Supply Chain Management Fundamentals / Lesson 5: Advanced Forecasting Topics

/ Lesson 5: Advanced Forecasting Topics

Lesson 5: Advanced Forecasting Topics

Introduction

Welcome to Lesson 5. Today we will cover a lot of ground. I hope you still have some life left in your calculator
batteries. This will be our last lesson on forecasting. I bet you thought for a minute that maybe you were taking a
marketing course instead of one on supply chain management principles.

In Lesson 5, we'll examine macroforecasting and investigate two new forecasting techniques: focus forecasting
and pyramid forecasting. We'll also discuss how to develop forecasts for new products. Since controlling a
forecast is so critical, we'll explore several techniques—including standard deviation and tracking signals—that
effectively control forecasts.

Let's get started!

Macroforecasting and Other Forecasting Techniques

Macroforecasting

Earlier in this course, you learned how forecasting helps a company create a planning system and also how a
forecasting system is used. All managers (or even all employees, for that matter) need to have a high degree of
confidence regarding what will happen in the future. In a world that is constantly changing, not having signals that
identify opportunities and threats makes for after-the-fact decision making. Since most plans can't be developed
and put into use immediately, making reactive decisions leads to undesirable results (such as losing market
share).

We've also talked quite a bit about creating a customer demand forecast. But customer demand is only a subset
of a larger forecast picture. Yes, it's important that you understand customer ordering patterns (microdemand),
but you must also understand the impact of macrodemand elements. Let's look at the pieces of the bigger picture.

1. Business cycles and economic conditions.

These two terms refer to the health and wealth of the economy. Inflation, depression, prosperity, and
deflation highly influence current and future customer demand. The responsibility for forecasting business
cycles and their impact on operations must reside at a very high organizational level. CEOs, presidents, and
executive staff members are ultimately responsible for predicting economic changes so they return value to
their stockholders.

2. Social factors.

Social factors are extremely varied in their nature and their influence on customer demand. A social factor
that I remember reading about pertained to preferences for air travel. A successful United States airline was
able to identify and capitalize on a variable that consumers valued—in this instance, low fares instead of
airline food.

3. Technology.
 This may be the most important factor due its dynamic nature. If a company fails to recognize an emerging
technology in time, sales will fall and may never recover. Companies that manufactured buggy whips during
the early part of the 20th century lost most of their customers because they didn't anticipate and respond to
the emerging demand for automobiles. These companies could have jumped on the automotive demand
bandwagon for fan belts. Forecasting technology is important in pure scientific areas (at universities) and in
commercial areas.

4. Environmental conditions.

Because people have been paying more and more attention to our environment, companies need to be
concerned with both what they take from and what they do to the environment. Two environmental factors
that influence consumer demand are shortages of natural resources and government legislation (laws
prohibiting or reducing usage due to adverse environmental impact). For example, conservation of trees has
led to the use of man-made materials for housing, and aerosol cans are being discontinued because of
damage to the ozone layer.

I hope this has given you a good grasp of macroforecasting factors. Now let's explore two innovative forecasting
techniques and discuss what it takes to forecast new products.

Focus Forecasting

Organizations that successfully use focus forecasting appreciate its simplicity and accuracy. Let's call it FF. Focus
forecasting is kind of a mouthful

FF utilizes a group of guidelines and a simulation technique that relies on trial and error, as well as applies easily
understandable rules to establish logical forecast models. To better understand what conditions are used and
how FF works, let's walk through an example together.

Take a look at the demand data for BE's lawnmower Model 50 for the past 18 months.

Fig. 5.1. FF data

This data really doesn't have any patterns, does it? What would you forecast for July and August? FF can help
tremendously. Here's how.

First, we need to develop some forecasting rules. For our example, we'll use three rules. In a real-world
application, many rules can be used, and computer software will create the rules, make decisions, and select a
forecast. Here are our rules, based on what the operations manager at BE used successfully at a prior company:
 1. Customer demand for the next two months will be equal to what customers demanded during the last two
months of this year.

2. Customer demand for the next two months will be equal to what customers demanded for the very same two
months last year.

3. Customer demand for the next two months will be equal to what customers demanded for the same two
months last year +25%.

Now that you know the rules, let's look at how they are used to develop a forecast.

Remember, we're interested in forecasting customer demand for July and August. To do this, we need to apply
each of our three rules to historical data and then determine which forecast has the greatest accuracy.

Rule 1: We need to look at customer demand for our most recent two months—May and June. Demand was
900 (489 + 411). Rule 1 states that the forecast for May and June should equal the previous two months'
customer demand—March and April. The demand for March and April was 751 (325 + 426). May and June's
demand exceeded March and April's by 19.8% (900 divided by 751). Using rule 1, we would expect July and
August's demand forecast to be 19.8% higher than May and June's.

Rule 2: We need to look at customer demand for May and June from the prior year and compare it to the
demand for May and June for the current year. The demand for May and June for the prior year was 905 (522 +
383). As we know, demand for May and June for the current year is 900. The demand is very close. The
demand for May and June for the current year is 1% lower than the demand for May and June for the prior
year.

Rule 3: Rule 3 is similar to rule 2, except we need to increase May and June's forecast for the prior year by
25%. When we do that, the demand should have been 1131 (905 × 1.25). The May and June demand for the
current year is 20.4% below what was expected using rule 3 (1 − (900 ÷ 1131)).

When we review our three rules, rule 2 is the most accurate. Our forecast for July and August for the current year
should be 707 (1% lower than July and August's customer demand of 714 from the prior year).

Note: A real FF model would take into account more months. I needed to simplify the example for the sake of
time.

Do you see how practical FF is? FF assumes that the forecasting rule which worked best last time will work best
next time.

Now let's travel on to another forecasting technique with an interesting name: pyramid forecasting. Sorry, it
doesn't have anything to do with Egypt or Mexico.

Pyramid Forecasting

Pyramid forecasting is used to disaggregate (break down) a group forecast to individual forecasts. It relies on a
"top-down, bottom-up" technique known as iterative planning.

Let's use a forecast for new lawnmowers to illustrate.

Let's say that BE recently implemented a new technology that utilizes remote-controlled steering. BE's
management wants to use pyramid forecasting to develop sales projections for the upcoming year. So they
develop this model of pyramid forecasting:

Fig. 5.2. Initial pyramid forecasting model

BE believes that consumers will buy 100 million dollar's worth of remote-controlled mowers. Based on the sales
history of rotary and reel mowers (48% and 52%), BE breaks down the $100 million at the next level: $48 million
for rotary and $52 million for reel. Based on marketing's estimated demand for the two remote-controlled models
(10 and 25), BE disaggregates the $48 million and $52 million into more detailed categories ($9.6 million, $38.4
million, $18.2 million, and $33.8 million).

Just before the launch date of the new mowers, BE discovers that fewer customers prefer the M25 rotary remote-
controlled mower than earlier thought (10% less). So we reduce the percentage for the M25 from 80% to 70% and
increase the percentage for the M10 from 20% to 30%. BE also learns that customers want $20 million more of
rotary mowers than originally planned. This changes the total for all rotary remote-controlled mowers from $48
million to $68 million and the total forecast for all remote-controlled mowers to $120 million.

Let's look at the new pyramid.

Fig. 5.3. Final pyramid forecasting model

This pyramid forecasting exercise demonstrates a complete pass (one time down, one time up). The first down
pass occurred when management set up the initial pyramid. The first time up occurred when changes were made
to the M25 and M10 percentages and when the total demand for remote-controlled rotary mowers was increased
by $20 million. You can use multiple passes until you are confident with your final forecast.

Let's move on to one of the most difficult forecasting issues: forecasting new products.

Forecasting New Products

Developing forecasts for new products is pretty straightforward, except for just one problem: the product has
never existed. I exaggerate a bit because many new products are actually more improved than new—existing
products with additional features. In some cases, there truly are new products never before seen by the human
eye. Let's identify and discuss some of the common methods to develop forecasts for these genuinely new
products.

1. Existing product comparison.

An example that I remember reading about pertained to a 19-inch portable color television. The company that
was about to release the product currently sold a 19-inch black-and-white TV and a 17-inch color television. So
they combined the two sets' historical sales to successfully develop a new product forecast.

Another example is from my experience in medical device manufacturing. My former company made one
heart catheter for blood pressure monitoring and another catheter to temporarily pace the heart. They then
developed one catheter that performed both functions. We relied on historical demand for individual
monitoring and pacing catheters to help develop the forecast.

In many instances, a new product replaces an existing product. This makes forecasting a straightforward
proposition because new customers are usually old customers.

2. Survey methods.

When you use survey methods, you contact potential customers to determine if they are interested in
purchasing a new product. This method is very inaccurate because of changing circumstances and potential
buyers not following through.

3. Test marketing.

This method involves distributing samples to gauge consumer interest. It has enjoyed a certain level of
success.

4. Pipeline filling.

This method is similar to test marketing, but it is based on limited production and market release to see what
happens. As customers begin to buy, demand patterns can be established, and production capacity can then
be increased.
Controlling Your Forecast
By now, you know that the forecast will never be perfect or even as accurate as everyone would like. Operations
personnel often blame inaccurate customer demand forecasts for late deliveries. I hear this statement all the time:
"Marketing doesn't know how many products they will sell. How can we possibly know what to build?"
Unfortunately, this type of attitude doesn't exactly foster a spirit of teamwork between marketing and operations.

Since the forecast will always be somewhat wrong, it becomes a case of making it "less wrong." To improve a
customer demand forecast, an organization needs to practice control methods and continually fine-tune or even
completely change their processes.

Let's talk for a few moments about the control process.

All control processes need a standard or target that can be achieved. Without a target, there can be no control
because there isn't anything to compare or control against. In SCM, the forecast is the target. If a forecast is
unrealistically high, it won't be taken seriously because it can't be reached. If a forecast is too low, it will be
exceeded with little effort. A forecast needs to be the best estimate that can be established using an informed
and objective approach.

Once you develop a forecast, you need to monitor actual demand at the right time and in the right way. The right
time means that you monitor results early and frequently so you can correct the forecast. The right way means
that you use a predefined method (such as computer reports or input from customer service representatives) to
control the forecast.

Time Fences

We briefly discussed time fences earlier in the course, but it's appropriate that we review them again. Before you
begin to compare customer demand with your forecast, remember to use time fences appropriately. Operations
will not be able to immediately respond to a new forecast. If lead time is 90 days, operations won't be able to
meet the new forecast until the 91st day. Unless operations can expedite materials and shuffle resources, they will
continue to make products using the prior forecast and will incorporate the new forecast at lead time.

Let's review an example that illustrates how a time fence is used to help measure forecast accuracy.

Last summer, operations and marketing agreed to a 90-day forecasting time fence. This means that marketing
won't ask for significant changes for 90 days. The forecast that marketing issued on October 1 did not have any
changes on it for October, November, and December. But the forecast reflected a 75% increase for January,
February, and March, as compared to the prior forecast released on September 1.

When operations received the new forecast on October 1 and identified the major increase for the first quarter,
they expedited purchase orders, hired more employees, and ordered additional equipment.

Today is January 1. Operations is producing the first quarter's schedule using the forecast that marketing issued on
October 1, 90 days earlier. (As an aside, marketing also issued forecasts on November 1, December 1, and January 1
that reflect no major changes compared to the October 1 forecast.) While this is how it's supposed to work (and
sometimes does), it usually doesn't. Let me share a more typical scenario with you.
Marketing understands the 90-day time-fence issue. But they have some new business opportunities that they
must capture now. Ninety days is too long to wait. Marketing typically asks operations these types of questions,
"What's the best you can do?" or, "What's preventing you from responding now? Can't you just throw money"—an
expediting fee—"at your suppliers?"

In this type of situation, the customer must come first. Operations usually responds that they will do their best;
however, they want to measure the demand forecast at the 90-day lead time. Operations wants to go on record
that marketing did not honor the time fence agreement.

I hope you clearly understand time fences. Make sure to compare actual customer demand to the forecast issued
at lead time (in this case, 90 days). A forecast can't be changed for measurement purposes inside a time fence.
Period.

After you compare actual demand to the forecast, you'll need to take corrective action to reduce forecast error.
The most common methods to reduce forecast error are stimulating customer demand, reducing the forecast, or
doing both. But first, you may be wondering where forecast errors come from and how they are measured. Let's
find out.
Forecast Errors

Here are a few sources of forecast errors.

Incorrect technique used for your business.

Using the Delphi method when an area has no experts is an example.

Correct technique used but applied incorrectly.

If you use exponential smoothing to forecast new products, your forecast will not reflect trends.

Incorrect assumptions.
If you use linear regression for variables that don't form a straight line, you will generate some very
interesting forecasts.

Consistent forecast errors are called bias errors. Unpredictable errors are known as random errors. Let's see how
forecast errors are measured.

Forecast Error Measurement Methods

Before forecast errors can be reduced, they must be measured. A number of methods measure forecast errors,
including cumulative forecast error (CFE), mean squared error (MSE), standard deviation (SD), mean absolute
deviation (MAD), and tracking signals (TS). Don't panic. These phrases sound much worse than they really are.
Let's look at each one.

1. Cumulative forecast error (CFE).

CFE also has another name—the running sum of forecast errors (RSFE). CFE measures bias errors. A large
positive CFE represents a chronic underforecast situation that produces backorders. A large negative CFE
represents a chronic overforecast situation that produces excess inventory.

2. Mean squared error (MSE).

 When you use MSE, you square line-item errors, add them, and divide the total by the number of line-items.
You may know MSE by its more official statistics name: variance.

When we measure forecast error, we want to know how far data points are from an average. On a number
line, distances to the right of zero are positive, and distances to the left of zero are negative. We can't use
negative distances in our calculations because they don't exist in the natural world. Can you imagine someone
asking you to drive your car negative five miles? Fortunately, when we use MSE, standard deviation (SD), and
mean absolute deviation (MAD), we avoid the issue of negative distances.

CFE and MSE are used like this:

Fig. 5.4. Cumulative forecast error (CFE) and mean squared error (MSE)

In my chart, you can find CFE in the Error column. It fluctuates from -20 to +20. Total CFE for six months is -10.
This means that there is an overforecast condition for the first six months, since 835 were forecasted and 825
were demanded. MSE is 175. What does that mean?

To answer this question, we need to compare MSE against a predetermined target or compare it to past
MSEs. A shortcoming of MSE is that the numbers quickly become large and distort understanding. An MSE of
175 is high for just six months of data. If we used 12 months, the MSE could be above 1,000. Consequently, SD
and MAD are more popular methods because they are more manageable numbers that we can relate to.

3. Standard deviation (SD).

Standard deviation (also called sigma) is a commonly used statistic. SD determines data point distance from
the mean in a normal distribution. SD is easy to calculate. It is simply the square root of MSE (or variance).
Let's calculate SD.

Fig. 5.5. Standard deviation (SD)

 From basic statistics, we know that 1 SD to the right of the mean and 1 SD to the left of the mean represent
about 68% of all data points. The mean demand in our example is 137.5 (825/6) and our SD for this problem is
13.23. If we subtract one SD from the mean and add one SD to the mean, our expected demand range at 68%
is 124.27 to 150.73.

Note: If you are struggling with standard deviation and what it represents, make sure to review the reference
on basic statistics that I've placed in the Supplementary Material section.

4. Mean absolute deviation (MAD).

MAD is popular because it is easy to use and understand. It equals the average error, and it involves absolute
value (ignores + or − signs). To calculate MAD, take the absolute value of each error (from the Error column),
sum them, and divide by the number of members in your data set.

Let's take a look.

Fig. 5.6. Mean absolute deviation (MAD)

The 11.67 value for MAD is very close to the SD of 13.23. MAD is more convenient than SD because you don't
have to square numbers and calculate square roots. You just need to determine the absolute value of the error
and divide by the number of data points.

5. Tracking signals (TS).

Tracking signals dynamically monitor the forecast. A TS uses two measurements of error that we have already
looked at, CFE and MAD. Let's return to our example to learn more about TS.

Fig. 5.7. Tracking signals (TS)

The first thing that I did was add three new columns (in bold): one for the calculation of monthly MAD, one for
the calculation of the tracking signal, and one for the tracking signal target. The tracking signal target was set
by management based on historical performance.
 We calculate TS by dividing the CFE by MAD (by period). A TS is a composite measure that shows the
accumulation of error and the degree of variability. When a TS is greater than the target (in our case +/- 2.0), it
is time to reforecast. Fortunately, in our example demand rebalanced in June to bring the TS back to an
acceptable level of -0.86. Provided that corrections from period to period bring CFE close to zero, we are in
good shape.

Earlier in the course, we talked about updating the customer demand forecast. Let's see what's involved with this.

Updating the Forecast

Once you determine that a forecast does not produce acceptable results, you must revise it. Most companies
revise the forecast too often or too infrequently (as indicated in the forecast cycle). Now that you know how to use
tracking signals, you understand that a forecast needs to be updated whenever the TS target is exceeded. If a
forecast produces good results and the TS target is not exceeded, no update is needed. That's an incentive for
accuracy.
Conclusion

Now that we've discussed forecasting for the past three lessons, how can you use forecasting successfully? Follow
these tips:

Implement sales and operations planning. S&OP establishes a process and forum for successful forecasting.

Make sure that responsibility to manage the forecast is clear. There can be no substitute for this.

Don't let the forecast be a wish list. It needs to reflect reality, not what someone would like.

Use the right computer hardware and software, and make sure sufficient support is provided.

Use the right forecasting technique for the right situation.

Monitor the forecast and make timely adjustments.

Today you learned a lot. You learned how macroforecasting is used, and you explored two new forecasting
techniques: focus forecasting and pyramid forecasting. You also learned how to develop forecasts for new
products and found out how to reduce forecast errors by using cumulative forecast error (CFE), mean squared
error (MSE), standard deviation (SD), mean absolute deviation (MAD), and tracking signals (TS).

Next time, as we continue with Lesson 6, we will discuss the production plan in detail. See you then!