Development Cost

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					             Development Cost
                  MANGT 497A
             Small Product Realization



March 2003                               1
                  Overview
• Engineering Cost Estimation
  – Labor and Material Analysis
  – Preliminary and Detail Design Estimation
  – Classification of Estimates
• The Effect of Time on Development
  – Effect of Time to Market
  – How to Reduce Time to Market


   March 2003         MANGT 497A               2
   Development Cost   R. Weissbach
                   Labor Cost
• Hourly Costs
   – Regular Hours (x wage rate)
   – Overtime Hours (x 1.5 x wage rate?)
   – Holidays, Vacation, Paid Sick Leave
• Non-Hourly Costs
   –   FICA (Social Security Tax)
   –   Workmen’s Compensation
   –   Unemployment Insurance
   –   Other Supplemental Insurance
   –   Uniforms, Tools, etc.
   –   Profit Sharing, Bonuses, Gifts


March 2003                MANGT 497A       3
Development Cost          R. Weissbach
           Material Costs
• Cost of Material can be estimated from
  historical or measured data
• Bill of Material (BOM)/Parts List
  – Itemized list of materials for a design
     •   Part Number or Symbol
     •   Descriptive Title
     •   Quantity
     •   Material
     •   Stock Size, Weight, Volume, etc.




   March 2003                MANGT 497A       4
   Development Cost          R. Weissbach
   Material Costs (Cont)
• Cost of Direct Material Equals…
  – [(Cost/Unit Shape) x Shape] – Salvage
• Shape
  – Actual shape of the material in units of area,
    volume, mass, etc.
• Sa = St(1+L1+L2+L3)
  –   Sa = Shape
  –   St =Theoretical Shape Required
  –   L1 = Loss Due to Scrap (human error)
  –   L2 = Loss Due to Waste (chips)
  –   L3 = Loss Due to Shrinkage (deterioration, theft, shelf
      life)




      March 2003               MANGT 497A                       5
      Development Cost         R. Weissbach
    Preliminary and Detail Design
         Estimation Methods
•   Opinion
•   Conference
•   Comparison
•   Unit
•   Cost Estimating Relationship
•   Probability Approach
•   Range


      March 2003         MANGT 497A     6
      Development Cost   R. Weissbach
  Preliminary and Detail
Design Estimation Methods
• Opinion – shortage of data or time
• Conference – each dept contributes
  –   Hidden Card Technique
  –   Estimate-Talk-Estimate (Persuasion)
  –   Lack of Analysis/Facts
  –   Needs a Moderator to Direct Discussion



      March 2003         MANGT 497A            7
      Development Cost   R. Weissbach
                      Exercise
• How much will it cost to hire someone
  to successfully design, build and test
  a system which will enable an
  uncooked egg to be tossed from the
  roof of the Hammermill Building and
  land without breaking?



   March 2003              MANGT 497A      8
   Development Cost        R. Weissbach
  Preliminary and Detail
Design Estimation Methods
• Comparison
  – Attaches a formal logic to the conference
    method
  – Take difficult design problem (a) and construct
    a simpler design problem (b)
     •   Clever manipulation of the original design
     •   Relaxation of technical constraints
     •   Branch to (b) to obtain facts pertinent about (a)
     •   Be conservative: Ca(Da) ≤ Cb(Db)



   March 2003                 MANGT 497A                     9
   Development Cost           R. Weissbach
  Preliminary and Detail
Design Estimation Methods
• Unit Cost
  – Cost per… (pound/mile/year/ft2, etc.)
  – Based on a mean cost (y=mx + b)
  – Errors Introduced
     • Cost may be non-linear (based on various
       parameters such as volume, etc.)
     • Slope (m) may not be correct



   March 2003           MANGT 497A                10
   Development Cost     R. Weissbach
                       Example
       Cast Iron Weight (lb)              Cost ($)
                 2                          2
                 3                          3
                 4                          6

The average cost per pound is $1.22, based on the
total weight of 9 pounds and the total cost of $11.




    March 2003             MANGT 497A                 11
    Development Cost       R. Weissbach
                      Concerns
• Can we estimate the future cost with
  a linear estimate?
• Would it be better to estimate
  linearly using a “best fit”?
• Can either method be used if the
  cost is non-linear?


   March 2003              MANGT 497A     12
   Development Cost        R. Weissbach
Different Analyses Yield
  Different Estimates
                        Comparison of Regression Analyses

                   16
                   14
                   12
                   10
        Cost ($)




                    8
                    6
                    4
                    2
                    0
                   -2     1    2      3      4     5      6     7       8
                                    Weight of Cast Iron (lb)

                                   Regression A          Regression B

  March 2003                              MANGT 497A                        13
  Development Cost                        R. Weissbach
 Preliminary and Detail Design
  Estimation Methods (cont)
• Cost and Time Estimating Relationships
  – Statistical regression models, based on
    past designs
  – Formulated to present estimates for end
    items
  – Design or performance parameters (weight,
    speed, etc.) are used to predict cost (“cost
    drivers”), since these parameters are
    available early


   March 2003         MANGT 497A                   14
   Development Cost   R. Weissbach
       Cost Estimating
      Relationship (CER)
• Suggested Approach
  – Obtain actual costs from past designs
  – Interview experts who have knowledge of cost
    and design
  – Find cost drivers
  – Plot data roughly and understand anomalies
  – Re-plot and perform regression analysis
  – Review for accuracy, publish, distribute


   March 2003          MANGT 497A                  15
   Development Cost    R. Weissbach
 Preliminary and Detail Design
  Estimation Methods (cont)
• Probability Approach
  – Looks at average and “expected value”
  – Requires knowledge of statistics
     • Analysis of historical data
     • Convenient approximations (e.g., normal, etc)
     • Introspection (opinion probability)
  – Cumulative probability of each event


   March 2003           MANGT 497A                     16
   Development Cost     R. Weissbach
                      Example
• Market research indicates a product
  will sell wholesale for $650 in year 1
• Questions:
  – What will be the sales volume in year 1?
  – What will be the cost per unit in year 1?
  – What will be the profit in year 1?



   March 2003             MANGT 497A            17
   Development Cost       R. Weissbach
                       Example
            Marketing Forecast
Annual Sales Volume Probability of Event Occurring
       15,000                      0.2
       20,000                      0.2
       25,000                      0.6

          Engineering Forecast
 Cost Per Unit ($) Probability of Event Occurring
       450                        0.7
       500                        0.2
       550                        0.1


    March 2003             MANGT 497A                18
    Development Cost       R. Weissbach
     Profit Analysis Options
• Look at most likely scenario
   – Most likely to sell 25,000 units at $450/unit ($200 profit)
   – Total Profit = $5M

• Look at the expected value
   – Expected Value of Sales
      • (15,000)(0.2)+(20,000)(0.2)+(25,000)(0.6) = 22,000
   – Expected Value of Unit Cost
      • ($450)(0.7)+($500)(0.2)+($550)(0.1) = $470/unit
   – Expected Profit per unit = $180
   – Total Profit = ($180)(22,000) = $3.96M

• A difficulty is being able to guess the opinion
  probabilities


        March 2003                MANGT 497A                       19
        Development Cost          R. Weissbach
 Preliminary and Detail Design
  Estimation Methods (cont)
• Range Estimation
  – Use the Beta probability density
    function
  – Estimated Cost = (L + 4M + H)/6 where
     • L = lowest estimated cost
     • M = most likely cost
     • H = highest estimated cost



   March 2003          MANGT 497A           20
   Development Cost    R. Weissbach
              Marginal Cost
• The added cost of adopting a change
  in operations or making an
  engineering change order for a
  product.
• Requires a detailed cost estimate to
  perform marginal analysis.



   March 2003         MANGT 497A         21
   Development Cost   R. Weissbach
    Marginal Cost (cont)
• Cm = d(CT)/d(n), where
      Cm = marginal cost ($/unit)
      CT = total cost function
              = nCv + Cf
      n = number of production units per period
      Cv = variable cost per unit
      Cf = fixed cost per period
• Requires polynomial regression analysis
• Measures the rate of increase of total cost and
  approximates the cost of a small additional unit of
  output from the given level.



    March 2003              MANGT 497A                  22
    Development Cost        R. Weissbach
          Marginal Return
• Parallel to Marginal Cost
• Rm = d(RT)/d(n), where
      Rm = marginal return ($/unit)
      RT = total revenue function
             = nRv + Rf
      n = number of production units per period
      Rv = variable return per unit
      Rf = fixed return per period (often = 0)



    March 2003          MANGT 497A                23
    Development Cost    R. Weissbach
    Breakeven Analysis
• The point of production or operation
  where there is neither loss, nor
  profit.
• n = (Cf-Rf)/(Rv-Cv)




   March 2003         MANGT 497A         24
   Development Cost   R. Weissbach
                Classification of
                   Estimates
 Design     Fundamental   Symbolic Measure              Example
            Characteristic       of
                           Economic Want
Operation Worker and Tool       Cost                  Crew Worker
                                                 Assembler and Hand Tools
Product       Quantity           Price                Toys, Vehicles
Project    Single End Item        Bid                     Bridge
                                                      Plant Addition
                                                         Refinery
 System     Configuration    Effectiveness           Weapon System
                                                         Hospital
                                                   Rapid Transit System



          March 2003                     MANGT 497A                         25
          Development Cost               R. Weissbach
                       Systems
• Made up of operations, products and
  projects
• Contains intangibles such as:
  – Function
  –   Beauty
  –   Safety
  –   Quality of Life
  –   Ease of Use
• No specific profit entry, instead looking at
  the value of “effectiveness”


        March 2003         MANGT 497A            26
        Development Cost   R. Weissbach
      System Effectiveness?
   • The ability to do the correct thing
     efficiently (e.g., hospital)
      Cost Item              Investment    Opportunity   Recurring Nonrecurring
                                Cost          Cost         Cost        Cost
    Contingencies
Marginal Cost Analysis                          x
 Operation Estimates                                        x
  Product Estimates              x                          x
  Project Estimates              x                                      x
Engineering Estimates                                                   x


          March 2003                      MANGT 497A                          27
          Development Cost                R. Weissbach
  The Effect of Time on
      Development
• Time to market is a crucial element in
  being successful in the global marketplace
• A six month delay can be worth 33% of
  life cycle profits (Reinertsen)
• There is a perceived trade-off between
  development speed and product quality




    March 2003         MANGT 497A              28
    Development Cost   R. Weissbach
                      Example
Writing a book takes 12-18 months.

Putting out a Sunday newspaper takes
  approximately one day.

Both have approximate the same
 number of words.


   March 2003             MANGT 497A     29
   Development Cost       R. Weissbach
  Why Develop Products
       Faster?
• Increased Sales
  – Customer loyalty
  – Higher peak sales
  – Higher profit margins
• Beat the Competition to Market
• Be Responsive to Changing Markets,
  Styles, Technologies


   March 2003         MANGT 497A       30
   Development Cost   R. Weissbach
  Why Develop Products
     Faster? (cont)
• Maintain a Market Leadership
  Position
• “More New Products” is the wrong
  focus




   March 2003         MANGT 497A     31
   Development Cost   R. Weissbach
    What Developing
 Products Doesn’t Imply
• Developing products in half the time
  doesn’t mean that productivity will
  double.
• It means providing more up-front
  resources to complete the project,
  with heavier staffing and people
  dedicated full time to the project.

   March 2003         MANGT 497A         32
   Development Cost   R. Weissbach
       The Basic Economic
        Modeling Process

Develop                             Calculate          Convert to
                   Develop
Baseline                           Total Profit         Decision
                  Variatons
 Model                               Impact              Rules

                              Development Expense Overruns
                              Initial Product Cost Overruns
                              Unit Sales Reduced due to Product
                              Problems
                              Product Introduction is Delayed


     March 2003                  MANGT 497A                         33
     Development Cost            R. Weissbach
     Potential Effects of
       Delayed Product
        Introduction
• Case 1 - Inelastic products with
  limited competition
  – Total unit sales do not decrease
  – Customers are locked into a product
  – Cost of delay is due to price erosion
     • Units are shipped during a relatively low-
       margin period in the product’s life



   March 2003           MANGT 497A                  34
   Development Cost     R. Weissbach
     Potential Effects of
       Delayed Product
     Introduction (cont)
• Case 2 - Timing of the peak in market
  demand is determined by the
  marketplace, rather than the date of
  the product.
  – Lower market share throughout the life
    of the product



   March 2003         MANGT 497A             35
   Development Cost   R. Weissbach
     Potential Effects of
       Delayed Product
     Introduction (cont)
• Case 3 – Delay results in loss of
  “design-in” victories (OEM markets)
  – Severe and continuous reduction in sales
  – Inability to dislodge the competitor




   March 2003         MANGT 497A               36
   Development Cost   R. Weissbach
Example: Product with a
   Long Product Life




 March 2003         MANGT 497A     37
 Development Cost   R. Weissbach
 Half of the time spent on
many development projects
 occurs before the design
  team is assembled and
        starts work
                           Team
Need                       Starts               Ship


  Inefficient Development Time




   March 2003                    MANGT 497A            38
   Development Cost              R. Weissbach
 Advantages of Reducing
  the “Fuzzy Front End”
• It lasts a long time
• It is a cheap place to reduce cycle
  time
  – Much cheaper than the cost of cycle
    time at the end of the development
    process
• It allows for competitive advantage

   March 2003         MANGT 497A          39
   Development Cost   R. Weissbach
 How to Improve Front-
    End Processes
• Make Front-End Cycle Time a
  Measured Parameter
  – Parameters not measured do not
    improve
  – Start the clock when the need is
    addressed to management




   March 2003         MANGT 497A       40
   Development Cost   R. Weissbach
  How to Improve Front-
   End Processes (cont)
• Calculate the Cost of Delay (Sensitivity
  Analysis due to reduced market share)
• Assign Responsibilities
• Assign Resources and Deadlines
• Capture Opportunities Early & Often
  – Ensure it’s easy to submit an idea to
    management



    March 2003          MANGT 497A           41
    Development Cost    R. Weissbach
 How to Improve Front-
  End Processes (cont)
• Overlap Planning and Design
  – Try to remove planning from the critical
    path as much as possible
• Create a Quick-Reaction Plan




   March 2003         MANGT 497A               42
   Development Cost   R. Weissbach
 Other Tips on Speeding
the Development Process
• Develop Your Own Process
• Move Beyond the “Phases” Mentality
  – Focus more on the critical path
  – Overlap activity timeframes
     • Requires more communication between teams.
• Find Examples where Processes were Sped
  Up Successfully



   March 2003             MANGT 497A                43
   Development Cost       R. Weissbach
              Deliverables
• Ensure the Final Business Plan
  includes at least one method of
  estimating development cost
• Quiz on Monday (4/7/03) on
  Development Cost




   March 2003         MANGT 497A     44
   Development Cost   R. Weissbach