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UNIT 2

Basic Concepts

This unit introduces the concepts that are used in translating controlimprovement into financial results. The basic concepts and terminology ofcapital budgeting are defined. Many terms are also defined inAppendix C.

Learning Objectives When you have completed this unit you should:

A. Understand the differences among control, process, and economicperformance.

B. Understand the concept of cash flow.

C. Know how projects are evaluated.

D. Know how probabilities can be used to combine cash flows ofdiffering scenarios into an expected cash flow.

2-1. Measures of Performance

In many fields, measures of performance are used to characterize howwell a given entity meets its objective. The appropriate measure dependson the objective. For instance, a baseball player's hitting performance may

be measured by batting average, while a team's performance is bettercharacterized by its won-lost record. When considering the implementa-tion of a control project, several measures must be considered, includingcontrol performance, process performance, and economic performance.

Control performance is a measure of how well the control system achieves

its objective. This objective is usually regulatory (i.e., holding a measuredor computed quantity at its desired value), and performance is measuredstatistically and expressed as some function of deviation from target, orvariability. Among the commonly used functions are range, maximumerror, and standard error. Range is the difference between the maximumand minimum values. Maximum error is the largest deviation from setpoint. Standard error is the root mean square deviation from set point. Ifthe loop is not biased, standard error is equal to standard deviationaround the mean value. Other measures include percent outside limitsand range within some percentage, typically 95%. Fig. 2-1 shows some ofthese measures.

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10 UNIT 2: Basic Concepts

Standard deviation and 95% limits are the best measures for typical pro-cesses, but other measures are more appropriate in certain cases. Forinstance, maximum error is the best measure when a large deviation fromset point can cause catastrophic failure. Percent outside limits is appropri-

ate for processes, such as wastewater pH control and averaging level con-trol, in which any value within limits is equally acceptable and any valueoutside limits is equally unacceptable.

Process performance is a measure of how well the process achieves its objec-tive. Various criteria can be used as measures. Reverting to the baseballanalogy, a hitter's performance can be measured in terms of production(number of hits per season) or efficiency (hits per time at bat, or battingaverage). Most processes use energy to convert raw material into product.Measures of process performance include production rate, expressed asunits of product per unit time, and efficiency, expressed as units of prod-uct per unit of raw material and/or energy.

Improvement of control performance does not necessarily improve pro-cess performance. Sometimes it does, but usually it only creates an oppor-tunity. More often, process conditions or operating procedures have to bechanged to take advantage of better control.

Economic performance is measured in financial terms. Processes are oper-ated to make money. Economic performance, like process performance,can be stated in terms of production or efficiency. Financial productionrate is expressed as dollars per unit time. Financial efficiency is expressed

as financial production per dollar invested.The relationship between process performance and economic perfor-mance is similar to that between control performance and process perfor-

Fig. 2-1. Some Measures of Variability

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UNIT 2: Basic Concepts 11

mance. Improved process performance does not guarantee that theprocess will make more money. Operating practice often must be changedto realize the potential benefits, as shown in Example 2-1.

Example 2-1: A blending plant installs feedback composition control,which reduces product composition standard deviation before batch cor-rection by 70% (a control improvement). The controls allow elimination ofdelays for product analysis, so the plant can now turn out 20% more prod-uct per day (a process improvement). There is no market for the additionalproduct, so unless operating practice is changed, the process improve-ment will result in a net loss, since the added product will require addi-tional raw material. One alternative is to change operating practice byrunning the plant only four days a week instead of five. Production will beunchanged, but labor costs will be reduced by 20% (an economic improve-ment).

2-2. Cash Flows

In economic terms, a project results in a series of cash flows over time.First, the cash flows out as costs are incurred, then once the project is com-pleted, cash flows in as revenues are generated. Net cash flow is definedas the difference between cash inflows (positive) and cash outflows (nega-tive) over a given period of time, usually one year. Fig. 2-2 shows a cash

flow diagram for a typical Project X with a cost of $100,000, annual reve-nues of $30,000, annual expenses of $8000, and salvage value after 10 yearsof $10,000. Cumulative cash flows for Project X are shown in Fig. 2-3. Thecash flow structure of this project is typical, but subject to many variations.Not all costs may be incurred initially. Revenues and expenses may varyfrom year to year. Salvage value may be zero or negative.

2-3. Costs

Costs are simply outgoing (negative) cash flows. Economists distinguishamong several types of costs. Those used in this text include first cost, whichis the initial cost of a capital project, and operating costs, which are the recur-ring costs incurred while running a facility. Operating costs are dividedinto fixed costs, which are unaffected by production rate, and variablecosts, which vary with production rate.

Two kinds of costs that are often used incorrectly in project evaluation aresunk costs and opportunity costs. A sunk cost is a cost that has occurred inthe past, before the project under consideration. It has no relevance to

project evaluation and should not be included in the first cost of theproject. Opportunity cost is income that must be forgone because of theproject in question (e.g., income that might be earned by an alternative use

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of the resources committed to the project). It is often ignored when itshould be included as a first or operating cost. For example, suppose anexisting supervisory computer can oversee three finishing lines and earns$10,000 per year per line. If a new control system is connected to the com-puter and ties up part of the computer's capacity so that it can overseeonly two lines, the forgone earnings of $10,000/year should be counted asan operating cost of the new system.

Fig. 2-2. Project X Cash Flow Diagram

Fig. 2-3. Project X Cumulative Cash Flow

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2-4. Benefits

Benefits are incoming (positive) cash flows. The most common sources ofbenefits are added revenue from additional sales and cost savings. Cost

savings are most likely to result from reduced usage of raw materials, util-ities, or labor.

Some benefits may require ingenious configuring to quantify. Pollutionabatement benefits can often be expressed as avoidance of disposal costsfor unwanted byproducts or avoidance of regulatory penalties for excessemissions. Benefits must be expressed in cash flow terms for the purposesof project evaluation.

2-5. Project Evaluation

Estimated costs and benefits can be combined to produce an incrementalcash flow table. This cash flow table lists all the inflows and outflows thatare directly related to a particular project. It is the basis for project evalua-tion. The cash flows discussed in this course are pre-tax and are notadjusted for inflation. Tax considerations are ignored for reasons of sim-plicity, avoidance of rapid obsolescence (tax laws on capital expenditureschange frequently and substantially), and canceling effects (costs and ben-efits are both reduced by taxes). Taxes do have some effect on viability ofmarginal projects. If taxes must be included in the calculation, assistanceshould be sought from an accounting or legal department, who are morelikely to be up to date on tax law. Inflation is ignored for simplicity. If cashflows are presented in current dollars, inflation is often accommodatedimplicitly by requiring a higher rate of return or faster payback to com-pensate for inflated revenues in later years of the project.

Any organization, whether private or public, has only a finite pool of capi-tal. This pool of capital is subject to myriad demands, of which process

control projects form a small part. The organization must set up somemethod of capital allocation. A large number of methods have been pro-posed, and several are in common use. This text discusses the most popu-lar, includingpayback, return on investment, net present value, and internalrate of return. Application of each method results in a single figure of meritthat characterizes a project. The figure of merit may be used as a decisiontool, to decide whether Project X should be funded, or as a ranking tool, todecide whether Project X or Project Y is more attractive. Example 2-2shows how payback, the simplest method, is applied.

Example 2-2:Payback is simply the time required to recover first costs.Project X, for which cash flows are shown in Figs. 2-2 and 2-3, has a pay-

back period of 4.55 years. This can be seen clearly in Fig. 2-3 as the time at

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which cumulative cash flow reaches zero. If the organization's criterion forinvestment is a payback period shorter than 5 years, the project qualifiesfor investment. In times of easy capital accessibility, this may be sufficient

justification. More commonly, there are more qualifying projects than can

be funded. If $500,000 is available for capital investment and Project X iscompeting with Projects A, B, and C described in Table 2-1, then onlyprojects A and C will be funded. In this case, payback in less than 5 yearsis a necessary but not sufficient condition.

2-6. Uncertainty and Probability

All of the discussion to date has assumed that we know what will happenin the future so cash flows can be estimated with certainty. In fact, no one

can know what will happen. Any of several sequences of events over time,or scenarios, may occur. One can make an educated guess at the likelihoodof a particular event. This educated guess is an estimate of theprobabilityof the event. Event probabilities can be used to calculate scenario probabil-ities. The sum of probabilities of all possible scenarios must be 100%.

Example 2-3:A new on-line analyzer is to be installed. The analyzer costs$15,000, and is expected to produce benefits of $4000 per year for the next5 years. The analyzer's sampling system is untried and may fail to work. Ifit is unsatisfactory, a tested sampling system can be installed at an addi-

tional cost of $5000. It will take one year to decide whether the originalsampling system is working properly, and the estimated chance of failureis 30% (event probability).

From this information two scenarios can be constructed. Scenario A, witha probability of 70%, shows the expected initial expenditure followed bythe expected benefits. Scenario B, with a probability of 30%, shows addi-tional sampling system expenditure and revised benefit timing.

2-7. Risk

All projects have some risks, technological and/or commercial. Technologi-cal risks apply to hardware, software, and implementation. A valve that

Project First Cost, $ Payback, Years

A 400,000 2.5

B 200,000 4.4

C 100,000 3.8

X 100,000 4.5

Table 2-1. Competing Projects

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may not control flow with the requisite precision is a technological risk; sois a programmer who may take 6 months longer than scheduled to codean on-line optimizer. Commercial risks apply to the business climate. Arecession two years after the project is completed may affect product sales.

A competitor may cut prices to increase market share. Technological riskscan affect both costs and benefits. Commercial risks usually affect benefits.

If the risks are negligible, it is reasonable to present a single expected cashflow scenario for project evaluation. If the risks are significant, multiplescenarios, accompanied by probability estimates, should be considered. Inmost cases, only reasonably likely scenarios with a probability of at least10% should be included. The threshold probability for a disaster sce-nario that would result in substantial impairment of the financial health ofthe organization should be lower, perhaps 1%. If a single number iswanted for project ranking, cash flow scenarios can be combined,weighted according to their respective probabilities.

Exercises

2-1. A vessel temperature is controlled around a set point of 200C. Iftemperatures are more than 5C from set point, product is discolored andmust be recycled. What is the most appropriate measure of controlperformance for this loop?

2-2. A blending process makes C by mixing A and B. C is required to contain atleast 20% of A, the more expensive component. The present control systemhas a composition range of 4% and makes no off-specification material. Anew system will have a range of 2%. Without any changes in operatingpractice, how much process improvement will be realized using the newsystem?

2-3. What change in operating practice to the process described in Example 2-2will generate a process improvement using the new system?

2-4. In Example 2-3, what would the cash flows be for Scenario A? For ScenarioB? Assume that if the sample system is not working properly, no revenuesare generated.

2-5. In Example 2-3, what would the payback be for Scenario A? For ScenarioB?

2-6. In Example 2-2, if Project X's first cost, could be reduced to $75,000, whichprojects would be funded?

2-7. If the scenarios in Example 2-3 were combined, what would the cash flowlook like?

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