Bullwhip effect: fluctuation in demand due to corona

It is widely known that misinterpretation or a lack of meaningful data along the supply chain can lead to the bullwhip effect. But what exactly does this mean and what are the specific effects? In this article, I would like to give you an overview of the bullwhip effect and the following questions:

1. What is the bullwhip effect?
2. What causes the bullwhip effect?
3. How can I counteract this with the right measures?
4. What should be done in the current situation?

The bullwhip effect

The bullwhip effect is a key topic within supply chain management. It describes how fluctuations in demand from the end customer build up within the supply chain. At the end of the supply chain, the producer of the goods is notified of an excessive order quantity. This leads to supply bottlenecks, higher stock levels and dissatisfied customers. During the coronavirus crisis, the mechanics and impact of this effect could be clearly observed using the example of simple household items such as toilet paper.

We would like to illustrate the effect using a simple model. Let’s imagine an ideal supply chain consisting of a producer, the producer’s central warehouse, a wholesaler, a retailer and the retailer’s end customers. Information and goods are exchanged between the players, whereby information is transferred much faster than goods are transported.

Example toilet paper

In our example, there is a demand shock and the customer unexpectedly buys a lot of toilet paper. The retailer reacts and increases his order with the wholesaler. However, they increase their orders disproportionately as they know that it will take time for the goods to arrive. The retailer is determined to meet future customer demand and therefore orders more than the actual demand. This effect continues throughout the supply chain. At every stage of the network, the order quantity is higher than the quantity actually demanded. The following diagram shows the progression of these order quantities and the resulting storage costs.

In this example, the customer constantly buys the same amount of toilet paper until period 5. A shock occurs in period 6 and the customer’s demand doubles. As a result, the wholesaler begins to increase its order quantity. The upstream value-added stages have no knowledge of the increased order quantity and initially keep their quantities constant. The bullwhip effect can then be seen in period 9. The order quantities at the distribution center and producers increase sharply. A second build-up can also be seen in period 13.

The consequences of this ordering behavior are additional inventories and the associated warehousing and opportunity costs, as the full demand cannot be met at every stage. In the course of the costs, it can be seen that the costs for all participants increase at the same time as the order quantities increase in period 9. The consequence of the bullwhip effect is therefore higher costs for all participants in the network. But why does the bullwhip effect actually occur? Why is there suddenly a demand shock?

Causes of the bullwhip effect

There are a number of factors that promote an undesirable build-up in supply chains. We would like to explain four reasons below.

Processing of demand signals

A one-off increase in customer demand is often misinterpreted as a signal for a permanent increase in future demand. This effect occurs above all when there is insufficient data on past demand or the available data is incorrectly evaluated. In addition to external, singular events such as the current coronavirus crisis, this effect can also be caused by incorrect planning parameters in a customer’s ERP system.

Order bundling

Companies have a great interest in minimizing their fixed order costs and taking advantage of graduated prices or volume discounts. They therefore tend to bundle orders. It is then difficult to forecast demand for items that are often bundled. The upstream stages in the supply chain in particular have problems with this, as they do not know which end customers prefer to bundle orders and which do not.

Bottleneck poker (hamster purchase)

If customers fear supply shortages, they will buy significantly larger quantities. This effect can be observed in the coronavirus crisis for toilet paper, for example. The increased demand accumulates across the stages of the supply chain. If these quantities are used as a benchmark for future demand and the demanded quantity is met, this leads to an extension of order intervals and an increase in inventories and therefore also costs in subsequent periods if there is no demand.

Price fluctuations

If a customer expects prices to rise in the future, he will increase his order quantity. However, the higher demand is not due to higher demand; in fact, the customer has merely increased his stock. In subsequent periods, he will order less. Therefore, even in this case it would not be advisable to increase production in the upstream areas.

Countermeasures

There are countermeasures for each of the aforementioned causes of the bullwhip effect. They can be divided into four categories: transparency, trust and good business relationships, high data quality and demand chain management.

Transparency

Transparency in the supply chain is the most effective measure to counteract the bullwhip effect. If everyone involved knows what customers and suppliers will demand in the future, everyone can better adapt to demand. To this end, it is important that all players in the supply chain share their knowledge. This can be achieved by sharing supply chain key figures, for example.

In addition, it is possible to link data from the respective ERP systems in such a way that CPFR – Collaborative Planning, Forecasting and Replenishment – is possible. This means that joint planning takes place across all stages of the value chain in line with actual demand. During the coronavirus crisis, SAP, for example, is offering its Integrated Business Planning service free of charge.

Trust and good business relationships

Another important measure to reduce inventory, increase customer satisfaction and avoid the bullwhip effect is mutual trust and good business relationships. As mentioned in the previous paragraph, if you want to share your knowledge about current and future demand, you need to be able to trust your partner’s data. Only then can all players in the supply chain optimize themselves. In addition, it can often make sense to conclude framework agreements on the basis of a good business relationship. This gives all parties greater certainty about future orders and deliveries and allows them to plan better.

High data quality

In today’s world, high data quality in all respects is immensely important for a company to be successful on the market. High data quality and the correct interpretation of data also helps to prevent the bullwhip effect. Forecast data or scheduling parameters, for example, determine which material is manufactured or ordered in which quantity.

However, if, for example, MRP parameters such as XYZ indicator, replenishment lead time, reorder point, safety stock or MRP procedures are maintained incorrectly, fluctuations in demand may be interpreted incorrectly. You should therefore check your MRP parameters at regular intervals. It is also a good idea to analyze the planning and scheduling processes and examine them for weak points. You can do this with the help of process mining, for example.

Demand Chain Management

Most companies focus on the supply chain (demand side) when combating the bullwhip effect. However, you should also look at the demand chain (market perspective). The better your information about the market, the more accurate your forecasts can be. Customer service, for example, can play an important role here. If you have precise data on the condition of the products you sell, you will know when spare parts are needed or when a complete replacement investment is due. Combining demand chain management and supply chain management in the direction of end-to-end sales and operations planning therefore helps you to optimize inventories and prevent the bullwhip effect.

Measures in the current situation

The current coronavirus situation poses major challenges for many supply chains in numerous industries. However, the right approach can mitigate side effects such as the bullwhip effect.

Finally, let’s look at the example of toilet paper again. In the following chart, you can see the demand for soap, disinfectant and toilet paper in the retail sector at the beginning of 2020. There is a demand shock for all items between week 9 and week 12 (in week 12, demand is three times as high). After that, however, there is a slump in demand.

You can see the result of the slump in the following photo from week 17. Retailers have accumulated large stocks of toilet paper and, as in this example, have to place their goods in front of the store and sell them at a special price. The bullwhip effect has taken full effect here.

What can you do specifically to prevent this from happening to you? Consider whether the orders you receive are sustainable and should therefore be incorporated into your planning as a clear signal of demand. Look at markets where the situation is already easing. In China, production is starting up well again. Pay attention to sales there and draw conclusions for your products.

Also talk to everyone involved in your supply chain to clarify who can supply which products in what quantities and where there are problems. Also pay attention to the end customer. If there is a sudden demand for unusually large quantities of a product, you should also talk to the end customer and discuss extending the orders. This is the only way to prevent a build-up across the various stages of the supply chain.

Summary

To avoid the negative effects of the bullwhip effect, you should take the right countermeasures. Focus on transparency in the supply chain and ensure that you achieve an overall optimum in your supply chain with good supplier management.