Proactively Managing Uncertainty in S&OP

Blake Johnson Consulting Professor Management Science and Engineering Stanford University Founder, Aztral, Inc.

© Blake Johnson

Successful S&OP and supply chain planning

But: Inherently difficult in an uncertain and dynamic world And: Sales incentive issues impact accuracy and bias

Forecasts are critical: Drive planning and investment

- Supply chain cost is key driver of margins and profits - Supply chain flexibility is critical to mitigating risk of lost sales, excess inventory, under-utilized capacity, expediting…

Supply chain must balance cost and flexibility

© Blake Johnson

But: Supply chain metrics impact willingness to invest in flexibility

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- Shortages - Inventory and liability - Poorly utilized capacity - Expediting and overtime

Profits

Revenues

Costs

Material cost

Write-downs

/ write-offs

Inventory

holding costs

Income statement

Profits

Revenues

Costs

Material cost

Write-downs

/ write-offs

Inventory

holding costs

Income statement

Assets

Inventory

Balance sheet

LiabilitiesMaterial liabilities

CapacityAssets

Inventory

Balance sheet

LiabilitiesMaterial liabilities

Capacity

Too much Cost

Too little

- Ours - Customers - Suppliers - Commitments - Coordination

Plan Reality Operating

performance

- Re-planning - Re-coordinating - Constraints - Fire-fighting - Cost and conflict - Damaged customer relationships

- Income statement and balance sheet impact - Lack of control - Lack of accountability

Impact of basing plans, coordination and metrics on best- guess forecasts

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Financial performance

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To date the focus has been trying to make the problem go away

1. Proactively plan for the range (probability distribution) of future demand and supply

Eliminate forecast error Impossible in an uncertain environment

Perfect “agility” Flexibility and lead time reduction have costs Real question: What is the right level?

Solution: “Range” planning

© Blake Johnson

2. Quantify and manage operational and financial performance over it

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The simple logic of “range” planning

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- Too little supply: Lost sales and customer satisfaction, unnecessary cost - Too much supply: Inventory, liability and excess capacity

- Sales and marketing - Supply chain

3. How can we proactively plan and manage our business to deliver the best possible operating and financial performance?

1. What is the range of our potential future demand?

2. How is our operating and financial performance exposed across that range?

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Capability#1: How forecastable is demand over planning horizon?

Forecasts: Best available demand information over planning horizon

Forecastability varies by:

Demand

Planning horizon

90th

75th

25th

10th

Forecast error percentiles

Forecast error by forecast horizon: Accuracy of that information by lead time

- Product - Stage of lifecycle - Level of aggregation - Market / geography - Season

Customer order lead time

Demand known within customer order lead time

Now

© Blake Johnson 6

Capability #2: What is the right type and amount of supply chain flexibility?

“Bucket” at end of “supply chain pipe”

Inventory

“Supply chain pipe” Materials

Production Shipping

Finished goods

Forecast accuracy lower further in future

Match size of “supply chain pipe” to forecast accuracy by lead time - Unless forecast accuracy = 100%, supply flexibility is required to match supply and demand - Lower forecast error less flexibility required

90th

75th

25th

10th

Forecast error percentile

Enable supply chain to proactively plan Minimize cost and risk

© Blake Johnson 7

Optimizing planning for high probability portion of demand range

Demand

Time

High probability demand

Cost savings opportunity varies by circumstance, but 5-10% is typical

Low end of Range Forecast as % of forecast

Savings opportunity: Examples

Cost reduction opportunity

70%

60% 5%

10%

X = Reduction in

overall cost (%)

3.5% 6%

Use predictability to reduce cost: - Lowest cost, long lead time production - Efficient capacity, materials and production planning - Large batch sizes, full truckloads, ocean vs. air… - Financial planning and risk management benefits

© Blake Johnson

Certain demand is cheap to serve (100% capacity utilization, no inventory buffer…)

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Optimizing planning for uncertain portion of demand range

Flex

Committed volume

Flex

Committed volume

Supply chain planning decisions by lead time

Demand

Month 3 4 5 6 1 2

Production start

Material sourcing

Capacity

Capacity lead time

Material lead time

“Right-size” upside by lead time - Minimize cost by pushing flex as far upstream as possible - Manage upside constraints over full planning horizon

High quality advanced planning information at each stage of supply chain

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Upside availability known, and delivered at lowest cost

Intelligently position “just in case” resources, sized based on cost vs. benefit

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Source: Venu Nagali, HP, presented at Real-options conference June 2007

Manage risks using structured contracts with suppliers

Flexible quantity

contract

Demand forecast (units)

Time

Fixed quantity

contract

0

100

200

300

400 Uncommitted

Hi scenario

Base scenario

Lo Scenario

1. Quantity Terms:

• Fixed Quantity

• Flexible Quantity

• Percent of HP

Demand

2. Pricing Terms:

• Market-based with

specified discounts

• Fixed price

• Price caps and floors

Structured Contract Terms

A combination of objectives from Assurance of Supply, Cost Savings & Cost

Predictability can be enabled by mixing & matching quantity and pricing terms

Capability #2: Quantify cost of supply chain flexibility

Jan Feb Mar Apr May Jan Feb Mar Apr May

Option 1: Low flexibility Option 2: High flexibility

Narrower supply chain pipe Wider supply chain pipe

Higher capacity utilization More inventory turns (materials, WIP, FGI) Lower cost

Lower capacity utilization Fewer inventory turns (materials, WIP, FGI) Higher cost

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Capability #3: What level of supply chain flexibility optimizes P&L and customer delivery performance?

Jan Feb Mar Apr May Jan Feb Mar Apr May

Option 1: Low flexibility Option 2: High flexibility

P&L:

Customer service: Low

P&L

Balance cost of supply chain flexibility with benefits to P&L and customer service

More lost revenue and margin More inventory and liability Lower supply chain cost

Customer service: High

Less lost revenue and margin Less inventory and liability Higher supply chain cost

Lost revenue and margin Damaged customer relationships

Inventory and liability

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Capability #3: Optimize performance and enable “no surprises, no excuses” alignment and accountability

1. “Dollarize” trade-offs (integrate operational and financial) 2. Create “menu” of performance alternatives for key stakeholders 3. Agree best choice and establish alignment and accountability

Demand Demand

Vs.

“Risk aware” S&OP process:

“Range” performance management

Plan

Demand

Today: Flying blind

Service level 98%

Inventory $2M

Cost $11M

Gross margin $3M

Liability $1.2M

Low Plan High

?

?

?

?

?

?

Service level 98%

Inventory $2M

Cost $11M

Gross margin $3M

Liability $1.2M

Low Plan High

?

?

?

?

?

?

Service level 100% 99% 97%

Inventory $2.2M $1.8M $0.3M

Cost $8.3M $11.3M $13.7M

Gross margin $2.5M $2.9M $4.1M

Liability $2.1M $0.8M $0.3M

Low Base High

Service level 100% 99% 97%

Inventory $2.2M $1.8M $0.3M

Cost $8.3M $11.3M $13.7M

Gross margin $2.5M $2.9M $4.1M

Liability $2.1M $0.8M $0.3M

Low Base High

Service level 100% 99% 95%

Inventory $3.1M $2.0M $0.1M

Cost $8.0M $11.0M $13.4M

Gross margin $2.6M $3.0M $3.8M

Liability $2.5M $0.8M $0.3M

Low Base High

Service level 100% 99% 95%

Inventory $3.1M $2.0M $0.1M

Cost $8.0M $11.0M $13.4M

Gross margin $2.6M $3.0M $3.8M

Liability $2.5M $0.8M $0.3M

Low Base High

Align sales, supply chain, and external partners on right level of flexibility by lead time

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Managing with a complete view of your business reality

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Maximize savings on predictable demand

Secure upside flex at lowest cost

Supply chain “range” plan 2

Potential supply chain flexibility

Quantify impact of supply chain plan on key metrics - Financial, operational, customer - Across potential demand outcomes

Service level 100% 99% 97%

Inventory $2.2M $1.8M $0.3M

Cost $8.3M $11.3M $13.7M

Gross margin $2.5M $2.9M $4.1M

Liability $2.1M $0.8M $0.3M

Low Base High

Service level 100% 99% 97%

Inventory $2.2M $1.8M $0.3M

Cost $8.3M $11.3M $13.7M

Gross margin $2.5M $2.9M $4.1M

Liability $2.1M $0.8M $0.3M

Low Base High

“Range” performance

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Performance of supply chain

flexibility over range forecast

Demand range forecast

Quantify demand uncertainty over planning horizon

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“Problem to solve”

Choose range plan with best overall performance - Cross-functional input, alignment and accountability “No surprises, no excuses” performance, across demand outcomes

4 S&OP

Organizational processes,

metrics and accountability

(Including uncertainty and your options for managing it)

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Q&A

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