There are certain types of products which aren’t easy to gauge in advance whether or not they’ll be successful.
For these, there are some tools that I learned during university and later from working in corporate finance that gave me a useful framework for making these decisions. The more experienced you are in your field, the better these tools can work for you. They should be thought of more as a guide or as another factor in your decision making toolkit rather than actually have this make the decision for you.
Before I get into it, there are a few situations where you really don’t need to do the whole analysis.
This is all relative to your company size and you can figure this out by common sense but if you’re a multimillion dollar company, then doing product launches that look promising that cost thousands of dollars should not be something that you need to spend too much time thinking about if revenues are in the millions. It would be a waste of time and company resources to use this framework on relatively insignificant projects. If it’s a few hundred thousand dollars on the other hand, then clearly some more analysis is required. If you’re Amazon on the other hand, then your threshold for significant consideration will change dramatically.
Availability of Verification Sources
If you already have existing sources where you can pre-sell, then you should always adopt this method first. Some examples include:
- Email List – you can launch a pre-order to your email list. The size of pre-orders alone can eliminate all risk of project uncertainty. For example, if the cost of a new project is $10,000 and you can cover the total cost of the new project by way of presales, it’s a no brainer to do this.
- Crowdsourcing – you can pre-sell using things like Kickstarter and Indiegogo. This is a bit of a mixed bag since the time and effort to run a successful campaign in itself can represent a fairly large commitment of time and resources (whereas writing a few emails to your list is relatively low cost in most instances).
- Expressions of Interest – if you’re in B2B, you or your sales team can gauge sufficient interest by simply asking your existing clients whether it’s something that they’d purchase. You can also ask for a deposit or full payment upfront in advance depending on the type of service/product being considered as well as the industry. This can apply to enterprise clients, distributor clients, etc.
The Smart Watch Company
Let’s say that you’re considering launching a new smart watch. You see a gap between the cheaper Chinese variations and Apple and price it at $127.00 and your total cost is $50.00
The total cost is $1.7 million dollars to launch the product and another $100,000 in marketing expenditure.
The $1.7 million is made up of $500,000 initial fixed costs including tooling, some research and development, and patent fees. The balance is the cost of the product, shipping costs, import taxes, etc. That means that you’ll have 24,000 units given the $1.2 million in variable cost.
You will need to pay the $500,000 in month 1 for the fixed costs, another $500,000 in deposit for manufacturing in month 2, and the balance of $700,000 on delivery in month 3. The product will arrive in month 4 and you’ll also need to spend the $100,000 in marketing fees by this stage, primarily on advertising and promotions generally.
You’re currently in the Internet of Things (IoT) business and you have some relevant customers for this product.
Your current annual turnover is $5 million dollars and you’ve got around $800,000 cash in the bank. In order to undertake this project, you’ll need to take a loan of $1 million from the bank.
You’ve thought about launching to your own customer list but the problem is that you make most of your sales on Amazon where you don’t get to keep customer information and your customer list is only 1,000.
You’re really confident about this product and you’ve added a unique twist to your smart watch which you think will really enable your innovative product to dominate the market but you’re worried about it going sideways which could potentially sink the entire company given the size of initial investment required.
Hence, you’ve decided to use some financial tools of the trade to assist you in making a judgement call.
The first thing you’ll need to nail down is the expected revenue and profit. The keyword here is expected. Since you don’t know how the mass market will react for sure, you can only guess and say that you expect a certain dollar amount to eventuate.
This is why I said initially that having experience is immensely useful. If you’re brand new to the industry, it’s going to be much harder to realistically gauge the probabilities of success. However, if you are indeed starting a new company or you’re an existing company venturing into an altogether different industry, then you can try the prototyping route if possible which is outlined in the sprint method. This can help you make better judgement calls here but it’ll never substitute actual industry experience. Part of the reason comes down to execution risk. A lot of great ideas fail because of this and to judge execution risk without ever having done it is quite difficult. For example, I’ve developed expertise around selling physical products online. I might decide that opening a physical store front is a great idea. However, since I’ve never worked a day in retail and given that retail is a fundamentally different business, I judge my ability to execute well as being very low. There are things I can do to mitigate that risk if I really, really want to go down that route like hire a retail expert but that’s another story (and maybe another article).
Expected Future Values
The nature of corporate planning typically spans many years and sometimes even decades, for example pharmaceutical companies when they’re researching and developing new drugs and trying to take them to market. They can afford to do this due their financial strength and certainty of future cash flows. For most small businesses, we tend to think in months and years more due to the lack of financial strength and lack of certainty around future cash flows. For that reason, I think it’s better to make these calculations in terms of months as oppose to years but of course, this will depend on your company’s financial situation and the nature of the projects you’re looking at.
We know the outlays which was outline earlier:
Month 1: $(500,000)
Month 2: $(500,000)
Month 3: $(700,000)
Month 4: $(100,000)
Now comes the guessing part. Let’s say that we’re going to pay our best influencers as part of our marketing expenditure in month 4 together with lots of social media advertising and Amazon sponsored ads spending. Based on previous product launches, we have a range of expected outcomes for how well our product will do during launch month which occurs in month 4:
20% chance of 4,000 units sold
45% chance of 2,000 units sold
30% chance of 1,000 units sold
5% chance of 0 units sold
Based on this, we expect to sell 2000 units in Month 4 (20% x 4,000 + 45% x 2,000 + 30% x 1,000 + 5% x 0).
That works out to being $254,000 in sales and $154,000 in operating profit (this excludes any interest charges the bank will inevitably charge us).
Let’s assume that months 4-9 stays the same but months 10-12, we expect sales to at least double or triple on average due to the holidays based on past experience. To be conservative, we’ll say that they just double during that period.
In this case, here is how the months will look:
Apr: $(100,000) + $154,000 = $54,000
This delivers $1,848,000 in operating profit and all 24,000 units have been sold. Averaged over 9 months, that’s $205,333 in operating profit per month. That works out to being approximately a 12% return on capital ($205,333 / $1.7 Million) per month or 145% per year.
Another way to look at it is that it will take a bit over 9 months to get your money back and then afterwards, it’s delivering cash at an average rate of $205,333 afterwards.
Whether or not everything happens according to plan is another story altogether. Maybe you’re working with a new factory and they screw up the whole thing leaving you with a lot of debt and unhappy customers wanting refunds. Or you were unable to obtain any patent claims and a competitor comes in the market a year later with a slightly better version of your product and you take a big hit to revenues. That’s why it’s important to think about what could go wrong and the potential impact to the company.
Protect the Downside
The ideal scenario you want is minimal downside risk and maximum upside potential. In the investment world, we refer to this as asymmetric risk. You are overcompensated given the lack of risk you’ve taken (or undercompensated because of the excessive risk you’ve taken).
In this specific scenario, we’ve outlined our odds of failure at 5%. Our expected payoff in the first year is 145%. That makes this a good example of asymmetric risk reward on the upside. Does that mean that you should automatically give this project the green light? Not necessarily.
The 5% risk can still occur and if it does, you need to figure out what it’ll mean for the company. If the project failing means sinking the ship, then it’s probably not worth it, especially since we’re needing to lever up in order to undertake the project. No matter what happens, you ultimately want to be able to stay in the game. Too many companies make this mistake, misjudge the risk, lever up and lose the game at some point.
In this specific example, the company is making $5 million a year. Let’s assume that it’s left with 30% after all expenses so that it’s left with around $1.5 million per year. At this rate, it’ll take less than a year to pay off the loan of a million dollars with typical business loan rates in case the smart watch launch fails completely. So that means we’re still protected on the downside. It’ll be a painful loss but we’ll still be in business even if it fails.
Judge Against Alternative Opportunities
The next point of analysis is to see the alternative uses of capital in opportunities that are available for us. Perhaps we have another 10 or 15 relatively small projects that costs between $20,000 and $150,000 to launch each product. Assuming we have the man power to be able to launch all of them effectively in the same time frame, we’ll need to estimate the expected payoff of the alternative projects using the same method that I’ve outlined above.
The reality is that launching that many projects will probably take much longer, say 1 year. That also means that not as much of our money is being utilized in making more money for us. The upside though is that we’re not so heavily invested in the one product and therefore, the risks aren’t all focused in the one place.
If the average of these other projects will return more money over the same period of time, then it certainly makes more sense to invest in these.
Ultimately though, after you’ve run through all of the numbers, you need to make a judgement call based on your intuition and business experience. This analysis should help you but not decide for you. There are always multiple factors involved. Perhaps the smart watch will have a longer product life since it’s unique, innovative and you’re able to secure a patent. This will potentially add a new offline stream of revenue as you’ll have more distributors knocking at your door. Then again, the industry could shift in 5 years time and render the product completely irrelevant because smart watches have been replaced by a new innovative high tech bracelet from Apple.
Having said all of that, you don’t want to fall into the trap of analysis paralysis either.
“The risk of a wrong decision is preferable to the terror of indecision.”