EML4550 2007 1

EML4550 - Engineering Design Methods

Engineering-EconomicsIntroduction, Project Economics

Ulrich and Eppinger: Chapter 11

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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

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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

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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?

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Project Economic Profile

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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)

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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?

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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

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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.

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Step 1: Financial Model - Costs

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Step 1: Financial Model - Timing

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Step 1: Financial Model - Cash Flow

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Step 1: Financial Model - Project NPV

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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

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Factors Affecting Profitability of a Development Project

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

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Step 2: Sensitivity Analysis - Parametric Study on Development Cost

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

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Step 2: Sensitivity Analysis - Parametric Study on Development Time

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Step 3: Use Sensitivity Analysis to See Trade-Offs

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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?

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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

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Step 3: Develop Trade-off rules for the Project

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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

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Step 4: Consider the Influence of Qualitative Factors

CompanyProject

Company

Market

Macro Economy

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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

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Project Interactions with the Market

Competitors Type and timing

Customers Shifting taste Substitute products

Suppliers Value chain impact Non-compete

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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