Look closer at out-of-stocks to improve forecast accuracy

Date Posted: April 12, 2021

When out-of-stocks occur, point-of-sale data, which is the basis for a good demand forecast, reflects lower demand than what consumers actually want to purchase. To keep from under-forecasting demand, you need to account for these events somehow in your data. There are three main options to do so, which we covered in a previous post.

Here we’ll describe situations in which you should use each method. Your chosen approach impacts the data you need and forecasting models you can use, which we’ll discuss too.

Getting this data preparation right might seem like a lot of work, but it helps ensure you’re using the best demand signals to build forecasts. Solutions like Alloy can help, and it ultimately gives you a head start on preventing further short or late orders, out-of-stocks and lost sales.

A quick recap

Once you know when out-of-stock events occur, each method for incorporating it has benefits and drawbacks.

  • Exclusion is simple and makes for a clean time series, but leaves gaps that may lead to under-prediction
  • Imputation fills those gaps with an estimate of demand if there had been no out-of-stocks, but requires knowing true demand
  • Flagging acknowledges OOS as a special category, but functions most effectively when there are consistent causes.
What is the cause of the out-of-stock?

One of the first questions you should ask yourself when deciding between methods is causation.  The reasons behind an out-of-stock range widely, from insufficient coordination between manufacturers and retailers, to extraordinary and unexpected demand, to supply issues.

Consider some sample scenarios:

  1. Say you had a one-time service disruption that caused a single late delivery and led to an out-of-stock. In this case, it’s reasonable to use exclusion and omit this event when developing your demand forecast. It doesn’t provide much insight, as long as it doesn’t happen more than once or twice.
  2. On the other hand, maybe the out-of-stock was caused by an event that’s likely to occur again, like a great promo. It’s best to use flagging since it can indicate the root cause. You can then incorporate these exceptional situations into your sales data and simulate how they will affect your demand forecasts.
  3. Now let’s say it wasn’t just a one-time disruption. Maybe shelves were empty due to consistently late delivery or another frequent cause. If demand is regular and predictable, then the best method to choose for forecasting is imputation. You can estimate what demand would have been using historical data from previous, similar situations when out-of-stocks did not occur and avoid gaps in the data.

Of course, a combination of scenarios could have caused your out-of-stocks. Ideally, you review each event separately and select the appropriate method for accounting for each one. Hybrid options combining multiple methods can also help balance out potential biases they each create.

 

What types of products or locations were out-of-stock?

You should also consider the actual products or locations in question because they impact how consumers react to the out-of-stock, and thus how important (and possible) it is to understand.

In general, imputation is ideal for products with regular demand, where it’s easy to track downward or upward sales trends.

Exclusion is the best option for low-volume products, such as new luxury items, and high volatility products, like non-tradable food. Because of the relative infrequency of out-of-stocks, it’s difficult to estimate their likely demand, and out-of-stocks are less valuable to understand more generally.

Flagging is applicable when out-of-stocks happen intermittently. Think of products or stores where demand is impacted by occasional events, like inclement weather or a local sporting event. With clear out-of-stock drivers, flags are useful for simulating future impact on demand when a similar event takes place.

After you’ve determined what method to use — exclusion, imputation, or flagging — you need to ensure you have the right data and forecasting models to support it. Best practice is to not let these factors determine how you account for out-of-stocks, and instead make your choice based on the characteristics of the out-of-stock, as we just described. You have options when it comes to getting the necessary data and building the forecast models, and it helps ensure your forecast reflects as close to true demand as possible.

Imputation: the most flexibility

If you’ve determined imputation is the right approach, your options are pretty open. It only requires aggregate sales data. As long as you have enough history, you can still make a good estimate of what true demand would be at all times. More granular data enables you to use similar locations and events to increase accuracy, but is not mandatory.

In addition, imputation leaves you with a clean, continuous time series. That gives you a lot of flexibility to apply different forecasting methodologies. The three primary classes of modeling methodologies – historical average, time series with added regressors and machine learning – can all work.

Exclusion: the most restrictive

In contrast, because exclusion creates gaps in the data, you need to be very careful when using it. You should pinpoint specific out-of-stock events that are one-time anomalies to exclude, so it requires very granular store/SKU/day data. If the data is at a higher level, you could be inadvertently excluding good data from your input.

Furthermore, some historical average models, like exponential smoothing, don’t behave well with any data gaps and so cannot be used with exclusion. Similarly, time series models typically like repeatability (e.g. seasonality, last week/last year comparisons) to identify patterns. If you’re excluding a lot, it could cause sparsity in places where you are missing the reference data and limit the models you can use. Machine learning methods can still work, but generally the more data you have to feed into them the better, so exclusion is not ideal.

Flagging: somewhere in between

Like exclusion, flagging requires granular sales data so you can add the right categorical indicator variable to each out-of-stock occurrence; otherwise, you have to know what fraction of locations or products were out-of-stock. However, if you only have aggregate sales data, there may be ways to intelligently fill in the gaps and get to more granular data for the purpose of flagging.

 

In terms of forecasting models, flagging works well with both time series with added regressors and machine learning models. For example, seasonal ARIMAX models, which compare different historical time periods and take additional factors into account, can easily make use of the out-of-stock flag. Machine learning systems can easily incorporate flagged data into their models too. Some of the flagged events could cause a downward bias in the overall estimate and in this case, combining flagging with imputation can help correct for it.

There’s a lot to consider with out-of-stocks and how to clean up the data mess it creates. From the cause, product and location to data requirements and forecasting model implications, you’ll need to invest in this first step of a best-in-class forecasting process to improve your forecasts. Then your team will be in a stronger position to focus on managing by exception, catching when actuals deviate significantly from your demand plan and making the right adjustments.

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