Abstract
[tag]Ron Fredericks[/tag] writes: [tag]Engineer[/tag]s want to build compelling products that meet their [tag]project[/tag] [tag]requirements[/tag]. Corporate [tag]executive[/tag]s want to [tag]invest[/tag] in innovative people that build products that, in turn, meet their market’s window; while, both want to stay within [tag]budget[/tag]. Yet both groups may feel overwhelmed with the prospect of expressing the very heart of their inspiration at some critical times during the life of these projects. In today’s post, I try to address this issue from the engineer’s perspective reaching out to the financial decision makers that ultimately control the purse strings of every project.
Table of Contents
Introducing Financial-Speak to Engineers
ROI Example: Embedded Linux
Evaluating Incremental Cash Flows
ROI Example: Simple Project Comparisons Using Net Present Value
ROI Example: Evaluating an Infrastructure Project
ROI Example: The Original Design Manufacturer
References
Errors and Changes Planned for this Blog Post
Introducing Financial-Speak to Engineers
In a previous post I introduced the idea that ethics might be the common framework between this dichotomy in communication between engineers, marketers, and executives. In this post, I suggest that engineers might apply this ethical approach by taking some time out to learn the language of business development from a [tag]financial management[/tag] perspective – a conversational framework suitable for an interdisciplinary team concerned with engineering risk and strategic business value, but expressed using financial definitions.
The term [tag]Return On Investment[/tag] (ROI) can be used for all three disciplines: engineering, marketing, and finance. ROI is just vague enough to cover most any discussion an engineer may encounter through-out the life of a project: from the initial decision to fund your project, to evaluating change requests during the design, build, test, and deployment cycle of an ongoing project. Evaluating ROI from a financial perspective is an ethical approach to decision-making because the financial terms I promote for this ethical framework have very precise meanings. So precise in fact, that I too have had to go back and rewrite several sections of this blog post thanks to One Nomad’s Blog comments received in this blog’s first posting.
It was the lack of financial precision embedded within my first draft for this blog post which my guest reader used to convince me of my own mistakes. Yet to be clear, identifying my mistake is also my gain. Effective communication is a process of two or more people sharing ideas…
Learning to converse and plan using financial terms for ROI decision-making can level the playing field between engineers, marketers, and business executives since ROI itself is not a common financial term. Engineers practicing Financial-Speak centered around ROI as the goal, can help reduce many of the common problems related to individuals trying their best to participate in team decision making. This leveling of the playing field – between team members – can also enhance the power of their conversation, leading the way for the much sought after innovations that are in popular demand today.
Consider building a financial model around ROI before presenting your most important technical needs to executives, marketers, and other decision makers. Read on to learn how. Of course ROI from a financial perspective is not the only way to build effective interdisciplinary teams with engineers involved. In a future post I may suggest a corollary to this ethical approach for executives and marketers who would like to reach out to engineers – using [tag]Six Sigma[/tag], [tag]CMMI[/tag], and emerging techniques developed by [tag]Dr. Thomas J. Buckholtz[/tag] as useful processes seeped in ROI terminology.
Figure 1: Net Present Value Equation
![NPV(CF_k, R, IV) := IV+delim{[}{sum{k=1}{N}{CF_k/(1+R/100)^k}}{]}](https://www.embeddedcomponents.com/wp-content/plugins/wpmathpub/phpmathpublisher/img/math_952.5_bfeb240f8e08138085d65c76df21909d.png "NPV(CF_k, R, IV) := IV+delim{[}{sum{k=1}{N}{CF_k/(1+R/100)^k}}{]}")
Where:
is the Net Present Value function, in dollars
is a project’s Cash Flow, in dollars
is the hurdle Rate, in percent per period
is the Initial Investment (a negative number), in dollars
And:
is the cash flow’s time increment, or period
is the total number of cash flow periods for
Time increment for and might be in years, quarters, or months, for example
ROI Example: NPV’s Effect on Embedded Linux
The equation in Figure 1 forms the heart of my “ethics in engineering” proposal. Namely, the sooner a new device gets to market, the sooner a firm can realize new income. New income realized sooner, is much better than income realized later. A finance discussion around NPV would call this time’s negative impact on the value of money. I’m talking about the exponential effect that the prevailing interest rate, R, has in the NPV equation shown in figure 1.
A few years ago several of the leading embedded operating system suppliers used this equation to show that embedded Linux was a poor choice for new embedded device development projects. One such paper published by Dr. Jerry Krasner in 2003, Total Cost of Development, presents the typical argument pretty well. At that time Dr. Krasner and many others may have been right. Now in 2007, times have changed significantly. A recent blog entry on CNET shows the missing element from Dr. Krasner’s report and is a Harold for the embedded industry going forward: Oracle touts Linux deals.
How times have changed…
Because of the significant adoption of Linux in enterprise projects, the total project cost of using embedded Linux has gone down too. Indeed, the migration and reuse of enterprise Windows operating system application programming interfaces (API’s), kernel components, and development tools into embedded device projects was a key part of Dr. Krasner’s report, see link above. Dr. Krasner concluded at the time that embedded Windows CE made the best choice for new projects from a total cost of ownership perspective – just another way of looking at NPV!
Now the ROI benefits behind projects that select embedded Linux follows Dr. Krasner’s logic perfectly. Embedded Linux is now experiencing the same reduced total cost of ownership that only embedded Windows CE enjoyed just a few years ago. The reduced total cost of ownership comes from new and improved tools, components, and API’s that cross over from enterprise projects to the embedded marketplace. There is a significant overlap in Linux kernel updates, components, and tools driven by enterprise projects that are also suitable for use in embedded projects.
The available pool of engineers that know how to work with Linux can now support embedded development projects that use embedded Linux too. The marketing movement around the value and excitement of using Linux may also reduce the cost of taking an embedded device to market. In short: lower upfront costs, more options, more solutions, and faster time to market. Even Dr. Krasner has decided to post an update to his old white paper showing total cost of development to be favorable for embedded Linux projects. Download his updated paper.
None of these enterprise driven benefits exist with respect to the traditional embedded real-time operating system (RTOS). To be clear, there are other benefits to using an RTOS. I discuss one significant benefit to using an RTOS in another post: How to Leverage the Value of a Board Support Package.
Evaluating a Project’s Incremental Cash Flow
NPV is just one example of applying the principle of ROI to making project decisions. NPV falls into the general category of capital budgeting, a process of evaluating proposed investments into new projects. The capital budgeting process is concerned only with incremental [tag]cash flow[/tag]s. So the vague concept of ethics can be transformed into a specific financial discussion.
Two financial functions can measure time’s effect on money:
(1) [tag]Net Present Value[/tag] (NPV) expressed as a monetary value,
and
(2) [tag]Internal Rate of Return[/tag] (IRR) expressed as a percentage.
Where:
Net Present Value (NPV) of a capital budgeting project is the dollar amount of change in the value of the firm as a result of undertaking the project [Ref: Financial Management: Principles and Practice P.234]. The mathmatic definition for NPV is:
NPV = IV + Sum[ CF(k) / (1+R)^k ], k ranges from 1 to N
Where:
IV = Initial Investment (a negative number)
CF(k) = cash flow value (project outputs – project inputs) for period k
R = hurdle rate per period
period = a unit of time, typically year, quarter, or month
N = total number of periods for the project
Present Value (PV) is the value today of a future, or expected, cash flow. The mathematic definition for PV is:
PV = Sum[ CF(k) / (1+R)^k ], k ranges from 1 to N
NPV can be expressed in termis of its present value (PV):
NPV = IV + PV
Hurdle Rate is the required rate of return before launching a new project. The hurdle rate must be carefully chosen. It can be expressed as a percent per period. The period is commonly defined as one year, but other convenient time period could be selected such as one quarter, or one month. The same unit of time will need to be associated with cash flow. Other rate terms can be used in addition to, or instead of, hurdle rate: discount rate, cost of capital, or interest rate.
Internal Rate of Return (IRR) is the discount rate at which the
NPV of the project is zero. [Ref: Financial Management: Principles and Practice P.240]. The mathematic definition for IRR is related to NPV:
0 = IV + Sum[ CF(k) / (1+IRR)^k ], k ranges from 1 to N
NPV and IRR are related to each other:
What follows is a list of relationships between NPV and IRR. Use these relationships after calculating the NPV and IRR for each of the proposed project alternatives.
(1) If NPV(CF,R, IV) = 0,
then the hurdle rate, R = IRR
(2) For any set of cash flows estimated for a prospective project,
there is only one value for NPV.
But, the same project model can result in several IRR values,
where NPV = 0.
(3) If IRR > [tag]Hurdle Rate[/tag],
then a prospective project may make an acceptable
investment.
(4) If IRR >> Hurdle Rate (i.e. significantly greater than),
then a prospective project may carry too much risk.
(5) The hurdle rate includes both a minimum desired rate
of return for a project, and a threshold representing risk.
(5-a) A typical hurdle rate for an E-Business project
might be 15%.
(5-b) A typical hurdle rate for an embedded systems project
might be 18%.
(5-c) Embedded Components, Inc. is focused on lowering risk
for its members by promoting the re-use of pre-existing
components through its online marketplace
for embedded device manufacturers and their
communities.
(6) In general seek to maximize NPV, not IRR.
(7) Yet, if two projects have NPV curves that cross over each
other,
then the interest R where the curves cross is called
the Crossover Point.
(7-a) If the Crossover Point > IRR,
then accept the project with higher NPV.
(7-b) If the Crossover Point < IRR,
then accept the project with higher IRR.
(8) An NPV value of zero also means the investment into that
project would neither gain nor loose value for the company.
Define a project’s return on investment (ROI):
1a) Profitability Index (PI), measured in % percent
1b) Open Source Profitability Index (PIFOSS)
2a) Payback Period (PP), measured in time such as years, quarters or months
2b) Open Source Payback Period (PPFOSS)
3) Sensitivity Analysis, a plot of NPV verses Interest Rate
Return on Investment (ROI) is a business case analysis concerned with the net financial impact associated with a set of costs and benefits. Most research around capital budgeting does not define a specific calculation associated with ROI. Unlike NPV and IRR, which use formulas generally agreed to by industry, ROI calculations can be industry specific. I found an excellent overview of ROI in a paper by Dr. Jeffery [Ref: Return on Investment Analysis for E-Business Projects equation 6, page 6]. In his paper Dr. Jeffery presents a definition for ROI as:
ROI = 100% x (Project Outputs – Project Inputs) / (Project Inputs)
Where:
Project Outputs represent the value created by a project such as new income generated, efficiency gains, cost savings from improved internal processes, new intellectual property created, and strategic benefits (such as increased marketshare, brand name recognition, incremental gains in product mix, and improved vendor relationships).
Project Inputs represent expenses related to a project such as the initial investment in software and tools, development costs (such as professional employee salaries), facilities expenses (including building depreciation, grounds maintenance, service level agreements, and equipment depreciation,) deployment costs (such as sales commissions, marketing, shipping, and 3’rd party software run-time fees), goernment fees (such as sales taxes, patent filings, and corporate governance), and legal fees.
The sections below are under re-construction as of 3/3/08
Profitability Index (PI):
PI adjusted for Free and Open Source Software (PIFOSS):
So one of several projects under consideration to fund, may be the most acceptable if its [tag]NPV[/tag] is a large enough positive number. In other words, a project is acceptable if the IRR is greater than or equal to the hurdle rate. Where the hurdle rate is defined as the expected rate of return on a potential investment that a manager demands before investing his or her money into a project. I have seen hurdle rates in the range of 8% to 18%, for example.
Measuring the risk of a capital budgeting project can be done by calculating the [tag]coefficient of variation[/tag] (CV) on the expected returns from a firm’s asset portfolio with and without the new project being undertaken. Since the CV is defined as the ratio of the [tag]standard deviation[/tag] to the [tag]mean[/tag], it can be used to determine how much volatility (risk) will be assumed in comparison to the amount of return expected from the proposed project.
There are several wrinkles in the capital budgeting decision process to consider:
(1) Non-simple projects,
(2) Projects that have multiple IRRs,
(3) Comparison of projects with unequal project lives, and
(4) Strategic benefits.
Read on to learn how to manage the financial data behind project proposals with all 4 of these complicating factors taken into account.
ROI Example: Project Comparisons Using Financial Terms
I developed a MathCad program to compare and plot two projects based on several financial terms. The MathCad equations can be used if you already have this math package. Download the MathCad template [tbd]
If you prefer to use Microsoft’s Excel, an open source office package, or google’s hosted office suite, then you can use the equations I develop here to handle the calculations.
In this Mathcad example, two projects with the same basic financial data are compared. Project A is a typical project with estimated sales (as a result of project completion) that builds up over time. Project B is not typical, but is a good test case. Project B uses equal payback amounts over time – similar to an annuity.
Define Initial Data for Two Projects
Time, N (in years)
Initial Investment, IV, in $ dollars
Interest Rate, Rate, in % percent
Cash Flow, CF, in $ dollars
Define Equations
Net Present Value, NPV, in $ dollars
Present Value, PV, in $ dollars
Coefficient of Variation, CV
Return On Investment, ROI
Compare Results for the Two Projects
Results for project A
Results for project B
Plot of Projects Over a Span of Rates
Discussion
The plot of NPV vs. Rate shows that if the Rate is zero, the NPV for both projects are the same. The plot also shows that the hurdle rate must be set much lower for Project A to be approved by a firm’s finance team in comparison to project B (looking at NPV equal to zero in the graph). Yet project B is not a likely outcome either because the sales forecasts aren’t realistic. Therefore the features and benefits of project A could be re-evaluated such that estimated sales over time increases enough to outweigh the initial lag in projected sales – to make up for the time-cost of money burden.
ROI Example: Evaluating an Infrastructure Project
I like this example even though it is far from [tag]embedded device[/tag] projects. It provides a solution to the comparison between project choices that go beyond just simple cash flow. It points out that the process of getting to an ROI number can be more important to the success of some projects than the number itself.
Beyond ROI … Justifying a Business Intelligence Initiative, Digital Review Magazine, January 2004, [tag]Thomas Groh[/tag]
ROI Example: The [tag]Original Design Manufacturer[/tag]
An [tag]ODM[/tag] is a good reference point for engineers and executives alike in the [tag]embedded systems[/tag] industry. An ODM is a design to manufacture house, often located in Taiwan, People’s Republic of China (PRC), or Singapore. These companies work with their local silicon vendors and other regional suppliers to keep themselves informed of what [tag]tools[/tag], [tag]application framework[/tag]s, [tag]middleware[/tag], and [tag]silicon[/tag] that may work together for various projects they are considering. To be clear, these local component vendors are integral partners for the ODM – right where the parts are often made. The ODM then has many advantages with respect to cash flow and its associate time-cost of money: lowest possible cost for parts, improved supply chain advantage without the need to pre-purchase in bulk, lower cost of knowledge, and cheaper labor costs. The ODM also focuses on the engineering effort rather than the marketing, brand recognition, and product sales efforts that their [tag]OEM[/tag] ([tag]original equipment manufacturer[/tag]) clients face. The goal of the ODM is to design cool stuff and manufacture all or part of the final product for its OEM client.
Figure 2: Sample Financial Spreadsheet
In Figure 2 above, I show a sample spreadsheet that would be a typical tool used by an ODM and its OEM client. How much should an ODM project cost? Take a look at the bottom line. For this project, the ODM figures on a shared [tag]IRR[/tag] of 43% over an 8 year time line (only 5 of the 8 years are shown in Figure 2) using this set of numbers. A rate of return higher than most any [tag]hurdle rate[/tag]. As a result, the OEM client may find funding this project to be attractive (remember that the OEM will have to factor in brand, marketing, and sales costs). The 8-year time line in this example may be too long for some projects. You can download a working copy of this cash-flow spreadsheet or their task-based budget spreadsheet from Bird Foundation’s web site and use any time-line you like for your next project.
Take a look at lines D, for development expenses, and C, for capital expenses. These two lines are where the operating system, development tool, and component vendors live. The cost of engineering and project management charged by the ODM lives here too.
The Bird Foundation
It is interesting to take note of the software tools and operating system choices available to the ODM. These are some of the only components that are not designed and built in or near the ODM’s location. Does Microsoft [tag]Windows CE[/tag] make a better choice, or Wind River’s [tag]VxWorks[/tag], or should an [tag]embedded Linux[/tag] version be the bases for [tag]development tools[/tag] on this project? Well it all depends. Flexing the financial estimates for these two lines D and C are often a point of significant debate for a sales team or a roll-your-own internal engineering team. In this case, startup and recurring costs are important. Time to market is another point of consideration – here again the time-cost of your firm’s monetary assets will come into play. I invite sales and engineering teams to study the other numbers on this sample spreadsheet and envision how their product or service value might affect the final calculation of IRR. There can be further discussion on the effect of each financial component with respect to your position – there is likely no single right or wrong answer. One ROI strategy for embedded components and tools software vendors is to consider building more relationships with an ODM’s trusted local hardware component suppliers.
So where can you get more information on this spreadsheet? The answer can be found with the [tag]Bird Foundation[/tag]. A grant giving organization that focuses on building engineering relationships between Israeli companies and OEM companies in United States – who in-turn may include an ODM partner. The spreadsheet example in Figure 2 comes right out of their guidelines for financial and [tag]project management[/tag] (see Proposal Preparation Guidelines page 28). I invite you to learn more about this foundation, how it may work in developing technical partnerships with international companies you can leverage; and their great guidelines offered on the Bird foundation web site. Indeed this is a great example of using ROI as an ethical framework between partner companies from a global perspective.
References
This section under construction as of 12/8/07
Internal Rate of Return
Perils of the Internal Rate of Return
http://hspm.sph.sc.edu/COURSES/ECON/invest/invest.html
Text Books
Research Papers
Return on Investment Analysis for E-business Projects
by Dr. Mark Jeffery, Northwestern University
The old reference section below
An overview of [tag]ROI[/tag] from a sales and [tag]marketing[/tag] perspective – a rich alternative perspective from the financial content on this blog post:
Customer Centric Thinking and ROI (turn your speakers on)
The Bird Foundation project guidelines, and project spreadsheets, can be reviewed and downloaded from here:
www.birdf.com/Index.asp?ArticleID=57&CategoryID=77&Page=1
A great Windows calculator (see Figure 3 below) for most of your engineering and financial needs can be downloaded from here:
www.hp41.org/LibView.cfm?Command=View&ItemID=458
The original HP financial support software module works within this simulated HP41 programmable calculator and can also be downloaded from the same site, here:
www.hp41.org/LibView.cfm?Command=View&ItemID=3
The original HP How To manual for financial decision making can be downloaded or read from this the site as well, from here:
www.hp41.org/LibView.cfm?Command=View&ItemID=445
Figure 3: The HP41 Calculator Emulated on a Windows Desktop
Next steps…
I invite you to use this blog post’s comment facility to share your experience as an engineer, innovator, sales manager, marketer, or executive. Do you think a financial vocabulary can be used to build an effective (and ethical) balance for your [tag]team[/tag] between [tag]consensus[/tag] and [tag]innovation[/tag]?
[tags]Ethics, Business, United States, Israel, China, Singapore[/tags]
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