Jose A. Briones, Ph.D.

SpyroTek Performance Solutions Twitter: @Brioneja

Agenda
Problem Definition € New Framework for Innovation Management € Discovery Driven Planning € Reverse Income Statement € The ³Flaw of Averages´ € Probabilistic Decision Analysis € Case Study: Forecast of iPad Sales
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Introduction
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Product innovation has been described as the way out of today¶s difficult business environment. The rate of success of development projects, in particular disruptive innovation projects remains too low.

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We believe that a reason for the low success rate is the erroneous application of analysis methods designed for incremental innovation like NPV and DCF to projects with high levels of uncertainty
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Background
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In this Chapter of the ³Beyond Stage Gate´ series we will discuss the use of Discovery Driven Planning and Probabilistic Decision Analysis in the management of innovation projects with high levels of uncertainty. Probabilistic Decision Analysis, when combined with the right management processes like Discovery Driven Planning is a very effective approach to evaluate and manage the risk and potential of innovation projects
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Clayton M. Christensen
We keep rediscovering that the root reason for established

companies failure to innovate is that managers don t have good tools to help them understand markets, build brands, find customers, select employees, organize teams, and develop strategy ‡ Some of the tools typically used for financial analysis, and decision making about investments, distort the value, importance, and likelihood of success of investments in innovation There s a better way for management teams to grow their companies. But they will need the courage to challenge some of the paradigms of financial analysis and the willingness to develop alternative methodologies
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‡

Classical Stage-Gate Process

Source: Product Development Institute, Inc.

Project is managed in a linear fashion ³The Stage-Gate system assumes that the proposed strategy is the right strategy, the problem is that except in the case of incremental innovations, the right strategy cannot be completely known in advance´ ± Clayton M. Christensen
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Challenge
Create a unified framework for innovation projects/product development that
1. Provides the flexibility needed for

innovation to work 2. Still has the metrics needed for proper measurement of progress and resource allocation.

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A New Innovation Project Categorization
Technical Uncertainty
High

Medium

Low

Low

Medium

High

Market Uncertainty
Source: Product Development Management Association

This categorization is based on the most critical variable for new innovation projects: Degree of uncertainty
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The Spiro-LevelΠ3-D Approach to Innovation
Resources Launch

Quadrant IV

Roadmap/Timeline Level 3 2

Quadrant I
Idea Generation VOC

Risk Analysis Customer Testing Time Supply Chain Analysis Value in Use Analysis Prototype Development

1 Time Technology Assessment Business Case Regulatory IP Strategy Resources

Quadrant III

Quadrant II

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Overall Project Management
Level 1
‡ Discovery Driven Planning ‡ Knowledge to Assumption Management

Level 2

‡ Product/Technology Roadmaps ‡ Multigenerational Product Planning

Level 3

‡ Linear Stage-Gate ‡ Agile/Lean Development ‡ Rapid Prototyping
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Financial Analysis
‡ Reverse Income Statement Level 1 ‡ Real Options ‡ Probabilistic Decision Analysis

Level 2

‡ NPV Level 3 ‡ DCF
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Discovery Driven Planning (DDP)
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Process for management of innovation and development projects with high levels of uncertainty such as disruptive innovations, new product/new market projects or game changers
y 1995: First Publication by Rita Gunther McGrath and Ian C.

MacMillan (1) y 2000: Popularity increases with publication of book ³The Entrepreneurial Mindset´ (2) y 2008: Endorsed by Clayton M. Christensen as an alternative to Stage Gate for high uncertainty projects (3) y 2009: Publication of book Discovery Driven Growth (4)
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Description
Discovery

Driven Planning turns the basic project map on its head
y Discovery Driven Planning is a plan to learn, not to

show that you had all the answers when you wrote the plan
³Learn as you go´

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DDP uses four basic documents
y µReverse Income Statement¶ models the business

economics. y µPro-Forma Operations Specs¶ defines operations needed to run the business. y µKey Assumptions Checklist¶ identifies the business hurdles and assumptions for the initiative. y µMilestone Planning Chart¶ specifies when the assumption needs to be tested.
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Reverse Income Statement
y Instead of estimating the market demand and

calculating the potential revenue/profit, DDP starts by defining the desired financial target that will meet the company¶s targets and strategy
y The method then defines the set of

assumptions, technical and commercial that MUST be proven true in order for the project to succeed
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Generic Reverse Income Statement
Reverse Income Statement Required Profits (MM$/yr) Return On Sales Target Revenue (MM$/yr) Market Share Penetration Market Size (MM$/yr) Unit Price, $ Unit Sales M/yr Production Capacity Per Line, Units/Day Production Lines Needed Capital Cost of a Production Line, MM$ Total Capital Investment Needed, MM$ $20 20% $100 30% $333 $500 200 100 6 $1 $6

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The Flaw of Averages
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The Flaw of Averages states that plans based on the assumption that average conditions will occur are usually wrong Can you drown in a river that is on average only three feet deep?
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Demand Forecast Problem
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Forecast for annual demand: ³Between 150,000 and 250,000 units´
y Average 200,000 units. y Plant is sized for average demand estimate y Profit is also calculated using average demand

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Flaw of averages: Profit WILL be lower than forecasted
y No upside to exceeding demand estimate due to plant

capacity limitations y Average becomes upper limit www.Brioneja.com
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Solution: Ranges and Probabilities
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Input data and results are expressed as ranges and probabilities
y 80% Chance of number being between 570 and

689K

Source: ³The Flaw of Averages´ Marketingnpv.com
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Probabilistic Decision Analysis
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Model uses @Risk probabilistic decision analysis software
y Monte Carlo simulation y Risk and opportunity analysis

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Designed for complex projects with high levels of uncertainty
y Inputs contain high number of variables, either technical or New product development assessment Capital spending decisions Value chain analysis Production and sales forecasting analysis

financial with a high degree of uncertainty, assumptions and dependencies

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Eliminates use of ³one at a time´ cases
y Analyzes thousands of cases simultaneously y Generates a range of outcomes www.Brioneja.com y Outcome charts are analyzed to make decisions on direction Twitter: @Brioneja

Input Ranges
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Input values are entered in range format ± Width and shape of range are critical inputs
y Definition of the input ranges is the most critical

step y Do not start with the typical value, start with the range, define the shape of the function (10%, 50%, 90% probability).
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There are multiple choices for the shape of the input range: y Triangular: Most common for initial assumptions y Normal distribution: Used when more accurate input data is available y PERT: When data is in form of probabilities y Gamma distribution: Good to model pricing distributions in www.Brioneja.com B-B cases
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0.4342 0.6448 5.0% 90.0% 5.0%

00 .3 05 .3 00 .4 05 .4 00 .5 05 .5 00 .6 05 .6 00 .7 05 .7

Reverse Income Statement Combined with Probabilistic Decision Analysis
Reverse Income Statement Required Profits (MM$/yr) Return On Sales Market Share Penetration Unit Price, $ Production Capacity Per Line, Units/Day Capital Cost of a Production Line, MM$ Min $15 15% 25% $400 75 $0.8 Target $20 20% 30% $500 100 $1.0 Max $25 25% 35% $600 125 $1.4

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Define ranges for each input variable
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Revenue vs. Market Size
Target Revenue (MM$/yr)
$81.00 0.030 0.025 0.020 0.015 0.010 0.005 0.000 $120 $130 $140 $150 $100 $110 $160 $60 $70 $80 $90
Target Revenue (MM$/yr) Minimum Maximum Mean Std Dev Values $64.17 $151.41 $101.06 $14.69 5000

$120.00 81.1% 10.8%

8.0%

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Revenue range is projected w level of probability

Market Size (MM$/yr)
$254.36 0.008 0.007 0.006 0.005 0.004 0.003 0.002 0.001 0.000
Market Size (MM$/yr) Minimum Maximum Mean Std Dev Values $191.09 $553.25 $338.49 $54.93 5000

$436.48 90.0% 5.0%

5.0%

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$150 $200

$400

$450

$500

$550

$250

$300

$350

$600

Unit Sales vs. Capital
Unit Sales M/yr
162.5 0.014 0.012 0.010
Unit Sales M/yr

250.0 79.6% 9.9%

10.5%

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Capital investment is expressed a range vs. unit sales

0.008 0.006 0.004 0.002 0.000 250 300 350 100 150 200

Minimum Maximum Mean Std Dev Values

114.11 338.25 203.46 34.00 5000

Total Capital Investment Needed, MM$
$4.20 0.35 0.30 0.25 0.20 0.15 0.10 0.05
Tidal Capital Investment Needed, MM$ Minimum Maximum Mean Std Dev Values $2.55 $12.64 $6.09 $1.40 5000

$8.00 83.8% 9.9%

6.2%

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$2

0.00

$10

$12

$14

$4

$6

$8

Capital Investment Sensitivity Analysis
Total Capital Investment Needed, MM$
Regression Coefficients
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Capital Cost of a Production Line, MM$ Production Capacity Per Line, Units/Day Return On Sales Required Profits (MM$/yr) Unit Price, $
-0.35
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0.50

-0.45 -0.45 0.44

-0.4

-0.3

-0.1

0.3

0.4

0.5

-0.5

-0.2

Coefficient Value

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Sensitivity analysis is a way to focus on the variables that are most important to reduce uncertainty
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0.6

0.0

0.1

0.2

Case Study: iPadΠIncome Projection A) Static Analysis
iPad 2010 Unit Sales (MM) iPad 2011 Unit Sales (MM) iPad 2012 Unit Sales (MM) Netbook 2010 Unit Sales (MM) Unit Price, $ iPad Cost of Materials, $/unit iPad Cost of Manufacturing, $/unit iPad Warranty Service, $/unit 7.1 14.4 20.1 43 $650 $264.3 $10.5 $20

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Static analysis uses projections prior to launch

iPad Indirect Expenses 2010 (MM$/yr) $2,100 iPad Indirect Expenses 2011 (MM$/yr) $2,500 iPad Indirect Expenses 2012 (MM$/yr) $2,700

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iPad Income Projection: Static Analysis

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B) Probabilistic Decision Analysis ² iPad Income Projection
Min iPad 2010 Unit Sales (MM) iPad 2011 Unit Sales (MM) iPad 2012 Unit Sales (MM) Netbook 2010 Unit Sales (MM) Unit Price, $ iPad Cost of Materials, $/unit iPad Cost of Manufacturing, $/unit iPad Warranty Service, $/unit iPad Indirect Expenses 2010 (MM$/yr) iPad Indirect Expenses 2011 (MM$/yr) iPad Indirect Expenses 2012 (MM$/yr) Target Max 1.3 7.1 12.9 8.6 14.4 55 14.3 20.1 63.3 36.6 43 58 $830 $335 $12 $25 $2,520 $3,000 $3,240

$500 $650 $219.0 $264.3 $9.0 $10.5 $15 $20 $1,680 $2,100 $2,000 $2,500 $2,160 $2,700

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iPad Market Share Projections
iPad Market Share vs. netbooks 2010
9.25% 8 7 6 5 4 3 2 1 0 30% 35% 10% 15% 20% 25% 0% 5% 13.1% 80.8% 24.25% 6.1% 2.0 1.8 1.6 1.4 iPad Market Share vs. netbooks 2010 1.2 1.0 0.8 0.6 0.4 0.2 0.0 100% 120% 140% 160% 20% 40% 60% 80% 0%
Minimum Maximum Mean Std Dev Values 2.83% 32.2% 15.6% 5.46% 5000 iPad Market Share vs. netbooks 2011 Minimum Maximum Mean Std Dev Values 17.3% 143% 57.3% 23.7% 5000

iPad Market Share vs. netbooks 2011
32.0% 13.7% 67.5% 80.0% 18.8%

iPad Market Share vs. netbooks 2012
41.0% 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 100% 120% 140% 160% 20% 40% 60% 80%
iPad Market Share vs. netbooks 2012 Minimum Maximum Mean Std Dev Values 27.5% 159% 71.7% 25.3% 5000

90.0% 68.1% 23.6%

8.3%

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Market share analysis projects potential level of penetration and substitution

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iPad Revenue Projections
iPad Revenue 2010 (MM$/yr)
$2,400 3.0 2.5 2.0 1.5 1.0 0.5 0.0 $10,000 $7,000 $8,000 $9,000 $1,000 $2,000 $3,000 $4,000 $5,000 $6,000 $0 Values x 10^-5 Values x 10^-4 8.6% 75.2% $6,350 16.2% 7 6
iPad Revenue 2010 5 (MM$/yr) Minimum Maximum Mean Std Dev Values iPad Revenue 2011 (MM$/yr) Minimum Maximum Mean Std Dev Values $5,144.81 $41,875.43 $17,165.42 $7,070.77 5000

iPad Revenue 2011 (MM$/yr)
$8,250 6.6% 83.9% $27,500 9.5%

4 $880.13
$9,811.24 3 $4,685.46 $1,637.15 2 5000

1 0 $30,000 $35,000 $40,000 $45,000 $10,000 $15,000 $20,000 $25,000 $5,000

iPad Revenue 2012 (MM$/yr)
$11,605 6 5 Values x 10^-5 4 3 2 1 0 $10,000 $15,000 $20,000 $25,000 $50,000 $5,000 $30,000 $35,000 $40,000 $45,000
iPad Revenue 2012 (MM$/yr) Minimum Maximum Mean Std Dev Values $8,217.53 $46,917.00 $21,472.35 $7,522.30 5000

$35,590 90.0% 5.0%

5.0%

Upper range of revenue shows dramatic upside potential € Max revenue value is from unit sales analysts estimates 7 months after launch
€

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iPad Gross Profit Projections
iPad Gross Profit, $/unit
$252.50 0.007 0.006 0.005 0.004 0.003 0.002 0.001 0.000 $150 $200 $250 $300 $350 $400 $450 $500 $550 $600
iPad Gross Profit, $/unit Minimum Maximum Mean Std Dev Values $165.47 $562.54 $356.74 $71.92 5000

$475.00 87.1% 5.5%

7.4%

iPad Gross Profit Margin

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Gross profit analysis can highlight areas of concern

45.25% 7 6 5 4 3 2 1 0 10.0% 85.0%

62.82% 5.0%

iPad Gross Profit Margin Minimum Maximum Mean Std Dev Values 31.6% 68.8% 53.6% 6.12% 5000

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30% 35%

55%

60%

65%

40%

45%

50%

70%

iPad Income Projections
iPad Income 2010 (MM$/yr)
$50 4.5 4.0 3.5 Values x 10^-4 3.0 2.5 2.0 1.5 1.0 0.5 0.0 -$2,000 -$1,000 $1,000 $2,000 $3,000 $4,000 $5,000 $0 0.2 0.0 -$5,000 $15,000 $30,000 $5,000 $0 $10,000 $20,000 $25,000 Values x 10^-4 1.0
iPad Income 2010 (MM$/yr) 0.8 -$1,869.82 $4,703.02 $431.87 $1,010.77 5000 iPad Income 2011 (MM$/yr) Minimum Maximum Mean Std Dev Values -$830.65 $26,029.39 $6,784.18 $4,206.06 5000

iPad Income 2011 (MM$/yr)
$2,250 $12,500 77.4% 10.6% 1.2 12.0%

$2,000 54.1% 7.2%

38.7%

Minimum 0.6 Maximum Mean Std Dev 0.4 Values

iPad Income 2012 (MM$/yr)
$5,000 1.2 1.0 Values x 10^-4 0.8 0.6 0.4 0.2 0.0 $10,000 $25,000 $30,000 $5,000 $0 $15,000 $20,000
iPad Income 2012 (MM$/yr) Minimum Maximum Mean Std Dev Values $467.14 $27,088.90 $8,893.70 $4,560.12 5000

$13,750 64.4% 15.1%

20.5%

€

Income analysis shows high potential for losses 1st year, but huge profit upside for 3rd year

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iPad 2012 Income Sensitivity Analysis
iPad Income 2012 (MM$/yr)
$5,000 1.0 0.8
iPad Income 2012 (MM$/yr)

$15,000 68.3% 11.2%

20.5%

0.6 0.4 0.2 0.0 $10,000 $15,000 $20,000 $25,000 $30,000 $5,000 $0

Minimum Maximum Mean Std Dev Values

$467.14 $27,088.90 $8,893.70 $4,560.12 5000

iPad Income 2012 (MM$/yr)
Regression Coefficients

iPad 2012 Unit Sales (MM) Unit Price, $ 0.48 -0.17 -0.05 -0.01

0.86

€

Sensitivity analysis shows where more market research is needed to reduce uncertainty

iPad Cost of Materials, $/unit iPad Indirect Expenses 2012 (MM$/yr) iPad Warranty Service, $/unit

-0.2

0.2

0.4

0.6

0.8

0.0

Coefficient Value www.Brioneja.com Twitter: @Brioneja

1.0

Actual iPad Sales Figures
€

2010 ±
y Original forecast

14.8 MM Units
7.1 MM Units

€

2011
y Jan-Mar 4.7 MM Units y Apr-June 9.3 MM Units y Jul-Sep ± 11.1 MM Units Apple sold more iPads than Dell sold in all its PCs together (10.6 million)

€

2011 Projection y Original forecast

~ 40 MM Units
14.1 MM Units
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Use of DDP
DDP has been successfully used by oil and pharmaceutical companies to tackle high uncertainty projects € More companies are adapting the method, but there is still strong resistance to leave Stage Gate behind.
€
y Stage Gate can be used after the results of

DDP have defined the project and reduced the level of uncertainty
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Summary
€

DDP combined with Probabilistic Decision Analysis provides discipline and framework to the discovery process but at the same time provides the flexibility necessary for the project to change direction or iterate as needed

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Contact Information
Brioneja@SpyroTek.com € www.Brioneja.com € Twitter: @Brioneja
€

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References
1. 2. 3. 4. 5.

Discovery Driven Planning, 1995,
http://hbr.org/1995/07/discovery-driven-planning/ar/1

The Entrepreneurial Mindset, 2000,
http://www.amazon.com/Entrepreneurial-Mindset-Continuously-OpportunityUncertainty/dp/0875848346/ref=sr_1_1?ie=UTF8&s=books&qid=1274888243&sr=1-1

Innovation Killers, 2008,

http://hbr.org/product/innovation-killers-how-financial-tools-destroy-you/an/R0801F-PDFENG?Ntt=innoation%2520killers

Discovery-Driven Growth, 2009,
http://www.amazon.com/Discovery-Driven-Growth-Breakthrough-ProcessOpportunity/dp/1591396859/ref=sr_1_3?ie=UTF8&s=books&qid=1274887263&sr=8-3

Discovery Driven Planning
http://faculty.msb.edu/homak/homahelpsite/webhelp/Discovery_Driven_Planni ng.htm
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Backup Data

iPad Market Share vs. netbooks 2010 iPad Market Share vs. netbooks 2011 iPad Market Share vs. netbooks 2012 iPad Revenue 2010 (MM$/yr) iPad Revenue 2011 (MM$/yr) iPad Revenue 2012 (MM$/yr) iPad Total Cost, $/unit iPad Gross Profit, $/unit iPad Gross Profit Margin iPad Direct Expenses 2010 (MM$/yr) iPad Direct Expenses 2011 (MM$/yr) iPad Direct Expenses 2012 (MM$/yr) iPad Total Gross Profit 2010 (MM$/yr) iPad Total Gross Profit 2011 (MM$/yr) iPad Total Gross Profit 2012 (MM$/yr) iPad Income 2010 (MM$/yr) iPad Income 2011 (MM$/yr) iPad Income 2012 (MM$/yr)
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16.5% 33.5% 46.7% $4,615 $9,360 $13,065 $294.77 $355.23 54.7% $2,093 $4,245 $5,925 $2,522 $5,115 $7,140 $422 $2,615 $4,440

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