At the end of last year, I made this podcast that predicted that 2022 was going to be the year of ‘anti-lean’ with inventory flooding the market and companies having to offer discounts to shift excess stock. My theory was that when we combine excess inventory with higher costs, higher interest rates, and a flagging economy, we have the perfect storm and that cash will become King for any business.
Succeeding in this milieu requires building cash reserves and performing effective cash flow forecasting. And that starts by taking a Finance-focused approach to S&OP and inventory management. This intersection between Finance and Ops is always important – but now more than ever.
To help get a handle on bringing S&OP and Finance together to help weather this upcoming economic storm, I spoke to Dean Sorensen, editor of Integrated Business Planning at the International Institute of Forecasters and founder of consulting firm IBP Collaborative. He has worked for companies such as Accenture, KPMG and AT Kearney, advising on finance strategy, cost and performance management and IBP.
The following questions and answers are taken from my conversation with him.
What’s the major difference right now between FP&A and S&OP?
First of all, S&OP and IBP focus on supply chain resources and costs. In most companies this represents anywhere between 50-60% of manufacturing cost structures. FP&A on the other hand focuses on 100% of the cost structure of the business.
Secondly, the structures of these processes are different. FP&A focuses on charts of accounts, whereas S&OP focuses on manufacturing and supply chain activities. In other words, FP&A is vertically-focused, whereas S&OP and IBP are horizontally-focused.
Third, S&OP has formal mechanisms for optimizing tradeoffs. The classic one being between service levels, supply costs and inventory levels. While an objective of FP&A is to optimize performance, there are no such tradeoff mechanisms to do so.
What’s the difference between a demand plan and financial forecast?
It really depends on who you talk to. Personally, I see absolutely no difference between S&OP and a rolling financial forecast; it’s exactly the same process albeit at different levels of aggregation. The leading indicator of both these processes is an accurate cash flow forecast.
For a good cash flow forecast you need to understand how resources are being consumed. If you don’t understand resource consumption you can’t possibly get cash right. That’s one of the reasons why 99.9% of global manufacturers really struggle with cash flow forecasting. It’s hard to do when you don’t have the right models and that’s something FP&A lacks.
An operationally savvy finance person would acknowledge that you can’t possibly get a good cash flow forecast without a manufacturing model. If you don’t have a lot of changes in volume and mix perhaps you can get away with it but the minute things start getting complicated, you’re stuck. You can’t really run an effective FP&A process without bills routings and a supply chain tool – it just doesn’t work.
If our goal is to understand 100% of the cost structure and get a top-down view of cash flow, which should be the goal of any business, we need to connect supply chain planning with FP&A.
Does S&OP capture the bigger picture of a business?
The other part of the cost structure which, in my view, is falling between the cracks of both FP&A and S&OP, are the overhead cost structures. FP&A tools are really simplistic and as somebody who’s done a lot of cost management and cost reduction projects, traditional costing models are just wrong. We’ve known that for 30 years.
S&OP tools on the other hand are very narrow and fail to consider 100% of the costs. The consequence of that for one particular company I worked with was that because they were planning in silos, they had between 500 million and a billion dollars of sub-optimized resource allocation. These things are still falling between the cracks of finance and ops.
We’re not showing the big picture of what’s happening inside companies and the overall health of the organization.
Is there redundancy across S&OP & FP&A?
If you look at S&OP and FP&A processes there are so many redundant and non-value activities between the two. We need to step back and look at the process as a whole and see it differently. It’s not that the standard five-step S&OP process is out of date, rather I think it’s missing some steps.
If you step back and look at the process more holistically you’re going to eliminate a whole bunch of things – you’re not going to need as many FP&A people, you’re not going to need a separate S&OP process, you’re not going to separate decision support process.
There’s a whole bunch of good reasons why one would want to have an integrated process that’s designed to be integrated from the beginning instead of operating S&OP and FP&A side-by-side.
What does that fully integrated process look like?
One of the biggest problems that companies still have is that we still haven’t fixed the functional silo problem. One of the things that’s missing is what I call productivity management where we look horizontally across the business. For example, in an order to cash process, you want people focused on the cost per order, not trying to meet a fixed budget number.
You also want them focused on customer/segment specific targets. The target for one might be ten dollars per order, while it might be five dollars per order in another. You might have read the book Beyond Budgeting [by Jeremy Hope and Robin Fraser]. It talks about the bad behavior caused by budgets where neither the rolling forecast nor S&OP have fixed the problem of people being focused on functionally based budgets.
If you want to get them away from that you’ve got to replace it with something so rather than people focusing people on fixed budgets I want to focus them on somebody who owns the order to cash process I want you to hit ten dollars an order or fifty dollars an order or whatever I think it is and those you know those targets may um vary by segment but that I want them focus on relative financial targets. That is an absolute must.
Beyond redundancy, what are the issues you’re seeing with current planning processes?
One of the biggest problems that companies have is they can’t connect targets to outcomes. Specifically, what do we want to achieve and how much is it going to cost?
Companies can’t manage the trade-offs between production costs, inventory levels, and customer service. From a finance perspective those trade-offs are between cost per order, order fulfillment days, and receivables.
If you take a walk around your company and ask who owns that trade-off you’ll find nobody owns it. The reality is that if you can’t manage those trade-offs, you don’t have a mechanism for optimizing cash flow.
How can demand planning ensure cash is King going forward?
Product mix is a good place to start. If we want to improve cash flow you may choose to offer products with a lower profit margin but will produce higher cash flow, as opposed launching a new product which is going to destroy cash flow. You can tilt decision making like this towards protecting cash.
I know a lot of S&OP processes miss the cash flow forecasting element, focusing instead on cost and service. And they look at inventory as just a target, not as a variable. Cash flow forecasting is missing in a lot of S&OP and FP&A processes right now and having that full visibility onto what cash outlook is important.
If you’re a 10- or 20-billion-dollar company, there’s no way that you’re going to do a cash flow forecast without a supply chain model. I see zero difference between a supply chain model and a cash flow model – it’s the same. If you have changes in volume, mix and price, you can’t possibly maintain that model in an FP&A tool.
Anybody who thinks they’re going to buy an FP&A tool and do cash flow forecasting is fooling themselves.
What you really want is to understand cash flow by business segment and understand resource consumption and cash flow by business segment. The only way that you can do that is by a forward-looking activity based costing model, i.e., a supply chain model.
This is the foundation for highly effective cash flow forecasting because If you can track changes in upstream activity which flow down to a downstream activity, you can relatively easily quantify how that impacts costs and cash flow.
Are planning tools up to the job of effective cash flow forecasting?
Most tools are not even remotely close to having the required level of sophistication. People in the FP&A software space are talking a lot about predictive analytics but the one thing you won’t see them talking a lot about is prescriptive analytics like the supply chain tools use.
The reality is that every finance guy is really going to want a prescriptive analytics tool because if I’m a treasurer I want to know how any given scenario is going to affect my cash flow, my working capital, my foreign currency exposure, my debt exposure, and whether I’m going to run into any debt covenant issues. This intersection between finance and ops is probably one of the least understood areas of business.
Hopefully companies will start heeding some of these warnings and there’s a big incentive to do so. What we’re talking about is optimizing the cost of complexity and that represents anywhere between kind of three to five percent of sales.
Join us in Orlando for IBF’s Business Planning, Forecasting & S&OP/IBP Conference from October 18-21. With 2 maturity level streams, you’ll find the specific knowledge you need to implement or improve S&OP/IBP and level up your planning skill set. With networking and socializing in a wonderful Florida setting, it’s the biggest and best event of it’s kind. Register now.