Evaluation of Products

8/2/2019 Evaluation of Products

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A report on

EVALUATION OF PRODUCTS

BITS Pilani

November 2011

BY

ROHAN SEN SHARMA

2009ABPS232P

B.E. (Hons) MANUFACTURING ENGG.

BITS PILANI


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ACKNOWLEDGEMENT

I am indebted to my ProfessorMr. 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, helpand for everything.


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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


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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 variousmethods 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


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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 withother 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-


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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%)

SOLN-

Product 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


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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. Cashinflows 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%.


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SOLN-

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.

Year Cash Flow PresentValue

T=0 -100,000/(1+0.1)^0 -$100,000

T=1 30,000-5000/(1+0.1)^1 $22,727

T=2 30,000-5000/(1+0.1)^2 $20,661

T=3 30,000-5000/(1+0.1)^3 $18,783

T=4 30,000-5000/(1+0.1)^4 $17,075

T=5 30,000-5000/(1+0.1)^5 $15,523

T=6 30,000-5000/(1+0.1)^6 $14,112


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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 totalcosts 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 are-

Selling price (per unit) = SP

Variable costs (per unit) = VC


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Fixed costs (total) = FC

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 andJon 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?

unitunittotal

units

VCSP

FCBE


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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

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.

XVCFCXVC221


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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 simplyas 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

SOLN-

To 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 whichthe internal rate of return can be determined.

Factor of internal rate of return (IRR) =Investment required / Net annual

cash inflow

= $16,950 / $3,000


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= 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. Howevermost 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 cashinflows 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.


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NPV vs. IRR

The net present value (NPV) method has several important advantagesover 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 realisticassumption about the rate of return that can be earned on cash flows from

the project.


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PAYBACK PERIOD

The payback period method ranks investments according to the timerequired 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 overtheir five year lives.

YearCash

Flow

0 -1000

1 300

2 500

3 100

4 300

5 100

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

its payback period

YearCash

Flow

0 -1000

1 500

2 400

3 200

4 200

5 100


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SOLN-

PRODUCT-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.

YearCash

Flow

Net Cash

Flow

0 -1000 -1000

1 500 -500

2 400 -100

3 200 1004 200 300

5 100 400

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 thirdyear. 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


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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.

YearCash

Flow

Net Cash

Flow

0 -1000 -1000

1 300 -700

2 500 -200

3 100 -100

4 300 200

5 100 300

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 fourthyear. 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.


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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 employedand 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 overthe entire economic life of the project.

2. The calculation is simple and straight-forward.


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De-merits of ARR method:

1. Like the pay-back period method, this method ignores the time valueof money.

2. This method takes into account the accounting profits rather than thecash 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-offrate of return in choosing the projects. This may not always ensure

the right selection.

4. The concept of average investment and average earnings differwidely 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:

Machine

A:

Machine

B:

Cost $56,125 $58,125

Annual estimated income after

depreciation & tax

Year$3,375 $11,375

Year 2 $5,375 $9,375Year 3 $7,375 $7,375

Year 4 $9,375 $5,375

Year 5 $11,375 $3,375

Total earnings $36,875 $36,875

Estimated life 5 years 5 years

Estimated salvage value $3,000 $3,000


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SOLN-

ARR = Annual average net earnings after taxes X 100Average 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.


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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 are-

1) 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 dueto 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?


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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 overallvalue. So the best decision would be to discontinue Product A.


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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

Evaluation of Products

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