You Can Almost Hear the Bullwhip Effect Cracking

Stephen DeAngelis

August 11, 2011

In early June 2011, Acer Inc., the world’s second-largest personal computer vendor by unit shipments after Hewlett-Packard, took “a one-time charge of $150 million to reflect disputed accounts receivables at its European operations.” [“Acer Reassesses Inventory Policies,” by Loretta Chao and Lorraine Luk, Wall Street Journal, 6 June 2011] According to Chao and Luk, “Acer said the main reason for the disputes was ‘high inventory’ carried by distributors of its products, reflecting an ‘inappropriate strategy’ in its European operations under the current market situation.” They note that “for PC companies, inventory management is crucial because large quantities of inventory stuck within distribution channels can hinder the delivery of newer products as the value of the unsold merchandise depreciates.” In sectors where technology changes rapidly, like electronics and computers, older inventory is often difficult to sell. As a result, getting inventory right is critical.

Acer isn’t the only manufacturer that wrestles with inventory levels. During the recent economic downturn, many manufacturers were caught off guard. Analysts at the Financial Times report:

“Producers of almost everything were left stranded when the global downturn took hold and retailers ran down inventories. On the way back up, the restocking of goods was so dramatic that most economists excluded the effect from their analysis, lest it skew the results.” [“Inventories: the bullwhip effect,” 31 July 2011]

As the headline states, the depletion and rapid restocking of inventory is called the “bullwhip effect.” The article continues:

“This frustrating phenomenon occurs when falling customer demand prompts retailers to under-order so as to reduce their inventories. In turn, wholesalers under-order even further to reduce theirs and the effect amplifies up the supply chain until suppliers experience stock-outs – and then over-order in response. The effect can ripple up and down the supply chain many times. The whip may now be cracking on the downside. Since the February peak, the European PMI has fallen to about 50, the second largest swing in at least a decade. The US has seen a similar fall. It seems many companies restocked too much after the stock market’s nadir in early 2009, and are now aggressively destocking.”

The Purchasing Manager’s Index (or PMI), according to Investopedia, is “an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.” According to that same source, “A PMI of more than 50 represents expansion of the manufacturing sector, compared to the previous month. A reading under 50 represents a contraction, while a reading at 50 indicates no change.” The Financial Times article continues:

“There are signs of stress in some supply chains. After many airlines parked surplus aircraft in deserts during the downturn, airframe builders Boeing and Airbus now have backlogs of about seven years, says Bernstein. Germany’s Merck, the world’s largest supplier of liquid crystals by sales, shipped higher volumes of its crystals last quarter, yet Sony, the Japanese electronics group, admitted an 18 per cent drop in second quarter consumer products revenues was primarily due to a difficult LCD television market. To break the unhealthy cycle of glut and shortage, procurement managers need to stay calm when supply changes. But that is clearly easier said than done.”

The article offers no recommendations beyond remaining calm. Because supply chains and inventory requirements are so different in various sectors, comparing them is difficult. Generally, however, the editorial staff at Supply Chain Digest reports that “Days of Inventory Outstanding numbers [have] not [been] very good over [the] past six Years.” On the other hand, the SCD staffers report, “Real Progress [has been] seen in restaurant chains, multi-line retail and chemical companies.” [“Inventory Performance by Industry 2005 to 2010,” 27 July 2011] The article continues:

“SCDigest did some work to make the industry sectors a bit more consistent from how most would look at supply chain data, and also for the first time used average DIO to assess performance in each industry sector. … The [the annual working capital scorecard data from Hackett Group/REL] study defines Days [of] Inventory Outstanding as how many days of sales the company is holding in inventory, and which it defines as: End of Year Inventory Level/(total revenue/365). As such, it is sort of the reverse of inventory turns, in that a higher DIO, all things being equal, means poorer inventory management performance, while a lower number signals improvement.”

The magazine “published a graphic showing the year over year changes in DIO across some three dozen industries, which readers can find here: 2010 Days Inventory Outstanding Performance.” In addition, the magazine’s staff “took that analysis a step further … and looked at DIO performance across these same sectors from 2005 through 2010, the scope of the REL data.” The article continues:

“The results are very interesting, and are displayed in the graphic [contained in the article]. It lists each sector we analyzed, the number of companies in the sector, example companies in the group (or all companies if four or less in the sector), the companies with the lowest and highest DIO figures for 2010, average DIO totals for 2005 to 2010 for each sector (in reverse order), and finally the change for the sector from 2005 to 2010. … Here are our observations from this data:

  • “12 of the 40 industry sectors we reviewed decreased DIO 3% or more in 2010 from the 2005 totals
  • “11 sectors saw basically flat DIO changes of +/- less than 3%
  • “17 sectors saw DIO increase 3% or more over the period.
  • “There can be some aberations in the data. For example, the top improvement number among sectors over the period was the average 57.8% decrease in DIO in the personal care products category. However, the 2005 number was artificially high based on a very high number from Alberto-Culver, which in turn was probably the result of some accounting peculiarity.
  • “Restaurant chains, multi-line retail chains,and chemical companies seemed to make true and consistent progress in reducing inventory levels over the six-year analysis horizon.
  • “Conversely, among the sectors showing 3% or greater increases DIO over the period, most were up and down over the six years, not showing any particular pattern. The one exception is Aerospace and Defense, where there is a progressive increase in DIO over the period, for reasons not immediately clear. One possible reason is that the US Dept. of Defense in recent years has asked major suppliers to take on more direct responsibility for spares management, and perhaps that has affected the numbers.
  • “We are surprised the food manufacturing sector hasn’t seen more progress over the period, given the focus on inventory reduction in that industry in recent years.

“The bottom line is that few sectors have made real progress since 2005, for reasons that are not readily apparent. The sharp rise in oil prices during this time could be one factor, as companies decided to trade off more inventory to reduce transport costs. Many also point to the impact of offshoring, saying that flat inventory performance in the face of much longer supply chains is actually an accomplishment. Maybe so, but we think this overall performance needs further investigation.”

I may be mixing apples and oranges, but the thing that surprised me most about the SCD data (especially in light of the Financial Times‘ article that claims we are still experiencing a bullwhip effect), is that there seems to be so little inventory fluctuation over time in a number of economic sectors. Sectors that did experience major changes, beyond aerospace and defense which were mentioned above, include: automobiles, building products, communications equipment, paper & forest products, and personal products. I’m not as surprised about the defense and aerospace industries as the SCD staff. Considering that we are still involved in Iraq and Afghanistan, their future as a supplier to the DoD could be determined by how well they respond to defense needs in times of conflict.

I’m also not surprised that multi-line retail chains are doing well. Nordstrom has been singled out by many analysts for its innovative approach to inventory management (see my post entitled Supply Chain Helps Nordstrom’s Bottom Line) and retailer’s like Macy’s are putting a lot of effort into making supply chain more efficient. [“Macy’s Focuses on Supply Chain Efficiencies to Outperform Competition,” by Adrian Gonzalez, Logistics Viewpoints, 22 June 2011] Gonzales reports, “Rather than doing big replenishment buys, Macy’s is focused on ‘replenish to sales,’ which means smaller, more frequent deliveries to stores, but also less inventory.”

When the bullwhip effect cracks, it doesn’t ripple through every supply chain at the same time. It is experienced differently by specific supply chains. As a result, there are no “silver bullet” solutions that can make it disappear. Until true demand driven supply chains are implemented, the best that can be hoped for is better collaboration that will help dampen the consequences of the bullwhip effect. Brent Nagy of TMC, offers “5 tips for successful Demand Smoothing”:

“1. Dedicated Assignment. Asking a supply chain or transportation employee(s) to fit this forecasting and planning responsibility in amongst their day-to-day tasks typically does not work well. Assign someone who has time to make it a priority.

“2. Supplier and Carrier Collaboration. Give ample warning to vendors and Tier 1 carriers so they know what’s coming. Often, they can make their own adjustments to help with surges in your demand.

“3. Metrics Monitoring. Understanding route guide and tender, fill rate, CWT and visibility by way of track and trace and potential late loads all act as ways to manage and isolate areas of concern and success. …

“4. Use Proven Modeling Tools. While it seems simple, there is a science to Demand Smoothing. There are TMS-related technologies and processes that can be powerful tools.

“5. Project 100 Days Out. Work with sales and manufacturing teams on the inside and with suppliers and carriers on the outside to create a Demand Smoothing plan that looks out 100 days.” [“Planning for the Bullwhip Effect,” TMC Managed TMS Blog]

Forecasting, planning, and modeling are all important, but they can add to the bullwhip effect when they are wrong just like they can dampen it when they are right. Alluri Raju, Senior Project Manager, Steelwedge Software, believes that “trading partner collaboration will minimize the ‘Bullwhip Effect.'” [“Lean Manufacturing Principles: Fundamental to Successful Enterprise Planning and Performance Management,” Perspectives on Enterprise Planning, April 2005] He concludes:

“The most effective way for manufacturers and suppliers to minimize the ‘Bullwhip Effect’ in the Supply Chain is to gain a clear understanding on what drives demand and supply patterns and then, collaboratively work towards improving information quality and compressing cycle times throughout the entire process.”

In the six years since Raju penned those sentiments, the call for more and better collaboration has only grown. Most supply chain analysts recognize that we are moving toward a demand driven supply chain and, when it is implemented, we can only hope that the bullwhip effect will be eliminated as completely as small pox.