Economic Analysis & Sensitivity Analysisfor Development of New Systems

Case Study

Quantitative analysis can capture only those factors that are measurable, yet projects often have both positive and negative implications that are difficult to quantify. Also quantitative analysis rarely captures the characteristics of a dynamic and competitive environment.Qualitative AnalysisQualitative analysis considers the interaction between the firm, the market and the macro economic environment

Economic Analysis ProcessFollowing four step method is used for economic analysis of product development project:1. Build a base-case financial model2. 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.

STEP 1: Build a base-case financial modelEstimate the timing and magnitude of future cash inflows and outflowsThe timing and magnitude of 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 costRamp up costMarketing and support costProduction costSales Revenues

Exhibit 15-5

Exhibit 15-6

Exhibit 15-7 Key factors influencing development profitability

A 20 percent decrease in development cost will increase NPV to $9,167,000. This represents a dollar increase of $964,000 and a percentage increase of 11.8 in NPV. This is an extremely simple case: we assume we can achieve the same project goals by spending $1million less on development, and we therefore have increased the project value by the present value of the $1million in savings accrued over a time period of 1 year. The CI-700 development cost sensitivity analysis for a range of changes is shown in Exhibit 15-9. The values in the table are computed by entering the changes corresponding to each scenario into the base-case model and noting the results. It is often useful to know the absolute dollar changes in NPV as well as relative percentage changes, so we show both in the sensitivity table.

Development Time ExampleConsider the impact on project NPV of a 25% increase in development time. A 25% increase in development would increase the development time from 4 quarters to 5 quarters. This increase in development time would also delay the start of production ramp up, marketing efforts and product sales.

To perform the sensitivity analysis, we must make several assumptions about the changes.

We assume the same total amount of development cost, even though we will increase the time period over which the spending occurs thus lowering the rate of spending from $1.25 million to $1.0 million per quarter. We also assume that there is a fixed window for sales which starts as soon as the product enters the market and ends in the fourth Quarter of year 4. In effect, we assume we can sell product from the time we are able to introduce it until a fixed date in the future. Note that these assumptions are unique to this project. Different NPD projects would require different assumptions. For example, we might have instead assumed that the sales window simply shifts in time by one quarter. The change to the CI-700s financial model is shown in exhibit 15-10

Exhibit 15-10

of the specific product context. In many cases the interactions are trade-off. For example, decreasing development time may lead to lower product performance. Increased product performance may require additional product cost. However, some of these interactions are more complex than a simple trade-off. For example, decreasing product development time may require an increase in development spending, yet extending development time may also lead to an increase in cost if the extension is caused by a delay in a critical task rather than a planned extension of the schedule.In general, these interactions are important because of the linkage between the internal factors and the external factors. For example, increasing development cost or time enhance product performance and therefore increase sales volumes allow higher prices. Decreasing development time may allow the product to reach the market sooner and thus increase in sales volume.While accurate modelling of externally driven factors (e.g., price, sales volume) is often very difficult, the quantitative model can nevertheless support decision making.Exhibit 15-12 potentialinteractions between internally driven factors

Step 4 : Consider the influence of the qualitative factors on project successMany factors influencing development projects are difficult to quantify as they are complex or uncertain. We refer to such factors as qualitative factors.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 the second; costs are known as negative externalities and benefits as positive externalities. As an example of a positive externality, development learning on one project may benefit other current or future projects but is paid far by the first project. How should the other projects account for such benefits gained at no additional cost? How should the first project account for resources spent which benefit not only itself, but also other current or future projects?Strategic fit: Decisions of the development must not only benefit the project, but also be consistent with the firms overall product plan and technology strategy. For example, how well does a proposed new product, technology or feature fit with the firms resources and objectives? Is it compatible with the firms emphasis on technical excellence? Is it compatible with the firms emphasis on uniqueness?

(Holding other things constant)