Financial forecasting is an important tool for any business as it helps you project estimates for your future sales and revenue. Even if you are pre-revenue or pre-sales, you need to go through this process — both for your own better understanding of your company’s cash flow and needs, as well as to help you to secure funding.
And forecasting isn’t just a once-in-a-company’s lifetime process, of course. Once the sales start rolling in, you’ll need to prepare forecasts on a regular (read: monthly) basis to help you to manage your cash reserves and increase your sales.
Many entrepreneurs use a top-down approach for financial forecasting. While this yields impressive numbers, they’re not always realistic. In fact, it’s the opposite: the results are usually completely unobtainable.
So, top-down or bottom-up forecasting? What do they mean and which approach should you use?
Top-down financial forecast
A top-down forecast looks at the overall market and uses this information to identify your company demographics and target mark. The assumption is that, given the existing market and potential market growth, your company can expect to capture a certain percentage share of the market in year one, a greater percentage in year two and so on.
A top-down analysis assesses how much of the market will buy your products or services? You then examine your company's strengths and weaknesses and how to amplify your strengths and remedy your weaknesses — and what to do about them.
For example, if your company has created an iPhone app, you might take a look at the number of consumers who have purchased apps for their iPhones. If there are 80 million active iPhone users and half of iPhone users buy at least one app per month, you can extrapolate from here. Being conservative, you could estimate that of the 40 million active iPhone users who purchase apps, 1% of these consumers will purchase your app. That would give you 400,000 new customers.
Pros of using top-down financial forecasting
One of the benefits of using top-down analysis is that it avoids statistical anomalies or data swings, common to lower level facts and figures. Businesses can uncover sales patterns and get a more accurate image of their prospective revenue with the aid of a top-down perspective on their industry.
They might be able to develop more precise models as a result for planning strategies and allocating resources. This approach typically offers a more upbeat perspective, therefore organizations may find it simpler to pique investor interest with it.
Companies don't require current point of sale (POS) data to estimate outcomes when using top-down forecasting. Businesses, especially new ones, may find it simpler to create estimates if they evaluate the available market income from the top down. A top-down perspective also assesses whether a market is growing or shrinking, which helps businesses quickly understand their long-term profit potential.
Sounds good, right? Unfortunately, too good.
While you want to be optimistic in your projections — enough so as to be interesting to investors — you should not be unrealistic about your potential growth. Entrepreneurs typically tend to be way too optimistic with their forecasting. Grounding your forecasting with facts and creating more realistic projections will provide legitimacy to your business, if there is real potential there.
Cons of top-down analysis
Top-down revenue forecasting has significant limitations, particularly for businesses that are expanding. The largest one is that because it is founded on generalizations rather than a strategy to reach a goal, it may be unduly optimistic or wrong. While an optimistic forecast may be helpful in drawing your investors interest, but they’ll want to see a credible operational plan for achieving that target.
Unsuitable for smaller organizations:
Smaller businesses find it challenging to adopt top-down forecasting, particularly if they serve a sizable Total Addressable Market (TAM). It is somewhat simpler for a major player in a sizable industry.
Also top-down revenue estimates aren't very helpful in terms of operations. The first thing to consider when growth exceeds or falls short of expectations is why. It's quite challenging to respond to that question if you don't have a forecast model that links how your company operates to the revenue it creates.
So how can you create a more realistic projection? Forecast from the bottom-up.
Bottom-up financial forecast
A bottom-up forecast is a detailed budget with spending plans by department. Hiring plans and revenue projections are based on actual sales forecasts. It’s essentially your operating expense plan, less the depreciation expense, plus capital expenditures. In other words, you calculate your potential revenue by multiplying the number of potential sales per product by the average sale value. Obviously, this is a more strategic approach wherein you take a real look at your current situation and capabilities and see where you can reasonably expect to go from here.
Using our previous example of your new iPhone app, you can see how your revenue projections would substantially shrink using this approach. Now, instead of looking at the market and its potential, you need to look at your own market (for example, your existing customers or Twitter followers) and map out how you can parlay your current standing into new sales.
Because you’re looking at real numbers and your real situation, it’s obviously much harder to get huge projections with bottom-up forecasting. With this approach, the only way to grow your numbers is to increase your overall exposure and make sure you are working all the angles to market and sell your product/service.
Pros of bottom-up forecasting
According to many experts, bottom-up forecasting provides a more accurate financial picture than the top-down model. Bottom-up approaches, in contrast to top-down forecasting, estimate revenue by dividing the average value per sale by the anticipated sales for each product. Bottom-up forecasting uses actual sales data, thus the forecast that results may be more accurate, allowing you to make more informed strategic choices going forward.
Better item-level forecasting
Profits from numerous goods and regions are averaged rather than taken into account one at a time in top-down forecasting. As a result, companies would have trouble selecting how to produce and market particular goods. A bottom-up financial projection might be the best course of action if you want to determine how to effectively devote your resources to particular goods.
Active employee participation
A bottom-up strategy has the advantage of giving managers and employees additional opportunities to participate in budgeting. Owners monitor operating costs and evaluate spending by department with a bottom-up method. Costs associated with employment, marketing and distribution are included.
Small business owners can give department heads and advisers the information they need to make smarter spending decisions by looking at these numbers. Plus, if managers were involved in budget creation, they were more inclined to follow it.
Cons of using bottom-up forecasting
Bottom-up forecasting can take a lot longer than top-down forecasting because of how detailed it is. And occasionally, without the proper tools, it can be too late to use the data that a business gathers and analyzes for a bottom-up projection.
Any mistakes a company makes at the micro level (such having an overly optimistic closing rate) are magnified as they get closer to the macro level. In order to exceed expectations, departments occasionally purposefully produce false estimates that sandbag the model and its targets.
Conclusion: Top-down versus bottom-up : the right choice?
Forecasting sales is fine, but it's better to proactively ensure that the company can achieve a sales objective. The greatest revenue projections combine aspects of top-down and bottom-up strategies because they can be used to balance one another.
A top-down forecast can be used to verify the validity of a bottom-up forecast. Additionally, a bottom-up forecast might shed light on the operational conditions that must exist in order to achieve the top-line objective.
Whether it’s top-down or bottom-up, the best way to approach forecasting is to use a rolling forecasting model
Do you use bottom-up or top-down forecasting? Tell us about it in the comments below or contact Early Growth Financial Services for help with your financial planning and strategy.
Frequently Asked Questions
What is an example of a top-down approach?
If your business develops an iPhone application, you can note users who purchased the app for their iPhones. You can extrapolate from this if there are 80 milion active iPhone users and 50% of iPhone users purchase at least one app every month. If you want to be conservative, you may assume that 1% of the 40 million active iPhone users who buy apps will do so for your app. You would gain 400,000 new clients as a result.
What is an example of a bottom-up approach?
If you wish to construct a template for a sales forecast, you'll normally start by describing how many orders are anticipated from each business channel. You could even start farther down with advertising conversion rates or the productivity indicators within a particular team if you wanted to go more in-depth.
Next, you project the prices that will be charged for those sales as you'll as the profit that the company will make from them. You will have the statistics you need to estimate revenue in larger terms once you have determined the value of low-level transactions after refunds, exchanges, return charge-backs and other relevant considerations.
Which is better top-down planning or bottom-up planning?
Bottom-up forecasting provides knowledge of which company activities have the most impact on financial performance whereas top-down forecasting provides a projection of the amount of market share required to be profitable. The use of forecasting will determine which strategy, if not both, you should employ and depending on that both can be quite advantageous for a business.
Why is the bottom-up forecasting approach better?
You may get a more precise, detailed and practical result by forecasting income from the bottom up. It weaves together the data and organizational structure and shows how the actions of the organization might affect its financial well-being. Bottom-up forecasting enables you to make decisions based on data.