Many companies treat value proposition development and product justification as separate domains, which are managed by different experts. First, a value proposition is developed by the marketeers and product managers. Afterwards, a financial business case is written by financial managers to justify expenditures. In some cases marketeers and product managers do not even care about the financials of a product, because a project is approved anyway, as long as the expenses stay within the yearly cost budget. This blog explains why this sequential way of working is limiting the impact of innovation and could actually harm a business. In this blog a concurrent way of working is proposed, in order to optimize the value proposition for maximum business impact.
The business case explained
The goal of every new product to be launched is to create value for the company. Expressed in financial terms, it means that sales revenues should be higher than the collective costs of a company. The collective costs consist of variable costs and fixed costs. The variable costs are costs which increase with the volume of products sold, like material costs or sales costs. The fixed costs are costs which are independent of the volume of products sold, like organizational costs. The profitability of a product is the determined by the revenues minus the costs.
The business case of a specific proposition is a prediction over time of sales revenues versus costs. Initially the product is sold in small volumes, resulting in an initial net loss. But later, sales volumes increase, resulting in a net income. The so-called break-even point is defined as the sales volume whereby the sales revenue equals the total costs. The business case predicts how much a product will contribute to the overall profit of the company. Every product should ultimately result in a profit, otherwise a business is not sustainable in the long term. Unless a company sells multiple products and uses the sale of some loss giving products to support the sale of more profitable products. But in principle, products which are not profitable must be either stopped or fixed in order to become profitable again.
The graph below shows a financial business model with the sales revenues and costs as a function of sales volume. It shows the sales volumes where the product makes a net loss and the sales volumes where the company creates net income. This graph is a helpful tool to predict the financial impact of a new proposition.
Predicting the financial impact of a proposition
A value proposition describes how value is created by addressing a customer target group with a specific offering or benefits which meets their needs. As such, a value proposition can be tested to make sure that there is a real need by a specific target group and that there are real benefits to the target group. However, a value proposition does not confirm that this can be done in a profitable way. It could happen, that in order to realize those benefits, the product costs are so high or the price that a customer is willing to pay is so low, that the product will never make a profit. For this reason it is important to create a high-level business case to check whether the product could result in a profitable business. The business case triggers a number of questions to be asked:
- What should the ideal price be of the product that the target group is willing to pay? The price is determined by the perceived value of a product and by competitive offering in the market.
- What would be the achievable sales volumes for this specific target group in this specific market? This is an estimation of the size of the target group and the amount of customers who is willing to pay the product for that specific price.
- What would be the predicted product costs in order to create the mentioned benefits? This is based on an assessment of the complexity of the functions and components costs to create the product benefits.
- What are the fixed costs the product needs to cover? This is determined by the organization, people, buildings, location etc. A basic question to answer is what the product margin should be to cover the fixed costs and the profitability target of a company.
By answering these questions a business case can be established, which predicts the financial impact of a proposition. This case gives a first indication whether the proposition could become profitable over time or whether the costs are so high that the sales revenues will never be enough to create a profitable business. In the last case it is better to stop working on this proposition and look for an alternative proposition that is more promising. In contrast, when the business case indicates that there is profit potential, then the project can be continued.
It is important to realize that any business case gives the profit potential of a product, not the real financial performance. The real financial performance is dependent on many other factors, like the product quality, service, communication, competitive products, consumer trends etc. But a proposition with a high profit potential is more likely to result in high real profit than a proposition with a lower profit potential.
Optimizing the proposition for value
The business case does not only provide a project justification, it is also of great help to optimize a product. The business case and proposition are mutually dependent. By changing the proposition, the business case will change, and in order to change the business case, the proposition must be changed. That is why it is important to develop the proposition and business case in parallel. This can be done by either universal people who master both product marketing and finance, or by collaboration of product marketeers and financial experts in an early stage of the innovation process.
To optimize the proposition for value, an initial proposition and financial business case a required. Based on these, a number of questions are asked:
- Could the sales price or sales volume be increased by offering one or more alternative benefits?
- What is the ideal combination of price and volume to realize maximum revenues?
- Could the costs be decreased by offering one or more alternative benefits?
- Could the costs be decreased for higher sales volumes?
- Are there alternative solutions to realize the same benefits for less costs?
- Are there ways to decrease fixed costs of the organization, so that the product margin to the cover fixed costs could be smaller?
By asking these questions, the proposition can be optimized for maximum profitability. Maybe some of the questions cannot be answered immediately, but trigger further investigations how to increase the profitability of a product. Think for instance about user surveys, to investigate what price a potential customer is prepared to pay. When a company is evaluating multiple propositions, a financial case should be made for each proposition, in order to compare the financial impacts and select the proposition which creates the most impact.
My experience is that this way of working is especially useful in competitive markets with low margins. In these markets the financial performance or a product determines the ultimate success of a company. But also to develop products for new markets with no direct competitors, it is essential to check whether a certain proposition could become ultimately profitable and to know what can be done to improve the financial impact of a proposition if needed.
Creating Feature Value
A value proposition and business case can also be made to justify a feature extension of an existing product or service. Examples of features are a navigation system in a car or additional memory in a mobile phone or tablet. In this case a value proposition is written for a single feature. The business case is used to investigate whether the incremental price a customer is prepared to pay is larger than the incremental costs to add that feature. Only if the balance is positive, value is created. Otherwise value is destroyed.
The question whether a customer is prepared to pay more for a feature can only be answered in context of the value proposition and intended price of the whole product. And it also time dependent, because it depends whether the feature is new to the market or whether competitor products have introduced this feature as well. Also the cost to add a feature depends on the design of the whole product. The costs to add a feature can also be time dependent, for instance when it is based on new components of which the price goes down with increased usage. The incremental price and costs are sometimes hard to estimate in an early stage of the innovation process, especially if the product or service is completely new. To make more accurate estimates, more detailed information about the design and execution of the product or service is needed.
Summary
In many companies, value proposition development and financial management are regarded as separate domains, with different experts working sequentially on projects. This blog proposes an alternative way of working, in which value proposition development and business case development happens in parallel. In order to develop a value proposition, a high-level business case is created, which predicts the financial impact of the proposition. The business case gives the estimated sales revenues and costs of the proposition over time. This is done for a complete product or service, but also for feature extensions of an existing product or service.
The business case must be profitable over time in order to contribute to the profit of the company. When a proposition is unprofitable, a proposition must be stopped or fixed. The business case is not only used to justify a proposition, but also to optimize the proposition for maximum impact. To optimize the proposition, a number of questions are asked, which are provided in this blog. Only when value proposition development and business case development are treated as a single activity, which is done in parallel, value propositions can be developed which result in maximum financial impact.
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