Finance is the calculus of growth. Engineers, product managers, and CEOs are all guided by financial metrics to lead the business to fulfill its purpose: sustainable, profitable growth. Meanwhile, the outside world uses finance to estimate firm value and potential. Perhaps due to the breadth of stakeholders, it’s easy for a company to slip into ineffective practices. Let’s look at five common missteps, “sins” if you will, that can restrict organic growth.
Net Present Value (NPV) is perhaps the most commonly used of all financial measures. It provides the “present value” of cash flows out into the future. By accounting for the time value of money and with the flexibility to choose a discount rate, the NPV method is logically sound. If a firm invests in a project with NPV>0, it has increased its value – and this project should be accepted. Of course, the NPV process uses many inputs, with various degrees of uncertainty and risk. Therefore, when we use only use a single scenario of inputs, we’ve created a false sense of precision.
Instead, the better approach is not just to compute one NPV, but three: a “best” case, an “expected case,” and a “worst” case. For each of these, you must first determine the inputs.
In this way, the NPV process isn’t about just getting a number, but it’s about understanding all the variables that will contribute to the success of a project – and estimating their values. If your worst-case scenario still has NPV>0, it’s probably a good project. But by looking at the range of differences between the worst, expected, and the best case scenario, you also learn the degree of possible variability. NPV used with multiple scenarios is an effective tool to evaluate a growth initiative. NPV alone, quite frankly, is an unreliable metric – that perhaps could cause more harm than good.
Customer insights, in the form of your customers’ desired outcomes, are the fuel for the growth engine. No fuel, no growth. If we cannot understand this, organic growth will stall since better informed competitors will move in. Think about this in a military setting.
Imagine this conversation:
Lieutenant: We need a reconnaissance mission to understand the location of the enemy and the terrain.
General: Reconnaissance mission? Sounds expensive and time-consuming. What’s the ROI on a mission like this?
Sound ridiculous? It is. Innovation, marketing, and new product development are problem-solving endeavors. We should take a lesson from “Step 1” of every problem-solving method which is to first define the problem.
When we pass on investment in market research, we’re acting as if the world will stay the same. But, of course, it will not. The truth is that someone will solve the challenges of our customers eventually. If not us, then our competition.
Of all the sins that hamper organic growth, this is the least defensible and yet is a widespread problem. Every basic accounting course preaches that sunk costs, by definition, are unrecoverable. And therefore, should not influence future investments. And yet, they still do. At the company level, if a couple million dollars have been spent on development for a new prototype, and later we learn that this product is unlikely to be successful, the collective intelligence of the company still wants to launch it. Why? Because if not launched, then it will be clear that the initial investments gone. But the problem is, that if the new product fails, then we’ve only lost more money, more time, and more credibility with our customers.
Dr. Robert Cooper, in his book Portfolio Management for New Products, suggests that companies use metric that eliminates sunk cost which he calls the “Bang-for-Buck Ratio.” This is simply the project’s Expected NPV divided into the total resources remaining to be spent. It’s a good idea to put a system in place, such as a “Bank for Buck” metric, to halt the influence of sunk costs on future decisions.
Finance controls new product investments. It also pushes for faster profits, creating pressure to launch products as soon as possible, certainly never later than scheduled, regardless of data suggesting otherwise. This logic ignores the reality that profits only occur if the new product is successful. And unfortunately, when schedules are crunched, the first place that managers rob are the customer insight activities. (Revisit Sin #2) You’ll know this is the case when you hear conversation such as:
“We’re just going to do a light version of voice-of-the-customer.”
“To save time, let’s do our customer validation in parallel with our tooling design work.”
“We have to get the voice-of-the-customer work complete in four weeks so that we can launch by the spring.”
Do these sound like reasonable comments? If so, let’s look a bit deeper. The amount of voice-of-the-customer work should be driven by the amount of market risk, not by schedule, or budgets, or appetite.
For risky technology projects, could you imagine someone saying, “We’re not that certain if this technology is going to work, but we have to launch by the spring, so we’re just going to do skip most of the prototype builds. We’re going to do prototyping-light.” Of course not! The amount of prototyping is driven by the amount of technical risk, and likewise, the amount of customer insight work should be driven by the amount of market risk. Never sacrifice accuracy for time. Nobody ever remembers if a product launches a little bit late. But the impact of success or failure lives on.
Most product development teams meet with finance representatives only for gate reviews within the stage and gate process. Finance, the auditor. The project team, the audited. As such, for the rest of the time, finance is kept at an arm’s length. Even worse, out of ignorance, finance might provide bad advice such as, “The ROI on this project is too low. You’ve got to raise the price.” As if raising the price has no impact on sales volumes.
Instead, every new product development team should have an accounting or finance person assigned to their team…as a team member. Remember those scenarios that we need for NPVs? It’s a perfect assignment for the finance rep to own the scenarios and participate with the team in creating them. They should do this work together. And along the way, the finance rep will also learn about the product, the market, and will become familiar with the rationale behind major decisions. They’ll be able to speak intelligently about the project up through the financial hierarchy.
Finance is the art of firm growth. Balance sheets, income statements, pro formas. The common theme behind the financial sins presented here, is that better communication and proper application of finance in its truest sense can restore this discipline as a major cylinder of the growth engine.