Computing product ROI is one of the most fundamental jobs of a Product Manager. ROI computation of the new product after determining the pricing and the model (SaaS or a perpetual model) is a simple sequence of steps. Product Manager with a flair for mathematics would get rid of this phase with utmost ease as long as (s)he can forecast units sold for each quarter for the entire lifetime of the product. Some of us falter as ROI computation is not an everyday activity. So through this blog post, I have tried to provide a step-by-step guide for calculation of ROI of the new product. To compute ROI for any new product, we should determine the following.
- Revenue estimation
- Cost estimation
- Operating costs – Cost of engineering, Capital expenses for buying equipment
- COGs – For HW products
- Royalty payments for IP (If applicable)
- License costs – If the new product incorporates SW of other vendors
- SG & A –SG & A covers sales, marketing and other administrative expenses associated with the new product. Standard mechanism is to calculate it as fixed % of overall revenues.
- Cannibalization impact
- Operating Margin
- Cash flow
- Breakeven or Payback period
- NPV (Net Present Value) of all future cash flows
- IRR (Internal Rate of Return) of all future cash flows
For better illustration, let us assume the lifetime of the new product as three years, and it took one year to develop the new product. Duration of a year is for conceptualizing the idea, validating the idea, building the product and finally, launching it. Completion of product validation through the MVP process also happens within a year. Even though revenues start flowing from the 1^{st} quarter of a 2^{nd} year, the ROI calculations should occur from the 1^{st} quarter of a 1^{st} year, as costs will be incurred for development of the new product and there will be capital inflow during the period. It is essential to include 1^{st} year to measure negative cash flows and calculate the payback period.
Important milestones for illustration
- The start of product development – Q1 Y1. The 1^{st} year includes all the activities related to product development – Idea validation, business review, product development, product development, MVP validation, etc.
- Product Launch – Q1 Y2. The launched product could be termed a minimum valuable product that a customer prefers to buy. The sales of the new product happen from Q1 Y2
Therefore, all calculations that I will do going forward will be done for 4 x 4 (4 quarters for 4 consecutive years)
Revenue estimation
Estimate the revenues for the perceived duration of the lifetime of the product. Ideally, I would suggest Product Manager estimates revenue based on a likely scenario. Later we can determine the worst scenario and the most optimistic scenario as % of a likely scenario. Most financials are computed on a quarterly basis, so let us follow the same standards to estimate the sales on a quarterly basis from the first quarter of enabling sales for the new products. There is a possibility to turn on pre-orders for few products before the actual launch. In such case, Product Manager should consider the date of enabling pre-order for estimating revenues and not use the actual launch date of the new product.
Q1 Y1 | Q2 Y1 | Q3 Y1 | Q4 Y1 | Q1 Y2 | Q2 Y2 | … | … | Q4 Y4 | |
Units | |||||||||
List Price / Unit | |||||||||
Discount % | |||||||||
Product Revenue |
Table 4 – Units forecast of the new product
Cost estimation
There are two types of costs incurred during the entire lifetime of the product (i) variable costs and (ii) fixed costs.
- Variable costs vary with the number of products sold to customers. For HW products, variable costs are incurred as soon as they are manufactured. However, for calculating ROI, it is ideal to account for variable costs after selling each unit. The costs of inventory are accounted for as sunk costs after killing the product and taking it away from the market.
- Fixed costs are costs incurred in developing new products, and they are independent of product sales. The product reaches breakeven when the revenues compensate for the fixed costs.
Variable costs of the new product are
- The cost of SW license added to the new product – The new product can include any SW from OEM vendors. The cost paid to vendors is proportional to the number of products sold
- COGs (Cost of Goods Sold) of the product – Applicable for HW products
- Royalty payment, cost of an Intellectual Property of an external entity
Each unit of the new product sold incurs the above cost. Always calculate per unit variable cost as the sum of all applicable costs listed above.
Fixed costs of the new product are
- Cost of equipment required for the new product development
- Engineering cost incurred to build, validate and support the new product.
The above costs can incur either once or at regular intervals. The above costs are independent of the number of products sold and they do not vary with the increase in sales.
Q1 Y1 | Q2 Y1 | Q3 Y1 | Q4 Y1 | Q1 Y2 | Q2 Y2 | … | … | Q4 Y4 | |
Units | |||||||||
List Price/ Unit | |||||||||
Discount % | |||||||||
Product Revenue | |||||||||
Variable Costs | |||||||||
Gross Margin | |||||||||
Gross Margin % |
Table 5 – Product revenue of the new product
Please be aware that only direct product costs are included in calculating gross margin. Fixed costs that that includes engineering cost and expenditure of capital assets incurred due to buying equipment to aid the new product development are not including for calculating gross margin. In addition to those costs, it is essential to account a few other operating expenses while calculating operating margin
Any cannibalization impact?
Consider the product revenue of any existing products that the new product might possibly cannibalize as a cost. Forecast how many units of existing product, do the new product cannibalize each quarter. Estimate the product revenue as outlined in Table-5. While calculating the net margins of the new product for each quarter, consider the product revenue of the cannibalized product as cost.
Q1 Y1 | Q2 Y1 | Q3 Y1 | Q4 Y1 | Q1 Y2 | Q2 Y2 | … | … | Q4 Y4 | |
Units | |||||||||
List Price/ Unit | |||||||||
Discount % | |||||||||
Product Revenue | |||||||||
Variable Costs | |||||||||
Gross Margin |
Table 6 – Product revenue of the cannibalized product
Total product revenue is the difference between the product revenue of cannibalized product and product revenue of the new product.
Using the above equations, I further proceed to compute the operating margin after accommodating the cost of cannibalization.
Q1 Y1 | Q2 Y1 | Q3 Y1 | Q4 Y1 | Q1 Y2 | Q2 Y2 | … | … | Q4 Y4 | |
Product Revenue | |||||||||
Variable Costs | |||||||||
Gross Margin | |||||||||
Gross Margin % |
Table 7 – Net product revenues of the new product
Operating margin
SG & A is the other major costs incurred by the new product. All expensed incurred for sales, marketing and administration of the new product are tagged under SG & A. In general, fixed % of revenue is allocated to SG & A. Please be aware of all the operation costs tracked in your organization. The majority of operating costs are calculated as fixed % of product revenues. For SG & A, let us assume SG & A spend is 10% of overall product revenues. Account fixed costs due to an expenditure of capital assets and engineering cost while calculating operating margin.
Q1 Y1 | Q2 Y1 | Q3 Y1 | Q4 Y1 | Q1 Y2 | Q2 Y2 | … | … | Q4 Y4 | |
Product Revenue | |||||||||
Variable Costs | |||||||||
Gross Margin | |||||||||
Capital Assets | |||||||||
Engineering Cost | |||||||||
SG & A | |||||||||
Operating Margin | |||||||||
Operating Margin % |
Cash flow
Cash flow indicates the amount of cash inflow after deducting all expenses from the product revenue.
Q1 Y1 | Q2 Y1 | Q3 Y1 | Q4 Y1 | Q1 Y2 | Q2 Y2 | … | … | Q4 Y4 | |
Operating Margin | |||||||||
Capital Expenditure | |||||||||
Cash Flow | |||||||||
Cash Flow (after Tax) | |||||||||
Cumulative Cash Flow |
Cash flow is mostly the same as operating margin unless there is a need to account for any additional capital expenditure that was not accounted for earlier. The early investment in the new product proposal was not consciously accounted, as it will be later spent on engineering, buying equipment etc. Those costs are accounted for anyways. Otherwise, we will double account the same money.
However, if there is any capital expenditure that we have not accounted until now should be accounted for in cash flow calculations, the formula is
Breakeven or payback period is the quarter during which the cumulative cash flow turns positive for the first time.
NPV (Net Present Value)
The entire lifetime of the new product is 3 years. Therefore, the organization earns revenue on the new product for 12 consecutive quarters. NPV indicates the current value of the sum of all future cash flows (both positive and negative) after deducting tax.
Use NPV formula in excel to calculate the NPV of both operating margin and capital expenditure.
- NPV of Operating Margin = NPV (LendingRate/4, Operating Margin of Q1Y1: Q4Y4).
- NPV of Capital Expenditure = NPV (LendingRate/4, Capital Expenditure of Q1Y1: Q4Y4).
- NPV of Cash Flow = NPV of Operating Margin – NPV of Capital Expenditure
Use the standard applicable lending rate and calculate the rate for a quarter.
IRR (Internal Rate of Return)
IRR is the rate at which the net present value of all future cash flows both negative and positive is zero. IRR is a measure of the attractiveness of investing in the new product. To calculate IRR, use IRR formula in excel.
- IRR = IRR (Cash Flow of Q1Y1:Q4Y4) * 4
Sometimes, we might have to present 3 scenarios for projecting ROI
- Less Optimal – This is the worst case scenario for the new product
- Optimal – Optimal situation and which is most likely to happen
- Most Optimal – Best scenario for the new product.
Product Manager can draw a scenario analysis to identify what factors would lead to each of those three scenarios. However, for estimating ROI for three scenarios, I would probably do it for an optimal scenario. For any scenario, estimating units forecast is the beginning. For less optimal and most optimal scenario, we can compute units forecast as % of units forecasted for an optimal scenario. Probably, I can use 80% for less likely and 120% for a highly likely scenario. After estimating units forecast, diligently following the above steps will help Product Manager compute all the required data for measuring ROI of a new product and build a financial summary for all the three scenarios.
Financial Summary | |||
Scenario | Less Likely | Most Likely | Highly Likely |
Product Revenue | |||
Variable Costs | |||
Gross Margin | |||
Gross Margin % | |||
Capital Assets | |||
Engineering Cost | |||
SG & A | |||
Operating Margin | |||
Operating Margin % | |||
NPV | |||
IRR | |||
Payback Period |
Table 7 – Financial Summary
The above table summarizes the entire elements related to the financials of the new product. CFO or VP Finance will be interested in checking whether NPV is attractive and IRR is above the expectations of the Organization. During the business review and later for pricing approval of the new product, the Product Manager will use the financial summary to summarize the overall attractiveness of the new product.
The excel sheet to perform the above ROI calculated could be downloadable from www.ProductGuy.in/The New Product – ROI.xlsx.
The contents are part of my eBook – Building Enterprise Products – Moving Targets of Customers’ Needs