Theory of a design goal:
Any human activity can be studied from an economic point of view. Characteristic for such studies is that at least some attributes of the object are measured on a monetary scale.
Even intangible cultural objects can be measured in money, albeit awkwardly. The study becomes much easier if the object is of a kind that normally has a value in money. Such is the case with any commodity. These are either objects (products) or services. Almost any industrial or commercial business can be studied as a process of buying, refining and selling commodities.
Beside monetary values, typical magnitudes that are studied in economy include quantities of raw materials and of products, time, energy, and number of people. Many of these are quantities that can easily be measured on an arithmetic scale, which means that economic research is mostly quantitative in character.
The quantitative style of research brings about many benefits: the study material is relatively unequivocal and collecting it is speedy. You can present the relations between quantities as exact models, you can contrive hypotheses, arrange experiments and use powerful statistical analysis when verifying a hypothesis. Often these benefits invite the researcher to operationalize, measure in quantities, even such concepts which are inherently qualitative, like the values that people give to commodities. Such simplification is permissible in research, but the results should then be applied with proper caution.
Another dubious technique when dealing with qualities is simply to omit them from the model and the hypothesis.
The values of economic benefits and costs are usually definitely subjective, for example a seller often regards as low the same price that the buyer judges as expensive. There perhaps is no such thing as objective study of economy. The researcher can take this in account by observing the following precautions:
Usual points of view in economic research are, among others:
Elsewhere is a discussion of typical points of view in research projects.
Benefits of a commodity include all those desirable
consequences that the commodity brings about. If the commodity is
to be sold out, its benefit can be exactly measured as the
price. The price becomes income as seen from the
On the other hand, when the commodity is not sold but used, the ensuing benefits are often difficult or meaningless to be measured in money. Some methods of measuring the non-financial benefits of commodities shall be presented elsewhere.
products are quite durable, and they will yield benefits during
many years. When you study such long term or recurring benefits
you should note that timing has an influence on the value
of a benefit. Possessing $1000 now is more valuable than
receiving $1000 in a year. The difference is due to the fact that
during a year the money will be augmented by interest. Always
when you transfer benefits or other financial amounts into
another point of time their value will be altered by the interest
paid in the time interval. This change of the amount depends on
the duration of the interval, and also on the rate of
interest: the higher the rate, the more the amount of money
will be altered in the transfer.
When comparing benefits which come at different points in time, the usual procedure is discounting. Discounting a future income to the present time means that the future (real or implied) payments of interest are subtracted from it.
Often there are not only one payment but a periodical series of future benefits like a monthly rent. Discounting all of them into a total value in the present time, or in any other point of time, is often called capitalizing.
|Number of yearly,
Beside the interest, another reason which can diminish the present value of a future benefit is the risk of not getting the benefit. The probability of a favourable outcome is often expressed as a percentage, which you then can multiply the discounted value of the benefit with, to get an approximation of the final value under the risk of not getting the benefit.
When one has bought a commodity, it is easy to identify the expenditure caused by it: it is simply the price. Instead, if you yourself fabricate the commodity, your expenditures will consist of material contributions or "inputs" like:
Such material substances have more or less standard prices, and by applying these you can calculate the incurred costs of producing the commodity.
Cost per unit is calculated by dividing total costs by the number of produced items.
Marginal cost (or variable cost) is equal to the increase of total cost when the produced quantity is increased by one unit. As a contrast, constant costs like rents and investments in machines do not vary in unity with the amount of production.
The point in time of costs and material contributions affects their value in the same way as the value of benefits is affected. Also similarly, discounting, that is, subtracting the interest from the future payment, is the method for transferring the value of cost into the present or to any other moment of time.
When calculating the costs of industrial production that is going to be started in the future there is the difficulty that the costs have to be paid in various points of time. The interest affects costs in the same way as it affects benefits or any other payments. Likewise, there are several alternative methods of finding the combined value of expenditures due to be paid in different moments of time.
One method of summing up payments from various moments is capitalization. It can be used to find the consolidated value of successive (e.g. annual) costs. Each payment is discounted and then the discounted values are added up, possibly together with the initial investment.
An alternative is the yearly cost method. It gives finally the same results than the capitalization method when you compare alternatives of new product design, of business management etc.: the economically best alternative will always be correctly pointed out among the alternatives. However, the yearly cost method may be more demonstrative in such a case that the yearly costs in fact are more important than the single initial investment. Such is often the case in continuous industrial production.
When calculating the yearly cost the investment is distributed along the whole time span that is being considered, and then the interest is added. The pattern of distribution of investment is selected so that the total yearly cost, or annuity, becomes constant. Here as in other calculations which were discussed above, it is the researcher's task to select a reasonable rate of interest.
A practical method of calculating the annuity is to use a
table like the one on the right. When you know the number of
years that an investment has to cover (e.g. the number of years
that you are going to profit from the investment) and the rate of
interest (in this table, 6%) you can multiply the investment by
the coefficient given in the table. The resulting annuity is
equivalent to the investment.
Larger tables with other interest rates can be found elsewhere, and again the calculator.com in the WWW can be used for the computations.
The figure on the left gives an example of
finding the agglomerated value of an investment and a number of
other expenditures which have to be paid later, during several
successive years. The example aims at finding out how heavy an
insulation you should select for a new building. The costs which
vary along with the thickness of insulation are its price (which
is proportional to its thickness) and the subsequent heating
costs of the building (which will be diminished if the insulation
An investment and the annual payments should not be added together as such, but if we first transform the investment into an average annual cost the addition is all right. Such an annual cost which is equivalent to the investment is presented as curve B in the diagram, while curve A shows the yearly heating costs. The optimum for an insulation will be found at the point where the sum of these two costs is at its minimum.
Beside those inputs of the production which are paid as costs by the manufacturer it is often appropriate to consider the impediments caused to other parties. A list of such outsider parties will be presented under the title Point of View.
Normative economics studies the methods of finding an optimum to the object of study. An optimum in economical matters means a good relation between benefits and expenditures.
A common task for a researcher assisting business management is to find out which one is best among two or more alternatives of future action, or among various proposals for a new product. In order to make the comparison, you do not necessarily need a complete -- and thus laborious -- model of the problem and the alternative solutions to it. To be sure, such a model would be useful, but if the time is sparse it is perfectly acceptable to simplify the task by omitting everything that is not essential in the comparison. Possible simplifications include:
The normal procedure for selecting the most economical alternative is as follows (as three versions, a, b and c):
Sometimes the situation is more complicated, and more than one indicator must be calculated for finding the most advantageous combination of several options. Some usual methods for this are:
In the following shall be discussed three situations where economical optimization is often used: optimizing a new product, its production and finally pricing.
The goal for product development is to find the optimal combination of desirable properties for the new product, together with a low level of inputs necessary for its production. Mathematically such an optimal combination would be found simply by observing which product proposal gives the highest ratio (or alternatively: difference) between outputs and inputs.
The highest ratio would be easy to find if there were only one property of the product that we have to optimize, like in the (invented) example on the right. The graphs illustrate the situation of a TV manufacturer selecting the screen size for a future series of TV sets. The heavy line shows the current market prices of TV sets with various screen sizes, while the thin line shows the estimated costs for manufacturing such TV sets.
Nevertheless, often the situation in product development is that there are a large number of attributes of the new product which are to be optimized. To that end it is necessary to operationalize each attribute so that it can be measured on a scale that is common to all the attributes. This can be achieved with the help of two mathematical procedures:
The relative weights of the properties of a product can be determined by several alternative methods, e.g.:
|Speed at least 100 mph||40|
|Easy to use, automatic||40|
unlike the competitors
There are two alternative techniques in building a table of weights:
In any case it will be advisable to minimize the size of the table of weights, to avoid too complicated calculations later on. For example, it is advantageous to combine groups of associated properties into one weight. Such families of attributes can be found with the help of factor analysis. Another possibility is to present a family of related properties in the pattern of a logical tree. See an example of such a tree of the targets of building design.
A subjective scale of value can be made to depict how much value a certain person puts on a certain property of a product. It is often represented as a table:
|Property xx of the product||Utility value:|
|Better than average||4|
|Less than average||2|
The standard table, above, can be differentiated to better explain the various levels of each attribute, e.g.:
|Property: Ease of use||Utility value|
|Most operations are automatic.||5|
|Several operations are automatic.
There is a detailed and easy to read instruction booklet.
|The operation and the instructions are mediocre.||3|
|The operation is sometimes clumsy or confusing.||2|
|The machine makes errors or reacts not as described in the booklet.||1|
Intersubjective scales describe the opinions of all potential customers or at least the opinions of a certain group. These scales are often fabricated on the basis of a questionnaire directed to a sample of customers. Some examples of intersubjective scales of utility are given below:
The (invented) diagram on the left depicts the common views of a group of customers, which we can translate as the opinion that a cycle should always possess at least two or three gears, while the rise in usefulness with more and more gears gets gradually lower.
Another example of intersubjective scale of utility is on the right. In this case a group of customers were asked about the capabilities of a CD player. The average opinion of the customers is that a CD player is to be rated poor if it only transmits voice until the 5 kHz limit. 10 kHz is just a little better, while 20 kHz is excellent. Thereafter higher abilities give no additional merit, probably because the human ear could anyway never hear voices over 20 kHz.
It is possible to measure, beside materialistic and utilitarian benefits, also humanistic attributes of products like beauty. An example is seen in the diagram on the left. The graph purports to indicate that there is a measurable optimum of the visual complexity of a work of art (or other product). The philosophy behind this type of aesthetic measurement is discussed in Beauty of products.
Objective measurement of utility is possible if all people agree on the utility value of the product. Such is often the case when the product has only one possible use. A pump might be such a product; its utility value would be its capacity of pumping, measured in litres per second. More examples of measuring the utility of products can be found under the title Ecology of Product Use, on the page Ecology of Products.
Another type of objective utility values are absolute requirements which often concern the safety of use of the product. Such a guideline is often specified through separate research projects carried out by specialists like physicians, occupational health and safety engineers, etc. It is usually best not to include mandatory requirements in the analysis which aims at optimization. It is better to make a separate list of the obligatory requirements. In that way it will be easier, in the final inspection, see if they are met. Those product proposals where these requirements are not fulfilled, are then simply rejected.
Normally the economic process - the flow of money in and around the firm - has roughly the same structure but opposite direction than the process of manufacture and the flow of materials and products, see the diagram below.
A thriving firm tries to get the greatest possible benefits for as small costs as possible. In such a pursuit the following concepts have been found useful:
Profitability, the difference between revenues and costs, is an important concept because only profits can maintain the cash that is necessary for continuous business.
Cost per unit indicates how much the firm had to pay for the making of one unit of the product.
Productivity is the ratio between produced output and the amount of input of a certain type that is used in the production. The productivity of labour, for example, is measured by the ratio (produced quantity) / (spent working hours). Likewise, the productivity of use of energy can be defined as (produced amount) / (used energy kWh).
Effectiveness goes a little further and measures not just the produced quantity but instead how well those products fulfil the needs of the customer. Satisfaction is sometimes defined as the amount of benefit as compared to the paid price; these definitions are, however, not universally established. It is advisable that the researcher states in the report which definitions he is using.
A normative use of the above statistics could mean simply setting high targets for them. However, with the help of some research it is usually possible to go a little further and find out how to reach the improved result with the least possible drawbacks. It is usual to start by finding out which types of costs are greatest. Often they are:
The biggest components can then be analyzed with methods that can often be adapted from the methodology of Methods Engineering and other methods of Developing an Activity.
In industrial production, the number of items produced has a great influence on the cost of production. However, the relationship is not linear. If you make a diagram showing the costs per unit as a function of the quantity of identical products it will often resemble the (invented) diagram on the right. In other words, whatever is the quantity, already producing the first item will cause a certain fixed (or constant) cost. Those additional costs which result from making additional items are usually called variable costs. When planning industrial production it is often useful to differentiate between these two types of costs (although there is no absolute divergence between them: the division depends on the temporal extent of your view). In any case, the costs of product development always belong to fixed costs.
Making a diagram like the one on the left can clarify the relations between constant and variable costs, and profit. It also defines the break-even quantity of sales that you have to surpass in order to get positive profit.
One obvious method of improving the profits of the company could be to increase the retail price per unit. The drawback is that some customers would then probably buy rivalling products. How much your turnover would diminish, depends on the price elasticity which you can express as the diagram on the right. It is defined as:
Price elasticity = (difference of sold quantity) / (alteration of price)
The value is always negative, and therefore the minus sign is often omitted. The exact value for each product must be found by experimenting or by survey.
Even though the curve of costs per unit seems to advocate selling as many products as possible, there are many types of products where the quantity will always be restricted. Extreme examples are buildings, bridges and ships, for which often only one item can be sold. For this type of products, you might sometimes consider another strategy: designing your product so that it consists of smaller components, and some of these are identical and they can be produced as a series. In the manufacture of these you then can benefit from the falling curve of costs. See, for example, Systems Building from prefabricated components.
An additional benefit of the strategy of designing with components is that it provides an economical technique of producing variants of your product so that you concentrate the variability into just a few components.
Beside the strategies above, you can try to improve the economy of your product by various practical improvements to the processes of production. Some of them are listed elsewhere, under Point of view of manufacturing.
A healthy economy is vital for the continuous operation of any business, and indeed most economic research is done inside enterprises. Internal researchers have the benefit of easy access to exact figures about current production, which numbers (costs per unit, for example) then can be used for planning future production, too. These figures can often be obtained directly from the accounts of the enterprise if these are detailed enough.
In economic studies the quantitative style of measurement is predominant if not absolutely indispensable. It opens up the possibility of using the powerful methods of Quantitative Analysis.
Costs are, of course, always measured in money which is a typical variable of the ratio scale.
Benefits are not quite as easy to measure, because they materialize near the customers which are usually dispersed and difficult to reach. One possibility is to look at the prices of comparable products on the market and assume that people, by and large, get roughly as much benefit from any product as they are willing to pay for it. This method is not accurate, but its advantage is easy measurement in monetary units.
Another, more laborious alternative is to use the survey method and ask either factual or potential customers what kind of product they require, what they would do with it and how much they would be willing to pay for it.
Analysis methods are usually selected among the Quantitative Analysis tools, which necessitates that not only prices but if possible all the benefits, side effects and other significant factors have been measured as variables in either money or some other suitable scale, preferably an arithmetical one. When necessary, this scale can even be a theoretical fabrication of the researcher like "measure of utility", "unit of chagrin" etc.
When optimizing a new product you will often want to compare two variables: benefits to costs, or incomes to outlays, or produced quantity to spent working hours, etc. and search for an optimum between these, which optimum perhaps also depends on other factors (parameters). Mathematical methods for such analyses include, among others, analyses of correlation and regression, and especially the Cost Benefit Analysis which is explained below.
Cost benefit analysis, which also goes by the name of value engineering, is a method of summing up all the important utility values of a series of product proposals (or any other alternatives) and finding their optimum together with the cost, price or other inputs affiliated with each alternative.
Cost benefit analysis is definitely a quantitative tool, and it necessitates the measurement of all the components to be analysed. The analysis is carried out in distinctive and logical steps:
or property of
|Alternative 1||Alternative 2|
|Ease of use||40||3||120||4||160|
August 3, 2007.
Comments to the author:
Original location: http://www2.uiah.fi/projects/metodi