EML4550 - Engineering Design Methods

1. EML4550 - Engineering Design Methods Engineering-Economics Introduction, Project Economics Ulrich and Eppinger: Chapter 11

2. 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

3. 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

4. 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?

5. Project Economic Profile

6. 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)

7. 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?

8. 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

9. 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.

10. Step 1: Financial Model - Costs

11. Step 1: Financial Model - Timing

12. Step 1: Financial Model - Cash Flow

13. Step 1: Financial Model - Project NPV

14. 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

15. Factors Affecting Profitability of a Development Project

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

17. Step 2: Sensitivity Analysis - Parametric Study on Development Cost

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

19. Step 2: Sensitivity Analysis - Parametric Study on Development Time

20. Step 3: Use Sensitivity Analysis to See Trade-Offs

21. 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?

22. 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

23. Step 3: Develop Trade-off rules for the Project

24. 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

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

26. 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

27. Project Interactions with the Market • Competitors • Type and timing • Customers • Shifting taste • Substitute products • Suppliers • Value chain impact • Non-compete

28. 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