Reverse Income Statement in Discovery-Driven Planning

Our previous article discussed a methodology designed to mitigate investment risks, particularly beneficial when contemplating a new business venture or embarking on a project to develop a product or technology amid uncertainty. The methodology in question is Discovery Driven Planning (DDP), developed by Rita Gunther McGrath of Columbia University and Ian MacMillan of Wharton Business Schools.

If you haven't had the chance to read our article titled "Mitigate Investment Risks with Discovery-Driven Planning," I encourage you to do so.

Originally crafted in the mid-1990s, DDP primarily targeted large enterprises. McGrath and MacMillan examined past product launches by major corporations, including notable failures like Disney's Euro Disney theme park.

Despite being more than 25 years old, DDP remains relatively underutilised as a business management tool, notwithstanding its numerous benefits.

Initially tailored for senior managers making critical decisions in global corporations, DDP's principles are adaptable and can be beneficial for startups, projects, or small businesses.

One of the DDP components mentioned in our article is a game changer because operating under uncertainty (like launching a new business or technology) takes a different kind of planning than an established business that has a good idea of what to expect.

Under these uncertain conditions, you will have to make assumptions in order to make up for the things that you don’t know. In order to be successful and avoid failure, you need to identify and test these assumptions and over time, as you learn more, you can replace these assumptions with real data and change your strategy accordingly.

This such tool is the Reverse Income Statement, a concept introduced in DDP to scrutinise, evaluate, and measure assumptions. Different of a conventional income statement, which delineates costs and expenses associated with sales and operations, the Reverse Income Statement flips this perspective.

The reverse income statement (RIS), also known as the reverse income approach or reverse engineering income statement, is a financial tool used to assess the feasibility and profitability of a business venture or project. Unlike a traditional income statement, which starts with revenues and subtracts expenses to calculate net income, the reverse income statement works backward. It begins with the desired net income or profit goal and then identifies the necessary revenues and cost structures to achieve that goal. This approach helps entrepreneurs and business owners understand the specific revenue targets, pricing strategies, and cost controls required to meet their financial objectives.

But before we understand the structure of the RIS, it is important to understand the traditional income statement.

If you are not an accountant, please bear with use, we promise that this is simpler than you imagine.

Income statement

The primary consideration related to a conventional income statement is that the Cost of Sales are costs directly associated with what you are selling while Selling, General and Administrative Expenses could be your rent, salary, marketing, and other costs that don’t go up every time you sell something.

This sounds trivial, but things get more interesting when you turn the income statement upside down.

Reverse Income Statement

For instance, envision a scenario where you aim to generate a minimum annual net profit of $100,000 after taxes with your new business venture idea. After factoring in overhead costs and production expenses, they ascertain the necessary gross profit. By incorporating assumptions like pricing based on competitor analysis, you can determine the required sales volume to meet their target.

In your country the tax rate charged is 10% and you have done an initial analysis on how much overhead costs you will have for rent, marketing, administrative expenses and others and you estimate that at $114,800 per month. Please note that this information can also be considered assumptions if you are not certain about them.

The product you will be selling costs you $50.00/unit to produce. With just some basic information and some backwards calculation, you are able to determine that you will need to make a gross profit of $224,800 per year in order to make your minimum net profit of $100,000.

The next step is to start plugging in assumptions and use it to help make some real decisions. Let’s consider that your competitors have prices around $80 so you assume you will practise the same price. With this exercise you are able to figure out exactly how many units you need to sell in order to meet your goal.

This is a good way to test your business model and to see if it is feasible and achievable. For instance, if the most units you thought you could sell was 5,000, then you realise that you probably should not go ahead with this business venture.

This method enables rigorous testing of business models and feasibility assessments. For example, if projected sales fall short of expectations, it signals a need for reassessment.

Furthermore, it facilitates:

• Adjusting pricing strategies based on sales projections.

• Allocating marketing budgets according to anticipated sales.

• Exploring various production scenarios to optimise costs.

However, if you have decided to proceed with your business venture, the next steps involve identifying strong assumptions in your reverse income statement. These are essentially values you are uncertain about, ones that could fluctuate during the course of your venture.

In our previous example, let's consider Marketing Expenses, Cost per Unit, Price per Unit, and Number of Units sold as variables prone to variation due to uncertainty. Running simulations by adjusting these variables allows you to gauge their impact on your financial outcomes, a process known as assessing sensitivity. Variables that significantly affect your overall financial results are deemed critical to your model.

Once you grasp the significance and sensitivity of each variable in your reverse income statement, the subsequent phase entails devising a plan to monitor them. Determine at what points in your business or project plan timeline you will assess these variables and establish an action plan for instances when they vary significantly, potentially impacting your financial outcomes negatively.

One final consideration is understanding the required investment to initiate and sustain this business venture while achieving the projected number of units sold. If the capital investment is substantial to the extent that the resulting net profit only represents a 4-5% return on investment, you may realise that pursuing the venture is not viable. In such cases, reallocating the funds to a safer option offering a comparable return may prove to be a wiser decision.

In essence, the Reverse Income Statement offers a structured approach for entrepreneurs to validate assumptions, make informed decisions, and refine their business strategies.

At AGCM we can help you to understand and use the Reverse Income Statement and Discovery-Driven Planning approaches in software, product and business development, and technology implementation where you don't have much information and the level of uncertainty is high. Get in touch with us for a free consultation.