Costs

How can I estimate the cost-to-revenue ratios of my innovation?

1. Bottoms Up - This method attempts to anticipate every expense that will go into the development, production, marketing, etc. of your new innovation.

2. Top Down - This method assumes that the costs associated with your innovation will be similar to the costs of other organizations delivering similar products and services. Working off that assumption, the top-down approach finds the cost-to-revenue ratio of comparable organizations, and then applies the same ratio to the new innovation.

At LaunchPath, we recommend the top-down approach in the early stages of a new idea. Here's why:

1. It's much faster and easier than the bottoms-up approach

2. The core assumptions regarding an innovation (e.g. it's market opportunity, it's key features, etc.) change so much in the early stages of the innovation process, that the bottoms-up approach probably won't prove to be any more accurate than the much faster and simpler top-down approach.

Following is a step-by-step approach to create a top-down estimate of your costs:

1. Find one or more organizations that a) are primarily producing a product or service similar to the innovation you are envisioning, and b) you can access their financial reports (e.g. perhaps your own organization and any publicly traded company)

2. Calculate the ratio of the comparable organizations' Cost of Revenue to Total Revenue by dividing the Cost of Revenue by Total Revenue. For best results, sample several organizations and periods of time and then average the samples.

3. Calculate the ratio of the comparable organizations' SG&A expenses to Total Revenue by dividing the SG&A by Total Revenue. Again, for best results, sample several organizations and periods of time and then average the samples.

4. Calculate the ratio of the comparable organizations' R&D expense to Total Revenue by dividing the R&D expenses by Total Revenue. For best results, sample several organizations and periods of time and then average the samples.

5. Once average ratios have been created for each cost category (e.g. 40% Cost of Revenue, 40% SG&A, 0% R&D), add these ratios to the Costs section of your idea.