Taming the Bullwhip Effect

"The best laid plans of mice and men..."

By Ram Reddy

On average, a firm loses anywhere between 9 and 20 percent of its value over a six-month period due to supply chain problems, according to a Georgia Technical University study. The recently conducted study focused on the relationship between a firm's supply chain system failures and its stock price.

The study also states that most evidence of return on investments from supply chain systems is anecdotal at best. A firm with supply chain problems suffered loss in value, irrespective of who or what was to blame - supply chain partners, software, and so on.

My personal experience in designing and implementing supply chain systems has led me to support the study from Georgia Tech along with the re-worded assertion that successful supply chain system implementation is necessary to realize substantial bottom-line benefits. Some firms I worked with faced part shortages, excessive finished goods inventories, underutilized plant capacity, and runaway transportation and warehousing costs despite successful installation of best-in-class supply chain management (SCM) systems. A major cause of these problems was the "whiplash" or "bullwhip" effect in supply chains. The bullwhip effect occurs when information about the demand for a product gets distorted as it passes from one firm to the next across the supply chain.

One factor responsible for the bullwhip effect is the traditional commission or incentive structure for sales and marketing personnel. In most firms sales and marketing departments rule, so efforts to change traditional sales commission practices to support SCM objectives have mostly been futile. Touting benefits from reduced shipping costs or effective plant utilization doesn't have the same pizzazz with executives and the financial community as a 15 percent increase in sales. Finally, a measure of SCM failure can make the case for removing a major cause of the bullwhip effect - sales incentive practices.

Synchronized Plans

SCM covers the process and technology of coordinating the uninterrupted flow of raw materials and products across the supply chain. Its goal is profitable utilization of every supply chain firm's resources. There are three areas that traditionally comprise SCM: supply chain planning (SCP), supply chain execution (SCE), and supply chain transaction (SCT) systems.

SCP systems let your firm generate various demand forecasts for a product and develop supporting plans to source and manufacture across the supply chain. The plans direct SCE and SCT systems to manage the detailed operational tasks such as scheduling the production facilities, releasing the purchase orders, and managing warehousing and transportation functions. SCM systems translate high-level strategic plans (from SCP) into weekly and daily tactical action plans using SCE or SCT systems. SCM tightly synchronizes these plans and stages materials at various partners across the supply chain to support the successful execution of these plans. Are they so tightly synchronized that firms can't respond to changing market conditions for the product? Most SCM systems let you change plans to meet market conditions. However, misaligned sales representative incentives frequently have the effect of throwing the proverbial wrench into this well-oiled machine.

Cause and Bullwhip Effect

SCM systems generate demand forecasts for a planning period, such as a quarter, month, or week. Participating sales representatives generate the sales forecasts. Based on these forecasts, the SCM systems stage, source, and schedule production and distribution facilities to meet your forecasted demand. Unfortunately, the sales force often changes the order quantities for a product before the close of the planning period. These deviations from the forecast are significant enough to cause a mismatch between what your company planned for production and what is actually needed to meet the amended orders. The deviations from the planned number of sales orders ripple through the supply chain, causing the bullwhip effect.

Amended sales orders exaggerate deviations as the information travels up the supply chain. If I am a component supplier one step up the chain, I will order raw material to build additional components and procure some material for safety stock. Next, my supplier will add its own safety stock to my amended order. These changes will continue up the supply chain, magnifying the original small deviation from planned orders. These oscillations cause all the firms in the supply chain to revamp their sourcing, manufacturing, and distribution plans. They now scramble to get additional raw material, add production lines, and restock distribution lines to meet the amended sales order quantities.

As a result of these oscillations from the bullwhip effect, firms across the supply chain are saddled with excess inventory, procurement cost overruns, additional warehousing and shipping costs, and most importantly, quality problems. The upstream firms have the option of taking the loss resulting from amended orders or passing on the costs by reducing other product attributes. Component quality is the biggest casualty of rush orders. Distributors or retailers often return products manufactured to meet the amended demand signals, thus placing additional burden on the supply chain.

Supply and Actual Demand

Sales personnel place last-minute changes to orders before the end of a quarter or a period for which they are measured for sales commissions. If the salespeople find that they have not met their target to qualify for the bonus, they get one of the indirect channel partners, such as a distributor or retailer, to place an additional order that would qualify them for their sales commission. The indirect channel partner cooperates with the salesperson, knowing that in times of short supply they can count on the salesperson to provide them with more than their allocated share of product. These types of gaming situations result either in significant quantities of returns or shortages for the less connected indirect channel partner.

The pricing and promotion policies followed within a firm are another factor that distresses supply chains. Frequent markdowns and sales to move product from distribution channels create havoc on the supply chains. The demand signals fed into the SCP systems from clearance sales and price markdowns not only train the customer to wait for such events before buying, but also compound the overstocking problem by getting the supply chain to overreact to the sudden stock shortage situation caused by a clearance sale. Certain strategies can dispose of excess inventory without causing the bullwhip effect. For example, you can rationalize demand signals from clearing excess inventories before you enter the data into SCM systems. In this area, the sales and marketing function can have an adverse impact on the realization of ROI from SCM systems.

Changing the sales commission and incentive structures and educating the marketing and finance functions on the impact of their pricing and promotion policies can help fight the bullwhip effect. In the past, it was difficult for the IT or supply chain manager to make a case for changing this behavior. The typical response from the salesperson would be, "If you don't fill this unplanned order, we will lose this customer. Do you want that on your head?" Rest assured, anyone who valued his or her career would not argue. However, the findings from the Georgia Tech study give some ammunition for changing age-old sales commission, pricing, and promotion practices. The effect on the firm's valuation provides a powerful argument.

Potential Remedies

You are fighting for a lost cause if you try to sell the idea of changing sales commission practices by touting the benefits from SCM implementation. It is tough to measure the benefits because efficiency gains are spread across all supply chain partners. Efficiency improvements from SCM system implementation will never be able to compare to the cachet of improving your sales by 15 percent. You are more likely to succeed by using the threat of a possible decline in the firm's valuation.

A simple remedy is to count only the money realized from a sale toward the commission targets of the sales staff. Of course, your sales executives would object and argue that they would lose their top performers. The "intelligent" manager can now demonstrate that those top performers in sales actually hurt the firm due to supply chain disruptions. Another approach would be to space out sales targets evenly over shorter periods to avoid the bullwhip effect.

Similarly, there are strategies to move product from store shelves without sending false demand signals up the supply chain. What was lacking before was a compelling and quantifiable reason for implementing these strategies. The Georgia Tech study goes a long way to make a quantifiable case for changing the sales practices that disrupt the supply chain.

Ram Reddy, [ramreddy@tacticagroup.com], is the author of From Supply Chains to Virtual Integration (McGraw-Hill, 2001). He is the president of Tactica Consulting Group (www.tacticagroup.com), a technology and business strategy consulting firm.

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