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To cite this document:
John G. Wacker Rhonda R. Lummus, (2002),"Sales forecasting for strategic resource planning",
International Journal of Operations & Production Management, Vol. 22 Iss 9 pp. 1014 - 1031
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Rhonda R. Lummus
Introduction
This article focuses on the link between forecasts and specific resource
allocation decisions. The importance of the tie between forecasts and resource
decisions cannot be overstated for manufacturing organizations. Without the
link between forecasts and resource allocation, it would be impossible to
acquire resources to make on-time deliveries to customers. Also, without a sales
forecast there could be no long-term production planning of future sales to
allow for sufficient capacity and labor needs. In short, having product available
to meet sales would not be possible without a sales forecast. Strategically, the
success of manufacturing organizations is tied to the effectiveness of the link
between the forecast and the resource allocation plan.
The purpose of this article is to give strategic managers practical
suggestions for better understanding the limitations of forecast methodology.
Once managers understand the limitations of the forecast methods, they can
then identify those strategic resource allocation procedures that are most
helpful to reduce the impact of forecast error. By understanding these methods,
both managers and forecast experts can reduce the impact of forecast errors on
resource allocation decisions.
A secondary purpose of the paper is to identify needed research on the
strategic impacts of forecasting on managerial decision making. Little research
in forecasting has been done to aid in understanding the managerial side of
forecasting. Much of the focus has been on forecast methods, sources of
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forecast error, and reducing forecast error. There is much potential for the Sales forecasting
improved use of forecasting, but little evidence of where to begin to better align
forecasters and strategic managers. This paper will begin by examining
previous forecasting research. A brief review of basic forecast theory is
included along with literature on the impact of forecast error on strategic
decisions. A discussion of the sources of forecast error and the costs associated
1015
with forecast error follows. Forecasts alone have little or no value, but what is
important is how they are used in making managerial decisions. This study
describes three basic forecast paradoxes that impact strategic resource decision
making. Suggestions are made for reducing the impact of forecast error on
strategic decisions. The paper concludes with suggestions for future research
to aid in understanding the managerial side of forecasting.
Forecast literature
Understanding forecast theory
A prerequisite for the effective use of forecasting is an understanding of
forecast theory. The foundation of forecast theory is based on whether or not a
forecast is reliable to managers. This point is put succinctly by Fischhoff
(1994), who states that there are different levels of ``pedigree'' or reliability of
numerical forecasts. The four levels of pedigree for numerical forecasts are:
(1) the highest level established theory that offers theoretical explanation
from causal analyses;
(2) the second level theoretical modeling that has causal relationships
hypothesized;
(3) the third level the computational model that approximates causality;
and
(4) the lowest level the statistical processing model that has no causality
offered to definitions/assertions (pure guesses).
The believability of the forecast is related to the strength of the theory
underlying the forecast. The forecast must include an explanation of how and
why it was constructed as well as an estimate of the accuracy of its predictions,
if it is expected to be more accurate. As a result, the significance of all business
forecasting depends upon forecast theory. For this research, the definition of
theory is that it answers the traditional questions of inquiry. Theory must
include the following four parts:
(1) definitions (answers ``who'' and ``what'' questions);
(2) domains (answers ``when'' and ``where'' the theory applies);
(3) explanations (answers ``how'' and ``why'' questions); and
(4) predictions (answers what ``should,'' ``could,'' and ``would'' happen)
(Bunge, 1967; Wacker, 1998).
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has cost impacts on organizations (Biggs and Campion, 1982; Ritzman and Sales forecasting
King, 1993). The impact is severe because forecasts are a major driver for all
strategic resource allocation plans. When forecasts are inadequate, planning
becomes haphazard, there are frequent costly revisions to the plan and
inventory increases (Vollman et al., 1992). Forecast inaccuracy presents
challenges for resource managers, as they are responsible for alleviating the
1017
adverse affects of forecast error.
However, not all the empirical research supports the conclusion that high
forecast errors cause higher costs and loss of competitiveness. Some empirical
results suggest that forecast error is not a significant factor impacting
manufacturing goals (Wacker and Hanson, 1997). Other studies suggest that
forecast errors do not necessarily increase costs to the organization (Lee and
Adam, 1986; Biggs and Campion, 1982). This suggests that well-run
organizations learn to compete despite rapidly changing forecasts and plans. In
fact, competitive organizations do not depend on accurate forecasts for
competitive advantage, but learn to cope with forecast error and still be
competitive.
Interest in the costs associated with forecast inaccuracy has motivated
research aimed at reducing forecast error. This research has focused in two
basic directions. One direction has been the effect of various quantitative
forecasting methods on numerical forecast error. There is a rich literature on
the effect forecasting methods have on forecast error (see Armstrong, 1984).
The second direction is on how forecasts are used for managerial planning. In
this direction, the literature is much more sparse. The literature does not offer
an in-depth understanding of the role of forecasts in resource allocation
planning or how managers can reduce the impact of forecast errors on resource
plans. The purpose of this study is to fill that void by offering managerial
insights into how the forecast is used in making resource allocations decisions.
These insights can aid managers in reducing the financial impact of forecast
errors on their strategic resource plans. Before beginning a discussion of
forecast use in resource planning decisions, it is first necessary to describe the
traditional limitations of forecasting.
Traditional forecasting shortcomings include:
.
ambiguity not being able to clearly state the events and their
likelihood of occurrence;
.
irrelevance not offering forecasts that address the clients' needs;
.
immodesty not recognizing the limits of the forecast; and
.
impoverishment not placing the forecast in broader decision-making
context (Fischhoff, 1994).
In other words, the forecast must be explicit, have a stated purpose, include the
forecast assumptions, and state its planned use for decision making. These
shortcomings highlight some of the practical managerial concerns about
forecasting. This study addresses the irrelevance and impoverishment
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net gross profit is lost because forecast inaccuracy causes overages and Sales forecasting
shortages in inventory (see for example Ritzman and King, 1993). Additionally,
the inaccurate forecast causes production replanning that creates purchasing,
financing, and scheduling difficulties. Managers make resource decisions
based on the forecast, only to find that in the increasingly competitive world,
product configurations change rapidly. These changes cause the product
1019
specific forecast to be inaccurate and require changing resource allocations
between products. Specific time horizons exist for resource commitments and
when changes are made within those horizons, costly misallocation of
resources can result. This misallocation occurs when the ``drop dead'' date for a
specific resource decision passes without a change in the resource allocation. A
change after the date increases costs, results in missed sales opportunities, and
decreases managerial performance. Managers tend to believe the resource
reallocation decision was missed due to forecast inaccuracy. Consequently,
they believe their lost opportunities are the result of ``poor'' forecasting. These
experiences may explain why less than 50 percent of managers are satisfied
with quantitative forecasting methods (Sanders and Mancroft, 1994).
These experiences lead managers to insist on more accurate forecasting
because they recognize the cost implications of changing forecasts. This
insistence provides interesting insights into strategic decision making. Managers
insist on more accurate forecasts because they use them to make strategic
resource plans for labor, materials and equipment. Forecast errors force the
organization to replan all the resources. The more difficult it is to replan, the
more important an accurate forecast is. In other words, the more inflexible the
resource plan, the more important forecast accuracy is. Many times managers
rely on forecast accuracy to overcome the managerial inflexibility of their
planning procedures. An accurate forecast is important, but if managers
understand the limitations of forecast accuracy they can plan their resources
effectively through tying resource decisions to specific forecasts.
Relating forecasts to managerial decisions
Time frames and resource decisions
Planning and forecasting are closely inter-related and ``Strategic planners
should probably spend more time underselling the importance of forecasting the
future and less time building up false expectations concerning forecasts with
techniques which, at best, have a mixed record'' (Naylor, 1983). The importance
of forecast accuracy for strategic planning is usually oversold since firms often
cannot differentiate between the level of detail needed for different resource
decisions. The level of detail includes determining the length of one forecast
time period (i.e. weeks, months, quarters, etc.). Forecasts are usually broken
down by time periods so they can be used for budgeting purposes or because
sales fluctuate radically between periods (Makridakis, 1996). Budgets are based
on marketing plans that become the basis for specific resource plans. A more
effective approach to strategic resource planning is to examine how resource
needs change if different marketing plans are implemented.
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labor is hired before the schedule is set, and materials are ordered after the Sales forecasting
labor force is in place. In both the fast food outlet and the nuclear power plant,
the medium, short, and immediate time frames are all sequentially shorter time
periods from long to immediate.
In all industries, the forecasting period is set by resource decisions that have
different chronological time periods depending on the organization. Managers
1021
must focus on the resource allocation decision that dictates the chronological
time period that must be forecast. All forecasts should be tied to the decisions for
which they provide information. As a general rule, forecasting beyond the longterm time frame is usually not worthwhile. Whatever the length of the forecast
horizon, there are other challenges for firms using forecasts for resource
decisions. One of these challenges is the effect of forecast error on strategic plans.
Forecast paradox
Forecast error and time frames
Table I shows the results of two of the most often cited studies on forecast
accuracy. A product group forecast is a wide grouping across many different
products. A product line forecast is more specific, with products classified
together based on the marketing strategy or production process. The product
forecast is for the individual stock-keeping unit. Reading across the row for
product group, the forecast error increases as the forecast goes farther into
future. The same holds true for product lines and individual products. The least
accurate of all forecasts is the long-term forecast (> two years). This forecast is
used for new facility strategic decisions that have long been considered the
most important financial decisions an organization can make (see for example
Hayes et al., 1984).
The result of long-term forecast error is an inherent paradox for all
organizations:
Paradox 1. The most important strategic decisions a company makes are
based on the least accurate information.
Wide product groups and forecast error
Referring again to Table I and reading down the columns from wide product
groups to individual product forecasts, it becomes apparent that the more
Aggregation level
Product group
Product line
Product
10 (10)
11 (12)
16 (16)
15 (10)
16 (12)
21 (12)
20 (15)
20 (19)
26 (27)
Notes: All numbers are mean absolute percent errors (MAPE). Numbers in parentheses are
for British managers
Sources: Mentzer and Cox (1984); Fildes and Beard (1992)
Table I.
Forecast errors and
levels of aggregation
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narrow the product grouping, the less accurate the forecast. The product
specific forecast is used for planning the specific resources (materials and
labor) required to build a particular product. Organizations make specific
resource decisions based on the product's specifications. However, the more
product-specific the forecast is, the less accurate it is. Consequently, there is a
second inherent paradox:
Paradox 2. Forecast information that is most useful for resource planning is
the least accurate.
Higher cost, longer lead time products and forecast error
Long-term product-specific forecasts are the least accurate, as shown above,
and in addition, forecasts for certain products may be less accurate than those
for others. The differences may relate to the product durability differences
between industries. Table II gives the coefficient of variation of demand of the
Standard Industrial Classifications (SIC) for durable and non-durable goods
for a ten-year period. At one end of the durability spectrum is the housing and
capital equipment markets, at the other end are items such as food and
clothing. Table II illustrates that generally durable products have a larger
coefficient of variation than non-durable products. Assuming that the more
variability there is in demand the more difficult it is to forecast, then durable
SIC Code
Table II.
The coefficient of
variation for various
goods by standard
industrial classification
(SIC) 1988-1997
SIC
SIC
SIC
SIC
SIC
SIC
SIC
SIC
SIC
SIC
SIC
SIC
SIC
SIC
SIC
SIC
SIC
SIC
512
504
506
511
509
516
503
507
519
513
508
505
502
515
518
501
517
514
Coefficient of
variation (%)
32.08
30.79
27.26
21.99
20.04
19.83
19.27
19.27
16.68
16.50
14.94
14.36
14.01
13.65
13.50
11.71
11.49
10.21
18.63
12.42
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goods are more difficult to forecast. An underlying rationale for these Sales forecasting
differences stems from the notion that the more perishable an item is, the
easier it is to forecast.
The forecast variability for durable products has economic justifications.
The more durable a good is (the longer it lasts), the higher the cost of the item.
When a product is durable, customers can postpone their purchasing decision
1023
to a time that is more advantageous. This postponement is usually to a time
when the customer has more disposable income (usually during upswings in
the economy). Consequently, forecasting highly durable goods is more difficult
since these goods are susceptible to external sources of error such as economic
changes. Durable goods also often have durable components and durable
components may have long lead times. Organizations that produce durable
goods that have higher costs and longer lead times need to use the most
accurate forecast. This difference between products leads to paradox 3:
Paradox 3. The organizations that need the most accurate forecast have the
largest forecast error.
Reducing the adverse effect of forecast error on decisions
Forecasts at all levels of aggregation have been shown to have significant
errors (see Table I). This table also illustrates that the forecast error is usually
between 10-25 percent, as measured by mean absolute percent error. A logical
conclusion is that forecast error is inevitable and managers are left to contend
with the impact of the errors. Although forecast error increases for longer-term
forecasts and more specific products, there are ways organizations can reduce
the adverse effects of forecast error. To some degree, organizations cause
themselves unnecessary difficulties from the inevitable, less than perfect
forecasts. The following sections describe three suggestions for reducing the
effect of forecast error on decisions.
Relate specific resource decisions to specific time frames
An earlier discussion describes how specific forecasts for specific periods of
time impact resource decisions. These decisions are also affected by the three
paradoxes described above. The adverse effects of forecast error are most
severe for the most important decisions, for the most specific information, and
for certain types of costly goods. Managers try to minimize the impact of
forecast errors on resource decisions by following this general rule, ``Postpone
resource decisions as long as possible.'' This rule affects both the forecast's
time dimension and specifics on product definitions. From a time standpoint,
the rule implies that managers should not forecast farther into the future than
the resource decision requires. For the product definition dimension, managers
should not forecast a more specific product than is necessary to make the
resource decision.
For example, one company contacted by the authors purchased material by
specific item for two years into the future. Their rationale was: ``It is nice to
know what you are going to buy in the future so you can make strategic
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Table III.
Resource allocation
decisions and their
time fences
Planning horizon
Material
Labor
Equipment
Plant
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Generally, the longer the time fence the less specific the forecast should be, as Sales forecasting
resource decisions made based on long-term forecasts are not product-specific.
For example, plant size is more product-flexible than plant equipment; plant
equipment and labor are more flexible than purchased material. Managers can
make the accuracy of the forecast less important by setting time fences and
keeping the forecast (and the resources) as general as possible for as long as
1025
possible. The time fences serve as ``trigger'' mechanisms to ensure that the time
period does not pass before the decision is made.
Managers can reduce the adverse effects of forecast accuracy by
understanding when to make resource decisions. Consequently, because
managers can reduce these adverse effects, empirical evidence suggests that
managers rate forecast flexibility, ease of use, and ease of implementation
almost as important as forecast accuracy in selecting a forecast method
(Yokum and Armstrong, 1995). Managers that understand the tie between the
resource decision and the forecast horizon can be more flexible in their resource
plans on long-term decisions. This flexibility facilitates better implementation
of forecasts and better strategic planning.
Agree on one forecast
A number of years ago, one of the authors was called on to improve the forecast
at a company. During the visit, the author asked the top-level managers for the
following year's forecast. The president stated there would be a 15 percent
increase in sales for the next year. The vice-president of marketing stated his
staff rolled-up the sales quotas and determined the forecast. The vice-president
of manufacturing operations stated his managers used an exponential
smoothing method using last year's production data to create a forecast, and
the controller stated that the operations research group (under his leadership)
had determined the sales using a statistical model. As might be expected, all
the forecasts were significantly different from each other. The president was
expecting a certain increase in sales, marketing was planning on another level
of sales, production was producing something other than what marketing
needed, and the pro forma statements for the next year were budgeting
resources based on another forecast.
It immediately became apparent that the forecasting method was not the
problem at all. The organization was producing one thing, it was selling
something else (resulting in stockouts for some items and excess inventory in
other items), and the firm was budgeting for other production levels. The
forecast model was not the problem, but the problem was the lack of a basic
agreement on which was the correct forecast, resulting in excess inventories in
some products and shortages in others. A simplistic interpretation of this
situation is that they had too many forecasts; however, each functional area
used the forecast for their own purposes. To some degree, each function felt
they were justified in developing their ``own'' forecast. When each separate
functional area generates a forecast for a different purpose, the result is
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sales forecasts indicate that forecast users are generally more dissatisfied with Sales forecasting
complex forecast methods compared to simple forecasting techniques (Mentzer
and Kahn, 1995). The complex forecast models, therefore, have two major
disadvantages: they do not greatly increase forecast accuracy, and their high
cost leaves managers viewing these forecasts as a waste of money and leaving
them with ``disconfirmed expectations''.
1027
A second conclusion from empirical studies is that combining several simple
techniques improves forecast accuracy, but little theoretical work has focused
on why this is true (Makridakis et al., 1982). Makridakis (1989) suggested
several hypotheses on why combining forecasts improves forecast accuracy.
These reasons include:
.
.
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its related forecast resource decision evaluated to determine the impact Sales forecasting
of the forecast error on the decision's effectiveness?
.
This study was designed to give strategic managers practical suggestions for
better understanding the limitations of the forecast. Through understanding
these limitations, managers can plan their reactions to forecast errors to enable
better performance. These suggestions are based on the recognition that
forecasts are derived to serve specific resource decisions, and that these
decisions must be congruent with the company strategy. Future forecasting
research should focus on broadening the understanding of the role of forecasts
in strategic decision making.
Through a review of the forecasting literature and an understanding of the
implications of the forecasting paradoxes, a need for future forecasting
research has been identified. Research is required that further analyzes the
impact of forecast error on managerial decision making. Decision makers are
not interested in the accuracy of the forecast method, but rather the success of
the forecast in decision making. Organizations should focus on alternatives to
reduce the adverse effects of forecast errors. Future forecasting research must
focus on broadening the understanding of the role of forecasts in strategic
decision making.
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1029
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Makridakis, S., Anderson, N. H., Carbone, R., Fildes, M., Hibon, R., Lewdowski, J., Newton, E.,
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Forecasting, Vol. 4, pp. 515-18.
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Dalrymple, D.J (1987), ``Sales forecasting practices: results from a United States survey'',
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Thompson, R.A. (1990), ``An MSE statistic for comparing forecast accuracy across series'',
International Journal of Forecasting, Vol. 6, pp. 219-27.
Sales forecasting
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Downloaded by Faculty of Economics and Business University of Lampung, Faculty of Economics and Business University of Lampung At 19:10 04 October 2016 (PT)
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National Technical University of Athens, Athens, Greece E. TavanidouNational Technical University of
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