What is Bottom-Up Forecasting?
Bottom-Up forecasting refers to the projection of micro-level inputs of a company to reach the revenue and income for a particular year. However, estimation of these micro factors that leads to the revenue is difficult to forecast as it is company specific and depends on various factors.
Example of Bottom-Up Forecasting
Let’s take an example to understand the concept:
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For eg:
Source: Bottom-Up Forecasting (wallstreetmojo.com)
Company ABC is a pen producing company. An investor is trying to forecast the revenue of the company Of The CompanyRevenue is the amount of money that a business can earn in its normal course of business by selling its goods and services. In the case of the federal government, it refers to the total amount of income generated from taxes, which remains unfiltered from any deductions.read more for the next year. The details are mentioned below:
Use Bottom-Up Approach to calculate the revenue
Solution:
Step #1: Determining Next year’s sale and price as per forecast
Step #2: Determine Operational ExpensesOperational ExpensesOperating expense (OPEX) is the cost incurred in the normal course of business and does not include expenses directly related to product manufacturing or service delivery. Therefore, they are readily available in the income statement and help to determine the net profit.read more and Interest ExpenseInterest ExpenseInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more as per Forecast
Step #3: The overall income statement looks like this –
Bottom-Up vs. Top-Down Forecasting
Bottom-Up Approach starts with Micro factors that are company-specific and reaches the revenue. On the other hand, the Top-Down approach helps in forecasting the revenue of a company by using macro factors. In Top-Down approach say the GDP is forecasted to determine whether the sell quantity of a company will increase or decrease. Sector-specific aggregate demand is forecasted to determine the demand for goods. Relaxation of export terms also increases the demand for goods. Depreciation of currency increases the demand for goods. So all these are macro factors that are considered while doing Top-Down Forecasting.
Advantages
- This approach is more practical than Top-Down. In Bottom-Up forecasting, the actual sales of a company are predicted by seeing its products demand in the market as the demand is being compared from the previous year to the current year. So it is more realistic. It deals with the companies fundamental data.
- This approach is dependent on the company’s data, so they are accurate. A Financial Analyst will not have to depend on third-party data to do the forecasting. Real data makes the forecasting stronger as the trends can be validated from the company’s past data.
- Companies may have different segments. Bottom-Up finds the demand of each segment, so it will help companies to allocate resources accordingly. It makes the company more efficient while making capital budgeting decisions.
- As the decision is based on micro factors, so it gives a clear picture of the higher management about the company. Management is aware of the expenditure being conducted by each segment and whether it will be possible to reduce the expenditure in order to improve productivity.
Disadvantages
- As it involves several micro factors, so it takes time for the study to get completed. All micro factors must be properly forecasted for this approach.
- It is costly. In will require a team to be dedicated to gathering data from individual departments to carry out the approach. So it is costly to make the forecast.
- The data collected will be provided by the specific department as per their productivity level. If a decision is taken as per the data, then it may happen that the forecast will not match reality if the key members of the team change.
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