New Product or Service

New Product or Service Reading

When you consider introducing a new product or service, there are a lot of questions that you have to
consider. Some of the most critical relate to what “problem” are you trying to solve, who your potential
customers will be, what process you will use to either manufacture your new product or provide your
new service, and who will be partners in this new adventure. When you’ve puzzled out some of those
important details, it will be time to move forward and consider a baseline financial analysis of the new
product and service.

The goal here is NOT to have a perfect forecast, and know in advance that no matter what you do here,
there is a good chance that the analysis will be revised many times as you learn and adapt. The
objective is to create a more in depth understanding of your eco-system and how the pieces move
together (or not), add a time dimension to your planning process, and of course introduce a financial
model so you will know in advance what type of funding you may need and when. Finally, you will gain
a much deeper awareness of the key drivers of financial success.

One of the most important notions that you need to be aware of is a concept called “incremental cash
flows”. In short, this just means that if you choose to move forward with your new product, what cash
flow triggers will occur – in other words, what cash flows will go up if you roll out your new product, and
where will the cash outflows happen. Let’s go through a comprehensive example together.
You have a business that produces wearable medical technology and your newest product is a bracelet
that people wear on their wrists or ankles and it dispenses nutrients automatically to people who need
it. The initial target market will be people over the age of 50 who need to take a multi-vitamin.
Eventually you are hoping to obtain approval from the appropriate authorities so the bracelet can
dispense other medications.

After careful discussions with vendors, equipment providers, potential customers, and others, you come
up with the following:

1. It will cost about $15000 in the next month to purchase and install the right equipment into the
empty space of a manufacturing facility that is currently not being used by your family’s other
business, which is producing traditional clothing. The utilities for the building (such as heat,
water and electricity) will not change by much, so your family will not charge you for using their
building. But the total utilities for the building are $50,000 and your equipment takes up about
10% of the building’s total space.
2. You forecast that you will be able to sell one thousand bracelets at a price of $20 a piece during
each of the first two years of operation.
3. The materials to produce the bracelets will be about $6 (for each bracelet sold). The supplier
says you must pay for these materials immediately.
4. When you sell the bracelets during the first year, this will reduce the cash flows from your other
earlier model bracelets by $4,000 total.

BPET.FINx © 2017 Mark Potter. All rights reserved.

 5. 90 percent of the bracelets you sell will be paid for during the first year. The remaining 10
percent consists of customers who purchase the bracelets at the very end of the year and pay
you during the following month (which would be during the second year of operations).
6. You remember that you spent $3,500 on research and development last year.
7. To get the money to purchase the equipment, you borrow the money and will need to pay
$1,200 in interest costs each year.
8. At the end of the two years, the company that sold you the equipment will buy it back from you
for $4,500.

So, which of these do you incorporate into your analysis, and how do you do it??? Remember a few
things. First, you want to focus on incremental cash flows – that is, follow the cash! Second, you want
to focus, at least initially, on the operating cash flows of the new product. To that end, let’s look again
at the list and fill out a cash flow map (with amounts and timing) as we go along:

1. It will cost about $15000 in the next month to purchase and install the right equipment into the
empty space of a manufacturing facility that is currently not being used by your family’s other
business, which is producing traditional clothing. You pay for the equipment immediately. The
utilities for the building (such as heat, water and electricity) will not change by much, so your
family will not charge you for using their building. But the total utilities for the building are
$50,000 and your equipment takes up about 10% of the building’s total space.
You will incur a cash outflow of $15000 today for the equipment and installation. There is no
cash outlay associated with using the space in the building. For this exercise we will specify cash
outflows by using parentheses, so (15000) for this outflow.

Immediately Year 1 Year 2

Equipment: (15000)

2. You forecast that you will be able to sell one thousand bracelets at a price of $20 a piece during
each of the first two years of operation.
Sales for each of the first two years will be 1000*$20, or $20,000. Below, there is a point made
about not collecting all the sales immediately (so we don’t get all the cash!). This is an
important point and will need to adjust for that later.

Immediately Year 1 Year 2

Equipment: (15000)
Product Sales: 20000 Product Sales: 20000

3. The materials to produce the bracelets will be about $6 (for each bracelet sold). The supplier
says you must pay for these materials immediately.
Costs for each of the first two years will be $6*1000 = $6000. There is no delay in payment.

Immediately Year 1 Year 2

Equipment: (15000)
Product Sales: 20000 Product Sales: 20000
Product Costs: (6000) Product Costs: (6000)

BPET.FINx © 2017 Mark Potter. All rights reserved.

4. When you sell the bracelets during the first year, this will reduce the cash flows from your other
earlier model bracelets by $4,000 total.
Since introducing the new product has a direct and measurable cash impact on one of your
existing products, we need to include the impact of (4000) into the analysis, but just for year 1.
This is called a product “externality” or “cannibalization”.

Immediately Year 1 Year 2

Equipment: (15000)
Product Sales: 20000 Product Sales: 20000
Product Costs: (6000) Product Costs: (6000)
Cannibalization: (4000)

5. 90 percent of the bracelets you sell will be paid for during the first year. The remaining 10
percent consists of customers who purchase the bracelets at the very end of the year and pay
you during the following month (which would be during the second year of operations).
So 10% of each year’s sales will move into the following year because this is when the cash flow
is collected. When you make a sale and customers wait to pay you, this creates an Accounts
Receivable. For year 1, our Accounts Receivable (also called “A/R”) balance will be
$20,000*10%, or $2,000. As you can see, an increase in the accounts receivable balance will
result in a decline in cash for year 1, because not all of our customers paid us. Year 2 will have
no impact, because the decline in year 2 cash from customers delaying payment will be exactly
offset by the year 1 customers who pay us during year 2. But we will now have some cash we
will receive in year 3 from year 2 customers who wait to pay us! In other words,
• Year 1 cash impact will be ($2,000) from Year 1 customers who delay paying until year 2.
• Year 2 cash impact will be ($2,000) from Year 2 customers who delay paying until year 3,
but also + $2,000 from Year 1 customers who pay us in Year 2. Thus there will be no
impact in year 2.
• Year 3 cash impact will be + $2,000 from Year 2 customers who pay us in year 3.
Ultimately, you can think about this another way. Revenue will still be $20,000 during years 1
and 2, but the cash flows will be 18000, 20000, and 2000 during the first three years of the
product’s life. This doesn’t look like a big difference, but remember that this is a relatively
straight-forward example and if we split it out by months, and incorporated delays of paying for
some things as well, we would have a fuller picture of cash inflows and outflows. This will be
critical when it comes time to seeking funding. Also, it will provide you, ultimately, with a set of
cash flow drivers. For example, could you convince your customers to pay early, or pay vendors
later? What will the impact on cash flow be? What if some of your customers do not pay at all?
How would that impact the financial situation? So here’s where we currently stand.

BPET.FINx © 2017 Mark Potter. All rights reserved.

 Immediately Year 1 Year 2 Year 3
Equipment: (15000)
Product Sales: 20000 Product Sales:
20000
Product Costs: (6000) Product Costs:
(6000)
Cannibalization: (4000)
Increase in A/R: (2000) No A/R impact Decrease in A/R: 2000

6. You remember that you spent $3,500 on research and development last year.
Think about this one a bit, and the idea of incremental cash flows. If you decide NOT to move
forward with the new product, you have still spent the $3,500. If you decide YES to moving
forward with the new product, then you have still spent the $3,500. So whether you decide to
move forward with the new product or not, there is no incremental cash flow difference, so you
do NOT incorporate these “sunk costs” into the analysis. This can be counter-intuitive, so let me
add one more unrelated example. Say you spent $5 million last year on market research. The
research came back and indicated that it would cost $1 million for the new product and you will
get back $3 million in a year and that’s it. Clearly this product is not going to be a winner since
in total you will spend $6 million and earn back only $3 million. But do you still move forward
with introducing this new product? If you do not move forward, then you will have lost a total
of $5 million. If you do move forward, then you will lose a total of $3 million (spent $5 on
market research and spent $1 on new costs, receive $3 later). So it is better to move forward
then to stop. If you considered the market research into the incremental analysis you would
end up worse off. So, do NOT incorporate sunk costs into the analysis of a new product or
service introduction but the purposes of making a decision about whether to move forward [but
definitely include it in a total estimation of what each product earns or costs over time].

Immediately Year 1 Year 2 Year 3

Equipment: (15000)
Product Sales: 20000 Product Sales:
20000
Product Costs: (6000) Product Costs:
(6000)
Cannibalization: (4000)
Increase in A/R: (2000) No A/R impact Decrease in A/R: 2000

Not included in the analysis:

• Sunk cost of $3,500

BPET.FINx © 2017 Mark Potter. All rights reserved.

7. To get the money to purchase the equipment, you borrow the money and will need to pay
$1,200 in interest costs each year.
Our focus should be on developing a detailed baseline model for the operations (revenue, costs)
of the proposed product or service, and this should not be impacted by the type of funding we
choose. For example, what if we were considering a new product, and if we use debt financing
we would have cash outflows each year for interest expense, but if we use equity financing we
would have no interest costs for any of the years. We might be inclined to lean towards all
equity financing just to make our new product look better, BUT using all equity may have other
drawbacks down the road. You should know that the smaller or younger the business is, the
more likely you will include financing costs into the model because there is a good chance the
business is not or barely breaking even, and you want to know about any and all cash inflows
and outflows over time. As a business matures, the financing decision becomes somewhat
separated from the operations of the company. In other words, the business decides what new
products or services it wants to invest in, and then determines the total amount of funding it
needs over a given time horizon, then it is up to the Chief Financial Officer to determine the best
mix of debt and equity financing overall, rather than for each specific product or service. For
our purposes, we are going to leave it out of the forecast so that the product’s financial situation
is not distorted due to our choice of specific funding vehicle.

Immediately Year 1 Year 2 Year 3

Equipment: (15000)
Product Sales: 20000 Product Sales:
20000
Product Costs: (6000) Product Costs:
(6000)
Cannibalization: (4000)
Increase in A/R: (2000) No A/R impact Decrease in A/R: 2000

Not included in the analysis:

• Sunk cost of $3,500
• Interest costs of $1,200 per year

8. At the end of the two years, the company that sold you the equipment will buy it back from you
for $4,500.
This is a tricky one and does not have a cut and dry answer. On the one hand, you will receive
cash in two years if you want to sell the equipment back to the company. On the other hand, if
the business is doing well then you probably want to keep the equipment and keep producing
and selling the bracelets. Ultimately, there are a couple rational ways to think about this one.
First, if the success of the product depends on whether or not you sell the equipment at the end
of the product’s life, it doesn’t seem like a great product on its own merits. Second, you could
consider the selling of the equipment as a source of future cash flows to seek if you need it. So
let’s NOT put it in the analysis and see how things look. This source of flexibility is sometimes
called a “real option”.

BPET.FINx © 2017 Mark Potter. All rights reserved.

 Immediately Year 1 Year 2 Year 3
Equipment: (15000)
Product Sales: 20000 Product Sales:
20000
Product Costs: (6000) Product Costs:
(6000)
Cannibalization: (4000)
Increase in A/R: (2000) No A/R impact Decrease in A/R: 2000
Total: ($15,000) Total: +$8,000 Total: +$14,000 Total: +$2,000

Not included in the analysis:

• Sunk cost of $3,500
• Interest costs of $1,200 per year
• Sale of equipment in year 2 for $4,500

So in total, the new product’s incremental cash flows are:

1. Product Launch Cash Flows: It will cost $15,000 to get the bracelet project up and
running
2. Product Operating Cash Flows: Cash inflows will be $8000 in year 1, $14000 in year
2, and $2000 in year 3
3. Product Terminal (or sunsetting) Cash Flows: There is the possibility that we will also
be able to receive $4,500 in year 2 if we want to sell the equipment.

What else is missing from the analysis? Well, we are not incorporating the sunk cost or the
interest costs, as we discussed previously. Also, we are not considering taxes in the analysis,
and we probably should talk about that. Essentially we will need to pay taxes on the additional
revenue, but taxes will be reduced because we have expenses to offset the revenue. We are
generally only going to pay taxes on the difference between the revenue and the expenses. We
might also have to pay taxes if and when we sell the equipment in year 2, depending on if we
have a “gain” or “loss” on the sale of the equipment.

In my experience, new ventures don’t typically incorporate taxes into the analysis because it’s
not a critical driver of success or failure. The exception to this is if your new product or service
has a specific characteristic that the government wants to accelerate (for example, solar energy)
and therefore you receive some sizable and specific tax advantage. Also, large companies don’t
typically incorporate tax impact on new products and services into the analysis because the
companies’ tax policies are determined at some central level and aren’t allocated product by
product. For those reasons, we will not incorporate tax impacts here, but know that it is
customary to see tax impacts in textbooks and in a traditional classroom setting.

So where do we go from here? We’ve mapped out the cash flows, and in practice we may want
to put them in a monthly or quarterly format, and of course there will likely be a lot more detail
for the estimates. In addition, we would want to put in any drivers that feed our financial
analysis, such as price per bracelet and units sold, so that we can adjust later when we make
changes. The same can be said for costs. But this gives you a pretty good recipe for how to
create a financial analysis of a new product or service!

BPET.FINx © 2017 Mark Potter. All rights reserved.