Chapter 15: Product Development

EconomicsProduct Design and Development

Fourth Editionby Karl T. Ulrich and Steven D. Eppinger

Adapted from Dr. Stamper

• Future Value:

• Present Value:

• Where:– F is future value– P is present value– i is interest rate (or discount rate)– n is number of periods

General Equations for Compound Interest

• NPV Costmachine A = $28,823 • NPV Costmachine B = $32,793• Costmachine A unadjusted = $29,500• Costmachine B unadjusted = $38,500

Net Present Value Comparison

Straight line depreciation Declining balance depreciation Sum–of–years-digits depreciation

Determining the Distribution

Return on Investment (ROI) Payback period Internal Rate of Return

Economic Metrics to Evaluate Projects

IRR spreadsheet example

1. Build a base-case financial model2. Perform a sensitivity analysis3. Use sensitivity analysis to understand

project trade-offs4. Consider the influence of qualitative

factors on project success5. Consider Uncertainty

Economic Analysis for Product Development(Ulrich and Eppinger)

Step 1: Build a Base-Case Model

Step 1: Build a Base-Case Model

Annual interest divided by number of periods per year

Number of periods

Payments Made Each Period

Future Value

Using Excel for Q4 of Year 1:

Present Value of Year 3 Costs:(-2250)/(1+0.10/4)^3= -$2089

Step 2: Perform Sensitivity Analysis

(e.g. 20% decrease in development costs)

Step 2: Perform Sensitivity Analysis

(e.g. 25% increase in development time)

Step 2: Perform Sensitivity Analysis

Ulrich & Eppinger, “Product Design and Development”

Step 3: Use Sensitivity Analysis to Understand

Project Trade-offs

Step 3: Use Sensitivity Analysis to Understand

Project Trade-offs (estimate Trade-off Rules from sensitivity analyses)

Ulrich & Eppinger, “Product Design and Development”

What are some situations when you might not pursue an option that presents the best NPV?

A Question:

Step 4: Consider the Influence of Qualitative

Factors

Ulrich & Eppinger, “Product Design and Development”

• Interactions between the Project and the Firm (e.g. strategic fit, risk/liability exposure)

• Interactions between the Project and the Market (e.g. competitors, customers, suppliers)

• Interactions between the Project and the Macro Environment (e.g. economic shifts, government regulations, social trends)

Modeling Uncertain Cash Flows

Dealing With Risk

Step 5: Consider Uncertainty

Probability that the Patent is allowed

NPV= Pa*PVa + Pb*PVb = 0.6($6.5 million) + 0.4($1.5 million) = $4.5 million

Determining NPV with probabilities.

NPV with market testing is $2,650,000