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Bullwhip Effect and

SC Partnerships

Ch 17 of Chopra

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Bullwhip EffectDistortion of demand information of a product while it passes from

one firm to the next across SC.» Misinterpretation» Unreliable EDI protocols» Loss during encryption / decryption» Buyback contracts: Rediform buysback planner from retailers. Its shipment data

is quite different from the planner of POS data. The retailers return a big chunk of the planners at the end of the season.

P&G found out that the diaper orders issued by the distributors have a degree of variability that cannot be explained by consumer demand fluctuations.– Diaper consumption should be stable with a low standard deviation.– P&G observed orders with a high standard deviation at the distributors.

At HP, orders placed by retailers to printer division have much bigger variations than consumer demands

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Bullwhip Effect

The information transferred in the form of “orders” tend to be distorted and can misguide the upstream in SC in their inventory and production decisions.

In particular, “variance of my orders” > “variance of my sales” – Or, variance of my production > variance of my demand

Information sharing in SCs is important– Sales Information deduced form the orders received from the

downstream should be used with great caution.

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Three causes of Bullwhip Effect

Suppose that we have three conditions– Finite supply shared by many retailers

» Rationing game: retailer orders more than demand

– Fixed ordering cost

– Wholesale price varies over time» Inflationary / deflationary environment

» Prices with no trend but variability

Each condition by itself leads to the bullwhip effect.

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The Rationing Game

Consider a product whose demand sometimes exceeds supply due to limitation in production capacity or uncertainty of production yield. – New, successful high-tech products

Manufacturer allocates capacity to retailers proportionally to their orders. – In order to secure more units, each retailer will issue an order which

exceeds in quantity what the retailer would order if the production is unlimited.

» IBM’s semiconductor manufacturing plants allocate capacity to products Memory, CPU, Telecommunication chips

» Units managing these products overestimate their orders.

Optimal order quantity for retailer in the rationing game exceeds the order quantity in the traditional newsvendor problem.

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Order Batching

Fixed ordering costs lump the demand together– Order in some periods in big quantities

– Ex. Given the demand rate of 1 per day. Suppose that ordering becomes infrequent with fixed ordering costs. What happens to the standard deviation of order sizes over a month of 30 days while the standard deviation of demand is constant at zero?

Order once

in 1 day

Order once

in 2 daysOrder once in 3 days

Order once in 4 days

Order once in 5 days

St deviation 0 1.017 1.438 1.799 2.034

Sales commissioned salespeople tend to close deals generally at the end of a period (such as a month or a year).

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Price Variations

Frequent markdowns or promotions by the supplier will distress SC. Smart retailers will wait for the lower price.

– Supplier’s demand will not be uniform because retailer shifts its orders to low price periods.

Overstocking will result Even when there is no price trends but variability, a risk sensitive

retailer will order in larger quantities to reduce the exposure to price variability.

» Southwest airlines buys jet gas in advance to reduce its risk exposure to oil prices

The reverse can be argued for a risk-seeking retailer. But many SC partners are not risk-seeking.

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Beergame results 2002

Factory DC W/H Retailer

112 93 71 46 Year 2002

46 45 48 47 Year 2002

50 51 51 51 Year 2002

Average demand=50, stdev=20, daily averages and stdev of orders:

Factory DC W/H Retailer

227 141 96 50 Year 2002

38 32 30 26 Year 2002

35 31 31 17 Year 2002

49 39 41 46 Year 2002

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Beergame results in 2005 Spring

Factory DC W/H Retailer

45 45 45 50 Year 2005

- 39 40 45 Year 2005

117 126 117 51 Year 2005

Average demand=50, stdev=20, daily averages and stdev of orders:

Factory DC W/H Retailer

32 38 16 18 Year 2005

- 41 19 18 Year 2005

127 143 122 15 Year 2005

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Further Reading on Bullwhip Effect

The Bullwhip Effect by Lee, Padmanabhan, Whang, Management Science Vol.43, No.4, April 1997

Forrester, 1961 pointed out that basic form and policies used by an organization can give rise to characteristic and undesirable behaviors in the supply chain.

Sterman, 1989 – “Beer Distribution Game” Economical point of view, Holt, 1960; Blinder,1982 and

Blachard,1983 Kahn,1987, positive serial correlation and backlogging

also results bullwhip effect.

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Is there really a bullwhip effect everywhere?In search of the bullwhip effect. Unpublished paper by Cachon, Randall and Schmidt

Claim is that there is not much empirical evidence for bullwhip effect.

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Is there really a bullwhip effect everywhere?In search of the bullwhip effect. Unpublished paper by Cachon, Randall and Schmidt

See the article for manufacturing industries.

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Information Sharing applications between SC members

Bullwhip effect propagates in an amplified form upwards the supply chain if each member processes order signals coming immediately from below.

Information sharing enhances SC in two fundamental ways– It enables supplier to respond consumer demand quicker by appropriately

scheduling production and replenishing retailer`s inventory» Continuous Replenishment Program (CRP)

» Vendor Managed Inventory (VMI)

– It improves accuracy of demand forecast» Collaborative Forecasting and Replenishment (CFAR) facilitates sharing of

both short term and long term demand forecasts between manufacturer and retailer

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Examples

Upstream partnerships: Cisco`s e-hub project, Cisco is able to see not only first tier supplier inventories but also second tier supplier inventories

3M, P&G, Wal-Mart Advance Information:

– Singapore Airport, flight schedule information is given to taxi drivers to reduce inside airport traffic

– Pre-registration at UTD

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Strategic Partnership (SP)

What is SP?– Idea is to achieve benefits of vertical organization with

independent companies by systematically driving independent players towards a single and common objective

» Use contracts to “align the misaligned objectives”

– It is not exclusive! What is SP not?

– Ownership– Franchising

» Franchising is exclusive

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Strategic Partnering: Types of SP:

Only POS: Retailer determines its order sizes and timing but in addition passes POS (point of sales) data to the supplier. POS improves Supplier’s forecasts.

– Recall the Japanese 7-eleven

Reverse Purchase Order: Retailer determines order sizes and timing after discussing with supplier. Suppliers often send their recommendations for order sizes and times, these recommendations are known as reverse purchase order.

– Panasonic (supplier) and BestBuy (retailer) decide on Bestbuy’s order sizes using the Reverse Purchase Order concept.

– Upside: Panasonic seems to be providing high service.

– Downside: Panasonic does not see the real demand.

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Strategic Partnering

Vendor Managed Inventory (VMI):

» VMI Projects at Dillard Department Stores, J.C. Penney, and Wal-Mart have shown sales increases of 20 to 25 percent, and 30 percent inventory turnover improvements.

» Continuous Replenishment: Vendors receive POS data and use it to prepare shipments at previously agreed upon intervals to maintain agreed levels of inventory.

Wal-Mart, Kmart

» Advanced Continuous Replenishment: Suppliers may gradually decrease inventory levels at the retailer’s store or distribution center as long as service levels are met. Inventory levels are thus continuously improved in a structured way.

Kmart

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VMI at VF and Wal-Mart VF headquartered in Greensboro, NC, engages in the design, manufacture, and marketing of

branded apparel and related products. The company offers its product lines under various brands, including Lee, Wrangler, Riders, Rustler, Vanity Fair, Vassarette, Bestform, Lily of France, Nautica, Earl Jean, John Varvatos, JanSport, Eastpak, The North Face, Vans, Napapijri, Kipling, Lee Sport, and Red Kap brands.

Its 2005 revenue is $6.5B.

VF does VMI with Wal-Mart. VF knows

– Wal-Mart inventories: VF ships to Wal-Mart when Wal-Mart inventories drop

– Wal-Mart store models: Each store’s demographics and psychographics (psychological characteristics of the consumers).

– Wal-Mart POS data: Somewhat useful for managing Latin America production, whose lead time is 4 weeks. Not so useful for far east production whose lead time is six months.

The North Face places three orders in a season to far east producers. The first order is small and it is for samples and sales people. The second order is larger and it is based on field research not POS. The last order, if necessary, is based on POS. Therefore, POS data are used to place the last order and to estimate the next season’s sales. The use of POS data increases as the lead times become shorter.

Source: “Planning at a Global Scale Pays off for VF corp.” in Supply Chain Leader, October 2006 issue, published by i2 corp.: 4-8.

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Strategic Partnering

Quick Response: Suppliers receive POS data from retailers, and use this information to synchronize production and inventory activities at the supplier. In this strategy, the retailer still prepares individual orders, but the POS data is used by the supplier to improve forecasting and scheduling.

– Good example: Milliken and Company: The lead time from order receipt at Milliken’s textile plants to final clothing receipt at several of the department stores involved was reduced from eighteen weeks down to three weeks.

– Bad example: Ordering a bridal dress from far east; lead time is 4 months

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Main Characteristics of SP

Criteria Types

Decision Maker

Inventory Ownership

New Skills Employed by suppliers

With POS and Quick Response

Retailer Retailer Forecasting Skills

VMI Supplier ? Inventory planning Continuous

Replenishment To Contractually Agreed

Levels Either Party

Forecasting & Inventory Control

Advanced Continuous

Replenishment

To Contractually agreed & Continuously Improved Levels

Either Party

Forecasting & Inventory Control

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Requirements for Effective SP

Advanced information systems

– Information Technology is a mean for SP not an end.

Top management commitment

Common standards and culture

Mutual trust

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Incentives to lie Think of a consortium of three companies (A,B,C), which

collects data from its members and publicizes industry trends based on this data.

Let us say that the industry trend is the sum of the sales (SA,SB,SC) made by A,B,C– Suppose that these sales are respectively sa, sb, sc– But company C lies and reports a sale of sc+x, while A and B tell the

truth to the consortium– The sum now becomes sa+sb+sc+x and that is what is announced by the

consortium– However, the true sum is sa+sb+sc– Which of the companies know the correct sum after the consortium’s

announcement?– Does any company have incentive to report the sales truthfully?

Unanswered question: What information sharing mechanisms prompt the companies to truthfully share their data? Are there incentive compatible data sharing mechanisms?

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Do banks report lower Interbank Loan Rates?Is Libor (London inter-bank offered rate) reliable?

Libor is based on information supplied by 16 banks all over the world. It is a measure of the average interest rate at which banks make 3-month loans to one another.

Libor=2.71594% on April 15, 2008 from the rates:– Top quartile HBOS 2.75%, Credit Suisse 2.74%, Bank of America 2.73%, JP Morgan 2.72%– Libor based on two center quartile HSBC 2.72%, Tokyo-Mitsubishi 2.72%, Barclays 2.72%, Norinchukin 2.72%, Bank of Canada 2.7175, Lloyds 2.71%, Westdeutsche Landesbank 2.71%, Radobank 2.71%.– Bottom quartile UBS AG 2.71%, Bank of Scotland 2.705%, Deutsche Bank 2.7%, Citigroup 2.7%.

“Some banks do not want to report the high rates they are paying for 3-month loans because they do not want to tip off the market that they are desperate for cash.”

– C. Mollenkamp, Bankers Cast Doubt On Key Rate Amid Crisis, Page A1, WSJ issue on April 16, 2008.

Bank for International Settlements (a bankers consortium) is concerned that banks might be reporting inaccurate rates as of Spring 2008.

A Citigroup analyst predicts that if banks provided accurate data about their borrowing costs, three-month Libor would be higher by as much as 0.3%.

– 0.3% change in interest rate is not small. For a 30 year mortgage for $200K, » $199 K is the total interest payments with 5.3% interest» $186 K is the total interest payments with 5.0% interest

Bottomline: Banks’ misrepresentation could mean that consumers are paying artificially low rates on their loans. … good for borrowers, but could be very bad for the banks.

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Important SP Issues

Inventory ownership:

– Supplier owns the goods until they are sold or,

» Dell’s suppliers own the goods which are maintained in a facility rented from Dell and the facility is only 15 minutes driving distance from Dell.

– Retailer owns the goods

Performance measures: Fill rate, inventory level, inventory turns

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Important SP Issues Confidentiality

– Problem: Nonexclusiveness. P&G partners with both KMart-Sears and Wal-Mart

– Solution: Partially-Hiding data smartly

– Problem: Data linking.

» Use publicly available records to link databases to makeup the hidden data

Real estate agent problem: Reveals that a house (known by address) is for sale. But hides the house owner information to avoid buyer’s direct negotiation with the owner. House tax records can be used to link house addresses to owners.

Communication and cooperation

– When First Brands (cleaning products such as clorox) started partnering with Kmart, Kmart often claimed that its supplier was not living up to its agreement to keep two weeks of inventory at all times. It turned out that this was due to the fact that the two companies employed different forecasting methods.

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Steps in SP Implementation

Contractual negotiations

– Ownership

– Credit terms

– Ordering decisions

– Performance measures

Reengineer SC operations

Develop or integrate information systems

Develop effective forecasting techniques

Develop a tactical decision support tool to assist in coordinating inventory management and transportation policies

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Advantages and Disadvantages of SP

Advantages

Fully utilize system knowledge

– Consider the partnership between White-Hall Robbins (W-R), who makes over-the-counter drugs such as Advil, and Kmart. W-R initially disagreed with Kmart about forecasts, and in this case, it turned out that W-R forecasts were more accurate because they have a much more extensive knowledge of their products than Kmart does.

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Advantages of SP

Decrease required inventory levels

Improve service levels

Decrease work duplication

– In apparel industry manufacturers prepare garments for sale at the stores, attaching labels, packaging.

Improve forecasts

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Disadvantages of SP

Expensive advanced technology may be required

Supplier/retailer trust must be developed.

Supplier responsibility increases.

Expenses at the supplier often increase.

– Cost sharing?