Three Keys to Financial Optimization for S&OP

If you google financial optimization, you'll see a list of mostly academic papers on portfolio analysis or asset allocation for financial investing.  But what about corporate finance?  What about the objective of maximizing shareholder value?  Could the lack of results be because performing financial optimization for any business can be a daunting task?

Think of all the expenses that a company incurs, both variable and fixed, across their value chain and the demand and income from all of the products and services.  Now imagine trying to accurately model the complex operational activities and how they impact financial statements.  No doubt this would be challenging for a company of any size.

However, financial optimization would certainly be well worth the effort if there were a clear path to get there. With this in mind, how could we leverage sales and operations planning (S&OP) as the jumping off point to financially optimize a business?

Three Simple Steps to Get Started

Understand Your Demand Optionality

Forecasting demand for your products and/or services is a key part of any S&OP process for a business, making S&OP a great place to start when trying to maximize shareholder return.  But key to optimizing financials is understanding what actions you can take to impact demand and what the implications for taking those actions will be.

For example, many companies have the ability to impact volume through advertising, promotions or discounts. We see this frequently in consumer goods with offers like "buy one get one free".  Other companies have the ability to impact demand through other incentives like sales spiffs, something I see all the time in software.  And other companies understand that their product or service is more commoditized and has a measurable demand elasticity that dictates the price they can expect given specific volumes they make available (oil, steel, etc.).

Each of these actions to influence demand come at a cost, and that tradeoff must be understood to drive financial optimization.  Furthermore, many of these tradeoffs can only be taken with respect to various constraints that may prevent a company from impacting demand (customer service level agreements (SLAs), contractual obligations, sustainability measures, market share targets, etc.).  

Some constraints can be broken at a cost or penalty which, if explicitly understood, multiplies number of decision possibilities.  But more complexity can also mean more potential for optimization and, ultimately, value capture.

Treat Costs Appropriately

Costs in a business can be dynamic.  Costs that are variable can become fixed and vice versa, depending on your decision time horizon.

For example, for many companies the S&OP process looks out across a 12- or 18-month time horizon, often focusing first on ensuring that next month's plan hits the revenue and profit targets that will help them achieve their quarterly or annual targets.  In that next month, production capacity of a plant will probably be a fixed cost. There's nothing this company can do to decrease or increase capacity between now and next month, it's fixed.

But looking at the same plant a year out is different.  The company has options to invest capital and increase capacity, or shut down lines and decrease capacity.  These options are variables for financial optimization and would now be represented as variable costs.

Applying the correct view of a cost helps a company avoid standard costing, or spreading cost uniformly across units.  Profit is made on the margin, and unit costs are not constants.  Unit revenue for many companies is not constant either.  In order to achieve financial optimization, a company must be aware of the point at which their marginal unit profitability runs out.  Without an accurate view of costs, financial optimization is impossible.

Calculate the Marginal Profitability of Constrained Resources

Now we understand how we can impact demand, and the costs of the business operation relative to the time horizon (both essential to financial optimization).   But in order to maximize shareholder value, we need to ensure that we are allocating resources and capital effectively, optimizing the balance sheet along with the P&L. 

To optimize capital allocation, we need to understand the marginal profitability of our resources, specifically the constrained resources.  Again, S&OP provides a great launchpad — the supply planning function of most companies has already identified the constrained resources in their operation.

By next understanding what additional products could be sold with an extra hour of each constrained resource (or with an extra day, if that's you level of granualrity), and netting the additional revenue against the additional cost of supplying the product, we can understand the value of releasing that constraint.  If we can also understand a) the tradeoffs of the products that can be produced and b) which combination will generate the highest marginal profit, then we can truly optimize for profit and capital allocation.

Closing Remarks

Of course, every company has tradeoffs with capital as well.  These typically take the form of balance sheet ratios like liquidity, leverage and working capital.  In order to financially optimize a business, those tradeoffs must be explicitly known and taken into consideration.  

These three measures, while not a guarantee of success, can help you on your way to mastering financial optimization building upon sales and operations planning.  The next step would be to change your objective from profit to something more aligned with shareholder value like Economic Value Added (EVA).

Case Study: River Logic Cox Wood


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