Product development

economics
Sreekumar.P

Product Development
Process

Product Design and

Development Process

Economic Analysis of a new

product
The profitability or financial viability of
the new product has to be checked
before deciding to produce it.
This Economic Analysis is done in 2
parts
1. Quantitative Analysis
2. Qualitative Analysis

Quantitative Economic
analysis
This based on the cash inflows
( investments/ costs) and expected
cash inflows in future, from the new
product.
The financial tools used for this analysis
are,
Payback period method
NPV ( Net present Value) approach
IRR ( Internal rate of Return ) method
Profitability Index
Sensitivity analysis

Qualitative analysis
A new product/project interacts with the
Firm, the Market and the Macro business
environment. So the influence on these
qualitative factors are to be considered
while evaluating a new product
1. Interaction between Product and the Firm
2. Interactions between the Product and the
market ( customers, suppliers, competitors)
3. Interaction between the product and the
Macro business environment in the country
( Political, social, economic environment)

Qualitative factors interacting

with the new product

Product
Firm
Market
Macro Business Environment

When to do Economic
analysis?
Go-No Go milestones within different
stages of Development. Eg. Between
Concept development and Concept
testing
Before taking Operational decisions
like Outsourcing a part of the
development, Speeding up
development time etc.

Economic Analysis process

Select a basic
financial
model

Perform
sensitivity
analysis

Understand
project Trade-offs
Consider the
impact of
Qualitative
factors

Financial Models
1.
2.

3.
4.

Payback Period method(PB method)

NPV model ( Net Present Value
Model)
IRR Model( Internal Rate of Return)
Profitability Index

Payback period method

Consider the total Investment required

for launching the new product and the
future profits that can be expected
every year due to the new product.
Add up the future profits and see in how
many years the total profits equals the
initial investment.
If Investment is I and future profits for 5
years are P1, P2, P3, P4, P5.
If P1+P2+P3 = I, then Payback period is
3 years.
While comparing several products,
select the one with the Least PB period.

Capital Expenditure Data for 2

new products

10-12

NPV model( Net Present

Value)
Principle- A Rupee tomorrow is worth
LESS than a Rupee today. ( a bird in
hand is worth more than 2 in the bush)
In this method, the future profits/
annual cash flows are discounted to
the Present value using a discounting
rate. This PV is compared with the
initial investment in the product. If
sum of PV is more than investment,
the project is profitable.

NPV
NPV = discounted sum of PV
Investment. If NPV is Positive, the
product is profitable.
If multiple projects are evaluated,
select the project with the HIGHEST
NPV.
Discounting rate is considering
inflation, cost of capital( bank
interest). Etc. Normally 10 to 15%

NPV Formula

Numeric Problem
A Project has Rs. 1,00,000 investment.
Expected cash flows are, Rs. 20000,
30000, 50000, 10000 in the end of
first, second, third and 4th years.
Assume Discounting Rate 12%.
Is the Project Profitable?

( PV Table, 12%, 0.89,.79,.71,.64)

IRR method ( Internal rate of

Return).
IRR is the % or rate that makes the
Discounted cashflows/profits EQUAL to the
Investment.
It indicates a No profit- No loss situation.
Cash flows discounted at IRR = investment.
Or, Cash flows discounted at IRR
Investment = 0.
If IRR is more than Cost of Capital ( bank
loan interest), the product is profitable.
In case of multiple projects, select the
project with Highest IRR.

Formula for IRR

Difficult to calculate IRR manually. So

use calculator function. Or by trial and
error. Start with IRR 10%, if the NPV is
positive, then increase IRR to 12 and
try.
NPV and IRR methods may give
different answers. Because the time
factor of cash flows is considered.

Profitability Index
Ratio of Discounted profits/ investment
If it is more than 1, accept the project
Profitability Index = PV/Investment

Economic Analysis process

Select a basic
financial
model

Perform
sensitivity
analysis

Understand
project Trade-offs
Consider the
impact of
Qualitative
factors

Sensitivity Analysis
After selecting the financial model for
project/product evaluation, the different variables in
the model are changed to see how it is influencing
the outcome or profit.
It is testing what if situations.
Eg. If we select IRR model and the result now shows
IRR 15% and capital cost( bank interest) 12%, the
project is acceptable. But we must do sensitivity
analysis assuming if bank interest increase every
year by 2%, and what will be the outcome/profit.
Or find sensitivity of profits if material costs
increase 2% every year. Or chages in development
time, cost etc.

Economic Analysis process

Select a basic
financial
model

Perform
sensitivity
analysis

Understand
project Trade-offs
Consider the
impact of
Qualitative
factors

Project Trade-offs

There are 4 major factors which

influence the sensitivity of the financial
models. We have to understand these
variables and their interactions. There
are 6 possible interactions.
Development
Time

Product
Performance

Product cost

Development
cost

Trade offs
Eg. Decreasing Development time may
result in lower product performance
Eg. Decreasing product development
time may result in increasing
development cost.
All such trade-offs are to be considered
Limitations of Quantitative Analysis
1. Focus on measurable data only.
2. Depends on validity of assumption.
3. Managers make excuses like too
much development time shortens lifecycle.

Economic Analysis process

Select a basic
financial
model

Perform
sensitivity
analysis

Understand
project Trade-offs
Consider the
impact of
Qualitative
factors

Qualitative factors interacting

with the new product

Product
Firm
Market
Macro Business Environment

Qualitative analysis of NPD

Interactions between project and Firm
1. Externalities- it is the cost or benefit
imposed by one part(department) of the firm
on another part. A Positive Externality
means , the learning from a NPD project will
benefit all future NPD projects. A negative
Externality means, the resources blocked for
one NPD project is delaying other NPD
projects.
Strategic Fit- means the NPD project should
be in tune with the over all growth
objectives or mission of the firm.

Interactions between Project

and market
Competitors- will introduce products directly
competing or substituting products
Customers- their expectations, tastes may
change over time. Eg. Denim, Jeans, Fuel
economy cars.

Interaction between project and

macro environment
Economic changes- bank rates, credit,
income, taxes, Forex rates
Govt. regulations- LPG policies,
Technology import, FDI rules, Start up
support
Social trends- changing demographics,
infra development, literacy rates,
environmental awareness, pressure
groups.