The Bullwhip Effect and How to Manage It

The bullwhip effect is a supply chain phenomenon related to sudden changes in demand signals, when a slight movement in demand can cause large swings throughout the supply chain. To avoid a destructive “whip crack” at the end, companies need to be prepared to mitigate the effect.

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Disruption has always been part of the challenges within supply chain management. When it occurs, managers must respond in a way that doesn’t result in too much or too little inventory. These disruptions can be managed by adjusting forecasts, purchasing agreements, and logistics decisions in normal times. But recent waves of disruptions have created a tsunami of disruptive forces.

Trade wars, tariffs, natural disasters, canal blockages, and other large-scale disruptions within the last few years were already underway when 2020’s COVID-19 pandemic took disruption to a whole new level. And while the world economy is slowly emerging from the chaos that ensued, new disruptive forces such as congested ports, labor shortages, shipping shortages, and odd demand patterns have taken root.

As supply chain managers struggle to respond to this new reality, new patterns are taking shape that must be considered in supply chain management.  However, one traditional problem remains and has become an even more significant danger because of these forces.  That problem is known as the bullwhip effect.

What is the Bullwhip Effect?

The bullwhip effect is a term used to describe a phenomenon related to demand signals.

We, humans, often tend to ’feel’ that small fluctuations from the norm will average out, and therefore, they do not matter. The bullwhip effect examplifies that when there is a tightly connected chain of interdependent events, the exact opposite is true. Instead of cancelling each other out, these many small deviations will add up and amplify, cause new deviations down the line and at the end may cause things to completely fall apart.

The analogy is related to a whip, where a small movement of the wrist is converted to large movements of the whip, which will cause the end of it to exceed the speed of sound and produce a destructive „crack“.

Demand is measured by the point of sale or use by customers. If that demand is suddenly higher or lower than usual, panic ensues if a company’s demand forecasting and planning system isn’t equipped to manage such variation. And in that panic where demand suddenly spikes upward or downward, this can trigger a chain reaction.

When this chain reaction occurs, the next immediate participant upstream in the supply chain will either over or undercompensate for the change in demand by a disproportionate margin. This reaction is followed by a similar disproportionate response by the following participant or vendor in the chain.  

This series of overreactions continues backward in the supply chain until that demand signal has been grossly amplified beyond reality.  Studies have shown that fluctuations as small as +/- 5% can move backward in the supply chain, where the cumulative change can result in as much as a +/-40%.

The bullwhip effect can often work in both directions, meaning that once an over or under-estimation occurs, supply chain participants then begin overcompensating in the opposite direction. In such cases, a company’s supply chain can collapse on some or all of its required material or components.  

What causes the Bullwhip Effect?

The bullwhip effect begins as a normal increase in demand signals. It is the response of the people within the supply chains to various vendor structures and the tendency for those players to look at safety stock or to create a guess at a lower stock level that starts the chain reaction.  

Causes of the bullwhip effect include:

• Demand forecast updating – As members of the supply chain begin to adjust their forecast to compensate for a significant swing upwards or downwards, they use data from the previous person in the chain. This updating can occur multiple times by supply chain members.  With longer chains, the size of the miscalculation is much greater. The new vendor production targets do not reflect the original demand signal by the end of the process.
• Order batching – Like forecast updating, order batching results from human decision-making done on the fly. The reasons may be to accommodate shipping and logistics issues such as full truckloads (FTL), equipment setup times, or inventory handling procedures. As more members round up or down, the more the demand signal is distorted.
• Fluctuating prices – Fluctuations due to inflation or seasonal stock drawdowns or ramp-ups may impact the bullwhip effect. Often during holiday seasons, retailers will increase orders significantly based on their internal sales research. Or they may conduct sales and discounting to reduce stock that is not moving or make room in the warehouse for new goods. All of these can read as a spike in demand and trigger the bullwhip in the upstream. It becomes even more challenging for the suppliers to understand when order quantities vary greatly.  The result is further adjustments to forecasts making them more inaccurate.
• Rationing and gaming – In tight supply times, many vendors will deliver smaller percentages of orders placed by the downstream customer. This delivery mode may be because they are capacity strained and trying to service more customers than they can handle with current production. It may be an attempt to reduce order quantities until their upstream supplier can deliver more components. When this rationing occurs, downstream customers may try and game the system to obtain their needs. They do this by upping the total order so that the percentage they receive covers their sales order position. Over time, they may reduce the overall order once they have received stock that meets their actual demand.
• Technological capability – Supply chain management was traditionally done with handshakes, face-to-face communication or phone calls, faxes, and email.  It consisted of the use of spreadsheets and a lot of human guesswork. And each member of the supply chain may have a different level of technological capability also. When this happens, one member may be using sophisticated software while their upstream supplier uses spreadsheets, and another upstream supplier uses an outdated on-premises MRP. This causes communication issues and means that the vendor’s data is either in error or is time-lagged.

Managing the Bullwhip Effect

The most effective tool for combatting the bullwhip effect is by using software. Most MRP and ERP systems will have native functionality that allows tight inventory control barcoding and inventory automation. This type of software also has functionality for managing and automating purchasing. It can forecast with near real-time data to accurately predict actual demand signals and develop achievable production schedules.

The extreme type and effect of disruption seen by today’s supply chain professionals mean that any company operating with spreadsheets and human intuition is more likely to cause the bullwhip effect. With robust ERP, MRP, or supply chain management software, the bullwhip can be managed effectively by:

• Improving communication – Linking suppliers across the supply chain gives all members end-to-end visibility of actual demand based on sales. This data is analyzed and applied to production at each vendor’s factory, where it can be further tied to BOMs and quality data.  Automating with software un-siloes the data and makes it accessible to all members, increasing collaboration and trust.
• Sharpening strategic planning – While stable demand allows some companies to operate with a push inventory, fluctuating demand may require a pull system.  It is critical that software contains functionality that allows for optimized inventory that is tied to accurate on-hand, where-used, and allocated buckets within production. It also allows companies to further automate through bar codes and scanning to track WIP and pipeline inventory.
• Ending order batching – Most modern MRP software can take multiple variables and inputs into account and create accurate forecasts and production schedules. This software may require the removal of human intuitive decision-making and allow for automated purchasing at levels that reflect actual demand. For example, if a planner rounds up or down to save $250 on a truckload of inbound stock and that decision causes a bullwhip effect that results in $2500 of unneeded inventory over time, the savings are negative. The software can link and automate this process and provide holistic reporting for accurate inbound quantities that reflect demand and not convenience.
• Eliminating rationing and gaming – MRP and ERP software accurately store historical data but combine it with near real-time production data to give demand a dynamic and continuously updated picture. This system also allows for perpetual inventory management. Hence, companies are always aware of their COGS and can build confidence in the automated adjustments so that they won’t overreact and trigger a bullwhip effect.

The bullwhip effect can be a devastating problem for manufacturers.  It causes confusion and creates shortages or overstock in warehouses; it impacts production output and can result in either the loss of cash or in cash flow restrictions by locking up operating capital in the form of inventory. Today’s ERP and MRP systems contain robust functionality that helps automate purchasing, optimize inventory, and link and analyze demand through production processes and BOMs.

Key takeaways

• The bullwhip effect is a supply chain phenomenon that occurs when a slight movement in demand can cause large swings throughout the supply chain.
• When demand suddenly fluctuates and a company’s demand forecasting and planning system is not equipped to manage it, panic could ensue, triggering a chain reaction where each following supply chain participant will disproportionately over- or undercompensate for the change, amplifying the fluctuation far beyond reality.
• The bullwhip effect can happen in both directions and it may end with a supply chain collapse.
• Factors that can cause a bullwhip effect are: demand forecast adjustments, order batching, fluctuations in prices, rationing and gaming, and uneven technological capabilities of the supply chain participants.
• Bullwhip effect can be mitigated with better communication practices, more effective strategic planning, by ending order batching and eliminating rationing and gaming.
• A good tool for managing the bullwhip effect is an ERP/MRP system that helps mitigate it by providing better communication, increasing the effectiveness of strategic planning, ending order batching and eliminating rationing and gaming.