The Smart Forecaster

 Pursuing best practices in demand planning,

forecasting and inventory optimization

Demand planning takes time and effort. It’s worth the effort to the extent that it actually helps you make what you need when you need it.

But the job can be done well or poorly. We see many manufacturers stopping at the first level when they could easily go to the second level. And with a little more effort, they could go all the way to the third level, utilizing probabilistic modeling to convert demand planning results into an inventory optimization process.

The First Level

 

The first level is making a demand forecast using statistical methods. Figure 1 shows a first level effort: an item’s demand history (red line) and its expected 12-month forecast (green line).

 

 The first level: A forecast of expected demand over the next 12 months

 

The forecast is bare bones. It only projects expected demand ignoring that demand is volatile and will inevitably create forecast error. (This is another example of an important maxim: “The Average is Not the Answer”). The forecast is as likely to be too high as it is to be too low, and there is no indication of forecast uncertainty accompanying the forecast. This means the planner has no estimate of the risk associated with committing to the forecast. Still, this forecast does provide a rational basis for production planning, personal scheduling, and raw materials purchase. So, it’s much better than guessing.

The Second Level

 

The second level takes explicit account of forecast uncertainty. Figure 2 shows a second level effort, known as a “percentile forecast”.

Now we see an explicit indication of forecast uncertainty. The cyan line above the green forecast line represents the projected 90th percentile of monthly demand. That is, the demand in each future month has a 90% chance of falling at or below the cyan line. Put another way, there is a 10% chance of demand exceeding the cyan line in each month.

This analysis is much more useful because it supports risk management. If it is important to assure sufficient supply of this item, then it makes sense to produce to the 90th percentile instead of to the expected forecast. After all, it’s a coin flip as to whether the expected forecast will result in enough production to meet monthly demand. This second level forecast is, in effect, a rough substitute for a careful inventory management process.

 

A percentile forecast, where the cyan line estimates the 90th percentiles of monthly demand.

 

Figure 2. A percentile forecast, where the cyan line estimates the 90th percentiles of monthly demand.

Going All the Way to the Third Level

 

Best practice is the Third Level, which uses demand planning as a foundation for completing a second task: explicit inventory optimization. Figure 3 shows the fundamental plot for the efficient management of our finished good, assuming it has a 1 month production lead time.

 

Distribution of demand for finished good over its 1-month lead time

 

Figure 3 shows the utilization of probabilistic forecasting and how much draw-down in finished good inventory might take place over a one month production lead time. The uncertainty in demand is apparent in the spread of the possible demand, from a low of 0 to a high of 35, with 15 units being the most likely value. The vertical red line at 22 indicates the “reorder point“ (or “min” or “trigger value”) corresponding to keeping the chance of stocking out while waiting for replenishment to a low 5%. When inventory drops to 22 or below, it is time to order more. The Third Level uses probabilistic demand forecasting with full exposure of forecast uncertainty to efficiently manage the stock of the finished product.

To Sum Up

 

Forecasting the most likely demand for an item is a useful first step. It gets you halfway to where you want to be. But it provides an incomplete guide to planning because it ignores demand volatility and the forecast uncertainty that it creates. Adding a cushion to the demand forecast gets you further along, because it lessen the risk that a jump in demand will leave you short of product. This cushion can be calculated by probabilistic forecasting approaches that forecasts a high percentile of the distribution of future demand. And if you want to take one step further, you can feed forecasts of the demand distribution over a lead time to calculate reorder points (mins) to ensure that you have an acceptably low level of stock-out risk.

Given what modern forecasting technology can do for you, why would you want to stop halfway to your goal?

Leave a Comment

Related Posts

Do your statistical forecasts suffer from the wiggle effect?

Do your statistical forecasts suffer from the wiggle effect?

What is the wiggle effect? It’s when your statistical forecast incorrectly predicts the ups and downs observed in your demand history when there really isn’t a pattern. It’s important to make sure your forecasts don’t wiggle unless there is a real pattern. Here is a transcript from a recent customer where this issue was discussed:

How to Handle Statistical Forecasts of Zero

How to Handle Statistical Forecasts of Zero

A statistical forecast of zero can cause lots of confusion for forecasters, especially when the historical demand is non-zero. Sure, it’s obvious that demand is trending downward, but should it trend to zero?

Recent Posts

  • Fifteen questions that reveal how forecasts are computed in your companyFifteen questions that reveal how forecasts are computed in your company
    In a recent LinkedIn post, I detailed four questions that, when answered, will reveal how forecasts are being used in your business. In this article, we’ve listed questions you can ask that will reveal how forecasts are created. […]
  • Businessman and businesswoman reading and analysing spreadsheetThe top 3 reasons why your spreadsheet won’t work for optimizing reorder points on spare parts
    We often encounter Excel-based reorder point planning methods. In this post, we’ve detailed an approach that a customer used prior to proceeding with Smart. We describe how their spreadsheet worked, the statistical approaches it relied on, the steps planners went through each planning cycle, and their stated motivations for using (and really liking) this internally developed spreadsheet. […]
  • Style business group in classic business suits with binoculars and telescopes reproduce different forecasting methodsHow to interpret and manipulate forecast results with different forecast methods
    This blog explains how each forecasting model works using time plots of historical and forecast data. It outlines how to go about choosing which model to use. The examples below show the same history, in red, forecasted with each method, in dark green, compared to the Smart-chosen winning method, in light green. […]
  • Factory worker engineer working in factory using tablet computer to check maintenance boiler water pipe in factory.Why Spare Parts Tradeoff Curves are Mission-Critical for Parts Planning
    When managing service parts, you don’t know what will break and when because part failures are random and sudden. As a result, demand patterns are most often extremely intermittent and lack significant trend or seasonal structure. The number of part-by-location combinations is often in the hundreds of thousands, so it’s not feasible to manually review demand for individual parts. Nevertheless, it is much more straightforward to implement a planning and forecasting system to support spare parts planning than you might think. […]
  • What to do when a statistical forecast doesn’t make senseWhat to do when a statistical forecast doesn’t make sense
    Sometimes a statistical forecast just doesn’t make sense. Every forecaster has been there. They may double-check that the data was input correctly or review the model settings but are still left scratching their head over why the forecast looks very unlike the demand history. When the occasional forecast doesn’t make sense, it can erode confidence in the entire statistical forecasting process. […]

    Inventory Optimization for Manufacturers, Distributors, and MRO

    • Businessman and businesswoman reading and analysing spreadsheetThe top 3 reasons why your spreadsheet won’t work for optimizing reorder points on spare parts
      We often encounter Excel-based reorder point planning methods. In this post, we’ve detailed an approach that a customer used prior to proceeding with Smart. We describe how their spreadsheet worked, the statistical approaches it relied on, the steps planners went through each planning cycle, and their stated motivations for using (and really liking) this internally developed spreadsheet. […]
    • Factory worker engineer working in factory using tablet computer to check maintenance boiler water pipe in factory.Why Spare Parts Tradeoff Curves are Mission-Critical for Parts Planning
      When managing service parts, you don’t know what will break and when because part failures are random and sudden. As a result, demand patterns are most often extremely intermittent and lack significant trend or seasonal structure. The number of part-by-location combinations is often in the hundreds of thousands, so it’s not feasible to manually review demand for individual parts. Nevertheless, it is much more straightforward to implement a planning and forecasting system to support spare parts planning than you might think. […]
    • Portrait of factory worker woman with blue hardhat holds tablet and stand in spare parts workplace area. Concept of confident of working with spare parts planning software.Spare Parts Planning Isn’t as Hard as You Think
      When managing service parts, you don’t know what will break and when because part failures are random and sudden. As a result, demand patterns are most often extremely intermittent and lack significant trend or seasonal structure. The number of part-by-location combinations is often in the hundreds of thousands, so it’s not feasible to manually review demand for individual parts. Nevertheless, it is much more straightforward to implement a planning and forecasting system to support spare parts planning than you might think. […]
    • Worker on a automotive spare parts warehouse using inventory planning softwareService-Level-Driven Planning for Service Parts Businesses
      Service-Level-Driven Service Parts Planning is a four-step process that extends beyond simplified forecasting and rule-of-thumb safety stocks. It provides service parts planners with data-driven, risk-adjusted decision support. […]