How to determine the Location Factor?

This article explains a method to determine the location factor as a crucial item in determining the fate of industrial projects during a feasibility study. It is based on historical data of oil & gas projects executed in Iran, but the methodology is applicable anywhere in the world.

Abstract

In countries where there are not well-documented data of project costs, determining the location factor cannot be easily and accurately achieved. In this article, a method described by AACE is used and all local data are developed based on Corporate past experiences in the projects executed in Iran.

Using a well-known method such as AACE’s practice to determine the location factor empowers the feasibility study report and can convince capital investors and bankers that a reliable and sound analysis can lead them to a good judgment for investment.

The results show that the Location Factor for Iran is 0.89.    

 Introduction

In the economically declining world and in the era of stagnation and depression, where profit rates are in a continuous declining track, the results of a feasibility study which specifies whether an investment should be financed and executed, becomes even more important than before and is a determining factor in project study and execution.

It is important to note that industrial firms are now multinational and they execute projects in various countries. Hence, it is becoming increasingly important for cost estimators to be able to estimate the cost of a project in different countries. Cost estimators may be very well familiar with the rates and cost data in their home country, but they are not necessarily familiar with other countries’ cost data sources.

Usually there is not enough data available about the target location, and since during the feasibility study the project is at its early stages, estimators must use cost indexes, location factors and historical cost data.

A location factor is a way of converting the cost of a plant from one geographical location to another location. It is defined as the ratio of the investment cost of a plant in a specific location to the cost of the same plant when built in the base location.

The location factor must be indicative of the local labor productivity, wages, main equipment and bulk material costs, freight, tax, custom duty, engineering and project management rates, etc. and it requires a well-formulated basis and well-registered data. 

  Location Factor Determination

  Methodology

The methodology used in this article is based on the Factoring method, described in AACE Recommended Practice 28R-03 [Ref. 1], which relies on a relationship between the cost of the main equipment and the other non-equipment cost items. This relationship is quantified by a set of factors, which are called distribution factors. In this method, the cost of the main equipment is first determined and then all other costs are estimated using appropriate factors.

Using factoring method to determine the location factor involves:

  • developing the distribution factors for base location. Base location is usually taken as the US Gulf Coast ;
  • determining the distribution factors for target location considering the differences in local labor, material and equipment factors, etc;
  • calculating the ratio of the new estimate to the base estimate to determine the location factor.

 Developing Location Factor for Iran

Considering that the AACE method been used in order to be acceptable for international financers, therefore, a US split of costs has been used. A set of rather simplified distribution factors is used here, which is a cost breakdown for a typical US chemical plant: 

  Items of costFactor
1.Main equipment1.00
2.Commodities0.49
3.Labor0.66
4.Engineering/Procurement Service/ Field Indirect0.71
  Total2.86
Table 1: Historical US split of costs for a typical chemical plant (Based on AACE practice 28R-03)

As can be seen, labor and services, which are essentially determined by local rates, have a significant effect on the total, around 50%.

Based on the above factors for base location, the breakdown in the target location is evaluated. Parameters like labor rate, labor productivity, the percentage of the material procured locally and the local add-on costs like freight rate, duty and tax are major items, which affect the distribution factors. These parameters are categorized as follows:

1.Procurement strategy:% of locally produced equipment and bulk material
2.Construction strategy:% of local and non-local workforce
3.Services strategy:% of local and non-local engineering workforce
4.Import add-on costs:% custom duty, % freight, % VAT
5.Local material factor 
6.Labor rate for construction:Construction all-in rate, labor productivity
7.Labor rate for services:Engineering all-in rate, engineering productivity
Table 2, Summarizing the Parameters Affecting the Location Factor

Relative cost differences between locally supplied equipment and material and imported items, and also the degree of import material are among parameters that affect the location factor.

Labor rate for construction, engineering and project management, labor productivity and the extent of using non-local workforce are also important parameters.

Labor productivity is usually determined by comparing the man-hour required to do a specific job at base location to the same job in target location. Productivity is affected by parameters like sociological factors, location-specific parameters, project and contract characteristics, human factors, field organization and management factors.

There are some methods to determine productivity. Some companies develop worksheets and checklists to evaluate productivity. Another method is using Monte Carlo statistical modeling technique [Ref. 3].

Maria Santacreu, 2015 [Ref.2] suggested a method to determine local productivity, based on easily measurable and country-specific variables: GDP. This method is used in this article to drive Iran’s productivity in Section 3.

 General facts about Iran

Iran has huge deposits of oil and gas, has plenty of educated population, and many skilled workers who have industrial experience with mega projects.

1.Type of governmentRepublic
2.CapitalTehran, 12.5 million
3.Area1,650,000 sq km
4.Population79.70 million *
5.GDP432 billion$
6.Inflation rate8.8%*
7.VAT9%
8.Ocean freight from USA8.5%-11.5%
9.Local freight4%
10.Exchange rate39000 Rials/ $
11.Import dutieswww. irica.ir
Table 3, General Facts about Iran
* CBI. Key Economic Indicators report. No. 85. (2016-17), [Ref. 5]

Distribution Factors for Iran

There is not much information available about how expensive is the total cost of a project in Iran relative to other countries. Cost data used in this paper is based on the recent projects executed in Iran.

The following figures can be indicative of the projects performed in Iran:

  •        General engineering and supervision services: 100% local (except for patented licensed units)
  •        Fabrication and installation of fixed equipment: 95% local
  •        Fabrication of machinery equipment: 20% local
  •        Installation of machinery: 100% local
  •        Fabrication and installation of electrical bulk material: 100% local
  •        Fabrication of instrumentation bulk material: 10% local
  •        Installation of instrumentation: 100% local
  •        Fabrication of piping bulk material: 90% local for carbon steel piping and 20% for stainless steel/ alloy piping
  •        Installation of piping material: 100%
  •        Fabrication and installation of civil and structure: 100% local

The local material index is the ratio of the local prices supplied by a local supplier to the one in the USA.

Based on the history of the projects executed in Iran, this factor is estimated. It is 0.9 for main equipment and 0.8 for bulk material.

Table below summarizes above figures, which will then be used to determine the local distribution factors:

1.Custom Duty%:0-10%
2.Local Main Equipment Index (LMI):0.9
3.Local Bulk Material Index (LBMI):0.8
4.% Locally Procured Equipment:20%
5.% Locally Procured Bulk Material:66%
6.All-In Rate For Local Construction Workforce:23 $/h (1)
7.All-In Rate For Local Engineering Activities:35 $/h (1)
8.Standard All-In Rate For Expat (WE) Construction Activities:85 $/h
9.Standard All-In Rate For Expat (WE) Engineering Activities:116 $/h
10.Local Construction Labor Productivity:2.4
11.Local Engineering Services Productivity:1.35
12.Expat Construction Labor Productivity:1.15
13.Expat Engineering Services Productivity:1.00
Table 4, Determining the Distribution Factors for Iran
Note 1: All-in rate includes base wage plus 15-30% for total fringe benefit, 5-10% for supervision, 15-20% for insurance, 15-20% for overheads, 10-15% for profits [Ref. 4].

Using the data in above table, the local distribution factors are determined as follows:

  Distribution factor
1.Main equipment1.18
2.Commodities0.50
3.Labor0.46
4.Engineering/Procurement/ Field Indirect0.42
  2.55
 Location Factor = 2.55 / 2.86 =0.89 
Table 5, Distribution Factors for Iran

Results

The location factor of 0.89, which is less than 1.0, is indicative of:

  • The lower labor rate, which is typical of the Developing countries;
  • Globalization of education and availability of training / software / hardware, which increase the productivity of the skilled workers in the developing countries;
  • Industrialization of Iran and many other developing countries.

The above two points are the main reasons that the capital investment in industrialized developing countries, has been increased.

CountryLocation Factor
Argentina0.91-0.96
China0.83-0.89
Egypt0.88-0.91
Indonesia0.85-0.89
India0.8-0.85
Libya0.92-0.96
Nigeria0.95-1.0
South Africa0.95-0.98
Syria0.9-0.96
Tunisia0.89-0.94
Turkey0.87-0.95
Table 6, Location factors for some countries
Reference: Compass International [Ref. 4]

 Productivity Estimation Methodology

Labor productivity varies significantly from country to country. Cost estimators collect the data on area productivity to be accounted for in their cost estimation. Typically, one area is selected as the base location with productivity of 1.0. Other location’s productivity is measured relative to the base area (usually, USA, Washington DC). Productivity less than 1.0 means it is more productive and productivity greater than 1.0 means less productive.

One of the methods to determine the productivity in a specific country is comparing the GDP relative to GDP of USA.

Gross Domestic Product (GDP) per capita (or GDP/ hours worked), are often used to determine labor productivity. GDP per capita is reported for every country. GDP/ hours worked can be calculated using the following equation [Ref. 2]:

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Iran’s productivity can then be calculated as the ratio of GDP/ hours worked for US per GDP/ hours worked for Iran:

 IranUS
Population ( million)79.70*322.6**
Unemployment ( million)3.35*9.5**
Economically active population  ( millions)26.40*160**
GDP/capita17400**59500**
Workers/Population 0.290.47
Hours worked / worker1,9431,707
GDP/ hours worked 32.074.7
Productivity 2.41 
Table 7, Determining the Labor Productivity in Iran
* CBI. Key Economic Indicators report. No. 85. (2016-17), [Ref. 5]
** Compass International, [Ref. 4]

Notes:

1- Economically active population: The economically active population comprises the population of 10 years old and over (minimum defined age) who either participated in the production of goods and services (were employed), based on the definition of labor, in the immediate week before the data collection week (reference week) or were unemployed but capable of participation. (Reference: CBI Annual Review-[Ref. 6])
2-Unemployment: According to Iran’s Statistics Department, all people older than 10 years who work at least one hour during the week are called employed.
3- Working hours: working hours in the base year, 2015 (1394 in Iranian calendar) was 1943 hours, taking into account bank holidays and annual leave. Average workers worked 1707 hours in the United States in 2015.

Conclusion

Location factor is an indicative factor parameter for the level of industrialization of a country, the country’s infrastructure, the availability of skilled workers, the labor rate, etc.

This parameter has a considerable effect on the results of feasibility studies and can change the fate of the business decisions. Hence, it is important to determine the location factor with good accuracy. It is also important that the location factor be updated regularly.

 References

1-    “Developing Location Factor by Factoring” AACE Recommended Practice 28R-03

2-    “Measuring Labor Productivity: Technology and the Labor Supply”, by Ana Maria Santacreu, 2015, presented in ‘Economic Synopses’

3-    “Skills and knowledge of cost engineering”, 5th Edition, AACE

4-    “Front-End Conceptual Estimating Yearbook”, 2016, 15th Annual Edition, Compass International

5-    “Key Economic Indicators. No. 85”, Central Bank of the Islamic Republic of Iran report

6-    CBI Annual Review, Central Bank of the Islamic Republic of Iran report 

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