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chapter 8

Economic analysis
of the specific proposal
8.1 Purpose
At this stage, the only purpose of this preliminary economic analysis of the
proposal is to supply information on the profit potential of the final plant,
which is needed to justify the continued expense for its development. This
is definitely not the kind of economic analysis that will be needed later to
approve the investment of tens or hundreds of millions of dollars in an
industrial plant (see Chapter 10).
The preliminary analysis can be done within the project team, if an
experienced cost engineer is available, or by a specialized consultant, or
it may be subcontracted to an engineering company. It is based on:
The process data contained in the preliminary design package, which
was described in the previous chapter
The cost data available in the files from previous projects
The input from the marketing experts
The non-committing, up-to-date quotations for the major equipment, obtained by direct contact with potential suppliers (not as formal tenders)
To save time, this economic analysis could be started on partial drafts of
the preliminary design package, which could be supplied informally, but
of course, the bottom line recommendation can only be completed after
the preliminary design package is completed and ready to be formally
presented.

8.2 Preliminary estimate of the Fixed Capital Investment


(revision 0)
The working methodology for the preparation of fixed capital investment
(FCI) estimates is well known from textbooks.1,2 It is also practiced in
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most engineering groups with good results and need not be discussed
here in detail.
Just to recall some fact-of-life: For a preliminary estimate, the purchase,
delivery, and installation costs of the major pieces of equipment are estimated
separately, from the companys own records, or from published cost correlations, but mostly from up-to-date quotations obtained on-the-wire from
suppliers. Note that such preliminary quotations can be obtained at this stage
from only three or four suppliers, as it is not intended to make a bid comparison, but only to select a reasonable average cost for this task. But if one
of the quotations received from the suppliers is way out from the average,
this could indicate a problem in the concept or the wording of the request
specification, which should be clarified.
Table 8.1 illustrates a typical example for a preliminary small project for
the production of 5,000 tons per year (tpy) of zirconium oxide according to
a novel process (Gorin-Mizrahi, described in Chapter 5, Figure 5.2). The list
of equipment is taken from the preliminary process flow-sheets and the
estimated installed costs for each are based from recorded data from other
projects, with the necessary conservative adaptation and updating. One
should note that 90% of the installed equipment cost can be attributed to
eight complete packages from specialized suppliers (kilns, dryer, ball-mill,
agglomerator, etc.), including their design and operating know-how.
The sum of the installed costs of all the major pieces of equipment is
then multiplied by different relative statistical factors, representing the cost
contributions of minor standard equipment, buildings, piping, electrical,
instrumentation and control, services connections and infrastructure, engineering and management, start-up, and miscellaneous. These different statistical factors are individually chosen by an experienced cost engineer on the
basis of the recorded analysis of previous projects, and are adapted to the
specific characteristics of the present case (such as its location, request for
explosion-proof conditions, large flows of gases, etc.). For the case described
in Table 8.1, it was estimated that a factor of 3.0 would be sufficient, considering a lower need for detailed engineering and electrical hardware.
Separate safety margins (reserves) are then chosen to fit the uncertainty
built into the present state of project definition. These safety margins are
added to the total sum obtained above, but they will have to be reconsidered
in each of the future revisions of this FCI estimate, as the process and
implementation conditions will be more focused and their uncertainty range
will be decreased. For the case under discussion, a safety margin of 30% was
added to reflect the early status of the estimate, bringing the total FCI
preliminary estimate to $16,510,000. This does not include the promoters
own expenses, or the cost of additional testing.
This is the usual methodology for a preliminary FCI estimate. The format
used is not critical, as a completely new format will be used later for the
real investment budget, when it will be prepared for approval of the plant
(see Chapter 10).
Copyright 2002 by CRC Press LLC

Tag
T-01
T-02
T-03
S-01
MT-01
MT-02
MT-03
MT-04
MT-05
MT-06
M-01 *
M-02 *
M-03
C-01 *
K-01 *
K-02 *
K-03 *
M-04 *
M-05 *
M-06
M-07
M-08
M-09
M-10
M-11
M-12

Name
HCl solution tank
Fuel tank
Water tank
Raw material silo
CaCl2 solution mixed tank
Slurry mixed tank
Leaching first mixed tank
Leaching second mixed tank
Leaching third mixed tank
Lime mixed tank
Grinding ball mill
FB Aglom. dryer
Clinker hammer mill
Adiabatic absorption tower
Kiln 1
Kiln 2
Clinker cooler
Belt filter
Product dryer (solids)
Cooling screw conveyor
Wet cake elevator
Overhead crane
Solids feeder
Bagging machine
Dry granules elevator
Wet magnetic separator

Number
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1
1

MOC**

Size
50
100
300
70
50
20
1.9
1.9
1.9
20
1.80 ID
1.48 ID
1.5
1.8 ID
0.87 ID
0.87 ID
1.0 ID
32
700
0.1 ID
1.5
5
0.4
1
2
0.8

m
m3
m3
m3
m3
m3
m3
m3
m3
m3
3.2 m. L
3.0 m. L
tph
8.0 m. L
12.4 m. L
8.62 m. L
10 m. L
m2
kg/h
2 m. L
tph
mt
m3/h
tph
tph
m3/h

FRP
MS
MS
MS
MS
MS
FRP
FRP
FRP
MS
RLS
MS
MS
FRP + RLS
BL
BL
SS / BL
FRP + RLS
SS
SS
FRP + RLS
MS
MS
SS
SS

Installed Cost
20,000
15,000
32,000
30,000
17,000
20,000
20,000
20,000
20,000
25,000
900,000
1,000,000
50,000
100,000
500,000
500,000
100,000
500,000
200,000
7,000
20,000
10,000
15,000
25,000
10,000
18,000
continued

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Table 8.1 Typical Preliminary Fixed Capital Investment Estimate

Tag
P-01
P-02
P-03
P-04
P-05
P-06/07
P-08
P-09
P-10
Fan-01
Fan-02
Fan-04
Fan-05

Name
CaCl2 brine pump
Slurry pump
Clinker slurry pump
Waste stream pump
Wash water pump
HCl solution pump
Fuel pumps
Water pumps
Milk of lime pump
From aglom. dryer
Air to combustion
Air to clinker cooler
To stack
total

Number
1
1
1
1
1
2
1+1
1+1
1
1
4
1
1

MOC**

Size
1.3
2
1.5
5
3
2
0.3
10
0.5
20
2
0.7
2.5

m /h
m3/h
m3/h
m3/h
m3/h
m3/h
m3/h
m3/h
m3/h
m3/sec
m3/sec
m3/sec
m3/sec

MS
MS
SS
PP
PP
PP
MS
MS
MS
MS
MS
MS
FRP

Installed Cost
2,500
2,500
4,000
5,000
5,000
10,000
3,000
6,000
2,500
5,000
6,000
2,000
2,000
4,162,500

* = complete package
** = material of construction
FRP = fiberglass reinforced polyester; MS = mild steel; RLS = rubber-lined steel; BL = brick-lined; SS = stainless steel; PP = polypropylene

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Table 8.1 Typical Preliminary Fixed Capital Investment Estimate

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But there is an additional item that is often neglected, in the experience of


this author. That is the purchase cost of the internal inventory that is needed to
arrive at the steady-state operation of the plant. At most, the relatively small
value of the work-in-progress is recorded, that is, the cost of the different
materials having intermediate compositions between the raw materials and the
products, contained in the different pieces of equipment piping and storage. The
cost of the work-in-progress depends on the unit costs of the materials and
on the various residence times (as an extreme case, consider for instance a solar
pond in a salt operation, which takes several years to fill and concentrate).
Many plants also require auxiliary purchased materials. For example, the
solvent stock in a solvent-extraction plant may account for a quite significant
part of the FCI, depending on the unit cost of the particular solvent used and
on the internal volumes required. A similar situation exists with mercury cells,
resins columns, circulating active-carbon, thermal oil, etc. There is definite
room for optimization in this area, which is not always appreciated.
This omission is often attributed to the fact that many certified accountants do not accept the value of this internal inventory as part of the FCI, which
is used to calculate the tax-allowed depreciation and profitability of the investment, and also to evaluate indirectly the cost of maintainance. Despite the
bookkeeping formalities, however, almost all of the value of this internal
inventory is a one-time expense, which cannot be recovered, even if the plant
is terminated, and which, furthermore, will require some periodical make-up.
Another controversial issue is how to handle past and future development
expenses, in relation to the FCI of the first plant, which could be build on a
modest scale. Again, many certified accountants do not accept these development expenses as part of the FCI. There are different practices in this regard.
Most corporations have probably already included the (recorded) past expenses
in their yearly balances, and they are now forgotten. Other corporations may
have capitalized these past expenses as part of their investment in special
subsidiaries (daughter companies, joint ventures) and these sums have to
reappear in a new plants investment. The same issue will be related to the
treatment of (expected) future development expenses, to the point when a
decision to build a plant is reached. After that point, all development expenses
are generally included in the engineering budget, a definite part of the FCI.
Furthermore, the governments of certain developing countries encourage the establishment of new industries (declared of national interest) by
contributing a grant of 20 to 40% of the FCI, subject to certain conditions.
Such a grant could change much of the rules-of-the-game.

8.3 Estimate of operating costs


These operating costs are generally divided into fixed costs and variable costs,
to allow studies on the effect of different production levels. (See a typical
example in Table 8.2.) Their estimate is a standard compilation of all the
different operating cost categories, that is delivery unit costs and the consumption of:
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Table 8.2 Typical Preliminary Operating Cost Estimate


Fixed Cost per Year

Units

Management / sales employees


Operation / shift employees
Other employees
Overhead on employees
Indirect taxes and insurances
Spare parts
Waste disposal
R&D
Total fixed costs per year

Man-year
Man-year
Man-year
Estimate
Estimate
Estimate
Estimate
Estimate

No.
3
12
8

Unit Cost
80,000
50,000
40,000

Interest on working capital per year


Variable Costs per Ton of Product
Raw material A
Ton
1.51
Raw material B
Ton
0.916
HCl (100% basis)
Ton
0.076
Lime
Ton
0.075
Heavy fuel
Ton
0.39
Water
m3
15
Electricity
Kwatt.h
425
Packing and transportation to
Estimate
CIF
Total variable costs

Total
240,000
600,000
320,000
250,000
100,000
100,000
50,000
180,000
2,000,000
263,000

435
100
35
100
35
0.32
0

656.85
91.60
2.66
7.50
13.65
4.80
25.50
44.00
846.56

Raw materials and different materials additives


Services (see below)
Any disposal cost of the waste streams
Any packaging needed and the shipping of the products
The maintenance of the plant, including property taxes
Any contribution to maintenance of the site, taxes to the city, county, etc.
The yearly cost of the plant staff and contractors
Sales expenses, with any duty and taxes (if relevant)
Financial costs, i.e., depreciation and interest on the operating capital
Miscellaneous other minor factors

To each significant cost category, a separate safety margin (reserve) is


added to reflect the present insufficient state of knowledge on consumptions and actual delivery costs. These reserves can be added either in the
units needed (i.e., number of kilowatts per hour) or in the unit costs. These
should be noted for the record and should be reconsidered in each future
revision of the operating cost estimate, as more reliable information is progressively accumulated.
Contrary to the FCI estimate, the detailed format used for this estimate
of operating costs will probably be used later in many revisions, by other
engineers and managers, for repeated economic studies and for routine
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production budget planning. So it is worthwhile to consider from the beginning the most convenient and detailed working format.

8.4 Expected net sales income estimate


The expected net sales income is generally the weaker point of the
preliminary economic study, since it has a very large leverage. It can
only be estimated, with the active contribution of the market experts and
consultants, from the expected sales of product, quantity and invoiced prices,
after deducting any possible expense related directly to sales, such as the
various freight expenses to bring the containers from the plant to the final
destination, agents commissions, bank transfer fees, customs duties, and
so on.
The confidence level in this estimate could be very different, if:
The product is intended to be sold in an already established market,
with a recorded market price history, or within an exclusive sales contract to a wholesale distributor
The product is relatively new or improved, and its expected sale price
can only be based on what it should be worth to users
In addition, the interest on working capital or the cost of the standing
credit at the bank should be estimated, from data on the percent of the
product in store, in transit or payment delayed as per sales conditions, on
the sales revenue and on the expected level of banking interest. For example,
in the above case, 3 months of credit at 7% gives an expense of $262,500 per
year for 100% production.

8.5 Profitability calculation


The expected profitability is calculated following one of several standard methods, which are used in different countries and industrial sectors. This profitability is generally expressed as the percent of return on investment (ROI), before
any taxes on corporate income or profits, or as the present value of the operation
of the implemented project over a period of time, for example 10 years.
Table 8.3 gives an example of the presentation preferred by this author,
at this stage of the project review. It includes:
A project cash flow for a period of 12 years, in which the first 2 years
are for construction and the following 10 years for production at
increasing rates. For example, 50% of the nominal production in the
third (start-up) year, 75% in the fourth (consolidation) year, 100% for
the next 5 years, then a slight but gradual increase of production to
110%. (Note that this last assumption has almost no financial consequence in a healthy project; it is only included as an expression of
confidence in the future.)
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Table 8.3 Typical Return On Investment Based on Cash Flow and on Present Value of Yearly Cash Flow (in $1,000)
Total Investment
Average Sales $/Ton CIF
Pecent of Design Production
Return on Investment
Year

16,770
3000
100
31.1%
1

Fixed Capital Investment


FC Investment grant
Production % of Design
Capacity
Total production sale value, CIF
Fixed Production expenses
Variable production expenses
Interest on Working Capital
Royalties
Net Cash Flow
Disc. Net Cash Flow PV (10%
rate)
project's present value at 10%
ROI
Disc. Net Cash Flow PV (ROI
rate)
Cum Disc. Net Cash Flow PV

(6,708)

Copyright 2002 by CRC Press LLC

2
(9,224)

10

11

12

(839)
50

75

100

100

100

100

100

105

107

110

7,500
(2,000)
(2,141)
(131)

11,250
(2,000)
(3,211)
(197)

15,000
(2,000)
(4,281)
(263)

15,000
(2,000)
(4,281)
(263)

15,000
(2,000)
(4,281)
(263)

15,000
(2,000)
(4,281)
(263)

15,000
(2,000)
(4,281)
(263)

15,750
(2,000)
(4,495)
(276)

16,050
(2,000)
(4,581)
(281)

16,500
(2,000)
(4,709)
(289)

(300)

(1,000)

(7,008)
(7,008)

(10,224)
(9,294)

2,390
1,975

5,842
4,389

8,457
5,776

8,457
5,251

8,457
4,773

8,457
4,340

8,457
3,945

8,979
3,808

9,188
3,543

9,502
3,330

(7,798)

1,390

2,593

2,863

2,184

1,666

1,270

969

785

613

483

24,828
(7,008)
9

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The projected capital investment is divided according to a reasonable


pattern, such as 40%, 55%, and 5% in years 1, 2, and 3, unless there
is a specific reason to differ. Any expected FCI grant is deducted.
The average net sales return per ton is taken as constant, for lack of
more information.
The calculated fixed production expenses (see above) start in year 1 as
15% of the average, and 50% in year 2.
The calculated variable production expenses (see above) are assumed to
be proportional to the production.
Royalty payments are generally not relevant at this stage, but interested parties could use this format in their eventual negotiation, to
see the impact of various royalty payments on the profitability. This
can be either a yearly fixed sum, a percentage of the net sales, or a
percentage of the profits according to some formula.
The net cash flow (negative or positive) is calculated for each year. If
it is discounted at 10% (say, as a normal safe investment), the present
value of the project is obtained from the sum at year 1, which represents
the potential contribution of the new proposal/know-how (nearly $25
million in Table 8.3).
In addition, a discount rate can be calculated by simple trial-and-error,
which results in present value = zero. This is in fact the ROI (31.1%
in Table 8.3).
Once prepared, this spreadsheet can be used easily to survey the effect
of various factors on either the ROI or the present value of the operation,
such as for instance, different values of FCI, net sales returns, raw materials
cost, and so on.
Different corporations use different standards to judge the attractiveness
of new process proposals, according to their prevailing strategy considerations.
As a general order of magnitude, however, we can say that in the free economy
of the Western world, the profitability test at this stage should probably show
an ROI of, at least, 25% before taxes, to justify the continuation of an intensive
development and implementation effort. But if this development opens new,
promising avenues to the corporation, it could well be that a lower ROI would
be accepted for the first plant (see also Sections 8.6 and 8.7 below).
Of course, the degree of taxation varies in different locations and situations. Certain countries promote the establishment of new industries by
providing them with an investment grant (say, as a fixed percentage) or with
a period of reduced (or no) income-tax payment.

8.6 Optimistic evaluation of the profit potential


in other applications
Together with the profitability study, the promoters could also develop and
present to the decision makers the possibility that the proposed process may
have a larger potential for profitable applications, once the first implementation
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is proven to be successful. Such larger profit potential can be in one or more


of the following forms:
1. The simplest formula is increased production volume at the same site
in the future. This extra product can be obtained practically with
the same management and services, by making use of the built-in
oversized facility and of the experience gained by the operating
staff, and could be sold in developing markets. Thus, instead of the
usual cash flow and profitability spreadsheet based on the present
nominal capacity for 10 years, an alternative spreadsheet could be
prepared in which the production would be increased by 10% (for
example) every 2 to 3 years and the span increased over 15 years,
reaching 150%. This is a frequently used format. Table 8.4 illustrates
this change with regard to Table 8.3 above. It can be seen that on
this basis, the projects net present value at 10% discount rate increased from $25 to $46 million. Note that the increase in ROI is
not as spectacular, only from 31.1% to 32.8%. This is typical of the
cases with quite high ROI, where the contributions of the later years
are felt less and less. For another case with an ROI of 15%, this
increased production could have raised the resulting ROI to 25%,
and this change would have made a different impact.
2. Another commonly considered possibility involves future repeat
plants built in other locations or countries, on the basis of the experience learned in the first plant.
3. A more complex possibility is the adaptation of the novel process
technology to the production or improvement of (a line of) similar
new products.
The presentation of such potential applications could change the perspective of the decision makers from short-term cash flow into a wider
corporate strategy. Of course, the access and exclusivity of these options
would need to be secured by adequate patents.

8.7 Possible synergetic effects with other


production facilities
In many cases, the promoters may also gain the goodwill of the decision
makers by pointing out synergetic (that is, mutually profitable) effects
between the proposed project and some other existing or planned industrial
facility of the corporation. For example, the proposed project may:
1. Use or upgrade the value of a by-product or waste stream. For example,
the recovery and profitable use of valuable acids from a waste stream,
instead of neutralizing them, or the utilization of excess concentrated
thermal energy, instead of dispersing it into the surroundings.
Copyright 2002 by CRC Press LLC

Total investment
Average sales $ /
ton CIF
% of design
production
Return on
investment
Year
Fixed Capital
Investment
F C Investment
grant ( 20% )
Production % of
Design Capacity
Total production
sale value, CIF
Fixed Production
expenses
Variable
production
expenses
Interest on
Working Capital
Royalties
Net Cash Flow
Disc. Net Cash
Flow PV (10%
rate)
project's present
value at 10% ROI
Disc. Net Cash
Flow PV (ROI
rate)
Cum Disc. Net
Cash Flow PV

16,770
3000
100
32.77%
1

(6,708)

(300)

(7,008)
(7,008)

(9,224)

10

11

12

13

14

15

16

17

(839)

50

75

100

100

110

110

120

120

120

130

130

140

140

150

150

7,500

11,250

15,000

15,000

16,500

16,500

18,000

18,000

18,000

19,500

19,500

21,000

21,000

22,500

22,500

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

(2,000)

(2,141)

(3,211)

(4,281)

(4,281)

(4,709)

(4,709)

(5,137)

(5,137)

(5,137)

(5,565)

(5,565)

(5,993)

(5,993)

(6,422)

(6,422)

(131)

(197)

(263)

(263)

(289)

(289)

(315)

(315)

(315)

(341)

(341)

(368)

(368)

(394)

(394)

(10,224)
(9,294)

2,390
1,975

5,842
4,389

8,457
5,776

8,457
5,251

9,502
5,364

9,502
4,876

10,548
4,921

10,548
4,473

10,548
4,067

11,593
4,063

11,593
3,694

12,639
3,661

12,639
3,328

13,685
3,276

13,685
2,978

(7,700)

1,356

2,496

2,721

2,050

1,735

1,307

1,092

823

620

513

386

317

239

195

147

(1,000)

45,791
(7,008)

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Table 8.4 Typical Return On Investment with increased production volume and on Present Value of yearly Cash Flow based on Cash Flow

1360_frame_C08 Page 140 Monday, April 29, 2002 3:37 PM

2. Make use of idle production capacity in certain operations, in packaging or in utilities generation, or exploit the significant cost advantage of larger installations.
3. Utilize available developed land, roads, warehouses, and similar
facilities.
4. Participate in a combined marketing effort aimed at the same users,
for example in the compound fertilizers market.
Such interactions would involve the management of the existing operation and, obviously, their essential cooperation and good will should be
secured by the promoters before the above claims are presented to a larger
audience.

8.8 Comprehensive report for the justification


of the specific proposal
The expected profitability is the bottom line of a comprehensive report
presented to the relevant corporate management for a detailed and exhaustive review leading to a no/maybe decision, which should include, with
an executive summary:

The preliminary process design detailed in Chapter 7


The economic estimates listed above in this chapter
The profit potential for other applications, described in Section 8.6
Some possible synergetic effects, described in Section 8.7

Many proposed projects have met their end at this stage (NO), as the
calculated profitability level was considered, in the eyes of the decision
makers, definitely not good enough and with no reasonable prospects of
improvement.
If the profitability potential does look promising (MAYBE), a go-ahead
will be given for the next stage of the development program, as discussed
in the next chapter. In this case, the above preliminary economic study will
be also used to emphasize those cost items that are really heavy, for which
improvements during the development program could result in a significant
positive effect.

8.9 Contractual agreements


Any authorization given by the corporate management for the next stage of
development will probably be conditional on the finalization of two contractual agreements.
First, relationships between the inventors/promoters and the implementing corporation need to be finalized at this point by a formal contract.
Prior to this, an exclusive option agreement may have been signed for a
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limited period, conditional on the decision by the corporation to build a


plant, by a certain date. The details to be included in such a contract depend
very much on the particular situation and cannot be discussed here, but the
basic interests of each party are clear:
The inventors/promoters really want the project to succeed, and
they generally believe that they can contribute to that success by
having a say in any major decision making in future. They also
want clear public recognition and, of course, the maximum financial remuneration possible, in relation to their optimistic profit
potential.
The implementing corporation wants to secure the full cooperation
and contributions of the inventors/promoters in the future, including
the assignment of (present and future) patents, exclusivity on their
past know-how and on their future work in this field for many years.
The corporation would like all this, of course, at a minimum cost
without conceding any part of its decision-making position. To assure
that position, the financial remuneration may be divided into progressive installments.
Once this contract is signed, the overall responsibility of the working
program will be transferred to the project manager appointed by the corporation. The inventors/promoters will generally continue their contribution as consultants.
Second, a suitable engineering company should be selected and
engaged by a service contract that, although quite standard in nature,
always includes many specific clauses (see also Chapter 10, Section 10.5).
The engineering company will provide many of the professionals needed
for the working program, mostly from their permanent offices, but some
of them may also be delegated to the project managers team or to the
different pilot sites.
The project manager will likely chose the engineering company based
on past experience and will generally include, as a basic condition, a list of
eight to ten key leaders, employees of the engineering company, who will
be assigned to work most of their time on the project.

8.10 Worth another thought


The only purpose of the preliminary economic analysis of the proposal is to supply information on the profit potential and to justify
the continued expense for its development.
The presentation of a larger potential of profitable applications, once
the first implementation is proven to be successful, could change the
viewpoint of the decision makers from the short-term cash flow to a
wider corporate strategy.
Copyright 2002 by CRC Press LLC

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References
1. Peters, M. S. and Timmerhaus, K., Plant Design and Economics for Chemical
Engineers, 4th ed., McGraw-Hill, New York, 1990.
2. Chauvet, A., Leprince, P., Barthel, Y., Raimbault, C., and Arlie, J. P., Manual
of Economic Analysis of Chemical Processes, McGraw-Hill, New York, 1981.

Copyright 2002 by CRC Press LLC