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Risk Analysis in Chemical

Plant Investment
E. L. Reynard

nvestment analysis has been given considerable Conaidor Malor Unce~iaintioaConMbuting to


I thought in recent years. Most current articles
Profit Unceriainty

center on ways to take into account the time value of When one is determining profitability of a future
money. But the use of this concept suffers from one investment, uncertainty comes from two major sources,
main problem-present value and internal rate of the economic environment and investment estimates.
return calculations use single-valued estimates of gross The economic environment may influence profitability
revenue and cost which imply certainty. Granted, in many ways. For purposes of illustration, attention
high risk can be expressed in present value calculations will be confined to product price and product volume.
by using a discounting factor corresponding to a high We must freely admit that the future of price and
interest rate (8). However, judgment has to be exer- volume is indeed uncertain. This in turn leads to
cised on the final revenue figure as a whole. In this reasoning that some probability distribution exists, but
method, judgment cannot be reasonably broken down is it practical to speculate whether the distribution is
and applied to the factors contributing to net revenue. skewed to the right or left? I think a simple guess that
In recent years the concept of decision trees has been the normal distribution applies is as far as our reasoning
introduced to cope with the problem of future uncer- can usually stretch.
tainties. In this concept, the array of alternatives is The other area of profitability uncertainty considered
displayed. For every alternative decision, best judg- in this illustration is in the investment estimate. Again,
ments are applied to the probabilities associated with the some probability distribution describes the uncertainty
events that could result from each decision. This
sequence is carried as far into the future as desired.
When future outcomes are evaluated, one can work
back to the present to select the immediate alternative
investment that is most suitable (5, 6, 9). The calcula-
tions are somewhat cumbersome and by necessity use
single-valued probability estimates.
As the real world of continuous uncertainty is in-
corporated (3, 4, computers are required to simulate
probability distributions describing uncertainty in the
relevant variables. This last reference (4) in easence
incorporates all of the good features (discounting and
sequential decisions) and eliminates most of the bad
features (single-valued estimates) of all of the literature
on investment analysis. But computer simulation of
probability distributions presupposes good knowledge
of the shape of the probability distributions.
While time value of capital considerations are im- ANNUAL PROFIT
portant, there are four points that are perhaps more so.

.Effort is better spent analyzing risk.


.Uncertainty of many factors influences profit.
.There is a limit on the precision with which we can
define uncertainty.
. We need a relatively simple approximation to
ascertain the profit uncertainty caused by the Figure 1. Uncntnintier in indimdual projectiani cause m e r t u n t y
combined influence of contributing uncertainties. profif projection

V O L 5 8 NO. 7 JULY 1 9 6 6 61
SENSITIVITY ANALYSIS OF THREE FACTORS VS. COMBINED UNCERTAINTY
In each case the potential variability of certam key factors involved with B chemical plant investment is recognized. Using the best information
Opfimirfic Pessimistic
Ertimofe Best Guess Erfimdlr
Price 401/lb. 35#/lb. 3O#/lb.
Annual volume 12,000,000 Ib. 9,000,000 Ib. 6,000,000 Ib.
Plant investment $1,500,000 $2,000,000 $2,500,000
Working capital $200,000 $200,000 t200,000
Variable cost 10#/lb.
Total investment $1,700,000 $2,200,000 $2,700,000

SENSITIVITY ANALYSIS APPROACH


Using the parameters for chemical X, we first find manufacturing costs:

Annual volume
.
12,000,000 Ib.
- 9,000,000 Ib.
_
I
.
6,000,000 Ih.
__
Total investments $1700 $2200 $2700 $1700 12200 $2700 $1700 s2200 t2700
- ~ _ __ -
_ ~ -
Variable costs (raw mat'ls) 1200 1200 1200 !NO 900 900 600 600 600
Fixed costs
A. Operating labor 250 250 250 250 250 250 250 250 250
B. Control lab 50 50 50 50 50 50 50 50 50
C. Overhead 250 250 250 250 250 250 250 250 250
D. Annual strai ht line dcprecia-
tian a t IO%, of plant invest-
ment 150 200 250 150 200 250 150 200 250
E. Taxes & insurance a t 2.5% of
plant investment 37.5 50 62.5 37.5 50 62.5 37.5 50 62.5
F. Maintenance a t 7.570 of plan1
investment 112.5 150 187.5 112.5 150 187.5 112.5 150 187.5
Total fixed costs 850 950 1050 850 950 1050 850 950 1050
Total mfg. costs $2050 $2150 82250 $1750 $1850 51950 $1450 $1550 $1650
~
-
a All dollaifigmts in rhournnds of dollorr
Ned,find annual profits for each price:

Annual volume 12,000,000 Ib. 9,000,000 Ib. 6,000,000 lb.


Total investment- $1700 I 12200 I $2700 81700 $2200 82700 $1700 $2200 $2700
Sales 4800 4800 4800 3600 3600 3600 2400 2400 2400
Mfg. costs 2050 2150 2250 1750 1850 1950 1450 1550 1650
__- ~- --
Pretax profit 2750 2650 2550 1850 1750 1650 950 850 750
Net profit at 48% tax 1430 1378 1326 962 910 858 494 442 390
Return an in". 84% 63% 49% 57% 41 % 32% 29% 20% 14%

Sales 4200 4200 4200 3150 3150 3150 2100 2100 2100
Mfg. wsts 2050 2150 2250 1750 1850 1950 1450 1550 1650
Pretax profit 2150 2050 1950 1400 1300 1200 650 550 450
Nct profit at 48% tax 1118 1066 1014 728 676 624 338 286 234
Return on in". 69 % 48% 38% 43% 31 % 23y0 20% 13% 9%

-
Sales 3600 3600 3600 2700 I 2700 2700 1800 1800 1800
Mfg. costs 2050 2150 2250 1750 1850 1950 1450 1550 1650
Pretax profit 1550 1450 1350 950 850 750 350 250 150
Net profit at 48% tax 806 754 702 494 442 390 182 130 78
Return on in". 47 % 34% 26% 29% 20% 14% 11% 6% 3%

A2 INDUSTRIAL A N D E N G I N E E R I N G CHEMISTRY
about the estimate, but the exact nature is unknown.
INVOLVING THREE FACTORS Approximating the probability with the normal dis-
tribution will be adequate for our purposes.
available, the following table is developed for chemical X:
P ROPQSEO STAT I ST I CA L APPROACH Use Familiar Statistical Concepts

Reduce computation by using the relationships developed in We do not need the age of computers to determine an
this article. Assume the same parameters as before.
encompassing measure of risk. Several concepts are
Annual profit = (sales volume) (price/lb.) - combined to produce the needed result. Standard
[fixed costs +
(variable costs) (sales volume)] deviations are common parlance in the field, of quality
Using the best guess parameters, we calculate annual profit as control. For our purposes, a standard deviation is a
follows : convenient way to view investment risk. Standard
Pretax profit = (9,000,000 Ib.) ($0.35/1b.) - deviation of profit nicely defines the interval which
[$950,000 +
($O.lO/lb.) (9,000,000 lb.)]
= $3,150,000 - [950,000
= $1,300,000
900,000] + has about a two thirds chance of enclosing expected
profit. In a loose statistical sense, we can say that
After tax profit = $1,300,000 - (0.48 ($1,300,000) annual profit has about a two thirds chance of falling in
= $676,000 the interval defined as: expected annual profit =k stand-
Annual return on total investment = $676,000/2,200,000 ard deviation of profit. The question that remains is
== 3170
how do we estimate this interval by some practical
The variability is calculated by using the following derived means?
relationship:
best guess - variable
cost ) Convert Accounting Factors into Algebraic Expressions

The first step is to relate our profit estimate algebrai-


cally to the factors that comprise it (2). Thus, an esti-
optimistic
volume
- pessimistic
6
volume )’ + (best guess)’
volume
mate could be of the following nature:
Expected
optimistic - pessimistic 2 annual
price price profit = Expected sales - expected cost of production income
6 > + = (best guess of price/unit) (best guess of volume) -

maint. % tax % depreciation fixed production cost +


(- of plant
inv.
- of+plant-
inv.
100
yo Of
plant inv.
(
estimated variable cost
unit >x
optimistic
(plant inv.
- pessimistic)~]1”
plant inv.
best guess of
( volume )] (1)
6
For estimating purposes, certain fixed production
Substituting we have: costs might be based on plant investment. For ex-
ample, annual fixed production costs might equal :
operating labor + control laboratory chemists +
overhead +
12,000,000 Ib. -
6
6,000,000 Ib.
)’ + (9,000,000 lb.)’ X depreciation at A70 of plant investment
at B7G of plant investment +
+
taxes and insurance
maintenance material and labor
at Cyo of plant investment
($0.40/lb. - $0.30/lb.
6 Thus, expected annual profit equals :
$1,500,000 - $2,500,000)z]1/2 best guess of
6 (best guess of price/unit)
u Pretax profit E $293,000 operating labor + control laboratory
u After tax profit E $293,000 - (0.48) ($293,000) chemists + overhead
$152,000
E

Thus, there is about a 2/3 chance that after tax profit lies be-
(” +l&+ ‘) (best guess of plant investment) +
tween
$524,000 and $828,000
estimated variable cost
unit ) best guess
(of volume)] (2)

Similarly, there is about a ‘/3 chance that return on total invest-


ment lies between:
AUTHOR E. L. Reynard i s Administrative Specialist at Staufer
3524,000
____ $828,000
22,200,000
and ~

c2,200,000
Chemical Co. in Richmond, Calif., with his professional em-
or
khasis currently on Budgetary and project analysis. He was
trained as a chemical engineer and has worked in process design,
24% and 38%
cost analysis, and operations research. The comments and
suggestions of Ramsey G. Campbell, Marlin Brnnett, John F.
Heil, and Guy W . Roy are gratefully acknowledged.

VOL. 5 0 NO. 7 JULY 1966 63


Relate Profit Uncertainty to Economic Uncertainties

Next, we need to relate uncertainty in the economic


optimistic
price
pessimistic
price )+ (-A -H -
100
c
and estimating variables to uncertainty in the dependent pessimistic
optimistic -
variable, profit. To do this we borrow a seldom used plant investment plant investment
(11)
statistical approximation ( 7 ) . 6

Reflection

where Y =f(X, W , Z ) ; cr2Y is the variance of Y. We now have a fairly convenient means of analyzing
investment risk without a computer. Thc ,jiidgments
Applying this statistical relationship to o w situation, needed are the same ones that wotilcl Iw i i s c ~ li n any
we get: reasonably thorough analysis. Onc coiiltl t ; i k ( . the
conventional sensitivity analysis approach a n d c.saiiiinc
dprofit ’ d profit all 27 combinations of optimistic, best estiiiiatc, and
02 profit (E) ”+
volume (d 5)price -+ cr2
pessimistic values for these three illustrated variables.
d profit But besides being an overwhelming amount of data,
UZ plant investment (4) extreme cases of all-optimistic or all-pessimistic variables
b plant investment)
are very unlikely. Other combinations have varying
The partial differentials are easily found by differen- degrees of likelihood. I t is more realistic to use the
tiating the profit relationship (Equation 2). single value for profit standard deviation which gives
effect to the likely uncertainty of all variables.
b_profit The proposed method easily permits inclusion of more
_ __-
d volume
- (best guess of price/unit) -
economic factors. A thoroiigh sensitivity analysis in-
(estimated variable cost/unit) (5) volving four variables would require calculation of 81
combinations. The proposed method would add one
a- profit
- more quantity to the profit standard deviation equation.
- best guess of volume
a price
An example is presented to illustrate the computational
profit differences between the proposed statistical approach and
b plant investment (7) conventional sensitivity analysis. The examples use the
rate of return on investment (ROI) project evaluation
Turning to the problem of estimating the variance of criterion for simplicity’s sake. Other project evalua-
these three important variables, we must borrow a page tion criteria involving annual cash flows and time value
from the literature on PERT (Program Evaluation and of money could conceptually use an annual profit
Review Technique) (7). uncertainty as input.
Using the same simplifying assumptions that guided
the PERT calculations for ,the successful Polaris Project, Conclusion
we get the following analogs.

u2 volume e
( optimistic
volume
pessimistic
volume
)
2

(8)
Basically, this paper discusses two points.
The uncertainties of economic and investment fac-
tors need to be individually analyzed and then
combined into a single, useful figure-overall profit
optimistic pessimistic uncertainty.
price price The basic input of each factor’s uncertainty can be
2 price = (9)
derived from optimistic, best guess, and pessimistic
estimates.
optimistic pessimistic
plant investment - plant investment
estimate estimate
u2 plant REFERENCES
6
investment
(1) Bennett, ( 2 . A , , Franklin, N. L., “Statistical Analysis in Chemistry and thc
Chemical Industry,” Wiley. New York, 1954
Hence, we finally get the standard deviation of annual (2) Churchman, C. I V . , k k o f l , R. L., Arnofl, E. L., “Introduction t o Opcrations
Research,” Wiley, New York, 1957.
profit by substituting Equations 5 through 10 into (3) Hertz D . B “Risk Analysis in Capital Investment,” Harirard Business Reciew
42 (11, b5 (19z4).
Equation 4. (4) Hespos, R . F.. Sirassman P . A. “Stochastic Decision Trees for the Analysis of
Investment Decision,’’ Mnn’agernen; Science 11 ( i o ) , August (1965).
( 5 ) Magee, J. F., “Decision Trees for Decision Making,” Horuard Business Reuiew

cr profit f:[( price


X
4 2 (4), 126 (1964).
( 6 ) M a g e e J. F “ H o w to Use Decision Trees in Capital Investment,” Harward
Business heuiea’k2 (5), 79 (1964).

+(
unit ( 7 ) PERT-Summary Report, Phase 1 , Special Projects Office, Bureau of Naval

(
LVeapons, Department of Navy, FVashington, D. C., 1 9 5 8 .
optimistic pessimistic)* best )2 (8) Quinn, J. B., “ H o w L O Evaluate Research Output,” H o w a r d Business Reciew
volume volume guess of 38 (Z), 69 (1960).
volume X (9) Schlaifler, Robert, “Probability a n d Statistics for Business Decisions,” McGraw-
Hill, New York, 1 9 5 9 .

64 I N D U S T R I A L A N D E N G I N E E R I N G CHEMISTRY

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