My last post compared bottom-up and top-down forecasts. This one expands on that comparison. To keep it very simple, let’s focus on forecasting just next year’s revenue for a startup business that has no historical track record. The business is a one-man car detailing service that will charge $100 per car and serve a market that has 20,000 cars.
(Assume that every numerical assumption has a reasonable basis, such as a motor vehicle census for the market of 20,000 cars.)
A top-down forecast is a macro take. It might go as follows. One of every 20 car owners will be interested in having their car detailed once next year. Next year, then, there will be 20,000 X 1/20 X 1 = 1,000 cars to be detailed. Our client thinks he can get a 10% share of the market, and thus detail 100 cars. His top-down revenue forecast is 100 X $100 = $10,000.
Double check: it takes one day to detail a car. Our client thus needs to reserve 100 working days (of 250 available) to do the work. This is feasible.
A bottom-up forecast is a micro take. It might go as follows. Based on the above, our client has 150 working days to make sales calls (The top-down forecast showed this). He can make 15 sales calls a day or 2,250 calls in the 150 days available. He expects a 4 to 5% close rate, or from 90 to 112 assignments. His bottom-up revenue forecast is $9,000 to $11,500.
The questions to ask about each forecast are all about the reasonability of the assumptions.
I’d venture to say that for an appraiser, the top-down forecast will be easier to think about (assuming we do not know a great deal about the business or the company), while the bottom-up one is easier for the client to think about. Both are only as good as the assumptions that underlie them: and the questions to ask about each are all about their reasonability and support.