The Business of Ideas: Reviewing the Revenue

Developing your intellectual property into a viable business opportunity is a complex proposition! In this series of posts, Porticos co-founder and President, Greg Patterson shares his insights on navigating the process. First written ten years ago, these posts revisit (and update) Greg’s original content for a new decade of product development.

Read previous post: Let the Numbers Speak

Our last post encouraged a pause to look at the numbers and make sure your idea can truly deliver. An attractive Return on Investment (ROI) is necessary to ensure this idea is worth following through on. Ideally, your product will offer a return of 10:1, meaning that for every $1 you invest, you earn a return of $10. We’ve calculated the costs, now let’s start to imagine what we might earn.

The revenue side of the equation is certainly more fun. Our first step is imagining what our product might sell for.

Bottoms Up

Estimating a successful sales price requires care and honesty. Our approach is called a “bottoms up” calculation, meaning start with the manufacturing price and end with the retail price. Take the Bill of Materials (BOM) costs you developed earlier and multiply by 2. This will give you what the preferred distributor price would be. For example, if you calculated the manufacturing cost at $1, then you would sell to a distributor for $2, netting you $1. Note that doesn’t necessarily mean $1 in profit as you still have other expenses that we discussed in the previous post. It is simply a $1 gain over the cost to manufacture the product.

Now take the distributor cost ($2 in this example) and multiply it by 2 again to determine the wholesale price ($4 in this example). This is the price that a store would pay to buy the product and put it on their shelves. 

Finally, multiply the wholesale price by 2 again to get the suggested retail price, $8 for our example. This is the price that the end consumer would pay.

Sale Price Success

This brings us to assumption #6: what will the market bear? The easiest way to determine if your suggested retail price is something that consumers will accept is to look at the actual retail prices for competitive products. People might be willing to pay more for higher quality or more innovative features, but probably less than you would like to imagine. You are going to need to stay competitive with your pricing to entice the buyer and be honest with yourself in your estimates. If you are not confident, you might want to consider the aid of a marketing company to do some price elasticity studies, but bear in mind there is no guarantee of accuracy when delivered to the marketplace.

Keep in mind these factors are budgetary only for the purposes of defining your revenue. Your product might sell directly to retail chains with no distributor markup. Similarly, the 2X factor may be lower in reality depending on the sell-thru and other factors. But for planning, a 2X factor is a good starting point.

Revenue

We are now ready to calculate our revenue. We’ve already assumed what our sales volumes will be (recall assumption #2 in the previous post). Now simply multiply the sales volumes by the distributor sale price; this will give you the revenue. If you want to be more accurate, consider how much product you plan to sell to distributors, versus selling retail or direct, and factor those additional revenues into your equation. But be careful not to be over-optimistic or use this practice to make a poor return appear more marginal. You will only be fooling yourself. 

Your ROI can now be calculated. How does it look? How does it compare with the 10:1 goal?

Licensing Considerations

If you plan to license your product or technology, you will need to do a few more calculations. Starting with the investment side of the equation, eliminate the material costs since those will be covered by the person you license to. But take care to keep development expenses in your calculations, such as those you might expect to incur for prototyping. Evaluate resource and business expenses similarly. 

The estimate of these expenses is assumption #7. At a minimum, you will need to devote some time and resources to developing the idea to the point that potential investors would be able to fully appreciate the concept. On the other hand, marketing costs should be greatly diminished as the company you are licensing to should address the advertisement and sales process.

The revenue side of the equation also has changes to consider. First and foremost, your revenue would be based on royalties from the sale of the product. Royalty agreements are varied and highly dependent on negotiations, market potential, etc., but a typical agreement provides a percentage of the revenue generated from each sale. To start, assume a royalty percentage of 10% to calculate what your revenue from royalty will be. 

You are going to need to stay competitive with your pricing to entice the buyer and be honest with yourself in your estimates.

One more thing worth noting. It is not uncommon for the licensor to receive some money upfront when licensing the product or technology. This functions as a “good faith” payment to show the licensor that the licensee has an incentive to go forward with the technology and take it into production.

Despite this, my recommendation is that you not consider that in your revenue calculations. The reasoning is two-fold. First, these upfront payments are not guaranteed and are a matter of negotiation. Second, when they are given they are quite often considered advancements on the royalty. Effectively, they are diluted when sales volumes start to reach the targets you’ve already accounted for in the royalty payments.

That’s it.  You are now capable of calculating the ROI from the licensing perspective.  How does this ROI look? One thing you should notice is that the ROI is substantially less than the ROI calculated from a manufacturing and sales perspective. This is indicative of the risk versus rewards philosophy we discussed in previous chapters.

ROI Return

We’ve focused on a lot of numbers and assumptions, but hopefully, you haven’t been scared off by the process or level of effort required. Don’t overlook these important steps! While you may be more interested in the benefits to mankind, the fact is all businesses must generate revenue. And at the risk of stating the obvious, the revenue must equal or preferably exceed expenses, or you won’t be in business long. 

So take your time and do the proper research to make sure your idea will yield the ROI you need to justify the risk before you invest too much of your time and money.

XL200P Exploded View

About Porticos

A WORLD OF OPTIMIZED PRODUCTS

Porticos, Inc. is a Product Engineering and New Product Development firm located in Research Triangle Park, NC.

Established in 2003, Porticos produces innovative and effective solutions for their clients and the markets they serve. Porticos provides broad expertise in development, planning, and production. 

Contact us for more information or support bringing your idea to market.