A Beginner's Guide to Demand Forecasting

Demand forecasting is a complex but essential business process for your company’s future. This guide breaks down what demand forecasting is and how to do it correctly in your business.

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Updated September 24, 2020

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Every business owner wishes they could look into a crystal ball and see their future. Will that new product under development be a roaring success? Is an industry about to have an explosion of growth, taking your sales into the stratosphere with it? Is a major economic shock coming that will have ripple effects on your business?

Alas, such a crystal ball doesn't exist, but you've still got to plan for the future. That's where demand forecasting comes in — it's a collection of techniques that allows you to make educated guesses on future sales based on historical trends, market movements, and other external and internal factors.

Effective inventory management isn't possible without good inventory control, and you won't have that if your demand forecasting process isn't up to snuff. Here's what you must understand about demand forecasting and how to do it right in your business.


Overview: What is demand forecasting?

Demand forecasting is the business process of using historical sales data to make an estimate of what future customer demand will look like, and therefore what future sales figures are likely to be. Demand forecasting allows companies to come up with an accurate estimate of the goods and services customers will purchase in the foreseeable future, making it a vital part of inventory accounting.

This process is essential for businesses seeking to make accurate assumptions about future turnover, profit margins, cash flow, capital expenditures, risk assessments and mitigation plans, capacity planning, and more.


The 4 types of demand forecasting

Demand forecasting methods come in many varieties, but they generally come in four categories.

1. Active and passive forecasting

Businesses choose between active and passive forecasting depending on their plans. In active forecasting, a growing business conducts aggressive forecasting so the business can scale. The business will project significant growth in marketing activities and sales volume, for example. A well-funded startup is an example of a company that would use active forecasting to prepare for major growth.

Passive forecasting is better for businesses that are stable and don’t project extreme growth. The business makes minimal assumptions about demand and goes basically off historical trends. Businesses that can’t easily be scaled, like a mom-and-pop convenience store, are more likely to use this forecasting because aggressive growth is not likely.

2. Short-, medium-, and long-term forecasting

Another method of forecasting involves the timespan the company is examining. The corporation may expect different demand in the short term compared to the long term, so the business may plot out different projections.

Shorter-term projections are based on the data while longer-term projections are more aspirational. Short-term sales forecasting would deal with the next quarter or maybe the next 12 months, considering seasonal demand patterns and historical sales data.

But when a business forecasts for the medium and long term, they look at other aspects of the business, like future product development, overall business strategy, capital expenditures, and other factors to make an educated guess about how demand patterns could change in a few years.

3. Macro and micro forecasting

Sometimes a business wants to look at the market overall to come up with an accurate forecast. In macro demand forecasting, the company looks at external factors from the wider market that will impact company production and sales. For example, a rapidly growing economy might give a company confidence to increase its sales figures in future quarters just based on growing consumer wages.

Micro demand forecasting gets more granular, looking at external impacts within a specific industry. For example, restaurants during COVID-19 would examine how decreased demand because of the pandemic would affect future sales.

4. Internal forecasting

With internal forecasting, a company is trying to understand how future internal operations are likely to impact things like sales figures, overall finances, and production. For example, in human resources, demand forecasting could help HR determine how many people they should hire and the roles that must be filled. This helps the company's operations run smoothly, and therefore, they’re better able to fill future customer demand.


Example of demand forecasting

Let’s look at a hypothetical widget manufacturer trying to predict sales for the next 12 months. The business owner would consider the past 12 months’ sales, noting seasonal impacts on sales and identifying the reasons for any dips or increases in sales or production in individual months.

The business owner would then take a look at market research for the economy, and then dial down into that industry to make educated guesses about how that will impact future sales. For example, 5% growth in that company’s industry might justify a similar 5% projected growth in sales for the company, all things being equal.

Finally the business owner would look at what changes to internal operations are expected over those 12 months that could impact growth, such as adding salespeople or the release of a new product.


3 benefits of using demand forecasting

Demand forecasting is essential for businesses for three main reasons.

1. It’s required to secure business funding

Your business needs a constant stream of funding, and if you’re looking to secure additional seed investment to expand your business, you’ll need accurate demand forecasting to convince investors you’re a good bet. All investors will expect you to provide financial forecasting and an expected return on investment, and a time frame.

2. It prevents business failure

Without proper demand forecasting, you risk inventory shrinkage and inaccurate assumptions with budgets, pricing strategy, and hiring — and that can be fatal, plunging you into the red and leaving you scrambling to get the business back on track. Demand forecasting gives you the confidence to make decisions about the future of your company.

3. It lays the groundwork for expansion

Demand forecasting helps business owners better predict the future and therefore identify opportunities for expansion. You can carefully make hiring decisions or develop new products with expansion in mind, knowing that the sales revenue will be there to support the continued operation of the business in the meantime.


How to use demand forecasting in your business

But how do you incorporate demand forecasting if you’re a small business? Here are a few steps you can take right away.

1. Choose a team

The first step is to create a team of key stakeholders who can provide the insight to create accurate forecasts. This includes key members of your marketing, sales, operations, and HR teams, for example. Set up an initial meeting to talk about what you hope to accomplish and get feedback. Assign roles and establish a process for coming up with forecasts during the meeting.

2. Identify market details and draft models

Stakeholders should get to work identifying market details and drafting forecast models, making assumptions on the number of customers in the target market, purchasing timing, buying patterns, and historical data. Each person with an assigned role should draft a forecasting model they can justify with data.

3. Consider a range of forecasts

Instruct your team to generate a range of forecasts. This will show you what a worst case scenario looks like and a best case scenario. You can examine each of these scenarios to determine which is most likely based on the data.

4. Do reality checks

Forecasts are overly optimistic, so be aggressive in factoring in possible delays and cost increases. Give yourself plenty of wiggle room to avoid the risk of being drastically off with your forecast.

5. Use multiple forecasting methods

Forecasting should be comprehensive to increase its accuracy. Use multiple demand forecasting methods together, which will create a complete, 360-degree picture of likely future demand.


Software will help with demand forecasting

Inventory management software is one of the most powerful tools in any business owner’s arsenal with demand forecasting. This software has powerful tools to help you use forecasting techniques to gather data on how much product you're moving in a month, which will assist you in making educated guesses on future demand.

The software will track vital data on carrying cost, back order rates, and inventory turnover ratio. Try out a few options to see which works best for your company before settling on one.

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