I lifted the following story from Grant Williams’s article from (John Mauldin’s “Outside the Box”) newsletter:
During World War II, [Nobel laureate, Ken] Arrow was assigned to a team of statisticians to produce long-range weather forecasts. After a time, Arrow and his team determined that their forecasts were not much better than pulling predictions out of a hat. They wrote their superiors, asking to be relieved of the duty. They received the following reply, and I quote “The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes.”
In my white paper on Forecasting under Uncertainty, I made the point that there are no accurate forecasts about the future, whether made by banks, governments, businesses or other entities. Arrow’s quote would seem to apply to many business forecasts today.
How Should You Forecast When Facing Uncertainty?
If you need forecasts for planning purposes, it is more useful to consider a range of values around each factor that make up the projection. For instance, when projecting the revenue to be generated from a new product, there will be uncertainties around price, market share, market size, competitors, margins and other factors. The range may be considerable, particularly if you are entering a new market and less so where you have deep experience. Even in the latter case, one can never be 100% sure.
- Market Size: How large is the total addressable market?
- Market Share: What percentage of that market will you capture?
- Price: What price will the market bear for your product?
- Operating Costs: What will your variable and fixed costs be?
Since there is no such thing as an accurate forecast, the best you can do — and should do — is to provide a forecast that reflects the impact of uncertainty, indicating that your project NPV “could be as low as ….” or “could be as high as …,” clearly indicating that you have addressed unknowns and, if prudent, have developed contingency plans.
How Can a Tornado Chart Help with Forecasting?
A “tornado chart” is a powerful tool for dealing with this challenge. It’s a type of sensitivity analysis that visually ranks the impact of different uncertainties on your projected outcome (like profit or revenue).
Ultimately, you can’t forecast a single, accurate future. But you can use forecasting to understand the range of possibilities and build a strategy that is robust enough to succeed within them.
As addressed in the blog “Resolving Conflict and Confusion with Objectivity and Evidence” by Somik Raha, the “tornado chart” is a most useful tool in dealing with uncertainty.
Key Takeaways
- Single-point forecasts are often inaccurate because they fail to account for inherent business uncertainty.
- Instead of seeking an impossible “correct” number, the goal of forecasting should be to support strategic planning by understanding a range of potential outcomes.
- Tools like a “tornado chart” help identify which uncertain variables have the most significant impact on results, allowing for more robust and informed decision-making.
