What’s Pumping Your Profits: An Internal Look at the ROI of Product Development?
- When are expenses not just costs?
- Why do risky assumptions become seductive?
- How can you master the future by measuring the past?
- Where do you find undiscovered strategic intelligence?
- What is your P&L not telling you?
Even when all seems well, your business could still be bleeding valuable financial resources and losing its competitive edge. Perhaps you already realize you’re limping along with lackluster profits but don’t know exactly why. With the right tools to perform a deep internal review, you may discover some critical insights into the health of your business.
A way to enhance your company’s performance and optimize every dollar spent is to take a different approach to viewing operating expense. Think of operating expense not just as a cost, but in the same way you think of capital investments, which are expected to deliver a positive impact on profit.
Unfortunately, the budget process doesn’t always tease this out. It’s easy to fall into the trap of asking how much can we afford to spend instead of how will our spending contribute to the bottom line. Unlike capital investments, which are usually subject to formal evaluation and review, many businesses fail to analyze the return on initiatives funded from operating expense, both before and after they are given the green light.
Product development, for example, is often a significant part of operating expense and the lifeblood of a business. As technological change accelerates, businesses are forced to move faster and faster while product life cycles get shorter. As a result, there is greater reliance on new product offerings to stay competitive, grow your business and sustain profitability. Performing critical diagnostic tests of the product development process could reveal valuable information to optimize your performance and pump your profits. There is a lot at stake.
First, understand your products’ life cycles to determine the period over which you should expect a positive return on your investment (Payback Period). Use the Payback Period in your calculation of product development ROI. Finally, assess the effectiveness of your product development efforts and use the business intelligence you’ve gained to help frame the economics of your business and stimulate strategic thinking.
THE DIAGNOSTIC TESTS
A useful approach to understanding life cycle is to develop an “aging” of product sales. This is accomplished by graphing each year’s aggregate revenues broken down by original year of product introductions. It will show the progression of your products’ revenue production over time after the initial year of introduction.
Your particular industry can provide a benchmark for average product life and success rate of new product introductions against which to compare your own company’s track record.
For example, breakfast cereals will obviously have a different life cycle profile than smart phones or flat screen TV’s. Your target product life cycle will determine the time horizon (or Payback Period) over which you should expect to see a positive return on product development investment.
Short life cycles demand more immediate investment returns out of the gate while longer life cycles may allow you to recoup your product development costs over a longer time horizon.
Individual Product Profiles
The accompanying graph provides a drill-down view of life cycle performance for individual products. This view can give insight into the life cycle pattern associated with certain product characteristics, pricing or promotion strategy.
The ability to track these trends could provide valuable intelligence for future product development efforts or stimulate strategic thinking about the fundamentals of your business model.
Determining Payback Period
When possible, use historical performance as a guide to carefully determine Payback Period. The objective is to recoup your investment as quickly as possible. Remember that time is risk. Don’t be seduced into assuming a longer life cycle to beautify the economics. Set the Payback Period shorter than the life cycle of your products.
Calculate the aggregate return by comparing the profit contribution of all new products within the Payback Period against the investment in their development. This is consistent with the usual ROI analysis of capital investments – but with a twist. The difference is that much of the investment is in the form of operating expense directly related to the development of those new products, not just capital expenditures. Operating expense and capital expenditures must be gathered from whichever period incurred. We are not matching period costs with period revenues as in a standard P&L.
The ROI calculation can be expressed by this simple equation:
ROI = First Year Profit Contribution / Product Development Cost
- ROI is expressed as a multiple of Profit Contribution over total Product Development Cost. In this example, we use a one year Payback Period.
- For Profit Contribution, capture costs directly tied to promotion, sale and distribution of new products.
- Gather Product Development costs from whichever period incurred, including internal costs such as personnel directly involved in development.
It’s unreasonable to expect all new products will be successful and profitable. Looking at the aggregate return reflects the importance of having strong performers compensate for the shortcomings of products that don’t meet profit hurdles or don’t make it past the development stage and into market. The specific hurdle you establish for a healthy return on new products will depend on the overall economics of the business.
As products continue to sell beyond the Payback Period, their profit contribution should cover all other operating expense not associated with product development. Again, the profit hurdle for those mature products will be determined by the economics of the business.
For a better understanding of aggregate results, drill down to individual products to pinpoint which ones exceeded target return and which ones fell short. Identify the components of each product’s performance by looking at key variances in sales, gross margin, development cost, promotional cost, etc. Uncovering the story behind variances provides insight for future planning and decision-making in the product development process.
DIAGNOSIS AND TREATMENT PLAN
The results of these tests will reveal otherwise undiscovered strategic intelligence and establish a framework for evaluating the economics of your business model that a standard P&L cannot.
Other benefits of this approach will allow you to:
Create a product development team scorecard to promote accountability, compensate success and reward top performers with high-profile projects.
Define success by establishing minimum hurdles for expected returns of new products which will roll up to your company’s overall profitability target.
Focus efforts and resources on best profit potential products by also using this framework as a tool for the new product approval process. Simply substitute historical for forecasted figures and compare those returns against hurdles. Then rank products by profit potential to intelligently focus resources.
This in-depth look at the Product Development ROI can inform you of what’s really pumping your profits and provide a prescription for the ongoing health of your business.
K. Armen Miamidian is a time-tested CFO for successful mid-market companies in a variety of industries. He has provided financial leadership through rapid growth and new market expansion as well as developed and executed a pre-emptive recession management plan which actually improved profitability and financial strength during the depth of the recession in 2009. Armen earned his MBA in Financial Management and Economics at Drexel University in Philadelphia. He currently resides in Orange County, California with his family.