Dealing with Uncertainty: Using your S&OP process to improve your capability to respond!
Updated: Jul 19
I originally wrote this article under the title: Are You Ready for the Recovery? Using S&OP to take advantage of the economic environment in March of 2010. If you recall, this was just two years after the economic crisis of 2008 and companies were still grappling with forecast uncertainty along with unpredictability within their supply chain. The article outlines 4 specific areas that should be reviewed as part of your S&OP process. Doing these will both improve forecasts, and reduce supply chain uncertainty. Although our overall economic situation has changed, the need to respond to market changes is as real today as it was then. Enjoy!
I’m an economist. Well, at least I studied to be one. There are some interesting challenges in the study of economics. First, it’s about predicting future behavior. We use models to explain the past, but we are really trying to develop one that allows us to look ahead. Secondly, economic predictions are made in an extremely complex environment. The “Economic Crisis” of the past two years is a prime example. Events in one part of the world have far-reaching impact in other parts of the world. Finally, the act of making economic predictions can influence the results themselves. A poor economic prediction affects consumer confidence, which can lead to less spending and increase our aversion to risk.
The truth is that economists, like the rest of us, don’t really know what is going to happen in the future. According to the predictions, we are either at the beginning of the upturn, on a temporary upturn awaiting a second drop, not at the bottom yet, or we are well into the recovery. Take your pick.
Despite the uncertainty, there is one thing that all economists agree on: the economy will improve. The cyclical nature of economics shows that every downturn is followed by an upturn. While we may all want to know when the upturn will happen, the real question is: Are you ready for it?
S&OP = Preparation
We can’t control the timing of economic change, but we can make sure we are prepared for it.
I believe a good S&OP process is fundamental to being prepared for uncertainty because it’s forward looking. It’s about coming up with a single “story” (if you’re not sure what I mean by that you should read Duncan’s article) for our future demand and supply plans.
In the process, you come to agreements on the risks and tradeoffs that are inherent in the future plans. We don’t know what exactly is happening, but we rely on the key players in S&OP: Sales, Operations, Supply Chain, Engineering, and Finance to develop a single set of plans that we can execute. Almost as important, it allows us to measure our performance against those plans and make adjustments as we go into the next month.
Positioning for Success
Over the past 18 months, many organizations have become internally focused. They’ve had to reduce resources, shut down or mothball production lines and plants, reduce inventory and re-negotiate contracts with suppliers. In survival mode, we “batten down the hatches”. Now is a good time to take a look around, evaluate where you are and make sure you’re prepared for the future. Here are four areas that I believe you should focus on to make sure you’re positioned to take advantage of the upturn.
1. Re-evaluate your suppliers. Over the past several months, your suppliers have been in the same situation as you have. They’ve reduced capacity and inventory levels. They’ve had to look for new customers to offset the reduced sales volumes from their current customers. If you assume that your suppliers have the same capability of responding to your demand as they did only six months ago, you may be very mistaken. The best way to evaluate your suppliers is to communicate with them.
If possible, you should evaluate the financial health of your suppliers. Losing a critical supplier due to bankruptcy can shut down your entire organization. Pay close attention to profitability and cash flow.
Present supplier risks as part of your S&OP meeting. Any forward looking plans that have significant changes in volume levels should include some level of analysis on supplier capability. Having the internal capability to deliver a plan, without suppliers that can meet your volume levels will not work.
Now is not the time to keep your critical suppliers at arm’s length. Where it makes sense, share the plans developed in your S&OP meeting with your suppliers. The more information you can share with them about what you think is going to happen, the better off you will be. Communication is a two-way street. If you provide information to them, they will reciprocate.
2. Understand what it will take to increase or reactivate mothballed capacity. During the downturn, many companies have shutdown production lines or entire plants. Depending on how long they have been shut down, restarting will require extra maintenance, rehiring, and re-priming of the supply chain. Having a good understanding of how long it will take to make this happen is important. This information then should be shared across the organization to ensure that everyone understands what the constraints are to increasing supply.
Use this information to develop short and long term plans. In the following example it will take three months to get the mothballed capacity back and running. If the decision is made in May to increase capacity, adding back the full 500 units of production will not happen until August. An alternate plan, using overtime, decreases the gap between the forecast and production capability. Understanding the time constraints, capabilities and costs will all be factors in deciding what action to take.
Communicate the constraints and costs of reactivating capacity as part of your S&OP family presentation. Use S&OP to monitor performance against your future plans, in order to evaluate both demand expectations and supply capability.
3. Identify and monitor the leading indicators for demand changes. These indicators may be extrinsic, intrinsic or both. Extrinsic indicators are more valuable if they are tied closely to your industry. For example, housing starts will be more applicable for someone selling air conditioning units or closet storage units.
Don’t ignore hard sources of data that may be available. If you distribute your data through retailers such as Home Depot or Lowe's, point of sale (POS) data may show information earlier than looking at the forecast provided directly from the retailer. Another example of this would be inventory levels in the outgoing supply chain. If inventory levels of distributors are declining, this may be a sign that future demand levels will increase to refill the pipeline.
Monitor your booking and backlog levels as early internal indicators of demand shifts. This should happen as part of your S&OP process. An increase in bookings and/or backlog is an indicator that business is picking up. Comparing the overall backlog level to a target level for each S&OP family will help you monitor the health of that business. In some cases you may even be able to monitor future quote levels. The level of quoting activity is often a leading indicator of bookings.
4. Identify forecasting biases. It’s true that all forecasts have a certain degree of inaccuracy. They are, after all, predictions of events that have not yet happened. There are two parts to the inaccuracy: bias and variability. Variability refers to the normal uncertainty or fluctuation in the forecast. Bias refers to the tendency for the sales forecast to be either understated or overstated. You first need to address the reasons for bias and then plan for the variability.
In a positive economic environment, forecasts are typically understated. Conversely, when business is on the decline the tendency is to over-forecast. Why? The full reasons behind this are probably worth another article, but simply put, on the upturn, Sales feels it’s better to under promise and over deliver, and on the downturn they are reluctant to present a real picture of what is going to happen.
The measurements and closed loop nature of S&OP will help you determine and address any forecast bias in your organization. As part of the process you should:
a. Separate the bookings and shipments forecasts. You can then assign responsibility of the bookings forecast to Sales. Shipments are the shared responsibility of Production and Sales.
b. Assign accountability for the forecast.
c. Measure forecast accuracy. Compare the actual demand for a period with the forecasted demand. Establish tolerance levels for accuracy. If the forecast is out of tolerance you should address it in the next step.
d. Determine reasons for inaccuracy. Look at how the forecast is generated. Is it a specific region that is causing the problem? Is the historical information overstating the forecast?
e. Address the reasons for inaccuracy. Don’t expect perfection. Remember an unbiased forecast is one where the variance is just as likely to be overstated as it is to be understated.
When a bias exists for a period of time, we start to second guess the forecast. Operations will base their operating plans on the discounted forecast, and when Sales sees an upturn in business, it is not believed. This may jeopardize the speed in which we respond to changes in demand. The bottom line is that it ends up costing us in expedites or lost sales as we scramble to catch up. Address the bias now to position your organization to respond proactively.
The future is uncertain. It always will be. The best way to face this is to be prepared. You can accomplish this by looking at your internal and external constraints (capacity, suppliers) and developing a good understanding across the organization of what these are. Use your S&OP process to improve your forecast and build trust across your organization. You can’t control the future, but you can be ready for it.