Last week I start by looking at what tools exist for making decisions. There are many tools for making decisions in the business world including decision trees, grid analysis, paired comparison, cost benefit analysis and Pareto Analysis (80/20 rule) to name a few (see Mind Tools additional tools). Other useful tools from the software world are best practices and design patterns. I then expanded upon paired comparision.
In this article I will look at cost benefit analysis.
Cost Benefit Analysis
cost benefit analysis or return on investment can be a very useful tool. This is the traditional decision on whether to start a project. You simply take the total cost of a project divide by the total financial payback. This gives you the payback time.
It can also be used in other ways especially by product companies. By targeting certain the return on investment against a benchmark for example the S&P, one can calculate how much revenue a product must sale at a minimum. For example, if I had a $100,000 I can invest it and historic returns should be around $11,000. Therefore any product development expenditure must return more than investment in various financial instruments.
This approach has several benefits. The first is that success of a product can be measured by its return on investment (ROI). This will assist management in allocating resources to various product developments efforts. Secondly, it can be used to evaluate whether to build, buy, or acquire an existing product. Third, it can establish clear gross margin goals and thus revenue targets that must be meet by a product or product line. Fourth pricing models can be more accurately created. If a product or product line cannot be seen as reaching its revenue goal and has no strategic value then an alternative can be evaluated for example:
- Can the product be built at a lower investment rate that can fulfill the revenue requirements?
- Can an acquisition solve both the revenue and cost equation?
- Is there another organization willing to invest money in the project and thus lower the cost?
- Is there another solution?
How can a product company formulate a required ROI that every product must meet at a minimum? The percentage needs to account:
- A particular benchmark such as the historical returns of the S&P
- Risk of development
- The lack of liquidity of product development i.e. it is harder to sell a non-publicly traded company or piece of a company than shares in publicly trade financial instruments like stocks.
- Additional overhead and sales cost to be covered by the product line
- Age and capability of the company.
This means our return must included the return of the S&P which is around 11%, and pay back all the investment cost of development over a set time period. In addition, the product has to generate revenue to cover additional overhead and sales. I use a 10 year time horizon. These means that over 10 years the software cost of the first year will be paid plus additional return greater than the S&P. Older companies can use higher returns since they can leverage their market power to increase sales.
Based on these criteria the ROI for a startup might be at least 50% per year. This is based on the traditional timeline for a startup, typically 5 years to break even. So in the first 5 years of a product the first year of development should be paid and at 10 years the first year of development should have been completely phased out. Or put another way
- 10% principal payback per year over 10 years for development
- 25% for overhead and sales cost
- 15% return on top of the principal as interest
At first glance it may seem ludicrous to assume the product in its current form will last 10 years, however, successful products like Office, Quicken, and SAP still have functionality that existed in the first version. And in the corporate world I and I am sure you have seen programs that were written several decades ago still lingering around both homegrown and commercially available software. Finally, if you are building a company that will last then a long payback time forces people to think and invest in the long term rather than short term thinking.
How can this technique help? It gives me two things. First I can project minimum revenue for each year. Secondly I can set minimum pricing.
Here is a real life example. InQPro is working with a startup software company and a venture capital investor. The company is looking at a hard dollar investment in product development of around $500,000 over the next year and a growth of 25% for the second year and 10% for subsequent years. Using this formula the marketing group needs to see if they can realistically sell the required revenue each year. If this number can not be met then either the cost is too high or the market is too small to support the company. In addition, more development dollars will be spent in the year and subsequent years thus increase the minimum required revenue goal. This creates additional revenue drivers.
If total development cost is US$500,000 in the first year that investment must make at a minimum US$250,000 per year for the next ten years. Additional investment in development adds additional revenue demands so if the company were to last 5 years then the company needs to deliver almost US$2 million in revenue at a cost of $1 million additional development costs. And in year 9 revenue would be US$4.5 million at a cost of US$1.5 million. It is important to note that revenue growth is outpacing development cost growth which leads to the cost of development as a percentage of revenue to shrink each year. Thus early years the company is losing money while later years are leveraging earlier development to make more revenue.
| Investment per year | Year 1 | Year 2 | Year 3 | Year 4 | Year 5 | Year 6 | Year 7 | Year 8 | Year 9 | Year 10 |
|---|---|---|---|---|---|---|---|---|---|---|
| $500,000 | $250,000 | $250,000 | $250,000 | $250,000 | $250,000 | $250,000 | $250,000 | $250,000 | $250,000 | $250,000 |
| $750,000 | $375,000 | $375,000 | $375,000 | $375,000 | $375,000 | $375,000 | $375,000 | $375,000 | $375,000 | |
| $1,328,671 | $664,335 | $664,335 | $664,335 | |||||||
| $1,461,538 | $730,769 | $730,769 | ||||||||
| $1,607,632 | $803,846 | |||||||||
| Total Revenue | $250,00 | $250,00 | $250,00 | $250,00 | $250,00 | $250,00 | $250,00 | $250,00 | $250,00 | $250,00 |
In 2002 a study by National Association of Software & Service Companies, Nasscom, found in a detailed analysis of 249 mid-sized ISVs with revenues less than US$100 million the following. The average size of the company was US$ 39 million, and the net margin was -26%. These companies jointly had revenues of US$9.7 billion. They spent US$12.2 billion losing US$2.5 billion. They would have been better off investing the $12.2 billion in the stock marketing. At the end of the year they would have had around US$13 billion or a gain of around US$800 million.
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