4.5 Tools: Financial Viability

Now that you have learned about the first two elements of the collaborative innovation infrastructure—deep customer insight and end-to-end product development—let’s take a moment to reflect. What are you really trying to accomplish with all of this work? Answer: Your goal is to consistently bring great new products to market that solve customers’ problems profitably!

Without profit, you won’t have the money needed to invest in the next generation of customer-pleasing products. With this goal in mind, you need to ask, “Can we justify the cost of bringing this new product to market?” This question is part of the discussion at each stage gate. Two tools are commonly used to evaluate financial viability: Break-even analysis and net present value.

Break-Even Analysis

Let’s return to the stage-gate process. The first “go/no-go” decision takes place right up front as you screen each new product idea. As part of your evaluation, you ask, “Does the product provide a positive return-to-risk ratio?” At this early design stage, you don't have enough information to perform a detailed profitability analysis. However, you can probably run a break-even analysis.

As the name implies, a break-even analysis asks, “Can you make money (i.e., break-even) with this product?” That is, are likely sales (in units) sufficient to cover the costs of making the product? The equation to calculate the break-even point is as follows:

Where:

Q_BE = Number of Units to Break Even

FC = Fixed Costs

P = Sales Price per Unit

VC = Variable Cost per Unit

Now, let’s talk through the logic of the equation. The total cost of producing a product is the sum of the fixed and variable costs (see Figure 4.9).

• Fixed costs exist regardless of how many units you make. They are the costs of being in business (e.g., overhead and insurance).

• Variable costs are the costs associated with making each unit and include direct labor and materials.

Assuming your sales price (P) is greater than your variable costs (VC), every time you sell a unit, you pay off some of your fixed costs. This amount (P-VC) is called the contribution to fixed costs. So, you break even when you sell enough units (Q_BE) to cover your fixed costs.

You may be wondering, “Where do you get the numbers needed to calculate the break-even point?” Because you are early in the design process, you really don’t have accurate numbers. Rather, you work off of forecasts made by your marketing team (price) as well as accounting (fixed costs) and production (variable costs) teams.

Now, let’s walk through an example. Imagine you want to start up a company to manufacture and sell sporty polarized sunglasses designed in university colors and featuring university logos. You’ve done your homework and estimate the variable costs (including trademark privileges) will be $57 a pair and the fixed costs to be $78,000. Answer the following two questions.

1. If you sell the sunglasses for $99 a pair, how many pairs do you need to sell to break even?

2. If you can sell 5,000 pairs to current students and alumni of your alma mater, how much money will you make?

Break-Even Quantity

Your break-even quantity is 1,857 pairs of your alma mater’s sunglasses.

Profit

You calculate your profit by subtracting your total costs (i.e., fixed plus variable) from your total revenue, which is equal to your price times the number of units you sell. That is,

Based on this quick-and-dirty analysis, deciding to "go" on to the next stage probably makes sense.

Net Present Value

If a product makes it past the first stage gate, your next step is to develop a rigorous business case analysis (BCA). Your goal: To determine whether expected sales, growth, and profit justify the investment. Simply put, you want to know if the product will be profitable. At this point, you need to perform a serious profitability analysis. The financial analyst on your NPD team will calculate the expected net present value (NPV) of the product.

The NPV is simply the current value of all cash flows (current and future) related to the product. To calculate the NPV, you first need to identify all relevant cash flows and their timing. Typically, you will incur three types of cash flows: Initial outlays, annual costs/revenues, and end-of-life cost/revenues.

Initial Outlay:

• What will it cost to develop and launch the product?

Annual Costs/Revenues:

• How many units of the product will you sell (on a year-by-year basis)?

• What will it cost to promote and sell each product (on a year-by-year basis)?

• What will it cost to produce and deliver each product (on a year-by-year basis)?

• How much revenue will you generate on each sale (on a year-by-year basis)?

End-of-Life Costs/Revenues:

• What will the product’s end-of-life costs (disposal) look like?

Once you’ve identified all of the relevant cash flows, you may want to build a table to help you organize your analysis (see Table 4.4).

Now, let’s work through the sunglasses example above using the cash flows shown in Table 4.4. Imagine your up-front design and launch costs are $90,000. You expect to sell 2,500 pairs of sunglasses the first year and 5,000 pairs each year for the following four years. Your sales price will be $99 and your costs per unit (including overhead) will be $88. At the end of the five years, you hope to be able to sell Alma Mater Sunglasses for $100,000. If your required return (aka, your discount or hurdle rate) is 15%, what is your net present value (NPV)?

NPV = Sum of the Present Value of All Cash Flows − Inititial Outlay (i.e., design and launch costs)

You can use either your calculator or Excel to run the numbers. Since each calculator model uses a different sequence of buttons to compute the NPV, refer to your calculator’s user manual or Google the instructions to learn how your calculator works. In Excel, you will use the =NPV function as follows: =NPV(.15,27500,55000,55000,55000,155000) − 90000.

The decision rule is to proceed with the product development if the NPV is greater than zero and favorable when compared to other products vying for capital investment. Since your NPV is $120,173, you need to ask, “Do you have any other options under consideration that provide a higher expected return?”