Lonnie VanZandt
Enterprise Architect
Sodius

An Economic Model for Estimating
Model-based Systems Engineering
Internal Rate of Return Benefits

Integration Ingenuity

TL;DR

Integration Ingenuity

Over the last two decades, innovative and forward-looking systems engineers have investigated new tactics for their engineering of complex, collaborative enterprises and have either been pioneers in introducing new forms of specification notations, visualizations, and analyses or have been early adopters of such new tactics within their organizations. Today, proponents of model-based systems engineering capabilities struggle to express to their organizations not only the improvements in personal productivity of switching from traditional practices to MBSE practices but, more importantly, the economic benefit of having entire business units, companies, or joint ventures switch from traditional engineering to MBSE tools and methods. MBSE proponents have found the making of economic arguments difficult because there has not been an effective way to numerically represent the value of an effective systems engineering practice. This paper presents a case study and an economic model that enables an organization to perform common business case financial decision making using Internal Rates of Returns versus the Cost of Capital for systems engineering practices, methods, and tools. The model affords MBSE service providers and MBSE tool vendors new ways to construct value-based revenue models that monetize their offerings. The model also provides MBSE proponents a defensible means of economically justifying changes in business practices to adopt MBSE across an enterprise.

Agenda

Integration Ingenuity

  • Business Needs
  • Related Work
  • Economic Models
  • Software Revenue Models
  • Finance-based Decision Making
  • Labor Rates
  • Case Study
  • Case Study Model
  • Advice, Cautions, Conclusions

Business Needs

Business Needs...

  • think strategically and look at the long-term implications of decisions and actions to set vision and course
     

  • turn ambiguous problem statements into clear, precise solution challenges for the team
     

  • maximize customer value by ensuring a direct tie of all engineering effort to the customer business or mission needs
     

  • facilitate decision making.

[@Walden2015]

Related Work

Related Work...

  • INCOSE MBSE Initiative                 [@INCOSEMBSEInitiative2016]
     

  • Delligatti SysML Business Case                           [@Delligatti2014]
     

  • INCOSE Fellow Eric Honour's PhD Thesis      [@HonourRoi2013]
     

  • Raytheon's Saunder's SE Lessons Learned      [@Saunders2011]

each offer subjective confirmation of MBSE benefits

Economic Models

Economic Models...

a theoretical construct representing economic processes by a set of variables and a set of logical and/or quantitative relationships between them.

a simplified framework designed to illustrate complex processes, often but not always using mathematical techniques.”

 

[@PalgraveMacmillan2016]

An Economic Model is

Economic Models...

  • Forecast economic activity in a way in which
    conclusions are logically related to assumptions

     
  • Present reasoned arguments to
    explain and influence company strategy
    at the level of the firm.

Software
Revenue
Models

SW Monetization...

Due to their intangibility and
to the subjectivity of the benefits obtainable
through their use,

Software and Information Services

lack readily evident monetization
“revenue models”

SW Monetization...

The two predominant models are

the traditional Perpetual License

and

the innovative Subscription License.

Two Predominant Models

[@Showalter2012]

SW Monetization...

Usually involves a large initial price and may include large annual fees for maintenance and upgrades.

 

Grants the buyer the right to
use the software as often as they like
for as long as they like.

Perpetual License

Seller: Immediate Revenue
Buyer: Ultimate Flexibility
Little Auditing

Buyer: Resistance to Purchase
Seller: Long Sales Cycle
No Ongoing Relationship

SW Monetization...

Usually involves a series of relatively small monthly or annual fees.

 

Grants the lessee the right to
use the software as often as they like
for the term of the subscription
and to automatically receive maintenance and support during their term.

Subscription License

Seller: Ongoing Revenue
Buyer: Low Risk
Ongoing Relationship
Immediate Feedback

Buyer: Recurring Payments
Seller: Delayed Profitability
Easier Mutual Terminations

SW Monetization...

Will substantially alter Revenue arrival and patterns.


Requiring resetting of:

Investor Expectations
R&D Funding
Sales Compensation.

Subscription License

Value-based
Pricing

Value-based Pricing...

“a strategy that sets prices primarily, but not exclusively,

on the value, perceived or estimated,
to the customer

rather than on
the cost of the product or historical prices."

Value-based Pricing

Improves Profitability
Improves Acceptance

Value is Subjective
Acceptance requires Persuasion
Prices vary per Buyer

Monetization...

Monetize
Sofware and Services
for Model-based Systems Engineering
using

Subscription Licensing

based on

Value-based Pricing

Recommendation

Monetization...

Read 

 

Price Waterhouse Cooper

"Software Pricing Trends"

 

https://www.pwc.com/us/en/technology-innovation-center/assets/softwarepricing_x.pdf

Recommendation

[@PriceWaterhouseCooper2007]

Monetization...

It is difficult to assess
a defensible approximate economic value
for many of the costs and benefits
of executing an enterprise to acquire a solution.

 

An effective proxy is the
organization’s cost of labor
to perform a set of tasks related
to a particular enterprise.

Challenge

Financial Deciding...

Labor roles, skills, and training levels for
Professional Engineering Services in systems-engineered projects, include GSA-871:
 

  • -1: Strategic Planning for Technology Activities
  • -2: Concept Development & Requirements Analysis
  • -3: System Design, Engineering & Integration
  • -6: Acquisition & Life Cycle Management

Labor Rates

140 $

[@USGeneralServicesAdministrationPES2016]

Finance-based
Decision-making

Financial Deciding...

Humans form enterprises to
collaboratively acquire solutions to problems
 

Businesses are human enterprises that strive to
earn profits from the sales of their solutions.
 

Business managers use Capital Budgeting
to determine which enterprises are likely to
earn profits
and which ones would
waste investors’ funding

Capital Budgeting

Financial Deciding...

  • Payback Period
  • Net Present Value
  • Return on Investment
  • Internal Rate of Return

Financial Tactics

[@Gad2016b]

Financial Deciding...

Effective discount rate
for which the NPV for a series of incomes and expenses is zero
 

Reject opportunities with IRRs that are
lower than the organization’s cost of capital
 

Cost of Capital is the effective interest rate
paid to borrow money

Internal Rate of Return

Financial Deciding...

Depends on:

  • corporate tax rate
  • cost of debt financing
  • ratio of equity to debt and equity
  • variability of its stock price (if it is a public corporation), and
  • primary industry.
     
  • In 2016, a survey estimated the cost of capital for US companies as 6.29%.
  • In 2017, this survey shows the CoC at 7.73%

[@Damodaran2016]

Cost of Capital

7.7 %

Financial Deciding...

IRR Inputs:

  • I : a matrix of Income amounts streamed over time
  • n : the number of Income streams
  • E : a matrix of Expense amounts streamed over time
  • m : the number of Expense streams
  • p : the number of constant-duration periods
  • R : a matrix of varying discount Rates for each period
  • c : the corporate's Cost of Capital

 

Model Parameters

IRR \equiv f\left( M \right) \rightarrow
IRR≡f(M)→IRR \equiv f\left( M \right) \rightarrow
\left\{ irr | \right.
{irr∣\left\{ irr | \right.
\left. NPV(M.I,M.n,M.E,M.m,M.p, \right.
NPV(M.I,M.n,M.E,M.m,M.p,\left. NPV(M.I,M.n,M.E,M.m,M.p, \right.
\left. M.R|{ r }_{ i,j }=irr) \equiv 0 \right\}
M.R∣ri,j=irr)≡0}\left. M.R|{ r }_{ i,j }=irr) \equiv 0 \right\}
NPV(I,n,E,m,p,R) \rightarrow
NPV(I,n,E,m,p,R)→NPV(I,n,E,m,p,R) \rightarrow
\sum _{ i=1 }^{ n }{ \sum _{ j=1 }^{ p }{ { a }_{ i,j }{ \left( 1+{ r }_{ i,j } \right) }^{ -j } } }
∑i=1n∑j=1pai,j(1+ri,j)−j\sum _{ i=1 }^{ n }{ \sum _{ j=1 }^{ p }{ { a }_{ i,j }{ \left( 1+{ r }_{ i,j } \right) }^{ -j } } }
-\sum _{ i=1 }^{ m }{ \sum _{ j=1 }^{ p }{ { e }_{ i,j }{ \left( 1+{ r }_{ n+i,j } \right) }^{ -j } } }
−∑i=1m∑j=1pei,j(1+rn+i,j)−j-\sum _{ i=1 }^{ m }{ \sum _{ j=1 }^{ p }{ { e }_{ i,j }{ \left( 1+{ r }_{ n+i,j } \right) }^{ -j } } }

Financial Deciding...

Financial Deciding...

Practical Matters

  • Textbook NPV scenarios assume a small number of streams of identical cash flows
  • Textbook NPV scenarios assume constant interest rates over the lifetime
  • Textbook NPV scenarions assume equivalent interest rates for earned and for borrowed cash
  • Spreadsheet NPV Formulas make all these assumptions to make facile their use

 

  • In practice, Reality requires a complex model of discrete, differing parameters.

 

Financial Deciding...

Given IRRs and a Cost of Capital

  • IRR < CoC ⇒ Endeavor isn't Profitable
  • IRR ≥ CoC ⇒ Endeavor might be Profitable
  • IRR1 ≥ IRR2 ⇒ First better than Second 

Model Decisions

Case
Study

Case Study...

  • 2015
  • California
  • Aerospace
  • 6-person SE Team
  • 3-year Business Window
     
  • Consideration: Manual or Automated
    Vendor-to-Vendor Model Migration

Context

Case Study...

  • Cost of Capital 7.57% 
  • PES GSA 871 Labor Rates for Modelers
  • PES GSA 871 Labor Rates for Architects
  • PES GSA 871 Labor Rates for Trainers
  • PES GSA 871 Labor Rates for Consultants
  • Perpetual and Subscription Fees for Old and New Tools and Maintenance
  • Income as the Saved Labor per Month

Model Inputs

Case Study...

Forecast IRR

Promoting
MBSE

Promoting MBSE...

  • Review published benefits of Systems Engineering and of MBSE.
  • Defend claims of improvements in: scalability, quality, performance, reliability, safety, clarity, maintenance, etc.
  • Understand “business as usual” without MBSE products, services, and practices.
     
  • Elicit:
    • the applicable Staff allocation, the duration of the acquisition phase and the operational phase, the need for any training of new skills, labor rates, the use and cost of any tools or services that would be obsolete after adopting the MBSE practices, and the need for any new supporting tools or services if MBSE practices were to be adopted.

Recommendation

  • Monetize expenses and incomes for both business as usual and for the organization if it were to switch to MBSE practices.
  • Negotiate with the Stakeholders a Value-based Economic Model that offers high IRRs in excess of the organization’s required rate of return.
     
  • Combine the subjective benefits and the economic benefits into a cohesive argument that can be appreciated by business stakeholders who may never see an MBSE tool or participate in an MBSE activity.

Recommendation

Promoting MBSE...

An Economic Model for Estimating MBSE IRR Benefits

By Lonnie VanZandt

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An Economic Model for Estimating MBSE IRR Benefits

A Presentation on MBSE IRR for No Magic World Symposium 2017

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