Step-by-step guide for ROI computation of new product

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 is able to forecast units sold for each quarter for the entire lifetime of the product. Yet, 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 computation of ROI of the new product. To compute ROI for any new product, we should determine the following.

  1. Revenue estimation
  2. Cost estimation
    1. Operating costs – Cost of engineering, Capital expenses for buying equipment
    2. COGs – For HW products
    3. Royalty payments for IP (If applicable)
    4. License costs – If the new product incorporates SW of other vendors
    5. 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.
  3. Cannibalization impact
  4. Operating Margin
  5. Cash flow
  6. Breakeven or Payback period
  7. NPV (Net Present Value) of all future cash flows
  8. IRR (Internal Rate of Return) of all future cash flows

For better illustration, let us assume the lifetime of the new product as 3 years and it took 1 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 MVP process also happens within the duration of a year. Even though revenues start flowing from the 1st quarter of a 2nd year, the ROI calculations should happen from the 1st quarter of a 1st 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 1st year to measure negative cash flows and calculate payback period.

Important milestones for illustration

  • The start of product development – Q1 Y1. The 1st 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 customer prefers to buy. The sales of the new product happens 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

Formula

 

 

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 a 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 as sunk costs after killing the product and taking it away from the market.
  • Fixed costs are costs incurred in developing the new products and they are independent of product sales. The product reaches breakeven when the revenues compensate the fixed costs.

Variable costs of the new product are

  1. 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
  2. COGs (Cost of Goods Sold) of the product – Applicable for HW products
  3. 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

  1. Cost of equipment required for the new product development
  2. 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 amount of 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

Formula

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 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.

Formula

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 as 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 %

Formula

 

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 same as operating margin unless there is a need to account for any additional capital expenditure that was not accounted earlier. The early investment on the new product proposal was not consciously accounted, as it will be later spent on engineering, buying equipment etc. Those costs are accounted anyways. Otherwise, we will double account the same money.

Formula

However, if there is any capital expenditure that we have not accounted until now should be accounted in cash flow calculations, the formula is

Breakeven or payback period is the quarter during which the cumulative cash flow turn positive for the first time.

 

NPV (Net Present Value)

The entire lifetime of the new product is 3 years. Therefore, 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 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

  1. Less Optimal – This is a worst case scenario for the new product
  2. Optimal – Optimal situation and which is most likely to happen and
  3. 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 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 Organization. During the business review and later for pricing approval of the new product, 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.