How to build a robust bottom-up revenue forecast

How To Build A Robust Bottom-Up Revenue Forecast

How to build a robust bottom-up revenue forecast

When approaching investors and lenders, the larger the degree of risk that’s perceived in your business, the less favourable the terms you are offered will be. A well-researched bottom-up revenue forecast will help to persuade those investors and lenders that your business model is economically viable, and help to reduce that perceived level of risk. Yet a revenue forecast is not only a tool for securing investment or credit. It’s a fundamental part of constructing your business plan, and should drive decisioning across recruitment, sales activities, and resource deployment and more. Here we show you how to build a robust bottom-up revenue forecast for your business.

The importance of forecasting

Forecasting is imperative for setting business goals, budgets, pricing, sales targets, production capacity, and assessing your business model.

A clear, detailed and flexible forecast can help you anticipate your profits, predict revenue fluctuations, address potential cash flow problems, identify break-even points and debt payback capabilities and will form the basis of your budget. An effective forecast will also help you to manage your supply chain more efficiently and economically. It will help you better understand where you need to be and what it will take to get there.

Top-Down and Bottom-Up forecasting

There are two primary methods you can employ to construct your revenue forecast. One is called a Top-Down and the other a Bottom-Up revenue forecast.

Top Down Forecasting

Top Down forecasting begins with a macro view of industry-wide estimates and works down to individual departments, products, and services. It looks at the overall market, factors in industry trends and supply and demand forces and uses the information to work out the potential size of your target market.

Once that market has been estimated, you figure out from there what you will need to achieve the market share you should expect to capture. You then analyse your business and look to optimise it in order to achieve the market share potential.

To be accurate, Top Down forecasting requires a significant amount of industry data to be available and can often result in the projection of unrealistic or unachievable figures. A common criticism of Top Down forecasting is that it lacks grounding in specific facts, and relies on extrapolation.

Profits from products and regions are normally averaged together when assessing market capitalisation. Trends and patterns become generalised. This makes deciding how to allocate resources and manufacture and distribute individual products more difficult.

Bottom Up Forecasting

Bottom-Up forecasts take the opposite approach, beginning with the specifics and working up to the general. They start with individual product sales estimates, production capacity, department-specific expenses, and then they assess the addressable market based upon those assumptions. Each department provides its own projections of sales and revenue, and you combine the components to form the forecast for the entire business.

The advantages of a Bottom-Up revenue forecast approach

The goal of forecasting is not to predict the future but to tell you what you need to know to take meaningful action in the present.

– Paul Saffo

Because it employs a more strategic approach, Bottom-Up revenue forecasts encourage you to assesses your current situation and capabilities and see where you can reasonably expect to go from there.

Greater employee input

Employees across the business are more involved in the process, allowing for a more realistic appraisal of your capabilities.

More accurate and realistic

Bottom-up forecasting uses actual sales and production data. It projects revenue by multiplying the average value per sale by the number of prospective sales per product. This provides a more realistic assessment of the potential revenue that can be expected. The resulting forecast may therefore be more accurate, enabling you to make more informed strategic decisions.

Aids strategy

Developing a forecast that assesses the individual capacity and performance of specific products and departments can be very helpful for setting sales, production and hiring goals and for allocating resources to obtain objectives.

Building a robust bottom-up revenue forecast

It is far better to foresee even without certainty than not to foresee at all.

-Henri Poincare

Building a revenue forecast requires you to decide on a timeline, forecast your sales, and forecast your expenses. You can use either past data or researched data.

It’s important to understand firstly that your forecast will be wrong. Why? Because there’s no way to predict the future. However, there are methods you can apply that will increase the likelihood of your forecast being both realistic and flexible enough to adjust to market forces.

There are five key elements to building a well-researched, realistic and relatively consistent bottom-up revenue forecast

Understand your sales funnel

You won’t be able to construct a meaningful revenue forecast without understanding the amount of time and effort needed to convert prospects to buyers. Make sure you know how your sales funnel operates based on the customer decision-making process.

A common sales funnel model is something like this:

Lead – Discussion – Proposal – Evaluation – Trial – Order – Install – Payment.

Make sure you understand all the variations that can arise within your sales funnel. How will you get leads? How long will it take to get from lead to order, install and payment?

What’s the conversion rate at various stages? How many leads will you need to get to achieve the sales necessary to reach your revenue projections? How many salespeople is it going to take to create the sales you need to achieve your revenue targets?

Understanding the requirements and limitations of your sales processes will enable  you to build a clearer picture of what it will take to achieve expected revenue. These are the ‘how’s’ that accomplish the ‘what’. Build your forecast from here.

Analyse your market

Never forget this simple truism: Forecasting is marketing, plain and simple.

– Barry Ritholtz

You need to understand market demand. This means analysing market trends, influences, price points and buyer behaviour.

For example, are there seasonal factors that influence how buyers act, and when they buy your product or service? This type of information will provide a solid grounding for constructing a realistic Bottom-Up revenue forecast.

Understanding your industry is essential when building the rules of thumb you should work with when creating a Bottom-Up forecast. So take a good look at other companies. What are they spending on marketing, sales, production and R&D?

What prices are being charged by your competitors? Constructing a Bottom-Up revenue forecast involves working out how many items you can sell at a particular price point over a certain time period. Therefore, if you can’t set a realistic price point, then you will undermine your forecast.

It’s crucial, particularly when addressing investors, to substantiate these market projections with real data. Market research can be expensive, so seek out free sources of information:

  • Tech and innovation hubs – these can provide you access to market analysis
  • The Internet – government websites, stats, census and benchmarking data on companies in your industry.
  • Annual reports on public companies in your industry – look at the management information and analysis in the annual reports.

 

Check your assumptions

The assumptions you use to underpin your Bottom-Up revenue forecast must be realistic and consistent. They must represent what is reasonably achievable based on not only the market demand, but also the resources you have, your expenses and your limitations. You must also form them around the critical success factors that will drive revenue in your business.

Be sure you have a requisite level of detail. If you have three products or three channels, make sure you have three sets of assumptions around revenues and costs. This will give you more credibility with investors.

Furthermore, your forecast should outline specifically how much money you require and what you’re going to use it for. Including day-to-day expenditure or ‘cash burn’, research and development, and other capital expenditure. Include both fixed costs and variable costs.

You don’t need to have a crystal ball. Your assumptions just need to be reasonable in the context of investors’ experience, industry benchmarks, your business model and other market data.

Above all, be wary of mistaking assumptions for facts. Share your assumptions with as many stakeholders as possible and allow them to be challenged. Because transparent assumptions tend to lead to smoother budgets.

Allow for contingency

Build in flexibility around the assumptions you’re making. It doesn’t matter whether you’re using top down or bottom up forecasting, your key assumptions should be sensitised so you can manipulate them. This will help you to work out different scenarios.

Always include contingency allowance in your financial forecasts, in case the unexpected happens (it invariably does).  Have ‘great’, ‘good’ and ‘conservative’ revenue scenario estimates. This process will prepare you for potential adjustments as well as help you understand your business and your market.

As previously mentioned, your forecast will be wrong. So, work from this premise and from there assess different scenarios.

For example: if your forecast is 20% wrong, then how will that affect your cash flow and capital requirements, and where will the tipping point for your business appear? This will help you figure out the relative risk of those scenarios, and will help you paint a clearer picture of that risk to management and potential investors.

Do it often

If you have to forecast, forecast often.

-Edgar R. Fiedler

Don’t make forecasting an annual event. Check your forecasts monthly. Find out who’s where in the sales funnel and adjust your revenue forecasts accordingly. Similarly, regularly check your assumptions and revise them when new information comes to light.

Forecasting often uses guesswork, theoreticals and assumptions which change over time as you adapt and begin to substantiate your business model or value proposition. This means you’re going to want to change and update your forecast on a regular basis.

Build your Bottom-Up revenue forecast so you can adjust it regularly. If your key assumptions are robust and well-researched and you understand the variables that you’re going to be working from, you can build out your model and adjust it over time without having to rework things too much. This keeps the technical integrity of your forecasting model intact, and allows you to update it in real time. Making sure your forecasting is as accurate and reliable as possible.