The Bullwhip Effect

The Diff, 2020-07-24

What is it and how does it look?

  • Def: a bullwhip effect is the observation that a small change in demand can lead to larger changes down the supply chain. [think of a literal bullwhip: a small flick of a wrist leads to a huge trajectory of the whip (aka a supply chain)]

  • The longer the chain, the more magnifications.

Toilet Paper Example

  • Crazy people buy all the tp. Retailers have to order much more (say, 3x) because of the negative impact on their image.

  • Tp manufacturers see that their orders are 3x. They increase their wood pulp order 4x to prepare for further demand spikes.

  • More trees harvested, planted, more equipment bought, etc.

  • Everyone stocks up for years ahead, and demand plummets. And then the reverse cycle starts. Rinse and repeat.

Why is all this?

  • Information asymmetry between links in the supply chain for a good with a value add.

  • Many industries are cyclical with different time scales for demand and supply (and different approaches to supply).

  • Cruise lines or airlines: plan demand based on the ‘business as usual’ models with capital outlays’ timing lagging the recovery. Hence, their suppliers (shipbuilders, Boeing/Airbus, etc) are even in a worse position as they supply those capital goods.

  • Information asymmetry is prevalent as it’s believed transparency reduces the strength of a negotiation position [now always correct, though].

How far can it go?

  • Bad news: being part of someone’s supply chain is being in a constant state of uncertainty (price-taking, no control over volume): boom or bust.

  • Good news: the longer the value chain, the less the bullwhip effect is pronounced.

o   “Gravity” (the longer the whip, the harder to move it) – increased use of multi-purpose raw materials to de-risk and have lower cost structure. Unless the materials are rare to obtain.

o   Effects can’t magnify indefinitely, mistakes diminish.

  • If your information consists of other people’s reactions, ask yourself: is everyone misreading things in the same direction?

Other examples

  • Supply chain of education (undergrad degrees). Lagging indicator, joining a uni at peak usually means graduating in a bust. Maybe vice versa, too.

  • Supply chain of US dollars. In many developing countries it’s cheaper/more reliable to borrow and transact in USD. Hence the demand for USD via banks —> central banks —> US Federal Reserve. Introducing layers of political and business risks.

  • Supply chain of opinions. Some writers are widely-read and rarely-cited due to many good ideas and poor filter for bad ideas.

  • Supply chain of hiring and management methodologies. Hires from big firms bring their methodology and philosophy —> amplification of big firms’ approaches (esp. including the hiring process) in smaller companies.

link