Market Your Systems Engineering With Business Skills

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1 Marke Your Sysems Engineering Wih Business Skills Tracy J. Farwell Space and Communicaions Group The Boeing Company Absrac. Several indirec mehods for quanifying he economic value of Sysems Engineering pracices are described. All are easily recognized as convenional valuaions. Sysems Engineers are more effecive when markeing heir core skills in a business conex. This paper suppors hose SEs who paricipae in he markeing of Sysems Engineering as Engineering. INTRODUCTION Engineering. As engineers we employ knowledge of physics and mahemaics as well as curren engineering sandards o design and develop producs and services ha have viable economic value in a paricular marke. When one chooses a branch of engineering such as sofware, civil, mechanical, power, ec. here is a corresponding marke which is disinc from oher engineering markes. Alhough he auhoriy for economic decisions is reserved for hose wih engineering managemen responsibiliy, every engineer knows why he end produc or service is markeable. Sysems Engineering. Cos is a variable parameer for he engineer o consider among oher parameers and cos efficiencies canno be achieved wihou considering all coss. The value of Sysems Engineering sems from he end-o-end scope of knowledge accumulaed from regarding he whole sysem as a oal produc. The Sysem Engineer is uniquely posiioned o discover leveraged cos sraegies and idenify key inpus for economic decision making. Moreover, he legacy of produc developmen principles, mehods, ools and processes ha Sysems Engineers bring o any projec inherenly acs o preclude problems during produc inegraion and insallaion. SE pracices which rely on early discussion of cusomer needs and objecives, analysis of alernaives, formal requiremens definiion wih es crieria, all ac o preclude laen design flaws. THE RIDDLE Virual Value. I s no jus he Sysems Engineers who have difficuly rying o idenify he coss saved due o problems ha were obviaed by Sysems Engineering pracices (Repenning 2001). Wha would have been he cos of a problem ha didn happen? Every problem ha is precluded by an effecive process is obviously one for which no cos is incurred. How do we deermine he would have coss? This siuaion poses an imporan disincion beween coss obviaed and coss incurred. Convenional accouning pracices deal effecively wih coss incurred. The Financial Accouning Sandards Board (FASB) ses accouning sandards for coss incurred ha are backed by he American Insiue of Cerified Public Accounans. Engineers oo deal effecively wih coss incurred. Wihou merics for accurae quanificaion of coss obviaed and herefore saved, a direc valuaion of Sysems Engineering achievemens, and even heir aribuion o Sysems Engineering, appears o be boh indeerminae and undeerminable. All is no los. We know of many oher domains of knowledge ypically associaed wih an inrinsic value ha is no direcly quanifiable. Wha is he value of law and order, of lieracy, science, ar, or accouning iself? Wha is he value of engineering? The value is in he discipline and Sysem Engineering praciioners and advocaes know his. So neiher Engineering nor Sysem Engineering can be reduced o a measurable commodiy, nor is engineering unique in his regard. Neverheless, every Sysems Engineer knows ha he value of Sysems Engineering is frequenly challenged, discussed, debaed and easily refued by hose who apparenly do no accep he virual value. One mus recognise of course ha any undeerminable value is easily debaed. The larger quesion is Why debae a all when any discipline, by is very naure, canno be mericized? THE MARKETPLACE Business Skills. All he dialecics aside, we promoe he inrinsic value of Sysems Engineering more effecively when we become conversan wih he erms and principles used in he business communiy o make sound decisions. Three approaches are addressed - 1

2 Engineering Economic Analysis, Reurn on Invesmen, and Real Opion Modelling. NOTE: Dollar values have been assigned in he following examples o esablish a business perspecive for each case presened. These values are enirely arbirary and do no in any way represen any business case known o he auhor. Unless noed oherwise, all $ unis are Engineering Economic Analysis. Undergraduae engineering curricula ypically include core or elecive coursework reaing engineering economics. Linear relaionships beween fuure and presen values are defined. For example, consider he cash flow diagram in Figure 1. A series of receips is equivalen o an iniial principal expense. Sysems Engineering mehods or ools. The cash flow model for his case is shown in Figure Figure 2. Projec Plan A saving in inegraion and es of 6 monhs is anicipaed as a resul of he decision o replan and add Sysems Engineers. This is represened in Figure Benefis Coss P A A A A A 0 Figure 1. Cash Flow Diagram Where P is he presen value, A is an annual paymen amoun in a series of paymens, i is he ineres rae and n is he number of years he paymens are made, P = A (1 + i)n - 1 i (1 + i) n This compuaion allows direc comparison of he ne presen value of a series annual license paymens (A) over n years for a Sysems Engineering ool applicaion as opposed o ourigh purchase a year zero. This approach is generally ermed Discouned Cash Flow (DCF) in he business communiy (Cox 2001). Reurn on Invesmen (ROI). Afer falling ou of favor in he lae 1980 s, ROI is sill used as a valuaion sandard. This approach offers an indirec valuaion of Sysems Engineering if one posulaes ha coss are incurred when Sysems Engineering is no employed during produc developmen. Consider a developmen conrac wih a budge of 10M per year for 5.5 years. Assume ha his plan has been paerned afer a similar projec ha did no employ Figure 3. Projec Replan Under he replan, 5M in projec expense is eliminaed. The presen value of his amoun is represened in Figure 4. P Figure 4. Presen Value of Esimaed Savings A presen value for he single amoun ha would have been expended a year 5.5 is evaluaed from he following expression: P = A (1 + i) n Wih i = 7% his yields a presen value of P ES = 3.5M for he esimaed savings. This is an example of DCF. To deermine he Reurn on Invesmen, he cos of Sysems Engineering mus be deermined. The following assumpions are made. SE Tool Cos a year 0: 30k Sysems Engineers per year (3) 60k ea The resuling cash flow is given in Figure

3 30k 180k 180k 180k 180k 180k value is shown graphically in Figure 6. Call Fee (Premium) C Figure 5. Esimaed SE Coss Compuing he presen value of SE coss, C SE is deermined from he paymen series equaion and is found o be 760K. ROI = P ES C SE = 3.5M 0.8M = 2.7M This would be considered a srong indicaor in favor of deciding o apply Sysems Engineering for his projec. Consider he oucome for an expeced budge of 1M per year raher han 10M. ROI = P ES C SE = 0.35M 0.8M = 0.45M. The replan is no effecive in his case since he esimaed savings do no offse he corresponding coss. Difficulies for Sysems Engineers posed by he ROI approach have been horoughly discussed in he lieraure (Sheard 1998). One of he mos serious is he need o quanify any esimaed savings wihou an acceped indusry sandard for such esimaes. Call Opion Modelling. To provide an alernaive valuaion ha considers he poenial fuure marke value of a given produc developmen projec, he Real Opion Model is proposed. Originally suggesed for evaluaing candidae conceps for research and developmen funding (Michell 1988), his mehod readily relaes o he valuaion of projec developmen opions o choose among candidae developmen projecs. The concep is aken from he Call Opion where he invesor who owns a cerain sock offers o sell his sock a a fuure dae for a fixed amoun (K), in exchange for a fee. The fee represens he value of he opion, and is independen of he idea o sell he sock for a price ha is higher or lower han he curren marke value. If he wrong fix is chosen, he opion will no be purchased. Once he opion is sold, he value of he opion o he owner will increase if he marke value of he sock happens o exceed K. If he marke value for he sock happens o decrease below K, he value (premium) of he opion is zero since here would be no buyer willing o pay more han he marke value for he sock. The value of he opion as a funcion of sock K Sock Price Figure 6. Opion Value Characerisic A model ha idenifies he value of any call opion for any marke condiions has become a common ool in he business communiy. The model consiss of a curve fi derived from years of daa recorded by he Chicago Board Opions Exchange (CBOE). The Black-Scholes Model (Nobel, 1997) requires he following inpus in order o produce an esimaed premium: S = curren sock price = ime unil opion expiraion K = opion sriking price r = risk free ineres rae N = cumulaive sandard normal disribuion e = exponenial funcion (2.7183) d ln(s/k) + (r + σ 2 /2) 1 = σ d 2 = d 1 σ σ = sandard deviaion of sock prices ln = naural logarihm To esimae he value ha he marke would impar o an opion, Black-Scholes approach subracs he presen value of he prediced exercise price on he expiraion dae from he value of he sock if purchased direcly wihou he opion. C = Theoreical Call Premium C = [Sock value (direc)] [Presen value of K a expiraion] C= SN(d 1 ) Ke ( r) N(d 2 ) This model has been validaed by comparing prediced and acual call premiums recorded by CBOE. The call opions and he corresponding pus are exchanged in he open marke as shown in Figure 7. The purchaser of he call opion is he invesor who offers o buy he sock by wriing a pu opion (Jarrow 1983). S 3

4 Opion o sell a sock for a sipulaed price unil he expiraion dae Call Marke Chicago Board Opions Exchange Lis Lis OCC Opion o buy a sock for a sipulaed price unil he expiraion dae Pu Price of Opion OCC - Opions Clearing Corp. Manages sales of opions Opion pricing daa exhibis predicable valuaions Figure 7. The Marke Deermines Call Opion Value Oher Opions. I is common pracice in he business communiy o apply he Black-Scholes model o invesmen opions ha do no involve sock rades a all. Typically only five inpus are needed o produce a valuaion he generalized use of he five parameers o evaluae a business case is noed below (Luehrman, 1998): Call Opion Sock Price Exercise Price Time o expiraion Risk-free ineres rae Variance of reurns on sock Parameer S K r σ 2 Business Opporuniy Presen value of business asses o be acquired Expendiure required o acquire he asses Lengh of ime he decision may be deferred Time value of money Riskiness of projec asses For example, consider he case of a modificaion o an exising produc. The cos o develop he modificaion is 10M. The presen value of fuure cash flow aribuable o he modified produc is 9M. Ne Presen Value = 1M. Now obain he Call Opion valuaion. The invesmen can proceed any ime in he nex 2 years due o an advanage gained by inellecual propery (paens, know-how). The average cos of capial is 7% and he volailiy in marke value has been 30% for several years. Parame S K r σ 2 Produc Modificai 2 9M 10M 7% 30% Using Black-Scholes, he Opion Value = 1.6M. Sofware o compue Black-Scholes valuaions is available for inerne download. Look-up ables are also available (Luehrman 1998). This resul facors in he prospec of a beer oucome from foruious marke condiions ha have been observed in he pas. Alhough Black-Scholes was validaed for he CBOE marke, i is used as a yardsick for business opporuniies in general. Why Differen Approaches. Recognizing ha owning a sock is differen from owning an opion, i is imporan o use he opion value mehod when i provides a beer insigh. The risk ha circumsances will change is somehing ha we undersand inuiively. When an invesmen has already been made (he sock case), circumsances are evaluaed as shown in Figure 8. 4

5 Inves Don inves Good news Bad news Good news Bad news Figure 8. Asses in-place For his siuaion DCF mehods are found very useful. When he principal invesmen has no been made (he opion case), circumsances are evaluaed as shown in Figure 9. Alhough here is a cos in owning an opion, he opion allows favorable siuaions o develop and become eviden, providing more informaion o he invesor prior o making a decision. Tradiional DCF mehods are no as effecive in idenifying value in his case (Luehrman, 1997). Good news Bad news Inves Don inves Inves Don inves Figure 9. Eviden Opporuniy SE As An Opion. Alhough Sysems Engineers find lile comfor in he prospec, Sysems Engineering is an opion when projec developmen decisions are aken. Few invesors can afford a deploymen cycle ha applies a full-up Sysems Engineering enerprise process model. Few SEs are employed solely o ailor an enerprise model o a given developmen projec. Even so, various SE process elemens can be and ofen are seleced for deploymen on a given projec, and are decided in erms of perceived value. The values perceived are ypically hose of markeing managers, projec managers and business planners, no SEs. Can Sysems Engineering be characerized as an invesmen opion? By now we should conclude yes. The opion analogy in he engineering domain is he value of he opporuniy o develop a produc wih confidence in he prediced cos of developmen. When aken as an effecive produc developmen mehodology, Sysems Engineering provides assurance ha a produc can be developed wih lower developmen risk han oherwise. Using he same parameers as he produc modificaion business case example, Black-Scholes can provide a valuaion for SE. Consider he case of a producion conrac involving he delivery of 9 unis in 2 years wih P = 1M ea. The cusomer assures a generous follow-on conrac if he projec succeeds wih uni cos. S = 9 M. Assume ha he finance esimaing eam predics ha he oal cos of design, inegraion, producion and es is 10M. K = 10M. Assume now ha he likelihood of succeeding wihin a 10M cos cap is esimaed as 70%, giving a risk of failure of 30%. σ 2 = 30% Taking he prevailing ineres rae as 7%, he Opion Value is (again) 1.6M. This is he fracion of he 10M oal cos o commi o Sysem Engineering in order o assure ha he overall design, inegraion and es coss do no cause an overrun of he 10M esimae. Higher risk esimaes (inerpreed as σ 2 volailiy in his example) produce a higher opion value using Black- Scholes. This approach yields a higher valuaion for SE when projec risk is high. The 1.6M for SE assures ha he cos cap of 10M is no exceeded. In his scenario, he cos of he opion o assure cusomer saisfacion for he firs 9 unis and o capialize on he follow on opporuniy is 1.6M. Sysems Engineering encompasses a legacy of buil-in lessons learned so ha cosly surprises are obviaed by skilful incorporaion of he legacy processes. When uilized, i assures ha he given developmen projec remains viable despie condiions ha can occur. These condiions consiue a significan dimension of he marke. Characerizing he Marke. Consider some of he qualiaive condiions ha influence our marke. The marke condiions ha can increase he perceived value of SE are 1) Concep changes ha occur during developmen, impacing he inended use of he produc, resuling in a reconsideraion of performance requiremens, 2) New sandards levied on a projec during 5

6 developmen ha mus be quickly incorporaed ino he requiremens managemen ools, 3) Changes o performance requiremens ha impac on-going design effor by adding or deleing required capabiliies and modifying es condiions, 4) Advances in new echnology ha mus be exploied quickly by rapid assessmen of compaibiliy wih exising conceps, requiremens and es plans, 5) Validaion or discovery of inellecual propery ha builds on curren conceps/analyses o esablish a new follow-on produc or capabiliy. Marke condiions ha erode he value of SE are 1) A reducion in he expeced qualiy of he end produc which occurs when projec sandards are rescinded or inerpreed loosely by he cusomer, 2) A shif of budge away from analysis in favor of es which emphasizes he discovery of problems raher han obviaing hem, 3) Exclusive reliance on risk managemen mehods ha reac o known problems by racking and miigaing, raher han uilizing he SE processes o sysemaically ferre ou and resolve he laen unknowns before hey emerge as problems, 4) Open ended or highly flexible markeing sraegies ha rely on poorly framed conrac requiremens or exemp engineering from producing baselined designs, 5) The absence of an accepable sandard as a basis for agreemen in esimaing obviaed coss, 6) Preference for reacive sraegies ha respond o emergen cos issues, raher han proacive projec planning. CONCLUSION A Sysems Engineering cos model has been posed as an exension of he call opion mehod employed in convenional business case analysis. A beer undersanding of his and oher business case mehods will enable he Sysems Engineer o convey he inrinsic value of Sysems Engineering o he business communiy in business erms as a proven produc developmen discipline. This prepares he Sysem Engineer o offer a prospecus of our knowledge base in any marke. A conex-based summary of he cos esimaion mehods is provided in Table 1. Paradoxes encounered in he effor o quanify a commodiy value for Sysems Engineering have been discussed. Even so, here should be no need o demand a higher sandard of economic jusificaion for SE han for engineering in general. Mehods Conex Commen Engineering Engineering Universally acceped Economic Analysis ROI Business Universally acceped Call Opion Modelling Sysems Needs a recognized Engineering business valuaion sandard for obviaed coss Sock Trades Validaed; Nobel 1997 R&D Decisions Sysems Engineering* Facors-in esimaed marke volailiy The value of he opion increases wih projec risk * The precision of he esimaes produced from his model would no be as rigorous as, for example, finie elemen sress modelling for bridge design. Table 1: Summary of Valuaion Mehods The bes course of acion is o advocae for developmen cos conainmen in building a paricular business case for SE. This would seem far more fruiful han rying o build a generalized business case for Sysems Engineering from direc sudy of cerain case hisories wih heir ineviable conroversies ha cause disagreemen over ROI. Engineering credibiliy sems from mahemaically jusified principles ha guide engineering design so oo for Sysems Engineering. This paper offers several ways for he Sysems Engineering praciioner o presen domain knowledge as inellecual capial from which o asser a convincing, convenional value proposiion. REFERENCES Cox, L., Overview of Basic Conceps in Engineering Economic Analysis, Indusry Workshop, Boeing, 2000 Jarrow, R.A., Rudd, A., Opion Pricing, Dow Jones- Irwin, Homewood, Illinois, 1983 Luehrman, T. A., Wha s I Worh A General Manager s Guide o Valuaion, Harvard Business Review, May-June 1997 Luehrman, T. A., Invesmen Opporuniies as Real Opions: Geing Sared on he Numbers, Harvard Business Review, July-Augus

7 Michell, Graham R., Opions for he Sraegic Managemen of Technology, Proceedings of he firs Inernaional Conference on Technology Managemen, Miami Florida, Feb 1988 Repenning, N. P., Serman, J. D., Nobody Ever Ges Credi for Fixing Problems ha Never Happen, California Managemen Review, Summer 2001 Sheard, S. A., Miller, C. L., The Shangri La of ROI, Proceedings of INCOSE, 2000 BIOGRAPHY Tracy J. Farwell has hiry years experience in sysems engineering of hardware and sofware sysems for aircraf, defense and space producs including US and UK assignmens. Currenly he is a principal sysems engineer for a major echnology demonsraion program. Mr. Farwell has served as an INCOSE Seale Chaper board member and presiden. He has paricipaed in he SE Principles Working group. 7