Essentials of Supply Chain Management

Excerpted from the book Essentials of Supply Chain Management, by Michael Hugos, with permission from Wiley, John & Sons Inc.

Chapter 4, Supply Chain Coordination and Use of Technology

After reading this chapter you will be able to:

  • Understand a common supply chain dynamic that is a major contributor to the "boom to bust" business cycle
  • Appreciate the factors that contribute to this supply chain dynamic
  • Evaluate ways to combat this dynamic
  • Assess the technology that is available to support and enable effective supply chain coordination

Essentials of Supply Chain Management
The spread of high-speed data communications networks and computer technology has made it possible to manage the supply chain with a level of precision that was not feasible as recently as the mid-1980s. Those organizations that learn to use the techniques and technologies that are now available can build supply chains that have a competitive advantage in their markets. Because the capability exists to react much more quickly to changes in market demand, this capability is now a point of competition. Business competition based on supply chain efficiency is becoming a central fact in many markets. To develop this capability, individual companies and entire supply chains need to learn new behaviors, and they need to enable these new behaviors with the use of appropriate technology.

The 'Bullwhip' Effect

One of the most common dynamics in supply chains is a phenomenon that has been dubbed "the bullwhip effect. "What happens is that small changes in product demand by the consumer at the front of the supply chain translate into wider and wider swings in demand experienced by companies further back in the supply chain. Companies at different stages in the supply chain come to have a very different pictures of market demand and the result is a breakdown in supply chain coordination.

Companies behave in ways that at first create product shortages and then lead to an excess supply of products. This dynamic plays out on a larger scale in certain industries in what is called a "boom to bust" business cycle. In particular this affects industries that serve developing and growth markets where demand can suddenly grow. Good examples of this can be found in the industries that serve the telecommunications equipment or computer components markets.

The cycle starts when strong market demand creates a shortage of product. Distributors and manufacturers steadily increase their inventories and production rates in response to the demand. At some point either demand changes or the supply of product exceeds the demand level. Distributors and manufacturers do not at first realize that supply exceeds demand and they continue building the supply. Finally the glut of product is so large that everyone realizes there is too much. Manufacturers shut down plants and lay off workers. Distributors are stuck with inventories that decrease in value and can take years to work down.

This dynamic can be modeled in a simple supply chain that contains a retailer, a distributor, and a manufacturer. In the 1960s a simulation game was developed by the Massachusetts Institute of Technology's Sloan School of Management that illustrates how the bullwhip effect develops. The simulation game they developed is called the "beer game." It shows what happens in a hypothetical supply chain that supports a group of retail stores that sell beer, snacks, and other convenience items. The results of the beer game simulation teach a lot about how to coordinate the actions of different companies in a supply chain.

Peter M. Senge in his book The Fifth Discipline (The Fifth Discipline: The Art and Practice of the Learning Organization, New York: Doubleday/Currency, 1990, Chapter 3) devotes a chapter to exploring how the bullwhip effect gathers momentum and what can be done to avoid it. The beer game starts with retailers experiencing a sudden but small increase in customer demand for a certain brand of beer called Lover's Beer. Orders are batched up by retailers and passed on to the distributors who deliver the beer. Initially, these orders exceed the inventory that distributors have on hand so they ration out their supplies of Lover's Beer to the retailers and place even larger orders for the beer with the brewery that makes Lover's Beer. The brewery cannot instantly increase production of the beer so it rations out the beer it can produce to the distributors and begins building additional production capacity.

At first the scarcity of the beer prompts panic buying and hoarding behavior. Then as the brewery ramps up its production rate and begins shipping the product in large quantities, the orders that had been steadily increasing due to panic buying suddenly decline. The glut of product fills up the distributors' warehouses, fills all the retailers' unfilled back orders, and exceeds the actual consumer demand. The brewery is left with excess production capacity, the distributors are stuck with excess inventory, and the retailers either cancel their beer orders or run discount promotions to move the product. Everybody loses money.

The costs of the bullwhip effect are felt by all members of the supply chain. Manufacturers add extra production capacity to satisfy an order stream that is much more volatile than actual demand. Distributors carry extra inventory to cover the variability in order levels. Transportation costs increase because excess transportation capacity has to be added to cover the periods of high demand. Along with transportation costs, labor costs also go up in order to respond to the high demand periods. Retailers experience problems with product availability and extended replenishment lead times. During periods of high demand, there are times when the available capacity and inventory in the supply chain cannot cover the orders being placed.This results in product rationing, longer order replenishment cycles, and lost sales due to lack of inventory.

Coordination in the Supply Chain

Research into the bullwhip effect has identified five major factors that cause the effect. These factors interact with each other in different combinations in different supply chains but the net effect is that they generate the wild demand swings that make it so hard to run an efficient supply chain. These factors must be understood and addressed in order to coordinate the actions of any supply chain. They are:

1. Demand forecasting

2. Order batching

3. Product rationing

4. Product pricing

5. Performance incentives

Demand Forecasting

Demand forecasting based on orders received instead of end user demand data will inherently become more and more inaccurate as it moves up the supply chain. Companies that are removed from contact with the end user can lose touch with actual market demand if they view their role as simply filling the orders placed with them by their immediate customers. Each company in a supply chain sees fluctuations in the orders that come to them that are caused by the bullwhip effect. When they use this order data to do their demand forecasts, they just add further distortion to the demand picture and pass this distortion along in the form of orders that they place with their suppliers.

Clearly, one way to counteract this distortion in demand forecasts is for all companies in a supply chain to share a common set of demand data from which to do their forecasting. The most accurate source of this demand data is the supply chain member closest to the end use customer (if not the end use customers themselves). Sharing point-of-sales (POS) data among all the companies in a supply chain goes a long way toward taming the bullwhip effect because it lets everyone respond to actual market demand instead of supply chain distortions.

Order Batching

Order batching occurs because companies place orders periodically for amounts of product that will minimize their order processing and transportation costs. As discussed in the section on inventory control in Chapter 2, companies tend to order in lot sizes determined by the EOQ (economic order quantity). Because of order batching, these orders vary from the level of actual demand and this variance is magnified as it moves up the supply chain.

The way to address demand distortion caused by order batching is to find ways to reduce the cost of order processing and transportation. This will cause EOQ lot sizes to get smaller and orders to be placed more frequently. The result will be a smoother flow of orders that distributors and manufacturers will be able to handle more efficiently. Ordering costs can be reduced by using electronic ordering technology. Transportation costs can be reduced by using third party logistics suppliers (3PLs) to cost effectively pick up many small shipments from suppliers and deliver small orders to many customers.

Product Rationing

This is the response that manufacturers take when they are faced with more demand than they can meet. One common rationing approach is for a manufacturer to allocate the available supply of product based on the number of orders received. Thus if the available supply equals 70 percent of the orders received, the manufacturer will fill 70 percent of the amount of each order and back order the rest. This leads distributors and retailers in the supply chain to raise their order quantities artificially in order to increase the amount of product that gets rationed to them.

This behavior greatly overstates product demand and it is called "shortage gaming." There are several ways to respond to this. Manufacturers can base their rationing decisions on the historical ordering patterns of a given distributor or retailer and not on their present order sizes. This eliminates much of the motivation for the shortage gaming that otherwise occurs. Manufacturers and distributors can also alert their customers in advance if they see demand outstripping supply. This way product shortages will not take buyers by surprise and there will be less panic buying.

Product Pricing

Product pricing causes product prices to fluctuate, resulting in distortions of product demand. If special sales are offered and product prices are lowered, it will induce customers to buy more product or to buy product sooner than they otherwise would (forward buying). Then prices return to normal levels and demand falls off. Instead of a smooth flow of products through the supply chain, price fluctuations can create waves of demand and surges of product flow that are hard to handle efficiently.

Answers to this problem generally revolve around the concept of "everyday low prices." If the end customers for a product believe that they will get a good price whenever they purchase the product, they will make purchases based on real need and not other considerations. This in turn makes demand easier to forecast and companies in the supply chain can respond more efficiently.

Performance Incentives

These are often different for different companies and individuals in a supply chain. Each company can see its job as managing its position in isolation from the rest of the supply chain. Within companies, individuals can also see their job in isolation from the rest of the company. It is common for companies to structure incentives that reward a company's sales force on sales made each month or each quarter. Therefore as the end of a month or a quarter approaches, the sales force offers discounts and takes other measures to move product in order to meet quotas. This results in product for which there is no real demand being pushed into the supply chain. It is also common for managers within a company to be motivated by incentives that conflict with other company objectives.

For instance, a transportation manager may take actions that minimize transportation costs at the expense of customer service or inventory carrying costs. Alignment of performance incentives with supply chain efficiencies is a real challenge. It begins with the use of accurate activity based costing (ABC) data that can highlight the associated costs. Companies need to quantify the expenses incurred by forward buying due to month-end or end-of-quarter sales incentives. Companies also need to identify the effect of conflicting internal performance incentives. The next step is to experiment with new incentive plans that support efficient supply chain operation. This is a process that each company needs to work through in its own way.

Executive Insight

Eliyahu Goldratt wrote a book titled The Goal, about a factory manager's quest to save his factory from being closed down for lack of profitability. It chronicles the process that the manager and his staff go through as they learn how to save their factory. What they learn is how to apply the principles of what Mr. Goldratt calls the "Theory of Constraints."

Mr. Goldratt and others have realized that the theory of constraints applies equally well to the operation of a whole supply chain as to the operation of a single factory within a supply chain. Lawrence D. Fredendall and Ed Hill in their book Basics of Supply Chain Management (Basics of Supply Chain Management, Boca Raton, Fla., St. Lucie Press, 2001) have put forth a clear explanation for how to apply the theory of constraints to synchronize the operations of a supply chain.

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