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What Is The Bullwhip Effect And How Can We Prevent It Next Time?

Claude is the CEO of DAT Freight & Analytics, the largest truckload freight marketplace in North America.

Whenever the popular media begins paying significant, or even obsessive, attention to an economic or business issue, you can bet it is a lagging, rather than leading, indicator of a critical problem that may have a global impact.

Thus, the media’s recent and relentless focus on empty store shelves and big supply chain disruptions can best be understood not as a “new” problem, but as the result of the whopping increase in demand for durable and nondurable goods since early 2020. You see, when Covid-19 sent 330-plus million Americans—and a huge percentage of the world’s 7.5 billion people—into some state of seclusion, a significant portion of us started doing the same thing: shopping online.

Unable to socialize or travel freely, we diverted a lot of the money that we otherwise would have spent on experiences to purchasing goods online. Groceries. Takeout and/or home delivery meals. Household goods in such large quantities that we triggered a nationwide shortage of toilet paper, which thrust our supply chains into the global spotlight. We indulged in new electronic gadgets to play around with during our downtime at home, and we took to home improvement, buying home repair and remodeling supplies from the likes of Amazon, Lowes, Home Depot and other online mass retailers.

In doing so, we collectively sent supply chains into hyperdrive when they weren’t ready to make that jump to meet unprecedented demand.

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To be sure, some big positives have come from those dramatic shifts in spending. In January, the U.S. Census Bureau reported preliminary total retail and food services sales in 2021 were up 19.3% from 2020, when Covid-19 first shocked the economy. That increase was juiced by the federal government’s distribution of $5.8 trillion in pandemic recovery assistance.

But all that spending helped create the supply chain issues with which countries around the world are grappling today. Understanding the full scope of those issues is critical if we’re to learn how to resolve them or function efficiently despite them.

The Bullwhip Effect

Overreacting to empty shelves just makes things worse. Back in the 1980s, economists at Proctor & Gamble identified what they prosaically called the “Bullwhip Effect.” That describes what happens when retailers overreact to a sudden jump in sales over a short time and thereby cause even bigger, longer-lasting problems.

When their shelves go bare, retailers tend to view that not as a temporary disruption but as a permanent or semi-permanent change in demand. So, they overcorrect by placing orders for more items than they ordered before the shelves emptied. If they previously ordered 100 widgets a week, they subsequently would order 110, 125 or even 150 items. That’s because they understandably fear further incidences of empty shelves that might send regular customers to rival retailers with inventory available.

In subsequent overreaction, distributors place bigger orders with manufacturers to cover retailers’ newly inflated orders, then add another 10%, 15% or even 25% on top. Like the retailers, distributors fear being caught again without enough product and losing regular customers to rival distributors that have larger inventories. Ultimately, even manufacturers overreact by churning out even more products—just to be sure.

Inevitably, overcorrection results in too much inventory that consumers won’t need or buy. That necessitates deep discounting to move all excess inventory, or worse, write-offs of unsellable goods. Either way, bottom lines get crushed.

That’s the Bullwhip Effect. If you diagram it, it’ll look like a bullwhip—a tool wielded by cowboys. What starts as just a small oscillation of the whip’s handle becomes an increasingly big wave as the energy moves down the whip. Out near the whip’s tip, the oscillations (or amplitude of that wave) are three or four times larger than the initial wave. Then the wave just stops once that energy moves past the whip’s cracking tip. That’s analogous to the manufacturer, transportation company or retailer that gets stuck with lots of unmovable merchandise.

Tough Questions For Getting Past The Bullwhip Effect

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Along with retailers and distributors, freight movers face difficult decisions when responding to today’s supply chain challenges. For starters:

  • Do they acquire more capacity, and if so, how much?
  • Do they hire more drivers, and how much more will they have to pay to attract them?
  • Will consumers’ shopping revert toward pre-pandemic patterns?
  • Will consumers shift spending back to entertainment, dining out and other experiences, leaving less money to be spent on goods that must be shipped?

In short, will the Bullwhip Effect ultimately sting them when the tip of the whip finally cracks and all that overreaction energy dissipates?

What The Future Holds

History suggests that retail sales continuing at the frenzied pace of the last 18 months is very unlikely. Thus, manufacturers and retailers should resist focusing solely on what customer demand is today and instead focus as much or more on what demand will be when we resume (at least partway) our pre-pandemic lives and spending patterns.

In fact, we saw slowdowns during the 2021 holiday season, the time of year when spending traditionally rises. While January spending is up again, the U.S. Commerce Department reported in January that December retail sales fell 1.9% from November, significantly more than the 0.1% decrease economists had expected.

Now, with the delta and omicron variants of Covid-19 fading, mask mandates lifting, more retailers fully reopening and businesses planning the return of workers to their offices, it appears the Bullwhip Effect is near its end. So now is the time when companies need to up their data collection, analysis and forecasting capabilities if they want to avoid setting themselves up for another painful Bullwhip Effect scenario.

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