Tuesday, November 27, 2007

The Bullwhip Effect on Supply Chain Management

Here is a fascinating piece about one of the bullwhip effect on supply chain management that currently effects the real estate market.

The basic concept behind supply chain management is simple: customers order products from you; you keep track of what you're selling, and you order enough raw materials from your suppliers to meet your customers' demand. So why is it that, in a recent article, the Economist claimed that, "Managing a supply chain is becoming a bit like rocket science?"

The problem turns out to be one of coordination. Suppliers, manufacturers, sales people, and customers have their own, often incomplete, understanding of what real demand is. Each group has control over only a part of the supply chain, but each group can influence the entire chain by ordering too much or too little. Further, each group is influenced by decisions that others are making.

This lack of coordination coupled with the ability to influence while being influenced by others leads to what Stanford's Hau Lee refers to as the Bullwhip Effect. Decisions made by groups along the supply actually worsen shortages and overstocks.

The bullwhip effect is illustrated by a story Prof. Lee tells about how Volvo found itself with extra inventories of green cars. To get them off the dealers' lots, Volvo's sales department offered special deals, so demand for green cars increased. Production, unaware of the promotion, saw the increase in sales and ramped up production of green cars.

Cisco faced a similar problem last year that resulted in a $2.2 billion inventory write-down. Only a few months before the write-down, Cisco wasn't able to get its products to customers quickly enough. Quoting a supplier to Cisco interviewed in CIO Magazine, "People see a shortage and intuitively they forecast higher. Salespeople don't want to be caught without supply, so they make sure they have supply by forecasting more sales than they expect. Procurement needs 100 of a part, but they know if they ask for 100, they'll get 80. So they ask for 120 to get 100."

Delays Wreak Havoc

But coordination isn't just about communication. Even in supply chains where communication is perfect, manufacturing and procurement delays can wreak havoc. That's because while customers are asking for increased orders, backlogs are building, and it is oh-so-easy to confuse backlogged orders with increases in demand.

Thousands have felt the frustration of supply chain management in a simulation developed at MIT's Sloan School of Management called the beer game. The simulation is run as a board game in teams playing the roles of retailers, wholesalers, distributors, and brewers of beer. As the backlog for orders increase, players order too much inventory, forcing their teammates into severe backlogs further down the supply chain. The game can be emotionally intense. John Sterman, Director of MIT's System Dynamics Group writes, "During the game emotions run high. Many players report feelings of frustration and helplessness. Many blame their teammates for their problems; occasionally heated arguments break out."

The Near Beer Game Simulation

You can try a version of the beer game called the Near Beer Game. It's called the Near Beer Game because, although it's not identical to the original beer game, it teaches many of the same lessons. It also teaches one extra lesson not in the original game: even with perfect information, even when there are no breakdowns in communication, you'll still feel the bullwhip effect due to procurement and manufacturing delays.

Here's how the Near Beer Game works: at the beginning of the simulation your supply chain is in perfect equilibrium. Customers are ordering ten cases of beer each week, you have ten cases in inventory, ten cases are brewing, and ten cases worth of raw materials are arriving from your vendors. In week two, demand increases to fifteen cases per week and remains at fifteen cases for the remainder of the simulation. The game ends when you manage to get your supply chain back in equilibrium for fifteen cases of beer.

Sounds easy right? Try it out and see how many weeks it takes you. See if you can bring the supply chain back into equilibrium without the bullwhip oscillations of stock-outs followed by over-supply.

How to Reduce the Bullwhip Effect

One way to reduce the bullwhip effect is through better information, either in the form of improved communication along the supply chain or (presumably) better forecasts. Because managers realize that end-user demand is more predictable than the demand experienced by factories, they attempt to ignore signals being sent through the supply chain and instead focus on the end-user demand. This approach ignores day-to-day fluctuations in favor of running level.

Another solution is to reduce or eliminate the delays along the supply chain. In both real supply chains and simulations of supply chains, cutting order-to-delivery time by half can cut supply chain fluctuations by 80%. In addition to savings from reduced inventory carry costs, operating costs also decline because less capacity is needed to handle extreme demand fluctuations.
In addition to cycle time reductions throughout the supply chain, Hau Lee, V. Padmanabhan, and Seungjin Whang recommend the following actions to reduce the supply chain management bullwhip effect:

  • Focus on end-user demand through point-of-sale (POS) data collection, electronic data interchange (EDI), and vendor-managed inventories (VMI) to reduce distortions in downstream communication.

  • Work with vendors to create smaller order increments and reduce order batching. Order batching exacerbates demand fluctuations.

  • Maintain stable prices for products. Price fluctuations encourage customers to over-purchase when prices are low and cut back on orders when prices are high, leading to large demand fluctuations.

  • Allocate demand among customers based on past orders, not present orders to reduce hoarding behavior when shortages occur.


mohican said...

How does this phenomena effects our local real estate market?

Prices are low and fundamental housing demand exceeds supply.

Developers react and start to build supply - - insert 18 month delay.

Meanwhile, sensing opportunity because of shortage and added to fundamental demand, more housing is ordered - - orders (pre-sales) increase.

Developers start building even more supply - - 18-24 month lag.

Hoarding behaviour begins to take place with people ordering more housing than they need, perceiving a shortage.

Developers begin completing initial units which begins to meet the fundamental demand.

Hoarding is common, speculation is rampant as there is still a perceived shortage - fundamental demand is low again.

This is where we are now.

Developers continue to complete inventory and the bullwhip effect begins to take place.

The backlog of demanded inventory is filled and hoarded units are added to supply as the perceived shortage is over thus exacerbating the effects of the backlog.



jesse said...

This used to happen with agricultural commodities before the advent of derivatives trading in things like pork bellies and FCOJ.

The automakers have tried to figure this out and are trying to work together to better match supply with demand and reduce price changes in the form of incentives, along with the supply chain improvements (some have done better than others). The housing market, even on local scales, is too fractured for this to occur.

freako said...

Sort of OT, but an infamous example is the fibreoptic buildout. As internet usuage increased, the infrastructure companies sped up their build out and added capacity. As soon as they had done this, internet usuage increased so they continued to build out.

Turns out that the company which estimated internet usuage, based the estimate on capacity, so it was a feedback loop that would perpetually would increase capacity. Until it all blew up. Don't know if there is truth to this or if it is an urban legend.

johnnyrent said...

Apropos of your post, here’s what the CEO of Centrex, a large, Texas-based builder noted yesterday:

“Timothy Eller, the CEO of Centex Corp., said, ‘There is no way to predict when this thing will bottom.’”

“Tomnitz said the current slump is different because speculators who had bid up prices disappeared. ‘Once those investors could no longer buy a home and flip it for 15, 20 percent more, they left the market,’ he said.”

I think his comments speak to one of the potential triggers for a correction here. Once we move towards low single digit appreciation, many existing speculative owners will be or could be offside and will want to exit. Other would be speculators will avoid investing. Already, 50% or more of DT condos are owned by investors, even as new building continues at a furious pace. It doesn't take a rocket scientist to figure out what will happen if (when) investment enthusiasm dries up.

Ryan said...

"Once we move towards low single digit appreciation, many existing speculative owners will be or could be offside and will want to exit."

Which is why I always chuckle a little when I see predictions that the market will "level out" or return to modest gains. There is no way it can level out, because as soon as it stops going up the speculators will dump their holdings. They have to. And once they do, the market will turn.

It's theoretically possible that the current feedback loop can continue and it'll keep appreciating toward infinity, but there's no way to return to a normal market without a crash.

wasim said...

Also note that it is similar to "hi", as a greeting, and is not expected customer behavior analysis in a threatening note or letter. Politeness is not expected in an angry threatening letter unless it has the appearance of sarcasm.