MODULE 4: ECONOMICS OF WASTES/RESIDUES IN FOOD PROCESSING AND FOODSERVICE FACILITIES

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ECONOMIC ASSESSMENT

This section is designed to increase understanding of economic assessment of waste management for an operation, a food processing plant, or a foodservice facility.  In this section, the fundamentals of a limited economic analysis (please, refer to Coltman and Jagels (2001) for further understanding) and the most common procedures are presented.  Examples are provided to illustrate many of the concepts.

• Importance of Economic Analysis

• Elements of Cost Analysis

• Method of Cost Estimation

• Measures of Profitability

• Case Study Scenario

Importance of Economic Analysis

An organization's goal, profit and nonprofit alike, is to maximize the utilization of its resources and minimize cost.  This goal must be considered when all decisions relative to expenses are made, including management of solid waste.  As discussed in Module 3, several waste management methods are available to dispose of wastes and food processing residues.  Some of these waste management methods require capital investments and decisions that would affect the long-term performance of a business.  Waste management options should be evaluated for several reasons.  These include: compliance with governmental regulations, reduction of disposal costs, conservation of natural resources, reduction in the use of landfills, and/or the development of a positive customer relationship (Byers, Shanklin, & Hoover, 1997).  According to a study by Sherman and Schelvan (1999), cost savings is a compelling incentive for the food industry to participate in organic recycling.  A key question that management must consider is whether or not alternative methods are feasible and meet the organization's goals.

Figure 4.1 shows the waste minimization assessment procedure proposed by the Hazardous Waste Engineering Research Laboratory of the EPA (1988).  The economic feasibility evaluation plays a major role in the assessment process.  In terms of operational costs, there are three possible categories in which the operation fits relative to alternative methods: (1) the operation pays more to manage the wastes, (2) the operation has no return and no expenses, and (3) the operation obtains an economic return from alternatives.  The level of economic return can range from minimal to substantial.

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Elements of Cost Analysis

The most common question arising when considering alternative waste disposal methods is how to compare the costs of the alternatives.  Comparing the costs of alternative methods is an approach that considers all of the cost elements, such as labor, equipment depreciation, level of technology, interest rate, tax, and insurance.  Therefore, estimating an accurate cost of each component to be evaluated is the first step in completing an economic evaluation of waste management methods.  The two major components of the overall cost of a project are capital costs and operating costs.

Capital Costs

Capital costs are those incurred in the planning and construction phases of a project and the equipment costs for processing and handling of wastes/residues (Rhyner, Schwartz, Wenger, & Kohrell, 1995).  Capital costs can be realized in the analysis of a project on a yearly basis as fixed costs by annualizing the costs in either depreciation or amortization (Criner, Allen, & Schatzer, 2001).

Operating Costs

Operating costs are those costs associated with the daily operation of a facility (Rhyner et al., 1995).  Operating costs may be separated into two categories: direct and indirect costs.  Direct costs are those directly involved in operating the facility, such as labor, materials, maintenance and maintenance supplies, replacement parts, and utilities costs.   Indirect costs are associated with, but not directly involved in operating a business, such as overhead, administrative fees, local property taxes, and insurance fees (Theodore & Theodore, 1996).

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Method of Cost Estimation

Once the total cost of the project has been estimated, all cost contributions should be annualized to determine whether the project would be profitable (Theodore & Theodore, 1996).  Costs are categorized as fixed costs or variable costs.

The following equation is used to compute the total cost estimation:

Total Costs = Fixed costs + (Variable cost per unit) x (Expected volume)

Variable costs and expected volume can be expressed on per ton or per cubic yard basis when evaluating alternative disposal methods.

Fixed Costs

Fixed costs are the costs that do not change with the level of operation.  The following components are the most common fixed costs that may be related to waste management decisions.

Depreciation.  Depreciation is a method of allocating the cost of a capital asset over the anticipated life of the asset (Coltman & Jagels, 2001).  The method used depends on the tax procedure selected by the operation.  The depreciation methods most used are estimated straight-line and accelerated depreciation method.

• Straight-line Method.  This method is the simplest of the depreciation methods because it allocates depreciation expenses over the expected lifetime of an asset.  The straight-line method is based on the assumption that the value of an asset declines at a constant rate over time (Dyckman, Dukes, & Davis, 1992).  The formula for computing periodic straight-line depreciation is (Coltman & Jagels, 2001):

Henderson and Perry (1976) do not support the use of the straight-line method.  They believe that the approach is not realistic because it does not consider the depreciation with the interest paid in the acquired asset.

• Accelerated Depreciation Method.  This method allows more depreciation in the early periods and less in the later periods.  Coltman and Jagels (2001) stated two main reasons for using this method.  First, it is used to balance the sum of an asset's maintenance and depreciation costs because asset maintenance costs are low in the early years, but increase with use.  Second, there are tax advantages when this method is used.  Since depreciation can be claimed as an expense, income tax will be reduced because of lower income.  Over the long run, the total tax will be the same regardless of the method used.

Interest on investment.  Funds for financing projects may consist of debt (borrowed) capital, equity (ownership) capital, or most often, a mix of both (White, Case, Pratt, & Agee, 1995).  Interest on investments is classified as a fixed cost.  The most common ways to charge this expense are as (1) interest on depreciated value, (2) interest on half of cost new, and (3) interest on total cost new.  The interest on half of cost new method is the most frequently used method with straight-line depreciation and interest is determined using the following formula (Henderson & Perry, 1976). 

Taxes and insurance.  The assessed value of the property and equipment is used to determine the dollar valuation for calculating taxes.  Insurance is usually prepaid for a period based on the current value of the property. 

Permit fees.  This item includes any types of permits required by the state or local government to operate a food processing plant or foodservice operation.  Permits required vary among states and locality.

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Variable Costs

Variable costs are operating expenses that vary directly with the level of the activity and the location.  This happens because the costs partly reflect local conditions, such as staffing practices and labor and utility costs.  The variable costs are calculated based on the unit cost of waste to dispose times the expected volume (ton).

Direct costs.  Because the direct costs depend on the production level, the unit cost may decline if the efficiency of the system is improved.  Examples of direct costs include: 

• Labor.  Labor costs, including base salary, wages, and benefits, are one of the major components of operating costs.

• Utilities cost.  Utilities costs include fuel and power costs for operating equipment and heating, ventilation, and cooling system, charges for water and sewage use, and waste hauling.

• Maintenance and repair costs.  Annual maintenance costs can be estimated as a percentage of the capital expenditure (Theodore & Theodore, 1996).

• Raw materials.  Commodities, ingredients, supplies, packaging material, labels, and other components of the finished products are classified as raw materials.

Indirect costs.  Local property taxes and insurance can be estimated as 1 to 2 percent of the total capital cost, and administrative fees can be estimated as 2 percent of the total capital cost (Theodore & Theodore, 1996).  Fines and penalties are other indirect costs that are accessed for violation of government regulations.

Revenues

In the economic assessment, revenues should be considered to compare the costs with other alternative methods.  These include any government grants received, tipping fees charged, revenues from sales of compost, and any avoided costs associated with the project (Criner et al., 2001).  Some costs may be partly offset by these revenues.

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Measures of Profitability

 There are several types of economic evaluations.  Payback period, net present value, internal rate of return and benefit cost ratio are the most commonly used methods to measure profitability.  The specific method selected is determined by the enterprise's policies and the availability of information.

Payback Period

The payback period is the estimation of the length of time it will take to recover the initial capital investment.  To use the payback ratio in the accept-reject decision, the firm sets a minimum or required standard payback period and accepts the project if the expected payback period is shorter than the determined minimum (Jones, 1992).  The most important aspect of this method is the clear identification of all the benefits that the achievement would generate for the firm (Flores, 2000).  The following formula is used to compute the payback period in years (Coltman & Jagels, 2001).

Net Present Value

The net present value (NPV) is a way to represent future receipts in present dollar terms so that the future receipts can be compared on an equivalent basis with whatever investment is required in the project under consideration (Flores, 2000).  The present value of a future return is calculated using the following formula (Damodaran, 1997).

                                    where

                               CF_t  =  Cash flow in period t 

                                    r =  Discount rate

                                    t =  Life of the project

In general, if NPV ³ 0 management should accept the project and if  NPV <0, management should reject the project (Jones, 1992).

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Internal Rate of Return

The internal rate of return (IRR) is a method measuring the value of long-term investment using the discounted cash flow concept.  The formula for the calculation of IRR is (Coltman & Jagels, 2001):

            where, 

          A₁~ A_n are the individual annual cash flows for the life of the investment

           i is the interest or discount rate being used, and

           IC is investment cost. 

In general, if the IRR is greater than the self-determined discount rate, the project will be accepted.  If the IRR is less than the discount rate, the project will be rejected (EPA, 2000).

Benefit Cost Ratio

The benefit cost ratio is the ratio of total benefits to total costs of a project.  A value greater than one indicates that benefits are greater than the costs of the investments.  However, this method only looks at the ratio of total benefits over total costs and gives no indication of the increase in net wealth.  This ratio is useful mainly as a rough indicator of whether benefits from the project exceed costs of the project (Sharma & Weitz, 1995).

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Case Study Scenario

To illustrate the calculations, the following example was developed.  ABC food processing company produces 4 tons of waste per day.  This example assumes that all the wastes can be composted.  The company wants to identify more cost effective waste management methods to reduce its current waste disposal fee (landfill tipping fee and hauling fee) of $70.00 per ton.  Land is available to develop a composting site; therefore, on-site composting is being considered.  The company is going to buy in-vessel composting equipment for $240,000 with 15 years life expectancy.  The manager wants to determine if on-site composting is feasible and cost effective.

The company should determine the total cost of the project and then compare the cost of composting the organic residue with the previous practice.  

Fixed Costs

Depreciation. Using the straight-line depreciation method, the cost per ton for depreciation is:

$240,000 (initial investment)/15yrs (expected useful life) = $16,000/year

$16,000 per year/(365 days x 4 tons/day) = $10.96/ton

Interest on investment.

½ (240,000) x 0.05 (5% interest rate) = $6,000/year

$6,000/(365 days x 4 tons/day) = $4.11/ton

Insurance.

$240,000 x 0.01 (1% of investment) = $2,400/year

$2,400/(365 days x 4 tons/day) = $1.64/ton

         Total fixed costs.  Depreciation ($10.96/ton) + Interest on Investment  ($4.11/ton) + Insurance ($1.64/ton) = $16.71/ton

Variable Costs

Maintenance.

($240,000 x 0.02 (2% of investment))/(365 days x 4 tons/day) = $3.29/ton

Labor

Estimated annual salary $24,000/ FTE

Estimated labor demand is 1.5 FTE

($24,000 x 1.5)/(365 days x 4 tons/day) = $24.66/ton 

Power and Utilities

Power = (10 hp x 2hrs x $0.07/kWh)/(4 tons/day) = $0.35/ton

Fuel = $0.65/ton

Overhead and administrative

($240,000 x 0.02 (2% of investment))/(365 x 4 tons/day) = $3.29/ton

Total variable costs

Maintenance ($3.29/ton) + Labor ($24.66/ton) + Power and Utilities ($0.35 + $0.65/ton) + Overhead and Administration ($3.29) = $32.24.

Total Costs

Fixed costs ($16.71) + Variable costs ($32.24) = $48.95/ton

Total Savings/year

Old method ($70 x 365 x 4) – New method ($48.95 x 365 x 4) = $30,733/year

• Payback period: $240,000 (initial investment)/$30,733 (annual net cost savings) = 7.8 yrs.

       It will take about 7.8 years to recover the initial investment.

• Net Present Value = $318,993 (sum of future receipts in present dollars) – $240,000 (initial investment) =  $78,993.  This value is greater than 0; therefore, management should accept the project at 5% interest rate.  However, if NPV is calculated at 10% interest rate, the result would be different.  For example the sum of future receipts in present dollars is $233,755.  Consequently the result is -$6,245.  This means that the project would not be economically feasible at a 10% interest rate.  Table 4.1 illustrates the present value at 5% and 10% interest rates.

Some of figures, tables, and appendixes are in PDF format.

If you do not have a PDF reader, you can download the Adobe version from the Acrobat Download Page.

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Introduction   |   Basics of Economic Assessment   |   Costs of Disposal   |   Cost Components of Alternatives   |   References

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