Inventory management isn’t just about knowing how much stock you have on hand and how long it might sit in a warehouse. Truly effective inventory management will allow you to understand how much stock you’ll need to carry in the coming quarter or year and how much you want to invest in inventory moving toward the future.
We call this practice demand forecasting, and it’s a valuable tool for businesses looking to ensure they always have the right amount of inventory on hand.
So, what is demand forecasting exactly? It’s a methodology where you take your previous sales data and use it to predict what customer demand will be in the future.
Like all forecasting, it’s not an exact science, but the more data you have at your disposal, the better chance you have of coming up with a prediction that’s relatively accurate.
There are a number of different ways to predict future sales and inventory needs, but first, let’s talk about why demand forecasting is so important for your business’s continued success.
Why is Demand Forecasting Important?
Before we break down all the different ways you can forecast demand for your business, let’s spend a few minutes talking about why it’s important in the first place.
Here are some common reasons for demand forecasting.
Helps Optimize Inventory and Increase Turnover Rates
By being able to predict your future inventory needs, your business is better equipped to make sure it has the right amount of stock on-hand. Carrying too much stock can tie up your capital and increase carrying costs, while having too little inventory can lead to missed sales opportunities and unhappy customers.
Striking the right balance with your inventory will also help improve your inventory turnover rates, which is particularly useful if you sell a product that has to be rotated for freshness or other issues.
The most obvious benefit to demand forecasting is that it allows for better planning overall. When you have a mathematically backed forecast showing what you can expect to happen in the future, it becomes easier to budget, stock, and set goals for your business.
Most forecasts aren’t going to be 100% accurate, but a good inventory demand forecast can help you make informed decisions rather than simply following your gut.
Better Cash Flow Management
When we forecast demand we can use that data to extrapolate other things, including how much money we’ll have on-hand for budgeting purposes. This ensures we’ll always have enough money on hand to cover expenses.
Demand forecasting will also provide insights into how much staff you may or may not need for the coming year or quarter. If demand projections are high, you might need to hire more people at key positions. If they’re below previous levels, this might be the time to reduce your staff and save money.
Better Pipeline Management
The sales pipeline is a lifeline for your business, but many companies don’t realize there are problems or kinks in their pipeline until it’s a problem.
With demand forecasting you can spot potential problems in your pipeline before they become full-blown issues. If your demand forecast predicts lower numbers, investigate why. Doing so may help you spot issues you didn’t even know you had.
There are many benefits to demand forecasting. These are just some of the things you can gain by implementing this type of data analysis into your business.
Key Forecast Metrics
You may be wondering what types of metrics you need to track when you’re creating a demand forecasting program. Here are several that will be highly useful to you.
Product Lead Time
This is simply the amount of time it takes to make or obtain a product. If you’re manufacturing your products, it could be the time from ordering raw materials to the final sale. It could also be from the time you order products until they’re ready for sale. However you define your lead time isn’t the important part here. That you’re tracking that lead time is what matters.
How long is the sales period you’re tracking? Is it months? Is it quarters? Is it a year or beyond? It’s important to define this and track all the sales data so that it can be incorporated into your next forecast.
You’ll need to know your stock levels to contextualize those sales numbers. Maybe you only sold 100 of an item for the sales period. Is that because only 100 people wanted it or were you under stocked and could only fill 100 orders? You’ll need to know these numbers to make informed decisions and accurate calculations.
How much money did you spend on materials and products? Understanding your profit margins is a good thing to know in almost any sales or inventory demand forecast.
Demand Forecasting Models
As mentioned earlier, there are a number of different ways to forecast demand for your business. There’s no one right or wrong method for calculating these numbers, so feel free to try a variety of different options and find the one that works best for you.
Passive Demand Forecasting
If you’re an established business with relatively stable growth over time, then passive demand forecasting could be the right choice for you.
This method (which is sometimes referred to as trend projection) is easily implemented, as it basically just builds off of your historical data (which is why it’s favored by companies with stable growth year over year). Passive demand forecasting operates under the assumption that your business will stay on the same basic trajectory and makes minor tweaks to the data you already have to arrive at new projections.
In many ways, it’s the equivalent of the old “take last year’s numbers and increase them by 3%” methodology a lot of smaller businesses employ.
While this approach isn’t practical for large companies or companies experiencing volatility or explosive growth, a small established business can make this work.
Active Demand Forecasting
Active demand forecasting is essentially the opposite approach of the passive demand method we just discussed.
In this forecasting method, you’ll crunch more data looking for both short and long term trends. Large businesses, or businesses located in industries with a high amount of volatility (or who are just experiencing rapid short term growth) are the most likely to benefit from this way of forecasting.
Here, you’ll not only be looking at your own numbers, but the numbers of your competitors and external economic factors as well.
Short Term Demand Forecasting
If you operate a business where seasonal fluctuations have a major impact on your bottom line, then a short term demand forecast could provide you with valuable insights.
Here, businesses will shorten the term of their forecast (usually dropping it down to 3-12 months) instead of taking a bigger picture view of a year or more.
This can be beneficial to companies who do the bulk of their business in a season. For example, if you sell swimwear, your forecasts are going to look a lot different for June through August than they will January through March.
The benefit here is that you’re able to project for your busiest seasons, making sure you maximize potential profit during the period your products are most in demand.
Medium to Long Term Demand Forecasting
Rather than go three to 12 months, this method takes a longer view of your business. Medium to long terms demand forecasts can consider periods of one to four years (and in some cases, beyond that), giving you a bird’s eye view of the future.
The benefit to making projections this far out is that it provides target goals for your team to hit, but it also allows you to think about big picture strategy. In a four-year forecast, you’re less focused on how any one individual sales cycle will go and are instead examining larger marketing, capital, expansion, and growth initiatives.
It’s always a good idea to run a medium to long term forecast, even when you’re running something like an active demand forecast. Losing sight of the big picture can be disastrous in the long run.
External Macro Level Demand Forecasting
The name of this one might be a mouthful, but don’t let that scare you off.
External macro level demand forecasting can be an extremely valuable tool for companies trying to navigate a crowded and competitive marketplace.
In this approach, you’ll base your forecast on broader economic trends and not just your own internal data. This is a great method for figuring out things like when to expand into new markets, how a potential market disruption would impact your business, and how to minimize risk overall.
While everyone can benefit from this type of demand forecasting, it’s probably most effective for larger companies.
Internal Business Level Demand Forecasting
Where the previous example makes predictions by looking outward, internal business level demand forecasting flips that on its head by focusing on your business exclusively.
This type of forecasting focuses on all the internal factors of your business, from cost of goods sold, to marketing, to manufacturing, and beyond.
This is a great way to get an overall sense of the health of your company, and the data can be really useful for internal benchmarking, quota setting, and budgeting for the future.
Market Research Forecast
Another simple way to gauge future demand is to simply ask your customers what they want.
Market research forecasting essentially involves you reaching out to customers to find out how interested they are in your products, how likely they are to make a purchase in a specific timeframe, what they think of your prices and offers, and so on.
The upside of this approach is you’re getting information straight from the people you’re trying to reach.
The downside is that customers aren’t always reliable when answering surveys. Their answers can be influenced by any number of factors, and there’s also a potential bias in that the people who answer these surveys skew toward “likely to buy” in the first place.
Beyond that, you can’t make the same level of detailed forecasts off of customer feedback.
Despite these challenges, market research can be a valuable tool when used in conjunction with some of the other methods we’ve already highlighted.
Sales Force Composite Forecast
Another interesting way to predict demands is by turning to your own sales team. A sales force composite forecast will allow your sales professionals to offer up insight into what they see looming on the horizon.
The benefit here is that your sales team is both intimately familiar with your internal numbers as far as product demand goes, but they’re also the main conduit between your business and the customer. As such, they can provide some pretty unique insights based on real-world interactions.
The challenges here are that a lot of sales guys will offer up anecdotal data. “this is what one customer thinks” can be valuable, but it’s not always wise to take that one viewpoint and extrapolate it out to the rest of your customers.
That being said, having your sales team involved in the forecasting can provide more insight. Just weigh those observations against your hard data.
Potential Issues with Demand Forecasting
If you’re ready to take the plunge and kick your demand forecasting initiative into overdrive, great! We firmly believe that using these methods can make you a better informed, more agile, and more profitable company.
However, here are a few of the potential issues you may encounter when getting started or in the early stages of setting up your demand forecasting program.
Not Enough Data
To make the most accurate and useful demand forecasts, you’ll need data. Lots of data. Unfortunately, newer companies haven’t yet amassed a mountain of historical analytics to comb through looking for clues.
Even larger companies can face this issue. If you haven’t been diligently tracking all of your sales data through your inventory management or sales enablement software, you may find yourself struggling to compile enough numbers to analyze.
If either scenario describes your company, don’t panic. It’s still possible to forecast demand with smaller data sets; you’ll just wind up with potentially less precise forecasts.
The key here is to move forward by making sure you’re compiling all sales and inventory data in an easy to understand and access way so that future forecasts will have more information to analyze.
Inferior Supply Chain Management
One of the key components to getting an accurate demand forecast is understanding your supply chain. Unfortunately, many companies struggle in this area.
If your supply chain management isn’t up to par, your forecast will be off. To truly take advantage of demand forecasting, you’ll need to have a stable and predictable supply chain set up.
What does that mean, exactly? For starters, it means you need to know all of your lead times on resources, materials, and products. You’ll need to understand how long it takes completed products to get from manufacturing to your fulfillment warehouses. You’ll have to essentially understand every aspect of your supply chain.
The good news is that wrangling control of your supply chain is easier than ever thanks to the multitude of inventory management software apps on the market. Find one that’s right for you and get that supply chain in order.
Lack of Inventory Control
Inventory management is a key component of creating reliable and accurate demand forecasts. If you don’t know what you currently have in your warehouses, there’s no chance you can actually create a forecast that’s going to hit the mark.
Having too much or too little of certain items is all but guaranteed in this scenario, which will throw all of your projections out of whack.
The first step to good demand forecasting is to make sure your inventory management is in top shape. As mentioned earlier, this process becomes a lot simpler thanks to the wealth of inventory management apps currently on the market.
There’s no excuse for bad inventory management. Grab the software that works for you and get to work.
If you’re not doing demand forecasting in your business currently, you’re almost assuredly missing out on opportunities.
Under stock and overstock both costs businesses money, just in different ways. Keeping the right balance of items on hand will allow you to avoid unnecessary carrying costs, while also ensuring your customers are happy and get the products they want.
Beyond that, demand forecasting gives us a great deal of insight into how our business is functioning. We can then take that information and create a roadmap to an even better future.
With a little effort and by making sure your inventory management is dialed in, you can start reaping the benefits of demand forecasting in your business. Don’t be intimidated. Creating accurate forecasts is easier than you think and the rewards will justify the effort.
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