The ladder / Level 4 · New products and services/ Business math
R&D budgets and market sizing
Prototype and phase budgets with contingency, burn rate and runway, budget variance, and TAM, SAM and SOM with a bottom-up check.
How numbers are rounded on these pages. Calculations are done at full precision and rounded only at the end, half up. Rupee amounts are rounded to the nearest rupee unless shown with paise, in which case to the nearest paisa. Percentages are shown to two decimal places, months to one decimal place, years and ratios (such as LTV : CAC) to two, and discount factors to four. Discounting assumes cash flows at the end of each year, compounded yearly. IRR has no exact formula: it is found by repeated trial and shown to two decimal places as a check value. Break-even quantities are rounded up to the next whole unit. All examples and quiz questions are Hypothetical: they show the method, not real prices or rates.
R&D and prototype budgeting
Build a development budget from the bottom up, phase by phase: design, prototypes, testing and certification, tooling, a pilot run. Prototype cost is the number of rounds (iterations) × units per round × cost per unit. New-product work almost always throws up surprises, so add a contingency: a percentage held back for overruns.
While the work goes on, watch the burn rate (cash spent per month) and the runway (how many months the cash will last). Compare actual spend with budget phase by phase (variance), and release money for the next phase only when the previous one has met its goals; many companies call this a stage-gate process.
The standard formulas
Terms used
- Prototype iteration
- One round of building and testing prototypes before changing the design.
- Contingency
- An amount added to a budget for costs that cannot be foreseen in detail.
- Burn rate
- Cash spent per month (net of any income).
- Runway
- Months until cash runs out at the current burn rate.
- Budget variance
- Difference between actual and budgeted spending, often as a percentage of budget.
- Stage-gate
- Approving and funding a project one phase at a time.
Worked examples
HypotheticalBasicPrototype cost
A team plans 3 prototype iterations of 5 units each; each prototype unit costs about ₹40,000 (parts, 3D-printing, machining).
- Prototype cost = 3 × 5 × ₹40,000 = ₹6,00,000
HypotheticalIntermediateA phase budget with contingency
A hardware start-up budgets its new product phase by phase, with prototypes as above:
- Design and engineering: ₹4,00,000
- Prototypes: ₹6,00,000
- Testing and certification: ₹3,50,000
- Tooling: ₹8,00,000
- Pilot production run: ₹2,50,000
- Base budget = ₹24,00,000
- Contingency 15% = ₹3,60,000; total = ₹27,60,000
HypotheticalAdvancedBurn, runway and an overrun
The team costs ₹3,00,000 a month and other spending ₹50,000; the company has ₹42,00,000 in the bank.
- Burn rate = ₹3,50,000 a month; runway = ₹42,00,000 ÷ ₹3,50,000 = 12.0 months
- Prototypes actually cost ₹7,50,000 against ₹6,00,000: variance = 25.00% over
- Contingency left (from the 15% contingency) = ₹3,60,000 − ₹1,50,000 = ₹2,10,000
Market sizing: TAM, SAM and SOM
Before building a product, estimate how big the opportunity is. Three standard terms (widely used by start-ups and investors) break it down:
- TAM, total addressable market: total yearly spending on this kind of product by everyone who could use it.
- SAM, serviceable available market: the part of TAM your product, price, channel and geography can actually reach.
- SOM, serviceable obtainable market: the part of SAM you can realistically win in the next few years, given competitors and your sales capacity.
The arithmetic is simple: number of buyers × how much each buys a year × price. The hard part is getting the inputs right; every number on this page is hypothetical. For a real plan, use sourced data and check the top-down SOM against a bottom-up plan (how many customers your team can actually sign).
The standard formulas
Terms used
- TAM (total addressable market)
- Total yearly demand, in rupees, for the product category.
- SAM (serviceable available market)
- The part of TAM your offer and channels can serve.
- SOM (serviceable obtainable market)
- The part of SAM you can realistically capture in a few years.
- Top-down
- Starting from the whole market and taking shares of it.
- Bottom-up
- Building up from customers you can actually reach and sign.
- Run-rate
- A period's revenue scaled up to a year (for example a month × 12).
Worked examples
HypotheticalBasicTAM for a cleaning-kit refill
An imaginary district has 20,000 small eateries, each buying 2 cleaning-chemical kits a month (24 a year) at ₹500 a kit.
- TAM = 20,000 × 24 × ₹500 = ₹24,00,00,000 a year
HypotheticalIntermediateFrom TAM to SAM to SOM
You can deliver only in three towns that hold 30% of the eateries, and expect to win 5% of those within three years.
- SAM = 30% × ₹24,00,00,000 = ₹7,20,00,000
- SOM = 5% × ₹7,20,00,000 = ₹36,00,000 a year, which is 7,200 kits a year or 600 a month
HypotheticalAdvancedChecking SOM from the bottom up
2 salespeople can each sign 15 eateries a month. Ignore customers who stop buying.
- Eateries signed in 12 months = 2 × 15 × 12 = 360
- Run-rate at month 12 (360 eateries, 24 kits a year each) = 360 × 24 × ₹500 = ₹43,20,000 a year
- The top-down SOM implies ₹36,00,000 ÷ (24 × ₹500) = 300 eateries
The bottom-up plan is a little above the top-down SOM, so the 5% share looks reachable on these assumptions, but only if few customers drop off.
Quiz: R&D budgets and market sizing
Pick an answer to see at once whether it is right, with a short explanation. Each question takes one try; your score appears at the end. No answers are sent anywhere. (Without JavaScript, open “Show answer” under each question.)