There’s one thing I’m reminded of almost every day at Smart Software that puzzle me: most companies do not understand how forecasts are created, and stocking policies are determined.  It’s an organizational black box. Here is an example from a recent sales call:

How do you forecast?
We use history.

How do you use history?
What do you mean?

Well, you can take an average of the last year, last two years, average the most recent periods, or use some other type of formula to generate the forecast.
I’m pretty sure we use an average of the last 12 months.

Why 12 months instead of a different amount of history?
12 months is a good amount of time to use because it doesn’t get skewed by older data but it’s recent enough

How do you know it’s more accurate than using 18 months or some other length of history?
We don’t know. We do adjust the forecasts based on feedback from sales.  

Do you know if the adjustments make things more accurate or less than if you just used the average?
We don’t know but are confident that forecasts are inflated

What do the inventory buyers do then if they think the numbers are inflated?
They have lots of business knowledge and adjust their buys accordingly

So, is it fair to say they would ignore the forecasts at least some of the time?
Yes, some of the time.

How do the buyers decide when to order more? Do you have a reorder point or safety stock specified in your ERP system that helps guide these decisions?
Yes, we use a safety stock field.

How is safety stock calculated?
Buyers determine this based on the importance of the item, lead times, and other considerations such as how many customers purchase the item, the velocity of the item, it’s cost.  They’ll carry different amounts of safety stock depending on this.

The discussion continued. The main takeaway here is that when you scratch just below the surface, far more questions are revealed than answers.  This often means that the inventory planning and demand forecast process is highly subjective, varies from planner to planner, is not well understood by the rest of the organization, and likely to be reactive.  As Tom Willemain has described it’s “chaos masked by improvisation.”   The “as-is” process needs to be fully identified and documented.  Only then can gaps be exposed, and improvements can be made.   Here is a list of 10 questions  you can ask that will reveal your organization’s true forecasting, demand planning, and inventory planning process.

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.

1. When we ask users how they create forecasts, their answer will often be “we use history.” This obviously isn’t enough information, as there are different types of demand history that require different forecasting methods. If you are using historical data, then make sure to find out if you are using an averaging model, a trending model, a seasonal model, or something else to forecast.

2. Once you know the model used, ask about the parameter values of those models. The forecast output of an “average” will differ, sometimes significantly, depending on the number of periods you are averaging.  So, find out whether you are using an average of the last 3 months, 6 months, 12 months, etc.

3. If you are using trending models, ask how the model weights are set. For example, in a trending model, such as double exponential smoothing, the forecasts will differ significantly depending on how the calculations weight recent data compared to older data (higher weights put more emphasis on the recent data).

4. If you are using seasonal models, the forecast results are going to be impacted by the “level” and “trending weights” used. You should also determine whether seasonal periods are forecasted with multiplicative or additive seasonality.  (Additive seasonality says, e.g., “Add 100 units for July”, whereas multiplicative seasonality says “Multiply by 1.25 for July.”) Finally, you may not be using these types of methods at all.  Some practitioners will use a forecast method that simply averages prior periods (i.e., next June will be forecasted based on the average of the prior three Junes).

5. How do you go about choosing one model over another? Does the choice of technique depend on the type of demand data or when new demand data are available? Is this process automated? Or if a planner chooses a trend model subjectively, will that item continue to be forecasted with that model until the planner changes it again?

6. Are your forecasts “fully automatic,” so that trend and/or seasonality are detected automatically? Or are your forecasts dependent on item classifications that must be maintained by users? The latter requires more time and attention from planners to define what behavior constitutes trend, seasonality, etc.

7. What are the item classification rules used? For example, an item may be considered a trending item if demand increases by more than 5% period-over-period. An item may be considered seasonal if 70% or more of the annual demand occurs in four or fewer periods. Such rules are user-defined and often require overly broad assumptions. Sometimes they are configured when a system was originally implemented but never revised even as conditions change. It’s important to make sure any classification rules are understood and, if necessary, updated.

8. Does the forecast regenerate automatically when new data are available, or do you have to manually regenerate the forecasts?

9. Do you check for any change in forecast from one period to the next before deciding whether to use the new forecast? Or do you default to the new forecast?

10. How are forecast overrides that were made in prior planning cycles treated when a new forecast is created? Are they reused or replaced?

11. How do you incorporate forecasts made by your sales team or by your customers? Do these forecasts replace the baseline forecast, or do you use these inputs to make planner overrides to the baseline forecast?

12. Under what circumstances would you ignore the baseline forecast and use exactly what sales or customers are telling you?

13. If you rely on customer forecasts, what do you do about customers who don’t provide forecasts?

14. How do you document the effectiveness of your forecasting approach?  Most companies only measure the accuracy of the final forecast that is submitted to the ERP system, if they measure anything. But they don’t assess alternative predictions that might have been used. It is important to compare what you are doing to benchmarks. For example, do the methods you are using outperform a naïve forecast (i.e., “tomorrow equals today,” which requires no thought), or what you saw last year, or the average of the last 12 months.  Benchmarking your baseline forecast insures you are squeezing as much accuracy as possible out of the data.

15. Do you measure whether overrides from sales, customers, and planners are making the forecast better or worse? This is just as important as measuring whether your statistical approaches are outperforming the naïve method.  If you don’t know whether overrides are helping or hurting, the business can’t get better at forecasting – you need to know which steps are adding value so that you can do more of those and get even better. If you aren’t documenting forecast accuracy and conducting “forecast value add” analysis, then you aren’t able to properly assess whether the forecasts being produced are the best you could make.  You’ll miss opportunities to improve the process, increase accuracy, and educate the business on what type of forecast error is to be expected.

Smart IP&O is powered by the SmartForecasts® forecasting engine that automatically selects the most appropriate method for each item.  Smart Forecast methods are listed below:

• Simple Moving Average and Single Exponential Smoothing for flat, noisy data
• Linear Moving Average and Double Exponential Smoothing for trending data
• Winters Additive and Winters Multiplicative for seasonal and seasonal & trending data.

This blog explains how each 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.

Seasonality
If you want to force (or prevent) seasonality to show in the forecast, then choose Winters models.  Both methods require 2 full years of history.

`Winter’s multiplicative will determine the size of the peaks or valleys of seasonal effects based on a percentage difference from a trending average volume.  It is not a good fit for very low volume items due to division by zero when determining that percentage. Note in the image below that the large percentage drop in seasonal demand in the history is being projected to continue over the forecast horizon making it look like there isn’t any seasonal demand despite using a seasonal method.

Statistical forecast produced with Winter’s multiplicative method. 

Winter’s additive will determine the size of the peaks or valleys of seasonal effects based on a unit difference from the average volume.  It is not a good fit if there’s significant trend to the data.  Note in the image below that seasonality is now being forecasted based on the average unit change in seasonality. So, the forecast still clearly reflects the seasonal pattern despite the down trend in both the level and seasonal peaks/valleys.

Statistical forecast produced with Winter’s additive method.

Trend

If you want to force (or prevent) trend up or down to show in the forecast, then restrict the chosen methods to (or remove the methods of) Linear Moving Average and Double Exponential Smoothing.

 Double exponential smoothing will pick up on a long-term trend.  It is not a good fit if there are few historical data points.

Statistical forecast produced with Double Exponential Smoothing

Linear moving average will pick up on nearer term trends.  It is not a good fit for highly volatile data

Non-Trending and Non-Seasonal Data
If you want to force (or prevent) an average from showing in the forecast, then restrict the chosen methods to (or remove the methods of) Simple Moving Average and Single Exponential Smoothing.

Single exponential smoothing will weigh the most recent data more heavily and produce a flat-line forecast.  It is not a good fit for trending or seasonal data.

Statistical forecast using Single Exponential Smoothing

Simple moving average will find an average for each period, sometimes appearing to wiggle, and better for longer-term averaging.  It is not a good fit for trending or seasonal data.

Statistical forecast using Simple Moving Average

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.

This blog will help a layman understand what the Smart statistical models are and how they are chosen automatically.  It will address how that choice sometimes fails, how you can know if it did, and what you can do to ensure that the forecasts can always be justified.  It’s important to know to expect, and how to catch the exceptions so you can rely on your forecasting system.

How methods are chosen automatically

The criteria to automatically choose one statistical method out of a set is based on which method came closest to correctly predicting held-out history.  Earlier history is passed to each method and the result is compared to actuals to find the one that came closest overall.  That automatically chosen method is then fed all the history to produce the forecast. Check out this blog to learn more about the model selection https://smartcorp.com/uncategorized/statistical-forecasting-how-automatic-method-selection-works/

For most time series, this process can capture trends, seasonality, and average volume accurately. But sometimes a chosen method comes mathematically closest to predicting the held-out history but doesn’t project it forward in a way that makes sense.  That means the system selected method isn’t best and for some “hard to forecast”

Hard to forecast items

Hard to forecast items may have large, unpredictable spikes in demand, or typically no demand but random irregular blips, or unusual recent activity.  Noise in the data sometimes randomly wanders up or down, and the automated best-pick method might forecast a runaway trend or a grind into zero.  It will do worse than common sense and in a small percentage of any reasonably varied group of items.  So, you will need to identify these cases and respond by overriding the forecast or changing the forecast inputs.

How to find the exceptions

Best practice is to filter or sort the forecasted items to identify those where the sum of the forecast over the next year is significantly different than the corresponding history last year.  The forecast sum may be much lower than the history or vice versa.  Use supplied metrics to identify these items; then you can choose to apply overrides to the forecast or modify the forecast settings.

How to fix the exceptions

Often when the forecast seems odd, an averaging method, like Single Exponential Smoothing or even a simple average using Freestyle, will produce a more reasonable forecast.  If trend is possibly valid, you can remove only seasonal methods to avoid a falsely seasonal result.  Or do the opposite and use only seasonal methods if seasonality is expected but wasn’t projected in the default forecast.  You can use the what-if features to create any number of forecasts, evaluate & compare, and continue to fine tune the settings until you are comfortable with the forecast.

Cleaning the history, with or without changing the automatic method selection, is also effective at producing reasonable forecasts. You can embed forecast parameters to reduce the amount of history used to forecast those items or the number of periods passed into the algorithm so earlier, outdated history is no longer considered.  You can edit spikes or drops in the demand history that are known anomalies so they don’t influence the outcome.  You can also work with the Smart team to implement automatic outlier detection and removal so that data prior to being forecasted is already cleansed of these anomalies.

If the demand is truly intermittent, it is going to be nearly impossible to forecast “accurately” per period. If a level-loading average is not acceptable, handling the item by setting inventory policy with a lead time forecast can be effective.  Alternatively, you may choose to use “same as last year” models which while not prone to accuracy will be generally accepted by the business given the alternatives forecasts.

Finally, if the item was introduced so recently that the algorithms do not have enough input to accurately forecast, a simple average or manual forecast may be best.  You can identify new items by filtering on the number of historical periods.

Manual selection of methods

Once you have identified rows where the forecast doesn’t make sense to the human eye, you can choose a smaller subset of all methods to allow into the forecast run and compare to history.  Smart will allow you to use a restricted set of methods just for one forecast run or embed the restricted set to use for all forecast runs going forward. Different methods will project the history into the future in different ways.  Having a sense of how each works will help you choose which to allow.

Rely on your forecasting tool

The more you use Smart period over period to embed your decisions about how to forecast and what historical data to consider, the less often you will face exceptions as described in this blog.  Entering forecast parameters is a manageable task when starting with critical or high impact items.  Even if you don’t embed any manual decisions on forecast methods, the forecast re-runs every period with new data. So, an item with an odd result today can become easily forecastable in time.

“Regardless of how much effort is poured into training forecasters and developing elaborate forecast support systems, decision-makers will either modify or discard the predictions if they do not trust them.”  — Dilek Onkal, International Journal of Forecasting 38:3 (July-September 2022), p.802.

The words quoted above grabbed my attention and prompted this post. Those of a geekly persuasion, like your blogger, are inclined to think of forecasting as a statistical problem. While that is obviously true, those of a certain age, like your blogger, understand that forecasting is also a social activity and therefore has a large human component.

What Do You Trust?

There is a related dimension of trust: not who do you trust but what do you trust? By this, I mean both data and software.

Trust in Data

Trust in data underpins trust in the forecaster using the data. Most of our customers have their data in an ERP system. This data must be understood as a key corporate asset. For the data to be trustworthy, it must have the “three C’s”, i.e., it must be correct, complete, and current.

Correctness is obviously fundamental. We once had a customer who was implementing a new, strong forecasting process, but found the results completely at odds with their sense of what was happening in the business. It turned out that several of their data streams were incorrect by a factor of two, which is a huge error. Of course, this set back the implementation process until they could identify and correct all the gross errors in their demand data.

There is a less obvious point to be made about correctness. That is, data are random, so what you see now is not likely to be what you see next. Planning production based on the assumption that next week’s demand will be exactly the same as this week’s demand is clearly foolish, but classical formula-based forecasting models like the exponential smoothing mentioned above will project the same number throughout the forecast horizon. This is where scenario-based planning is essential for coping with the inevitable fluctuations in key variables such as customers’ demands and suppliers’ replenishment lead times.

Completeness is the second requirement for data to be trusted. Our software ultimately gets much of its value from exposing the links between operational decisions (e.g., selecting the reorder points governing replenishment of stock) and business-related metrics like inventory costs. Yet often implementation of forecasting software is delayed because item demand information is available someplace, but holding, ordering and/or shortage costs are not.  Or, to cite another recent example, a customer was able to properly size only half their inventory of spares for reparable parts because nobody had been tracking when the other half was breaking down, meaning there was no information on mean time before failure (MTBF), meaning it was not possible to model the breakdown behavior of half the fleet of reparable spares.

Finally, the currency of data matters. As the speed of business increases and company planning cycles drop from a quarterly or monthly tempo to a weekly or daily tempo, it becomes desirable to exploit the agility provided by overnight uploads of daily transactional data into the cloud. This allows high-frequency adjustments of forecasts and/or inventory control parameters for items that experience high volatility and sudden shifts in demand. The fresher the data, the more trustworthy the analysis.

Trust in Demand Forecasting Software

Even with high-quality data, forecasters must still trust the analytical software that processes the data. This trust must extend to both the software itself and to the computational environment in which it functions.

If forecasters used on-premises software, they must rely on their own IT departments to safeguard the data and keep it available for use. If they wish instead to exploit the power of cloud-based analytics, customers must trust their confidential information to their software vendors. Professional-level software, such as ours, justifies customers’ trust through SOC 2 certification. SOC 2 certification was developed by the American Institute of CPAs and defines criteria for managing customer data based on five “trust service principles”—security, availability, processing integrity, confidentiality, and privacy.

What about the software itself? What is needed to make it trustworthy? The main criteria here are the correctness of algorithms and functional reliability. If the vendor has a professional program development process, there will be little chance that the software ends up computing the wrong numbers because of a programming error. And if the vendor has a rigorous quality assurance process, there will be little chance that the software will crash just when the forecaster is on deadline or must deal with a pop-up analysis for a special situation.

Summary

To be useful, forecasters and their forecasts must be trusted by decision-makers. That trust depends on characteristics of forecasters and their processes and communication. It also depends on the quality of the data and software used in creating the forecasts.

Read the 1st part of this Blog “Who do you Trust” here: https://smartcorp.com/forecasting/the-role-of-trust-in-the-demand-forecasting-process-part-1-who/

“Regardless of how much effort is poured into training forecasters and developing elaborate forecast support systems, decision-makers will either modify or discard the predictions if they do not trust them.”  — Dilek Onkal, International Journal of Forecasting 38:3 (July-September 2022), p.802.

The words quoted above grabbed my attention and prompted this post. Those of a geekly persuasion, like your blogger, are inclined to think of forecasting as a statistical problem. While that is obviously true, those of a certain age, like your blogger, understand that forecasting is also a social activity and therefore has a large human component.

Who Do You Trust?

Trust is always a two-way street, but let’s stay on the demand forecaster’s side. What characteristics of and actions by forecasters and demand planners build trust in their work? The above quoted Professor Onkal reviewed academic research on this topic going back to 2006. She summarized results from practitioner surveys that identified key trust factors related to forecaster characteristics, forecasting process, and forecasting communication.

Forecaster characteristics

Key to building trust among the users of forecasts are perceptions of forecaster and demand planner competence and objectivity. Competence has a mathematical component, but many managers confuse computer skills with analytic skills, so users of forecasting software can usually clear this hurdle. However, since the two are not the same, it pays dividends to absorb your vendor’s training and learn not just the math but the lingo of your forecasting software. In my observation, trust can also be increased by showing knowledge of the company’s business.

Objectivity is also a key to trustworthiness. It may be uncomfortable for the forecaster to be put in the middle of occasional departmental squabbles, but those will come up and must be handled with tact. Squabbles? Well, silos exist and tilt in different directions. Sales departments favor higher demand forecasts that drive production increases, so that they never have to say “Sorry, we are fresh out of that.” Inventory managers are wary of high demand forecasts, because “excess enthusiasm” can leave them holding the bag, sitting on bloated inventory.

Sometimes the forecaster becomes a de facto referee, and in this role must display overt signs of objectivity. That can mean first recognizing that every management decision involves tradeoffs of good things against other good things, e.g., product availability versus lean operations, and then helping the parties strike a painful but tolerable balance by surfacing the links between operational decisions and the key performance metrics that matter to folks like Chief Financial Officers.

The Forecasting process

The forecasting process can be thought of as having three phases: data inputs, calculations, and outputs. Actions can be taken to increase trust in each phase.

Regarding inputs:

Trust can be increased if obviously relevant inputs are at least acknowledged if not directly used in calculations. Thus, factors like social media sentiment and regional sales managers’ gut instincts can be legitimate parts of a forecast consensus process. However, objectivity requires that these putative predictors of profit be tested objectively. For instance, a professional-grade forecasting process may well include subjective adjustment to statistical forecasts but must then also assess whether the adjustments actually end up improving accuracy, not just making some people feel listened to.

Regarding the second phase, calculations:

The forecaster will be trusted to the extent that they are able to deploy more than one way to calculate forecasts and then articulate a good reason why they chose the method eventually used. In addition, the forecaster should be able to explain in accessible language how even complicated techniques do their job. It is difficult to put trust in a “black box” method that is so opaque as to be inscrutable. The importance of explainability is amplified by the fact of life that the forecaster’s superior must themselves in turn be able to justify the choice of technique to their supervisor.

For instance, exponential smoothing uses this equation: S(t) = αX(t)+(1-α)S(t-1). Many forecasters are familiar with this equation, but many forecast users are not. There is a story that explains the equation in terms of averaging irrelevant “noise” in an item’s demand history and the need to strike a balance between smoothing out noise and being able to react to sudden shifts in the level of demand. The forecaster who can tell that story will be more credible. (My own version of that story uses phrases from sports, i.e., “head fakes” and “jukes”. Finding folksy analogs appropriate to your specific audience always pays dividends.)

A final point: best practice demands that any forecast be accompanied by an honest assessment of its uncertainty. A forecaster who tries to build trust by being overly specific (“Sales next quarter will be 12,184 units”) will always fail. A forecaster who says “Sales next quarter will have a 90% chance of falling between 12,000 and 12,300 units” will be both correct more often and  also more helpful to decision makers. After all, forecasting is essentially a job of risk management, so the decision maker is best served by knowing the risks.

Forecasting communication:

Finally, consider the third phase, communication of forecast results. Research suggests that continual communication with forecast users builds trust. It avoids those horrible, deflating moments when a nicely formatted report is shot down because of some fatal flaw that could have been foreseen: “This is no good because you didn’t take account of X, Y or Z” or “We really wanted you to present results rolled up to the top of the product hierarchies (or by sales region or by product line or…)”.

Even when everybody is aligned as to what is expected, trust is enhanced by presenting results using well-crafted graphics, with massive numerical tables provided for backup but not as the main way of communicating results. My experience has been that, just as a meeting-control device, a graph is usually much better than a large numerical table. With a graph, everybody’s attention is focused on the same thing and many aspects of the analysis are immediately (and literally) visible. With a table of results, the table of participants often splinters into side conversations in which each voice is focused on different pieces of the table.

Onkal summarizes the research this way: “Take-aways for those who make forecasts and those who use them converge around clarity of communication as well as perceptions of competence and integrity.”

What Do You Trust?

There is a related dimension of trust: not who do you trust but what do you trust? By this I mean both data and software….  Read the 2nd part of this Blog “What do you Trust” here  https://smartcorp.com/forecasting/the-role-of-trust-in-the-demand-forecasting-process-part-2-what/