Question

Distinguish the differences and similarities between the top-down approach and the bottom-up approach for preparing a sales forecast. Please elaborate and use examples.

Answer 1

Forecasting is the process for projecting estimates for your future sales and revenue. Even if you are pre-revenue, 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 tomanage your cash reserves and increase your sales.

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.

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 80M 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 40M active iphone users who purchase apps, 1% of these consumers will purchase your app. That would give you 400K new customers.

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.

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 forecast. 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.

On a top-down basis, sales may be forecasted starting with broad categories of products or components, then broken down into successively narrower categories, and eventually to specific items. The process also may generate further detail by factors such as sales channel, geographic sales region, customer category or even specific customer (in the case of especially large customers that contribute a significant portion of the firm's sales). A bottom-up methodology, by contrast, would start with projections for each specific product or component, perhaps also by sales channel, geographic sales region, or customer type.

Top-down budgeting and forecasting methods may have greater potential accuracy regarding large aggregates. A bottom-up approach may have errors that accumulate as one rolls up results to larger totals. However, disaggregating the high-level totals in a purely top-down process may have a significant element of force fitting to it, thereby producing some unrealistic numbers at the level of individual departments and products. Meanwhile, proponents of bottom-up processes insist that a logically coherent estimate of an aggregate must flow from its component parts.

Even purportedly bottom-up methods often must have a significant top-down element mixed in. For example, departments and business units frequently budget by factoring the prior year's results up or down by set percentages, instead of taking a truly bottom-up approach to each line item of revenue or expense. Producing a truly bottom-up budget for employee compensation, for instance, would require projections of each individual's pay and bonus for the year. With new hires, it also would rely on estimates of when each person would start work. Budgeting at such a finely-grained level of detail often is deemed to be impractical.