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