A ‘reverse income statement’ is an uncertainty antidote.
There is a great fallacy in business planning, one that my colleague Willie Pietersen at Columbia introduced me to. It’s called the Parmenides Fallacy. When humans compare where they are today with some potential choice for the future, they tend to consider the status quo safer, more secure and more pleasant than the uncertain, unpredictable future that departing from the present implies. Wrong.
The correct comparison is to compare that future choice with where we will be at that future time if we do nothing differently in the present. Compare future states with future states.
One way to do this is via the ‘reverse income statement.’ The idea is that instead of starting with today and using that to anchor our approach to the future, we start with the future and work backwards to what would have to be true today for that future to happen. It’s a remarkably efficient way to quickly discard ideas that won’t work and to flesh out ideas that might.
You start with how much revenue you made in a given period, and break costs into those that are directly associated with making that revenue (cost of sales) and those that are associated with running the business. Straightforward enough.
Here’s where the first typical fallacy enters into this kind of calculation. People will say things like, “The market for haptic-enabled virtual technology is projected to be $2 billion by 2023, and all we need is 5% of that market.” With that as the core assumption, the person making the pitch will put that $100 million in the revenue box, assume 50% costs, and mentally book a profit of $50 million. This calculation is sheer fantasy.
Instead, you can do this an entirely different way and get to reality very quickly. Consider a business my mom really wanted someone to start. Her proposed invention was an automatic door opener that would open and close the French door so she could easily bring food backward and forward from her patio. “Okay,” I said, always trying to be a good sport (at least where my mom is concerned), “let’s use a reverse income statement to test this out.” The first thing you posit is what ‘good’ looks like – how much profit would you have to earn? She said if she could make $200,000 in a year on the business, she’d be happy. You can then look up what the return on sales for a business like that might look like – we guessed about 35%, typical for an industry like this. We’d calculated annual revenues at about $570,000.
We then talked about how much she’d pay for something like this if it was for sale in, say, Home Depot. She thought $75 per unit would be reasonable. That tells us we’d need to sell around 7,600 of the things to make our revenue numbers. How many does that mean would have to be sold in a typical Home Depot? Well, at the time of the analysis, Home Depot had about 1,800 stores, while Lowe’s had about 1,000. In either case, it would be a business that would be way too small for such stores to bother with. We either drop the idea of selling in big-box stores or get a lot more ambitious about how big the business would have to be. See? Now we’re working with facts, and learning.
You can then go through and model many of the other assumptions you might make in a business. By working backwards, you can test whether they are realistic.
At times like now, when uncertainty is sky high, the reverse income statement comes to the fore. It is a tool of innovation that is incredibly helpful in setting your agenda for testing and learning.
Rita Gunther McGrath is professor of management at Columbia Business School.