Returns from Product Development
A business needs to see that the investments it makes are driving a financial return. This sounds simple but “desirable returns” looks different to different businesses and these differences, explicit or implied, end up driving how product development is viewed and run.
Consider, for example, the typical venture capital funded startup. The shareholders of this startup are making investments now that will likely lead to near term losses but that later will hopefully lead to significant gains in the value of their equity.
Compare this to another example where a family owned packaging company has started developing software to automate a packing process. The family owned company has built significant wealth through profitability over the years and that profitability is desired by the family so that they can live how they choose.
The startup will see product development as an investment in future equity that will likely be valued as a multiple of revenue. The family owned packaging company will likely see product development investments as investments in reducing future costs or improving profitability.
These differences in how a company’s shareholders, its board and management think about returns feed through to what can end up being substantially different approaches to product development.
Rather than fight these differences, it’s better to first understand and accept them and find out how to work with them.
This article provides an outline of the different types of returns that companies doing product development are typically looking for. This context is important because not everyone understands how a company’s financials work.
This will give shareholders, boards, executives and product development leaders a common frame of reference to work from.
Returns from Product Development
The different types of returns companies doing product development typically look for are:
- Equity Gains: the technology built leads to an increase in the value of the company.
- Revenue Growth: the technology built leads to an increase in the company’s revenue.
- Increased Profit: the technology built leads to an increase in the company’s profits.
- Cost Savings: the technology built leads to a decrease in costs.
- Improved Cashflow: the technology built leads to better cashflow.
- Reputation: the technology built increases (or decreases) the company’s reputation.
This list isn’t mutually exclusive, there is overlap between each of these types of returns. A reduction in cost may increase profits. An increase in profits may increase
In practical terms, however, for our purposes here it is useful to simply consider them as discrete focuses, given the way companys and shareholders tend to think and behave.
Let’s look at each one of these types of returns in more detail.
Equity Gains
Equity, in the context of returns on product development, refers to the value of the company. It may also get referred to as the company’s shares, enterprise value or value.
Equity in its most simple form and its value is determined based measurable factors like revenue, profits and assets as well as harder to measure factors like good will, defensibility and intellectual property. The subject of valuing equity is far beyond the scope of this post.
A loss making company with minimal revenues can still have highly sought after equity. For example, that company may have a major contract expected to bring future gains or that company might have a new invention.
Other companies, with minimal intellectual property or assets may be solely valued on a multiple of their profits or a multiple of their revenue.
The state of the market can also have a bearing on the value of equity. Within the last few years due to shifts in the broader economic environment the value of profit making businesses has increased relative to loss making companies.
Examples of Equity Returns from Product Development
Product development targeting equity returns usually looks something like the following:
- Development of new invention (i.e. an algorithm, patentable solution, or robot)
- Investing more in product development now than revenue can currently cover with a hope that the product development costs are recouped in future increases in equity value (many VC backed businesses follow this).
Revenue Growth
Revenue is the money a company receives from customers and third parties, usually in exchange for providing something in exchange like products, services or use of an asset.
Examples of revenue are:
- Income received from customers when charging them a monthly subscription for the software the company built
- Income received from selling goods to a customer
- Income received from charging a customer for the effort personnel spent on providing a service.
- Income received for charging a percentage of the transaction or income your customer receives.
There are many more examples of revenue but these are listed here to illustrate what revenue can be.
Examples of Revenue Returns from Product Development
Product development targeting revenue returns usually looks something like the following:
- Development investments where the costs meet or exceed the near term revenue gains and profitability, but are expected to lead to revenue growth in the long term.
- Development efforts about building sufficient scale, with a view to achieving profitability later.
- Development efforts focused on increasing revenue from customers
- Development efforts focused on increasing signups or activation.
Profit
Profits are the money a company keeps after it has paid its expenses. Put differently, profits are a company’s revenue minus its expenses.
Profits, in practice, are a little more complicated with various definitions and measurements available. There are gross profits, profits made before you cover your overhead expenses and net profits, profits you make after all your expenses are covered. There are after tax and before tax profits as well. For our purposes here, we will just think of profits in their simplest form of revenue minus expenses as well as gross profits and net profits.
When profitability is a focus of returns a company will aim to make sure that it spends less on product development than it plans to charge customers.
Examples of Profitability Returns from Product Development
Product development targeting profitability returns usually looks something like the following:
- The cost of development for a customer must be covered by the income from that customer. Sometimes the cost may be shared across customers.
- The cost of development must be covered by the revenue expected to be received from customers.
- The cost of development must stay within a certain percentage of revenue from a prior year or measurement period (e.g. last quarter).
Cost Savings
Costs are the amounts a company must pay to conduct business. Cost savings are reductions to the amount of money a company must pay. Sometimes this is referred to as cost efficiencies or just efficiencies.
Examples of costs are:
- The cost of the product development team’s salaries
- The costs of the servers and infrastructure your technology requires
- The cost of parts if you’re making hardware or manufacturing
- The cost of goods
- The cost of property or leases
- The cost of capital
Examples of Cost Returns from Product Development
Product development targeting cost returns usually looks something like the following:
- An ongoing cost needs to be reduced or removed, some amount less than the cost saving can then be invested in product development to get the saving.
- A process needs to be automated because it has too many manual steps. The cost of those manual steps sets the upper limit of the budget for product development.
- A supplier’s costs are becoming too much so product development focuses on replacing the supplier with less cost.
Cashflow
Cashflow is somewhat similar to profits and costs except subtly but materially different. Cashflow looks at the flows of cash into and out of a business.
Consider the cashflow of many retailers. Retailers buy the inventory, say clothes, they want to sell. They often pay upfront. Then they need it to arrive, then sell it. This can take weeks and months. So cash goes out upfront to buy the goods then weeks later the retailer receives cash from its customers.
A company can be perfectly profitable yet go out of business due to cashflow. Often, when a company is growing quickly it will also experience cashflow issues because the company is having to spend to deliver the revenue.
Examples of Cashflow Returns from Product Development
Product development targeting cashflow returns usually focuses on:
- Development efforts that reduce the time between spending money and receiving it. The budget could be roughly thought of as the gain to the business for having cash sooner.
- Development efforts that allow the company to make better use of cash the business has.
Reputation
Reputation is the only non-financial return listed here. It’s listed because of how often it appears in the wild, often with higher importance on it than financial measures.
Reputation is about the benefits or losses that a company stands to gain or incur as a result of an investment in product development.
Examples of Reputation Returns (and Loss Avoidance) from Product Development
Product development targeting reputation returns or loss avoidance usually focuses on:
- Development efforts around security
- Development efforts that target a current trend with no clear financial value, but media or partner mindshare.
Originally published at https://terem.tech on August 16, 2023.
