It seems a contradiction. Calculating a financial return on a new product, something that does not exist yet. It is one of the biggest struggles for product developers. It is also a major component of the decision to go ahead with the development. And it can be a huge cost if you do not meet the target launch date!
Whatever type of project you do, there is no way around finances. When you as a product developer speak to your CEO, or the shareholders, inevitably one of the questions is “How much”. How much will it cost to get it done?... How much will I see as a return?
The simple truth is that the financial return on the launch of a new product is an important success criterium. But how do you calculate and predict the financial return of a new product before it even reaches the market?
The answer is the Net Present Value, or NPV. This is the common tool to calculate the value of a new product. This is also the way to calculate the impact of a launch delay. Before we can do that though, we need to collect some input data. Let’s take a look at the financial metrics that you can estimate and gather in the early phases of a new product development.
A side note: this works best for physical products, ie products that need manufacturing. For other type of product development - like software - the financials are a little different.
The customer insight phase
Every product development starts with the customer. You could start a new product development because you see the sales of a current product decline. You also might want to add a product to your portfolio to serve an upcoming customer need. You might want to change the whole industry by launching a breakthrough product. Whatever the reason to start a new product development, it starts with the customer.
In this phase you can estimate two pieces of financial data related to the customer. First you can check what value the customer attaches to your future new solution. Second you can assess how many customers will actually buy your future product - if it meets its promises.
The financial data in this first phase are price and volume estimates.
The product proposal phase
Once you have defined what problem to solve, or what 'need' to meet, you start working on the how. This is where you develop the physical product solutions – or rather proposals. I am a big fan of doing this with users in an iterative way. This way you can test your product proposals with customers as early as possible. It will give you valuable feedback and insights on what they like, and what they hate. This way you can get to an optimized product proposal fast. As you zoom in on what customers want, the willingness to buy increases.
Once you have your final product proposal, you can make an estimation of production cost. Also you can assess whether you need investments. These could include investment in a new production line, or in molds for packaging or….
The financial data in this phase are cost and investment.
The bottomline: product value
From the financial data so far, you can project the net turnover, the cost, the investment, and the profit. All these data you get in the time it takes to get to an optimized product proposal. With focus and the right structure you can get to this point in a few weeks, at most.
Once you have settled for your best product proposal, you can estimate the time it will take to get to launch. It is after this phase that you can give a launch date. Now you have to hit it!
Now that we have some financial data, we can calculate the value of the new product for the company. As there is still uncertainty, this is helpful when comparing options. For example, what is the value of your new product if you drop a benefit but develop faster. Also, it can help you compare projects if you have more than one development. And last but not least, you can calculate the financial impact of a late launch.
The most used financial tool to calculate the value of a new product is the Net Present Value.
The Net Present Value or NPV
The Net Present Value (NPV) is the understanding that time affects the value of money. Money earned today has higher value than money earned some months or years from now. This is because the money of today can be invested and start earning returns without delay.
Today you invest money. That money will result in a new product that generates a net income for a defined number of years. Each year that net income is worth a little less. This little less is the discount rate, usually the cost of capital. Below a simple example to illustrate the NPV calculation.
We have to invest 2 M into our new product development to get to launch. It will take one year to develop.
After this year, the product will generate 0.6 M in net income each year.
The expected life is 10 years, and we assume the net income is constant.
The discount rate is 10%.
The NPV is 1.69 M (only first 5 terms given):
The NPV in this example is 1.69 M.
A positive NPV means that doing the project increases the value of the company by the NPV value. A negative NPV means we are destroying company value by doing the project.
The NPV of 1.69 M means we are writing ourselves a check today of almost 1.7 million. That is a product development worth doing!
The cost of a launch delay
You can use the NPV to calculate the cost of delay.
Let us take a 3 months delay in our example. A delay of 3 months means we have 3 months less sales. The product cycle of our new product is still 10 years. Competition and the market determine the cylce, not when you launch. You will not get your 3 months sales. In numbers, it means your sales in the first year go down from 0.6 to 0.45.
Now we can recalculate our NPV with the lower sales in year 1. The result is an NPV of 1.55M.
Incredible! By loosing 3 months of the 10 year sales cycle, we loose more than 8% of the value!
If anything, this demonstrates how important it is to launch on time to meet your financial goals. The market does not give you back your missed earnings. This decreases the value significantly.
This is ofcourse only an example. The impact will differ from project to project. Variables like the investment, the time it takes to develop the new product, and the length of the product cycle all have significant impact. But it is also true that money you earn today is worth more than the money you earn tomorrow. Always feel a sense of urgency to launch as soon as possible, and on time.
You can calculate the value a new product brings to your company, even before you develop it. You use the Net Present Value to do this. A positive NPV means you write the company a check today for that NPV value, just by doing the project.
Once you promise the NPV, you have to stick to delivery on time of your new product. The penaly of a late launch is huge: your NPV quickly decreases with delay.
Want some help?
Would you like to discuss the value of your projects? I specialize in new product development.