Putting Theory Into Practice Part 7: Identifying Key Assumptions Upfront
Now that we have created an initial forecast in Part 6: Scoping the Opportunity, we should have a good handle on the scope of opportunity to help us decide if the product concept represents a good business opportunity. As we discussed in Part 6, forecasting new product sales is always imprecise, and sometimes completely wrong!
The key concept I want to stress is that our forecast is built on layers of assumptions that make forecasting difficult if not impossible to achieve any degree of precision. Thus we need to recognize upfront that the numbers will be only best guesses and the real opportunity is to identify the key assumptions we use to build the forecast and test these assumptions early and often to validate and learn what is working and not working to adjust and respond accordingly.
The Reverse P&L is a method and tool created by Rita Gunther McGrath and Ian MacMillan that helps clarify the business objectives and brings to the surface the key assumptions that underlie the business model.
The Reverse P&L recognizes that forecasting based on assumptions will be wrong but:
“the real errors for an innovation team lie in being wrong without being conscious why, in spending too much before they have validated critical assumptions, and in not learning from every mistake that gets made.” (McGrath)
Over time, learning occurs through discovery and assumptions can be validated, refined, or refuted. The heart of the Reverse P&L is to work backwards starting with the bottom line (profit) and then determine how much you have to sell to meet financial hurdles – and then ask: “does this make sense?” and “Can we do it?”
To create the reverse P&L we need to create “what victory looks like” – or put differently – what the desired business should look like at “steady state” in terms of a P&L based on the forecast we just created.
But instead of using the traditional P&L where we start from zero and work our way up to the projected steady state sales and profits, we start “backwards” with what we have to deliver in profitability as defined by the organization’s goals. What the organization defines as a “worthwhile” business opportunity defined by bottom line contribution to profits.
Starting with the bottom line we specify:
Required Profitability at Business Maturity = Necessary Revenues Minus Allowable Cost.
We can also define:
Require Return on Assets = Required Profits Divided by Allowable Assets.
Now as we work our way down (or up I guess) from the bottom line we determine the required sales level and estimate major cost factors in our business model. This is why it’s good to be thinking about the business model early on to make sure our strategy is grounded in reality.
In the reverse P&L we explicitly define assumptions like sales channel productivity – this provides a terrific sanity check. For example is it realistic to believe a sales force of 100 Full-Time-Equivalents (FTE’s) can sell 1 million location aware tool units (from our fictitious company Teknovantage) per year at steady state? It may or may not be feasibly – but now the assumptions is out front and center for everyone to see.
Each line on the Reverse P&L will either be:
Business objectives based on management decision – i.e. required profit contribution, gross margin, etc. Management is responsible for defining its revenue goals and financial performance. What we should have is a minimum expectation of what our return on resources should be for management to consider the opportunity worthwhile.
Assumption we make to build the business case – i.e. price per unit, number of units we can sell, sales channel productivity (i.e. sales per year per sales person) etc. Assumptions are what we are trying to identify up front.
Calculations to derive P&L numbers – i.e. revenue = sales price x number of sales per year. These are simple equations we use to derive numbers – nothing complicated about them.
What the Reverse P&L does is forces us to identify key assumptions that we need to address to validate the opportunity as it evolves. We create an Assumption Check List and define check points where we will test the assumptions and either validate, refine or refute our assumptions. Check points we use include VoC research projects, beta test, pilot launches and so forth.
The Reverse P&L is an excellent tool to help frame the uncertainty and create a methodology to address risk step by step – applying iterative discovery and design into the project – i.e. test early, test often and test cheaply.
With the Reverse P&L we now know what we need to test and we can formulate our test plans using the checkpoint assumption chart (schedule). We now know the nature of some of the questions we need to address in our VoC project.
There is much more to be said about the Reverse P&L than what I covered today. Here are some resources and links you can go to learn more about this valuable tool:
Discovery Driven Growth, A Breakthrough Process to Reduce Risk and Seize Opportunity– McGrath & MacMillan
Discovery Driven Planning: Turning Conventional Planning on Its Head
Discovery Driven Files: Professor Ken Homa Georgetown University
In the next blog we start getting into the ins and outs of creating a VoC research project where the rubber literally hits the road.
Keep innovating and learning!