We can improve our predictions in strategic planning by predicting with leading indicators. You may have hear of the Composite Leading Indicators, a statistic used by the Federal Reserve to predict recessions. This tool is a good way to anticipate changes in a dynamic system. Choosing important leading indicators for your business may be simpler than it would appear.
The first step in understanding leading indicators is to recognize the shape of the curves predominant in your system. As mentioned earlier, there are three basic types – stable, oscillating and geometric. Most important assumptions we will have to make will involve stable and oscillating curves, as geometric curves tend to reach some limit fairly quickly.
If you are looking for leading indicators for a stable change, you’ll want to look for any event or change that tends to happen before change in your industry. For example, food consumption in most countries will grow with the population. While babies don’t usually consumer lobster, for example, it’s fairly easy to predict that a part of the population will want to eat lobster some of the time when they are older. This means that an increase in births will be followed by an increase in lobster demand – a few years later.
This approach can be applied to many markets with fairly stable demand. Appliance sales, for example, have two components – appliances bought for new dwellings, and appliances purchased to replace old appliances. Both can be predicted relatively well with information about new housing construction and appliance longevity. This type of correlation can be complicated by the fact that one of the components – new housing construction – may be affected by how easily people can purchase new dwellings. Even so, good predictions can be made about appliance sales based on these two factors.
With oscillating curves, you have a slightly more difficult task predicting with leading indicators. This is because the wavelike form of the oscillating curve can vary a lot in both frequency (the number of waves per time period) and amplitude (the distance between the top and the bottom of the curve). Usually, we can understand both by examining historical data. For example, if you look at the graph here, you see data on car sales in the USA from 1951-2019. You can see that there is clear oscillation, largely driven by purchasing ability. While the frequency varies from decade to decade, there is a clear 3-5 year space between the peaks in the curve and the valleys that follow in most cycles. This would be a decent frequency to assume for future cycles in auto sales.
The amplitude of this curve is a little more difficult to estimate. In this time period, we see swings by as much as 3 million vehicles, but we also see some cycles with swings of only about 1 million vehicles. In addition, some upward swings are small while the downward portion is much larger. Still, it’s reasonable to assume that future swings will be in the 1-3 million vehicle range.
For accurate leading indicators, you would need to examine any data you can find relating to things that would explain the shift from increase to decrease in the curve. For auto sales, it’s practical to assume a large part of this oscillation is driven by the economy. Indeed, the decision making process in purchasing a car usually starts with an assessment of whether a new vehicle is affordable. This means that personal income and interest rate numbers would make good leading indicators. It also means that the things that cause upward and downward shifts in those numbers are likely to set the frequency of the auto sales numbers.
A simple way to help predict such oscillating numbers, then, is to ask what leading indicator shows us the inflection point – where the curve shifts from up to down, or down to up. This will make predicting with leading indicators much more useful with an oscillating curve.
Looking at our predictions for things like sales and costs can be a critical part of strategic planning. If you’d like to improve your own understanding of making assumptions and using them in your strategy, you’ll want to attend our live online seminar on Simplified Strategic Planning.