Evaluating Profitability with Reverse Income Statement

Reverse income statement is a very good and intuitive way to evaluate the profitability of you business idea. It starts with your profit goal and results in how many units you have to sell to reach this goal.

10.2.2023

Heikki Immonen, Karelia University of Applied Sciences

What is profitability?

Profit is defined as sales minus costs. In other words, profitable businesses earn more money and/or resources than they spend. It the sum is positive, the business is profitable. If it is negative, meaning the business is spending more then it receives as sales, the business is unprofitable.

A way to evaluate whether your business has realistic chances of being profitable, is to calculate it’s required sales using a technique called reverse income statement.

What is reverse income statement?

Reverse income statement (RIS) is the opposite of normal income stamen (IS). When you do a normal IS, you start with the total sales (= revenue) your business generated in a year (this is a typical time-period) and the subtract from the incoming money all the costs (outgoing money). What you have in the end is your profit.

However, when you do a RIS, you start with your annual profit goal and work backwards to calculate how many units of products or service you need to sell during the year to earn that profit.

When you have the numbers, you can easily assess whether the numbers are realistic or not. If the required number of sold product (or service) is unrealistically high, you should think whether or not you can raise the price or lower the costs.

Next you can find a simplified reverse income statement calculator.

RIS Calculator

Reverse Income Statement Calculator

Results:

Start with annual profit goal

How much annual profit you want or need your company to make? This is important because without profit you cannot invest to growth, pay dividends to shareholders, weather economic downturns or attract new investors. If you have zero profit, you are awfully close to not being able to pay all the costs.

Assign a certain sum as your target profit. This way you can asses whether or not your plan has realistic changes of earning that profit.

Fixed costs

Fixed costs are those cost that you will pay and are committed to regardless of how many units of your product or service you manage to sell. Fixed costs remain constant.

NOTE. Always mark the costs without value added tax (VAT).

Calculating salary costs

Salaries are often the largest part of fixed costs. We recommend that you also calculate your own earnings as an entrepreneur as salaries. That way you can realistically evaluate whether or not you can realistically reach your desired earnings level.

To calculate your annual salary costs multiple the monthly salary (before personal taxes) with the number of months. If the employee (or entrepreneur) is working full-time, then the number of months is 12. If it is a part-time position, then the number of months is less than 12. For example for 50 % working time contract, the total number of months is 6.

Next multiple the product of monthly salary in number of months per year with multiplier 1,4. This 1,4 approximates all the social security fees and insurances an employer needs to pay in the Finnish system.

Repeat this calculation for all the employees (or entrepreneurs in the organization)

Other common fixed cost

Other common fixed costs are costs like rent, electricity, phone and internet connections, accounting fees etc. For all these different cost types calculate the total costs in a year.

Sometimes marketing budget is calculated as fixed costs. Sometimes marketing cost is calculated as variable cost, meaning marketing cost per sold product. You can try both ways.

Depreciation

Depreciation helps you see how much the investments you make affect the profitability of your business. Investments included in this calculation can be tools and equipment, software, buildings etc.

The key point is that you don’t calculate any investment as a one-time cost. Instead, you spread the cost of that investment to several years. For example, if you buy equipment at the cost 10000 €, you could calculate it as an 2000 to 3333 EUR annual depreciation cost. This means that the cost of that investment would be spread to 3-to-5-year time-span.

When you put something to depreciation costs, you know that you can invest that much every year to equipment maintenance and improvements (after the initial investment has been paid of).

If your business takes a loan to buy something valuable, it is common to set the annual depreciation costs as the same as the annual sum you pay back the loan every year.

Price

Price is what your customer pays to you for each unit, package or bundle of product or service. In these calculations, price must be marked without the value added tax (VAT).

To calculate price without VAT from a price that includes VAT, divide the price with 1.X, where the W is the VAT percentage. For example, the price without VAT of a 2 euro cup of coffee that includes a 14 % VAT is 2 € / 1,14 = 1,75 €.

Variable costs (per unit)

Variable costs are those cost that are directly linked to each bundle, package or unit of your product or service that you are selling. Common examples are materials and packaging for physical products.

Remember to mark these costs with VAT.

Unit margin

Unit margin is a VERY important number in profitability an in business in general. You calculate unit margin of a product or service by subtracting variable cost from the price of that product or service. In other words,

UNIT MARGIN = PRICE – VARIABLE COSTS.

Why unit margin is important? It is important because unit margins is the money business uses to cover its fixed costs and its profit goal.

Required number of units sold

Required number of units sold is an excellent way to evaluate how realistic chances the business has to be profitable. You calculate required number of units sold (in a year) by dividing the sum of fixed costs and profit goal with the unit margin:

REQUIRED NUMBER OF UNITS SOLD = (PROFIT GOAL + FIXED COSTS) / UNIT MARGIN

When you look at the resulting number, do you think it is realistic? Is it realistic given the number of working hours or the tools and equipment you are planning to use? Is it realistic given the number of potential customers in your target market?

This evaluation can become more intuitive, if you calculate from this annual number the required number of units sold per month or week or day. For example, to calculate the monthly requirement, divide the annual requirement with 12 (the number of months in a year).

Note that by looking at this equation, you realize the smaller your unit margin, the larger the required number of units sold will be. More units you need to sell means less realistic chances of actually becoming profitable.

Required annual revenue

Finally, calculating required annual revenue is a straightforward action. To do this multiply the required number of units sold with the price of product or service.

REQUIRED ANNUAL REVENUE = REQUIRED NUMBER OF UNITS SOLD * PRICE

The required revenue tells you how high your sales have to be each year to cover your fixed costs and bring you your target profit.

About this article

The writing of this article was supported by the INnoVations of REgional Sustainability: European UniversiTy Alliance project. https://www.invest-alliance.eu/ . This project is funded by the Erasmus+ Program.

The content of this article represents the views of the author only and is his sole responsibility. The European Commission and the Agency do not accept any responsibility for use that may be made of the information it contains.