The Financial Side of Product Management

Product managers need to establish a framework of financial plans,
budgets and controls related to their products, services, and customers to be able to make sound decisions. The starting point is a foundation of financial and managerial accounting to better understand the profit contribution of their offerings so that decisions on product rationalization,
pricing, and product-line management can be made. From a broader
financial perspective, product managers should understand key ratios and concepts drawn from an understanding of financial statements.

General Cost Classifications

In manufactured product environments, there are two major cost classifications, manufacturing and nonmanufacturing, each of which has sub classifications.

Manufacturing costs include all those related to the transformation of raw materials into final products, including direct materials, direct labor, and manufacturing overhead.

• Direct materials, such as wood in tables and steel in cars,
  become an integral part of the finished product and can
  be considered direct costs. Other materials, such as glue,
  may be more difficult to link to individual units of
  production and may be classified as indirect materials to
  be included in overhead.
• Direct labor includes the labor directly traceable to the
  creation of products. Research and development, support staff
  time, and other labor not directly related to manufacturing
  are included in indirect labor.
• Manufacturing overhead includes all costs of manufacturing,
  excluding the direct material and direct labor costs
  described above. Included in this category are items such
  as indirect material, indirect labor, heat, light, and depreciation.
  

Nonmanufacturing costs include the marketing, sales, administrative, and support costs unrelated to the production of products. These are typically included on the SG & A (selling, general, and administrative) expenses line of an income statement.

Historically, the nonmanufacturing costs have been less significant than the manufacturing costs for most products. However, the growth of services and the emergence of various technologies have reversed the relative weight of these costs in many companies.

• Marketing and selling costs include advertising, shipping,
  sales commission, and salaries.
• Administrative expenses include executive, organizational,
  and clerical salaries.

Both manufacturing and nonmanufacturing costs result from the
normal operation of a business. In addition, there may be other expenses, such as the purchase of an asset, that are charged to the income statement for the period, even though they are not operating expenses. These costs are presented in the simplified income statement on the next page. The cost of goods sold includes the direct material and labor as well as manufacturing overhead.

The data are frequently derived from standard costs and are a combination of fixed and variable expenses. (Standard costs are
predetermined cost amounts that represent what cost should be under the most efficient methods of operation; in other words, they are benchmarks for measuring performance.) Similarly, the overhead expenses (comprised of the nonmanufacturing or SG & A expenses) may be a combination of fixed and variable costs.
The income statement resulting from the above process of listing
costs provides a historical review of the results of operations. It does

not necessarily provide the information for planning and improving
the decision-making process of product management. To provide this type of information, it is necessary to distinguish between the variable and incremental costs associated with products to better understand their contributions to overhead and profit.

Concepts of Segmented Reporting Variable costs are those that vary in direct relation to the activity level.

If activity level doubles, variable costs double in total. This is true
because the cost per unit stays approximately constant over a relevant range of activity. Direct materials and direct labor are variable production costs, and sales commissions represent a variable sales expense.

In addition, there may be step-variable (similar to incremental or semi fixed ) costs. Setup time, seasonal labor, and similar activities related to the amount of business can be considered variable to that piece of business.

Fixed costs, on the other hand, do not change regardless of
changes in the level of activity. Since fixed costs remain constant in
total, the amount of cost per unit goes down as the number of units
increases. It is sometimes said that variable costs are the costs of doing business, whereas fixed costs are the costs of being in business.

Once costs have been separated into fixed and variable elements,
it is easier for product managers to determine the contribution of different products or customer segments. It is also easier for companies to evaluate the performance of several product managers. A comparison of a traditional income statement (using historical cost information) and a contribution income statement (separating fixed and variable costs) is shown in Figure 11.2.

Note that in Figure 11.2 the top line (sales revenue) and the bottom
line (net income) are the same using both approaches. However,
using the contribution margin approach it becomes clear that these
particular sales contribute $9,300 to fixed costs (prior to break-even) and profit (after break-even is achieved). (See Chapter 12 for a discussion of break-even analysis as it is applied to pricing decisions.) This concept of contribution reporting can be applied to business units, departments, product managers, product lines, customers, or similar units of analysis. When applied to these segments, direct costs and common costs must be understood.

Direct costs are those that can be identified directly with a particular
unit of analysis (i.e., product manager, product, customer, etc.) and that arise either because of the unit or because of the activity within it. Common costs are those that cannot be identified directly with any particular unit, but rather are identified in common with all units. The common costs (most likely fixed costs) cannot be allocated except through arbitrary means.

example, company revenues are $900,000, of which $500,000 come from Product Manager 1 and $400,000 come from Product Manager 2. They contribute $80,000 and $170,000, respectively, with $160,000 in overhead not allocated to either. The $400,000 revenue of Product Manager 2 comes from a standard model ($150,000) and a custom model ($250,000) contributing $70,000 and $140,000, respectively.

Product Manager 2 has $40,000 of fixed expenses not related
directly to either product. The custom product receives $180,000 from contractors and $70,000 from residential customers to generate its $250,000 in revenue. The segment contributions are shown without an arbitrary allocation of the $10,000 of fixed costs for the custom model which aren’t directly related to either customer group.

Cost Drivers

Before a product manager can price a product or evaluate a product
line, he or she must understand what the cost drivers are for the various products and customers. Some customers require additional expediting charges, others require special shipping and handling, while others expect free services. Each of these costs should be allocated to the particular product or customer to determine the true financial contribution.

Financial Statement Analysis

As suggested earlier, financial statements are historical documents indicating what happened during a particular period of time. This perspective helps a product manager judge past performance through the use of ratios. In addition, by comparing changes in the statements over time, it is possible to identify performance trends and use the information for subsequent decisions.

Investment Decisions

Directly or indirectly, product mangers may be involved in capital budgeting decisions in the preparation of investment proposals for new products, new markets, or new business ventures. The most common methods of evaluating different proposals are average rate of return, payback period, present value, and internal rate of return.
The average rate of return is the ratio of the average annual profits
to the investment in the project. Using this method, the product
manager prepares a forecast of the improvement in profit over a number of years from a given investment. The total profit is divided by the number of years to give an average annual profit, and this is then expressed either as a percentage of the original investment or as a percentage of the average investment per year. Assume the following stream of profits from, for example, a new product:

Year 1: $100,000
Year 2: $200,000
Year 3: $300,000 Average: $240,000
Year 4: $250,000
Year 5: $350,000
Total: $1,200,000

 

If the initial investment was $1 million, the average annual profit
would be the $240,000 as a percent of $1 million, or 24 percent. Alternatively, the $240,000 could be expressed as a percentage of the average investment for each of the five years. In either case, the rate would be compared to hurdles used by the company or to industry norms. The payback period is calculated by determining the length of time (number of years) it takes to recover an initial investment.

In the above example, the investment of $1 million is paid back during the fifth year. After four years, the cumulative profits are $850,000, with the remaining $150,000 being earned sometime during the final year. Here again, the payback as an absolute value is less important than looking at the relative values of different projects.

The present value (or net present value) refers to the value of future
cash inflows compared to the current outflow of the initial investment.

 

The internal rate of return is the interest rate that makes the present
value of all projected future cash flows equal to the initial outlay
for the investment. In other words, it is the rate that makes the net
present value (NPV) equal zero. The calculation is somewhat complex mathematically, and since it is a value that would be provided by your financial group, the definition should be sufficient for our purposes.

Launch

The next step of the new-product-development process, launch, results in the introduction of the product into the market. Decisions need to be made about timing (when to launch the product), geographic strategy, target market prospects, sales and customer service support, and final marketing strategy.

 

Timing can be a critical component of new-product success. If competitors might be (or are) entering the market, the product manager must decide whether to get there first, concurrently, or after the competition.

First entry usually provides an advantage, but if rushing results
in a flawed product, the result can be more damaging than good. Timing

an entry with competition can neutralize the competitor’s potential
first-mover advantage as well as possibly increase the potential market faster. Delaying an entry until after competition is in the market might make it possible to capitalize on competitive flaws as well as benefit from any competitive advertising that educates the market. Timing is also important if there are seasonal or cyclical aspects to a product, or if the introduction impacts the sales of existing products.

 

It is also necessary to make decisions on a geographic strategy. On
some occasions, a national launch is appropriate, but most new products start with a roll-out strategy. Prioritize the markets (e.g., regions, industries, or countries) and decide on an entry sequence.

For example, it might be desirable to first enter the most attractive markets in terms of size and dollar potential. Or it might be more desirable to enter markets where competition is weak, providing an ability to gain experience, exposure, and market position. In other situations, the selection of roll-out markets is based on different product applications, pipeline inventory in the markets, ability to gain distributor or retailer support, company reputation in the market, or a host of other factors.

 

Although the roll-out might appear similar to test marketing, it differs in a couple of important ways. First, in a test market the product manager targets regions that are representative of the final launch. This is not the case with a roll-out. The markets are selected based on their ability to provide an early cash flow or to gain commitment from an influential market needed for the continued roll-out. Second, the test market is a final test before the commercialization decision is made. The roll-out is the first step in commercialization after the decision is made.

As part of this geographic strategy, identify specific target market
prospects. This is particularly important in the business-to-business
market where clients/prospects can be listed by name. The more detail that can be provided here for the sales force, the greater the chances of encouraging them to sell the new product.

That leads right into sales support. Work closely with the sales force to provide them with information that will help them sell. Prepare “how to sell it” booklets that discuss customers (not target markets), applications (not features), and useful questions to ask on a sales call. Make sure that customer service stays in the loop with sufficient communication through internal newsletters, informal and formal meetings, and various announcements.

The last part is fine-tuning of the introductory marketing strategy.
This action plan details introductory pricing, base price, and option
pricing; press releases and product announcements; direct mail to select customers; shipping policies and procedures; channel and end-user communications; and training for the sales force and/or customers.

The sales training in particular should help salespeople sell the product rather than simply pitch the product.

The sales training that is part of the product launch should educate
and motivate the salespeople to sell your product. In other words, why should the salespeople believe the product will perform as claimed?

What motivation is there for them to sell it? For an existing product,
the best proof is past sales success. For new products, a bit more persuasion is necessary. Results from test marketing or beta testing, statements from sales managers or other salespeople indicating their success in a roll-out region, sales that you (as product manager) have personally made, or trade shows and lead generation programs in place can convince salespeople that the product is worth their time and effort to pursue. In addition, financial and nonfinancial motivators should be considered. Higher commissions, better bonuses, and desirable contests can work under the right circumstances.

Nonfinancial motivators could include customer input suggesting that less sales effort is necessary to be successful, the ability to sell the product along with another product with a minimal increase in selling time, or unquestionable proof of competitive superiority.
A portion of the training might also include a motivational explanation of the need for and use of market intelligence by product managers, and how providing this information can help the salespeople. A standard intelligence report form can be built into a call report, designed into the menu system on a computer, or included as part of the expense form. Because this information typically comes into sales management or sales administration, a process would need to be established to send a copy of relevant product-related data to the appropriate product manager.

• The type of information useful for submission might include the following:
  • New-product announcements by competitors
  • Effective and ineffective approaches to selling a product
  • Changes in competitive strategies
  • Unusual product applications by customers, especially if
  they indicate a trend
  • Perspectives on market trends that might affect company
  strategy
  

 

Project Evaluation

After (or during) the launch stage, some type of project appraisal should be completed. The main objectives of this stage are to improve future product development efforts and to move the product from a new product status to being an ongoing product requiring long-term maintenance.

There may also be a need on occasion to relaunch a product
that is not meeting expectations. The relaunch should be considered as early as possible, and hopefully will have been uncovered by the early indicators as discussed in the prelaunch section of this chapter. If the product is still an acceptable product, changes to the marketing strategy may need to be made to make it a success.

Prelaunch

The prelaunch is the period prior to commercialization when the product manager verifies that all preparations have been made for the actual product introduction. During this stage, the product manager must identify all stakeholders and determine their information requirements.

Customer service needs to be prepared to handle inquiries and fulfill
orders. Technical support personnel may require specialized training.

The distribution channel may require advance warning of any unique
requirements of the product or service.

Also at this time, there may be a need to consider a market test or
a simulated market test to determine whether the strategy (not just the product) is ready for introduction. Various use tests already should have determined the viability of the product, but the tests might not have addressed the best way to go to market.

Test marketing helps assess whether the right price is being charged, whether the appropriate message is being communicated through advertising, and whether the proper distribution strategy is being employed. Of course, test marketing is expensive in terms of both money and time. Therefore, it should be undertaken only when the risk of not doing it is great.

 

For a typical test market, the product manager selects a geographic
area that is as representative of the product’s target market as possible and markets the product on a limited basis in that region. The key decisions to be made include how many test markets, which ones, and how long the tests should run. Most companies select two or three test markets that provide good representation of their target customers.

Good representation refers to assuring that critical demographic variables are dispersed in the target area in about the same proportion as exists in the total market area. The length of the test market will vary depending on the type of product. Some will require six to nine months, and others will need two years. The factor to consider is the length of the buying cycle, with the test market being at least as long as two buying cycles.5

Based on this information, a launch plan can be developed. The
launch documentation should contain three specific components: (1) a milestone activities chart, (2) the marketing strategy to support the
launch, and (3) an early indicator chart. (See Figure 10.7.) All of these guide the launch and early commercialization.

The milestone activities chart lists the desired dates of completion for significant activities such as purchasing equipment for the launch, finalizing package design, obtaining legal clearance, subcontracting specialized labor, and preparing the owner’s manual. Each of these may require several steps and may vary in importance depending on the project. Their potential impact on product success must be considered in assessing priority.

For example, electronic or high-tech consumer products require
clarity in technical documentation to be successful. Customers are increasingly seeking simplicity in a complicated world. However, as a recent Business Week article stated, “Plain English is a language
unknown in most of the manuals that are supposed to help us use electronic products.”6 The format of the milestone activities chart can vary from a simple list of activities and dates to more formal project schedule and control techniques like Gantt and PERT charts. (Refer to operations management or project management books for more details.)

The marketing strategy component of the launch materials details
the tactical components of the launch. Branding, packaging, pricing,
advertising, and all aspects of marketing are studied. As with the
annual product plan, the new-product marketing plan should start with an objective such as “Convert 25 percent of current customers to the product upgrade and obtain trial by an additional 25 percent.” The marketing tactics would then be put into place to accomplish this objective. A sample outline for this new-product marketing strategy is shown as Figure 10.8. Some companies include all or most of the listed components; others will need to be more selective.

Figure 10.8 The Supporting New-Product Marketing Plan

Line extensions might require only an abbreviated outline, whereas breakthrough products will need extensive marketing strategy plans.
As mentioned earlier in the chapter, a decision will need to be made
whether to price a product high initially to recover the development
costs or to price it low to gain market share faster.

Now you have more information than was available early in the process and you are able to fine-tune the pricing.

A number of factors affect this decision:

• First, how likely is it that competitors will enter the market soon? The ability of competitors to enter the market will be based on the investment required to enter, the ease of entering, and their own strategies. The faster that competition is likely to enter, the more appropriate a penetration (low) price strategy.
• Second, is there a large enough segment of customers willing to pay a high price for the product initially? Third, is the company, product, or service positioned appropriately for the
  price strategy being considered?
• Finally, what are the payback period, “hurdle rates,” and return required by the company?

The final component of the launch documentation (after completing the milestone activities chart and the various event calendars and schedules from the marketing plan) is a calendar of early indicators of potential launch success. Early indicators refer to outcomes, such as the number of inquiries, that can help predict or provide early indicators of the level of launch success.

For example, history might indicate that thirty inquiries typically convert to one sale. In that case, tracking the number of inquiries could provide an early indicator of future sales. Other early indicators might include the number of sales calls made on the new product, the percentage of distributors willing to carry it, the awareness level of the market, the number of facings retailers give to the product, and so on.

After identifying the early indicators, the next step is to set time-based (e.g., weekly, monthly) goals to achieve for each. The early indicator chart, then, lists the outcomes expected by the end of designated time periods (e.g., each month), enabling the product manager to compare actual against expected performance without waiting for final sales data.

 

With launch documentation prepared, the product is ready to move
to the launch phase. It’s worth noting that sales training may sometimes be required during the prelaunch phase (perhaps six to nine months prior to the official launch). The information on sales training is presented in the next section covering the launch stage.

Porter’s 5 forces

Five Forces model of Michael Porter is a tool used for evaluating company's competitive position. Michael Porter provided a framework that models an industry and therefore implicitly also businesses as being influenced by Major Five Forces.

What is good about Porter's Five Forces model?

Porter has the ability to represent complex concepts in relatively easily accessible formats. His book about the Five Forces model is written in a very easy and understandable language. Even though his model is backed up by some complex model, the model itself is simple and easily comprehensible at all levels.

Porter's Five Forces model provides suggested points under each main heading, by which you can develop a broad and sophisticated analysis of competitive position. This can be then used when Evaluating different target segments or creating strategy, plans, or making investment decisions about your business or organization.

What is the basic idea behind Porter's Five Forces model?

Porter's Five Forces model is made up by identification of 5 fundamental competitive forces:

· Barriers to entry

· Threat of substitutes

· Bargaining power of buyers

· Bargaining power of suppliers

· Rivalry among the existing players

 

Sometimes we need to consider different factors under each title then When putting all these points together we get Porter's Five Forces model which looks like this:

Force 1: Barriers to entry

Barriers to entry measure how easy or difficult it is for new entrants to enter into the industry. This can involve for example:

· Cost advantages (economies of scale, economies of scope)

· Access to production inputs and financing,

· Government policies and taxation

· Production cycle and learning curve

· Capital requirements

· Access to distribution channels

Patents, branding, and image also fall into this category.

Force 2: Threat of substitutes

Every top decision makes has to ask: How easy can our product or service be substituted? The following needs to be analyzed:

· How much does it cost the customer to switch to competing products or services?

· How likely are customers to switch?

· What is the price-performance trade-off of substitutes?

If a product can be easily substituted, then it is a threat to the company because it can compete with price only.

Force 3: Bargaining power of buyers

Now the question is how strong the position of buyers is. For example, can your customers work together to order large volumes to squeeze your profit margins? The following is a list of other examples:

· Buyer volume and concentration

· What information buyers have

· Can buyers corner you in negotiations about price

· How loyal are customers to your brand

· Price sensitivity

· Threat of backward integration

· How well differentiated your product is

· Availability of substitutes

Having a customer that has the leverage to dictate your prices is not a good position.

Force 4: Bargaining power of suppliers

This relates to what your suppliers can do in relationship with you.

· How strong is the position of sellers?

· Are there many or only few potential suppliers?

· Is there a monopoly?

· Do you take inputs from a single supplier or from a group? (concentration)

· How much do you take from each of your suppliers?

· Can you easily switch from one supplier to another one? (switching costs)

· If you switch to another supplier, will it affect the cost and differentiation of your product?

· Are there other suppliers with the same inputs available? (substitute inputs)

The threat of forward integration is also an important factor here.

Force 5: Rivalry among the existing players

Finally, we have to analyze the level of competition between existing players in the industry.

· Is one player very dominant or all equal in strength/size?

· Are there exit barriers?

· How fast does the industry grow?

· Does the industry operate at surplus or shortage?

· How is the industry concentrated?

· How do customers identify themselves with your brand?

· Is the product differentiated?

· How well are rivals diversified?

Rivalry is the fifth factor in the Five Forces model but probably the one with the most attention.

Conclusion:

After Segmentation we must start to evaluate each segment in order to know will it be profitable if targeted or not.

Thus, to evaluate the different segments, we need to apply Porter’s five forces on each segment in addition to the following factors in order to decide which segment to target:

• Company objectives and resources
• Segment size and growth
• Indicator for profitability
• Large size segment with high growth rate is not suitable for small companies
• Sales estimate
• Cost estimate

Who is Michael Porter?

Michael Porter is a professor at Harvard Business School and is a leading authority on competitive strategy and international competitiveness. Michael Porter was born in Ann Arbor, Michigan.

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Source:

1) Maxi Pedia

2) Competitive Strategy: Techniques for Analyzing Industries and Competitors