Protect your Demand Planning Process from Regime Change

The Smart Forecaster

Pursuing best practices in demand planning, forecasting and inventory optimization

No, not that kind of regime change: Nothing here about cruise missiles and stealth bombers. And no, we’re not talking about the other kind of regime change that hits closer to home: Shuffling the C-Suite at your company.

“Regime change” has a third meaning that is relevant to your profession as a demand planner or inventory manager. To researchers in economics and finance, regime change means sudden shifts in the very character of a time series of random observations. The random time series in question here is the sequence of daily (or weekly or monthly) demand counts for your products and inventory items.

Most forecasting software uses statistical algorithms to process historical demand. It may add additional steps, such as incorporating field intelligence from sales people, but everything starts with the demand history of whatever item you must manage.

The question raised by regime change is, which data do you use? The simple answer is “All of it”, because that leads to the most accurate forecasts — but only if your data world is stable. If your data world is turbulent, then using all the data means you are basing forecasts on bye-gone conditions. In turn, inputting obsolete data into your forecasting algorithms inevitably leads to reduced forecast accuracy.

Note that dealing with regime change is not the same as dealing with outliers. Outliers are usually one-off exceptions caused by transient events, such as a kink in your supply chain caused by a huge blizzard choking off all transit paths. In contrast, regime change persists over a longer period and is therefore capable of doing more damage to your forecasts. Here’s an analogy: Outliers are about weather, and regime change is about climate.

The most drastic forms of regime change are existential. Figure 1 shows an example of an existential change: There was no demand at all for a long time, then suddenly there was demand. If you had no demand for an item because it didn’t exist but you retain zero demand values in your database, and then the item goes live and you do have sales, the transition from nothing to something is an extreme regime change. Including all those zero demand values from before “Day One” is sure to bias statistical forecasts down below where they should be. The same thing happens if you kill off a product but keep recording zero demand: Including all those recent zeros degrades your demand forecasts.

In principle, careful record keeping should eliminate these problems. You should record only meaningful zero values. If you have a new item, start recording when it goes live. If you no longer have any demand for an item and expect none, purge it from your database, or at least forecast zero demand.

Unfortunately, there is a difference between principle and practice. We see many instances in which the data records for both new and dormant items are not properly kept, with “fake zeros” confounded with “real zeros”. This problem is not necessarily the result of incompetence: Usually, it is a byproduct of the scale of the problem, with too few people trying to keep track of too many items.

These existential regime changes are relatively easy to deal with compared to more subtle forms, which appear to afflict more items. Figure 2 shows two examples of regime changes in a pattern of ongoing sales. There are any number of factors that can change the demand for an item: salesforce performance, marketing and advertising efforts, competitor and supplier actions, new customers arising or old customers disappearing, etc. If demand for an item has been chugging along at a steady 1 unit per day but suddenly doubles (or vice versa), that’s a regime change. In the new world order, demand is 2 units/day and forecasts should reflect that. Instead, statistical forecasting algorithms will forecast too little demand if fed all the data, including that from before the regime change.

How do you protect yourself from regime change? The answer is the same for the cruelest dictator or the most innocent demand planner: Intelligence. And because threats are many, the intelligence is best automated. Modern software systems have the capability to screen tens of thousands of items for signs of regime change. Then the software can call your attention to the problematic items and prompt you to designate which recent data to use in calculations. Or the software can automatically detect and correct for regime change, working quickly at a scale that would easily defeat any busy person working “by hand”.

 

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Protect your Demand Planning Process from Regime Change

Protect your Demand Planning Process from Regime Change

No, not that kind of regime change: Nothing here about cruise missiles and stealth bombers. And no, we’re not talking about the other kind of regime change that hits closer to home: Shuffling the C-Suite at your company. In this blog, we discuss the relevance of regime change on time series data used for demand planning and forecasting.

Don’t Become a Victim of Your Forecast Models

Don’t Become a Victim of Your Forecast Models

Generally, the supply chain field has lagged behind finance in terms of the use of statistical models. My university colleagues and I are chipping away at that, but we have a long way to go. Some supply chains are quite technically sophisticated, but many, perhaps more, are essentially managed as much by gut instinct as by the numbers. Is this avoidance of analytics safer than relying on models?

Reveal Your Real Inventory Planning and Forecasting Policy by Answering These 9 Questions

Reveal Your Real Inventory Planning and Forecasting Policy by Answering These 9 Questions

In this blog, we review 9 specific questions you can ask to uncover what’s really happening with the inventory planning and demand forecasting policy at your company. We detail the typical answers provided when a forecasting/inventory planning policy doesn’t really exist, explain how to interpret these answers, and offer some clear advice on what to do about it.

Don’t Become a Victim of Your Forecast Models

The Smart Forecaster

Pursuing best practices in demand planning, forecasting and inventory optimization

Quants and Financial Meltdowns

I spend much of my time developing new quantitative methods for statistical forecasting, demand forecasting and inventory optimization. For me, this is an engaging way to contribute to society. But I know that the most prudent way to do algorithm development is to stand a little to the side and cast a skeptical eye on my own work.

The need for this skepticism was highlighted for me recently as I read Scott Patterson’s book The Quants: How a New Breed of Math Whizzes Conquered Wall Street and Nearly Destroyed It (Crown Publishing, 2010). This book reviewed the “quants” whose complex financial models were largely responsible for the financial meltdown in 2007. As I read along and thought “What was wrong with these guys?” I began to wonder if we supply chain quants were guilty of some of the same sins.

Models versus Instincts

Generally, the supply chain field has lagged behind finance in terms of the use of statistical models. My university colleagues and I are chipping away at that, but we have a long way to go. Some supply chains are quite technically sophisticated, but many, perhaps more, are essentially managed as much by gut instinct as by the numbers. Is this avoidance of analytics safer than relying on models?

What makes gut instinct dangerous is that it is so amorphous. Everyone who works long in a job develops instincts, but longevity is not the same as wisdom. It is possible to learn all the wrong lessons over a long career. It is also possible to miss the chance to learn the right lessons because certain informative scenarios may never arise in one person’s career. It is also possible to have good days and bad days; even gurus can mess up. Gut instinct is also anti-productive, since all decisions have to pass through that one gut, which becomes an enterprise chokepoint. And Golden Guts eventually reach their Golden Years and take their Golden Watch and go off into a Golden Sunset; at that point, whatever expertise had been present has walked out the door.

In contrast, models have certain advantages. Relative to gut instinct, models are:

  • Explicit: The theory of the supply chain operation is exposed for all to see.
  • Adaptive: Because the theory is visible, it can be reviewed, critiqued, tested against data, and evolved.
  • Consistent: Models may be more or less true, but they are not subject to day-to-day variability.
  • Comprehensive: At least potentially, models can accumulate a wide range of empirical experience, including scenarios never encountered during any one person’s career.
  • Instructive: Models are collections of relationships among variables. If the model’s “guts” are made visible, users can learn about those relationships.

Model Error

Nevertheless, despite all their virtues, models can also be wrong. In fact, that is a given. A constructive way to live with this is encoded in the famous aphorism by Dr. George Box, one of the best modelers of the last half century: “All models are wrong. Some are useful.”

The finance quants’ models were wrong by being oversimplified. They started with a quasi-religious belief in the efficiency of markets and developed statistical models that made certain assumptions that were more likely to be true of the physical world than the financial world. Among these were Normal distributions of changes in asset prices and independence of events across various corners of the market. They also assumed human rationality.

It should be a bit alarming that the Normal distribution and independence assumptions also underlie many of the models in supply chain software. In fact, there are alternative models of supply chain dynamics that do not require these simplifying assumptions, so this is an unnecessary risk being run by many, perhaps most, of the users of supply chain software.

But even with more robust and realistic model assumptions, there is no denying that model error is a constant risk. So, can you be victimized by your models? Of course you can.

Self-Protection: Look at the Data

Every supply chain professional who uses models, then, is subject to model risk. But unlike with decisions based on gut feel, decisions based on model calculations can be exposed and compared to real-world outcomes. Repeated checking is the best way to protect against model error, because it not only tests whether the model is realistic but also signals when it is time to update the model.

As noted above, a model is a set of functional relationships between key variables. Those relationships have parameters that tune the model to the current operating context. For instance, supply chain models often rely, in part, on estimates of demand volatility. Historical demand data are used to calculate numerical values for these parameters. If demand volatility changes, the model becomes obsolete and likely to produce inapt recommendations. Therefore, good practice demands frequent updates to model parameters.

Even when parameter values are current, there may still be trouble due to incorrect functional relationships. For example, consider the relationship between the mean and standard deviation of demand for spare parts. Generally speaking, the greater the average demand, the greater the demand volatility as measured by the standard deviation.

Now consider simplified “old school” models that describe spare part demand as a Poisson process. The Poisson process is widely useful and relatively simple, so it often shows up in Statistics 101 classes. Because of their relative simplicity, Poisson models are the white rats of supply chain analytics for spare parts, i.e., people do computer experiments and theory development based on the behavior of Poisson models of demand. For Poisson models, the standard deviation of demand equals the square root of the mean. However, when we look at our customers’ actual demand data, we discover that the actual relationship between the mean and standard deviation of demand is better described by a more general power-law relationship. Thus, the simple model may use accurate estimates of mean and standard deviation but still not accurately reflect their relationship. This in turn leads to incorrect recommendations about reorder points for spare parts. Checking real data is the best antidote to cavalier assumption-making.

What to Do Next

I do not sense that today’s supply chain models are on the brink of creating the kind of meltdown we saw in the start of the Great Recession. But those of us who are supply chain quants need to show more professional maturity than our financial colleagues. We need to not fall in love with our models, and we need to alert our customers to correct model hygiene.

So, model users, wash your hands frequently as we begin flu season, and wash your models thoroughly through hard data to be sure that the models you rely on are both up-to-date and grounded in reality. Both those steps will protect you from being victimized by your models and let you exploit their advantages over management by gut feel.

Appendix: Technical Tips

Supply chain analytics provide various types of outputs. In the realm of forecasting and demand planning, the obvious empirical check is to compare forecasts against the actual demand values that eventually reveal themselves. This same “forecast then check” approach can also be used in the generation of forecasts.  In the realm of inventory management, the models can build on forecasts to recommend policy choices, such as reorder points and order quantities or Min and Max values. There is a smart way to confirm the accuracy of recommendations of reorder points and Min’s.  See our blog The Right Forecast Accuracy Metric for Inventory Planning

 

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Related Posts

Protect your Demand Planning Process from Regime Change

Protect your Demand Planning Process from Regime Change

No, not that kind of regime change: Nothing here about cruise missiles and stealth bombers. And no, we’re not talking about the other kind of regime change that hits closer to home: Shuffling the C-Suite at your company. In this blog, we discuss the relevance of regime change on time series data used for demand planning and forecasting.

Don’t Become a Victim of Your Forecast Models

Don’t Become a Victim of Your Forecast Models

Generally, the supply chain field has lagged behind finance in terms of the use of statistical models. My university colleagues and I are chipping away at that, but we have a long way to go. Some supply chains are quite technically sophisticated, but many, perhaps more, are essentially managed as much by gut instinct as by the numbers. Is this avoidance of analytics safer than relying on models?

Reveal Your Real Inventory Planning and Forecasting Policy by Answering These 9 Questions

Reveal Your Real Inventory Planning and Forecasting Policy by Answering These 9 Questions

In this blog, we review 9 specific questions you can ask to uncover what’s really happening with the inventory planning and demand forecasting policy at your company. We detail the typical answers provided when a forecasting/inventory planning policy doesn’t really exist, explain how to interpret these answers, and offer some clear advice on what to do about it.

Reveal Your Real Inventory Planning and Forecasting Policy by Answering These 9 Questions

The Smart Forecaster

Pursuing best practices in demand planning, forecasting and inventory optimization

In our last blog we posed the question:  How can you be sure that you really have a policy for inventory planning and demand forecasting? We explained how an organization’s lack of understanding on the basics (how a forecast is created, how safety stock buffers are determined, and how/why these values are adjusted) contributes to poor forecast accuracy, misallocated inventory, and lack of trust in the whole process.

In this blog, we review 9 specific questions you can ask to uncover what’s really happening at your company. We detail the typical answers provided when a forecasting/inventory planning policy doesn’t really exist, explain how to interpret these answers, and offer some clear advice on what to do about it.

Always start with a simple hypothetical example. Focusing on a specific problem you just experienced is bound to provoke defensive answers that hide the full story. The goal is to uncover the actual approach used to plan inventory and forecasts that has been baked into the mental math or spreadsheets.   Here is an example:

Suppose you have 100 units on hand, the lead time to replenish is 3 months, and the average monthly demand is 20 units?   When should you order more?  How much would you order? How will your answer change if expected receipts of 10 per month were scheduled to arrive?  How will your answer change if the item is the item is an A, B, or C item, the cost of the item is high or low, lead time of the item is long or short?  Simply put, when you schedule a production job or place a new order with a supplier, why did you do it? What triggered the decision to get more?  What planning inputs were considered?

When getting answers to the above question, focus on uncovering answers to the following questions:

1. What is the underlying replenishment approach? This will typically be one of Min/Max, forecast/safety stock, Reorder Point/Order Quantity, Periodic Review/Order Up To or even some odd combination

2. How are the planning parameters, such as demand forecasts, reorder points, or Min/Max, actually calculated? It’s not enough to know that you use Min/Max.  You have to know exactly how these values are calculated. Answers such as “We use history” or “We use an average” are not specific enough.   You’ll need answers that clearly outline how history is used.  For example, “We take an average of the last 6 months, divide that by 30 to get a daily average, and then multiply that by the lead time in days.  For ‘A’ items we then multiply the lead time average by 2 and for ‘B’ items we use a multiplier of 1.5.” (While that is not an especially good technical approach, at least it has a clear logic.)

Once you have a policy well-defined, you can identify its weaknesses in order to improve it.  But if the answer provided doesn’t get much further past “We use history”, then you don’t have a policy to start with.   Answers will often reveal that different planners use history in different ways.  Some may only consider the most recent demand, others might stock according to the average of the highest demand periods, etc.  In other words, you may find that you actually have multiple ill-conceived “policies”.

3. Are forecasts used to drive replenishment planning and if so, how? Many companies will say they forecast, but their forecasts are calculated and used differently. Is the forecast used to predict what on hand inventory will be in the future, resulting in an order being triggered?  Or is it used to derive a reorder point but not to predict when to order (i.e. I predict we’ll sell 10 a week so to help protect against stock out, I’ll order more when on hand gets to 15)? Is it used as a guide for the planner to help subjectively determine when they should order more?  Is it used to set up blanket orders with suppliers?  Some use it to drive MRP. You’ll need to know these specifics.  A thorough answer to this question might look like this: “My forecast is 10 per week and my lead time is 3 weeks so I make my reorder point a multiple of that forecast, typically 2 x lead time demand or 60 unit for important items and I use a smaller multiple for less important items.  (Again, not a great technical approach, but clear.)

4.  What technique is actually used to generate the forecast? Is it an average, a trending model such as double exponential smoothing, a seasonal model? Does the choice of technique change depend on the type of demand data or when new demand data is available? (Spare parts and high-volume items have very different demand patterns.) How do you go about selecting the forecast model? Is this process automated?  How often is the choice of model reconsidered?  How often are the model parameters recomputed? What is the process used to reconsider your approach?  The answer here documents how the baseline forecasts are produced.  Once determined, you can conduct an analysis to identify whether other forecasting methods would improve forecast accuracy.  If you aren’t documenting forecast accuracy and conducting “forecast value add” analysis then you aren’t in a position to properly assess whether the forecasts being produced are the best that they can be.  You’ll miss out on opportunities to improve the process, increase forecast accuracy, and educate the business on what type of forecast error is normal and should be expected.

5. How do you use safety stock? Notice the question was not “Do you use safety stock?” In this context, and to keep it simple, the term “safety stock” means stock used to buffer inventory against supply and demand variability.  All companies use buffering approaches in some way.  There are some exceptions though.  Maybe you are a job shop manufacturer that procures all parts to order and your customers are completely fine waiting weeks or months for you to source material, manufacture, QA, and ship.  Or maybe you are high-volume manufacturer with tons of buying power so your suppliers set up local warehouses that are stocked full and ready to provide inventory to you almost immediately.  If these descriptions don’t describe your company, you will definitely have some sort of buffer to protect against demand and supply variability.  You may not use the “safety stock” field in your ERP but you are definitely buffering.

Answers might be provided such as “We don’t use safety stock because we forecast.”  Unfortunately, a good forecast will have a 50/50 chance of being over/under the actual demand.  This means you’ll incur a stock out 50% of the time without a safety stock buffer added to the forecast.  Forecasts are only perfect when there is no randomness. Since there is always randomness, you’ll need to buffer if you don’t want to have abysmal service levels.

If the answer isn’t revealed, you can probe a bit more into how the varying replenishment levers are used to add possible buffers which leads to questions 6 & 7.

6. Do you ever increase the lead time or order earlier than you truly need to?
In our hypothetical example, your supplier typically takes 4 weeks to deliver and is pretty consistent. But to protect against stockouts your buyer routinely orders 6 weeks out instead of 4 weeks.  The safety stock field in your ERP system might be set to zero because “we don’t use safety stock”, but in reality, the buyer’s ordering approach just added 2 weeks of buffer stock.

7. Do you pad the demand forecast?
In our example, the planner expects to consume 10 units per month but “just in case” enters a forecast of 20 per month.  The safety stock field in the MRP system is left blank but the now disguised buffer stock has been smuggled into the demand forecast.  This is a mistake that introduces “forecast bias.”  Not only will your forecasts be less accurate but if the bias isn’t accounted for and safety stock is added by other departments, you will overstock.

The ad-hoc nature of the above approaches compounds the problems by not considering the actual demand or supply variability of the item. For example, the planner might simply make a rule of thumb that doubles the lead time forecast for important items.  One-size doesn’t fit all when it comes to inventory management.  This approach will substantially overstock the predictable items while substantially understocking the intermittently demanded items. You can read “Beware of Simple Rules of Thumb for Managing Inventory” to learn more about why this type of approach is so costly.

The ad-hoc nature of the approaches also ignores what happens the company is faced with a huge overstock or stock out. When trying to understand what happened, the stated policies will be examined. In the case of an overstock, the system will show zero safety stock.  The business leaders will assume they aren’t carrying any safety stock, scratch their heads, and eventually just blame the forecast, declare “Our business can’t be forecasted” and stumble on. They may even blame the supplier for shipping too early and making them hold more than needed. In the case of a stock out, they will think they aren’t carrying enough and arbitrarily add more stock across many items not realizing there is in fact lots of extra safety stock baked into process.  This makes it more likely inventory will need to be written off in the future.

8. What is the exact inventory terminology used? Define what you mean by safety stock, Min, reorder point, EOQ, etc.  While there are standard technical definitions it’s possible that something differs, and miscommunication here will be problematic.  For example, some companies refer to Min as the amount of inventory needed to satisfy lead time demand while some may define Min as inclusive of both lead time demand and safety stock to buffer against demand variability. Others may mean the minimum order quantity.

9. Is on hand inventory consistent with the policy? When your detective work is done and everything is documented, open your spreadsheet or ERP system and look at the on-hand quantity. It should be more or less in line with your planning parameters (i.e. if Min/Max is 20/40 and typical lead time demand is 10, then you should have roughly 10 to 40 units on hand at any given point in time.  Surprisingly, for many companies there is often a huge inconsistency. We have observed situations where the Min/Max setting is 20/40 but the on-hand inventory is 300+.  This indicates that whatever policy has been prescribed just isn’t being followed.   That’s a bigger problem.

Going Forward

Demand forecasting and inventory stocking policy need to be well-defined processes that are understood and accepted by everybody involved.  There should be zero mystery.

To do this right, the demand and supply variability must be analyzed and used to compute the proper levels of safety stock.   Adding buffers without an implicit understanding of what each additional unit of buffer stock is buying you in terms of service is like arbitrarily throwing a handful of ingredients into a cake recipe.  A small change in ingredients can have a huge impact on what comes out of the oven – one bite too sweet but the next too sour.  It is the same with inventory management.  A little extra here, a little less there, and pretty soon you find yourself with costly excess inventory in some areas, painful shortages in others, no idea how you got there, and with little guidance on how to make things better.

Modern inventory optimization and demand planning software with its advanced analytics and strong basis in forecast analysis can help a good deal with this problem. But even the best software won’t help if it is used inconsistently.

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Protect your Demand Planning Process from Regime Change

Protect your Demand Planning Process from Regime Change

No, not that kind of regime change: Nothing here about cruise missiles and stealth bombers. And no, we’re not talking about the other kind of regime change that hits closer to home: Shuffling the C-Suite at your company. In this blog, we discuss the relevance of regime change on time series data used for demand planning and forecasting.

Don’t Become a Victim of Your Forecast Models

Don’t Become a Victim of Your Forecast Models

Generally, the supply chain field has lagged behind finance in terms of the use of statistical models. My university colleagues and I are chipping away at that, but we have a long way to go. Some supply chains are quite technically sophisticated, but many, perhaps more, are essentially managed as much by gut instinct as by the numbers. Is this avoidance of analytics safer than relying on models?

Reveal Your Real Inventory Planning and Forecasting Policy by Answering These 9 Questions

Reveal Your Real Inventory Planning and Forecasting Policy by Answering These 9 Questions

In this blog, we review 9 specific questions you can ask to uncover what’s really happening with the inventory planning and demand forecasting policy at your company. We detail the typical answers provided when a forecasting/inventory planning policy doesn’t really exist, explain how to interpret these answers, and offer some clear advice on what to do about it.

How to Tell You Don’t Really Have an Inventory Planning and Forecasting Policy

The Smart Forecaster

Pursuing best practices in demand planning, forecasting and inventory optimization

You can’t properly manage your inventory levels, let alone optimize them, if you don’t have a handle on exactly how demand forecasts and stocking parameters (such as Min/Max, safety stocks, and reorder points, and order quantities) are determined.

Many organizations cannot specify how policy inputs are calculated or identify situations calling for management overrides to the policy.   For example, many people can say they rely on a particular planning method such as Min/Max, reorder point, or forecast with safety stock, but they can’t say exactly how these planning inputs are calculated.  More fundamentally, they may not understand what would happen to their KPI’s if they were to change Min,Max, or Safety Stock. They may know that the forecast relies on “averages” or “history” or “sales input”, but specific details about how the final forecast is arrived at are unclear.

Often enough, a company’s inventory planning and forecasting logic was developed by a former employee or vanished consultant and entombed in a spreadsheet.  It otherwise may rely on outdated ERP functionality or ERP customization by an IT organization that incorrectly assumed that ERP software can and should do everything. (Read this great and, as they say, “funny because it’s true,” blog by Shaun Snapp about ERP Centric Strategies.)  The policy may not have been properly documented, and no one currently on the job can improve it or use it to best advantage.

This unhappy situation leads to another, in which buyers and inventory planners flat out ignore the output from the ERP system, forcing reliance on Microsoft Excel to determine order schedules.  Ad hoc methods are developed that impede cohesive responses to operational issues and aren’t visible to the rest of the organization (unless you want your CFO to learn the complex and finicky spreadsheet).  These methods often rely on rules of thumb, averaging techniques, or textbook statistics without a full understanding of their shortcomings or applicability.  And even when documented, most companies often discover that actual ordering strays from the documented policy.  One company we consulted for had on hand inventory levels that were routinely 2 x’s the Max quantity!  In other words, there isn’t really a policy at all.

In summary, many current inventory and demand forecast “systems” were developed out of distrust for the previous system’s suggestions but don’t actually improve KPI’s.  They also force the organization to rely on a few employees to manage demand forecasting, daily ordering, and inventory replenishment.

And when there is a problem, it is impossible for the executive team to unwind how you got there, because there are too many moving parts.  For example, was the excess stock the fault of an inaccurate demand forecast that relied on an averaging method that didn’t account for a declining demand?  Or was it due to an outdated lead time setting that was higher than it should’ve been?  Or was it due to a forecast override a planner made to account for an order that just never happened?  And who gave the feedback to make that override?  A customer? Salesperson?

Do you have any of these problems?  If so, you are wasting hundreds of thousands to millions of dollars each year in unnecessary shortage costs, holding costs, and ordering costs.  What would you be able to do with that extra cash?  Imagine the impact that this would have on your business.

In our next blog, we’ll review specific questions you can ask to uncover what’s really happening at your company, detail the typical answers provided when a forecasting/inventory planning policy doesn’t really exist, explain how to interpret these answers, and offer some clear advice on what to do about it.

 

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Related Posts

Protect your Demand Planning Process from Regime Change

Protect your Demand Planning Process from Regime Change

No, not that kind of regime change: Nothing here about cruise missiles and stealth bombers. And no, we’re not talking about the other kind of regime change that hits closer to home: Shuffling the C-Suite at your company. In this blog, we discuss the relevance of regime change on time series data used for demand planning and forecasting.

Don’t Become a Victim of Your Forecast Models

Don’t Become a Victim of Your Forecast Models

Generally, the supply chain field has lagged behind finance in terms of the use of statistical models. My university colleagues and I are chipping away at that, but we have a long way to go. Some supply chains are quite technically sophisticated, but many, perhaps more, are essentially managed as much by gut instinct as by the numbers. Is this avoidance of analytics safer than relying on models?

Reveal Your Real Inventory Planning and Forecasting Policy by Answering These 9 Questions

Reveal Your Real Inventory Planning and Forecasting Policy by Answering These 9 Questions

In this blog, we review 9 specific questions you can ask to uncover what’s really happening with the inventory planning and demand forecasting policy at your company. We detail the typical answers provided when a forecasting/inventory planning policy doesn’t really exist, explain how to interpret these answers, and offer some clear advice on what to do about it.

The 3 levels of forecasting: Point forecasts, Interval forecasts, Probability forecasts
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The Smart Forecaster

Pursuing best practices in demand planning, forecasting and inventory optimization

Most demand forecasts are partial or incomplete: They provide only one single number: the most likely value of future demand. This is called a point forecast. Usually, the point forecast estimates the average value of future demand.  Interval forecasts provide an estimate of the possible future range of demand (i.e. demand has a 90% chance of being between 50 – 100 units).  Probabilistic forecasts take it a step further and provide additional information.  Knowing more is always better than knowing less and the probabilistic forecast provides that extra information so crucial for inventory management. This video blog by Dr. Thomas Willemain explains each type of forecast and the advantages of probabilistic forecasting.

 

Watch Now

 

 

Point forecast (green) shows what is most likely to happen.  The Interval Forecast shows the range (blue) of possibilities.

 

Probability Forecast shows the probability of each value occurring

 

 

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Related Posts

Protect your Demand Planning Process from Regime Change

Protect your Demand Planning Process from Regime Change

No, not that kind of regime change: Nothing here about cruise missiles and stealth bombers. And no, we’re not talking about the other kind of regime change that hits closer to home: Shuffling the C-Suite at your company. In this blog, we discuss the relevance of regime change on time series data used for demand planning and forecasting.

Don’t Become a Victim of Your Forecast Models

Don’t Become a Victim of Your Forecast Models

Generally, the supply chain field has lagged behind finance in terms of the use of statistical models. My university colleagues and I are chipping away at that, but we have a long way to go. Some supply chains are quite technically sophisticated, but many, perhaps more, are essentially managed as much by gut instinct as by the numbers. Is this avoidance of analytics safer than relying on models?

Reveal Your Real Inventory Planning and Forecasting Policy by Answering These 9 Questions

Reveal Your Real Inventory Planning and Forecasting Policy by Answering These 9 Questions

In this blog, we review 9 specific questions you can ask to uncover what’s really happening with the inventory planning and demand forecasting policy at your company. We detail the typical answers provided when a forecasting/inventory planning policy doesn’t really exist, explain how to interpret these answers, and offer some clear advice on what to do about it.

Undershoot is Sabotaging your Service Level!

The Smart Forecaster

Pursuing best practices in demand planning, forecasting and inventory optimization

Service level is a key performance indicator for companies that put a premium on satisfying customer demand. Service level is defined as the probability of surviving a replenishment lead time without stocking out.

Inventory management best practice begins with setting service level targets, then calculates reorder points (also called Mins) to achieve those targets. These calculations should account for variability in both demand and replenishment lead time. There are many software systems available for doing these calculations. If everything works out, the achieved service level ends up very close to the target service level. Unfortunately, there is often a painful gap between the two.

One reason for the gap is unrealistic models of demand. In many cases, software for calculating reorder points uses textbook formulas based on mathematical assumptions that make analysis simple at the expense of realism.  Many “Inventory 101” textbooks use formulas that assume demand has a Normal distribution (a.k.a. the “bell-shaped curve”) for finished goods and the Poisson distribution for spare parts. Fortunately, there are now inventory optimization and forecasting systems that process the actual demand histories of the inventory items using probabilistic forecasting.  These solutions calculate an accurate estimate of the distribution – not some idealized version.  To learn more check out this past blog on probabilistic forecasting:

But there is a second source of error in textbooks that operates invisibly in many inventory software package:  “undershoot”.

Calculations of reorder points almost always assume that stockouts arise when the total demand during a replenishment interval exceeds the reorder point. For example, assume that demand averages 1 unit per day. If lead time is 5 days, then on average lead time demand is 5 units. Setting the reorder point at 5 units would yield a laughable service level somewhere in the vicinity of 50%. Adding safety stock to the calculation might result in a reorder point of, say, 11 units, which might correspond to a service level of 95%. Another way to say this is, starting at a reorder point of 11 units, there should be a 95% chance of surviving the 5 day lead time without experiencing cumulative demand of more than 11 units. Theoretically!

What’s missing from this analysis is the undershoot phenomenon. Undershoot means that the lead time begins not at the reorder point but below it. Undershoot happens every time the demand that breached the reorder point took the stock down below (not down to) the reorder point. The figure below shows replenishment cycles with and without undershoot.  Undershoot picks your pocket before you even begin to roll the dice. It deludes the inventory professional into thinking his or her reorder points are sufficient to achieve their targets, whereas actual performance will not make the grade.

There is only one situation in which undershoot is not a worry: when demand is always either zero or one unit. In that case, undershoot is impossible. But in all other cases, undershoot is sure to happen to some extent, and it can seriously undercut the service level actually achieved by a given choice of reorder point. Our analyses show that the conditions most vulnerable to undershoot involve highly intermittent and skewed demand with very short lead times – the very conditions being made most common by market trends.

What can be done to protect yourself from the effect of undershoot on reorder point calculations?  Use inventory optimization and forecasting software that isn’t tied to the old textbook assumptions and instead automatically accounts for undershoot when calculating the service level produced by any choice of reorder point.

To see Smart Software’s Inventory Optimization solution in action, register to see a recorded demo below:

 

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