Much of the current way we think about managing start-ups now comes from the Lean Startup. Words like “pivot” and “minimum viable product” have become pretty standard vocabulary for anyone who is trying to get a business off the ground.
But something that often gets forgotten, is that in writing the Lean Startup and developing his methodology over the years, author Eric Ries took inspiration from lots of different sources and prior research in the space.
One of these works was written by professors at Columbia and Wharton business schools and not only does it make for an interesting read, but they produced a tool that I find so helpful that I find myself coming back to it with nearly every single start-up that I advise.
Used creatively, this tool can do anything from checking the feasibility of a business idea, setting your price, putting limits on your marketing budget, to forecasting the number of units you need to sell.
First, a little background
The paper that I’m referring to is called Discovery Driven Planning and was written by Rita Gunther McGrath of Columbia and Ian MacMillan of Wharton business schools.
Their original work was produced in the mid-1990s and was primarily aimed at large enterprises. They looked at historical product launches from large companies that ended up as failures. One notable example they used was Disney’s launch of the Euro Disney theme park. (that give you an idea how old it is!)
Despite being 25 years old, their primary recommendations will sound strikingly modern:
- Operating under uncertainty (like launching a startup or a new product) 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
It’s pretty easy to see how the Lean Startup was influenced by Discovery Driven Planning, with it’s relentless focus on identifying assumptions and testing them.
The major difference is that Discovery Driven Planning was originally intended for senior managers making large, strategic decisions at the largest corporations in the world. Steve Blank and Eric Ries then took inspiration from this and other works and tailored created the framework that we know now as Lean Startup.
But that doesn’t mean that we can’t still learn more from Discovery Driven Planning. In fact, because it was aimed at larger more sophisticated companies, it was a more comprehensive planning methodology — which means there are more tools hidden away that we can adapt to our needs as startups or small businesses!
And one of these tools is a real game changer that I use with almost every startup I advise: the Reverse Income Statement.
Think in Reverse
The Reverse Income Statement is one of the primary tools that Discovery Driven Planning had suggested in order to track, test, and measure assumptions.
Just as a reminder, a normal Income Statement looks something like this:
You start with Revenue (cash earned from sales) on the top line, then work down to the Net Profit after subtracting expenses incurred for different purposes.
The primary thing of note here for someone who hasn’t been that exposed to accounting in the past, is that that 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.
That’s all great for your accountant, but things get much more interesting when you turn the income statement upside down.
So let’s say that you have a new idea for a new startup venture but you are not sure it’s worthwhile. In order to go ahead with it (and say, quit your job), you figure that you need to make at least $50,000 per year.
You live in a country that charges a 30% tax rate and you have done an initial analysis on how much overhead costs you will have for rent and marketing and you estimate that at $1,000 per month. The product you will be selling costs you $20.00/unit to produce.
With just this information, you have a powerful model to make decisions!
Here’s what it looks like:
With just some basic information and a little bit of working backwards, you are able to work out that you will need to make a gross profit of $77,000 per year in order to make your minimum net profit of $50,000.
But that’s not all — then you can start plugging in assumptions and use it to help make some real decisions. Let’s say that most of your competitors have prices around $30 so you start out by assuming you will have to price about the same:
Just like that, you are able to figure out exactly how many units you need to sell in order to meet your target!
This is a great way to test business models and to see if they are feasible. For example, if the most units you thought you could sell was 3,000, then you would know you should probably keep your job for now!
And it doesn’t stop there, you could:
- Figure out what price you need to charge based on how many units you think you can sell
- Determine your marketing budget based on existing sales
- Experiment with different scenarios for production by investing in equipment to reduce your cost per unit
These are just a few off the top of my head… I’m sure there are much more out there, depending on what big decisions you have coming up. And if you’re not sure what to do, try thinking in reverse!