A report on EVALUATION OF PRODUCTS

BITS Pilani November 2011

BY ROHAN SEN SHARMA 2009ABPS232P B.E. (Hons) MANUFACTURING ENGG. BITS PILANI

ACKNOWLEDGEMENT

I am indebted to my Professor Mr. RB Kodali, Professor Mechanical Engineering Group, BITS Pilani for providing me an opportunity to do my report work on EVALUATION OF PRODUCTS. This work allowed me to study in detail the various ways in which real world problems are tackled in the areas of product evaluation. Last but not least I wish to avail myself of this opportunity, express a sense of gratitude and love to my friends for their manual support, strength, help and for everything.

Contents

i)ACKNOWLEDGEMENT...................................................................................... 2

1)INTRODUCTION .............................................................................................. 4

2)NET PRESENT VALUE ....................................................................................... 5

3)BREAK EVEN ANALYSIS .......................................................................... 9

4)INTERNAL RATE OF RETURN ......................................................................... 13

5)NPV vs. IRR ................................................................................................... 15

6)PAYBACK PERIOD .......................................................................................... 16

7)AVERAGE RATE OF RETURN METHOD (ARR) ................................................. 19

8)SCORING MODEL .......................................................................................... 22

ii)BIBLIOGRAPHY .............................................................................................. 24

INTRODUCTION

When decisions are being made about adding or dropping a product, most managers will make a financial evaluation of the product and they may try to get some sense of the riskiness of the decision. They will also probably consider the effect of the add/drop decision on other products in the line. The focus of operations management is to add value during the transformation process. However this value added, which is ultimately determined by the customer, cannot exceed the actual cost of the transformation. Therefore operations management includes various methods and tools for financial analysis and evaluation of products With these financial tools, the operations manager can properly assess the consequences of various courses of action relative to the transformation process, specifically with respect to capital investment decisions. Some of these financial tools used by operations managers are-

1) NET PRESENT VALUE (NPV) 2) BREAKEVEN ANALYSIS 3) INTERNAL RATE OF RETURN (IRR) 4) PAYBACK PERIOD 5) ACTUAL RATE OF RETURN (ARR) 6) SCORING MODEL

NET PRESENT VALUE

A present value is the value now of a stream of future cash flows, negative or positive. The value of each cash flow needs to be adjusted for risk and the time value of money. A net present value (NPV) includes all cash flows including initial cash flows such as the cost of purchasing an asset, whereas a present value does not. The simple present value is useful where the negative cash flow is an initial one-off, as when buying a security. The net present value method is commonly used in business. With this method decisions are based on the amount by which the present value of the projected income stream exceeds the cost of an investment. NPV is an indicator of how much value an investment or project adds to the firm. With a particular project, if Rt is a positive value, the project is in the status of discounted cash inflow in the time of t. If Rt is a negative value, the project is in the status of discounted cash outflow in the time of t. Appropriately risked projects with a positive NPV could be accepted. This does not necessarily mean that they should be undertaken since NPV at the cost of capital may not account for opportunity cost, i.e. comparison with other available investments. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected. LIMITATIONS OF NPV 1) Qualitative factors not measured. 2) We assume that I is constant for a time period.

We will consider the following examples-

EXAMPLE-1 A firm is considering 2 alternative products: the first, Product A, costs $30,000 and the second, Product B costs $50,000.The expected yearly cash income streams for each of the 2 products are shown in the following table-

To decide which of the 2 products is better, we will be finding out which has a higher net present value (we will assume the rate of interest as 8%) SOLNProduct A Present value factor (PV) = (1/1.08 +1/1.08^2 +1/1.08^3 +1/1.08^4 +1/1.08^5) =3.993 Present value=10000(1/1.08 +1/1.08^2 +1/1.08^3 +1/1.08^4 +1/1.08^5) =3.993*10000 =$39,930 Less cost of investment=$30000 Net present value=$9,930

Product B Present value factor (PV) = (1/1.08 +1/1.08^2 +1/1.08^3 +1/1.08^4 +1/1.08^5) =3.993

Present value=15000(1/1.08 +1/1.08^2 +1/1.08^3 +1/1.08^4 +1/1.08^5) =3.993*15000 =$59,895 Less cost of investment=$50,000 Net present value=$9895

Therefore based on purely economic criteria, management would prefer product A because the net present value exceeds that of product B.

EXAMPLE-2 A corporation must decide whether to introduce a new product line. The new product will have start-up costs, operational costs, and incoming cash flows over six years. This project will have an immediate (t=0) cash outflow of $100,000 (which might include machinery, and employee training costs). Other cash outflows for years 16 are expected to be $5,000 per year. Cash inflows are expected to be $30,000 each for years 16. All cash flows are after-tax, and there are no cash flows expected after year 6. The required rate of return is 10%.

SOLN-

Year T=0 T=1 T=2 T=3 T=4 T=5 T=6

Cash Flow -100,000/(1+0.1)^0 30,000-5000/(1+0.1)^1 30,000-5000/(1+0.1)^2 30,000-5000/(1+0.1)^3 30,000-5000/(1+0.1)^4 30,000-5000/(1+0.1)^5 30,000-5000/(1+0.1)^6

Present Value -$100,000 $22,727 $20,661 $18,783 $17,075 $15,523 $14,112

The sum of all these present values is the net present value, which equals $8,881.52. Since the NPV is greater than zero, it would be better to invest in the project than to do nothing, and the corporation should invest in this project if there is no mutually exclusive alternative with a higher NPV.

BREAK EVEN ANALYSIS

In economics & business, specifically cost accounting, the break-even point (BEP) is the point at which cost or expenses and revenue are equal: there is no net loss or gain, and one has "broken even". A profit or a loss has not been made, although opportunity costs have been paid, and capital has received the risk-adjusted, expected return Types of costs involved in analysis are Fixed Costs Expenses such as rent that remains constant over a wide range of output volumes. Variable Costs Expenses such as material and direct labor that vary proportionately with changes in output. Sunk Costs Expenses already incurred that have no salvage value. Break-Even Analysis Determination of product volume where revenues equal total costs or costs associated with two alternative processes are the same. Revenues versus Costs (Assumptions) The selling price per unit is constant. Variable costs per unit remain constant. Fixed costs remain constant. Parameters in computation areSelling price (per unit) = SP Variable costs (per unit) = VC

Fixed costs (total) = FC

FCtotal BEunits SPunit VCunit

EXAMPLE-1 Allison and Jon, to earn extra money, have a small catering business. They provide a variety of freshly made sandwiches. The average cost per sandwich is $2.55.The school has recently offered to lease them a small kitchen on campus. The rent for the kitchen is $360 per month Allison and Jon estimate that they will be able to produce the sandwiches at this new location at an average cost of $1.80 per sandwich. How many sandwiches a month do Allison and Jon have to sell in order to be indifferent to the costs of working at home versus working in the kitchen on campus?

Alternative 1: working at home Total costs=Tc1=Vc1*X Where Vc1=variable costs/sandwich=$2.55 X=number of sandwiches sold Or Tc1=2.55*X Alternative 2: working on campus Total costs=Tc2=Fc2+Vc2*X Where Fc2=Fixed costs=$360/month Vc2=Variable costs /sandwich=$1.80 The breakeven point is where the two total costs lines intersect The breakeven point is calculated as follows: Tc1=Tc2

VC1 X FC2 VC2 X

2.55X=360+1.80X 0.75X=360 X=480 sandwiches/ month Thus they should make 480 sandwiches per month in order to be indifferent to the costs of working at home versus working in the kitchen on campus.

INTERNAL RATE OF RETURN

The internal rate of return (IRR) is the rate of return promised by an investment project over its useful life. It is some time referred to simply as yield on project. The internal rate of return is computed by finding the discount rate that equates the present value of a project's cash out flow with the present value of its cash inflow In other words, the internal rate of return is that discount rate that will cause the net present value of a project to be equal to zero. The IRR should be as high as possible. EXAMPLE-1 A school is considering the purchase of a large tractor-pulled lawn mower. At present, the lawn is moved using a small hand pushed gas mower. The large tractor-pulled mower will cost $ 16,950 and will have a useful life of 10 years. It will have only a negligible scrap value, which can be ignored. The tractor-pulled mower will do the job much more quickly than the old mower and would result in a labour savings of $ 3,000 per year. Compute the internal rate of return SOLNTo compute the internal rate of return promised by the new mower, we must find the discount rate that will cause the new present value of the project to be zero. The simplest and most direct approach when the net cash inflow is the same every year is to divide the investment in the project by the expected net annual cash inflow. This computation will yield a factor from which the internal rate of return can be determined.

Factor of internal rate of return (IRR) =Investment required / Net annual cash inflow = $16,950 / $3,000

= 5.650 Now 5.650 = (1/r +1/r^2 +1/r^3----------------------1/r^10) The above equation can be solved by various mathematical tools. However most books and articles give us tables to compute the rate value in such cases .We shall be using a Table as given

From this table we get the value of r as 12%. Using a 12% discount rate equates the present value of the annual cash inflows with the present value of the investment required in the project leaving a zero net present value. The 12% rate therefore represents
the internal rate of return promised by the project.

NPV vs. IRR

The net present value (NPV) method has several important advantages over the internal rate of return (IRR) method. First the net present value method is often simpler to use. As mentioned earlier, the internal rate of return method may require hunting for the discount rate that results in a net present value of zero. This can be a very laborious trial-and-error process, although it can be automated to some degree using a computer spreadsheet. Second, a key assumption made by the internal rate of return (IRR) method is questionable. Both methods assume that cash flows generated by a project during its useful life are immediately reinvested elsewhere. However, the two methods make different assumptions concerning the rate of return that is earned on those cash flow. The net present value method assumes the rate of return is the discount rate, whereas the internal rate of return method assumes the rate of return is the internal rate of return on the project. Specifically, it the internal rate of return of the project is high, this assumption may not be realistic. It is generally more realistic to assume that cash inflows can be reinvested at a rate of return equal to the discount rate - particularly if the discount rate is the company's cost of capital or an opportunity rate of return. For example, if the discount rate is the company's cost of capital, this rate of return can be actually realized by paying off the company's creditors and buying back the company's stock with cash flows from the project. In short, when the net present value method and the internal rate of return method do not agree concerning the attractiveness of a project, it is best to go with the net present value method. Of the two methods, it makes the more realistic assumption about the rate of return that can be earned on cash flows from the project.

PAYBACK PERIOD

The payback period method ranks investments according to the time required for each investment to return earnings equal to the cost of the investment. The rationale is that the sooner the investment capital can be recovered, the sooner it can be reinvested in new revenue producing products. Thus supposedly a firm will be able to get the most benefit from its available investment funds. The Payback Period represents the amount of time that it takes for a Product to recover its initial cost. The use of the Payback Period as a Capital Budgeting decision rule specifies that all independent products with a Payback Period less than a specified number of years should be accepted. When choosing among mutually exclusive products, the product with the quickest payback is preferred. EXAMPLE-1 Consider 2 Products-Products A and B which yield the following cash flows over their five year lives.
Year 0 1 2 3 4 5 Cash Flow -1000 500 400 200 200 100 Year 0 1 2 3 4 5 Cash Flow -1000 300 500 100 300 100

Thus this means that the product needs an initial investment of 1000 $.Find its payback period

SOLNPRODUCT-A To begin the calculation of the Payback Period for project A let's add an additional column to the above table which represents the Net Cash Flow (NCF) for the project in each year.
Year 0 1 2 3 4 5 Cash Flow -1000 500 400 200 200 100 Net Cash Flow -1000 -500 -100 100 300 400

After two years the Net Cash Flow is negative (-1000 + 500 + 400 = -100) While after three years the Net Cash Flow is positive (-1000 + 500 + 400 + 200 = 100) Thus the Payback Period, or breakeven point, occurs sometime during the third year. If we assume that the cash flows occur regularly over the course of the year, the Payback Period can be computed using the following equation:

Payback period =2 + (100/200) =2.5

PRODUCT-B To begin the calculation of the Payback Period for project B let's add an additional column to the above table which represents the Net Cash Flow (NCF) for the project in each year.
Year 0 1 2 3 4 5 Cash Flow -1000 300 500 100 300 100 Net Cash Flow -1000 -700 -200 -100 200 300

After three years the Net Cash Flow is negative (-1000 + 300 + 500 +100= -100) While after four years the Net Cash Flow is positive (-1000 + 300 + 500 + 100 +300 = 200) Thus the Payback Period, or breakeven point, occurs sometime during the fourth year. If we assume that the cash flows occur regularly over the course of the year, the Payback Period can be computed using the following equation:

Payback period =3 + (100/300) =3.33 Therefore according to payback period analysis Product A should be chosen.

AVERAGE RATE OF RETURN METHOD (ARR)

According to this method, the capital investment proposals are judged on the basis of their relative profitability. For this purpose, capital employed and related incomes are determined according to commonly accepted accounting principles and practices over the entire economic life of the project and then the average yield is calculated. Such a rate is termed as accounting rate of return. It may be calculated according to the following methods: ARR = Annual average net earnings after taxes X 100 Average investment over the life of the project ARR = Annual average net earnings after taxes X 100 Original Investment The term "average annual net earnings" is the average of the earnings after depreciation ad taxes over the whole of the economic life of the project. In case of annuity, the average after tax earnings is equal to any years earnings. The amount of "average investment" can be calculated according to any of the following methods: Case 1: If there is no salvage value: Average Investment = Initial investment/2 Case 2: If there is a salvage value for the asset: Average investment = (Initial investment-Salvage value)/2 Case 3: If there is a requirement for working capital in the first year: Average investment = (Initial investment-Salvage Value)/2 + Working capital + Salvage value. Merits of ARR method: 1. As against Pay-back method, this method considers the return over the entire economic life of the project. 2. The calculation is simple and straight-forward.

De-merits of ARR method: 1. Like the pay-back period method, this method ignores the time value of money. 2. This method takes into account the accounting profits rather than the cash inflows and hence ignores the fact that the actual cash flows can be re-invested. 3. It is the discretion of the management to choose the arbitrary cut-off rate of return in choosing the projects. This may not always ensure the right selection. 4. The concept of average investment and average earnings differ widely and hence may produce different results.

EXAMPLE-1 Let us choose which product to get into production using the ARR for the following 2 alternative products:

Cost Annual estimated income after depreciation & tax Year

Machine A: $56,125

Machine B: $58,125

$3,375

$11,375 $9,375 $7,375 $5,375 $3,375 $36,875 5 years $3,000

Total earnings Estimated life Estimated salvage value

Year 2 $5,375 Year 3 $7,375 Year 4 $9,375 Year 5 $11,375 $36,875 5 years $3,000

SOLN-

ARR = Annual average net earnings after taxes X 100 Average investment over the life of the project Average earnings = Total earnings / Estimated life in years For machines A:- $36,875 / 5 = $7,375 For machines B:- $36,875 / 5 = $7,375 Average investment = (Initial investment - Salvage Value) / 2 + Working capital + Salvage value. For Machine A: ($56,125 - $3000) / 2 + 0 + 3000 = $29,562.50 For Machine B: ($58,125 - $3000) / 2 + 0 + 3000 = $30,562.50 ARR for Machine A: 7375/29562.50 * 100 = 24.95% or 25% ARR for Machine B: 7375/30,562.50 * 100 = 24.13% or 24%. Machine A would be preferred as ARR is higher.

SCORING MODEL

The above methods discussed are not holistic approaches. They do not analyse the product in all possible ways. Therefore the scoring model was developed to take into account, as many factors as could be taken, and analyze the products on various parameters. The scoring model method gives some value to the qualitative aspects of the product. The steps for the scoring model are1) Decides the relevant factors in a decision and assign maximum possible score to each factor. 2) Consider each product in turn and assign a score to each factor. 3) Add the total score for each element. 4) Identify the best product as one with highest total score.

EXAMPLE-1

A company has is currently producing 4 different products. However due to shortage of manual labour it has to close down one of its product lines. The analysis of the different products based on various factors is given in the table below. Which product should be discontinued?

SOLN-

As we can see from the table we have followed the scoring model method. We have considered various aspects of the products (technical, finance, competition etc) and rated every product in each field. According to our analysis we see that product A has the lowest overall value. So the best decision would be to discontinue Product A.

BIBLIOGRAPHY

BOOKS 1) Heizer Jay, Render Barry and Rajashekhar, "Operations Management", 9th Edition, Pearson, New Delhi 2) Russell R. S. and Taylor, B. W., "Operations Management: Quality and Competitiveness in a Global Environment", 5th Edition, John Wiley and sons 3) Mahadevan B., "Operations Management: theory and Practice", 2nd Edition, Pearson, 2010 4) Chary, S. N., "Production and Operations Management", 3rd Edition, Tata McGraw- Hill, 2006 5) Davis Mark, Chase Richard and Aquilano,Fundamentals of operations management, International edition, Mc Graw hill

WEBSITES

Wikipedia.org Google.com Moneyterms.co.uk Experiglot.com Tutorsonnet.com Financial-dictionary.thefreedictionary.com