15) Product Development Economics Abdulaziz M. El-Tamimi
Product Development Process Planning Concept Development System-Level Design Detail Design Testing and Refinement Production Ramp-Up Go/No-Go Decision Gates Sensitivity and Trade-off Analysis
When Economic Analysis is performed? 1) Go/No-go milestone: it is the decision process gate evaluating the progress for either to continue or disregard or change. It is arise typically at the end of each development phase. 2) Operational design and development decisions: it involves the detailing costing to tradeoff for save cost and time. Economic analysis usually a continual process and updating economic information.
Types of Economic Analysis 1) Quantitative Analysis: this is based on cash inflows (revenues) and cash flows (costs) in life cycle of a successful new product. Sales, cost, and cash flow Development and production Cost Negative cash flow Cash Flow Sale Revenue Introduction Growth Maturity Decline Net Revenue (profit) Loss Percent of total cost 10 80 60 40 20 0 Product Life Cycle Costs Costs committed Costs incurred Ease of change Concept Detailed Manufacturing Distribution, design design service, prototype and disposal The limitation of this approach are: It focuses only on measurable quantities It depends on validity of assumptions and data. Bureaucracy reduces productivity.
Types of Economic Analysis 2) Qualitative Analysis: this is concerned with: Factors/issues can not measured and have often +ve or ve effect on developments costing and timing. Analyzing these factors may be using techniques such as: brainstorming, what-if by project team, and/or structured techniques (e.g. trategic analysis, game theory, and scenario analysis methods). s
Economic Analysis Process 1) Build a base-case financial model 2) Use Sensitivity Analysis to understand Project Trade-offs 3) Use Sensitivity Analysis to understand Project Trade-offs 4) Consider the Influence of the Qualitative Factors on Project Success
Economic Analysis Process 1) Build a base-case financial model: this consists of: 1) Estimating the timing and magnitude of future cash inflows and outflows. 2) Computing the Net Present Value (NPV) of the cash flows. Inputs for NPV Base Case Development cost and timing Testing cost and timing Tooling investment and timing Ramp-up cost and timing Marketing and support cost and timing Sales volume and lifetime Unit production cost Unit revenue Discount rate Net Present Value NPV NPV = = periods N S S i= 1( 1 period cash flow ( 1+ discount rate) Ci i + r) period
Product Development Cash Flow Sales Revenue Operating Costs Operating Profit Cumulative Cash Inflow or Outflow ($) Investment ( ) Time Development Time Payback Time Investment Break Even Time
Economic Analysis Process 2) Perform Sensitivity Analysis: this is concerned with calculating the change in NPV corresponding to change in the factors included in the financial model. The factors are: 1) Internal factors: factors influenced by development teams (e.g. program expense, development speed, production cost, and product performance). 2) External factors: those cannot arbitrary change (e.g. market response, sales volume, product price.
Economic Analysis Process 3) Use Sensitivity Analysis to understand Project Trade-offs: this is concerned with understanding the relative magnitude of financial interactions of changes between internally driven factors. Six potential interactions should be managed as shown. A set of rules are developed for trade-off
a) Economic Analysis Process 4) Consider the Influence of the Qualitative Factors on Project Success: it focuses basically on the interaction between project, firm, market and macroeconomic environment. a) Interaction between project and firm. this relates decision to firm context as a whole. Two key interactions are externalities and strategic fit b) Interaction between project and market. This relates to decisions impacts the market. Three groups beside development team have impact: competitors, customers, and suppliers c) Interaction between project and macroeconomic environment. This takes into account key macro factors: major economic shift, government regulation, and social trends
Product Development Economics Example: Polaroid Color Photo Printer CI-700
Product Development Economics Example: Polaroid Color Photo Printer CI-700 1- Build a base-case financial model: a) Data b) Project schedule- Gantt chart (schedule from inception through market withdrawal)
Product Development Economics Example: Polaroid Color Photo Printer CI-700 1- Build a base-case financial model: c) Develop cash flows and tabulate Merging the project financials & schedule into a cash flow table (all $value in thousands)
Product Development Economics Example: Polaroid Color Photo Printer CI-700 1- Build a base-case financial model: d) Compute NPV, example given for year 3 Total cash flows, present values, and net present value table (all $value in thousands)
Product Development Economics Example: Polaroid Color Photo Printer CI-700 2) Perform Sensitivity Analysis: a) Calculate development cost sensitivities Financial model with 20% decrease in development spending(all $value in thousands)
Product Development Economics Example: Polaroid Color Photo Printer CI-700 2) Perform Sensitivity Analysis: b) Calculate development time sensitivities Financial model with 25% increase in development time (all $value in thousands)
Product Development Economics Example: Polaroid Color Photo Printer CI-700 3) Use Sensitivity Analysis to understand Project Trade-offs a) Sales volume sensitivities Financial model with 10% increase in development cost (all $value in thousands) b) Trade-off rules
Application of Decision Trees to Product Design Particularly useful when there are a series of decisions and outcomes which lead to other decisions and outcomes Procedures 1) Include all possible alternatives and states of nature - including doing nothing 2) Enter payoffs at end of branch 3) Determine the expected value of each branch and prune the tree to find the alternative with the best expected value 2011 Pearson Education, Inc. publishing as Prentice Hall, Heizer, CH5, operation management
Decision Tree Example Purchase CAD Hire and train engineers Do nothing (.4) High sales (.6) Low sales (.4) High sales (.6) Low sales $2,500,000 Revenue - 1,000,000 Mfg cost ($40 x 25,000) - 500,000 CAD cost $1,000,000 Net EMV (purchase CAD system)= $800,000 Revenue $388,000-320,000 Mfg cost ($40 x 8,000) - 500,000 CAD cost - $20,000 Net loss $2,500,000 Revenue - 1,250,000 Mfg cost ($50 x 25,000) - 375,000 Hire and train cost $875,000 Net EMV (hire and train engineers)= $800,000 Revenue $365,000-400,000 Mfg cost ($50 x 8,000) - 375,000 Hire and train cost $25,000 Net $0 Net = (.4)($1,000,000) + (.6)(- $20,000) = = (.4)($875,000) + (.6)($25,000) = 2011 Pearson Education, Inc. publishing as Prentice Hall, Heizer, CH5, operation management
Decision Tree Example 2 Cost for on time project EV= (0.3)(1.8) + (0.5)(1) + (0.2)(0.4) = $1.12 Cost delayed project at decision point 3 EV= (0.1)(1.4) + (0.5)(0.8) + (0.4)(0.3) = $ 0.66 Cost delayed project at decision point 2 EV= (0.3)(0.66) + (0.7)(0) 2.0 = - $ 1.8 cost of project at decision point 1 EV= (0.5)(1.12) + (0.5)(0) 4.0 = - $ 3.44 decision Project should not have been undertaken (cost too high to be warranted or expected payoff is too modest) Dieter, G., Engineering Design pp 203-206, McGraw Hill.