In my previous post in this series on essential concepts, “What is ‘A Good Forecast’”, I discussed the basic effort to discover the most likely future in a demand planning scenario. I defined a good forecast as one that is unbiased and as accurate as possible. But I also cautioned that, depending on the stability or volatility of the data we have to work with, there may still be some inaccuracy in even a good forecast. The key is to have an understanding of how much.

This topic, managing uncertainty, is the subject of post by my colleague Tom Willemain, “The Average is not the Answer”. His post lays out the theory for responsibly confronting the limits of our predictive ability. It’s important to understand how this actually works.

As I briefly touched on at the end of my previous post, our approach begins with something called a “sliding simulation”. We estimate how accurately we are predicting the future by using our forecasting techniques on an older portion of history, excluding the most recent data. We can then compare what we would have predicted for the recent past with our actual real world information about what happened. This is a reliable method to estimate how closely we are predicting future demand.

Safety stock, a carefully measured buffer in inventory level we stock above our prediction of most likely demand, is derived from the estimate of forecast error coming out of the “sliding simulation”. This approach to dealing with the accuracy of our forecasts efficiently balances between ignoring the threat of the unpredictable and costly overcompensation.

In more technical detail: the forecasts errors that are estimated by this sliding simulation process indicate the level of uncertainty. We use these errors to estimate the standard deviation of the forecasts. Now, with regular demand, we can assume the forecasts (which are estimates of future behavior) are best represented by a bell-shaped probability distribution—what statisticians call the “normal distribution”. The center of that distribution is our point forecast. The width of that distribution is the standard deviation of the “sliding simulation” forecast from the known actual values—we obtain this directly from our forecast error estimates.

Once we know the specific bell shaped curve associated with the forecast, we can easily estimate the safety stock buffer that is needed. The only input from us is the “service level” that is desired, and the safety stock at that service level can be ascertained. (The service level is essentially a measure of how confident we need to be in our inventory stocking levels, with increasing confidence requiring corresponding expenditures on extra inventory.) Notice, we are assuming that the correct distribution to use is the normal distribution. This is correct for most demand series where you have regular demand per period. It fails when demand is sporadic or intermittent.

In the next piece in this series, I’ll discuss how Smart Forecasts deals with estimating safety stock in those cases of intermittent demand, when the assumption of normality is incorrect.

Nelson Hartunian, PhD, co-founded Smart Software, formerly served as President, and currently oversees it as Chairman of the Board. He has, at various times, headed software development, sales and customer service.

Fluctuations in an inventory supply chain are inevitable. Randomness, which can be a source of confusion and frustration, guarantees it. A ship carrying goods from China may be delayed by a storm at sea. A sudden upswing in demand one day can wipe out inventory in a single day, leaving you unable to meet the next day’s demand. Randomness creates frictions that make it hard to do your job.

At first blush, it sometimes seems best to respond to randomness with the ostrich approach: head buried in the sand. You can settle on a prediction and proceed on the assumption that the prediction will always be spot on. The flaw in that approach is that it ignores statistical methods that allow us to make use of a wealth of knowledge about our knowledge itself—how confident we can be in our predictions, and what breadth of possibilities confront us. The efficient approach to tackling the problems that stem from randomness is not to ignore uncertainty, but to embrace it with eyes open.

As a fundamental tenet of Smart Software’s approach to forecasting, we will always provide you with an assessment of the level of uncertainty in forecasts. If you are expecting nothing more than an absolute figure—the demand for widgets in February will be 120 units—you may dismiss the added element of uncertainty as a negative, or lose faith in a forecast you had hoped would be definite. But we argue for what we consider the adult approach; you need to know what you are risking when you commit to a forecast and premise your decision-making upon it.

Your forecasts can have big consequences that go beyond inventory stocking levels. They can determine your raw materials needs or staffing levels—forecasts drive many important resource allocation decisions. If you have too much faith in the most likely outcome, without also specifically considering just how likely it is, you aren’t really understanding the risks you face, and you may put yourself in a precarious position.

The need to make fully informed decisions forces us to see, in a forecast, the plus/minus range of results with a certain likelihood of occurring. In the specific case of forecasts that are going into inventory systems, this is an important part of deliberately planning for contingencies. This is how you determine not only the inventory you need to maintain in order to satisfy typical demand, but also the additional inventory you need on hand to deal with most unexpected outcomes.

This importance only increases when you are trying to maintain a reliable store of critical spare parts. Between the cost of stocking additional inventory, and accounting for the degree of reliability in your forecasts, there is a balance that crystallizes when an airplane that you need in the air is grounded—because you don’t have the replacement for a damaged part.

(While stocking extra inventory relies on the high end of the uncertainty range, if cash flow is tight, it’s the low end of the range that becomes important. Treasury-minded users find value in this other side of uncertainty in scenarios where even minimal overstocking can be more of a problem than a missed sales opportunity, for example. Reliable information about the lowest likely outcomes pays off at this time.)

Inventory theory says that you need to think about the outer ends of likely possibilities and prepare to cope with more scenarios than just what is most likely. Randomness is a reality that can’t be ignored. The average is not the answer.

Thomas Willemain, PhD, co-founded Smart Software and currently serves as Senior Vice President for Research. Dr. Willemain also serves as Professor Emeritus of Industrial and Systems Engineering at Rensselaer Polytechnic Institute and as a member of the research staff at the Center for Computing Sciences, Institute for Defense Analyses.