Introduction
Project management is a very important activity in business because its scope determines the extent to which a business optimizes the strategic potential of its long-term investments (Callahan, Stretz, & Brooks, 2007). Business must always strive to ensure that their investment costs associated with projects commensurate the long-term benefits of the investments. Capital projects particularly consume huge sums of the financial resources (Callahan, Stretz, & Brooks, 2007). Returns from such projects can only be achieved over a period of time. This paper analyzes the aspects of minimization strategies for project costs with reference to British Petroleum Company (BP).
Project Costs Minimization Strategies
BP’s forecast of the project costs shows that the company set out its targets to invest a significant portion of its projected cash flows in capital investments. To achieve this, the company streamlined its downstream activities through divestments and subsequently optimized on the NPV of its upstream activities. The company began disposing of its non-profitable businesses, operational units, and non-strategic interests in 2010. BP aimed at achieving $38 billion in disposals by 2013 (BP Annual Report and Form 20-F, 2011). The streamlining of the company’s downstream activities was necessitated by the high costs of variable costs that resulted from these activities.
Variable costs portend significant financial burden to the activities of a business because they grow with an increase in output. As such, the extra outputs realized by the company are effectively diluted by the costs incurred to achieve these outputs. Therefore, in a scenario where 50 percent of the company’s initial costs are committed towards equipment and the rest towards overhead costs, extremely low rates of recovery for the initial investments would prevail. This is because as the output from the investments is greater, then the overhead costs increase as well, but the project’s rates of return become lower.
Long-term project costs vary according to the scope and needs that are unique to each particular organization (Callahan, Stretz, & Brooks, 2007). It is for these reasons that BP continued to place greater emphasis on the strategic expansion of its upstream investments, in addition to enhancing the safety of the upstream activities. In 2011, BP invested $14 billion in a project in the UK North Sea and another $1.6 billion in its alternative energy projects (Annual Report and Form 20-F, 2011). More interesting was the fact that that BP had invested a total of $6.6 billion in its alternative energy projects between 2005 and 2011 (Annual Report and Form 20-F, 2011). This meant that the company prioritized investments in capital projects because its upstream activities primarily involved exploration and the management of deepwater activities. However, the success of these capital projects was largely hinged on the company’s strategies for minimizing costs.
Going by the $14 billion, BP invested in a project in the UK Northern Sea then Variable costs, fixed costs, and indirect costs are the most appropriate cost classification categories that BP will need to adopt so as to minimize its project costs. Now, assuming that 50 percent of the initial investment is equipment cost, and the remainder is installation, overhead, or other projected costs, the breakdown of the project costs would be as follows:
- Variable costs: $7 billion will be directed towards equipments because it is a variable cost that will increase or decrease relative to changes in output. Considering that oil and gas outputs increase with time, this figure will definitely increase over time.
- Fixed costs and indirect costs: $7 billion will be split among installations and overheads with the objective of employing their fluctuating flexibilities to output so as cut down on their expenses. This is because, although fixed costs are not dependent on the changes in output, they decrease with increase in output levels on a per unit basis. As for indirect costs, they are blanket in nature and they are incurred for the benefits of a number of units or departments.
Therefore, BP can optimize the strategic mix of fixed costs and direct costs so as to decrease operational costs relative to increase in the output of oil and gas production of the project. Fixed costs fluctuate on a per unit basis while indirect costs cover various departments thereby providing a basis for interdepartmental cost allocations. Considering that the increased output will attract higher equipment costs, the savings accumulated from the combination of fixed costs and direct costs would be directed towards additional funds that will be required for the equipments.
Cost Classification
Fixed costs, variable costs, direct costs, indirect costs, and conversion costs are the cost classification categories that were assessed for purposes of determining their feasibility for this particular forecast of project costs. Fixed costs generally remain constant irrespective of the output levels that are obtained within a given range (Titman, Keowon, & Martin, 2011). Fixed costs are not dependent on the changes in output and include items, such as salaries, rent, and depreciation. On per unit basis, however, fixed costs decrease with increase in output levels. Variable costs, on the other hand, change in direct proportion with the levels of output (Titman, Keowon, & Martin, 2011). As such, any increments in output cause subsequent cost increments and, in result, influence cost of raw materials, labor, and direct expenses.
Also known as prime costs, direct costs are associated with particular products or department and may include the costs of labor, materials, and direct expenses (Titman, Keowon, & Martin, 2011). Indirect costs are not associated with any particular product or department (Titman, Keowon, & Martin, 2011). This is because they are incurred for the benefits of a number of units or departments. Indirect costs are also referred to as overheads and may include rent, water bills, and salaries. As for conversion costs, they emanate from the process of changing raw materials to finished goods (Titman, Keowon, & Martin, 2011). These costs generally comprise the totals of overheads and direct labor.
Conclusion
As a discounted cash flow method for project appraisal techniques, NPV has great merits considering the time value of money. Indeed, by accurately discounting the estimates of cash flows expected to be generated from each and every project, NPV enables the management of business to make sound judgments on the feasibility and future benefits from the projects. The BP case study has clearly demonstrated that NPV is a very effective project appraisal technique, particularly, when the company is to make choices among mutually exclusive projects. It may also help when the company is to allocate its financial capital resources according to the priority levels of different projects. This way, BP is able to craft and implement appropriate strategies that effectively minimize its overall project costs.
References
BP. (2011). Annual report and form 20-F, 2011. Web.
Callahan, K. R., Stetz, G. S., & Brooks, L. M. (2007). Project management accounting: Budgeting, tracking, and reporting costs and profitability. Hoboken, NJ: John Wiley & Sons.
Titman, S., Keown, A. J, & Martin, J. D. (2011). Financial management: Principles and applications (11th ed.). Boston, MA: Pearson/Prentice Hall.