Monday, December 20, 2010

Bottoms Up! – Use a ‘reverse’ income statement to achieve your business goals


"Begin with the end in mind". You may know this as the second habit in Steven Covey's book, "The 7 Habits of Highly Effective People". Did you know it's also the power behind the 'reverse' income statement?
When crafting your business' 2011 goals, don't start with a sales target. Instead, establish your profit target first. Then use the 'reverse' income statement to figure out what business activities are required to meet the target.
You may hate reading accounting reports, but the 'reverse' income statement ("RIS") is one tool you'll love using. It's not a traditional profit and loss statement like the one your accountant prepares.
Instead, you construct a RIS using only the 7 levers that drive the bottom line of every business. These 7 levers are only things you'll need to ensure that you'll meet your profit target:
  1. # of new business leads
  2. % of leads that result in a new customer
  3. % of prior customers who purchase from you this year (customer retention)
  4. Average sale amount
  5. Number of transactions/year per customer
  6. Gross margin %
  7. Fixed cost amount
Here's how one company put these RIS levers to work to create its 2011 plan (the name has been disguised).
In 2010, Turicum Dental Associates turned a profit of $47,885 after all fixed and variable expenses, including the dentist's/owner's salary. Turicumt wanted to develop a plan to grow its 2011 profit to $85,000. Enter the RIS.


Using its 2010 results, Turicum could see that it had:
  • Fixed costs of $87,250
  • A 45% gross margin
  • An average sale per visit of $110
  • 7 visits per family per year
  • 88% customer retention rate, or 350 families who continued to use its services
  • 50% inquiry/lead conversion rate
  • 80 inquiries (leads)
After careful consideration, Turicum identified a series of strategies to reduce its fixed costs by 5% and to increase its gross margin %, average sale per visit, customer retention rate and conversion rate by 10% each.
These strategies had a decent impact on the bottom line, but they weren't enough to meet the $85,000. To get there, Turicum recognized that it also had to implement new marketing activities. Specifically, It had to increase its number of new customer leads/year from 80 to 116, an increase of 45%.
Year
2010
Projected
2011
Plan
Actions needed to meet profit target
Leads Generated
80
116
45%
more leads needed to meet profit target
x
Conversion Rate
50%
55%
10%
increase in conversion
=
-----------
-----------
New Customers
40
64
+
Old Customers
350
337
10%
increase in retention
=
-----------
-----------
Total Customers
390
401
x
Transactions/Customer
7.0
7.0
0%
increase in # transactions
x
Average Sales
$110
$121
10%
increase in average sale
=
-----------
-----------
Revenue
$ 300,300
$ 339,647
x
Gross Margin %
45%
49.5%
10%
increase in gross margin
=
-----------
-----------
Gross Profit
$ 135,135
$ 168,125
-
Fixed Costs
$ 87,250
$ 82,888
5%
reduction in fixed costs
=
========
=======
Net Profit
$ 47,885
$ 85,238

By working from the bottom up, Turicum was able to back into the number of leads required to meet its profit target. Instead of focusing on the top line only, Turicum worked its way up the 'reverse' income statement. In doing so, Turicum was able to identify various strategies that led to lower fixed costs, better margin %, increased average sale, better retention of existing customers and a higher rate of conversion of leads to customers.
These strategies reduced the amount of top line growth needed to meet Turicum's goal.
If Turicum had instead focused solely on growing sales to meet its profit target, while ignoring the other 6 levers, it would have needed a 300% increase in new customer leads, not the 45% shown here. Since it is almost always more expensive to generate customer leads than it is to move the other 6 levers in the right direction, you'll save yourself quite a bit of money.
You'll find the RIS to be a powerful planning tool. Remember to "start with the end in mind". Set your net profit goal first. Then work up the RIS, starting at the bottom. At each step, ask yourself, "What can I do with each of the levers to drive my results for the upcoming year?"
Finally, calculate what increase, if any, you'll need in the number of new customer leads to meet y our profit target.
Have an awesome 2011!

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