Role of Operating Costs in Determining Net Present Value

There are many factors used by municipalities for the selection of capital equipment from among competing providers.

By James A. Sullivan and John P. Platz

There are many factors used by municipalities for the selection of capital equipment from among competing providers. The factors employed range from subjective (reputation, relationship, etc.), to quantitative (price, operating cost, etc.). This article focuses on some of the requirements of an accurate and objective cost comparison.

Over the operating life of a piece of process equipment (20 years is common), the cost of operation can dwarf the original capital cost of the equipment. A net present value calculation is an effective tool used to evaluate projects based on cash outflows and inflows. The NPV discounts cash flows to a present value and allows the evaluator to compare projects based on the results.

The challenge in preparing a meaningful NPV comparison lies in the accuracy and timing of the cash flows. Compounding the issue is the fact that information about operating costs which make up the majority of the cash outflows are provided by vendors. NPV calculations based on inaccurate cash flow data will misrepresent the costs of operation and may result in sub-optimum equipment selection.

Ideally, manufacturers would provide detailed and accurate operating cost information including parts replacement, energy consumption, routine maintenance, and associated labor costs. In practice, evaluators must examine a vendor’s claims and compare them with the guarantees provided by the vendor. For all cost components there must be a reasonable relationship between guaranteed and expected values used in an NPV calculation.

As an example, using a 20 year expected life for a component with a five year guaranteed life in the calculation of NPV would be misguided. Allowing this sort of distortion could justify a higher capital expenditure based on promised lower operating costs that will not be realized. In practice, the relationship between guaranteed life and expected life is impossible to establish with any accuracy so it is prudent to use the guaranteed life in the NPV calculation and dispense with the expected life altogether.

This approach should be applied to all aspects of operating cost – energy consumption, routine maintenance, etc. In a competitive market, this requirement will have the result of improving the warranties provided by the equipment suppliers as they strive to win jobs via the NPV calculation.

The evaluator must carefully select the operating conditions at which he makes the NPV comparison. While it is quite logical to design a plant that addresses peak demand, future expansion, or particularly difficult conditions, these are not the conditions that should be used as the basis for the NPV evaluation. Design conditions are often selected as the basis of calculating the operating NPV under the guise of conservatism but in fact, this approach is simply wrong.

Analyzing costs at conditions that are rarely if ever experienced could have the effect of justifying higher capital expenditures based on anticipated operating savings that are never realized. The evaluation must be made based on the conditions most likely to exist when the equipment will be operated.

A common mistake in NPV evaluations is the use of artificially high, fixed values for costs as opposed to gradually escalating or event driven increases. As an example, if higher utilization is expected in year seven, there is no reason to calculate the NPV as if the higher utilization begins immediately. Similarly, higher costs projected for the future (energy, labor, etc) should be inserted into the calculation in later periods as opposed to applying them over the entire operating life.

The nature of the NPV calculation is one of time-value weighting – higher costs later in time have a diminished effect on the present value of the cash flow. This issue can be dealt with by way of costs defined in multiple time periods.

In summary, the calculation of the net present value of ownership of competing equipment offerings is a critical component in making a proper selection. The approach described here provides a method to assure a reasonable relationship between vendor claims and guarantees and may even enhance the guarantees that are offered. Making the comparison based on the conditions most likely to be encountered will also give the evaluator the best picture of actual costs.WW

About the Authors:

James A. Sullivan is Vice President of UV and Corporate Business Development for Calgon Carbon Corp., a Pittsburgh, PA, based global manufacturer and supplier of activated carbon and innovative treatment systems. He serves on WWEMA’s Board of Directors. John P. Platz is the Director of Sales for Calgon’s UV Technology Division.

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