Lots of Movement, Little Improvement
A classic supply chain problem rears its ugly head in the wake of the pandemic.
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It does not take a business genius to tell you that supply chains are “off” these days. Empty shelves are a visible consequence of the ongoing COVID-19 pandemic, as are the higher prices that retailers are charging to compensate for the scarcity of the product that they do have. The answer to this problem, unsatisfying as it may be, does not lie in politics or policy. Instead, a fundamental rethink of the links that connect supply chains themselves will help smooth the flow of goods in good times and in bad, and the “bullwhip effect”, a classic problem concerning supply chain inefficiencies, can help illustrate what happens when things go wrong.
Some Quick Background
The bullwhip effect1 is a phenomenon that occurs when demand distortion travels upstream through a supply chain from customers to retailers, to the wholesalers that supply the retailers, to the manufacturers that supply the wholesalers, and so on (below).2 Demand distortion (i.e., incorrectly forecasted demand at a given point in the supply chain that does not reflect underlying end demand) can occur for a number of reasons: demand forecasts might be updated, buyers might batch orders for their own efficiency, sellers might offer quantity discounts, and players throughout the system may game order sizes and timing to meet incentives or avoid penalties.
Small demand distortions here and there are rarely an issue. Forecasts are rarely perfect, and adjusting them as time passes and more information becomes known is just good business. Order batching is a science unto itself: a calculus exists between ordering costs, holding expenses, and potential lost sales that can optimize working capital usage. Quantity discounts allow sellers and buyers to take advantage of economies of scale, and the incentives and penalties that can distort demand are often put into place for other valid and useful reasons. The real problems occur when those distortions—particularly those downstream at the customer level—are large and/or unexpected.
Slow and Steady…
Global supply chains are finely tuned machines that run on reliability and predictability. The intricate ballet of materials, workers, factories and trucks that puts food on the table and toys under the Christmas tree only works because materials and workers arrive on time, factories operate efficiently, and trucks leave full of products for customers.
Nothing in this sequence should happen out of time. Premature arrival of raw materials, for example, might cause a pile-up in the factory and take up storage space, not to mention tie up valuable working capital on its balance sheet. A shortage of trucks would, of course, prevent finished goods from reaching their customers. Like the insides of a fine Swiss watch, a functional supply chain should operate in harmony: nothing moving too quickly or slowly, with nothing sitting in a particular place until it needs to be there.
Never at a loss for visuals, supply chain thinkers have created an analogy for this synchrony to pair with the “bullwhip” that its failure can create. Taiichi Ohno, the late Japanese industrial engineer who is credited with creating Toyota’s trailblazing lean manufacturing system in the 1990s wrote:
“The slower but consistent tortoise causes less waste and is much more desirable than the speedy hare that races ahead and then stops occasionally to doze. The [system] can be realized only when all the workers become tortoises.”
Aesop’s The Tortoise and the Hare is indeed a useful allegory for illustrating how the bullwhip effect can manifest itself. Over the years the story has picked up some alternative meanings, but its best-known “slow and steady wins the race” moral is what we’ll focus on here.
The story, as many of us know, involves a fictitious tortoise and hare who both live in some fictitious forest. Hare, conceited little thing, was ridiculing Tortoise one day for being slow, as tortoises tend to be. Tortoise, cool and confident, rejected the notion and challenged Hare to a race to prove it. Hare agreed, the two went to the starting line, and the race was on. Hare bounded away so quickly that he thought he had the race in the bag.
Some distance in, Hare decided to stop and take a nap either to rest or to wait for Tortoise to catch up, so he could make a show of winning. Hare overslept; Tortoise trundled on. Hare woke up and saw Tortoise ahead of him, but despite his best bunny efforts he could not catch up to Tortoise, who maintained a steady pace throughout the race. Tortoise won the race. The ordeal was a marathon, not a sprint.
Cartoon animals notwithstanding, the tale offers a good visual for the dynamics behind the bullwhip effect.3 By racing ahead (overordering inventory), puckering out (sitting on product and not staying abreast of the market), and then playing catchup (ordering even more after being caught off guard), we create disruptions throughout the supply chain that create more problems further down the line. Tortoise, assuming he is still alive, might find work today as a particularly effective supply chain executive.
…Is the Ideal Case
A “slow and steady” approach to supply chain management certainly sounds like a great proposition. Eliminating demand volatility throughout the chain (effectively flattening the orange variability curve in the above illustration into a straight line) would result in no lost sales and no obsolete inventory, perfectly predictable order cycles and no additional or underused warehouse space. A customer would demand a unit of product, and a one-for-one, near-instantaneous transfer of information would occur up the supply chain to trigger its production.
This is, of course, not realistic. The causes of demand distortion noted prior play a role in creating uncertainty, as do constraints of materials and labor availability, factory capacities, warehouse sizes, and so on. Circumstances change, and human psychology comes into play. Perhaps it is easier in some industries to lie low and feed supply to demand one-for-one. The metals industry, for example, is so predictable and long-term oriented that it is not unusual for mining firms to bring ore freighter fleets in-house. Many other industries, though, do not enjoy this luxury. They must monitor demand and make relatively quick procurement decisions that may have major upstream effects and conflicts—the failure of which can lead to the bullwhip effect.
OK. So?
So why go through this effort to rehash a textbook supply chain concept? Doesn’t this stuff happen all the time? Sure, but not often to this extent. Pandemic-related demand shocks have worked in tandem with pandemic-related transportation disruptions over the past two years to create what might be the most unusual supply chain environment in a generation—and the bullwhip effect is largely to blame.
Large retailers tracked by Standard & Poor’s reported inventories 26 percent higher than at this point last year, due largely in part to extra ordering to cover for rising (though clearly not entirely certain) consumer demand and transportation bottlenecks, which are still a problem at the country’s largest seaports. Excess inventories, of course, tie up valuable working capital (i.e., cash on the balance sheet), incur extra storage costs, and increase the risk of product obsolescence.4
The bullwhip effect isn’t only visible in consumer-facing products, either. Amazon, in its own efforts to synchronize and scale up its own distribution network, may have ironically created a glut of warehouse space itself—an overreaction which may not fit into the classic definition of the effect but still bears similarities to the “underspend-overspend” whiplash that can occur when companies do not plan carefully enough.
Miscalculations in demand for automobiles and electronics may have also led to capacity conflicts with computer chip makers that created a bullwhip effect in that industry, the effects of which are being felt further downstream as the chip supply chain problems reverberate on through the automobile supply chain into which it feeds. The list goes on, and for good reason: supply chains are more interconnected than ever before.
Some Silver Lining
What goes up, of course, must come down. Demand volatility is inherently mean-reverting and with it comes prices. The excess stocks piling up at Walmart, The Home Depot, and Target will by necessity require price cuts to keep them moving if demand does not continue apace—something the Federal Reserve seems keen not to allow. This “good deflation” might already be here:
Discount tags at CVS (above) are as ubiquitous as their receipts are lengthy, but indications are that this is probably the case on a larger scale as well. Rising inflation and fuel prices are putting the kibosh on consumers’ spending appetites for physical goods and the bets that retailers made on stimulus checks and an end to the pandemic appear not to be working out as planned. This “handoff”, as independent economist Joey Politano notes, would signal a return to pre-pandemic spending preferences of services over goods—unfortunately at this pace the consumer’s choice might be “neither”. “Hurry up and wait” might be the most virtuous approach to finding out what will happen at the tail end of this particular pandemic bullwhip; might as well grab some cheap Häagen-Dazs at CVS to snack on while waiting it out.
Avoiding the Pull of the Bull
Completely avoiding the bullwhip effect in supply chains is a worthy, but likely futile, endeavor. In all but the shortest of supply chains there will always exist some element of human judgment, the error of which can set off a butterfly effect that creates a mountain out of a molehill. We can, however, work to minimize the miscalculations and biases that accumulate to create the bullwhip—and information is the key.
This is, clearly, easier said than done. Even inside a single company, legacy software systems abound and critical data sit in not-so-intelligent spreadsheets and emails that need human intervention to move properly. Those humans themselves often have deep institutional knowledge which has yet to be formalized into a decision matrix or process narrative, and even then there would still be decisions to be made. Those choices, coming from even from the best-trained and most-experienced supply chain managers, will never be 100 percent correct. The most that the perfect decision maker could wish to achieve in many cases is some blended-average representation of reality, the estimate of which is inherently “wrong” most of the time.
Sharing point-of-sale transaction data between retailers and their wholesalers is an obvious start. This is just one link in the chain, however, and probably the most low-consequence and already-predictable one. Of course the “Frozen”-themed cereal will sell well when the sequel to that movie comes out, and of course ice cream sales will pick up in advance of Memorial Day picnics.
Customers downstream would have no way of communicating, though, pandemic levels of toilet paper demand, and suppliers further upstream probably would not have predicted the effect that a coronavirus of officially indeterminate origin would have on pulp and paper supplies. Even the most “perfect” of supply chain information sharing designs would ignore the exogenous shocks that affect it most.
The answer lies in reflexiveness and resilience. Demand forecasts can only be so good; the best that a supply chain planner can do is nail down the average. Real value, then, must come from the creation of a supply chain—not just physical, but informational—that can react quickly to changes in demand and supply; to broker the relationship between the two in the most efficient and timely way possible.
The bullwhip effect is also known as the whiplash effect, the whipsaw effect, demand amplification, variance amplification, or the Forrester effect, the last of which is a nod to Jay Forrester, the engineer who pioneered the concept.
Critically, the effect is shown through increased volatility in demand, not increases in order sizes themselves—of course an end customer has a smaller order size than a retailer.
Another visual might involve driving in stop-and-go traffic: why bother speeding up and slamming on the brakes every few seconds when one could just idle along at five miles per hour and smooth out the system?
Curiously, inventory shortages such as those of toilet paper in the early days of the COVID-19 pandemic were probably evidence of attempts to avoid the bullwhip effect, not of the bullwhip effect itself. Ramping up raw materials and production capacity at toilet paper manufacturers as an immediate response to the demand shock of more people staying at home would have resulted in excess resources for the producers of the stuff once demand died down, potentially leading to layoffs and unneeded equipment.
Brilliant! I like the 5 mph on the highway.