Counting the Cost: A Smart Guide to Budgeting Your Next Big Product or Feature Investment

How to Approach Costing Out a New Product or Feature Investment

When planning to develop a new product or feature, it’s essential to build a financial model that accounts for all anticipated costs. This model provides transparency around the true investment needed and allows for informed decision-making when considering potential returns. Here’s a step-by-step guide on how to identify and calculate fixed, variable, and ongoing costs, as well as how to account for maintenance costs over the product’s lifecycle.

1. Identify the Cost Categories

• Fixed Costs: These are one-time expenses incurred during the initial development of the product or feature. Examples include:
  • Development Costs: Salaries or contractor costs for engineers, designers, and testers.
  • Equipment and Software: Specialized hardware or software tools.
  • Licensing Fees: Initial fees for necessary software or technology.
  • Initial Marketing Research: Any market research costs to assess demand or validate assumptions.
• Variable Costs: Costs that vary based on usage or volume. For example:
  • Server Costs: Cloud hosting costs, often increase with product adoption.
  • Transaction Fees: If the feature involves transactions, each one may have an associated fee.
  • Marketing and Sales Costs: Costs that scale with user acquisition or market penetration.
• Continuing Costs: Ongoing costs for maintaining the product or feature over its useful life.
  • Customer Support: Salaries for customer support teams or contracted support services.
  • Updates and Bug Fixes: Regular maintenance and periodic improvements.
  • Compliance and Security: Costs associated with maintaining compliance or security standards.
• Sunsetting Costs: Eventually, products reach end-of-life. Sunsetting includes removing the product, notifying customers, and any associated compliance or legal requirements.

2. Building the Cost Model

For an accurate investment model, you’ll want to forecast each cost type across the product lifecycle. Here’s how to approach it.

a. Total Cost of Ownership (TCO)

TCO is a comprehensive metric that includes all costs associated with the product from inception through its useful life. For each category, you’ll build a TCO estimate using:

TCO = Fixed Costs + Variable Costs + Continuing Costs + Sunsetting Costs

Breaking down each term:

• Fixed Costs: These are often the most straightforward to forecast as they are typically known upfront. Simply sum all development, initial setup, and one-time marketing costs.
• Variable Costs: You’ll need to project usage growth and model this with assumptions about growth rate, user adoption, and other variables:
  Total Variable Costs=∑(Cost per Unit×Estimated Units)
  For instance, if server costs are $0.10 per user per month, and you anticipate 10,000 users in year one, variable costs for servers would be approximately $1,000 per month.
• Continuing Costs: Calculate ongoing maintenance, support, and operational costs. If customer support costs are $5 per user per month, and you have a growing user base, model these costs to increase proportionally.
• Sunsetting Costs: Account for product retirement costs by estimating resources required to phase out the product when it reaches end-of-life, based on compliance, customer notifications, and decommissioning of infrastructure.

b. Cost per Unit / Marginal Cost

Understanding the cost per unit is essential for pricing and scaling. Marginal cost represents the cost of adding an additional user or unit.

Marginal Cost (MC)= ΔTotal Cost / ΔQuantity​

For products with a heavy digital infrastructure component, marginal costs often decrease over time due to economies of scale. However, always account for the possibility that certain variable costs (like customer support) may grow linearly with users.

c. Product Useful Life and Depreciation

Estimate the product’s useful life to determine how long costs will be incurred and to calculate depreciation for fixed costs. Depreciation allocates the initial fixed investment over the product’s expected useful life, making it possible to determine annualized fixed costs:

Depreciation per Year= Fixed Costs( Asset Cost – Salvage Value ) / Useful Life in Years​

For instance, if you expect a feature to be active for five years, a $500,000 fixed cost will translate to $100,000 per year.

3. Key Financial Metrics

• Return on Investment (ROI): Calculate ROI to understand profitability over the product’s lifecycle.
  ROI = (( Total Revenue − Total Cost of Ownership ) / Total Cost of Ownership ) × 100
• Break-Even Point: The point at which total revenue matches total costs. Calculate this to understand when the product will start generating profit:
  Break-Even Point (in Units) = Fixed Costs / ( Revenue per Unit−Variable Cost per Unit )
• Net Present Value (NPV): NPV accounts for the time value of money, essential for long-term projects. Discount future cash flows using an appropriate discount rate:
  
  Where t is the year, r is the discount rate, and Cash Flow​ is the net cash flow in year t.
• Total Lifetime Cost per Customer: Helps understand the investment per customer and informs pricing and profitability analysis:
  Total Lifetime Cost per Customer = TCO / Total Number of Customers over Product Life

4. Modeling Example

Consider an example where we’re launching a new feature with the following costs:

• Fixed Costs: $500,000
• Variable Costs: $0.10 per user per month
• Continuing Costs: $5,000 per month for maintenance and support
• Expected Useful Life: 5 years
• Estimated User Base: 10,000 in year one, growing by 15% annually

Using the above metrics, you can build a cash flow forecast for each year, adding fixed, variable, and continuing costs, and calculate ROI, break-even, and NPV based on revenue assumptions.

Wrapping up…

Cost modeling provides clarity and supports sound decision-making. By identifying all costs, understanding their implications over time, and modeling various financial metrics, you can comprehensively assess a new product or feature’s profitability and make adjustments before the development even begins. This approach supports not only better investment decisions but also long-term strategic planning and financial success.