1 Rev: 5/05/07 MSE-415: B. Hawrylo Chapter 15 Product Development Economics MSE-415: Product Design Lecture #14

2 Rev: 5/05/07 MSE-415: B. Hawrylo Lecture Objectives: Discuss Product Development Economics

3 Rev: 5/05/07 MSE-415: B. Hawrylo Product Development Economics A product is economically viable if the value in the market is greater than the cost by a designated margin justifies the investment required to produce the product. Cash Inflows  Revenue from the product sale Cash Outflows  One-time development cost (engineering)  Production cost (labor, equipment, etc.)  Marketing  On-going production cost (raw material, maintenance, etc.)  Support cost

4 Rev: 5/05/07 MSE-415: B. Hawrylo Example: Fingernail Clipper

5 Rev: 5/05/07 MSE-415: B. Hawrylo Product Development Cash Flow Sales Revenue Operating Profit Operating Costs Break Even Time Payback Time Development Time Time Net Profit $’s + Investment -

6 Rev: 5/05/07 MSE-415: B. Hawrylo Inputs for Economic Analysis Initial Expenses  Development cost and timing  Testing cost and timing  Tooling investment and timing  Ramp-up cost and timing  Marketing and support cost and timing Ongoing Expenses  Marketing cost and timing  Product support cost and timing  Unit production cost  Displaced product revenue Ongoing Income  Unit revenue  Sales volume and lifetime Discount rate  Cost of acquiring money in the company

7 Rev: 5/05/07 MSE-415: B. Hawrylo What is money worth? You give me $50 this year and I will give it back in a year?  No interest You give me $50 this year and I will give you $53 next year?  Accrued interest You give me $47 this year and I will give you $50 next year?  Discounted interest

8 Rev: 5/05/07 MSE-415: B. Hawrylo Net Present Value NPV = period cash flow (1 + discount rate) period periods  NPV = C (1 + r) i  N i i = 1

9 Rev: 5/05/07 MSE-415: B. Hawrylo Net Present Value Example NPV = C (1 + r) i  N i i = Dollars per year for the next 5 years 6% interest (discount rate) NPV = 100/(1.06) + 100/(1.06) /(1.06) /(1.06) /(1.06) 5 NPV = 100/ / / / /1.34 NPV = $421.24

10 Rev: 5/05/07 MSE-415: B. Hawrylo Example X corporation must decide whether to introduce a new product line. The new product will have startup costs, operational costs, and incoming cash flows over six years. This project will have an immediate (t=0) cash outflow of $100,000 (which might include machinery, and employee training costs). Other cash outflows for years 1-6 are expected to be $5,000 per year. Cash inflows are expected to be $30,000 per year for years 1-6. All cash flows are after-tax, and there are no cash flows expected after year 6. The required rate of return is 10%. The present value (PV) can be calculated for each year:

11 Rev: 5/05/07 MSE-415: B. Hawrylo Example (Answer)  T=0 -$100,000 / = -$100,000 PV.  T=1 ($30,000 - $5,000) / = $22,727 PV.  T=2 ($30,000 - $5,000) / = $20,661 PV.  T=3 ($30,000 - $5,000) / = $18,783 PV.  T=4 ($30,000 - $5,000) / = $17,075 PV.  T=5 ($30,000 - $5,000) / = $15,523 PV.  T=6 ($30,000 - $5,000) / = $14,112 PV. The sum of all these present values is the net present value, which equals $8,881. Since the NPV is greater than zero, the corporation should invest in the project.

12 Rev: 5/05/07 MSE-415: B. Hawrylo Project Financial Analysis Most companies use NPV analysis of project cash flows. First, compute base model NPV projection. Sensitivity and trade-off analysis supports development decisions. Qualitative factors also influence decisions.

13 Rev: 5/05/07 MSE-415: B. Hawrylo Qualitative Factors Project technology has application to other future projects Competition Keep product line current Comprehensive product line Social Trends Support or auxiliary products Potential breakthrough technology Government trends The boss likes it etc.

14 Rev: 5/05/07 MSE-415: B. Hawrylo What is money worth? Bank Interest 5-6% Corporate Earning Rate 10-12% Marginal Rate for new projects 10-18%  Why would Marginal rate be higher?  Risk of new development  Other opportunities for use of funds.

15 Rev: 5/05/07 MSE-415: B. Hawrylo PDA High Capacity Disk Drive Should we develop a new PDA attachment?

16 Rev: 5/05/07 MSE-415: B. Hawrylo 500,000 units at $56/unit = $28,000,000 Cost of 500,000 units at $46/unit = $23,000,000 Gross profit $5,000,000 Invest $2.6M to make $5M -- sounds good to me. But……… What did we leave out? Marketing expenses of $ 250K + $80K per year Time value of money Quick calculation

17 Rev: 5/05/07 MSE-415: B. Hawrylo Inputs for New Disk Drive 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 $1.8million, 18 months $400K, 1 year $250k, 6 months $150k, 6 months $250k + $80k/year for product life 200k units/year, lifespan 2.5 years= 500k units $44/unit + $2/unit overhead $56/unit wholesale 10%/year

18 Rev: 5/05/07 MSE-415: B. Hawrylo What to Remember Financial analysis is driving product development decisions Be supportive of ridiculously early requests for development costs, intervals, product costs, etc. Economics can help drive your design decisions  Product development time versus product cost  Custom development, tooling, test fixtures versus product cost

19 Rev: 5/05/07 MSE-415: B. Hawrylo Next Week Presentations May 17, 2007 Presentation – 100 Points  (30 minutes max)  Remember you are promoting your invention to venture capitalists who have money to invest in your idea. Think about: – How complete is your product development process? – How much money do you need, and why? – What is unique about your invention? – How is your invention better than the competition? – Why should I invest in you invention? Cost to manufacture Profitability Development cost Homework – Ex. 2 & 3, p. 325