All businesses develop products which have a limited economic life and defined product lifecycle. Each year new products are developed and introduced to the market to replace older models which are starting to become obsolete. Typical examples include, software, computers, cars, and fashion.
It is important that the financial projections and the business plan make allowance for these product lifecycles, as any errors in the timing of product development can lead to revenue, net income, and cash flow shortages, ultimately resulting in the failure of the business.
Product Lifecycle Stages
The revenue, net income and cash flow from the financial projections of a single product business will follow a distinct pattern as the product goes through its lifecycle. Typically, the life cycle of a product is split into four phases.
During this phase funds are invested to develop the concept, design the product and the production process, build and test prototypes, and to set up the manufacturing facilities. During this phase there is no revenue and losses are made. Finance, either by way of equity or debt, may need to be found to fund the development phase. Our research and development cost model can be used to estimate the costs to include in the financial projections template.
In the second phase of the product lifecycle, the product is selling, as it is new to the market it hopefully, generates lots of interest, and substantial amounts of revenue and cash. There is usually considerable investment in marketing at this stage.
In the third phase, the product matures, there is still revenue and cash coming in, but the growth in sales stops and starts to decline. At this stage the aim should be to maximize profits.
In the final phase of the product lifecycle the product has become obsolete, the market for it is declining and revenue and cash flow start to fall. Eventually, the product will have to be abandoned altogether. At this stage the aim is to minimize losses. The diagram below shows the four stages of the product lifecycle.
Multiple Product Lifecycle
A business with one product might be successful over the life time of the product, but it will start to decline as soon as the product reaches maturity and starts to become obsolete. Revenues and cash flow will decline and sooner or later the business will run out of cash and fail.
The solution to this problem is for the business to have multiple products existing at the same time. However, it is very important that the financial projections take into account the timing of each product lifecycle. If the timing is wrong, and for example multiple products enter the development phase at the same time, this can create a serious drain on cash flow, and without adequate finance in place could lead to the failure of the business.
Overlapping Product Lifecycles
Normally a business will plan so that the life cycle of a product will overlap at a different stage in the life cycle of another product, similar to that shown in the diagram below.
In this example, the business starts with product 1 and must provide funding either from debt or equity for the development phase. If it starts product 2 too early, then it will need additional finance to fund the development phase of product 2 at the same time. Unless adequate finance facilities are in place this timing could lead to a major gap in both revenue and cash flow.
However, in the diagram above, the business delays the start of product 2 until product 1 reaches its selling phase. The income from product 1 now funds the development phase of product 2. In addition, as product 1 starts to mature, product 2 takes over and enters its selling phase.
The process now repeats itself, the income from the selling phase of product 2 now funds the development phase of product 3 and so on.
By adopting this approach, the peaks and troughs in revenue and cash flow generated by a single product business can be avoided and the level of additional debt and equity funding needed reduced.
Effect of Product Lifecycle on Cumulative Net Income
The diagram below shows the cumulative net income assuming all three products are started at the same time (red line) compared to that generated when the financial projections allow for careful timing of the product lifecycle (blue line).
The diagram clearly shows that if all three products are developed at the same time (red line), the amount of debt and equity funding needed in the development phase is substantially higher. By using phased product development within the financial projections, the time scale is longer, but a smaller amount of funding is needed to start the first product, and the income from product 1 funds the development of product 2, which in turn funds the development of product three. It is important to note that the total income from all three products is the same in each case. it is simply the timing of the product lifecycles in the financial projections which differs.
Ultimately the approach taken to product lifecycle when producing the financial projections depends on the level of external funding available. The development of multiple products at the same time clearly generates the income in the shortest timescale, the downside to this approach is the high level of external funding needed. The phased product development approach spreads the income out over a longer time scale but needs a smaller amount of external funding.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Plan Projections. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.