chapter11 economics

Elec3017:Electrical Engineering Design

Chapter 11: Economics and Costing

A/Prof David Taubman

September 5, 2006

1 Purpose of this ChapterIn Chapter 3 we discussed product pricing and its interaction with costing. Inthis chapter we begin by considering methods to develop reasonable cost esti-mates for a new product. Together with a selling price and marketing estimatesof the expected sales volume, we will then be in a position to build a businessplan for our product development activity. This is the subject of Section 3,in which we develop an economic framework for making product developmentdecisions. We conclude the chapter in Section 4, with a brief discussion of non-economic factors, which should also be taken into consideration when makingdecisions.

2 Elements of a Costing SystemIf a manufacturing company were to produce only one product, and all costswere directly proportional to the number of units of that product produced,costing would be a relatively simple process. There are several things whichmake costing difficult. One of these is the fact that many manufacturing costsare shared across multiple products. Examples include rent, lease or deprecia-tion on machinery, and development costs which might not even contribute tosaleable products (e.g., aborted development projects). Another source of diffi-culty is that certain costs may be difficult to reliably anticipate: manual labourrequirements may be hard to predict; foreign exchange rates may fluctuate; andso forth.To address these difficulties, it is helpful to identify two separate elements

of a costing system. The first is a cost accumulation system (i.e., an accountingsystem), which keeps track of all actual costs, classifying them according tothe nature of the activity. The second element is a set of cost cost objectives.In our case, the cost objectives are the manufactured products from which weexpect to derive our revenue. At the end of the day, our goal is to attribute

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c°Taubman, 2006 ELEC3017: Economics and Costing

electronic components

unpopulated PCB(outsourced)

package & shipping

product promotion

dedicated producttesting staff

materials handling

component insertionmachinery

soldering machinery

rent & utilities

managerial staff

new product development

Product A

Product B

Accumulateddirect costs

Accumulatedindirect costs

Cost objectiveselectronic components

unpopulated PCB(outsourced)

package & shipping

product promotion

dedicated producttesting staff

materials handling

component insertionmachinery

soldering machinery

rent & utilities

managerial staff

new product development

Product A

Product B

Accumulateddirect costs

Accumulatedindirect costs

Cost objectives

Figure 1: Attributing accumulated costs to cost objectives (products). Listedcosts are for illustrative purposes only. Dashed lines are used to highlight thefact that indirect costs can only be approximately assigned to cost objectives.This is done through “cost drivers.”

all accumulated costs to cost objectives. This includes not only those costswhich are directly related to the products we manufacture, but also indirectcosts (overhead). This allocation of costs to objectives is illustrated in Figure1.As suggested by the figure, direct costs and indirect costs need to be treated

differently. Direct costs are those which are incurred as a direct result of man-ufacturing a specific product. Examples include the cost of purchasing compo-nents, the cost of packaging and shipping products, and the direct labour costsassociated with personnel who work solely on the production a single product.All other costs are indirect, and a meaningful basis must be found for attributingthese indirect costs to products; this is the subject of Section 2.2 below.The reason for attributing all costs to products (cost objectives) is that these

are the only means we have of recovering our costs. In order to determine theprofitability of a new product development effort, it is important to ascertainthe degree to which profits will eventually outstrip costs. If we do not accountcorrectly for all costs, applying our resources to seemingly profitable productsmay leave us bankrupt.


2.1 Direct Costs

The most obvious example of a direct cost is the cost of the various componentsfound on our product’s BOM (Bill of Materials). At a simplistic level, we cansay that this cost is directly proportional to the number of product units whichwe manufacture and sell. In practice, of course, the cost of components willvary with the quantity in which we buy them, but this can readily be factoredinto the costing model for the new product we are developing.More generally, any cost which can be directly related to the number of

produced units of a particular product is best considered a direct cost. Figure 1shows some other examples. In some cases, costs associated with personnel canbe considered direct. This is true if a product requires dedicated staff (directlabour), whose resources cannot be shared with other products. One approach isto identify permandent internal staff as indirect costs, and external contractorsor casual workers as direct costs.

2.2 Indirect Costs and Cost Drivers

Many of the accumulated costs associated with running an organization cannotbe directly allocated to individual products. Examples include:

• Senior managers, supervisors, office staff, maintenance and cleaning staff;• Depreciation or lease of manufacturing equipment;• Rent, utilities (e.g., electricity) and insurance;• Computers, photocopiers and office consumables;• Staff development training;• The costs of aborted development efforts.One way to handle indirect costs is to factor them into an overhead margin.

This can only be done based on experience. Over time, for example, we mayfind that our indirect costs average out at around $5,000,000 per year and thatour direct manufacturing costs for revenue generating products typically cometo around $20,000,000 per year. Based on this information, we determine thata 25% margin should be added to the direct costs of every product, in order tocover indirect costs. This overhead margin is added prior to any profit margin.This method is very simple, but does not properly reflect the impact of designdecisions on costs. In particular, this method provides no incentive to developnew products which place less demand on expensive manufacturing machinery,require less labour supervision, and so forth. The margin approach also fails torecognize the impact of sales volume on the per-unit costs of a product.For these reasons, it is desirable to more carefully attribute at least some of

the indirect costs to specific products and the number of units of these productswhich we expect to manufacture. In this context, we introduce the notionof a cost driver. A cost driver is any factor which affects the cost of other


activities. For example, component handling costs are affected by the numberof components which must be handled. The cost driver in this case is the numberof components. Depreciation or leasing costs for manufacturing machinery areaffected by the amount of operating time consumed in manufacturing each unitof a product1. This, in turn, can usually be decomposed into more detailedcost drivers, such as the number of components which an insertion machinemust insert into our product’s PCB. Again, the cost driver here might simplybe number of components, although more complex examples will be consideredin lectures.If an activity has only one cost driver, the accumulated costs associated with

that activity can be simply converted into a costs per unit of the relevant costdriver. For example, if component handling labour costs amount to $300,000per annum (based on experience), and our component handling staff typicallyorder, receive, sort and load 5,000,000 components per annum (also based onexperience), the cost of these activity is identified as $0.06/component. Thiscan then be attributed to the cost of each unit of a product under development,simply by multiplying the number of components in that product by $0.06. Ofcourse, the method is far from perfect. If we are a small firm, with too manymaterials handling personnel, they have time on their hands so it will not costus anything extra if we manufacture more units of a product — it will simplygive them more work to do. The cost driver method essentially assumes thatare able to efficiently use our resources.There can, of course, be multiple cost drivers for an activity. For example, a

machine might be capable of performing component insertion and wave solderingin a tight pipeline. We can convert the annual leasing costs of this machine toan hourly rate, based on an assumed operating schedule. However, the amountof time taken to manufacture a unit of our product depends on which of the twopipelined operations takes longer. If our product has a lot of components, sothat component insertion takes longer than wave soldering, the amount of timetaken to process a unit of the product depends on the number of components,which becomes the cost driver. On the other hand, if the number of componentsis small, wave soldering might dominate so that the cost driver is the numberof PCB’s2. In this case, each cost driver has an associated per-unit cost (per-component or per-PCB in our example), but only one cost driver is applicable,depending on the design.In the end, a mixture of direct costing, cost drivers and naive overhead

margins are used to attribute all costs to cost objectives (products). Directcosting is used where possible. For the remaining indirect costs, cost driversshould be identified where possible. Finally, all remaining indirect costs arecovered by a single overhead margin.

1The reasoning here, is that if we need to operate a particular type of manufacturingequipment for twice as much time, we probably need to lease or purchase (and depreciate)twice as many machines. At least this is true if our manufacturing operation is big enough tofully consume the resources that we have available.

2For wave soldering, each PCB takes the same amount of time to solder, no matter howmany components it holds.


2.3 Costing your ELEC3017 Design Project

For your ELEC3017 design project, you are required to estimate manufactur-ing costs. In a real production environment, costing is a careful activity whichstrives to achieve accurate outcomes. Quotes from third party manufacturer’sare obtained and converted to firm contracts. Labour and machine time require-ments are calculated from detailed knowledge of the design and close interactionwith manufacturing managers. The level of accuracy required depends on yourexpected profit margin. For high volume commodity products, profit marginsmay be little than 10%, so costing must be very accurate to avoid the possibil-ity that the product loses money. For lower volume, specialty products, profitmargins may exceed 100%, which reduces the burden on accurate costing.Even in real product development, accurate costing is not achieved all at

once. During the early design phases, rough estimates are all that is possible.This is reflected in your own design proposal, for which estimates will be basedmainly around critical components. For your final report, costing should bemuch more thorough. The costing procedures you should use are itemized below.Note carefully, however, that these are all manufacturing costs. They do notinclude any profit margin for the manufacturer; nor do they include marginsadded by retailers. For more on such matters, refer to the general discussion ofpricing strategies in Chapter 3.

2.3.1 Electronic Components

If possible, obtain the wholesale price for quantities of 1000 or 10,000 at a timefrom manufacturers’ web-sites. If you cannot do this, divide the price you payfor components from an electronics store such as Jaycar, Altronics or RS Farnellby about 4. As an example, you should find that individual resistors cost about$0.01 each, while small ceramic capacitors cost around $0.02 each.

2.3.2 Printed Circuit Board

Most projects will require one PCB. For the sake of uniformity, you should pricethe PCB at $2.00, plus $0.01 for each IC pin and passive component lead. Thislast cost could be understood as a drilling cost, but many components employedin final designs may use surface mount technology. It is better understood as away of reflecting the impact of design complexity on the size of the PCB. Thesecosts include the soldering of components onto the PCB.

2.3.3 Mechanical Enclosures

The easiest way to price mechanical enclosures is to find a suitable plastic ormetal case from an electronics hobby store and divide their price by 4. Youmay, however, have a more reliable means to estimate such costs — be sure tojustify whatever method you choose.


2.3.4 Component Handling and Insertion Costs

Assume that the combined handling and insertion costs associated with eachcomponent amount to $0.25. The only exception to this is resistors and ca-pacitors, whose handling and insertion costs should be estimated as $0.10 each.Note that this may provide you with an incentive to use resistor or capacitornetworks in your final design. The cost of handling and inserting networks is tobe quoted as $0.25 each (as for IC’s), but each network typically includes 4 ormore individual components.

2.3.5 Packaging and Shipping of the Product

For simplicity, assume that packaging, handling and shipping of the final productcosts (k + 1) dollars, where k is the expected weight of your final product, inkilograms.

2.3.6 Overhead Margin

To accommodate all other indirect costs, add a 20% margin to the costs identi-fied above — i.e., everything from components through to packaging and shippingcosts.

2.3.7 Personnel

For your final report, you need to include the cost of development activitiesleading up to manufacture and sale of your product. To that end, you shouldestimate the total cost of each design engineer to be $120/hour. This is intendedto include salary, payroll tax, superannuation, office space occupied by the engi-neer, ongoing staff development training, and the cost of related administrativesupport. This cost is not subject to any additional overhead margin.

3 Cash Flow and the Time Value of MoneyProduct design and development can (and should) be understood as a finan-cial investment. During the development phases, financial resources (materials,salaries and overheads) must be invested. During the initial phases of commer-cialization, cash outflows also exceed inflows. Components must be purchased,manufactured product stock must be accumulated and product must be distrib-uted to retail chains before any financial return can be expected. In the longrun, you hope that cash inflows from sale of the product will exceed your cashoutflows. Figure 2 illustrates the cumulative outward (-ve) and inward (+ve)cash flows associated with a typical product, starting from design and runningthrough to the point when the market becomes saturated so that sales drop tozero. Cash flows such as these are the main features of a business plan.Since cash outflow precedes cash inflow, we have to be careful to account for

the time value of money. If I spend $1000.00 today and recoup $1000 one year


Production costs

Marketing andsupport costs

Ramp-up costsDevelopment costs

Cum

ulat

ive

inflo

w/o

utflo

w

Production costs

Marketing andsupport costs

Ramp-up costsDevelopment costs

Cum

ulat

ive

inflo

w/o

utflo

w

Figure 2: Cash flow for a typical product life cycle.

later, this is not a break even proposition. The $1000 I recoup in the future isworth less than the $1000 I spend today. One way to understand this is thatinflation has degraded the value of my money. Another way to understand itis that I could have invested the original $1000 safely in a bank and earnedinterest, doing nothing in return. Thus, to consider that an investment breakseven, I need at least to recover the interest that I might otherwise have earned.There are, of course, a variety of more complex factors that should be con-

sidered in a sound business plan. Spending money today for a reward tomorrowinvolves risk. New product development is certainly a more risky enterprise thaninvesting money in a bank. The market dynamics may change over time, foreignexchange rates may adversely impact both selling price and costs, competitorsmay emerge, and unexpected technical difficulties might be encountered. Therecould also be unexpected legal liabilities. In view of these risks, we should ex-pect a higher rate of return on our product development investment than theinterest offered by banks.In the following sub-sections, we discuss ways of evaluating and expressing

the profitability of a product development activity, so that it can be comparedwith other forms of investment. You may also refer to Ulrich and Eppinger [1,Chapter 11] for a discussion of these issues.

3.1 Net Present Value (NPV)

As mentioned above, a dollar today is generally worth more than a dollar tomor-row — just how much more depends on the assumed discount rate, r. You canthink of r as the annual compound interest rate paid by a reference investmentscheme. For your product development activity to break even, it must achievethe same performance as this reference investment scheme. This means thatY dollars, earned t years in the future, will exactly offset an expenditure of X


dollars today so long as

Y = X ·³1 +

r

100

´tThis is just the compound interest formula, with r expressed as an annualpercentage rate.Following this argument, we may convert any future revenue Y (t) into an

equivalent value Y (0), measured in today’s dollars, according to

Y (0) =Y (t)¡1 + r

100

¢tThe same may be done for future expenses, in which case Y (t) and Y (0) arenegative quantities. We say that Y (0) is the Present Value (PV) of the futurecash inflow or outflow Y (t), at time t.We have said that our product development investment will break even if

it performs as well as a safe reference investment, paying interest rate r. Anequivalent way to express this break even condition is that the PV of all futurerevenue minus the PV of all future expenses equals 0; that is, the Net PresentValue (NPV) of all future cash flows equals 0.

3.2 Ways of Expressing Profitability

One way to express the profitability of a development investment is to simplymeasure the NPV of all future cash flows, based on an assumed discount rater. This is somewhat useful, but it does not tell us how sensitive the NPV is toour selected value for r.In practice, it is hard to know exactly what value for r is most appropriate.

A more interesting question than the magnitude of the NPV, therefore, is thevalue of r at which the NPV becomes 0. This value is known as the Returnon Investment (ROI). The ROI allows us to compare our product developmentactivity with other forms of investment. An ROI of 7% is probably not all thatattractive if lower risk investments such as bank deposits are paying interest ata rate of 6%.Another method which is sometimes used to express profitability is the pay-

back period. This is the period P , such that the NPV of all cash flows prior totime P is zero. The payback period is primarily of interest in identifying risk.A development activity with a payback period of 20 years exposes us to a lot ofrisk, since it is hard to predict cash flows with any reliability that far into thefuture. Quite often, the payback period is evaluated at a discount rate of r = 0.While this reduces its validity somewhat, the actual value of r has only a smallimpact on short payback periods.

3.3 Economic Decision Making and Sunk Costs

The purpose of cash flow analysis is ultimately to help us make informed deci-sions. As part of the ongoing process of planning, project managers must weigh


Product Development

Project

External Factors• Product price• Sales volume• Competition

Internal Factors• Research anddevelopment costs

• Development time• Production costs• Product performance

Product profit(net present value)

Product Development

Project

External Factors• Product price• Sales volume• Competition

Internal Factors• Research anddevelopment costs

• Development time• Production costs• Product performance

Product profit(net present value)

Figure 3: Factors affecting product profitability.

the consequences of investing more (or less) development time, adding (or re-moving) product features, using more (or less) expensive components, and soforth. Each of these decisions has an impact on expected future cash flows andhence profitability.For example, if more features are added, the product will become more costly

to manufacture, but marketing intelligence may suggest that this will be morethan offset by increased product attractiveness, leading to a higher selling priceand/or a larger market volume. On the other hand, adding more features tothe product requires a larger up front investment in development, with a longerdevelopment period. NPV analysis shows that the ROI is nevertheless improvedby the addition of more features, although the payback period is increased,exposing us to more risk. This type of analysis (with hard numbers) is exactlywhat management needs, to determine whether or not the decision to add morefeatures should be taken.Figure 3 illustrates some of the different types of factors which can influence

profitability of a product development activity. Some of these factors (the in-ternal ones) are at least partly under our control; others are outside our control,but still need to be taken into account. Considering the many factors whichinfluence product profitability, economic analysis provides us with a frameworkfor making good decisions. By computing NPV, ROI and payback period undera range of different scenarios, it is possible to understand the potential benefitsand risks of a various design decisions.In other words, the purpose of economic analysis is to answer “what if” ques-

tions. The answers to these questions are not often obvious, due to conflictingfactors. Figure 4 illustrates the conflicting implications of the internal factorsidentified in Figure 3. For example, product performance can generally be en-hanced by increasing development time, increasing development costs (e.g., byinvolving more personnel), and/or including higher quality components. Devel-opment costs and higher performing components both add to the product cost.On the other hand, it may be possible to decrease the product cost, withoutsacrificing performance, by investing more time in development to come up withefficient designs.Perhaps the most important decision of all to be made with the help of


Development Time Product Cost

Product Performance Development Cost

reduce

increase increase

increase

Development Time Product Cost

Product Performance Development Cost

reduce

increase increase

increase

Figure 4: Complex interaction between internal factors over which we have con-trol.

economic analysis is whether the product development activity should proceed ornot. These so-called “go/no-go” decisions are typically taken at several points,such as:

1. during an initial design review, shortly after concept generation;

2. once an initial functional prototype has been constructed; and

3. prior to manufacturing ramp-up.

Like all planning decisions, go/no-go decisions should be forward looking.The fact that we have already spent $10,000,000 developing a revolutionary newproduct should not in itself either positively or negatively influence our decisionto proceed (or not to proceed) with the development. All such previous expendi-ture (and revenue, if any) is known as sunk costs. All we are interested in, froma rational economic perspective, are future expenses and returns. This is whyNPV is computed based only on future cash flows, converted to present values;previous cash flows are not relevant. More likely than not, previous expendi-ture has brought us closer to finalizing the development activity so that futurecosts are lower than they were at the start. As a result, each time we reviewour economic forecasts, we would normally expect NPV and ROI to increase,while the payback period decreases, making it progressively less likely that wewill take the decision not to proceed. Nevertheless, it is always possible thatchanged circumstances render the activity unprofitable from a forward lookingperspective. When that happens, you should resist the gambler’s compulsion torecoup sunk costs by plunging blindly on.

4 Non-Economic ConsiderationsBased on the foregoing discussion, one might conclude that economic merit isthe only sound basis for product development decisions. The reality, however,is much more complex. First, we should remember that economic indicatorssuch as NPV are based on estimates of future cash flows, which are far fromperfect. The fact that we can compute answers to 2 decimal places should not


Qualitative factors specific to your company– ability to leverage design experience for future products– degree to which product fits long term strategic objectives– impact on employee morale– impact on stock price and credit rating– risk in relation to the company’s financial resources

Qualitative factors in your target market– expected reaction of competitors to your products– impact on the brand-name perception amongst consumers

Qualitative factors in the socio-economic environment– impact of potential changes in consumer buying power– impact of government regulations– impact of social trends and expectations of consumers

wha

t you

know

bes

tw

hat y

oukn

ow le

ast

Figure 5: Various qualitative factors to supplement economic factors as a basisfor product development decisions.

fool us into thinking that they are any more accurate than the underlying dataon which they are based. Indeed, an analysis should normally be conducted todetermine how sensitive our NPV, ROI or payback period conclusions are to themost critical underlying assumptions. A simple way to do this is just to re-runthe calculations under a variety of different scenarios.Sometimes, the time and effort required to carefully estimate future cash

flows can get out of hand, detracting from the core business of design. This canlead to lost productivity and perhaps missing a window of opportunity. Likeall aspects of design, therefore, we must be prepared to accept a compromisebetween the quality of the information we have and the need to bring a successfulproduct to market quickly. Simply put, there needs to be an appropriate balancebetween the effort spent planning and forecasting and the effort spent actuallydoing the work of design.Beyond money itself, there are a number of more qualitative factors which

should be factored into product development decisions. From a strategic per-spective, it may make sense to pursue an economically unprofitable developmentactivity, because we expect that it will help us to capture a segment of the mar-ket which we can exploit with future, more profitable products. From a humanresources perspective, it may make sense to continue a development activity inwhich engineers have already invested a large amount of design effort, so as toavoid low morale. Low morale may lead to the loss of experienced personnelto our competitors, along with their accumulated technical knowledge. Figure5 provides a more extensive list of qualitative factors which may need to be


factored into decision making processes.

References[1] Ulrich, K. T. and Eppinger, S. D., Product Design and Development 2 ed ,

McGraw Hill, 2000.

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