Jones D.S.J., Pujado P.R. Handbook of Petroleum Processing
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856 CHAPTER 17
A unit is not built overnight. Expenditures normally accrue over the procurement,
fabrication, and construction period that, for a plant of average complexity, can usually
take anywhere from 2 to 4 years. Not knowing further details, 2 years may be assumed
for relatively simple units and 3 years or more for more complex ones; very simple
units may be assumed built in one to one-and-a-half years.
It is common practice to assume that the cost of the capital expenditures that accrue
over the construction period is covered by a short-term loan on a 100% debt basis.
This assumption is not unreasonable: even if the funds are provided on an equity basis,
the expenditures represent a short-term opportunity cost that can be accounted for
through the short-term loan concept. It is true that, often, funds are provided through a
long-term loan, but this is of relatively little consequence over the construction period;
assumption of a short-term loan at worst provides for a more conservative estimate.
How are the capital expenses allocated over the construction period? Unless actually
known, there is no common school of thought as to how construction costs ought to
be spread. Equal shares (i.e., one-third each over a three-year period) can be used
for simplicity; others might prefer to use a 30%–50%–20% distribution over a 3-year
period to account for the fact that expenses tend to occur up-front.
Regardless of the way used to allocate capital over the construction period, the interest
charges accrued over this period are accumulated and capitalized (usually on a year-
end basis) as part of the erected cost of the unit. If properly accounted for, separate
allocations should be made for items within battery limits and for offsite items. In fact,
because different individual items such as columns, heat exchangers, etc. may have
to be retired and replaced at different times over the life of the unit, a running count
of interest expenses should be maintained for each individual piece of equipment.
To provide an example in a similar, but unrelated, situation in a plane the jet engines
have a different depreciation schedule and tax treatment than the main body within
the fuselage. It is therefore always advisable to account for the capitalization of as
many individual items as possible; it is not an impossible task with a relatively small
computer to keep track of events and charges.
Royalties
Royalties are normally added to and capitalized with the plant investment even though
a different depreciation schedule may be used for royalties.
Adsorbent, catalyst, and metals inventories
Catalyst base and metal make-up, additions and reprocessing costs should be han-
dled as an operating expense, along with chemicals and other consumables, in the
production cost summary.
ECONOMIC ANALYSIS 857
A question arises as to how to handle a catalyst base inventory or an adsorbent
inventory, principally when the life of the catalyst or adsorbent is expected to span
several years.
Essentially there are two ways:
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We can treat the catalyst as a consumable with the annual consumption calculated
by prorating the inventory over the expected life span of the catalyst. The catalyst
inventory itself can still be treated as a capital item for the purposes of calculating
interest on capital, if the investment is leveraged.
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We can treat the catalyst inventory purely as a capital item. The catalyst inventory
can then appear in the production cost summary as (a) an amortization term and
(b) interest on capital.
Tax law considerations may favor or dictate which approach should be taken. In
general, however, the latter approach is preferred; namely, the catalyst or adsorbent
inventory is capitalized and amortized over its expected useful life. While, in principle,
both approaches would seem to be numerically equivalent, the amortization approach
has a more favorable impact on the cash flow since amortization is an add-back
item. Whenever allowable, this approach also makes it possible to use accelerated
amortization schedules.
Catalysts should never be amortized and treated as a consumable at the same time!
Those metals that are not recovered and are disposed of with the catalyst base are
treated as an integral part of the catalyst and accounted for as the catalyst base.
Metals—principally noble metals—that are recovered at the end of the useful life of
each catalyst batch are carried only as working capital and, therefore, appear in the
production cost summary only as an interest item.
Small metal losses incurred when the spent catalyst is reprocessed and the cost of
reprocessing itself can also be amortized over the useful life of the catalyst, but are
most often handled as operating expenses.
Catalyst stockpiled as inventory for future use is part of the working capital.
Working capital
Working capital items are those items that:
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require an additional front-end investment even though they are not part of the
physical plant
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accrue additional interest charges, usually in the form of short-term loans
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can be recovered at the end of the useful life of the project
858 CHAPTER 17
For timing purposes, working capital is usually assumed to be available upon com-
pletion of construction. The following items comprise the working capital in most
economic studies:
Additive items
Feedstock inventory
Supply of raw materials valued at delivered prices. Excluded are any materials that
are not normally stored (gases, for example). Unless specified otherwise, a 1/2 month
supply or equivalent liquid and solid feedstock storage is assumed.
Finished product inventory
Supply of principal products and by-products, if any, valued on a gross cost of pro-
duction basis. Again, a 1/2 month storage is assumed unless differently specified.
Excluded too are items that are not normally stored (e.g., hydrogen or light ends).
Accounts receivable
Typically it is assumed to consist of one-month’s worth of production. Production
includes main products, by-products, and any other items that might be sold on a
regular basis.
Cash on hand
Typically estimated as the equivalent of one week’s cash flow.
Adsorbent, catalyst, and metals
Normally, only those items that are fully recoverable, and thus not amortizable, are
part of the working capital. Typical is the inventory of noble metals in the plant.
Warehouse and spare parts inventory
Any spare items kept in storage on a regular basis are included as part of the working
capital. Excluded are items ordered and kept in storage on a short-term temporary basis
until installed. Typical working capital items would be spare loads of adsorbents or
catalysts and spare parts such as compressor rotors, rotary valve gaskets, replacement
pumps, etc. Since a detailed inventory of spare parts is not usually available for a
preliminary economic analysis, it is common practice to assume that the total amounts
to, say, 2 or 3% of the erected cost within battery limits.
Subtractive items
Accounts payable
Typically assumed as one month’s worth of raw materials and other consumables at
delivered prices.
ECONOMIC ANALYSIS 859
Cost of production
The concepts usually included as part of the Cost of Production summary were item-
ized in the opening section. Essentially, they were grouped under five major sections:
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Variable costs
Materials
Utilities
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Operating costs
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Operating expenses
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Capital items
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Taxes
Variable costs
Variable costs are those that can be directly associated with the production process
as concerns the consumption of materials and services or utilities. A characteristic of
variable costs is that they are roughly proportional to the amounts produced. Thus, if
the total annual production were to increase by, say, 20%, the annual variable costs
would be expected to also increase by roughly 20% (any differences would be due to
changes in production efficiencies only) so as to maintain a uniform variable cost of
production per unit item. Typical variable costs of production are:
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Raw materials costs
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Catalysts and chemicals
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Utility requirements
and, in general, any other consumables expended in the production process.
Although not part of the costs, it is customary practice to subtract here any variable
credits such as:
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By-product credits
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Utility credits
More appropriately, these concepts should be entered under a separate heading of
variable credits.
If the establishment of a cost of production is the main objective of the analysis, all
the various costs are added up to the final grand total. If, on the other hand, it is desired
to calculate an income or cash flow result, the various costs will be added up and the
result subtracted from a base term that will comprise the revenue generated by the
production of all major products or co-products assumed sold at prevailing market
prices estimated at an equivalent production level from other manufacturers.
860 CHAPTER 17
Operating costs and operating expenses
These are typically fixed operating charges unless there is a major revision of the
plant’s operating conditions. Typical items are:
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Labor
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Maintenance
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Plant insurance
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Property taxes
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Direct overhead
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General plant overhead
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Sales and administration expenses
and, possibly, many others depending on an individual plant’s characteristics and
accounting basis. In general, all these expenses are fixed in that they remain about the
same on an annual basis irrespective of the plant’s actual running capacity. Naturally,
if business is poor and production rates are low on a consistent or extended basis, we
can expect that measures will be taken to lower these charges to the extent that it may
be feasible (e.g., reduction in labor through lay-offs or reduction in overheads through
some other belt-tightening measures) but, in general, changes in these concepts will
always be limited, short of shutting down the plant.
Labor
Labor includes the personnel required at various skill levels to operate the unit on
a 24-hr basis. Since shifts usually run for 8 hr, a minimum of three operators are
required to staff each position. Actually, because of holidays, vacation, leave time,
etc. the staffing requirements are considerably higher.
An average year of 365.25 days consists of 8766 hr. The basic work load per individual
at 8 hr/day and 5 days/week is about 2090 hr/year, corresponding to an average of 4.2
operators/shift. This value is often seen in economic estimates, but is not quite correct.
If we instead estimate the time off as follows:
days/year
Weekends 104
Vacation (3 week average) 15
Holidays 10
Sick leave (estimate) 10
139
The corresponding annual workload is 1,810 hr. Therefore, the number of individuals
required to fill each shift position is 4.84 (say 4.8) rather than 4.2.
ECONOMIC ANALYSIS 861
Labor rates are those prevailing within a particular geographical area. Base labor rates
are typically used. Fringe benefits, often estimated at 35–45% of base labor rates, are
more commonly accounted for as direct overhead.
Supervision, including overall supervision and shift foremen, is frequently estimated
as 25% of labor. Otherwise, one foreman per shift may be assumed together with one
single overall supervisor on a day shift basis only.
Maintenance
Maintenance labor and maintenance materials are always accounted for as a percent-
age of the investment cost within battery limits (ISBL). This percentage may be as
high as 4 or 7%, but it should be estimated based on past experience. Often an al-
lowance of 3% and in many cases as low as 2% is often sufficient for most of refinery
or petrochemical units built according to heavy duty specifications (e.g., API). The
periodic replacement of parts due to corrosion, wear, etc. should be accounted for as
part of the overall annual maintenance allowance.
Property taxes and plant insurance
It is customary to estimate the total of these charges at about 2% of the plant erected
cost within battery limits (EEC). (Others may use, say, 1.5% of fixed investment,
including battery limits, and offsites.)
Direct overhead
Direct overhead in its usual interpretation consists of fringe benefits and other labor
related concepts (personnel department, etc.). It is often allowed for at 35–45% of
the total charges for labor and supervision. Some estimates include direct overhead
as part of labor expenses.
General plant overhead
This allowance is best estimated based on past experience; it may vary considerably
depending on each company’s practice. A common practice is to assign to it, say, 65%
of the total of labor and maintenance. Others may use, say, 80% of labor.
The general plant overhead concept is meant to include the costs of operating shops,
labs, etc. as they are allocated to the operation of the plant. Research and analytical
expenses are often allocated also as part of plant overhead unless accounted for
separately.
Sales and administration
In order to avoid further complexity it is best to assume that these expenses are
included as part of the general plant overhead. At times, however, this is not practical,
principally if the plant is part of a more extensive organization. A corporate overhead
entry may be included in these cases. If not part of the general plant overhead, sales,
862 CHAPTER 17
and administration can then be assumed to be part of corporate overhead. At other
times a cost of sales, say 5%, is allocated as a percentage of product revenue.
The actual accounting for this item is largely immaterial except for those few cases
when one wishes to distinguish a cost of production from a cost of manufacturing,
thus making a distinction between plant-related costs and other extraneous costs.
Capital items
Capital items are those directly related to the plant investment and include:
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Depreciation
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Amortization
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Interest on capital
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Interest on working capital
Depreciation and amortization expenses are significant in that they are substantial, but
are not real. Thus, while both depreciation and amortization charges are subtracted
in order to calculate a net (pre-tax or post-tax) income, they in no way affect the cash
flow out of the unit and, therefore, are added back for the purpose of determining the
cash flow.
Depreciation
Depreciation represents a capital recovery. As such, it is a certain amount of money
related to the capital investment spent up-front that is set aside on a regular basis,
without interest, over a certain period of time to represent the recovery of the original
capital.
Depreciation is accounted for separately, apart from any return-on-capital (ROI). The
reasoning behind this practice is that, as the plant ages, provision should be made
to accumulate capital for its eventual replacement. Obviously, in actual practice,
financing of an actual replacement, if any, will rarely depend on capital accumulated
in such a manner. If viewed as a capital build-up for plant replacement, depreciation
would be equivalent to a zero-interest sinking fund.
Apart from philosophical interpretations, the real value of depreciation is that it is
almost universally tax deductible. On the basis that depreciation represents a gradual
recovery of the original capital, it is regarded as not being part of the profits generated
by the plant and, therefore, not subject to taxation.
An interesting—and legal—dichotomy arises at this point. From an actual operating
viewpoint one wishes to show as much profit as possible and, therefore, as little
depreciation as possible. However, from a tax viewpoint, one wishes to maximize
depreciation so as to minimize the immediate tax liability. This is the only place
ECONOMIC ANALYSIS 863
where two perfectly legal and different accounting methods can be applied that lead
to different results.
For financial reporting purposes, the Financial Accounting Standards Board (FASB)
in the United States dictates what minimum depreciation levels should be used. If
not subject to any particular requirements, it is customary to use 10-year straight-line
depreciation for plant equipment and 20-year straight-line depreciation for (most)
offsites. (Sometimes, however, in order to bring depreciation schedules closer to
those used for tax accounting 5- and 10-year straight-line depreciations are used for
plant and offsites, respectively.)
For tax accounting purposes it is advisable to use whichever fastest rate of depreciation
is allowable under the local current tax laws. (Whenever allowed, it may be advisable
to start with the fastest rate of accelerated depreciation allowable and later, when
the amount to be depreciated is relatively small, switch to, say, straight-line so as to
prolong the depreciation benefits.) The golden rule in tax accounting is
pay the least and the latest...within the law!
Since tax effects are ignored in most of our representations, this discussion is largely
irrelevant. However, when tax effects are included it becomes apparent that the tax
liability incurred under financial accounting principles is much higher than the tax
actually paid. This gives rise to a deferred tax liability. The reasoning is that eventually
this deferred tax will have to be paid; in actual practice, if sufficient capital items are
added or replaced over the life of the plant, depreciation can be rolled over so as to
largely neutralize the effects of deferred tax liabilities.
Amortization
Amortization is akin to depreciation. Amortization is the general term for the process
of allocating the acquisition cost of assets to the periods of benefits as expenses. It is
called depreciation for plant assets, depletion for wasting assets or natural resources,
and amortization for intangibles.
We use the general term amortization to allocate expenses for the initial catalyst
inventory costs. (In the sense that a catalyst life is relatively brief we could think of
this amortization as a depletion allowance.)
It is customary to amortize the catalyst inventory over its estimated useful life, irre-
spective of what the actual life might be.
Interest on capital
Though very important in real life, interest on capital should not be used in a prelim-
inary economic analysis.
864 CHAPTER 17
Most commercial plants are heavily leveraged; namely, most plant owners choose to
borrow as much capital as possible instead of investing their own money. Usually,
the final investment will consist of a certain amount of debt (amount borrowed as
long-term loans) and the rest equity (investors’capital). If the return-on-capital is
calculated relative to equity, its value is distorted by the relative percentage of debt.
For example, if the plant is financed through 100% debt, a net return of $1.00 will
represent an infinite rate of return for the investors who have exposed none of their
own capital.
Also, the interest paid on capital ultimately is part of the plant return-on-investment
and should be added back to the usual return-on-investment calculation in a traditional
analysis.
Finally, if interest on capital must be used, it should be used on an average interest
basis as explained in Appendix 17.2.4. The base interest rate, typically the prime rate
applicable to a large long-term loan, will be averaged over the pre-established life of
the loan or calculated on a year-to-year basis if a cash flow analysis is performed over
time.
Interest on working capital
Working capital is normally assumed carried as 100% debt. Because of its nature,
working capital revolves somewhat like a line of credit and, therefore, is more rep-
resentative of a short-term loan for which a higher rate of interest applies than for a
long-term loan. Also, there is no interest averaging for working capital loans as they
are assumed renewed on a year-to-year basis.
Reporting parameters
Several terms are often used for reporting purposes:
Cost basis
The summation of all costs without capital items leads to what is called the cash cost
of production. The cash cost of production represents the total of raw materials costs,
chemicals and catalysts costs, utility costs, operating costs, and overheads.
The net cost of production is obtained by taking the cash cost of production and
adding capital items: depreciation and amortization. As indicated above, interest
on capital should not be used; interest on working capital may or may not be in-
cluded at this point depending on individual practice. It is customary to include it,
but others prefer to calculate cash flows on a total equity basis, including working
capital.
ECONOMIC ANALYSIS 865
Return basis
The simplest parameter is the return-on-investment (ROI). This simply is the differ-
ence between product revenue (product value) and net production cost divided by the
total investment. For this purpose, total investment is normally viewed as total fixed
investment or total plant investment. Total fixed investment is the plant investment
(EEC) within battery limits (ISBL) plus the plant investment outside battery limits
(OSBL). EEC may be used instead of total fixed investment if clearly understood and
agreed upon that this is the case. ROI’s are normally calculated on a pre-tax basis;
they can also be estimated on a post-tax basis, if desired. Royalties and interest during
construction should be included as part of the total plant investment.
A second simple return parameter often used is pay-out time (or pay-back time). This
represents the ratio of total fixed or plant investment to operating cash flow. (This type
of pay-out time will not agree with the pay-out times calculated on a discounted cash
flow (DCF) basis.)
Typical rules of thumb are that a new smallish project is attractive if a, say, 25%
pre-tax ROI can be obtained. If this is coupled with overall depreciation estimated at
10% (10-year straight-line), the corresponding simple pay-out time is about 3 years.
Very large, expensive projects may be justified with longer pay-out times of about 5
or even 7 or more years.
Higher pre-tax ROIs and shorter pay-out times are usually required for revamps or
retrofits. Typical 1–2 years maximum pay-out times are often required for revamp
projects, again depending on their relative magnitude.
Other parameters
Other common reporting parameters are:
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discounted cash flow (DCF) rate of return (internal rate of return)
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required sales price for a given DCF rate of return
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cash flow pay-out time
These parameters are associated with the use of discounting over a time series of cash
flows.
Cash flow analysis
The previous section examined the economic summary prepared at one particular
point in time, usually a “typical”production year. In this section we examine the
economic analysis extended over an extended period of operation, usually 10 or
20 years.