Product Development Economics

In one line: Build a simple cash-flow model of the project, discount it to net present value, and then ask which assumptions and decisions move the answer most. That is how development choices are connected to money.

Core idea

Engineers make decisions every week that have financial consequences: add a feature, slip a schedule, cut unit cost, raise the development budget. A product development economic model makes those consequences visible. Ulrich and Eppinger recommend a base-case net present value (NPV) model, followed by sensitivity analysis and a look at the qualitative factors the numbers can’t capture [1].

How it works

1. Build a base-case model. Estimate timing and size of cash flows by period: development cost, ramp-up cost, marketing and support, production cost, and sales revenue.

2. Compute NPV. Discount each period’s cash flow to today:

   $$\text{NPV}=\sum _{t=0}^T\frac{C_t}{(1+r{)}^t}$$

   where $C_t$ is the net cash flow in period $t$ and $r$ the discount rate per period. A positive NPV means the project creates value, at that discount rate.

3. Do sensitivity analysis. Change one variable at a time, such as development time, development cost, sales volume, price or unit cost, and see how much NPV moves. Common lessons:

   • Schedule slips often cost more than budget overruns, because they delay and shrink revenue.
   • Unit cost compounds over every unit sold.

4. Consider qualitative factors: interactions with other projects and the platform, strategic positioning, competitors’ moves, and the macro environment.

In practice

The program uses a spreadsheet model in class and asks for thought questions on development economics and on managing projects. Two habits make the method useful beyond formal business cases:

• Price a decision before arguing about it. What is a month of delay worth? What is a 5% unit-cost saving worth?
• Find the two variables that dominate the outcome, and spend analysis effort there.

Challenge projects need the same logic in their business case. Sponsors compare many possible investments and fund the ones that show value in their terms.

Questions to ask yourself

• What is one month of schedule slip worth on my project, in dollars?
• Which assumption in our business case, if wrong, would flip the decision?
• Which qualitative factor would we still weigh even if the NPV were negative?

Connections

• Decisions it informs: Product Planning, Trade-off Analysis. Tracking cost and schedule: Earned Value Management.
• The company-level view: Reading an Annual Report. A personal application: Engineering Leadership Challenge Project.
• Capabilities exercised: Decision Making, Communicating and Advocacy, Vision.

Sources

• Ulrich and Eppinger - Product Design and Development [1]

[1]

K. T. Ulrich and S. D. Eppinger, Product Design and Development, 6th ed. New York, NY, USA: McGraw-Hill Education, 2016.