The Folly of Forecasting: The Effects of a Disaggregated Demand Forecasting System on Forecast Error, Forecast Positive Bias, and Inventory Levels

Abstract

Periodic demand forecasts are the primary planning and coordination mechanism within organizations. Because most demand forecasts incorporate human judgment, they are subject to both unintentional error and intentional opportunistic bias. We examine whether a disaggregation of the forecast into various sources of demand reduces forecast error and bias. Using proprietary data from a manufacturing organization, we find that absolute demand forecast error declines following the implementation of a disaggregated forecast system. We also find a favorable effect of forecast disaggregation on finished goods inventory without a corresponding increase in costly production plan changes. We further document a decline in positive forecast bias, except for products whose production is limited owing to scarce production resources. This implies that disaggregation alone is not sufficient to overcome heightened incentives of self-interested sales managers to positively bias the forecast for the very products that an organization would like to avoid tying up in inventory.

The Relation between Internal Forecasting, Misreporting and the Importance of Meeting Performance Benchmarks

“…Ittner and Michels (2017) find that using forecasting methods that explicitly incorporate uncertainties, the development of more realistic estimates, and the development of contingency plans for meeting goals under different scenarios can improve firms' forecasting accuracy. Brüggen et al (2018) show that explicit labeling of some part of the aggregate sales forecast as dependent on the unfolding of a contingent demand 'event' results in lower sales forecast errors and lower inventory 'buffer' stock.…”

“…For example, Davila and Foster (2007) show that firms in an early stage adopt financial planning systems, comprised of operating budgets and sales and cash flow projections, to facilitate the control of their operations. 5 Brüggen et al (2018) document the role of sales forecasts as a coordination device between sales and production. Some scholars emphasize that organizational learning is embedded in the periodic updating of budgets and forecasts (Campbell et al 2011;Simons 1994).…”

“…Target setting is often informed by strategic objectives, which coincides with intuition that the role of forecasting is to strive for realism whereas the role of target setting is to provide effort-inducing incentives. While accurate numbers are needed for planning and coordination, using this information for performance evaluation and incentive compensation purposes encourages strategic behavior of employees as self-interested managers may have an incentive to increase proceeds from their incentive plans by not truthfully revealing their private information (Brüggen, Grabner, and Sedatole 2018;Cassar and Gibson 2008). In many organizations though, internal forecasting has been largely decoupled from internal target setting because internal forecasting is a more continuous process (e.g., monthly rolling forecasts) relative to the annual target setting and performance evaluation cycle (Henttu-Aho and Järvinen 2013; Libby and Lindsay 2010).…”

“…Most literature in this area focuses on the evaluation and incentive role of budgeting, though several authors find that the planning and coordination role of budgeting is important for firms (Hansen and Van der Stede 2004;Libby and Lindsay 2010). Our paper specifically speaks to the (relatively understudied) planning and coordination role of budgeting (e.g., Becker, Mahlendorf, Schäffer, and Thaten 2016;Brüggen et al 2018;Campbell, Epstein, and Martinez-Jerez 2011). We also show how the role of internal forecasting in relation to meeting performance benchmarks and misreporting only holds when firms emphasize the use of forecasting information for planning and control purposes (as opposed to evaluation and incentive compensation purposes).…”

Does Learning by Disaggregating Accelerate Learning by Doing? The Effect of Forecast Disaggregation on the Rate of Improvement in Demand Forecast Accuracy.

“…In practice, however, demand forecast disaggregation can take many forms (Schunk 2012). In this study, we focus on the disaggregation of forecasts based, not on hierarchical level, but on sources of demand uncertainty, distinguishing between more certain versus less certain events (Brüggen, Grabner, and Sedatole 2021). Our study examines whether forecast disaggregation accelerates the rate of "learning by doing" in demand forecasting.…”