Commentary: Caution—Bullwhip Effect Ahead

Date: Tuesday, June 15th, 2021
Source: The Wall Street Journal

Even though global supply chains are regaining their footing as the Covid-19 pandemic begins to ease in much of the industrialized world, recent data suggests that many businesses are about to be knocked off their feet again.

Uncertainty surrounding the demand predictions needed to drive supply-chain decisions-making increased markedly during the past 15 months as the ripple effects of the pandemic disrupted traditional supply-and-demand patterns around the world. Toilet paper shelves were empty in most stores, and the construction and travel industries ground to a halt.

Now, pent-up demand, the dissemination of pandemic relief checks and vaccinations are spurring spikes in consumer spending, triggering shortages of many products that were overabundant a year ago. From lumber to semiconductors, markets are experiencing price run-ups and stockouts, stoking inflation fears.

The overall ratio of business inventories to sales fell to 1.23 in March, the lowest level in U.S. government records dating back to 1992. This measure is on a steep downward trend from a high of 1.68 in April 2020.

The result is that many companies will want to kick manufacturing into high gear, replenishing inventory on expectations that today’s surging demand will continue. Firms should follow a “make more” strategy with caution, however, lest they become victims of what is known as the bullwhip effect.

The bullwhip effect is a business phenomenon first described in the early 1960s by Jay Forrester at the Massachusetts Institute of Technology and more recently explored by researchers at Stanford University.

The principle describes how companies typically respond to a spike in demand by ordering more products than required to hedge against potential continued growing demand and to avoid stockouts. This demand distortion is then passed along and amplified at each stage of the supply chain, with orders to suppliers furthest away from the point of sale far removed from the realistic views of consumer demand.

The phenomenon can lead to the rapid expansion of manufacturing capacity, including accelerated procurement of supplies, labor, warehouse space and transportation for finished goods, often at a cost premium.

Many of these same operating and distribution cost increases will be passed on to buyers in the supply chain, and ultimately to consumers at the point of sale.

But just as the initial information reporting demand spikes takes time to reach upstream suppliers and manufacturers, so too does information about stabilizing demand.

The bullwhip effect takes hold in supply chains because long lead times are required to build capacity and significantly increase output. By the time companies reach peak capacity, demand may have stabilized at lower levels, leaving firms with excessive inventory.

The risk of overbuilding is highest in industries that may see demand surge as society reopens, such as tourism, dining and entertainment. Data indicate that consumer spending is already shifting away from “lockdown” spending on things such as home entertainment, workout and home-office equipment, and food-delivery services.

Just look at toilet paper.

The household staple was a “canary in the coal mine” of sorts in the early days of the pandemic, disappearing from stores and serving as a harbinger of shortages across a range of goods. As a rush on store shelves took hold, toilet paper makers converted supply-chain capacity from away-from-home product lines (used in schools, hotels, workplaces, restaurants and so on) to home-use products to meet heightened demand, only to find purchasing of products tailored for home use waning as the industrial-use market recovered.

The lumber industry has guarded against a bullwhip effect by boosting output from existing infrastructure rather than by adding expensive new capacity. Firms in other at-risk sectors would be wise to follow suit and proceed with caution.

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Companies should closely evaluate sharp upticks in demand to avoid amplifying false-demand signals. After all, toilet paper demand at stores was up over 700% in March of 2020 even though most Americans certainly didn’t use seven times more toilet paper.

Similar phenomena occurred in other lockdown-sensitive industries. Ramping up manufacturing to meet transitory demand creates the bullwhip effect. Companies that don’t acknowledge this may find their supply chains once again struggling to regain their footing.

Ted Stank leads the Advanced Supply Chain Collaborative program at the University of Tennessee, Tom Goldsby is the Haslam Chair in Logistics at the university and Lance Saunders is a supply-chain management professor there.


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