Supply Chain Management & The Paralyzing Curse of the Bullwhip Effect

1. Supply Chain Management & The Paralyzing Curse of the Bullwhip Effect Mark Van Oyen Loyola University Chicago School of Business (Based on material from Burak Kazaz and David Simchi-Levi)

2. What is Supply Chain Management? • Efficiently integrating suppliers, manufacturers, warehouses, and customers so that products are produced and distributed at the right quantities, to the right locations, and at the right time, in order to minimize system wide costs while satisfying service level requirements. • every player in the system has to be considered • minimize costs across the system • efficient integration includes all activities from strategic to operational level • information flow is upstream (from retailer to supplier), but product flow goes downstream

3. A MULTI-ECHELON SUPPLY CHAIN • Suppliers (Duracell, Motorola, Barrels) • Manufacturer (Laser Focus) • Wholesalers • Retailers, e-commerce (Office Max, Office Minnie, SkyMall)

4. Suppliers Manufacturing Warehousing Customers A MULTI-ECHELON SUPPLY CHAIN

5. Logistics Example: • Triple Crown Services • Trucking • Volumes of Routes • Shown by Lines

6. DIFFERENT Ideas of Inventory • Suppliers & Manufacturers • MTO (Make to order) using MRP II (ERP), APS, or custom • MTS (Make to stock) using MRP II, custom, or JIT (Kanban, CONWIP, etc.). Note that JIT demands a stable production flow. • Wholesalers & Retailers • Maintain inventory to avoid stockout. Forecasting, inventory theory, & judgment used to determine order quantities and timing of orders (recall ROP).

7. Supply Chain Examples • It takes a box of cereal 3+ months from factory to supermarket. Efficient Consumer Response (ECR) initiative – (by Kurt Salmon Associates) - estimates $30 billion opportunity by streamlining grocery supply chain • Travel time for new car from factory to dealership < 5 days; yet the typical lead time including waits is 15 days. • Matching supply and demand: “Boeing lost $2.6 billion in Oct. 97 due to raw material, internal, and supplier shortages…” (W.S.J., 10-23-97) Supply chain management is closely tied to strategic partnerships and logistics (cross-docking logistics & inventory practices at Walmart helped them beat Kmart)

8. THE BULLWHIP EFFECT Demand information in a supply chain is often distorted from one part of the chain to the other. Such distortions, known as the bullwhip effect, can lead to deadly inefficiencies of a supply chain: • excessive inventory investment • poor customer service • lost revenues • misguided capacity plans • inefficient production and transportation schedules

9. PROCTER & GAMBLE (P&G) P&G Pampers disposable diapers - best selling product • sales of the product at retail stores were fluctuating, but the variabilities were not excessive. Reason & data suggest that diaper sales should be fairly constant because birth rate is constant over a year! • orders placed by the distributors to P&G exhibited a much greater variability • P&G orders to supplier, 3M, had even greater swings and variability!

10. THE BULLWHIP EFFECT

11. THE BULLWHIP EFFECT

12. THE OUTLINE 1. How did this come about? 2. What can companies do to mitigate the effect?

13. HEWLETT-PACKARD (HP) LaserJet III sales at a major reseller • expected variations with an underlying trend, based on the product’s life cycle phase • orders placed by this reseller showed much bigger swings and variations around the same trend • orders placed by the printer division to the company’s integrated circuit division had even worse swings “Crack that WHIP! You’ve got to whip it, whip it good …” from Whip It by Devo

14. WHIP IT! Demand propagates from the lower levels of the supply chain (consumer end) to the upper levels (supplier end). Unfortunately, variability does the same and is amplifiedby each echelon of the chain. Terms for this include • Information distortion • Bullwhip Effect Modest movement at the whip handle (representing consumer demand fluctuations) leads to wild swings at the whip’s tip (demand experienced by the supplier). Bullwhip cracks are loud because of the Doppler effect (e.g. as seen visibly in a boat’s wake) which generates a small sonic boom as the whip tip breaks the sound barrier at about 800 mph. The supply chain bullwhip crack can be heard through bankruptcy filings as vulnerable suppliers and manufacturers experience deadly cash flow variability.

15. CAUSES OF THE BULLWHIP EFFECT 1. Demand Forecast Updating 2. Order Batching 3. Price Fluctuations & Promotions 4. Shortage Gaming (Inflated orders during shortages) Others: • Long lead times (increase variability) • Ineffective IT or lack of partnerships keep everyone starved for real, consistent information

16. DEMAND FORECAST UPDATING Use of immediate downstream order data as a signal about the trend of the market demand by each entity in the supply chain. (This is myopic, but limited information prevents suppliers from looking all the way down to point-of-sale demand!) Example: Wholesaler experiences variability/noise, but thinks they perceive/hear an increased demand trend, so they further inflate/crank up the volume on order quantities in anticipation of trend. The result is an amplification of noise transmitted up the chain! Principle: Extrapolation (projection) amplifies noise [e.g. lin. Regr.]. Interpolation (averaging) attenuates/reduces noise [e.g. exp. Smoothing & MA].

17. ORDERS PLACED BY COMPUTER RETAILER TO MANUFACTURER Trend Line Exp. Smoothing used for forecasting, which leads to revised Safety stock levels. See effect above in change from dealer orders to Manuf. orders.

18. ORDER BATCHING • P&G estimates that many manual interventions needed in its order, billing, and shipment systems, result in a processing cost of $35-$75 per invoice. [ERP opportunity!?] • Many companies use forecasting, inventory theory, and judgment to order quantities on a periodic basis, e.g., weekly • Many suppliers receive purchase orders (PO’s) generated by MRP systems, which are often run monthly, resulting in a monthly order cycle to suppliers. This synchronization of order cycles across many companies (e.g. end of month) causes a severe bullwhip effect, called MRP-jitters. • Economical, full-truckload (FTL) vs. less-than-truckload (LTL) rates encourage larger, less-frequent orders. [Tradeoff exists between amount of inventory carried and transportation costs!] • Sales incentives are often structured around the measurement of salespeople on a regular basis, such as quarterly or annually.

19. PRICE FLUCTUATIONS • Price discounts, quantity discounts, coupons, and rebates (55%) manufacturer’s trade deal offered to the distributor/wholesaler (25% of the total marketing budget of US industries in 1991) • Overstocked!  sale consumers stock up; Understocked!  no sale! consumption drops • Distorts the information regarding the consumption pattern of the customers, introduces more uncertainty • Promotional pricing offered by the manufacturer. Retailers, distributors respond with forward buys. (e.g. $75 to 100 billion worth of them (75%) in the grocery industry!) • Campbell’s Chicken Noodle Soup reflects a seasonal demand pattern. The shipment quantities from Campbell’s to the distributor had a much wider swing due to the price discounts. Fortune article cited such a practice as “the dumbest marketing ploy ever.”

20. SHORTAGE GAMING • Potential shortages of key components or the product itself can trigger the bullwhip effect. • Rationing scheme: the allocated amount is proportional to the amount ordered. Provides incentive for customers to “exaggerate” their real needs, placing“phantom orders”. Later, when the demand slows, phantom orders suddenly disappear as cancellations pour in. • E.g: 1992 and 1993 Xmas shopping season, Motorola unable to meet demand for handsets and cellular phones, forcing many distributors to turn away business. Distributors like AirTouch Communications and Baby Bells, anticipated the possibility of such shortages in 94 and acted defensively, drastically over-ordering at end of 1994 (Business Week, March 6, 1995). Once Wall Street learned that dealers were swamped with inventories and the new orders were phantoms, Motorola’s stock tumbled almost 10%! Same story applies to IBM Aptiva.

21. COUNTER ACTIONS • Avoid Multiple, Conflicting Demand Forecast Updates 1A. Use strategic partnerships to share information across the supply chain. • Heinekin Beer – uses local weather forecast information at retailer locations to anticipate demand! • Giving suppliers point of sale (POS) information (or at least sell-through information from resellers) on demand in near real-time allows much more accurate demand forecasting by suppliers and allows them to spot phantom orders. • EDI helps reduce “information lead time” Use exceeds 67% of manufacturers, 65% of distributors, 40% wholesalers. • Still, having conflicting forecasts still leads to problems unless we …

22. COUNTER ACTIONS 1A cont’d. Move from a “PUSH supply chain” to a “PULL supply chain” • PUSH supply chain: A manufacturer uses orders from the warehouses (not the retailers) to forecast customer demand. It therefore takes much longer to react to changing marketplace. • PULL supply chain: A manufacturer’s forecasts are driven by actual customer demand at the retailer, leading to • Better forecasts • Reduced “Information flow lead times” result in reduced overall lead times and hence the warehouses can carry less inventory! • Decreased variability faced by manufacturers enables reduced inventory levels across the supply chain.

23. COUNTER ACTIONS 1B. Agree upon a common forecast of demand & coordinated buying practices • Collaborating on a forecast enforces consistency across the supply chain. Although a single enterprise which subsumes the entire supply chain (i.e, a vertically integrated company) can do it, how do independent companies achieve agreement? • JIT proposes replacing the competitive relationship of manufacturer to supplier based on getting the lowest cost with a cooperative relationship which places greater importance on supplier quality. • VMI = Vendor Managed Inventory [HP, Motorola, Apple, TI, P&G]; CRP = Continuous Replenishment Program [Campbell, Mars, Nestle, Quaker Oats, Nabisco, P&G] [If you fail to plan, you are planning to fail!]

24. COUNTER ACTIONS 2. Break the Order Batches (and Reduce Lead Times) • EDI-based information transmission, lower the transaction cost; CAO = computer-assisted ordering (< Info. Lead time) • Third party logistics for small companies can avoid large order sizes; or balanced replenishment coordinated with supplier (< production & shipment lead times) • P&G gives discounts for mixed-SKU loads (LTL< FTL) 3. Stabilize Prices (supported by ABC – Activity Based Costing) • Every Day Low Price (EDLP), e.g. P&G, Kraft, Pillsbury. • P&G’s Value Pricing worked wonderfully. P&G aggressively slashed the promotions to trade customers by 12-24 % between 1992-94: In 1994, highest profit margins in 21 years. 4. Eliminate Gaming in Shortage Situations • An alternative allocation rule is to allocate in proportion to the past sales records, not amount ordered (e.g. GM, TI, HP)

25. Design for Supply Chain Mgmt. • Postponement: design the product and the mfg. process so that differentiation can be delayed until mfg. is underway Benetton knitwear • stores place orders 7 months earlier due to long leadtime • process: get yarn; dye; finish; mfg garment; join parts => little flex. • Delay: get yarn; mfg garment; join parts; dye => 10% more expensive, requires new equipment, but compensated by better forecasts, lower surplus inventories, and higher sales • Hybrid approach: most manufacturing done in traditional manner (conservative forecasts), then use flexible/more costly process to fill in according to demand.

26. Design for Logistics - HP • [OLD] HP DeskJet sold to Europe; LT (lead time) ~ 4-5 weeks • Mfg in Vancouver, LT ~ 1 week; customize for markets, including manuals and power supply in Vancouver • High inventory at US and Europe; different manuals Postponement: Ship unlocalized printers to Europe, localize at the dist’n center (DC). • Inventory models show 35% inventory decrease ~$1M/y • Change mfg process so that power supply modules can be installed in Europe; language-specific decals attached locally. • Other issues: insurance; freight cost; goodwill

27. Strategic Alliances (SA) - 3PL (Third Party Logistics) • SA: Goal oriented long term partnerships between two companies where risks and rewards are shared. • Third Party Logistics: use of an outside company to perform the firm’s material management and prod. dist. • From transaction based single function specific to SA • Saturn (GM) and Ryder: Saturn orders raw material via EDI, Ryder picks up the orders from 300+ suppliers and delivers to Saturn. Also, Ryder distributes cars to dealers. • Advantage: Core strength; 3PL have more flexibility to incorporate new technology and geographic locations. • Disadvantage: Loss of control/touch with the customer

28. Strategic Alliances--Retailer/Supplier • Quick Response: Supplier receives POS (point of sale) data to improve forecasting and scheduling & retailer gets delivery info. • Continuous Replenishment: Vendor receives POS data and uses data to prepare shipments to maintain previously agreed to inventory levels. • Vendor Managed Inventory (VMI): The supplier determines the inventory policies and maintains the inventory levels at the retailer. • Wal-Mart and P&G; Issue of Inventory ownership – move to “consignment” e.g. Wal-Mart no longer owns many items on the floor such as most of its grocery stock on the floor. e.g. Ace hardware lumber & mat’ls: service level up from 92 to 96% • Kmart’s 200 VMI partners by 1992. • Increased sales results and higher inventory turnover ratio

29. Summary • Supply Chain is a complex system (bullwhip effect is one important example) • Most of the problems are new • IT has been the driving force of improvements in SCM • There is room for huge gains for everybody • Dedicated management, effective communication, and strong IT backbone are the cornerstones