S&OP/SUPPLY CHAIN: HOW TO INTEGRATE WITH FINANCE
A vision for the next generation Sales and Operations Planning process needs to be developed, but given the wide disparity of understanding, it would be best to start at a more tactical level. Therefore, I’ve set forth a set of basic principles that companies, consultants, and analysts can use to develop their vision for evolving S&OP to the next level:
Financials are both an input and output of the process – The easiest way to include financials as part of S&OP involves translating the constrained supply plan into financials using standard costs. While an advancement over simple demand and supply matching, this approach is only a first step and in most cases can be easily skipped over. The end objective is for financials to be included as an input just as the Demand Plan and the Constrained Supply Plan are. This requires firms develop a solid forecast for raw material, labor (straight/overtime), transportation, fixed/variable processing, and other costs that affect performance. Using financials as inputs allows true understanding of costs and profitability, and it enables S&OP financial managers to evaluate and manage the impact of cost changes easily.
The S&OP process plan is optimized to financial outcome vs. heuristics whereas most S&OP processes are merely centered on matching demand and supply while taking into account manufacturing and supply chain constraints. More advanced approaches require users to enter unit costs by facility as an input into supply chain planning, which then seeks a solution that minimizes overall cost based on these inputs. The problem with this approach is unit costs will vary depending on examples such as:
- raw material input costs
- volume manufactured in each facility
- transportation costs
- use of overtime
Asking users to enter unit cost as an input – typically standard costs which are updated yearly or quarterly at best – makes it impossible to truly optimize the plan to maximum profit or minimum cost. A more aspirational objective would be for the S&OP process to take full ownership of calculating financials every week or month and then use these in the creation of the optimal plan.
Unit cost and profitability are generated as part of each plan – This goes in line with the ability to optimize to financial outcome. Unit costs and unit profitability are impacted each time the plan is updated. Therefore, these need to be derived from operational plans and at the same level of detail. It’s a similar approach to Activity Based Costing/Modeling (ABC/ABM), with the primary difference that these costs and profits are forward-looking and a direct output of a supply plan optimized to financials. In contrast, ABC numbers are typically historical, and forward-looking scenarios do not consider constraints and are not optimized. Having unit costs and profitability generated simultaneously with the Supply Plan enables S&OP practitioners to quickly understand the impact of their plans on product/customer profitability and the performance of their key assets. In addition, it eliminates the tedious work of having to export the plan into spreadsheets or other tools to calculate the financial impact.
S&OP supports advanced scenario analyses – Now that the base plan is built using detailed financial inputs, it should be possible to run a much wider range of financially-oriented scenarios. For example, S&OP managers can evaluate the impact of a commodity price increase and instead of estimating the impact on unit cost, they directly re-optimize the plan to take advantage of regional cost differentials. Additionally, they can evaluate changes in product mix, trade promotion strategies, or even using alternative product recipes. Other scenarios include demand shaping, profitable to promise, procurement strategies, fuel cost changes, use of outsourcers, and evaluation of working capital policy.
Marginal profitability analyses that consider system-wide impact – One of the great misunderstandings in the industry is that the unit costs for a given time period are constant. This might sometimes be the case, but there are some situations where the next unit of output can easily swing from profit to loss or vice-versa. The reasons for this are found when evaluating the system-wide impact of these volume changes. A few examples include:
- use of over-time labor
- moving production to a higher cost facility (or outsourcer) that is also farther away due to constraints in the lower cost facilities
- incurring higher input costs
When evaluating demand shaping or product mix scenarios, it is critical that S&OP managers be able to consider marginal profitability analyses to understand the likely impact of their scenarios. (At River Logic, we call these opportunity values.)
These principles have the potential to elevate the impact of the S&OP process significantly, and to position it as a true driver of business strategy and decision making. Achieving them requires specialized tools and commitment, as well as process and cultural changes. Fortunately, some brave souls have already made significant progress, generating rewards for themselves and their companies and in the process, they’ve laid out a path of best practices (and pitfalls to avoid).
In the future, I plan to talk more of these and also dive into scenario analyses, another exciting component of the S&OP process which has great potential for delivering new value.