Last editedAug 20213 min read
Forecasting is an important process for any business. It involves estimating future sales and revenue which in turn helps a company determine its cash flow and spending going forward. After a process of forecasting, a business should have a decent idea of how they may perform in the future.
There are two ways to perform forecasting that garner different results: top-down forecasting and bottom-up forecasting. Each has its own advantages, so here we’ll outline the differences between the two and when they should be used.
What is financial forecasting?
A company can and should be forecasting even pre-revenue, and should continue forecasting on a regular basis in order to best manage their financial performance.
Financial forecasts may not be 100% accurate, but forecasting is far less about complete accuracy and more about informed decision making. A robust financial forecast will help your business get a solid idea of how much cash they have available each month, helping to set realistic budgets and business goals. It helps businesses plan ahead for unexpected changes; a financial forecast can indicate just how prepared a company is for a sudden shift. Financial forecasting is also essential for businesses looking to secure funding, as it can be used to show that the business is a viable investment.
What is top-down forecasting?
A top-down financial analysis involves assessing the entire market that the business operates within. It starts with measuring the market size currently available to the business while considering existing market trends, before making predictions about how the business might perform within the market. The strengths and weaknesses of the business are then examined in relation to the potential of the wider market.
Top-down forecasts offer a broader perspective when it comes to revenue potential, and are a great way to get a more informed idea of the demographics and audience you should be targeting. It looks at the existing market and the potential for market growth to predict what percentage share of the market a business is able to capture over a set period.
Say you run a business selling eco-friendly kitchen products. Top-down forecasting would involve assessing the overall market for eco-friendly kitchen products and determining market capacity – how many customers are willing to buy every month. This may be done through processes like market research and competitor analysis.
Then, you’d predict how many of those buyers (what percentage of the market capacity) would buy from your business specifically (your market share), and how much revenue you can expect to make per sale.
So, you start at the top by looking at the entire market, and work your way down towards predicting your business’ share of the market – hence ‘top-down’.
What is bottom-up forecasting?
A bottom-up analysis is less concerned with the wider market and focuses more so on the product or service itself and the activities of the business. Bottom-up forecasting involves assessing factors like production capacity, marketing costs, hiring costs and more – any activity or factor that may have an impact on finances is considered when undertaking bottom-up forecasting.
Bottom-up forecasting focuses on what a business needs to do in order to compete in the market, by examining its activities. This involves cash flow forecasting and analysing sales, costs of goods sold, operational costs, staffing and so on, in order to get an idea of how your money is spent and how this will impact future financial reports.
After bottom-up financial forecasting, a business will be able to offer a more accurate answer to ‘What-if’ questions like, what if the business were to increase production capacity? What if we spent less on marketing? What if we doubled our workforce?
Through bottom-up forecasting, you can gain an understanding of how each individual factor influences the bigger picture.
Top-down vs bottom-up forecasting
Top-down forecasting offers a prediction of how much market share is needed to be profitable, while bottom-up forecasting offers an understanding of which business activities have the biggest impact on financial performance. Both methods can be hugely beneficial for a business, and deciding which one to go with, if not both, will depend on what you’re using forecasting for.
Advantages of top-down forecasting
Top-down forecasting offers a more optimistic view. Being less grounded in actual business data, it allows a business to forecast a more favourable prediction of their potential market share. This makes top-down forecasting an easier way to offer a more positive outlook for directors or potential investors, as it evaluates performance based on percentage of market share, instead of being based on actual business activities.
Top-down forecasting is much quicker and easier to execute than bottom-up, as you won’t need to analyse every single detail of your business’ activities.
Advantages of bottom-up forecasting
Bottom-up forecasting offers more realistic results. Bottom-up forecasting makes use of real sales data from the business, offering a more focused look at how the activities of the business may impact their financial growth. Bottom-up forecasting allows for a more detailed analysis of specific products or strategies.
Taking into account factors like marketing, hiring costs, production costs and so on, bottom-up forecasting allows for greater input, and output, across departments. You may find through bottom-up forecasting that it would be beneficial to increase marketing spend while finding ways to reduce labour costs, for example – so you’re able to devise more focused strategies for each area of the organisation.
Therefore, bottom-up forecasting is a better method when predicting which specific products or services present the best opportunities or which areas of the business should be prioritised.
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