The forecasting process is built around 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 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.
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.
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.
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 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.
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.
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