But how can you be sure that your projects are actually going to increase the NPV of the company?
Well, it’s simple – just use an NPV calculator to measure your projects.
OK, but hang on… what is NPV?
What is NPV and why is it important in product development projects?
Net Present Value (NPV) is a measure of the value of a future stream of cash flows, discounted to the present.
There are two types of NPV:
- The Accounting NPV method, which calculates the net present value (NPV) for each individual project
- The Portfolio NPV method, which calculates the net present value(NPV) for a portfolio of projects
Accounting NPV is the preferred way to analyse investments when looking at each individual project. Portfolio NPV is the preferred way to look at a group of individual projects when making decisions about capital budgeting.
So for product development projects, what’s the difference between Accounting NPV and Portfolio NPV?
Well, Accounting NPV focuses on cash flow projections for each project. This basically means that it adds together all the positive cash flows from a project and calculates their present value against time. It then scales up all the negative cash flows in proportion to match the positive ones. This gives the NPV of each individual project.
However, Portfolio NPV is more precise when it comes to looking at a group of projects. It takes all the cash flows from individual projects and calculates their present value against time – but this time, instead of looking at them individually, it looks at the whole portfolio as one big project. This makes Portfolio NPV more accurate than Accounting NPV because it combines all the individual cash flows to give an overall picture of the project.
NPV is important for companies who are struggling with deciding which projects to invest in, or how many resources to put into their product development portfolio. The greater the NPV – the more ‘worth’ it is for the company to invest in your product development project.
What is the formula for calculating NPV in a product development project?
Using a formula to calculate NPV can be broken down into four steps.
Step 1 – Calculate the Initial Investment/Cost of the project
The initial investment is basically just the research and development costs to build your product. If you’re working on a new launch, this would be the first round of funding you need to get started. You should include other costs here too, such as the cost of patents for example.
Step 2 – Calculate the Net Cash Flow/Revenues over the lifetime of your project
The net cash flows are all the incoming revenue your product will generate over its lifetime. This includes sales, royalties and licensing fees, but should not include any operational costs or other fixed costs that might accumulate over the lifetime of the project.
Step 3 – Calculate the Present Value (PV) of all your cash flows
Calculating this is basically just working out what the value would be in today’s money if you were to receive that amount now. You can do this by using a reverse discount rate calculator. The higher the discount rate, the less likely it is that your project will be successful and vice versa.
Step 4 – Add up all your Present Values (PV)
The total PV of all your cash flows is basically the NPV for the product development project. This number should become more positive as you develop your project and make it more likely to succeed.
Examples of how NPV can be used in product development :
- If the NPV of a project is greater than zero, it is worth investing in. If not, no further investment should be made in the project.
- The higher the NPV, the better your product development project is doing. As your PV number increases, so does how ‘good’ you’re doing with this particular product development project.
- A negative NPV means your business is actually losing money by investing in the project and therefore should not go any further with it. This is because you’re spending more than what you’ll be making back from it, so your company as a whole will lose out if you continue to invest in that particular product development project.
Advantages and disadvantages of using NPV as a metric :
- Gives you a more accurate picture of the ‘worth’ of your product development project.
- Easy to understand and calculates automatically using a formula.
- Aids in strategic decision making, such as what projects to invest in or how many resources to put into each product development project.
- NPV only tells you how much money the project will make, but does not give you any other information about your product development activity. For example, it cannot tell you what the quality of the finished product is like or whether it will meet market demand.
- Ignores social and environmental factors when calculating the ‘worth’ of your product development project.