E. Economics-4
Download
Report
Transcript E. Economics-4
EML4550 - Engineering Design Methods
Engineering-Economics
Introduction, Project Economics
Ulrich and Eppinger: Chapter 11
EML4550 2007
1
Engineering-Economics
Design under ‘constraints’
Physical (materials, environment, fits, laws of physics)
Economic ($ to design, $ to produce, $ to operate)
Dealing with the combination of technical and cost
constraints is engineering-economics
EML4550 -- 2007
Engineering-Economics (Cont’d)
Project economics
How much should we spend on design?
How big will the market be?
Product economics
What is the initial cost of the product
What are the operational costs of the product
What is the product’s life-cycle cost?
Same questions but asked from the manufacturer and
customer perspectives
EML4550 -- 2007
Project Economics
How much effort (time and $) should a company spend
developing a product?
What tools are used to determine the optimum level of
development expenditures?
What type of analysis and reports are needed to convince
management to proceed with a development project?
EML4550 -- 2007
Project Economic Profile
EML4550 -- 2007
Project Economics: Quantitative Analysis
Project cash flows span a product lifetime (sometimes many
years)
How do we compare an expenditure ‘today’ to an income
‘tomorrow’?
Concept of ‘Net Present Value’ (NPV)
EML4550 -- 2007
NPV Analysis - Observations
What interest rate to use?
Discount rate or hurdle rate
Must be higher than opportunity lost by company by investing in this
project as opposed to something else
Must be higher than prevailing interest rates
Low growth industries – 10%
Typical for the 90s (bull market) – 20%
Aggressive growth (venture capital) - ~50%
Connection to prevailing interest rates as set by Federal
Reserve?
EML4550 -- 2007
Project Economics: Methodology
Build a ‘base-case’ financial model
Perform sensitivity analysis to understand the importance of
the different assumptions of the model
Use the sensitivity analysis to understand trade-offs
Consider impact of ‘qualitative’ factors not covered on the
financial model
Will work through an example
EML4550 -- 2007
Step 1: Build a Financial Model
Need to estimate the magnitude and timing of all project
expenditures and product revenues
Design and development costs
Ramp-up costs
Marketing costs
Introduction, direct sales, and service costs
Production costs
Direct and indirect costs
Sales revenues
Consider tax implications, impact on existing sales, etc.
EML4550 -- 2007
Step 1: Financial Model - Costs
EML4550 -- 2007
Step 1: Financial Model - Timing
EML4550 -- 2007
Step 1: Financial Model - Cash Flow
EML4550 -- 2007
Step 1: Financial Model - Project NPV
EML4550 -- 2007
Step 1: Financial Model - Conclusions
The project NPV is positive
Management can quantify NPV and weigh it against risk, or
compare with other potential projects to reach a go/no go
decision
Management needs answers to ‘what if’ scenarios before
committing to a project
Sensitivity Analysis
EML4550 -- 2007
Factors Affecting Profitability of a Development Project
EML4550 -- 2007
Step 2: Sensitivity Analysis - 20% Reduction in
Development Cost
EML4550 -- 2007
Step 2: Sensitivity Analysis - Parametric Study on
Development Cost
EML4550 -- 2007
Step 2: Sensitivity Analysis - 25% Increase in
Development Time
EML4550 -- 2007
Step 2: Sensitivity Analysis - Parametric Study on
Development Time
EML4550 -- 2007
Step 3: Use Sensitivity Analysis to See TradeOffs
EML4550 -- 2007
Step 3: Understanding Trade-Offs
If development costs need to be increased by 10%, what
sales volume increase is needed to justify it?
10% increase in development cost decreases project NPV by
5.9% (see table)
What increase in volume would be needed to compensate
for that decrease?
EML4550 -- 2007
Step 3: Understanding Trade-Offs
10% increase in sales leads to 21% increase of NPV.
(21%/10%)*I=5.9% I=2.8% by assuming linear
distribution → Through interpolation, one needs a 2.8%
increase in sales volume to compensate for the 5.9%
decrease in NPV brought upon by the 10% increase in
development costs
EML4550 -- 2007
Step 3: Develop Trade-off rules for the Project
EML4550 -- 2007
Limitations of Quantitative Analysis
Focuses only on measurable quantities, neglects the
‘intangible’, and encourages investment only on those things
that we ‘know how to measure’
It depends entirely on the validity of assumptions and
estimates that may be wrong
Bureaucracy and over-management may stifle the
development project
EML4550 -- 2007
Step 4: Consider the Influence of Qualitative
Factors
Project
Company
Company
Market
Macro Economy
EML4550 -- 2007
Project Interactions with the Company
Externalities
Failure of other project
Learning from other projects or from this project (‘unpriced’
advantage)
Strategic Fit
Technology advantage
Corporate image
Expansion plan
EML4550 -- 2007
Project Interactions with the Market
Competitors
Type and timing
Customers
Shifting taste
Substitute products
Suppliers
Value chain impact
Non-compete
EML4550 -- 2007
Project Interactions with the Macro Economy
Major economic shifts
Interest rates
Stock market
Trade
Recession
Globalization
Government regulations
Regulatory impediments
Regulatory opportunities
Social Trends
Environmental concerns/Global warming
EML4550 -- 2007