As shown in Figure 6.1, an economic analysis is the key to management decision in product design policy. Having obtained sufficient information about customers’ requirements and market potentialities
on the one hand and a detailed study about the functional, operational, and quality aspects of the proposed product on the other, the economic analysis can proceed by seeking an answer to the following questions:
What capital expenditure is required for manufacturing the new product?
What total production costs per piece are envisaged?
What is the reasonable margin of profit that can be expected?
Do the price (= total costs + profit) and the features of the product render it competitive in the market?
In what numbers is the product expected to be sold?
Here, again, the interdependence of variables should be strongly emphasized. Not one single question in this list can be isolated and solved independently of the others. The economic analysis is in fact a cyclic and repetitive procedure. Each question is weighted in the light of the answer and the data provided by the previous question, and all the answers are checked when their turn comes again to be re-evaluated in the following cycles, until a state of equilibrium is reached and no further modifications to these answers are required.
PROFITAND COMPETITIVENESS
The measure of competitiveness of the product corresponds to the portion of the market it succeeds in capturing. This is largely dependent on the value the customer is prepared to put on the product, and on the ratio of this value to the price. As customer assessment of value is not universally uniform but subject to preference of features, performance, or taste, ratios of values to prices vary with customers. A state of equilibrium is formed in which the market is divided between different preferences. This equilibrium may change: If the ratio of value to price of the product becomes more favourable, when compared with other products, the product increases its portion of the market and becomes more competitive.
Such an equilibrium is shown in Fig. 6.3 where the total costs include set-up, materials, overheads, storage, and distribution. The total profit is determined by the margin of profit per unit and by the sales volume. If the organization seeks to increase its profit, it can try one of the following methods 6.3:
(a) Increase the margin of profit per unit, hence the sales price, but leave the total production to costs unchanged. If such a course would not affect the sales volume, the total profit would be proportional to the increase in the margin of profit per unit. Such an increase, however, can upset the market equilibrium unfavourably, in that both the ratio of customers’ value of the product to its price will deteriorate and the products of competitors will become more attractive. The market may shrink, and the total profit, far from attaining the expected value, may in extreme cases fall below its original level.
(b) Leave the total costs unchanged, but try to improve the ratio of value to price and thus widen the market. This can be done (1) by producing a better or more attractive product at the same cost, (2) by launching an intense advertising campaign in order to boost the customer’s assessment of the product value, or (3) by reducing the sales price at the expense of the margin of profit per unit, in the hope that the market will expand enough to increase total profit. Too marginal a profit per unit is, however, undesirable, as it allows little protection from possible fluctuations in the market, and even slight instabilities may turn a small profit into a sizeable loss.
Fig. 6.3 Methods for increasing total profit
(c) Reduce the total production costs and pass some of the benefit to customers in the form of reduced sales prices. If both the profit per piece and the size of the market increase, a substantial improvement in total profits will be achieved. This course calls for a continuous search after better methods, better processes, better materials and their utilization, and better management to reduce overheads. There are, however, some limitations to the rate of improvement one can attain, such as
basic labour and material costs and limited resources or credit hampering expenditure on new equipment and machines. Minimum requirements of quality should also be studied and met, as a reduction in price at the expense of quality is easy enough; customer’s assessment of the product value, however, deteriorates accordingly. But reducing production costs and thereby expanding the market, while sustaining accepted quality standards, offers a challenge to the production engineer.
Probably the most characteristic feature of this process is that it is both dynamic and continuous, that each success is a further advance along the spiral of increasing productivity and standard of living (see Figure 6.4).
Fig.6.4 Spiral of increasing productivity and standard of living
(Courtesy: The British Productivity Council, Report on Metulworking Machine Tools, 1953).
THE THREE S’S
The three S’s refer to standardization, simplification and specialization—three related subjects that are at the root of any economic analysis of product design. The three S’s can be defined as follows:
Standardization is the process of defining and applying the “conditions” necessary to ensure that a given range of requirements can normally be met with a minimum of variety and in a reproducible and economic manner on the basis of the best current technique.
Simplification is the process of reducing the number of types of products within a definite range.
Specialization is the process whereby particular firms concentrate on the manufacture of a limited number of products or types of products.
The three processes are usually linked together and develop as a logical sequence. From a wide range of requirements it is first necessary to sort out the essential features, define them, and then work out in a scientific manner, the minimum variety required to meet these essentials. This is a process of standardization, and it is mainly an engineering process. Within a given range, whether covered by standards or not, a process of simplification can be carried out with the view of reducing the variety of products or materials that are produced or purchased. This is both an economic and an engineering process, and specialization is one of its natural outcomes.
STANDARDIZATION
Standardization covers a wide field of activity, which may be described by the following main categories:
Physical dimensions and tolerances of components within a defined range.
Rating of machines or equipment (in units of energy, temperature, current, speed, etc.).
Specification of physical and chemical properties of materials.
Methods of testing characteristics or performance.
Methods of installation to comply with minimum precautionary measures and convenience of use.
The first three categories relate to limitation of the number of sizes or grades and some aspects of quality, one of the important aims being interchangeability of components or assemblies. Adherence to standards of raw materials is one of the fundamentals of product design, since any deviation from the standards in this respect may cause a substantial increase in the cost of materials. Industry is rich with examples in which designers specify “special” materials wheareas the standard grades can do just as well.
Standardization and interchangeability impose certain limitations on the designer and demand higher skill and effort in planning. It is easy enough when designing a new component to decide that no standard really meets the special requirements of the case in hand and that a special part has to be specified. What designers seem to forget is that one of the purposes of standards is to provide solutions to relieve them of the task of having to solve afresh some basic problems, and thereby allow them more time to concentrate on the broader aspects of the design.
Another prerequisite of interchangeability is the precision required of the manufacturing process in order to obtain production within the specified tolerances. This implies that production control has to be tightened so that any deviations from the given standards will be immediately noticed and appropriate action can be taken to avoid the process getting out of control.
Standardization has, however, many advantages, some of which may be briefly listed below:
Reduction of material waste and obsolescence.
Concentration of effort in manufacturing; hence, simplification and specialization.
Reduction in inventories, both of materials, semifinished, and finished products.
Reduction in bookkeeping and other paper work.
Lowering the grades of skill required in manufacture and assembly.
Reduction in price; hence expansion of the market.
Reduction of repair and maintenance costs.
SIMPLIFICATION
Simplification is a constant source of disagreement between the sales department and the production personnel. A production engineer prefers little variety, minimum set ups, and long runs (Figure 6.5).
Simplification enables the production department to improve planning, achieve higher
Fig. 6.5 Effect of variety on scheduling
rates of production and machine utilization, and simplify control procedures. The salesman, on the other hand, strives to satisfy the customer by giving him a choice or by offering him the nearest to what he wants. The pro’s and con’s simplification are given in the accompanying listing.
Pro simplification Pro variety
Reduce inventories of materials and finished products. Satisfy a wide range of demand.
Reduce investment in plant and equipment. Enable better contact with the market to study its tastes and requirements.
Save storage space. Avoid losing orders for more
salable products because the customer directs all his orders to other vendors.
Simplify planning and production methods. Create demand.
Simplify inspection and control.
Reduce required technical personnel.
Reduce sales price (through production simplification.
and reduction of distribution costs); hence expand.
the market and the plant.
Shorten or eliminate order queues.
The last point in favour of variety deserves, perhaps, some further clarification. Some sales people claim that variety encourages consumption and that, especially where consumer goods are concerned, the psychological effect of plenty creates demand. Furthermore, market research by some firms seems to suggest that in some cases similar products tend to capture roughly the same portion of a given market. The prospects of increasing total demand on the one hand and the firm’s portion of the market on the other, may have been the main causes for boosting variety to the extent
found nowadays in industry. From the customer’s point of view this is a very unsatisfactory state of affairs. A flood of variety confuses the customer, who ceases in many cases to appreciate the fine differences between similar products and has either to make a haphazard choice or to invest effort, time, and study (and quite often money) to enable him to make an intelligent choice.
This is undesirable for the firm as well. Apart from missing all the advantages listed above when simplification is applied, an analysis of the market sometimes shows that variety has long passed the saturation point and that an increase in variety will not be even noticed in the market. Also, the division of the market between too large a number of products makes each portion so small that prices have to be kept at high levels to avoid losses.
Fig. 6.6 Analysis of sales by products
When a great variety exists, a sales analysis can be made to establish the salability of the products. When the accumulative sales income is plotted against the number of products offered for sale, it is very often revealed that a comparatively small number of products contributes very little in this respect (Figure 6.5). This is sometimes referred to in industry as the “25% to 75%” relationship because in many cases it was found that 25 per cent of the products brought in 75 per cent of the income, although in some extreme cases studies revealed as small as 10 to 90 per cent relationships.
This leads to unnecessary drain of the firm’s efforts, which should be directed to promoting the more profitable products. A more desirable situation is when responsibility for income is more evenly distributed between products (i.e., when the curve is “flat” as is the lower one in (Figure 6.6), which is achieved through reduction of variety.
The effect of quantity on the profit contribution of the product is illustrated in Figure. 6.6, where the sales income is represented by the straight line bQ, in which Q is the quantity sold and b is the income per unit. The costs to the firm consist of:
Fixed costs F, which are independent of the quantity produced and include executive salaries, depreciation of plant and equipment, etc.
Variable costs aQ, where a respresents the constant total costs per unit, including materials, labour, and other direct costs that vary with the plant activity. The variable costs are shown in Figure 6.7 by the straight line aQ.
Fig. 6.7 A break-even chart
The division into fixed and variable costs represents only an approximate interpretation of the total costs function and may not be valid for a very wide range of Q.
The total costs are given by the summation of fixed and variable costs (F + aQ), and the point of intersection of this line with that of sales income is the break-even point (BEP) corresponding to a sales volume Q1 gives profit. At the point of intersection,
hence
1 1
1
= =
= −
F aQ bQ
Q F
b a
(6.1) If a plant is operating at point Q2, it is working with a margin of safety (denoted by ∆), which can be defined as follows:
2 1 2
1 1
− 1
∆ = Q Q = Q −
Q Q (6.2 a)
and it can be shown that
∆ = Z
F (6.2 b)
where Z is the profit of the plant. The desirable level of the plant activity can be expressed in terms of the safety margin or the profit as
2= 1(1+ ∆ =) 11+
Q Q Q Z
F (6.3)
Fig. 6.8 An annual break-even chart
The break-even chart may be either on a monthly (Figure 6.8) or yearly (Figure 6.8) basis. A low BEP is hightly desirable because it increases the safety margin of the product. From Eqn.(6.1) it is obvious that the BEP can be lowered by three methods (see also Figure 6.9) as follows:
Reduce the fixed costs from F to F′, thus lowering the BEP to
1 1
Q Q F F
′ = ′
Reduce the variable costs coefficient a to a′; hence
1 1
b a
Q Q
b a
′ = −
− ′
Increase the slope of the income line from b to b′, the new BEP being
1 1
b a
Q Q
b a
′ = −
′ −
Fig. 6.9 Methods for lowering the break-even point
A similar diagram to the break-even chart, called the profit-volume chart is shown in Figure 6.10, where the fixed costs are marked as a negative quantity on the ordinate. The BEP is given by the intersection of the income line with the abscissa. Operation below the abscissa incurs a loss;
operations above it, a profit.
Fig. 6.10 An annual profit-volume chart
The profitability of the product is indicated by the slope of the income line, called the P/V (Profit-Volume) ratio and denoted by ϕ:
1
Fixed costs (Profit) + (Fixed costs)
Volume at BEP Volume
F b a
ϕ = = =Q = −
and the profit
( )
Z= −b a Q F− = ϕ −Q F (6.4)