At each point in the supply chain beyond the consumer, parties typically protect themselves from stockouts by holding safety stock to accommodate changes in demand. The cumulative impact of each of those safety stock holdings, is a significant buffer of inventory.

How does the Bullwhip Effect occur?

Suppose that there is an unexpected surge in demand for a particular product by the consumer (every reader will be able to think of a product that experienced a rational or irrational surge in demand because of COVID). Seeing the increased demand, the retailer places an order with the local supplier, adding a little extra for safety stock to protect against an out of stock. The local supplier then places an order with their wholesaler, again adding a little extra for safety stock. There is a domino effect up the supply chain with the consequence that the raw material supplier sees a demand for raw materials which far exceeds that which is warranted by the original increase in demand at the consumer end of the supply chain.

The magnitude of the demand has been amplified at each link in the chain, so the whole supply chain is now bloated with safety stock at every point. Because of lack of transparency, those at the supply end of the chain ‘see’ a distorted view of the real consumer demand. 

In the early stages of the global pandemic, production capacity was severely reduced, and one of the critical impacts was in the production of semiconductors. With lockdowns occurring in various regions around the world, there was a surge in demand for a number of categories including home appliances which rely on semiconductors. The combination of reduced capacity and surging demand has created a well-documented global shortfall in semiconductors, impacting industries as diverse as healthcare, automobiles, defence, cosmetics and construction. The Ford Motor Company is on record as saying that they will lose 1.1 million units of production in 2021 as a result of semiconductor shortages.

The WSJ article cautions against manufacturers falling into the Bullwhip Effect trap. The obvious response to the surging demand and shortfall in availability is to re-build capacity and indeed add new capacity. However, that takes time, and there is a very real risk that just as that capacity comes online, demand stabilizes, and very quickly the industry has an oversupply. (As a side note, the chemical industry is notoriously cyclical for similar reasons. Short supply leads to price hikes, which encourages manufacturers to build new capacity, which creates a glut of supply down the road, and prices subsequently collapse, creating a negative return on investment.)

Sharp fluctuations in demand need to be carefully evaluated to determine whether the sales growth is temporary or sustained, and what the underlying demand is going to be before committing to increased production. The obvious example is toilet paper, which has become the manifestation of panic buying, creating massive ripple effects up and down the supply chain. As the WSJ article dryly observes, consumer demand for toilet paper in the US may have risen by 700%, but that does not mean the average American is using seven times more paper at home! Indeed, toilet paper is a classic example of inelastic consumption. Low prices might convince you to buy more, but that does not mean you use more. You are simply creating another bucket of safety stock in your home, and inadvertently contributing to the Bullwhip Effect.

Causes of the Bullwhip Effect

If you read any business definition of the Bullwhip Effect, you will see that the most commonly cited causes revolve around pricing, batching and poor communication. 

Pricing is a fairly self-evident one. An effective price promotion will cause a short-term spike in sales, often at the expense of a rival brand. Unless there is clear transparency up and down the supply chain, that temporary disruption in normal demand can lead to distorted demand forecasting and over production. 

Batching refers to a supplier receiving an order from a retailer but holding onto it to accumulate multiple orders for the sake of efficiency. This can lead to lumpy order patterns, which, as it oscillates along the supply chain, gets amplified, resulting in an artificially high apparent demand at the raw material end of the supply chain.

However, the most fundamental contributor to the bullwhip effect is poor communication along the supply chain. Fluctuations in demand, driven by marketing initiatives and by batching, should not result in misinterpreting of the distorted demand if there is supply chain transparency.  All that means is a degree of collaboration between customers and their suppliers, built on the sharing of information. ‘The more I understand about my customer’s demand, the better equipped I am to build that into my own forecasting and planning.’ 

That could be as simple as keeping suppliers informed about planned marketing initiatives, talking about seasonality, or the opening up of new channels or new ranges. A more effective collaboration is built upon sharing of sales forecasts, both medium and long term.

Keeping supply chain partners better informed makes economic sense. Better visibility of expected demand helps all the links in the supply chain to plan more efficiently, ensuring that stock is available when required, but at the same time reducing the cash tied up in unnecessary safety stock. After all, that safety stock is there as an insurance policy because of uncertainty about demand. Better production planning, better working capital utilization, and lower inventory levels all contribute to lower costs, from which everyone benefits.

The ultimate solution is to share a common platform, so that all the players in the supply chain have visibility of the same demand data, and there is no better source of data than the Point-of-Sale data, which shows what the consumer is buying and where they are buying. That level of transparency leads to demand driven supply chain management, where deviations from the forecast can be assessed and reacted to in an appropriate manner without the distortion of guesswork operating in an information vacuum.

At Krunchbox we have firsthand experience of working with retailers and their suppliers, sharing a common platform of dashboards and reports, so that retailer and suppliers alike see the same sales data at the sku/location level.

The retailer shares the POS data with the supplier, and the supplier shares their available inventory with the retailer via the Krunchbox platform.

Forecasts can be shared and aligned, leading to joint business planning, demand driven supply chain decisions, reduction in unnecessary safety stock, fewer markdowns to shift excess inventory, and better margins.

What is not to like about that?