Welcome back to this series on financial forecasting where we address the burning questions beginners to the topic have, this week we’re covering financial forecasting methods.
In this edition, we’re going to be discussing two methods of financial forecasting, and more specifically the top-down and bottom-up methods.
Now, if you’ve used Brixx, you’ll know which method we favour (bottom-up), but I’ll do my best not to be biased in this article!
If you’re interested in reading more about the world of financial forecasting, be sure to take a look at the other articles in our Forecasting Fundamentals series:
- What is Financial Forecasting?
- How Long Should a Financial Forecast Be?
- Are Financial Forecasts Accurate?
- Do I Need a Budget or a Forecast? | Budget vs Forecast
- The Top 4 Advantages of Financial Forecasting
- What’s the right tool for creating a financial model?
- How to create a financial model
- Financial Planning And Analysis (FP&A) | A Brief Overview
What is top-down forecasting?
In short, for top-down forecasting, a business assesses its market size and how much potential customers are willing to pay for its goods or services.
This method is called “top-down” because it starts with the size of the potential market and works back from this to determine the business’ potential share of this market.
Market size can be estimated through traditional market research methods such as competitor analysis. Using this information, they can then estimate how much revenue they might make per sale.
Your market share gives an impression of total revenue and profit, which is based on a percentage of the total number of willing-to-buy customers (market capacity) that they believe they can capture. You might then increase this market share each year of forecasting, to create a vision of longer term performance.
What is bottom-up forecasting?
Bottom-up forecasting is based on what it takes to get your product to market and is much more detailed.
This is described as “bottom-up” forecasting as it begins with the business’ actual activities and builds a forecast up from these activities.
You’ll include a sales forecast, staffing, marketing, operational costs, costs of goods sold, the works.
Using this sales forecast and the outcomes of business activities, you can start to generate a picture of your business – just like we do here at Brixx.
So that’s a brief overview, but how do they compare?
The pros and cons of the to-down method
One of the biggest draws to using the top-down method is it’s quick and easy if you know your market. It takes far less time to set-up than the bottom-up method as you don’t need to go into minute detail, you need to do your market research though.
It’ll also please directors, as it tends to have a more positive outlook than the bottom-up method. This is because you’re evaluating your performance based on a percentage of market share, rather than the impact of business activities.
The business activities come later and are more of an output rather than an input (as is the case with Brixx and bottom-up forecasting), more of a “This is the market share I need to be profitable, here’s the activities I’m going to do to achieve this market share”.
The major downside is the lack of detail that you get from the top-down method. Pinpointing how you will achieve the desired outcome is a challenge because you work these out after creating your forecast.
This makes making strategic decisions difficult, as you lack clarity around the impact of activities, so for example you can’t say that you need to increase PPC spend as you wouldn’t know if that was having an impact.
The pros and cons of the bottom-up method
As you’d expect the bottom-up method is the opposite of the top-down method. It involves planning out your business in explicit detail, representing your income and expenditure to the best of your knowledge.
The advantage of planning in such detail is you produce a picture of your business, that you can test and flex to model internal and external changes.
Testing your business with scenarios in this way helps you understand what business activities have the most effect on your financial reports.
Being able to answer and understand key “What-if” questions such as, when you might hire extra staff, increase production or introduce a new product or service is crucial for planning and strategising the growth of your business.
Laying out all the moving parts of your business means you can be as accurate as possible, at least in the short term, but the downside is it can take time, in fact, quite a lot of time compared with the top-down method. But the time spent is often worth the effort!
Let’s roundup this introduction to the two most common financial forecasting methods.
The top-down method works by carrying out market research. Assessing market size, customer traits, and finally estimating a percentage of that market you’ll be able to capture.
The bottom-up method works in the opposite way. By setting out all income & expenditure, you build a picture of the business which allows you to run scenario tests. Running these tests allows you to plan for multiple scenarios and the strategic future.
Both methods have their advantages and disadvantages – which method you opt to use will ultimately depend on what you’re trying to achieve, the top-down method is great if you just want a quick estimate of your business’ potential.
We’d always recommend that people use the bottom-up method due to the detail and flexibility it offers, but it does take time, so wouldn’t it be great if there was a tool that made bottom-up forecasting a less time-consuming and painful process?
That’s where we come in! Brixx handles bottom-up forecasting with ease, with a clever component-based system that turns your business into numbers. Switch components on and off for quick scenario tests, whilst key reports and charts are generated automatically on demand.
Give Brixx a spin today with a free trial!