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Interpreting Normalized Profitability Metrics

By Chris Burk, Burk Engineering LLC |

Normalized profitability metrics provide a basis for comparing the efficiency of capital investments, but they are often misunderstood. New interpretations of these metrics can help engineers to make more informed decisions In a financial sense, a large capital project can be viewed as a series of cash flows into and out of an enterprise. The cash flows vary in timing and size, depending on the project and its characteristics. Cost engineers mathematically reduce these cash-flow patterns into discrete profitability metrics, such as net present value (NPV) and internal rate of return (IRR) so they can be more easily compared. However, such metrics are often misunderstood. This article uses graphs to illustrate practical interpretations of three different metrics — two standard and one recently developed. Figure 1 presents a typical series of cash flows, which are the basis for the examples given in all other graphs in the article. As shown in Figure 1, cash flow for a typical capital project has four stages: One to two years of negative cash flow while capital is committed One or more years of subnormal cash flow during startup Some period of normal operation A final year with higher-than-normal cash flow, when working capital…
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