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Innovation Principles, 5/7

“Price is what you pay. Value is what you get.”

—Warren Buffett

The Business Case addresses the profitability potential of the envisioned business offering (i.e., can this endeavor make money?). On the other hand, the Business Model (The Innovation Spiral, Step 9) is meant to address different approaches to monetize the intended offering (how will this endeavor make money?)—for example, Uber versus taxi business models. The Business Case is where our solution is the most vulnerable and where most often an entrepreneur would decide to pivot or even discontinue. It typically happens if the anticipated customer willingness to pay a premium is not sufficiently higher than the cost to deliver the solution. Another unfortunate crossroad emerges if the solution ended up being not sufficiently desirable at the profitable price point to drive expected adoption and growth.

The Innovation Spiral – Business Case step

The Gross Profit Margin

The use of a Gross Profit Margin (GPM) percentage is a recommended quick profitability check based on the core business activity before indirect expenses are added [1]. Key inputs to the Gross Profit Margin model are the COGS estimate from Step 5 and revenue range estimates (selling price x units sold) drawn from product desirability and strength of our value proposition (Steps 1, 2, and 3). GPM can also help us understand how the offering would perform within its target market. GPM could be as low as 10%–15% for capital-intense industries such as the automotive sector or be more than 70% for medical consumables and some software applications.

Key factors affecting Gross Profit Margin (GPM)

Net Present Value (NPV) is a slightly more sophisticated indicator of profitability than GPM. NPV employs the time value of money, a finance concept implying that an amount of money today is worth more than the same amount generated in the future [1]. The time value of money concept also facilitates a comparison of different investment alternatives since we can use today’s money for different investments or even do nothing by putting it in the bank to earn interest. Given that new entrepreneurial initiatives are funded by today’s dollars for future gains, NPV is an insightful tool to quickly check whether the project is worthy of investment. NPV sums all future discounted earnings and outlays for a selected number of years (including R&D and capital expenditures).

Besides other inputs required to model future earnings expectations, one of the key NPV variables is discount rate, also known as hurdle rate. It is a company or opportunity-specific rate of return that investors or stakeholders expect from the project. If NPV is positive, it means the returns are larger than our pre-set hurdle rate of return, and the project is profitable. NPV relies on assumptions and therefore provides room for error. We can mitigate some of the inaccuracy by working with the ranges (e.g., optimistic to pessimistic) rather than specific assumed values. In addition, we can do sensitivity analysis across applicable ranges for key variables to understand their relative impact to anticipated profitability targets.

Net Present Value (NPV) definition

Reverse Income Statement

In dealing with the risks and uncertainties associated with a new product launch, be it in a startup or larger company, we can use a Reverse Income Statement to size the opportunity, test assumptions, and evaluate whether the intended business offering has the potential to fulfill the growth strategy and meet anticipated profitability targets at a relevant scale.

“It is better to be roughly right than precisely wrong.”

—John Maynard Keynes

In order to meaningfully assess the business viability of a new entrepreneurial initiative, it is imperative to define success at the beginning of the innovation journey. In short, what specific financial outcome will constitute success at the end of an applicable timeline (e.g., five years growth plan)? What profitability level (i.e., rate of return and profit potential) would make the idea a worthy investment? This is absolutely vital and existentially relevant in both startups and larger enterprises.

Any new opportunity can be evaluated as an investment option with a rate of return and associated risk profile. Both investors and companies would expect higher returns on higher-risk projects. Many large companies understand that today’s core business is unlikely to remain their ongoing primary growth engine. Without bold, differentiating growth strategy and clearly defined success metrics, those companies are unlikely to displace the competition and substantially grow over time. This is easier said than done. Once a meaningful growth strategy is effectively framed, we only completed the first step while rising to the corporate entrepreneurship ultimate challenge—translating growth strategy into relevant value innovations. It is an art of “dream catchers” that, if successful, results in specific, actionable, and commercially lucrative development projects.

The pragmatic approach described by Rita McGrath and colleagues [2] proposes the use of the Reverse Income Statement (RIS) to model different profitability scenarios. Assumptions are tested to gain critical insight into what needs to hold true in order to hit the net profit target. For an existing business, a conventional Income Statement (P&L) is the basis to determine profitability over a specific time period (typically a quarter or a year). Early on in the incubation of a new idea, revenue is not being generated, and conventional Income Statement inputs are not available. Instead of listing revenue on the top line with expenses to be subtracted to determine the bottom line, the Reverse Income Statement flips the order.

Example of a conventional income statement

The target net income in the RIS occupies the top line and allows the practitioner to play with the key variables to determine what revenue (units sold x ASP) is required for a given solution (includes direct and indirect costs) to meet the profit target. RIS modeled over multiple years (e.g., 5 to 10 years) and including R&D and capital expenses can reveal the time frame necessary to achieve stable profitability as well as return on investment.

An example worksheet of a reverse income statement

To mitigate risks associated with a multitude of pro forma assumptions, it might be insightful to employ probabilistic financial modeling (e.g., Monte Carlo method) and/or sensitivity analysis. That will help the team understand the interactions and relative impacts of different inputs and assumptions such as product adoption rates, pricing scenarios, capital expenditures, and development times.

References

[1] Berman, K., et al. (2013). Financial intelligence: A manager’s guide to knowing what the numbers really mean. HBR.

[2] McGrath, R. G., et al. (2009). Discovery-driven growth: A breakthrough process to reduce risk and seize opportunity. HBR.

Editor’s Note: Selected topics from Milan Ivosevic’s book, Eureka to Wealth, will be featured as part of this Innovation Principles series in the following months:

  1. Introduction (Oct. ’23)
  2. Entrepreneurial Perspective: Human-Centered Design Entrepreneurship (Nov. ’23)
  3. Entrepreneurial Perspective: End to End Product Innovation Framework (Dec. ’23)
  4. Opportunity Incubation: The Innovation Spiral (Jan. ’24)
  5. Opportunity Incubation: Business Case (Sizing the Opportunity and Go / No Go check) (Feb. ’24)
  6. Product Delivery: Development Strategy (Mar. ’24)
  7. Product Delivery: Delivery Effectiveness (Apr. ’24)

Contributor

  • Milan Ivosevic

    Milan Ivosevic is an executive leader, entrepreneur, and innovator. From a blacksmith forge to engineering laboratories, from startups to Fortune 500 board rooms, Milan’s calling card has been his prowess in the successful commercialization of advanced technologies and new product innovations. With numerous contributions and patents in sectors ranging from advanced aerospace coatings to disruptive medical devices, his contributions have stirred market spaces and positively impacted areas such as medication management, drug delivery, blood collection, robotic surgery, and reproductive biotechnologies. In Eureka to Wealth, Milan weaves decades of value creation experience into an easily understood framework that is as valuable for executives as it is for innovation practitioners.

 
 

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