Economic Analysis &

Sensitivity Analysis
for
Development of New Systems

Case Study

Qualitative Analysis
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 analysis considers the interaction between the firm, the market and the
macro economic environment

Economic Analysis Process

Following four step method is used for economic analysis of product development project:
1. Build a base-case financial model
2. 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 model

Estimate the timing and magnitude of future cash inflows and outflows
The 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 cost
Ramp up cost
Marketing and support cost
Production cost
Sales Revenues

Exhibit 15-5

Exhibit 15-6

Internal factors
Development expense
Investigation cost
Development cost
Development speed
Investigation time
Development time
Production Cost
Product Performance

Product
Development
Project

External factors
Product Price
Sales Volume
Competitive Environment

Net Present Value

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.

Change in Development
Change in
Development
Cost,
Development Change in
Cost,% $ Thousands Cost, $Thousands NVP, %
50
20
10
Base
-10
-10
-30

7,500
6,000
5,500
5,000
4,500
4,000
2,500

2,500
1,000
500
base
-500
1,000
2,500

-29.4
-11.8
-5.9
0.0
5.9
11.8
29.4

Change in
NVP,
NVP,
$Thousands $Thousands
5,791
7,238
7,721
8,203
8,685
9,167
10,615

-2,412
-964
-482
0
482
964
2,412

Development Time Example

Consider 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 potential

interactions between
internally driven factors

Step 4 : Consider the influence of the qualitative factors on project success

Many 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)