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Forecasting

is a Process, Not a Number!


Demandforecastingestimatesthequantityofaproductorserviceconsumerswouldpurchasewithina
specifictimerangeinthefuture.Therearenumerousmethodsemployedtothisend,quantitative
methods,likestatisticalmodelusinghistoricaldemandandqualitativemethods,likeeducatedguesses
orthecombinationofboth.
Furthermore,demandforecastingcanoftenbeinfluencedbysubjectiveand,tosomeextent,biased
viewsfromstakeholdersfromsales,finance,operation,etc.Although,havingbroadviewsshould
improvequalityofthefinalforecast,howcanwequantify,monitorand,ifnecessarily,adjustthe
parameterstomitigatethesubjectiveinfluences?
Demandforecastingisneitheramagicalnumberchewedoutbyablackboxmodelforthismonthorthe
next,noritisahitormissgame.Demandforecastingisanongoingprocessundertakenbyseveral
stakeholderstoimproveaccuracyandreliabilityovertime.
Duringourconsultancyengagementwithmanyofourcustomers,severalkeyquestionscomeup,
almostalways:howdoIknowmydemandforecastsarereliable?Thereareseveraltechniquesto
estimatedemands,whichonegivesbetterresults?IhavetensofthousandsofdifferentSKU,sohowwe
summarizetheoverallforecastaccuracy?Etc.
RastProtheflagshipdemandplanningsolutionfromIdeumGroupspecializesinimprovingthe
forecastaccuracyforbetterinventorycontrol:Betterdemandforecastaccuracyresultsinlower
inventorylevelsandlesslostsalesduetostockoutforthesamefillrate.Inotherwords,thebetter
forecastperformance;thebetteristhereturnoninventoryinvestment.
Inthisdiscussion,wewillfocusondemandforecastingforsupportinginventoryreplenishment
decisions:SafetyStock,reorderpoint,fillrateandorderquantity.

Forecast Performance Measure


Fortheprocesstobeeffectivelymonitored,forecastaccuracy(orerror)shouldbequantifiedovertime.
Themeasureshouldbesimpletounderstand,usableforallproducts(e.g.stable,intermittent,etc.),and
bescaleindependentsoyoucanaggregateitforgroupofproducts.
Letsconsiderthefollowingexampleofaweeklyforecast:


Week Demand Forecast
1
2
3
4
5
6
7
8
9
10
11
12

At
100
90
120
140
180
120
150
100
130
152
200
180

Ft
150
130
90
110
200
90
100
150
70
120
150
250

Assumingthattheorderleadtimeis1week,thenaweeklyforecastcanbeusedtoestimatethe
demandinonereplenishmentcycle.
Therearenumerousmethodstoestimateforecastaccuracy.Practitionersoftenusethemeanabsolute
percentageerror(MAPE)toestimatethedemandforecasterror:

MAPEt

1 N 1 At i Ft i
A
N i 0
t i

Note:Nisthenumberofobservationsusedincalculatingthemeasure.
Unfortunately,theMAPE,and/orsymmetricMAPEdonotworkinaserieswheredemandvalueiszero
(0).Ademandtimeserieswithoneormorezerovaluesaremorecommon,especiallyforproductswith
intermittentdemands(e.g.spareparts).Inpracticemanywouldextractobservationswithzerovalue,
andusetherestoftheobservations(nonzerovalues)tocalculatetheMAPE.Bydoingso,theinput
seriesnature(e.g.intermittentstable)wouldbealtered,andthecalculatedvalueisirrelevant,at
best,totheforecastinquestion.
InRastProsolution,weopttouseasimilarmeasureMAD/MEAN.DissimilartoMAPE,the
MAD/MEANisarobustforecastaccuracymeasuretotheintermitteddemand,aswellothers.The
MAD/MEANisdefinedasfollow:

MADt
MAD-To-MEAN t t

MEAN t

1
N

N 1

i 0

1
N

At i Ft i
N 1

A
i 0

t i

N 1

A
i 0

t i

Ft i

N 1

A
i 0

t i

Where:

At i istheactualdemandiperiodsago

Ft i istheforecastmadeiperiodsago

N isthemovingaveragewindowsize

Inanutshell,theMAD/MEANistheratiobetweentwomovingaverages:theforecasterrorandthe
actualdemand.Weuseafinitewindow(i.e.N)totrackthelatestchangesinboththedemandandthe
forecasterror.
WhatvalueshouldbeuseforN?Choosingasmallvalue(sayN=2)willresultinameasurevolatilebiased
towardrecentperiods,andlesstofundamentallongrunmeasure.However,makingNtoolong,like25
periods,willresultinastablemeasure,butcanbeinsensitiveandslowtoreacttosuddenchanges.A
balancemustbedrawnso,inourexampleletschooseN=6periods.
Anotherimportantconsideration,especiallyforintermittentdemand,isthedurationofazerorun.
Usersdonotwantthemovingaveragetobezeroatanytime,soyoushouldchooseNtobelarge
enoughtoavoidthiscasefromoccurrence.
Usingthesameexample,letscalculatetheMA,MADandMAD/MEANwitha6weekaveragewindow:
Week Demand Forecast

Error

Error

Demand

At

Ft

Et

MAD

MA

MAD/MEAN

100
90
120
140
180
120
150
100
130
152
200
180

150
130
90
110
200
90
100
150
70
120
150
250

50
40
30
30
20
30
50
50
60
32
50
70

33
33
35
40
40
45
52

125
133
135
137
139
142
152

27%
25%
26%
29%
29%
32%
34%

1
2
3
4
5
6
7
8
9
10
11
12

RastProsetsthemovingaveragewindowsize,bydefault,tosix(6),buttheendusercanoverridethis
value,onperSKUbasis.
IMPORTANT:Thechoiceofthemovingaveragewindowsizeismerelydrivenbystatisticalconsideration
forstabilityversussensitivity.

Which Forecast I should use? Weekly, BiWeekly, Month, etc.


Whatistheforecastwindoworspanofconcern?Well,thatdependsonwhatyouwishtousethe
forecastfor.Forinventorycontrolandreplenishmentrelateddecisions,demandistheconcernduringa
replenishmentcycle(i.e.orderleadtime).
Waitaminute!Theleadtimeisdeterminedbyourchoiceofsupplier,sotheforecasthorizoncanbe
differentfordifferentSKU,andalso,ifweweretochangesourcingsupplier,theforecastwindowof
concernwillchange.
Inanutshell,supplierperformancedeterminestheappropriateforecastwindowofconcernandraises
thefollowingquestionsfromourcustomers:
1. Ourorderleadtimeisnotaconstant,butratherarandomvariablewhatshouldweuse?
[Answer]Usetheaverageorderleadtime.
2. Wehaveseveralsuppliersand/orservicelevelsforeachSKU,whichoneweshoulduse?
[Answer]Usethelastsupplierand/orservicelevelleadtimeinformation.
3. Wehaveonlymonthlyforecastfromsales&marketing,butourleadtimeis2week.
[Answer]Inthiscase,RastProhasnochoice,buttoassumeonemonthforecasthorizon.
4. Wehaveonlymonthlyforecastfromsales&marketing,butourleadtimeis2months.


[Answer]ForRastPro,theforecastwindowofconcernis2months,soyouwillneedtoconvert
(i.e.aggregate)themonthlyforecasttobimonthly.

Goingforward,tocomputetheforecastperformancemeasureforagivenSKU,youcompletethe
following:

SelectaForecasthorizonclosefromtheorderleadtime(e.g.2month).
Generatethedemandandforecasttimeserieswithperiodequalstoforecasthorizon(e.g.2
month).
Selectamovingaveragewindowsize(e.g.N=6).
CalculatetheMADtoMEANfortheSKUatgiventime(e.g.now)

Soundssimple?Itis!Doingitfor50,000SKUisadifferentstory.Fortunately,RastProcompilesthe
requireddataandcalculatesbehindthescenepresentingyouwithfinalvalues.

Forecasting Performance Index


Uptothispoint,wediscussedtheforecastperformancemeasureforoneSKU.Atypicalretailer
nowadayscarriesthousands(ifnottensofthousands)ofdifferentSKUs,andweneedarepresentative
macrolevelindextomeasureandtracktheoverallforecastperformanceprocess.
Earlier,werequiredtheselectionofanyforecastperformancemeasureistobescaleindependent,so
youcanaggregatethevaluesofagroupofSKUs.Initially,youcanchooseasimplearithmeticaverageof
allSKUsMAD/MEANvalues,astheperformanceindex( ).

1
M

i 1

(i )
t

Where:

t istheforecastingperformanceindexattimet

t(i ) istheMAD/MEANvalueforithSKUattimet

M isthenumberSKUinourportfolio

Fromadecisionmakingstandpoint,asimpleaverageisagoodstart,butitassignsequalweighttoeach
SKU,thus,givesanaiveviewoftheforecastprocesscapability.
Notallproductsareequallyimportanttoacompanyduetodifferentprofitmargins,valuetocustomer,
competitiveadvantage,andsoon.Toreflectthat,letsrevisethedefinitiontouseaweightingscheme:

t i t(i )
i 1

i 1

Where

i istherelativeweightfortheithSKU

Next,letusrevisittheinventorycontrolandreplenishmentscenario.Companiesmaintainasafetystock
(SS)toabsorbuncertaintyindemandandorderleadtimethroughoutareplenishmentcycle,which
reducesthechancesofalostsalesduetooutofstock.
Thesmallertheforecastingerror,thelowertheSafetyStock,andtheexpectedlostsalesduetostock
outisloweraswell.Ifyouweretoreducethedemandforecasterrorby,say,5%,thecompanywillsave
moneybyrequiringlowersafetystock,andincreaserevenuesbyreducingexpectedlostsalesdueto
stockout.
Fromademandplannerperspective,he/shewouldliketoidentifytheSKUthathashighestcostsaving
potential,andallocatehis/hertimeandefforttoimprovetheforecastaccuracy.
Fromthecompanysperspective,theSKUwithhighinventorycost,orpossiblyhightotalgrossmargin,
aremoreimportanttothebottomline,andthusshouldbeassignedhigherweightsintheperformance
index.

Forecast Performance Sensitivity


Acompanybearstwooperationcostsformaintaininganinventoryforanyproduct:opportunitycostof
thetiedworkingcapital,andthecostofcarry(storagerent,spoilage,etc.)fortheproductsinthe
warehouse.
Ifacompanyhasenoughinventorytomeetstochasticdemandthiswillreducethechancesofalostsale
eventsduetostockoutsituation.

Inventory Cost Utility Function


Foragivenfillrate( r ),demand( d , d )andorderleadtime( l , l ),letusdefinetheinventory
reorderlevel( ROP )andexpectedlostorder( LS )asfollow:

ROP f (r , d , d , l , l )
LS g (r , d , d , l , l )

Next,definetheutilitycostfunctionbycombiningcostofcarryandexpectedopportunityloss.

U Q(r , d , d , l , l ) E[ R] CoC LS Margin

ROP
CoC LS ( P C )
2

Thecostofcarry( CoC )canbefurthersimplifiedbyassumingitsvalueasapercentage( )oftotal


cost(e.g.4%permonth).

ROP
C LS ( P C )
2

Bearinmind,thebaseunitoftimeisonereplenishmentcycle(averageleadtime),sothecostofcarry
used(i.e. C )mustcorrespondtothesameduration.
Changingthetimeunitfromaproductsreplenishmentcycle,toproductindependentunitsayone
year,youneedtocalculatethecorrespondingutilitycostfunction( U y )perannum.

U y(i ) U (i )

365

Where:

l isthereplenishmentcycle(orleadtime)indays.

RastProusesthevalueoftheutilitycostfunctiontodeterminetheweightsforthedifferentSKUsinthe
forecastingperformanceIndex.
M

U
i 1

(i )
y

t( i )

U
i 1

(i )
y

Insum,theRastPromethodologytiesuptheweightingschemeoftheforecastperformanceindexwith
theinventorycost.

Demand Planning
Fromdemandplannersperspective,he/shemightwishtoprioritizetheirtimeandeffortsonthoseSKU
withhighestsensitivity( U )todemandforecasterror.
So,computethechangeintheutilityfunction( U )whenthedemanderrorchangesby5%,while
keepingeverythingelseconstant.

U H (r , d ,1.05 d , l , l )

ROPH
C LS H ( P C )
2

ROPb
C LSb ( P C )
2

ROPL
U L (r , d , 0.95 d , l , l )
C LS L ( P C )
2
U UL
U H
2
U ( r , d , d , l , l )

Changingthetimeunitfromaproductsreplenishmentcycle,toaproductindependentunitsayone
year,youdneedtocalculatethecorrespondingchangeinutilitycostfunction( U y )perannum.

U y U

365

Conclusion
Inthispaper,wehavediscussedindetailstheperformancemeasureofthedemandforecastingprocess
foroneSKU,andfollowedwithadefinitionforamultiproductsperformanceindex.Theselected
measureisdefinedtobeintuitive,yetrobusttoprovideinsightoftheunderlyingprocess,andtrack
overtime,detectchangesand,conductcorrectionswhenneeded
Havingdoneso,theimportantquestionweoftenfaceis:howcanweimprovetheforecastprocess?This
isatopicforaseriesoffollowuppapers,butfornowherareafewpointstoconsider:

Forecastsources:Forecastvaluesoriginatefromdifferentsources:analyticalmodels,internal
sources(e.g.marketingresearch),external(e.g.customersforecast,industryexperts,etc.).

Blendingschemeoftheforecastsources:youneedtoblendthedisparatesources,andmake
onefinalofficialforecast.Asyoucansee,itisnotjustthenumbers,buthowdowechooseor
incorporatetheforecastsourcesintothefinaldecisionthataffectstheperformanceofthe
forecastprocess.

Suppliersorderleadtime:Suppliersperformanceisadriverthatisoftenoverlooked,butit
influencesthespanoftheforecastwindow.Forexample,forecastingoneweekdemandhas
inherentlylowererrorthanforecastingdemandforthenextmonths.

DomainandMarketIntuition:Plannersanddomainexpertscanprioritizehis/hertimeand
improvetheforecastingofthoseproductswithhighestsensitivitytoforecastingerror,and
achievethegreatestimprovement.