In this series, I’m exploring some of the hard benefits you should expect out of S&OP. The goal is to help you understand how S&OP can deliver these expected benefits and provide a way for you to calculate the ROI of implementing S&OP for your organization.
If you haven’t already, go back and take a look at the first post in this series, click the link here. In that post, I introduced how generally S&OP can be linked to these business outcomes. I also introduced an expected improvement table that comes from research by Tom Wallace, Author of the Sales and Operations Planning ‘How to Handbook.’ Based on this table, Tom provided the high and low values for each of these benefits, and an expected or middle outcome as well. I will be using this to walk through some numbers for each benefit.
In this article, we’re exploring the relationship between Sales and Operations Planning (S&OP) and inventory reduction. The key question is: How much inventory reduction can you reasonably expect from implementing S&OP? This question is crucial and complex, as illustrated by Tom’s table, which shows a broad range of potential reductions, between 12% and 70%. To determine what you might expect, it’s essential to understand where to focus your efforts. This article aims to provide insights and ideas specific to your situation, helping you get started on optimizing your inventory levels.
Obsolete Inventory
The first area to examine is obsolete inventory. Many organizations regularly write off obsolete inventory, which provides a clearer starting point for understanding potential reductions. Obsolete inventory often results from various issues, such as overestimating sales for specialized products, poor forecasting, mismanaged marketing campaigns, or ineffective new product launches. These issues typically stem from poor communication, an area where a robust S&OP process can make a significant difference.
At its core, a formal S&OP process improves communication across different organizational silos: Sales, Marketing, Operations, Supply Chain, and Engineering. By aligning these departments and reducing ad hoc decisions, S&OP helps prevent the disjointed planning that leads to obsolete inventory. Monthly meetings should address the assumptions in the plan and present key operating parameters for each product family to mitigate these issues.
Excess Inventory
Excess inventory presents a more challenging problem to quantify. Various sources contribute to excess inventory, so it’s crucial to identify which ones are most prevalent in your organization. For example, excessive production plan changes can lead to excess raw materials, work-in-progress (WIP), or semi-finished products as firms adjust to schedule changes. Improved management of the supply plan and better alignment with the master production schedule can help address this issue.
Another source of excess inventory is the lack of clear operational objectives for a product family. Operational objectives should be documented and include customer lead times, inventory targets, and the balance between make-to-stock and make-to-order strategies. Without a documented strategy, decision-making becomes ad hoc, leading to inefficient resource use and unnecessary inventory accumulation.
Calculating Savings
To estimate the savings from reducing obsolete and excess inventory, we’ll break down the calculations for clarity. First, consider the reduction of obsolete inventory. Suppose your company, with $100 million in sales and $15 million in inventory, writes off 2% of its inventory as obsolete, amounting to $300,000. If you aim for a 30% reduction in obsolete inventory, that translates to a $90,000 saving. For greater accuracy, aiming for a reduction closer to 50-60% may be more appropriate due to the core improvements in communication provided by S&OP.
Next, let’s calculate savings for excess inventory. For example, if $3.75 million of your $15 million inventory is in finished goods, and you estimate a 15% reduction through better coordination, this would free up $2.25 million in trade working capital. Adding the savings from obsolete inventory, the total benefit would be $2.34 million in freed trade working capital. This amount should be phased over three years to account for the implementation process, with a suggested distribution of 20% in the first year, 80% in the second year, and 100% in the third year.
To understand the annualized return, you can apply a carrying rate (e.g., 20%) to calculate the annual savings from carrying less inventory.
Conclusion
This single measurement may not be enough to justify S&OP for your organization, but hopefully this post provides you a good starting point for linking the quantifiable returns you can achieve through S&OP. Stay tuned for the next posts to dig further into where else S&OP can bring significant benefits.
If you're wondering where you can start realizing the benefits of S&OP for your organization, I highly recommend taking our S&OP Clarity Compass. This free scorecard only takes 3 minutes to complete and provides you with a personalized report and recommendations for improving your process.
At DBM Systems, our consultants have over 20 years of experience providing S&OP leadership to businesses worldwide. We equip teams with coaching and the tools to quickly start and sustainably run an effective S&OP process. Learn about our process and unlock the power of S&OP in your organization.