EML EML Engineering Design Methods Engineering-Economics Introduction, Project Economics Ulrich and Eppinger: Chapter 11

EML Engineering-Economics nDesign under ‘constraints’ lPhysical (materials, environment, fits, laws of physics) lEconomic ($ to design, $ to produce, $ to operate) nDealing with the combination of technical and cost constraints is engineering-economics

EML Engineering-Economics (Cont’d) nProject economics lHow much should we spend on design? lHow big will the market be? nProduct economics lWhat is the initial cost of the product lWhat are the operational costs of the product lWhat is the product’s life-cycle cost? nSame questions but asked from the manufacturer and customer perspectives

EML Project Economics nHow much effort (time and $) should a company spend developing a product? nWhat tools are used to determine the optimum level of development expenditures? nWhat type of analysis and reports are needed to convince management to proceed with a development project?

EML Project Economic Profile

EML Project Economics: Quantitative Analysis nProject cash flows span a product lifetime (sometimes many years) nHow do we compare an expenditure ‘today’ to an income ‘tomorrow’? nConcept of ‘Net Present Value’ (NPV)

EML NPV Analysis - Observations nWhat interest rate to use? lDiscount rate or hurdle rate lMust 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% nConnection to prevailing interest rates as set by Federal Reserve?

EML Project Economics: Methodology nBuild a ‘base-case’ financial model nPerform sensitivity analysis to understand the importance of the different assumptions of the model nUse the sensitivity analysis to understand trade-offs nConsider impact of ‘qualitative’ factors not covered on the financial model Will work through an example

EML Step 1: Build a Financial Model nNeed to estimate the magnitude and timing of all project expenditures and product revenues lDesign and development costs lRamp-up costs lMarketing costs §Introduction, direct sales, and service costs lProduction costs §Direct and indirect costs lSales revenues lConsider tax implications, impact on existing sales, etc.

EML Step 1: Financial Model - Costs

EML Step 1: Financial Model - Timing

EML Step 1: Financial Model - Cash Flow

EML Step 1: Financial Model - Project NPV

EML Step 1: Financial Model - Conclusions nThe project NPV is positive nManagement can quantify NPV and weigh it against risk, or compare with other potential projects to reach a go/no go decision nManagement needs answers to ‘what if’ scenarios before committing to a project Sensitivity Analysis

EML Factors Affecting Profitability of a Development Project

EML Step 2: Sensitivity Analysis - 20% Reduction in Development Cost

EML Step 2: Sensitivity Analysis - Parametric Study on Development Cost

EML Step 2: Sensitivity Analysis - 25% Increase in Development Time

EML Step 2: Sensitivity Analysis - Parametric Study on Development Time

EML Step 3: Use Sensitivity Analysis to See Trade- Offs

EML Step 3: Understanding Trade-Offs nIf development costs need to be increased by 10%, what sales volume increase is needed to justify it? n10% increase in development cost decreases project NPV by 5.9% (see table)see table nWhat increase in volume would be needed to compensate for that decrease?

EML 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

EML Step 3: Develop Trade-off rules for the Project

EML Limitations of Quantitative Analysis nFocuses only on measurable quantities, neglects the ‘intangible’, and encourages investment only on those things that we ‘know how to measure’ nIt depends entirely on the validity of assumptions and estimates that may be wrong nBureaucracy and over-management may stifle the development project

EML Step 4: Consider the Influence of Qualitative Factors Company Project Company Market Macro Economy

EML Project Interactions with the Company nExternalities lFailure of other project lLearning from other projects or from this project (‘unpriced’ advantage) nStrategic Fit lTechnology advantage lCorporate image lExpansion plan

EML Project Interactions with the Market nCompetitors lType and timing nCustomers lShifting taste lSubstitute products nSuppliers lValue chain impact lNon-compete

EML Project Interactions with the Macro Economy nMajor economic shifts lInterest rates lStock market lTrade lRecession lGlobalization nGovernment regulations lRegulatory impediments lRegulatory opportunities nSocial Trends lEnvironmental concerns/Global warming