Case Study
Real Options for Machine Transition to Ethernet
Katrina Jennings
Fall 2023
This report presents a detailed financial model for transitioning heavy equipment communication protocols from CAN and ISOBUS to Ethernet. The study utilizes a real options analysis to evaluate the economic impact of integrating Ethernet ports upfront, facilitating increased technology and feature integration in heavy equipment. This transition addresses global challenges related to the increasing pressure for efficiency in operations using heavy equipment and adapting to rapidly evolving technology demands while managing rising costs and stringent environmental regulations.
image by Artinun @ Adobe Stock
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Key Idea Description
Resilience of Ethernet transitions in heavy equipment, focusing on the economic and strategic benefits of integrating Ethernet-based communication systems.
- Broad Area: Resilience, Precision, Profit Maximization
- Main issues of case: Technology Choice, Automotive Design, Capacity Expansion
- Main analytic topics: High-level Technology model, High-level Screening model, Uncertainty Analysis, Multidimensional Comparison of Alternatives
Insights
- Ethernet Adaptability as a Core Strategy: This study emphasizes the crucial role of Ethernet in enhancing data transfer capabilities essential for advanced automation of heavy equipment. Transitioning to Ethernet not only improves machine efficiency but also expands revenue opportunities through new software features, preparing for future technological demands.
- Modular Design Benefits: The report highlights modular design as a key strategy in heavy equipment development. This approach allows for adaptable Ethernet port expansions, managing upfront costs and adapting to future technological needs, thereby optimizing long-term investment returns.
Training
Relevant lectures:
- Paradigm change in engineering systems and planning
- How to optimise design and decision-making under uncertainty
- How to manage the design process
Abstract
Over the last decade, various industries relying on heavy equipment have been experienced shifts in response to escalating costs of commodity, material and inputs, driving equipment users across sectors to seek increased efficiency and productivity while navigating increasing pressure in environmental standards and regulations.
In order to support this new business need from customers, heavy equipment machinery and industrial systems manufacturers must now support an industry shift where solutions are more software feature-based and the technological capabilities of equipment are rapidly increasing. This has driven the equipment industry to focus on new business strategies to unlock recurring revenue opportunities. One agricultural machinery manufacturer has even set an aggressive financial goal of 10 percent recurring revenue by 2030. (John Deere, 2022) By adding technology on to the machines, the companies will enable the increase of margins (profits) that are not made directly from the sale of the iron.
To support this demand for increased technology, there is a general trend in equipment to transition from traditional on-machine communication protocols like Controller Area Network (CAN) and ISOBUS to Ethernet-based solutions. Ethernet better supports an increase in software-based solutions due to its capability to offer higher data transfer rates, greater bandwidth, and improved flexibility compared to the older protocols, making it more suitable for handling the increasing complexity of added features and devices.
Traditional cost structures of large equipment companies pass all product costs, including electronics for communications, along to the customer, and then apply some profit to calculate product pricing. The financial target metric cost/price ratio (Also commonly referred to as “C/P Ratio”) of the heavy equipment products can prevent absorption of high up front cost for the sake of upside gain (in modularity and other areas).
The rest of this report will analyze a project business model for ethernet-based machine communication physical layer and explore three types of flexibilities built into the system design that aim to inform decision makers on real machine infrastructure options based on project returns.
The value that will be analyzed will be a cashflow analysis that considers the time value of money, resulting in a net present value (NPV) value. The Annual Revenue from Device-Enabled Feature Sales is 100% of the annual revenue considered for the project, while the Expenses are broken out into Annual Part Costs, Cost of Machine Space, Operating Expenses to Maintain Design, and R&D Costs for switching the network. The financial model used in this project is outlined in the System Model section of this report.
The base case was actually analyzed in a way that the typical heavy equipment machinery manufacturer viewed as highly costly up front that may not be financially feasible for part costs but is easy to integrate because of modularity. The entire ethernet physical layer is converted at once to support all potential features a customer may wish to subscribe to during the machine’s lifecycle, although the subscriptions may not be available or desired in the first few years of ownership.
First, a cashflow analysis of the base case with static input variables was analyzed. The NPV of this deterministic base case was found to be $22.06M, using a discount rate of 12%. Next, the same model was analyzed while applying uncertainty to the input variables of annual machine sales volume, part expenses, Device-Enabled Feature subscription volumes, and Price Per Device-Enabled Feature. After running a Monte Carlo simulation of 2000 runs, the average NPV was found to be between $16.5M and $16.6M with 95% confidence, which is much lower than the deterministic NPV of $22.06M. This can be expected when accounting for variability of the aforementioned factors, and exposes the innate weaknesses in the deterministic calculations to account for both risk and opportunity, and with variation factored in, decision-makers can be much better informed in decisions for the system lifecycle.
Additionally, this report examines real options that build flexibility into the system design. The first flexibility I explore varies the number of ports (via the modules housing the ports called the “switch”) based on demand for average number of features. In the second flexibility, I look at integrating the individual ports into the existing network of controllers up front. Running the Flexibility 1 with an IF statement in the sensitivity analysis, yields as expected, very little variation to the NPV. To test the potential option for integrating many years of individual ports into the existing network of controllers up front (Flexibility 2), I ran the Monte Carlo simulation with 2000 runs, yields an average NPV that is between $17.1M and $17.3M with 95% confidence. Flexibility scenario 2 offered increased upside and downside gains as compared with the base case scenario with variability, and higher probability of realizing those upside gains as well. This report recommends implementing Flexibility 2.
It is critical to note that if a business were to optimize the financial metric Cost-Price Ratio (C/P Ratio) of each product sold, Flexibility 1 would be the obvious choice, due to the lower part costs per unit sold. This analysis shows that C/P ratio is not a metric that drives decision-makers to consider real options, and looks only at immediate, or short term, time frames of cost structure. However, when considering the longer-term value to a company, Flexibility 2 scenario holds the greatest potential for higher reward in all areas of consideration, as opposed to optimizing the single metric of cost-price ratio.
A future effort on the nature of combinations of switches, and switch families for different machines, is recommended for further refinement of the model. Additionally, exploring the lost opportunity cost that cannot be captured from machines that don’t have the hardware capabilities early on, but demand for the automation features in used equipment increases.
In order to support this new business need from customers, heavy equipment machinery and industrial systems manufacturers must now support an industry shift where solutions are more software feature-based and the technological capabilities of equipment are rapidly increasing. This has driven the equipment industry to focus on new business strategies to unlock recurring revenue opportunities. One agricultural machinery manufacturer has even set an aggressive financial goal of 10 percent recurring revenue by 2030. (John Deere, 2022) By adding technology on to the machines, the companies will enable the increase of margins (profits) that are not made directly from the sale of the iron.
To support this demand for increased technology, there is a general trend in equipment to transition from traditional on-machine communication protocols like Controller Area Network (CAN) and ISOBUS to Ethernet-based solutions. Ethernet better supports an increase in software-based solutions due to its capability to offer higher data transfer rates, greater bandwidth, and improved flexibility compared to the older protocols, making it more suitable for handling the increasing complexity of added features and devices.
Traditional cost structures of large equipment companies pass all product costs, including electronics for communications, along to the customer, and then apply some profit to calculate product pricing. The financial target metric cost/price ratio (Also commonly referred to as “C/P Ratio”) of the heavy equipment products can prevent absorption of high up front cost for the sake of upside gain (in modularity and other areas).
The rest of this report will analyze a project business model for ethernet-based machine communication physical layer and explore three types of flexibilities built into the system design that aim to inform decision makers on real machine infrastructure options based on project returns.
The value that will be analyzed will be a cashflow analysis that considers the time value of money, resulting in a net present value (NPV) value. The Annual Revenue from Device-Enabled Feature Sales is 100% of the annual revenue considered for the project, while the Expenses are broken out into Annual Part Costs, Cost of Machine Space, Operating Expenses to Maintain Design, and R&D Costs for switching the network. The financial model used in this project is outlined in the System Model section of this report.
The base case was actually analyzed in a way that the typical heavy equipment machinery manufacturer viewed as highly costly up front that may not be financially feasible for part costs but is easy to integrate because of modularity. The entire ethernet physical layer is converted at once to support all potential features a customer may wish to subscribe to during the machine’s lifecycle, although the subscriptions may not be available or desired in the first few years of ownership.
First, a cashflow analysis of the base case with static input variables was analyzed. The NPV of this deterministic base case was found to be $22.06M, using a discount rate of 12%. Next, the same model was analyzed while applying uncertainty to the input variables of annual machine sales volume, part expenses, Device-Enabled Feature subscription volumes, and Price Per Device-Enabled Feature. After running a Monte Carlo simulation of 2000 runs, the average NPV was found to be between $16.5M and $16.6M with 95% confidence, which is much lower than the deterministic NPV of $22.06M. This can be expected when accounting for variability of the aforementioned factors, and exposes the innate weaknesses in the deterministic calculations to account for both risk and opportunity, and with variation factored in, decision-makers can be much better informed in decisions for the system lifecycle.
Additionally, this report examines real options that build flexibility into the system design. The first flexibility I explore varies the number of ports (via the modules housing the ports called the “switch”) based on demand for average number of features. In the second flexibility, I look at integrating the individual ports into the existing network of controllers up front. Running the Flexibility 1 with an IF statement in the sensitivity analysis, yields as expected, very little variation to the NPV. To test the potential option for integrating many years of individual ports into the existing network of controllers up front (Flexibility 2), I ran the Monte Carlo simulation with 2000 runs, yields an average NPV that is between $17.1M and $17.3M with 95% confidence. Flexibility scenario 2 offered increased upside and downside gains as compared with the base case scenario with variability, and higher probability of realizing those upside gains as well. This report recommends implementing Flexibility 2.
It is critical to note that if a business were to optimize the financial metric Cost-Price Ratio (C/P Ratio) of each product sold, Flexibility 1 would be the obvious choice, due to the lower part costs per unit sold. This analysis shows that C/P ratio is not a metric that drives decision-makers to consider real options, and looks only at immediate, or short term, time frames of cost structure. However, when considering the longer-term value to a company, Flexibility 2 scenario holds the greatest potential for higher reward in all areas of consideration, as opposed to optimizing the single metric of cost-price ratio.
A future effort on the nature of combinations of switches, and switch families for different machines, is recommended for further refinement of the model. Additionally, exploring the lost opportunity cost that cannot be captured from machines that don’t have the hardware capabilities early on, but demand for the automation features in used equipment increases.
Summary
Introduction to Real Options for Machine Transition to Ethernet
The report analyzes the transition of heavy machinery communication protocols from traditional CAN and ISOBUS to Ethernet-based solutions. This transition supports increased technological capabilities, higher data transfer rates, and improved flexibility, addressing the industry’s need for more software-based solutions and recurring revenue opportunities.
Understanding the Project’s Scope
The traditional cost structure of heavy equipment, passing all costs to customers, is challenged by the need for modularity and higher initial investment. This report explores a business model for an Ethernet-based communication layer, aiming to inform decision-makers on the financial implications and benefits of integrating flexibility into the system design.
Base Case Analysis:
- Static Base Case: The deterministic NPV of the static base case was $22.06M using a discount rate of 12%. This case assumed all Ethernet capabilities were integrated upfront, which was easy to integrate due to modularity but highly costly.
- Uncertainty Analysis: A Monte Carlo simulation with 2000 runs revealed an average NPV between $16.5M and $16.6M, showing the impact of variability in input factors such as annual machine sales volume, part expenses, subscription volumes, and price per feature.
Flexibility in System Design
Two flexibility options were explored to integrate Ethernet into the machinery effectively:
- Flexibility Option 1: Varies the number of ports based on demand, resulting in minimal variation to the NPV. The hypothesis showed limited impact on NPV sensitivity.
- Flexibility Option 2: Integrates individual ports into the existing network of controllers upfront, yielding an average NPV between $17.1M and $17.3M with 95% confidence. This option showed increased upside and downside gains compared to the base case with variability.
Economic Performance
- Base Case NPV: $22.06 million
- Probabilistic NPV Range: $16.5 million to $16.6 million
- Flexibility Option 2 Probabilistic NPV Range: $17.1 million to $17.3 million
Implications for Industry
This case study illustrates that incorporating flexibility into the design of heavy industrial and agricultural machinery not only supports technological evolution but also provides a financial hedge against uncertainty. By enabling Ethernet-based communication, manufacturers can unlock new revenue streams and adapt more rapidly to market demands.
Conclusion
Recommended for its potential to maximize long-term value despite higher initial costs. It minimizes risk while offering significant upside gains. While optimizing C/P ratio may favor Flexibility 1 due to lower part costs per unit, long-term value analysis supports Flexibility 2. The analysis underscores the importance of considering real options and flexibility in system design, particularly in industries undergoing technological shifts. By adopting Ethernet with strategic flexibility, heavy machinery manufacturers can better accommodate future technological advancements, potentially enhancing profitability and adaptability.