Loans among friends can quickly impact their friendship in a negative way. I have learned that loaning a book to a friend really means giving them the book. Not intentionally, people lose or damage the items they have borrowed so they cannot return them. (Or are embarrassed to admit it.)
My dad was a CPA, so I also learned at a very early age that family and friends should never loan money to family and friends. He spent many hours sorting out promises and loans in the estates of his clients, including treasures of furniture and jewelry along with monetary wealth. Nothing good ever came from these squabbles among family members.
That’s why throughout time, advanced societies use neutral parties for loans. Americans borrow money from banks and repay those loans over an agreed-upon period of time. The bank charges interest because they do not have the use of that sum during the loan. Interest also covers the risk that the borrower may never repay the loan. Where there is higher risk, the interest rate is also higher.
New product development (NPD) is much like a bank loan. A company is making an investment gamble and cannot use the resources committed to a project in any other way. For example, human resources can only work on one thing at a time. If you choose to design and develop a new product, your human talent cannot also simultaneously work on production improvement. Hiring more staff allows multiple initiatives to occur at the same time, but we are all restricted – as human beings – to doing only one thing at a time.
NPD is like a bank loan from the perspective of investment. Financial experts do not loan money to every person who walks through the door. Entrepreneurs are well aware that they must prepare a legitimate business case to receive a bank loan. The banker is evaluating whether the investment will pay off as well as considering other investment options. Money, like time, can usually only be spent once.
Product development is an investment by a firm in the idea. Management must be convinced that the business case (market and technology) for the new product is the best use of limited financial resources. Just like bankers, management considers trade-offs on the use of limited resources (time, money, equipment, and staff). Product development is often a long-term investment for a firm.
Again, banks take risks that some people will default on their loans. Just as I have learned that “loaning” a book to a friend really means “giving” them the book, bankers recognize that a certain percentage of loans will go bad. Not only has the bank made an investment by loaning that money, the risk is they will lose not simply the gains (interest) but also the principal. In other words, they may be worse off because the transaction took place.
New product development is inherently risky. We do not know – at the beginning of a project – whether we can develop a cost-effective technology or whether consumers will buy the product at a price to deliver a profit. Some product designs will never be commercialized, and the investment is lost, just like a defaulted loan.
Banks often ask for collateral in exchange for risking their money. If you borrow money to buy a car, the car itself holds value. If you default on the loan, the bank can repossess the car to regain some of their investment. Similarly, if you take out a home mortgage, the house itself serves as collateral for the loan.
While investment and risk have ready parallels between NPD and bank loans, collateral is a little more esoteric. Companies specialize in certain products, technologies, and markets. Their knowledge, including patents and license or franchise potential, serve as long-term collateral for product development.
For example, if the R&D group at your firm investigates a new plastic treatment for a part on a new product, they retain that knowledge whether or not the part is used on a commercial product. Learning and knowledge are key to successful product design and development. That’s what companies mean when they say, “Our people are our greatest asset.” The knowledge asset is the collateral for an NPD gamble.
NPD is Like a Bank Loan
Banks take risks and invest money where they expect a payback. They charge interest to earn a profit on those investments. Loan risks are balanced by collateral, or assets, that will recover a portion of the investment if the borrower defaults. This system is fair for both the lender (the bank) and the borrower.
New product development (NPD) is an investment risk taken by companies of all sizes. They hope that sales revenues will deliver a profit on the investment made in designing and developing the new product. The risk of a failed project is balanced by the collateral of increased corporate knowledge.
Do you need to understand and evaluate NPD risks? If so, please contact me and we’ll discuss how processes and portfolios can reduce the inherent risk of NPD. We strive to help our clients improve speed-to-market and improve effective team collaboration.
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Brian Cohn says
Interesting analogy. When I think of an investment model for product development, I think of it more as buying options than making a loan for a couple of reasons.
First, the return on investment on NPD, especially as it gets less incremental, is far less certain than making a loan.
Second, investing in product development is the price you must pay to get to the point of being able to decide whether or not to sell (and sell at a particular price) the thing you have developed.