The bullwhip effect
Modern market economy is a complex system in which the smallest changes in one point of the supply chain can affect all involved. At the center of this system are supply and demand. These two variables are directly correlated and not only determine the economic success of a company, but also form the basis for all strategic decisions. However, when assessing demand, companies have to draw upon data from different areas in order to forecast market conditions and trends reliably. The further away a company is from the customer in the supply chain, the less the direct demand reflects actual market conditions. This dynamic is called the bullwhip effect, also known as the Forester effect.
Explanation and causes of the bullwhip effect
The term bullwhip effect illustrates how a demand curve moves along the supply chain. Like cracking a whip, a small movement (change) at the beginning of the whip is enough to cause a large movement at the end of the whip. In this analogy, the material suppliers are the end of the whip, and customers trigger the motion at the beginning of the whip.
To illustrate, let’s look at a more detailed example of the bullwhip effect:
For example, the demand for a particular product increases as customers buy more of it. There may be various reasons why, which we will not go into at this point. In response to increased demand, the retailer will order more from wholesalers to meet customers’ requirements and to have the product in stock when needed. This in turn requires the wholesaler to increase stock and order a larger quantity from the manufacturer. The manufacturer then requires more materials from suppliers to meet the increasing order volume.
Usually, order quantities increase at each point in the supply chain because the number of customers at each point is bigger, and therefore delays due to shipping and production can be expected. As the distance from the customer increases, it becomes more important to have the required products or the necessary raw materials in stock so that customer needs can be met as quickly as possible. As a result of this, even a slight increase in retail demand is noticeable for suppliers.
This example covers the entire supply chain, from the material supplier to the customer. However, the bullwhip effect does not necessarily have to start with the customer. It can also originate from any other part in the product chain.
The bullwhip effect can be caused by any of the following factors:
- Demand: A company has or expects an increase in demand. It responds by increasing the demand for the products from its suppliers. In doing so, the company not only orders the quantity actually requested, it also orders more inventory in order to respond faster to other increases, and to maximize its profits. This sequence of events increases demand along the supply chain.
- Order bundling: Many companies consolidate their orders, or order far more than what they actually need to benefit from volume discounts or save on shipping costs.
- Expecting bottlenecks: A company may expect bottlenecks in the supply of certain materials or products and therefore increase their order.
- Price fluctuations: Increased demand can cause prices to rise, as explained in our article on price elasticity of demand, leading a company to increase its order quantities in order to maximize its profits. In addition, discounts sometimes lead retailers to acquire larger goods inventories.
Why is the bullwhip effect problematic for companies?
The problem with the bullwhip effect is that, often, not all developments along the supply chain are comprehensible or predictable for the companies involved. In practice, this means that the manufacturing company does not know why the retailer is increasing its order volume, for example. When this happens, it is important to differentiate between a strategic bulk order and a real increase in demand. In the case of a bulk order, the manufacturer won’t expect the retailer to place another order, whereas in an increase in demand will mean the company to ramping up production to increase sales.
However, there is a risk of overproduction if a company changes its strategy because it assumes that orders will increase without being certain of it. This not only leads to an imbalance between investment and profits, it also results in higher warehousing costs and unrealistic targets that can send a company into debt.
How can the bullwhip effect be avoided?
As you can see, the bullwhip effect itself does not actually pose a major problem as long as all companies are aware of this dynamic and there is good communication within the supply chain. This is the task of supply chain and risk management, which are indispensable for large companies. They not only provide the necessary models and methods for calculating the bullwhip effect, they also enable companies to identify potential risk factors and develop the necessary strategies to avoid them.
The bullwhip effect can often be prevented by maintaining clear communication and information sharing between all participants in the supply chain. This can be accomplished in various ways:
- By allowing retailers to pass on their sales figures directly to wholesalers and manufacturing companies so these companies can match order numbers to real sales.
- By using cloud-based stock management software, which informs retailers, production companies and suppliers when a stock up is needed.
- By planning early and agreeing on discounts with all participants in the supply chain.
- By agreeing on regular shipments with consistent volumes, though containing different products based on demand.
To plan successfully, a company should keep an eye on its own purchasing and sales figures, and also focus on those of its suppliers and customers. This is the only way for a company to realistically forecast sales and market trends as well as minimize business risk.