A reader asks which is better: top down or bottom up analysis? Here's what you need to know about both.
We've developed a new product, are about to take it to market, and need to develop a market analysis for our business plan. Which forecasting approach is better: top down or bottom up?
-- Name withheld by request
Understanding market size, and understanding your ability to penetrate that market, is all-important: If your market is too small you can't make money, no matter how innovative the product or how competitive your pricing. Top down and bottom up analyses are two basic ways to evaluate that market.
A top down analysis is calculated by determining the total market, then estimating your share of that market. A typical top down analysis might go something like this: "Hmm... I will sell a widget everyone can use, and since there are 300,000 people in my area, even if I only manage to land 5 percent of that market I'll make 15,000 sales."
Sound a little fuzzy? Sound a little optimistic? That's how a top down analysis usually goes; it's like the stereotypical, "2 percent of a $1 billion market is $20 million!" sales forecast heard in hundreds of pitch meetings every year.
A bottom up analysis is calculated by estimating potential sales in order to determine a total sales figure. A bottom up analysis evaluates where products can be sold, the sales of comparable products, and the slice of current sales you can carve out. While it takes a lot more effort, the result is usually much more accurate.
Here's how a bottom up analysis might work in real life. Let's pretend you just developed a prototype for a bicycle pump and you want to determine if there is a market for your pump--a profitable market that will sustain a real business.
Let's walk through the steps:
1. Where are bike pumps typically sold? Most are sold, fairly obviously, in bike shops, but also by major retailers, and online. You decide to focus on bike shops for now, since landing shelf space at Walmart or Target isn't particularly likely, at least not at first.
2. How many bike shops are there in the U.S.? We'll assume you don't want to try to sell and ship overseas. With some research you find there are approximately 4,100 bike shops (a number I just found on the Internet, which of course means it's dead-on.)
3. How many of those bike shops will be willing to stock your pumps? Here's where it gets tricky. Talk to as many bike shops as you can to see if they would be willing to carry your pumps. Say you talk to 100; if 30 claim they would, be conservative and cut that number in half. (While an owner may agree in principle today, they may not come through in fact tomorrow. Plus you may be physically unable to get product into every willing bike shop's hands.)
Then extrapolate. If 30 out of 100 say they would carry your product, and you cut that number in half, then it's reasonable to assume that 15 percent of bike shops may actually be willing to carry your product. 4,100 times 15 percent equals 615, so your pumps could potentially be sold in approximately 600 bike shops.
4. Historically, how many bike pumps has each shop sold over the course of a year?
That's a good question, but a better question is, "How many bike pumps like mine does a bike shop sell in a year?" If yours is a premium or specialized pump that could limit your market. Always compare apples to apples.
Say the bike shops you talk to say they sell, on average, 200 pumps a year. That's great--but how many can you sell to each store? The answer isn't 200. Every shop carries a variety of pumps. So you decide to be conservative and assume you can sell 30 pumps a year to each shop.
The math is easy: 615 bike shops times 30 pumps per shop equals 18,450 pumps a year. What's hard is pulling together the data so you can do the math.
What's even harder is feeling confident in that data. Even though I kept using the word "conservative," the assumptions we just made are still fairly optimistic. You have to get every shop to stock your pumps. You have to carve out a slice of existing premium pump sales.
So factor in some sensitivities: Double the number in the event your results exceed expectations, and cut the number in half in case things don't go as planned. And throw in a factor for your ability to market to every bike shop; contacting each one, especially since most are independent, will take time and money you may not have. (Of course you could try to sell your pumps through a distributor; here's a primer on finding and working with a distributor.)
The key to sizing up your market is to stay objective and make an honest and unbiased evaluation of how viable your product or service will be. In most cases a bottom up analysis will be sobering, but that's okay.
Always go into business with realistic expectations--that way the only surprises, at least where sales are concerned, will be pleasant ones.
JEFF HADEN learned much of what he knows about business and technology as he worked his way up in the manufacturing industry. Everything else he picks up from ghostwriting books for some of the smartest leaders he knows in business. @jeff_haden