If the 12 per cent opportunity cost is representative of the investment possibilities open to the firm in Year 1 , i t would not be possible to obtain the same benefits from Project A as are available from Project B. Now looking at Project 3 , i t would be necessary to borrow §2000 in Year 1 against the $ 3 0 0 0 which will be received in Year 2 , in order to obtain the same benefits as are obtainable from Project A. Providing that borrowing is available at a rate of less than 5*0 per cent, this is possible. Hence on this basis, Project B is also superior. - 131 -The best project i s indicated d irec t ly by the maximum npv. Project B has a npv of $1380 as opposed to $790 for Project A, and hence is preferable. In this case, the time value of money i s calculated using a r e a l i s t i c rate of 12 per cent, rather than the internal rate of return which may or may not r e a l i s t i c a l l y represent the time value of money to the firm. This simple i l l u s t r a t i o n i s unl ikely to be representative of actual investment p o s s i b i l i t i e s , and certainly not of large capital projects, which a r e the focus of this thesis . It does, however, show how the reinvest-ment rate enters into evaluation of investment proposals, and how use of the internal rate of return as the sole parameter for investment analysis can lead to erroneous decisions when comparing alternatives. 

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