Sales Forecasting: A Bottom-up and Top-down Approach
Many an entrepreneur or small business owner is bedeviled with the challenge of forecasting sales activity, whether it be for cobbling next year’s budget or convincing a friendly banker to provide financing. For many, the process is viewed to be about as reliable as fortune-telling and as clear as mud.
Business owners can take a couple of steps rooted in common sense to bring structure and clarity to the forecasting process. By combining a “Bottom-Up” assessment of the firm’s internal capabilities—production and distribution capacity, sales and marketing infrastructure, and pricing power, among others—and a “Top-Down” analysis of market opportunity, the sales forecast can be de-mystified.
The Bottom-Up Assessment
Sales, and the revenues that they generate, are subjected to some fundamental limitations. Depending on the type of business these may include hours in the day, capacity of a machine or plant to produce widgets, or numbers of sales people making customer calls, to name a few. Beyond these physical limitations the firm is also bound, in most cases, by pricing constraints imposed by competitors for comparable products and services. Think of this collection of limits as the supply side of the forecast.
The Top-Down Analysis
This is the demand side of the forecasting process. A business can only sell as much of a product or service as there exists demand for it regardless of its capacity to create same. A credible forecast will rely on an objective, quantitative analysis of current and projected demand in a targeted market, whether defined by customer type, geography or other attribute important to the firm.
Each of these components of the forecast is necessary, but not sufficient, to establishing a credible projection. When combined, however, they can serve as an effective yin and yang offering a holistic solution to the forecasting conundrum.
Putting the Two Approaches Together
Let’s use a hypothetical start-up business to demonstrate how sales and revenues might be projected using this tandem approach.
George is thinking about opening a barber shop. He wants to estimate his revenue potential. Using the Bottom-Up method George has determined that he will be open 8 hours a day six days a week. He also knows that an average cut requires about 45 minutes. Based on his research on prices charged by other barbers in his area he will need to price a standard cut at no more than $20.
George’s maximum “unit sales” per week is 64 and his maximum revenue opportunity is, therefore, $1,280. As a practical matter, George knows that he will not be operating at maximum capacity each and every week. He estimates that he can generate sufficient traffic to be busy 75% of the time. His weekly revenue opportunity is forecast at $960.
To test the reasonableness of this revenue estimate George next researched market demographics and spending patterns of households in his town. Additionally, he identified the number of barber shops in a 5-mile radius of his favored location. His research revealed that households in this area spent $1,000,000 on haircuts last year at 10 different shops. If he hits his revenue target he would command just under 5% of the available market and would operate a shop about one-half the size of competitors. Armed with these findings George concluded that his revenue projection was reasonable and decided to press forward with his venture.
Imagine, however, if the local market for haircuts was only $250,000 with 10 competitors. George would need to capture 20% of the market to achieve his revenue goal and generate twice the revenue of the average existing shop in his area. These are significantly more daunting hurdles than those in the previous scenario and may cause George to think twice about starting his business—or an outside lender or investor about committing capital to the venture.
How the Indiana Small Business Development Center can help
ISBDC Business Advisors can help George and other aspiring entrepreneurs and business owners on a number of fronts to bring focus and clarity to the sales forecasting process.
Advisors can work with clients to develop a business plan that can aid in creating a clear focus on operational capacity (the Bottom-Up part) and target markets. They also are able to employ market research tools to objectively and quantitatively size up opportunities (the Top-Down part). Advisors are also able to apply tools to compare projected performance against a wide array of industry metrics as another means to assessing the reasonableness of projections.
Once the sales forecast is completed the ISBDC Advisor can assist a client in developing robust financial projections that incorporate revenues, operating expenses and capital expenditures. An essential requirement for business owners seeking outside financing, the financial projections provide a road map for ascertaining cash flows, break-even points and debt coverage capabilities, among other important measures of business well-being.