Unlock the power of bottom-up forecasting for your business

Introduction

Are you tired of feeling uncertain about your business’s financial future? Do you wish you had a crystal ball to help you make well-informed business decisions? Say no more! We’re here to save the day with the help of bottom-up forecasting. 

Learn about the benefits of bottom-up forecasting and how it can help your business make informed decisions. This detailed and granular approach involves forecasting sales at the most basic level and aggregating them to arrive at a total sales forecast.

It's particularly useful for small and medium businesses as it allows them to take into account specific drivers of demand. Take control of your business and confidently forecast the future using bottom-up forecasting.

Applying financial forecasting to your business will give you a clearer understanding of its expected revenue, cash availability, allow you to create realistic budgets, and set achievable business goals. 

There are a variety of forecasting models that can be used to predict future financial performance including bottom-up, top-down, scenario-based, and time-series forecasting to name a few.

Let’s start by taking a look at two of the most common methods top-down vs bottom-up forecasting.   

Top-down forecasting vs. bottom-up forecasting 

Top-down forecasting:

It starts with the company’s overall financial picture and works down to the details, whereas bottom-up forecasting will start with the individual components of a business and work up to the overall financial forecast.

A top-down forecasting model starts by looking at the overall market whilst taking into account macroeconomic factors which can include the expected economic growth, inflation, and exchange rates before breaking the information down into various smaller aspects. A business may also use market share as an indicator to make an educated guess about their product's future performance. 

Top-down forecasting is generally less detailed and accurate than bottom-up forecasting because it can fall into the assumption that one seasonal pattern fits all which is often not the case (Kahn, 1998). However top-down forecasting can still be useful for quickly creating broad financial projections. 

Bottom-up forecasting

It is a detailed, granular approach that involves forecasting sales at the most basic level and then aggregating those forecasts to arrive at a total sales forecast. This approach can be particularly useful for small and medium businesses.

This method allows them to take into account the specific drivers of demand for their products or services, such as promotions, inventory levels, and the performance of individual salespeople. Though it can yield wonders, the drawback is that this process is more time-consuming and labor-intensive.

What is bottom-up forecasting? 

In the previous section we briefly touched upon bottom-up forecasting, but now let's get into the nitty-gritty! 

This method of creating financial projections starts with the individual components of the business taking into account sales, revenue, expenses, and production costs, and works up to the overall financial forecast for the business. 

Here are a few examples of how bottom-up forecasting might be used in practice:

1. An e-commerce store might use bottom-up forecasting to forecast its sales for the next quarter. The store might start by forecasting the sales of each individual product it sells, based on past sales data, current inventory levels, and any promotions or sales that are planned. The store would then aggregate these forecasts to arrive at a total sales forecast for the quarter.
2. A manufacturing business might use bottom-up forecasting to forecast the demand for its products over the next year. The company might start by forecasting the demand for each of its products, based on market trends, customer demand, and the performance of its sales teams. The company would then aggregate these forecasts to arrive at a total demand forecast for the year.
3. A consulting firm might use bottom-up forecasting to forecast its revenue for the next fiscal year. The firm might start by forecasting the revenue from each of its individual consulting projects, based on the scope of work, the duration of the project, and the expected rate of billable hours. The firm would then aggregate these forecasts to arrive at a total revenue forecast for the year.

In each of these examples, bottom-up forecasting involves starting with the most basic elements (individual products, individual projects, etc.) and aggregating them to arrive at a more comprehensive forecast.

This method is especially useful if you have different products or services, as you can create more accurate forecasts on a per-product or per-service basis.

How do you calculate the bottom-up forecast?

To start bottom-up forecasting for your business, you will need to gather data on the individual components of your business that contribute to the overall financial forecast. 

An example of these components include:

1. Sales: data on the expected sales of each product or service offered by your business, including the volume of sales, the price per unit, and any discounts or promotions that you plan to offer.
2. Expenses: gather data associated with your fixed costs this can include raw materials, labor, rent, and other overhead expenses. Expenses typically do not vary with changes in your level of business activity.
3. Production costs: this refers specifically to the associated costs with producing each additional product or service, and can include raw materials, labor, and any other costs such as shipping or packaging.

Once you have gathered this data, you can use it to create financial projections for your products or service, and then combine these projections to create an overall financial forecast on the expected revenue that your business can generate in the coming period.

Let’s get more specific! Here’s a simple step-by-step example of bottom-up sales forecasting. 

Let’s say you’re the owner of an e-commerce store selling pillows and you want to forecast your total sales for the next month. Here's how you might go about it:

1. Determine the number of pillows the store expects to sell each day. This can be based on past sales data, current inventory levels, and any promotions or sales that are planned.
2. Multiply the daily sales forecast by the number of days in the month to get the total number of pillows the store expects to sell for the month. For example, if the store expects to sell 50 pillows per day and there are 30 days in the month, the total forecast for the month would be 1,500 pillows.
3. Calculate the average price per pillow based on the mix of different pillow types and sizes the store sells. For example, if the store sells standard, queen, and king-size pillows at different price points, the average price per pillow will be a weighted average based on the mix of sizes sold.
4. Multiply the total number of pillows forecast for the month by the average price per pillow to get the total sales forecast for the month. For example, if the store expects to sell 1,500 pillows at an average price of $50 per pillow, the total sales forecast for the month would be $75,000.
5. Next, you can improve your forecast by taking into account shipping costs, returns and cancellations, promotions and competition from other stores. This information can be drawn from historical data or other sources as we’ll touch upon in the next section.

We hope we’ve provided you with a good starting point!

Let’s start planning! What is bottom-up forecasting planning?

Remember that your forecasts are only as accurate as the data you input! Successful bottom-up forecasting requires close collaboration from both your Sales and Operation Planning divisions of your business (Lapide, 2003).

If you’re a small nascent business with limited data for your forecasts try your best to provide “proof” behind your numbers particularly if you lack historical data to draw from. 

The next time you’re planning to do a bottom-up forecast, here are some potential sources of information that you can draw from: 

Historical data:

One of the most common methods for gathering data for bottom-up forecasting is to analyze your company's own historical data. This can include data on past sales, costs, and revenues, as well as data on factors that may have impacted those metrics, such as promotions, changes in the market, and changes in operations.

Customer research:

Another method for gathering better data for a more accurate bottom-up forecast is to conduct research on your potential customers. This can include surveying needs and preferences, and analyzing market trends and the competitive landscape.

Financial modeling:

This involves building a mathematical model of your company’s financial performance based on a set of assumptions about its future performance. Financial modeling can be a useful tool for gathering data for bottom-up forecasting because it allows you to test for different scenarios and see how each might impact your financial performance.

Expert judgment:

In some cases, you may rely on the expert judgment of key stakeholders or subject matter experts to gather data for bottom-up forecasting. This can be particularly useful when data is limited or when there are significant unknowns that need to be taken into account.

Other sources:

These include industry reports, government data, or data from third-party sources.

Conclusion

Ultimately, bottom-up forecasting is a powerful tool that can help you to take control of your business’s financial projections and make informed decisions about the future.

By starting with the most basic elements of your business and aggregating them to arrive at a more comprehensive view, bottom-up forecasting allows you to take into account the specific drivers of demand for your products or services, and develop a financial plan that is grounded in real-world data and assumptions.

While it may be more time-consuming and resource-intensive than other forecasting methods, bottom-up forecasting can yield significant benefits for your business.

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