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The following scenario came out of a discussion during one of our recent happy hours at Wizeline HQ…

It all started when Matt wagered the average Fortune 500 company spends $50 million a year on products that never generate revenue and/or are shelved before they even reach the market. The conversation then spread to the difficulties of accurately gauging the opportunity costs above and beyond the $50 million figure. We eventually came up with this nifty SWAG formula:

Step 1: Assume a company breaks even.

Step 2: Assume that the company’s successful products must pay for its unsuccessful ones. Example: if a company invests $2 million to develop an unsuccessful software product that is never released, its successful products must generate at least $2 million to cover the loss.

Step 3: Take x as the share of a company’s products that are successful.

Step 4: Take y as the change in the product success rate. A positive y leads to an increase in revenue to the tune of Y/X, while a negative y value has the opposite effect.

Step 5: Run the numbers.

Example #1: A company with $100 million in revenue just breaks even. They have a 33% success rate on new products — meaning that a third of the products in which they invest are released and end up generating revenue. Driving a modest 5% increase in their success rate — from 33% to 38% — would lead to a 15% increase in profitability. All of a sudden, the company is generating $15 million in profits.

Example #2: What happens when we decrease the same company’s product success rate to 30% from 33 percent? That same breakeven company would quickly be generating a $9 million loss.

Like any model, ours makes a tradeoff between accuracy and complexity. We ignored the COGS considerations and, instead, did our best to capture the notion of opportunity cost. In our model, activities that don’t result in successful products have a direct impact your company’s revenue potential. It’s self evident, but even modest improvements in product success rates can drive substantial increases in profitability.

Final note: We did consider pouring more time and resources into developing a better model — but we then recognized the high opportunity cost of building the world’s best opportunity cost calculator and, well, you get the idea…

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Peter Moore Posted by Peter Moore on Thursday, April 10, 2014.


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