Improving Inventory Demand Forecasting by Using the Sales Pipeline: A Case Study

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Improving Inventory Demand Forecasting by Using the Sales Pipeline: A Case Study By Shankha Bhattacharyya EXECUTIVE SUMMARY The inventory demand forecasting is a critical function in a manufacturing

1 Improving Inventory Demand Forecasting by Using the Sales Pipeline: A Case Study By Shankha Bhattacharyya EXECUTIVE SUMMARY The inventory demand forecasting is a critical function in a manufacturing organization as it impacts the major financial metrics like inventory valuation, gross margin and net margin. The currently used demand planning processes often fail to incorporate input from the Sales pipeline. Failure to do so provides challenges of how to increase the lead times for the supply chain process. This can be accomplished by introducing input criteria from the Sales pipeline. This case study is an attempt to provide such mechanism. SHANKHA BHATTACHARYYA Mr. Bhattacharyya has over 20 years of experience in the areas of revenue management and margin analysis, as well as budgeting, forecasting, and financial statement preparation. His experience spans a wide range of industries including manufacturing, financial services, information technology, and venture capital. He holds an honors degree in Accounting as well as an MBA from the Schulich School of Business at York University in Toronto, Canada. Advanced Manufacturing Inc. (AMI) is a midsized business located in Southern Ontario. It has around 35 employees and has been in business for nearly six years. Its products are engineering items that are sold to clients in Canada, the United States, and Europe. To increase the value proposition of its products, the company often acts as a reseller of third party products. It procures specialized equipment from external vendors, integrates them with AMI products, and offers the integrated unit as a final product. The organization is well structured with specific departments responsible for fulfilling their re spective roles in the value chain. The Sales team is responsible for securing the business, and when a Purchase Order is received from the client, the sale is deemed final. After securing an order, a job is created for it. The job is passed on to the Project Management team, which then allocates resources and coordinates with the Supply Chain, Copyright 2014 Journal of Business Forecasting All Rights Reserved Spring

2 Production, Engineering, Quality Assurance, Finance, and Shipping teams. Once this project management cycle is complete, the product is shipped to clients. Inquiries that arise from clients after receiving the product are handled by the Client Response team. The organization has established a reputation for high-level product quality. Most of the client inquiries are software related. Most of the jobs are defect free, and that is what has enhanced the client loyalty. This has been proven by clients who place repeat orders with AMI, and act as advocates for the organization in their business community. As a result of the successful workflow and the efficiency of the Sales department, the organization is doing well, and has future plans of expansion. AN EMERGING PROBLEM As discussed earlier, AMI secures contracts and executes them within the time period specified in the Purchase Order. The time period required to execute the order is determined by the Applications Engineering team. It is indicated on the quote, which is a part of the response to the Request for Proposal (RFP)/ Request for Quotation (RFQ). Depending on the internal resources available for the execution of the job, the time required for a job to be executed is quoted in the form, and that ranges from 6 to 8 weeks from the receipt of a Purchase Order. It is this project-execution time period that is creating challenges for the Supply Chain team. As discussed earlier, AMI acts as a reseller to increase the value proposition of its products. This means that it has to procure specific engineering items from external vendors. This requires negotiating prices, shipping to AMI at the correct phase of the project, and establishing terms of payment that are convenient to the company. In the case of AMI, most of the projects are unique. The Supply Chain team has to contact a larger number of external vendors and negotiate terms with them. Since they are ordering items on a projectby-project basis, they are unable to provide a guaranteed volume to the vendor and secure a price break. Also, the price of the same item can go up by as much as 10% to 15% between two successive orders that may be 60 days apart. The combined effect of price uncertainty and inability to secure a price break results in lower gross margins on certain projects. What is alarming is the fact that projects with higher revenue are showing a greater drop in gross margins due to the proportionately higher amount of resale items. Since Sales, General and Administrative (SG&A) costs are more or less fixed, a lower gross margin is adversely impacting the net income. This is causing lower performance ratios. For example, one such ratio is the interest coverage ratio, which indicates the ability of the organization to cover its interest expenses. The ratio is calculated by dividing Operating Income (income before interest and taxes) by interest expense. The company pays very close attention to such performance ratios, which have now become so serious that they have to be addressed. Given the constraints of the Supply Chain, something has to be done to have a longer lead time that can enable the company to secure lower prices. KEY FACTORS IN THE CURRENT PROCESS As per the current workflow, it is the Purchase Order from the client that initiates the project. If the Purchase Order specifies that product will be delivered between 6 to 8 weeks after the Purchase Order is issued, it creates a hard deadline, to which the Supply Chain team must comply. Bound by this constraint, the Supply Chain team focuses on shipping the items to the appropriate phase of the project to avoid non-availability. In so doing, it compromises on its negotiating power, its relationship building, and its demand forecasting ability. In some cases, it has to pay higher shipping and brokerage fees to ensure items are available when needed. This situation can be mitigated by allowing the Supply Chain team a longer lead time. This is where an apparent contradiction arises among different groups. The Sales team would like to offer a competitive project execution period, so that the needs of their clients are met. The Applications Engineering team has a different perspective of the project execution time, which is influenced by the availability of their internal resources. And finally, the Supply Chain team has a third perspective as they feel that their value in the organization is driven by their ability to secure favorable terms for AMI. What is required, therefore, is a solution that harmonizes all three perspectives, and ensures that budgeted gross margins are met, which is critical for the organizational growth. Bound by the constraints that the Sales team and the Applications Engineering team face, the need is to improve demand forecasts and increase lead time for the Supply Chain team. If the vendors are given an estimate of items that would be ordered during the next two quarters, they are more likely to give better Copyright 2014 Journal of Business Forecasting All Rights Reserved Spring

3 terms, a price break, and value added features. The net effect of these will be lower costs, which will help the organization to maintain the gross margin at the budgeted level. Since AMI cannot give more time to vendors, we need to make some changes internally to achieve this end. SOLUTION FOR A BETTER FORECAST AND LONGER LEAD TIME As discussed earlier, it is the receipt of the Purchase Order that starts a project job. The receipt of a Purchase Order actually impacts two cycles. First, it closes the sales cycle and second, it starts the project job cycle. Let us now look at the three phases of the sales cycle, all of which precede the receipt of the Purchase Order (see Table 1). Phase I Lead Qualification: When an external party shows interest in a product, it is designated as prequalified lead, implying the party is likely to make a purchase in the next four quarters. Those that don t fall in this group are deleted from the pipeline, but retained in the marketing database for informational purposes. These leads now move to Phase II, Figure 1 Sales Cycle Process Flow Lead Qualification Sales Qualified Prequalified Evaluation Quotation Budget Available Assessment of Needs which is the evaluation phase. Phase II Evaluation: To assess the needs, technical discussions are held to find out what exactly the client wants, and whether AMI can fulfill them. If the answer is yes, the lead moves to the next phase. Here, the focus is on the financial end; thus, the client is asked how the project will be funded. If the customer is unable to commit funds over the next three quarters, he is not moved to the next phase. Otherwise, a quote is presented to the client and inquiries are made as to the time it will need to make a decision. Phase III Negotiation and Offer: At this point, the discussion is mostly focused on the finer details of the project. The client is given an in-depth understanding of how its needs will Table 1 Different Phases, Their Values, and Number of Days in a Phase and Percentage of their Moving to the Next Phase Phase Total Value of Aging Days in This Category Percentage of That Move to the Next Phase Technical Discussion $35,000, % Price Negotiation $10,000, % Verbal Confirmation $5,000, % Closed and Won $4,750, % Note: Aging Days in this Category, means how many days it takes to complete this phase. Negotiation and Offer Technical Discussion (30%) Price Negotiation (50%) Verbal Confirmation (95%) Closed and Won : PO Received (100%) be best met. Based on our experience, about 30% of the projects at this stage proceed to the final stage, and the contract is won. Here there are different levels of negotiations and their success: Price negotiation: In order to build a long-lasting client relationship, some more value is added to the quote. These include free consulting services, installation of certain parts, etc. Normally 50% of the projects at this stage make it to the final stage. Verbal confirmation: The client informs Sales that he is in agreement with the terms, and will make the purchase. He completes all the documentation, and forwards them to the purchasing office to complete the process. 95% of projects at this stage make it to the final stage. Closed and won: At this stage, the client issues a Purchase Order and the probability of winning the contract becomes 100%. It is worth noting that this phase can last for about 70 days, and it is here where the main ingredient of our proposed solution lies. The entire process flow during the Sales cycle is depicted in Figure Copyright 2014 Journal of Business Forecasting All Rights Reserved Spring 2014

4 The current workflow defines that a project job can commence only when the Purchase Order is received. This is what we want to change. The workflow was developed based on a highly conservative approach, that is, to create a job project only when the Purchase Order is received. This conservative outlook delays the project, resulting in lower net margin. This raises a question as to whether or not we can give up our risk-averse approach and adopt one that has an element of risk. We will discuss this in the next section. LOOKING DEEPER INTO THE SALES PIPELINE The new approach calls for looking deeper into the Sales pipeline. This was not the process used earlier, mostly because it was believed that the Sales pipeline belongs only to the Sales team; no one else can benefit from it. The new approach breaks away from this and establishes the Sales pipeline as a useful input tool for the demand forecasting process. To analyze this, let us look at a sample sales pipeline report. Looking at the verbal confirmation level of Phase III, we notice that leads remain in that phase for an average of 21 days, but 95% of these leads actually get converted to the next and final phase closed and won. The new process uses the verbal confirmation phase as the mostly likely phase of winning the order, replacing the closed and won phase. In this way, we gain an additional 21 days of lead time; therefore, we can start the project earlier and expand the total project execution period by an equal length of time. IMPLEMENTING THE NEW PROCESS In the new process, it is the Applications Engineering team that has to take the lead. Currently, the Bill of Materials (BOM) and Parts Tracker (PT) are developed in the closed and won phase, after the Purchase Order (PO) is received. The BOM and PT will now have to be developed for jobs that are in the verbal confirmation level of Phase III, which is the phase immediately preceding the closed and won phase. Once the PT is generated, the Supply Chain team will prepare the total requirements for parts and establish a demand plan. Now the demand plan is ready and negotiations with the vendors should have started 15 days prior to receiving the Purchase Order. This 15-day period signifies the added lead time, which was identified as a problem earlier. At this time, the Supply Chain team is not worried about meeting the shipping deadline, and they are totally focused on parts sourcing and getting the best terms for the organization. By the time the Purchase Order is received, which vendors have to be used are finalized, and the value of items that would be procured is established. When the Purchase Order is received from the client, our Purchase Order would be issued to the vendor with the pre-negotiated terms. With favorable terms and best possible prices for items, the pro fitability goals of projects, in cluding budgeted gross margin and net income, will be met. The demand forecasting process will become robust. WHAT CAN GO WRONG? The biggest assumption here is that we assign the probability of 95% for the conversion of the verbal confirmation phase to the closed and won phase. But this is very close to what the company is currently experiencing. With increasing competition and financial challenges faced by clients, it is likely that the conversion rates may fall. Clients may retract from their verbal offers and go back to the negotiation phase to secure a better deal. At this stage, if the conversion rate goes down, the inventory demand will be overstated. In that case, it would be better to get inputs from the account manager about individual probabilities to be assigned to each project, as against a single value for all the projects. The new process proposed here is quite simple and intuitive. The information already exists; what this process does is integrate two parts by adding a probability value lower than 100% (95% in our example). But, the complexity of this process stands out when we realize that the current demand planning process is based on inputs from confirmed jobs (which are assigned a probability of 100%). The difference between the two levels of probability introduces the risk element, which is quite bearable. This requires a major behavioral change on the part of the Supply Chain team. Therein lies the complexity and the challenges in implementation. Once implemented, the new process will create a stable and robust workflow, eliminate the current problems faced by the company, and ensure that targeted financial goals are met. (info@ibf.org) Copyright 2014 Journal of Business Forecasting All Rights Reserved Spring

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Trade and Logistics II in Microsoft Dynamics AX 2009 Course 80025A: 3 Days; Instructor-Led

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