The following is taken from a course that I developed and currently teach at the Cox Graduate School of Business at the Southern Methodist University (SMU) in Dallas, Texas, named “Evaluating Entrepreneurial Opportunities” (CISB 6226)
The subject of this article is the million (or 10 million, or 100 million, or a billion ) dollar question. Why would my target market buy the new product or service I have to offer?
The simple answer is “because it’s better.” But that’s over-simplified. A more accurate answer would be:
because the new product or service offers a better return on investment than the existing product or service.
Make no mistake: there is a current product, and your customers are using it. It might look different, feel different, completely different, but if it fulfills the same need or does the same job, this is the product you are trying to replace with your invention, and you will do that only if the return on investment from your invention is better than the return on investment from the existing product.
The return on investment is simply the value that the customer gets from the product, divided by the cost of owning that product. Sounds simple enough. However, while it’s simple enough to calculate the cost, or even total cost of ownership, calculating value might be a bit trickier. Or, is it?
In this article I will show you a simple way to determine the value and return on investment.
First of all, let’s start with calculating the cost. The cost, even for a product, is not necessarily limited to the purchase price. If you can sell the product when you are done using it (for example, selling a used car), then you should deduct the projected selling price from the cost. If there are costs in maintaining the product (or service), then you must add them. If you can make money off the product, then you should deduct it. You may apply net present value calculation to the future cost items as you see fit. More importantly, as the customers perceive them.
Once you calculated the cost, it’s time to calculate the value. How can you quantify value, specifically in dollar terms? Isn’t the value somewhat intangible and thus unquantifiable? It’s actually simpler than you think. You can assume that the economic market forces of supply and demand drove the price to the point where customers are willing to purchase it. How do you decide to purchase something? Because you perceive the value you get from it to be at least as much as its cost. Let’s assume that it’s exactly the same, and thus the ratio of value to cost is 1. That means that once you calculated the cost, the value will have exactly the same number.
And now we get to the main question: will customers buy your invention? Well, they will if the value-to-cost ratio is greater than the existing product, or greater than 1. If the new ROI is lower than the existing ROI, customers will definitely not buy. They will likely not buy even if the new ROI is the same as the old ROI (assuming switching costs were included in the ROI calculation). After all, “if it ain’t broke, why fix it?” They will possibly buy if the new ROI is higher than the old ROI, and will likely buy if the new ROI is significantly higher than the old ROI.
You must now add and subtract the incremental cost and value to the equation:
Customers will be more likely to buy your product if any of the following conditions gave a ratio better (or much better) than 1:
- The new product has a lower cost, and offers higher value;
- The new product has the same cost, but offers more value;
- The new product offers the same value, but at a lower cost;
- The new product has higher cost, but offers much higher value; or
- The new product offers lower value, but at a much lower cost.
One more possibility is that your new product offers a new dimension of value, that didn’t exist before. However, you can treat this just like having a higher value.
When you consider cost, you must also consider switching costs. If the customer doesn’t use any product at this point to perform this function, then it’s enough to have a better value-to-cost ratio based on the cost and value of the new product. However, if the customer is already using an existing product, and has no need to switch, the switching costs must be added to the cost of the new product. In other words, the new ROI must be attractive with the switching costs included.
Once you calculated the cost of the new product, it’s time to calculate the new value. One way to do that is by listing out all the value elements of the new product, including the value that the old product provided. Take, for example, a new LED light bulb that could change colors, be controlled by your phone, be responsive to music, and more features.
List all those features. Don’t forget to include “giving light” as a feature. Assume that this is the only feature that the old light bulb had. Now, assign percentage of value to every feature out of 100% of the overall value the customer gets from the new product. Would you agree that the value of “giving light” is at least 50% of the overall value that the new light bulb offers? If so, then the value of the new light bulb is twice as much as the value of the old light bulb, which had only one feature: It gave light.
If this is the case, then the cost of the new light bulb cannot be more than twice as much as the old light bulb. In fact, if the cost was exactly twice, then it would offer exactly the same value-to-price ratio as the old light bulb (both the new value and the new cost are double). If the cost was more than double that of the old light bulb, while the value, pragmatically, was double, then the ratio is lower, and nobody will buy it.
Two things to consider, though:
- What is your target market segment for this product? What is the income level at that target market, and how important are the added values to its members?
- Based on the answer to the previous question, what is the price elasticity of these kinds of products? The more elastic the price curve is, the less pressure there is on the value-to-cost ratio to be higher than the existing product.
The answer to the second question might actually define the answer to the first one, by defining a market segment that has the desired price elasticity for this type of product.
This framework would apply to the introduction of any new product or service, and should be used very pragmatically, to avoid making costly mistakes.