Evaluating an S&OP Process
May 5, 2016
What drives an effective Sales and Operations Planning (S&OP) process? The answer is quite simple: alignment. However, alignment is more difficult to achieve than initially perceived. When alignment is achieved, how can the S&OP process evolve to be a driver of competitive advantage? How are supply and demand optimally balanced? Before answering this, it is important to evaluate key operational and financial symptoms of an ailing S&OP process.
Three key metrics transcend operations and result in a financial impact: 1) excess inventory (raw materials, work-in-process, and finished goods); 2) expiry or obsolescence of products; and 3) lost or deferred sales due to back orders.
1. Excess Inventory (interest expense): this prolapses all areas of inventory (raw materials, work-in-process, and finished goods), as each operates in tandem. The root cause of excess inventory is uncertainty; an organization will carry more inventory than required to protect fluctuations in sales. If there is uncertainty within the demand planning function or the supply chain, the entire supply chain will bloat. This causes safety stock levels to build within each inventory category and combines to from an inventory glut.
2. Scrap (COGS): Almost all inventory has a corresponding shelf life, or a ‘salable shelf life’. There is a linear relationship between inventory volumes and scrap, modelled below using a multi-variable linear regression to achieve a 0.73 adjusted R squared.
3. Lost or deferred sales due to back orders (revenue or interest expense): Demand uncertainty causes an organization to carry excess inventory – but is it the right type of inventory? Part of the issue with uncertainty is that an organization may, on an aggregate basis, stock the correct volume of stock but get the SKU mix incorrect. Imagine an organization that labels products in two languages: English and French. If they stocked too much English product and not enough French product, the end result is a loss or deferred sales volume in the French product market.
The purpose of any organic S&OP process is to establish an equilibrium between supply and demand. Therefore, any imbalance between supply and demand occurs due to an ineffective S&OP process. There are key organizational considerations that may disrupt this equilibrium:
1. Forecast Accuracy Method and Accountability: how an organization derives a forecasting method has a profound effect on demand plan as well as accountability placed on the forecast. Forecasting ownership needs to be determined to leverage accountability. Additionally, accuracy should be tracked on both an aggregate and per SKU basis to ensure greater precision in future forecasts. Forecast considerations may be as simple as ensuring that every region submits a forecast.
2. Supply Chain and Inventory Visibility: the amount of visibility that an organization has on its inventory levels impacts the S&OP process. The less visibility and inventory control that an organization has, the greater the amount of inventory is carried due to an inability to readily identify and ship salable product. Organizations need to gain insight through visibility into global inventory levels, and consider how to manage short-dated products.
3. Safety Stock Subjectivity: inventory safety stocks are often misunderstood because most organizations assume that this is the amount of inventory that they should
hold; but that’s not the case and often results in higher inventory levels. The basic safety stock formula is as follows:
= [Z Fill Rate X Square Root (Average Demand) X Standard Dev. Demand] + [Avg. Demand X Lead Time Days]
Despite the above formulaic capability of determining safety stock volumes, most organizations justify safety stocks subjectively. To introduce flexibility for speculative externalities while maintaining objective accuracy, it is recommended to complement the formula with subjective projections.
4. Organizational Culture: S&OP is a culture. It’s a culture of regional cooperation and harmonious policies that benefit the global organization. Organizations often
have regional leaders that operate for the benefit of their own region, which may be contradictory to the benefit of the overall organization.
It is not easy to address and eliminate the issues stated above. However, their profound nature can lead to millions in lost free-cash-flow each year. This has a direct impact on market valuations. If you are interested in us assessing your S&OP opportunities, please contact us today.
This blog was written by Peter Hryniak, Associate Principal. He leads client assessments and engagements. Peter has proven his ability to build lasting client relationships and implement sustainable improvements in the energy and healthcare industries.