The problem is that the most commonly used ROI techniques are built upon a set of project conditions that often are not valid for your innovation project. If those conditions are not understood and accounted for, the wrong decision can be made. You may choose to do a project you shouldn’t do, choose not to do a project you should do, or take the wrong approach for a project. Let’s look at the most commonly used project ROI measures.
The Breakeven Analysis places the emphasis of the ROI calculation on the size of the market opportunity. Breakeven Analysis answers the question, “How many units must I sell to generate enough money to pay for this project?” It is determined by dividing the cost of the project by the gross margin of a unit of the product. If it is likely that you can sell more than the breakeven point; do the project. If not; don’t do the project.
The deception with this technique is estimating the size of the market. For truly innovative products, the market size is unknown. There is no existing product or service that can be used to estimate the size of the market. Ken Olsen, the founder of Digital Equipment Corporation (DEC) is famously quoted as saying in 1977, “There is no reason that anyone would want a computer in their home.” But the market forecast is not always underestimated. Alex Lewyt, the president of Lewyt Vacuum Company said in 1955, “Nuclear powered vacuum cleaners will probably be a reality in ten years.”
So how do you estimate the size of the market? This is one where I recommend that you do a three point analysis, best case, worst case and most likely. Consider the opportunity and risk with each case. But don’t overlook the need to stimulate demand. You can create a market with advertising, product placement, endorsements, and marketing events. Innovative product development projects need to be about more than just the cool technology. Include in your product development project the promotion efforts to make your product go viral in the market.
The Payback Analysis places the emphasis of the ROI calculation on time to market. Payback Analysis answers the question, “How long until I have generated enough money to pay for this project?” It is determined by dividing the cost of the project by the amount of gross margin the new product sales generate every month (or year, or day, or fortnight). The answer is the number of months until payback. The business must then decide if they can wait that long to get all the money back.
There are two points of deception with this technique. The first is the cost of the project. The easiest way to get a rapid payback is to have a very small project cost. Of course that typically means that you won’t do a truly innovative new product, but instead just make a minor incremental improvement on an existing product. The second point of deception is that Payback Analysis doesn’t take into consideration what happens after the payback point in time. Do product sales grow exponentially or do they flatten out and quickly die off? We don’t know with Payback Analysis, we only know how fast we earn our money back.
With these inherent deception points, why would anyone use Payback Analysis? If your company is in a cash flow bind, Payback Analysis is very helpful. But if you are not strapped for cash, using Payback Analysis to decide which project to do will almost always decide against innovation. The Payback Analysis is the most risk adverse of the ROI calculations. Frankly, I don’t recommend it for new product development. It is good for incremental improvement projects and “one-off” projects; but it does not adequately consider the benefit of new innovation.
Net Present Value/Internal Rate of Return
I will discuss Net Present Value (NPV) and Internal Rate of Return (IRR) together since they use the same equation, just solving for a different variable in that equation. These techniques consider the long term value of the project. They are a time value of money calculation. They sum the incremental cost of the project and the incremental benefit of the project over some period of years and discounted at some time value of money discount rate. Using the formula you either solve for the value using a fixed discount rate, or you solve for the rate which results in the cost being equal to the benefit. A high value or a high rate means you have a good project.
The point of deception in this technique is determining the window of opportunity. The calculation assumes some number of years of sales that is usually based upon an estimated product lifecycle. What is often overlooked is the effect of competition on the sales during the lifecycle. Innovative products normally have little or no competition at the beginning of their lifecycle. The gross margins at this time are usually higher than later in the life cycle when competition is in the market. I have often heard the discussions about whether the product life cycle could or should be extended and additional years added to the calculation. I seldom hear the discussion about what could be done to radically accelerate the project so that the time period in which benefits start is much sooner. Those early benefits are during the window of no competition. The company can dominate in the market and lock is such a commanding share that competitors look for other opportunities.
When using NPV or IRR I strongly recommend that you challenge the team to provide an alternative plan that cuts the development time in half. Yes, this plan is likely to cost more. But innovative projects often are multi-year projects. Getting to market a year sooner with no competition can be extremely profitable, even with the higher project cost. The long time frame used with NPV and IRR can lead to a lack of urgency on completing the project. With that lack of urgency is lost opportunity.
Conclusion?So whether it is Breakeven Analysis with its market focus, Payback Analysis with its time focus or NPV/IRR analysis with the value focus; there are potential points of deception to consider. Understand these, account for these, and you will make better business decisions concerning innovation projects.