The Ghost Metrics in S&OP/ IBP: Practitioners Beware!

Jan 16, 2024 | Metrics and Data Analytics

I’m a ghost living in a ghost town sings Mick Jagger from The Rolling Stones. Likewise, in the S&OP/ IBP world, we live with ghost metrics.

They are invisible in the financial statements, but, we can feel their presence and their financial effects. They haunt Supply Chain and Finance. In this article, we will cover the following three ghost metrics:

  • Lost Sales
  • Cost Avoidance
  • Inventory Owned by Co-manufacturers

Ghost Metric #1 – Lost Sales

Sales are the top line in the Income Statement—also known as Profit and Loss Statement (P&L). These are actual sales; when companies ship their products to customers.

However, actual sales may not match the demand plan. There can be variances in quantity, price, and/or product mix. For example, because of the unavailability of some raw materials, production couldn’t meet the plan, which in turn, resulted in a lower quantity sold.

When demand is higher than supply, companies have lost sales. Lost sales are nowhere in the P&L. They are like a ghost haunting us because we know that sales could be greater.

Companies address these lost sales in different ways. One common way is to postpone sales. By following our example, the customer waits until product is ready to ship.

Other times, the company agrees with customer on product substitutions. In the worst case-scenario, these lost sales never get to hit the P&L because the customer decides not to buy.

All these situations have different financial impact. Revenue can be greater—if we are lucky with product substitutions— or lower, postponed, or never realized.

It’s important to track this ghost metric in addition to On Time In Full (OTIF) because it could happen that the sales order is not entered in the system when the product is not available.

Ghost Metric #2 – Cost Avoidance

The P&L contains several cost line items including Cost of Goods Sold (COGS) and Operating Expenses (OPex), among others.

Cost avoidance doesn’t have any direct impact on the P&L. This is another ghost metric invisible in the financial statements.

It also haunts us because even though they are not recognized in the P&L, if companies don’t work on cost avoidance, the different cost line items in the P&L could skyrocket.

Nobody wants to pursue cost avoidance. The unrecognition of cost avoidance in the P&L makes it an unwanted metric by Finance.

This also makes it unwanted on the supply chain and procurement side. Besides being a ghost metric, cost avoidance is controversial.

Although the concept is quite straightforward given its name, the challenge is to measure cost avoidance and assess if it is real or just a ghost that will disappear. Let’s look at an example.

The company has a two-year-contract with a critical packaging supplier. The terms state a 3% increase for year two. When year two arrives, the procurement team successfully negotiates that price remains the same in a contract amendment.

This cost avoidance creates a brief smile in Procurement, no smile in Finance, and no impact on the P&L. Important to the business? My answer would be yes.

The cost avoidance ghost metric has an indirect impact on the P&L. Like with lost sales, it’s important that companies track cost avoidance, having worked on a clear definition and agreed on how to measure it.

Ghost Metric #3 – Inventory Owned by Co-manufacturers

When balancing demand and supply in S&OP/ IBP, a company may decide to work with third-party manufacturers to add capacity. Examples are Nike and SC Johnson. There are two main business models:

  1. Contract Manufacturing — this is all-in. The co-manufacturer produces the finished goods and acquires raw materials and packaging. The co-manufacturer owns the inventory.
  2. Tolling Manufacturing — Production also takes places in the third-party manufacturing facility, but the company buys and owns the inventory.

These business models have different financial effects. In tolling manufacturing—when the company owns the inventory—we can find such inventory on the balance sheet, within current assets.

Current assets are those that turn into cash in 12 months or less. They are part of the working capital of the business.

Instead, in contract manufacturing inventory is not on the balance sheet, as the company doesn’t own the inventory. However, this off-balance sheet inventory is a ghost metric.

It is not visible on the books—no where on the balance sheet—and haunts us because they are potential liabilities. Here is why.

When the co-manufacturer experiences changes in the demand or consumption from the company, the company may still be responsible for all or part of the inventory.

For example, the company sends an original production plan that then reduces by 50%. If the co-man had acquired inventory to cover the full plan, this change involves that half of the inventory quantity won’t be utilized.

If the inventory left consists of regular or standard parts that other customers can use, there may be no issues but, if they are customer-specific, they become liabilities for the company.

Similar situations involve contract termination, product discontinuation, etc. It is critical to track this ghost metric for finance to create the proper reserves or accruals.

Conclusion

We have ghost metrics in the S&OP/ IBP town. They share that they are not visible on the financial statements, and they haunt us because of the potential effects.

Beware of the ghost metrics that include 1. Lost sales, 2. Cost avoidance, and 3. Inventory owned by co-manufacturers. Track the ghost metrics. They are invisible, but important. Let’s make it happen, ghostbusters!

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