MSE-415: Product Design Lecture #14

1. MSE-415: Product DesignLecture #14 Chapter 15 Product Development Economics

2. Lecture Objectives: • Discuss Product Development Economics

3. 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. Example: Fingernail Clipper

5. Sales Revenue Operating Costs Operating Profit Net Profit Break EvenTime DevelopmentTime PaybackTime Investment Product Development Cash Flow + $’s - Time

6. 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. 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. Net Present Value S period cash flow NPV = period (1 + discount rate) periods N C S i NPV = i (1 + r) i = 1

9. Net Present Value Example N C S i NPV = i (1 + r) i = 1 • 100 Dollars per year for the next 5 years • 6% interest (discount rate) NPV = 100/(1.06) + 100/(1.06)2 + 100/(1.06)3 + 100/(1.06)4 + 100/(1.06)5 NPV = 100/1.06 + 100/1.12 + 100/1.19 + 100/1.26 + 100/1.34 NPV = $421.24

10. 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. Example (Answer) • T=0 -$100,000 / 1.100 = -$100,000 PV. • T=1 ($30,000 - $5,000) / 1.101 = $22,727 PV. • T=2 ($30,000 - $5,000) / 1.102 = $20,661 PV. • T=3 ($30,000 - $5,000) / 1.103 = $18,783 PV. • T=4 ($30,000 - $5,000) / 1.104 = $17,075 PV. • T=5 ($30,000 - $5,000) / 1.105 = $15,523 PV. • T=6 ($30,000 - $5,000) / 1.106 = $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. 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. 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. 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. PDA High Capacity Disk Drive Should we develop a new PDA attachment?

16. Quick calculation 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

17. 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. 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. Next WeekPresentationsMay 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