Top-Down Forecasting

What is Top-Down Forecasting?

The Top-Down Forecasting is a strategic methodology that involves projecting future sales by applying an indicated market share percentage to an estimated overall market size.

By beginning with high-level market data and working "down" to revenue, top-down forecasting is a technique for predicting a company's future performance. This strategy starts by looking at the big picture before focusing on a particular business.

Forecasting is a crucial activity for any organization. It entails forecasting future sales and revenue, which aids a business in determining its cash flow and spending.

A business should have a good concept of how it may perform after the forecasting procedure.

To manage its financial performance to the best of its ability, a firm can and should forecast even before it receives any income. It should also continue forecasting regularly.

A thorough financial forecast will help your company clearly understand how much cash is available each month, which will help you set reasonable financial goals and budgets.

It assists organizations in preparing for unforeseen events; a financial projection can show how well-prepared a company is for a sudden change. In addition, financial planning is crucial for companies seeking funding since it may be used to demonstrate that the company is a wise investment.

Understanding Top-Down Forecasting

Top-down forecasting presents a more upbeat perspective. It enables businesses to foresee a more positive prognosis of their potential market share because it is less based on actual business data.

Because top-down forecasting bases success evaluation on market share percentage rather than on actual company operations, it is simpler to provide directors or potential investors with a more optimistic outlook.

Top-down forecasting is considerably quicker and simpler to implement than bottom-up forecasting because you won't have to examine every aspect of your company's operations.

The use of forecasting will determine which method, if not both, you choose to employ. Both can be very advantageous for a business.

How To Perform Top-Down Forecasting?

To project a company's income, the top-down forecasting method adopts a "bird's eye" perspective of the entire market that is practically possible.

A particular company's Total Addressable Market (TAM) is multiplied by an expected market share percentage in the top-down forecasting approach to creating revenue projection.

The top-down method is easier to use and takes less time than the bottom-up one.

However, practitioners frequently choose bottom-up approaches because they concentrate on the particular unit economics of the business rather than taking a broad picture of the market, which may make the underlying assumptions more tenable.

Alternative Forecasting Methods

Pro forma figures are quite helpful when predicting income, costs, and sales. One of the seven financial forecasting techniques that calculates future income and growth rates frequently supports these conclusions.

Forecasting may be divided into two main categories:

1. Quantitative 
2. Qualitative

Quantitative Techniques

Business executives frequently use quantitative projections—assumptions about the future based on previous data—to produce reliable forecasts.

1) Sales as a percentage

Internal pro forma statements are frequently produced utilizing sales forecasts as a percentage. This approach converts future financial line item indicators to a proportion of sales.

For instance, using the same growth rate estimate makes sense because the cost of items sold is expected to rise proportionally with sales.

2) Straight line

The straight-line approach relies on the firm's previous growth rate being constant. To predict future revenue, a corporation's previous year's revenue is multiplied by its growth rate.

Straight-line forecasting, for instance, implies that if growth was 12 percent last year, it would again be 12 percent the next year.

Although straight-line forecasting is a great place to start, it doesn't consider supply chain problems or market changes.

3) Moving Average

Using a moving average, you may predict the future by averaging—or weighting—previous periods. This strategy entails looking more closely at a company's high or low needs and is frequently useful for short-term forecasting.

By averaging the prior quarter, you may, for instance, predict the sales for the following month.

Moving average forecasting estimates several indicators. It is frequently used to forecast stock prices and income.

Qualitative Approaches

The full picture isn't always shown by numbers when predicting. There are other non-quantifiable elements that affect performance.

In contrast to quantitative forecasting, which uses historical data, qualitative forecasting uses the expertise and understanding of specialists to forecast performance.

1) Delphi Approach

To anticipate a company's success, specialists who have studied the market communicate with each other.

A facilitator contacts those experts with questions and requests for company performance predictions based on their expertise.

After compiling their analyses, the facilitator distributes them to other specialists for feedback. The objective is to keep circulating them until an agreement is found.

2) Market Analysis

Market research is crucial for developing a company. It aids corporate executives in gaining a comprehensive understanding of the market based on rivalry, shifting circumstances, and consumer trends. When previous data is unavailable, it's crucial for startups as well.

Financial forecasting is advantageous for new firms since it's necessary for attracting investors and setting up a budget for the first few months of operation.

Top-Down Forecasting Approach Advantages

Several advantages can be pointed out for top-down forecasting, specified elaborately below:

• The primary benefit of using a top-down approach to revenue forecasting is that it is quick and simple.
  Businesses don't have to examine every facet of their operations in depth to produce a projection, which can save a lot of time and money.
• Top-down revenue forecasting also gives a broad picture of what the market may hold. Thus this method gives the flexibility to re-forecast against a variety of potential options based on new market data if you operate in a dynamic environment or are a young startup with many options on the table.

Through special management techniques, the top-down strategy may have a wide range of advantageous business effects, including the following:

• Establishing distinct lines of power
• Uniformity of goods and services
• Assisting quality assurance
• Doing work more quickly and attaining goals

Top-Down Forecasting Approach Disadvantages

Top-down revenue forecasting has considerable drawbacks, especially for growing organizations. Some of these disadvantages are:

• The biggest one is that it could be too optimistic or inaccurate since it is based on generalizations rather than a plan of action. Investors could be intrigued by a positive outlook, but they will want to see a compelling operational plan for achieving it.
• Top-down forecasts are difficult for smaller companies to implement, especially if they serve a substantial Total Addressable Market (TAM). However, it is slightly simpler for a significant participant in a huge industry.
  • For instance, if Microsoft Azure had 22% of the cloud market in Q3 of 2021, it is reasonable to assume that it will have a similar market share in Q4. Microsoft's market share in dollars may, therefore, be calculated using the predicted growth of the whole cloud industry. If market dynamics somewhat changed, for example, if SmallCo had 0.01% of the cloud market, the Q4 result may have been very different.
• A top-down revenue projection does not consider organizationally modifiable elements like the number of sales reps recruited or the sum of marketing expenditures.
• Top-down sales forecasts aren't especially useful, realistically speaking. So when growth exceeds or falls short of expectations, it is important first to ask why. If you don't have a prediction model that connects how your business runs to the revenue it generates, answering that question is difficult.

Bottom-Up Approach

A bottom-up forecast’s main approach is to focus on the firm first and then the market as a macro variable to be analyzed.

This approach involves evaluating variables like production capacity, marketing expenses, recruiting expenses, and more - considers every action or variable that could impact finances.

People using this approach must focus less on the market and more on the product. This forecasting technique looks at a company's operations to determine what it has to do to compete in the market.

Understanding how your money is spent and how this will affect future financial reports requires projecting cash flow and analyzing sales, costs of goods sold, operational costs, staffing, and other factors.

This method may reveal that, for example, it would be advantageous to raise marketing spending while looking for ways to cut labor costs, allowing you to develop more targeted strategies for each area of the organization.

Since top-down forecasting provides analysis based on industry first, it provides a projection of the market share required to be profitable, which makes it kind of unrealistic in terms of coming up with an analytical conclusion.

Results from bottom-up forecasting are more realistic because the analysis of the activities which have the most impact on the company's financial performance is provided by bottom-up forecasting.

Top-Down Vs. Bottom-Up Forecasting

Let us understand the difference between the two approaches below:

Conclusion

The Top-Down Forecasting approach projects future sales by applying a stated market share percentage to the anticipated total market size.

Forecasting is a key task for every firm. It comprises projections for upcoming sales and income, which helps a firm determine its cash flow and expenditure needs. After the forecasting process, a firm should clearly understand how it may perform.

Accurate forecasting is essential for financial planning, attracting investors, and setting budgets, making it a fundamental tool for any business, whether established or a startup.

Bottom-up forecasting produces more realistic results. In addition, bottom-up forecasting gives a more in-depth view of how operations could impact future financial success using real sales data from the organization.

The market's potential is also broadly portrayed through top-down revenue projections. Additionally, top-down revenue forecasting requires little to no historical data.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Forecasting Cash Flow
• Forecasting Methods
• Foundations of Real Estate Financial Modeling
• Top Financial Modeling Courses
• Top Time-saving Tricks for Financial Modeling