Thursday, November 8, 2012

Simple Modeling

For all you people who thought I was going to talk about supermodels, you can stop reading now.

Today's post is about the kind of model you use to determine your forecasted sales or the effects of a future rebate or the effect of a new product introduction. I have been thinking a lot about this kind of modeling lately because of Nate Silver, the statistics genius who accurately predicted the election results two nights ago. Today, the Guardian had an awesome explanation of the likely content of Nate Silver's model which is worth reading in its entirety.

Although Silver apparently uses an advanced statistical technique called hierarchical modeling to perform his analysis, a manager needn't have a degree in statistics to use something more basic but still useful. I put together a similar but simpler model at Strategic Energy using Crystal Ball, an Excel spreadsheet plug-in now owned by Oracle. The software allowed me to build inputs that had an effect on energy prices and then run a series of simulations describing what would happen to electricity prices if my various inputs fluctuated. I chose how each input would fluctuate (for example, natural gas prices might fluctuate in a normal curve by plus or minus 10%) over a period of time, and the model told me the statistical likelihood that the electricity price would get into the range at which we could compete against the regulated utility price.

It's relatively easy to use this kind of modeling in all sorts of applications. I used it again at PPG to help forecast exterior paint sales, using simple inputs we knew to affect our sales such as temperature, rebates, competitor rebates, advertising, and price competition. This analysis helped to show how unprofitable our existing rebate program was and how dramatically temperature spikes increased our paint sales, both of which led to savings and greater on-shelf inventory at our retail customers.

Amidst all this usefulness, I'm constantly amazed when managers prefer to use experience and judgement rather than data to make decisions. Crystal Ball costs all of $995. Why leave your decisions up to chance when you can get fairly accurate help from a fairly simple model for a fairly cheap price (or free if you're willing to learn the R statistics package)? Alternatively, you could spend hundreds of millions of dollars and just ignore the models like this guy did. Good luck with that.

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