Demand and supply planners are supporting decision-making efforts that have financial ramifications for the company. The company has many stakeholders who have a financial interest in the company with whom the management must communicate and interact. So, finance is an important skill and language for those who are leaders in the demand planning and supply planning efforts.
As demand planners and supply planners, we are committed to supporting the business decisions that are essential to making the company successful, making growth possible, and creating value for all of the company’s stakeholders. Through the demand planning and the Sales & Operations Planning processes, we facilitate the evaluation and selection of business alternatives that advance the company financially. Let’s review some of the financial metrics and issues that are of special interest to demand and supply planners.
The company’s financial statements are used to evaluate its financial condition. The financial statements are comprised of the profit and loss statement, the balance sheet, and the statement of cash flow. These elements make it possible to review sales resulting from sales and marketing efforts. They also contain assets and liabilities information, which reveals the resources used in the business process as well as the financial commitments made to support the business process.
The profit and loss statement often gets the most attention, since it shows the revenue, the cost of goods sold, and the period costs and profit of the company. These results are shown for the current accounting period as well as for the fiscal year to date. The results are often compared to budget and to prior year results, allowing the user to see the financial performance directionally relative to prior performance. Key items for demand and supply planners reflected on these statements are revenue, cost of goods sold, gross profit (product profit margins), and selling and marketing costs. They are all affected by demand planning and supply side actions and reactions.
Revenue corresponds to shipment volumes monetized by the net purchase price charged for the product. (The net purchase price reflects any discounts, promotional pricing, or other price adjustments affecting the stated price that would otherwise be charged for the product.) The cost of goods sold includes all costs required to produce and/or acquire the finished product. This includes both direct and indirect costs of production. Direct costs include all costs directly required to produce a product, such as raw material costs, modules, and direct labor costs of production. Indirect costs, often called manufacturing overhead, include all non-direct costs related to the production of the product. Importantly for the demand and supply planners, the cost of goods sold is also related to valuation of inventory being placed in storage as finished products.
The gross profit, which measures the variable profit made from the sale of products during the period, is a key business metric. It represents the profit realized from the selling efforts, marketing programs, and production and distribution activities of the company. The gross profit is being affected by both the profit margin (%) and the sales volume. It is important that demand planners and supply planners know and understand the profit structure of their products.
A metric followed closely by investors, lenders, and the company’s senior management is a measure of operational cash flow before tax. The measure is earnings before interest, tax, depreciation, and amortization (EBITDA). This is an important building block used by businesses in estimating the value of the business, and the value creation potential of investments and business alternatives for the company.
The balance sheet shows the balances related to assets and liabilities for the company. The balance sheet contains financial values for both financial assets and physical assets. In the physical asset classification, work-in-process (WIP), raw materials, and finished goods inventory are particularly important to supply and demand planners. They represent a use of cash that ensures acceptable customer service and hedges against the uncertainty and volatility of demand with which the planner must deal. Using the cost of goods sold from the income statement, one can calculate the inventory turns being experienced by the company. One can also evaluate the impact of improved accuracy in forecasting, reduced volatility of demand, and other such considerations on the level of inventory required. Inventory is a use of cash, so anything that makes the inventory more efficient (for a given level of customer service) will improve the cash position of the company.
FINANCIAL BENEFITS OF THE PLANNING PROCESSES
Any planning process is an investment by the company, one that reflects the expectation of operating and financial benefits. The company management is charged with re¬ presenting all of the company’s stakeholders, and very significant ones are the company’s shareholders, lenders, and employees. The financial performance of the company and its creation of value for its investor community is an essential element of a successful business. So, the expenditure of funds has to be considered in light of its contribution to the company’s goals and to the impact that it has on value creation. This is a responsibility of the management across the company, and the senior management and executives of the company in particular.
Planning process value can be created and enhanced in two ways. The first is by making the investment in process more efficient by producing more value with less investment. The second is to add incremental financial benefits as a result of the investment. The basic case for the Demand Planning and S&OP processes is that the company has more efficient operations, higher revenue, higher profits, better customer service, and a more efficient inventory as a result of an effective planning process. So, how do we measure the trade-off between the cost of initiating and running the processes vis-à-vis the benefits that are being realized?
We can estimate the cost of the processes on an ongoing basis, monetizing the compensation costs and other costs associated with the planning process. We can also estimate the quantitative and related financial benefits resulting from our planning efforts. Some of the potential benefits would be recurring cash flows and some benefits would be one-time cash benefits. And we can assess the related qualitative benefits that result from the processes. So we are balancing the quantitative and the qualitative results from the process and the company’s investment in it.
Let us consider the recurring benefits that may be resulting from the planning processes first. The possible recurring benefits could in¬clude higher fulfillment rates, higher customer satisfaction, greater revenue growth, lower product costs, lower transportation and storage costs, lower mark-downs and obsolescence, greater cross-functional efficiency, shorter product lead times, and overall higher profitability. And there are many more specific benefits that could be unique to your industry and to your company that would deserve your attention as well. Each of these can be analyzed to determine the cash impact of each, and can be included in a cash flow model to determine their value in comparison to the value of the costs of the process itself.
In addition to the recurring benefits of the process, there can be one-time cash benefits. The one-time benefits may be part of EBITDA, but most often they are cash benefits that are reflected in the values on the balance sheet of the company. In our case, the most probable benefits would be more efficient inventory—raw materials and finished goods—resulting in lower levels of inventory for any given level of customer service and sales volume.
The next step is to compare and evaluate the costs and the financial benefits of the process, along with the qualitative benefits expected. Using this information, we can bring together all of the costs and benefits into a holistic presentation and the desired course of action. It is important to boil this down to the essence of the sources of costs, the sources of benefits, and the net value that is created—both quantitative and qualitative.
Be holistic and creative in con¬sidering the costs and the benefits that can accrue to the demand planning and S&OP processes. Be honest and objective in your evaluation of the decision trade-offs. And be energetic in your recommendations for actions to management.
MONETIZING PROCESS IMPROVEMENT INVESTMENTS
All of the evaluations undertaken for improvements are comparative analyses measuring incremental im¬ pacts on costs and benefits. This can be achieved, for example, by comparing:
- Revenue growth with gross profit growth;
- Profit margins with sales volumes;
- Order fill-rates with inventory levels or inventory turns;
- Inventory levels with customer service levels;
- Cost of markdowns and discounts with revenue and profit margins;
- Cost of sales, marketing, and pricing programs with changes in revenue; and
- Inventory levels and inventory turns with product lead times.
These are just a few examples of how this comparative evaluation can be structured. We are looking for relationships that help us take actions that positively affect company performance and value.
The demand forecast and plan is a reflection of the historical demand patterns of customer behavior as well as the customer and market forces that are shaping future demand. It also reflects the volatility of demand and its effects on inventory and customer service performance. One can begin process improvement, for example, by ensuring that there is an ongoing activity for data cleansing to adjust the actual data for data shifts, structural changes, missing data, and data outliers. This will improve forecast accuracy. One could further enhance process results by ensuring the selection of the best forecasting model. This includes both availability of models appropriate to the demand patterns and selection of the best model. The result is concerned with how much it costs to cleanse data and find the best model in comparison to how much benefit will result from these efforts.
We can also assess how much the plan accuracy can be improved along with the financial effects of doing so. We can then progress from that to looking at the specific means of improving plan accuracy—making the action plans more effective and efficient in their design. The forecast itself may or may not meet the company goals. Most often, it will not. The responsibility of the planners is to build from the most accurate demand forecast available to the best plan that can be programmatically structured to achieve company goals, or get as close to them as possible. When the forecast and the plan are different from each other, which they usually are, the particular business actions and programs undertaken by the company to create the plan must be carefully and objectively evaluated. What are some of these actions and programs?
The business actions and pro¬ grams of which we are speaking relate primarily to actions that can change or shift demand, thereby affecting the revenue and associated profit experienced by the company. These typically encompass product pricing, product promotion, seasonal and other events, and discount programs, to name just a few. Often, these programs are estimated based upon judgment, intuition, and rules of thumb. The demand lift expected on these actions and programs can reflect the biases and the hopes of those who are responsible for them. We really need empirically reliable means of estimating the demand lift if we are to improve the accuracy of our estimates. The use of regression models to more accurately measure the effects of pricing and discounts, as well as the demand lift resulting from the marketing, promotional, and advertising programs can materially improve the estimates incorporated into the plans. This greater accuracy in estimating demand can be evaluated relative to the change in accuracy and the financial and qualitative benefits resulting from it. This allows us to measure the contribution of each to improvement in financial performance, and the related effects on company performance and value through the EBITDA, EBITDA multiple, expected growth, and working capital levels.
So, there is a cost of obtaining the greater accuracy in all of the above considerations. It may be personnel costs, research costs, contract costs, software acquisition and installation costs, and/or other such expenses. These can be compared to the benefits derived from the greater accuracy to determine the net benefit from the undertaking, which can then be translated into the impact on enterprise performance and market value. And it is this market valuation effect that is of greatest concern to shareholders and owners of the company.
DEMAND AND SUPPLY PLANNERS’ FINANCIAL DASHBOARD
Given all of the various uses of financial metrics, what kinds of financial metrics and financial drivers should appear on a dashboard used by demand and supply planners? How should they be tracked? Essentially, any of the metrics are best used when shown as a trend through time, compared to goals, budgeted values, industry performance, and other benchmarks that enhance the usefulness of the tracking information. Some of the particular financial metrics that should be considered for inclusion follow:
- Revenue and revenue growth
- Shipment fulfillment rates and their trend
- Sales discounts—% of revenue and trends
- Product costs—their level, % of revenue, and trend
- Gross profit margin—level, % of revenue, and trend
- Selling Costs—level and % of revenue
- Sales program lift effects
- Marketing Costs—level and % of revenue
- Marketing program lift effects
- Finished goods inventory and inventory turns
- Raw material and work-in-process inventory — level and % of revenue
These metrics would provide a view into the macro financial performance and relationships within the business that are being affected by the efficiency and effectiveness of the forecasting and planning activities. There are many more that can be chosen, depending upon the financial dashboard being used by the company management participating in the processes and the executives who are making higher level business decisions. It is important to integrate the financial metrics being used by the company management into the dashboards being used by demand and supply planners in our companies. We can communicate more effectively the financial ramifications of our recommended actions and better present the financial implications of different scenarios, plans, and forecasts for the company performance. It also aids in our designing the most efficient, effective, and balanced forecasting and planning processes to advance the goals of the company.
So, look at the actions taken in the demand and supply planning activities, and relate these to the financial metrics that you choose to follow on your dashboard. A good indicator of what is important is to listen to the management speak about metrics that they are following in their respective areas. The more closely you can synchronize your dashboard with the concerns of the management in their fiduciary role, the more effective you can be in communicating with them and in providing information that is valuable to them in their management decisions. And after all, we are trying to provide better information for use in management decisions in an effort to benefit all of the company stakeholders.
Finance is an important tool and language in use by all businesses. Being aware of its use and applying it effectively can increase the value of the information that we provide to management as demand and supply planners. It can help us to forge a more productive relationship with the Finance & Accounting function, and better synchronization of our activities to create value for the company’s stakeholders. The demand forecasting demand planning, and Sales & Operations Planning processes are important to the efficiency and effectiveness of the company in meeting and satisfying customer de¬mand. Company performance and growth are dependent upon the success of these efforts. We are sources of value creation in our forecasting and planning efforts, and should ensure that we are as effective as possible in both the financial and non-financial dimensions that we affect.
As published in the Fall 2015 issue of the IBF’s Journal of Business Forecasting (JBF). All Rights Reserved.
Meet Mark Lawless at IBF Academy 2016 in Las Vegas, where he will be leading sessions on “Long-Term Demand Planning & Forecasting: The Key to Corporate Strategic Planning”, as well as “CASE STUDIES in Demand Planning: The Issues, Opportunities, and Approaches to Situational Solutions”.