5.7 Verify Financial Viability

Now that you have learned about the first two elements of the cycle of satisfaction—deep customer insight and end-to-end 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.

To determine profitability, 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. We will discuss NPV in detail in Chapter 13. For now, let's keep our discussion simple. In essence, you will want to identify all relevant cash flows and their timing:

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

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

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

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

If your NPV analysis reveals that the product will not be profitable, you have two options. Most likely, you'll kill the concept (this is the no-go decision). However, sometimes a product concept is too important to your company's future to simply kill. For example, when the finance guys at Honda calculated the profitability of its newly redesigned 1998 model Accord, to everyone's shock, the results showed that Honda would lose money on every Accord sold. Two findings riveted decision makers' attention:

1. The new design really was what Honda needed to bring to market in order to compete.

2. Rivals offered competing vehicles for 25% less than Honda's new design.

After carefully considering these two facts, the Honda team initiated a rigorous target-costing analysis. Figure 5-10 shows the six-step target costing process. Let's briefly comment on each step.

• Step 1: Product Characteristics. Product characteristics define the product; that is, both what it should do for the customer and how it will do it.

• Step 2: Target Sales Price. The sales price is determined by "what the market will bear." This market-bearing price is determined by three factors. First, what do competitors' offerings look like? Second, what do customers expect? Let's make a key point here: The Internet has increased pricing pressure. For example, customers can visit Best Buy, check out the products they are interested in, and then go home and look for a lower-priced equivalent on line. This practice is called showrooming. Similarly, you can download a manufacturer's invoice price from Edmunds.com before going to an auto dealership to negotiate the price of the new car you want to buy. Third, how distinctive is your product? Few companies offer a distinct-enough product to be able to set their own price. Even Apple had to bring out a low-cost iPhone to stay competitive!

• Step 3: Target Cost. The target cost is simply the target sales price minus the target profit (i.e., how much you need to make from each product sold).

• Step 4: Cost Breakdown. The cost breakdown is where target-costing's rigor comes into play. At this point in the analysis, you need to identify all of the components that make up your product. For a product as simple as a watch, you would want to consider the band, the case, the dial assembly, the timing mechanisms, the battery, et cetera. For a car, the component list is much longer.

• Step 5: Target Costing Process. The target costing process takes place at the component level. Each component team goes back to the proverbial "drawing board" and asks a series of questions:

  • If we changed the design, could we reduce the costs?

  • If we changed the materials, could we reduce the costs?

  • If we changed specifications, could we reduce the costs?

  • If we work with suppliers to help them build better skills, could we reduce the costs?

  • What other cost trade-offs could we evaluate to take costs out of the product/process?

• Step 6: Product Launch or Kill. If the target costing process is successful, you can proceed to launch. If not, it may be time to kill—or radically redesign—the product.

You may have already deduced the outome of Honda's target-costing initiative for the 1998 Accord. Working closely with suppliers, the product team actually reduced the cost of the new design by 30%. The launch was successful and target costing became a standard tool in Honda's NPD process.