17.Product Development Economics

17.Product Development Economics

1. 17.1.Elements of Economic Analysis

   • 17.1.1.Quantitative Analysis
     • Economically successful products are profitable; that is, they generate more cumulative inflows than cumulative outflows. A measure of the degree to which inflows are greater than outflows is the net present value (NPV) of the project, or the value in today’s dollars of all of the expected future cash flows
     • The value of quantitative analysis is not only in providing objective evaluations of projects and alternatives but also in bringing a measure of structure and discipline to the assessment of product development projects.
   • 17.1.2.Quality Analysis
     • Quantitative analysis can capture only those factors that are measurable, yet projects often have both positive and negative implications that are difficult to quantify.
     • The approach to qualitative analysis is to consider specifically the interactions between the project and (1) the firm, (2) the market, and (3) the macroeconomic environment.
   • 17.1.3.When Should Economic Analysis Be Performed?
     • Economic analysis, which includes both quantitative and qualitative approaches, is useful in at least two different circumstances:
       • Go/no-go milestones: For example, should we try to develop a product to address this market opportunity? Should we proceed with the implementation of a selected concept? Should we launch the product we have developed? These decisions typically arise at the end of each phase of development.
       • Operational design and development decisions: Operational decisions involve questions such as: Should we spend $100,000 to hire an outside firm to develop this component in order to save two months of development time? Should we launch the product in four months at a unit cost of $450 or wait until six months when we can reduce the cost to $400?
     • The analysis done at the beginning of a project can usually be updated with current information so that it does not have to be created in its entirety each time. Used in this way, the analysis becomes one of the information systems the team uses to manage the development project.
   • 17.1.4.Economic Analysis Process
     • We recommend the following four-step method for the economic analysis of a product development project:
       • 1. Build a base-case financial model. 2. Perform a sensitivity analysis to understand the relationships between financial success and the key assumptions and variables of the model. 3. Use the sensitivity analysis to understand project trade-offs. 4. Consider the influence of the qualitative factors on project success.

2. Step 1: Build a Base-Case Financial Model

   • Estimate the Timing and Magnitude of Future Cash Inflows and Outflows
     • The timing and magnitude of the cash flows is estimated by merging the project schedule with the project budget, sales volume forecasts, and estimated production costs.
     • The most basic categories of cash flow for a typical new product development project are:
       • Development cost (all remaining design, testing, and refinement costs up to production ramp-up). • Ramp-up cost. • Marketing and support cost. • Production cost. • Sales revenues.
     • Depending on the types of decisions the model will support, greater levels of detail for one or more areas may be required. More detailed modeling may consider these same five cash flows in greater detail, or it may consider other flows. Typical refinements include:
       • Breakdown of production costs into direct costs and indirect costs • Breakdown of marketing and support costs into launch costs, promotion costs, direct sales costs, and service costs. • Inclusion of tax effects, including depreciation and investment tax credits. • Inclusion of such miscellaneous inflows and outflows as working capital requirements, cannibalization , salvage costs, and opportunity costs.
     • A common method of representing project cash flow is a table. The rows of the table are the different cash flow categories, while the columns represent successive time periods.
   • Compute the Net Present Value of the Cash Flows
     • Computing the NPV requires that the net cash flow for each period be determined, and then that this cash flow be converted to its present value
       • 1. The period cash flow is the sum of inflows and outflows.
       • 2. The present value of this period cash flow discounted at 10 percent per year (2.5 percent per quarter) back to the first quarter of year 1 (a total of eight quarters) is $1,436,306.
       • 3. Project NPV is the sum of the discounted cash flows for each of the periods, or $8,203,000.
   • The Base-Case Financial Model Can Support Go/No-Go Decisions and Major Investment Decisions
     • The NPV of this project, according to the base-case model, is positive, so the model supports and is consistent with the decision to proceed with development.
     • We now consider sensitivity analysis as a technique for readily understanding multiple scenarios for ongoing product development decisions.
   • Constructing the base-case model consists of estimating the timing and magnitude of future cash flows and then computing the NPV of those cash flows.

3. Step 2: Perform Sensitivity Analysis

   • Development Cost
     • By making incremental changes to development cost while holding other factors constant, we can see the incremental impact on project NPV.
     • It is often useful to know the absolute dollar changes in NPV as well as the relative percentage changes, so we show both in the sensitivity table.
   • Development Time
     • To perform the sensitivity analysis, we must make several assumptions about the changes.
     • These sensitivity analyses inform the team about which factors in the model have a substantial influence on NPV.
     • Sensitivity analysis shows that NPV is highly dependent on uncertainties in some base-case input values and less dependent on others.
   • Sensitivity analysis uses the financial model to answer “what if ” questions by calculating the change in NPV corresponding to a change in the factors included in the model. Both internal and external factors influence project value.

4. Step 3: Use Sensitivity Analysis to Understand Project Trade-Offs

   • Six Potential Interactions
     • Development teams attempt to manage six potential interactions between the internally driven factors.
     • The potential interaction between any two internal factors depends on the characteristics of the specific product context.
     • These interactions are important because of the linkage between the internal factors and the external factors.
     • Some of these interactions are more complex than a simple trade-off.
   • Trade-Off Rules
     • The near linearity of many sensitivity analyses allows the team to compute some trade-off rules to inform day-to-day decision making. These rules take the form of the cost per unit change in the internal and external factors.
     • The trade-off rules are easily computed from the base-case model and can be used to inform the team of the relative magnitude of the sensitivities of the project profitability on factors under its control.
   • Limitations of Quantitative Analysis
     • Financial modeling and sensitivity analysis are powerful tools for supporting product development decisions, but these techniques have important limitations.
     • Quantitative analysis suffers from some of the following problems:
       • It focuses only on measurable quantities. Quantitative techniques like NPV emphasize and rely on that which is measurable. However, many critical factors impacting product development projects are difficult to measure accurately.
       • It depends on validity of assumptions and data. Product development teams may be lulled into a sense of security by the seemingly precise result of an NPV calculation.
       • Bureaucracy reduces productivity. Detractors of financial analysis assert that such activities provide a high level of planning and control at the expense of product development productivity.
     • Development teams should understand the strengths and limitations of the techniques and should be fully aware of how the models work and on what assumptions they are based.
   • Typically, the development team will make such a change only if some other offsetting gain is expected, such as a better-quality product with higher sales volumes. We therefore need to understand the relative magnitude of these financial interactions.

5. Step 4: Consider the Influence of the Qualitative Factors on Project Success

   • Projects Interact with the Firm, the Market, and the Macro Environment
     • Decisions made within a project in general do have important consequences for the firm as a whole, for competitors and customers in the market, and even for the macroeconomic (macro) environment in which the market operates.
     • The most basic approach to qualitative analysis is to consider (1) the interactions between the project and the firm as a whole, (2) the interactions between the project and the market in which the product will be sold, and (3) the interactions between the project and the macro environment.
     • Interactions between the Project and the Firm as a Whole
       • Externalities: An externality is an “unpriced” cost or benefit imposed on one part of the firm by the actions of a second; costs are known as negative externalities and benefits as positive externalities.
       • Strategic fit: Decisions of the development team must not only benefit the project, but also be consistent with the firm’s overall product plan and technology strategy.
     • Interactions between the Project and the Market
       • Competitors: Competitors may provide products in direct competition or products that compete indirectly as substitutes.
       • Customers: Customers’ expectations, incomes, or tastes may change. Changes may be independent or may be driven by new conditions in markets for complementary or substitute products.
       • Suppliers: Suppliers of inputs to the new product are subject to their own markets’ competitive pressures. These pressures may, indirectly through the value chain, impact the new product.
     • Interactions between the Project and the Macro Environment
       • Major economic shifts: Examples of typical major economic shifts that impact the value of development projects are changes in foreign exchange rates, materials prices, or labor costs.
       • Government regulations: New regulations can destroy a product development opportunity. On the other hand, a shift in the regulatory structure of an industry can also spawn entire new industries.
       • Social trends: As with government regulations, new social concerns such as increased environmental awareness can also destroy existing industries or create new ones.
   • Carrying Out Qualitative Analysis
     • For most project teams, the most appropriate qualitative analysis method is simply to consider and discuss the interactions between the project and the firm, the project and the market, and the project and the macro environment.
       • Then the team considers these interactions in concert with the results of the quantitative analysis in order to determine the most appropriate relative emphasis on development speed, development expense, manufacturing cost, and product performance.
   • Many factors influencing development projects are difficult to quantify because they are complex or uncertain. We refer to such factors as qualitative factors.

6. Erik Enrique Martínez Hernández

   • Ulrich, K. T., & Eppinger, S. D. (2012). Product Design and Development. New York: McGraw-Hill. ISBN 978-0-07-340477-6
     • "Doy mi palabra de que he realizado esta actividad con integridad académica"

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