Economic Justification ofNPD projects

and Financial ToolsUnder supervision of Dr.

Sadeghi By:

Ali BayaniAli Heydari

Elnaz mahmoodiKooshan Gholami

Spring 2011

Financial ToolsThree tools for Economic Justification:

Cost EstimatingEconomic Measures Of MeritSetting Project Priorities

Financial ToolsCost Estimating:

MaterialsLaborUtilitiesMaintenancePlant overheadsDepreciation, taxes, and insuranceGeneral and administrative

Financial ToolsMaterials:The equation for estimating material is material price times quantity produced (units) divided by yield:

Price * (units/yield)

Financial ToolsCase Study: Total Materials Used

Improvement ProbeProbe sells 600$Calculate material costs

Financial ToolsCase Study: Total Materials Used

So they set a target for improvement Probe’s materials

Financial ToolsLabor:1) Total number of people directly working on the

product2) Average wage rate

Financial ToolsLabor cost:Vacation factor: 1.11(Hours per year – vacation/holiday = Total hours worked)Relief factor = 1.23Benefits factor = 1.3Supervision factor = 1.3

Financial ToolsAnnual labors cost:

Number of operation * $ wages rate * 2080*(1.11*1.23*1.3*1.3)

Financial ToolsCase Study: Estimating Labor to Produce Scanning InstrumentsAnalyze two suppliersCalculate the labor cost

Financial ToolsCase Study: Estimating Labor to Produce Scanning Instruments

The labor costs for the scanning machines were considerable. Of its $5,400 price tag, Supplier A’s labor costs were $2,184 per unit ($436,800 divided by 200 instruments).Supplier B was indeed more automated so Mark was a little puzzled at this point as to why its price was $5,150 when its labor costs were only $1,613 per unit ($322,560 divided by 200 instruments).

Because of his efforts, he was able to secure a quote for the 200 instruments from Supplier B at a cost of $4,650.

Financial ToolsUtilities:Include all the power associated with running the equipment used to produced the product.

Annual utilities costs are 2 percent of investment

Financial ToolsUtilities:We must estimate not only what it would cost to buy the equipment new, but multiply it by three to include installation, project management, and facilities associated with getting the equipment ready to run.

Utilities = Total investment (TI) × .02

Financial ToolsMaintenance:Maintenance includes both labor and materials to keep the process that is making the product or service, such as a mainframe computer, maintained and producing in an efficient manner. The estimate of annual maintenance cost is calculated at 6 percent of the total investment.

Maintenance = .06 × total investment

Financial ToolsPlant Overheads:General plant burden Overtime Plant administration (management and staff) Employee relations Medical Fire and plant protection Internal transportation (shipping and receiving) Carrying and acquisition costs Communications Computers and telephone systems Engineering assistance to operationsGrounds upkeep Cafeteria

Financial ToolsPlant Overheads:

The problem with assigning or allocating overhead costs to a product or service when there is more than one product or service produced at a given location is defining the costs to be distributed correctly. A good formula for estimating for overheads is .75 times labor:

Overhead = .75 × labor

Financial ToolsDepreciation, Taxes, and Insurance:

Depreciation is one of the most misunderstood concepts associated with cost sheet and cash flow analysis. Depreciation is an accounting element, a noncash cost in total costs. Basically it is an investment incentive that the government gives to corporations to encourage them to continue to invest.

Investment depreciation = 10% × total capital investment

Financial ToolsDepreciation, Taxes, and Insurance:

To this calculation add property taxes and insurance on the facility at 1 percent and the final equation will be:

Depreciation, taxes, and insurance =11% × total investment

Financial ToolsGeneral and Administrative Costs:Selling expenses (personal selling expenses such as travel, salaries, commissions, sales office rental, service, advertising, promotions, and other marketing functions) Executive compensation Staff departments Legal Finance Purchasing

Financial ToolsGeneral and Administrative Costs: Accounting Central engineering Office space Insurance Property taxes Clerical

General and administrative expenses =15% × total expenses

Economic Measures of Merit• net present value (NPV)• discounted payback period (DPP)• Internal rate of return (IRR)

NPV

Performing a Cash Flow Analysis

• Step 1: Estimate the cash flow streams produced by the project for 10 years.

• Step 2: Discount the streams by the cost of capital, so that all streams are in today’s dollars.

• Step 3: Cumulate the discounted cash flow streams and plot.

Step 1: Estimate the Cash Flow Streams.

Revenue -cash expenses -depreciation =Before Tax Operating Income - taxes = Net Income + depreciation - capital investment = Year-End Cash Flow

Step 1: Estimate the Cash Flow Streams.

Step 2: Discount the Streams by the Cost of Capital

• Next year:

Step 2: Discount the Streams by the Cost of Capital

• Weighted Average cost of capital

Equity 15% × 2/3 = 10%

Debt 7% × 1/3 = 2%

Weighted average cost of capital = 12%

Step 3: Cumulate the Discounted Cash Flow Streams and Plot.

Step 3: Cumulate the Discounted Cash Flow Streams and Plot.

Setting Project Priorities

IRR NPV = 0

Case study• Company XYZ has $800,000 in its capital forecast for next year and

must prioritize from the projects shown below

Case study

• A quest for a comprehensive life cycle economic model has been launched

• Classical manufacturing cost models, cost and management accounting models, and microeconomic models are not adequate

• A comprehensive life cycle economic model is needed for evaluation of the costs of 'doing' and 'not doing' the right things to make products and processes environmentally safe.

LIFE CYCLE ECONOMIC

• The pace of product and process innovation in the intensely competitive world market is accelerating

• Everyone has realized that bringing products rapidly to market by listening to the voice of the customer

• by deploying concurrent (or simultaneous) engineering can be accomplished only if all issues including economics are considered up front before the first production run is made

LIFE CYCLE ECONOMIC

CLASSICAL COST MODELS

Taylor's Cost Model

• Metal cutting economics began with the introduction of the now classical Taylor time and cost models:

Cutting time per cut, tt = (ts + tc + td) = ts + Ic/V + (lc/VT)td (1) Cost per cut, cc = ts Cr+ lc Cr/V+ (lc/VT)td Cr + (Ic/VT)Y (2) Taylor tool life equation: logT = a constant - m 1ogV (3)

• By differentiating equations (1 ) and (2) with respect to V and substituting the value of T from equation (3), Taylor obtained optimum speeds for minimum cutting time and minimum cost

CLASSICAL COST MODELS

Traditional Accounting cost model• who introduced 'Scientific Management' that the efficiency and

utilization of labor, material and equipment began to be measured against 'one best way of doing work’:

Total Cost= Fixed Cost + Variable Cost Fixed Cost=Overhead; Variable Cost=Material Cost + Labor Cost

Microeconomics of Firm• The classical microeconomic concepts deal with the theory of firm in

pursuit of maximizing its profits and the theory of consumer behavior during maximization of satisfaction

• Although the classical microeconomic theory provides a much needed firm foundation, cost models have not resulted from the theory because it is difficult to establish a production function in practice.

RECENT DEVELOPMENTS

Macro- and Micro- economic Models• The Taylor tool life relationship and its subsequent

refinements mentioned above treated speed or feed or depth of cut one variable at a time during the determination of the time and cost optima.

• variables simultaneously leading to a truer optima for machining tinie and cost; this culminated in the form of cutting Rate-Tool Life-Functions (R-T-F) which describe the basic trade-off between tool life and cutting rate and consequently, machining time and cost.

Economic Models for New Process Development• Traditionally, the economics of new process development

is investigated only after the technological feasibility of the process has been established and in most cases.

• The introduction of the conditions for economic feasibility of a process provided a measure of how much improvement is necessary and sufficient to justify investment in the new process and the desirable working regions where the process should prove economically feasible, while the technological feasibility is being established.

The necessary condition of economic feasibility

• states that the cost savings and the value of time savings by switching to the new process should be greater than zero.

Δ cc+ Δ tc(oc) > 0where tc = [(Vr) + (v+va)/R + (v/RT)tdcc = [(l/r) + (v+va)/R + (v/RT)td]Cr + (v/RT)YΔ tC=tC-td ; Δ ==cc-cd

tc=time per cut (oc)=opponunity cost (money/hour) cc=cost per cut (money/cut) l=rapid traverse distance Y=tool cost per usage (money/usage); Cs V=cutting speed (distance/time); v D=depth of cut (AD=Axial; RD=Radial); a. R=cutting rate (volume/time); CIRP equi., 2

td=tool indedchange time (time); Is..

• The time saved at a processing unit can be utilized for processing additional parts of the same kind or of a different kind, and hence, the opportunity cost (oc) of time savings is recognize by valuing these savings at the rate it costs to farm out work done by the machine.

• The above equations apply to the individual cut or a sequence of cuts within a single setup on a machine tool, and, hence, these equations are called micro-economic models.

The necessary condition of economic feasibility

• Since a corporation exists in a competitive environment, the frame work for a life cycle economic model must start from the competitive strategy that a corporation must employ.

• Often employed successful strategy emphasizes capturing a desired portion of the market share by the timely introduction of a product with features and quality desired by the potential users at a competitive price.

The necessary condition of economic feasibility

• A target cost is determined by subtracting the desired profit from the competitive price.

• By concurrently designing the products, processes, and systems that can be continually improved, the actual cost is brought closer and closer to the target cost.

• Many Japanese companies are known to sacrifice initial profitability to gain the desired portion of the market share and subsequently harvest profits as volume increases with the increase in market share.

COST AND SHARE

• On the other hand, the actual cost of the product must include not only the cost of materials, labor, consumables, and all support functions, but also, the potential penalty costs resulting from the environmental risks while the product is being manufactured, stored, in use, disposed or recycled.

• There are also potential opportunity costs, which allow advantageous positions to be secured by timely competitive actions, including environmental and ecological responsiveness, which must be recognized.

RISK AND OPPORTUNITY COST

• Therefore, the life cycle economic model must take the following form:

(Actual Costs + Penalty Costs - Opportunity Costs) ≥ Target Cost

• Implicit in the costs is the question of timing. Timing can be deployed only if the strategies are correctly formulated, the necessary resources deployed, and the logistics executed so as to achieve competitive introduction of the product:

(Actual Time-to-Market + Penalty Lags - Opportunity Leads) ≥ Target Timing

LIFE CYCLE ECONOMIC MODEL

• It is well known that over 80% of the costs of a product are committed before a first production run is made.• The opportunities for influencing the costs are few

once the production begins.• The more successful the concurrent engineering

process is the larger the portion of costs that will be committed prior to the production run.

HINTS

Economic Justification of Advanced Manufacturing Technology

Advanced Manufacturing Technology(AMT)Technologies for increasing competitiveness of manufacturing

firms.

Benefits from AMT

Intangible or

soft

Direct And

quantifiable

Justification of AMT

Traditional capital budgeting

techniques are inadequate for Justification of

AMT.

The capital investment is vary large and cannot be implemented in a

piecemeal manner.

Many of the significant benefits are not easily quantifiable in

cash flow terms.

AMT Justification

Organizational decision making

analysis

Justification of the proposal

Economic analysis

Strategic analysis

Framework for the financial justification of AMT

Level ΙDCF analysis with refinements

NPV=V1

Level ΙΙValue of flexibilities mathematical

programming models PV=V2

Level ΙΙΙValue of time series linkages

learning curve models PV=V3

Level ΙVResidual strategic benefits

qualitative analysis

V1≥0

G1=V1Gap

V2≥G2G2=G1-V2Gap

V3≥G2G3=G2-V3Gap

Economically not OK Economically justified

Benefits ≥G3Benefits <G3

Level 1

Analyze the easily quantifiable costs and costs using the traditional discounted cash flow(DCF) models.

Examine the limitations of the traditional DCF analysis and discuss some refinements.

Mechanics of the DCF analysisAssumption of the status quo of the current cash flowsTerminal Value of the projectTreatment of inflation

Level 2a stochastic mathematical programming model to quantify the

strategic benefits such as flexibility and quality

Analysis at Level2 becomes necessary if the Level1 analysis results in a negative NPV.

Level 3Quantify the benefits of the time series linkages between the

project currently being justified and a related future project using a learning curve model

Level 4A qualitative assessment of the benefits which were not

included in the evaluation at the first three levels.