What Is the Cost of Your Forecast Error

Executive Summary|Forecast Accuracy, a metric that permeates throughout a company's multi-faceted functions, impacts both the top-line sales revenue and the bottom-line profit margin. Even though managers of organizations are well aware of it, they are reluctant to go through the rigor required to reap its full benefit. This article explores why many organizations and their managers fail to fully capitalize on forecast-accuracy information and what can be done to change it.Over the past several years, the computer hardware industry, especially in the retail channels, has witnessed dramatic changes in the landscape. Customers today not only have a plethora of choices among competing brands and products, but they also expect quality at the most competitive prices. Companies are quickly adapting to these new rules of the game, and fight intensely for their market share and growth. In this highly competitive landscape, accurate demand planning and forecasting are critical.Forecast Accuracy (FCA) is a metric that permeates throughout a company's multi-faceted functions. Ultimately, it impacts both the topline sales revenue and the bottomline profit margin. Managers within an organization are fully aware of the benefits of robust forecasting, but for one reason or the other, don't take advantage of it. Many of them are quick to dismiss FCA as purely an'Operational or supply chain metric without realizing its impact on the financial and business performance. Used correctly, the FCA can be a Sales GM's and/or a Financial Controller's strongest ally in improving business performance. This study explores the forecast metric and shows why organizations and their leaders fail to fully capitalize on it. It also explains how understanding the anatomy of FCA can be used to maximize ROI (Return on Investment) in business.FORECASTING PROGRAMS AND FINANCIAL OBJECTIVESThe FCA can be used as a planning tool to determine what to sell, and then achieve the plan's goals within a reasonable tolerance. Such achievement can result in tangible benefits, as listed in Figure 1 . Improved forecasts increasesales and lowercosts, which ultimately improves efficiency in the supply chain. When put together, they result in improvement in ROI for the entire organization.Both over- and under-forecasting in demand planning are detrimental to the financial health of a company. Under-forecasting results in lost demand (retailers call it shadow demand), which negatively impacts the top line in sales revenue. To recover the lost sales, companies have to make unplanned investments, which costs money. Some obvious costs are procuring components at higher costs and/or using unfavorable logistics options (shipping by air instead of by sea, for example). Shortages also increase lead times and backlogs, delaying customer deliveries, which impacts customer service and customers' perception about the company.Over-forecasting, on the other hand, leads to fire sales that erode the profit margin; in some cases, the result is plain loss because products have to be sold at below cost. Obsolescence is not uncommon in the case of overforecasting. Warehouse cost and holding excess inventory are other costs that the manufacturer has to bear.Figure 2 shows the effect of forecast performance on the balance sheet of a company. It shows how the service level, inventory, and low-cost logistics are related to forecast accuracy at a SKU level. With every improvement in forecast accuracy, the service level gets better. In fact, at 80% forecast accuracy, the customer service hits 100%. This figure also shows that with the improvement in accuracy, the percentage of items shipped via sea (low-cost shipping) also increases. In addition, the figure reveals that when accuracy drops from 100% to 70%, the service level remains pretty much at a high 85% level, which happens partly at the expense of high expediting costs and partly at the expense of holding larger inventory. …