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Session 15

The document discusses the bullwhip effect in supply chains. It defines the bullwhip effect as the distortion of order quantities as orders move upstream through the supply chain, resulting in increased variability. Two key causes of the bullwhip effect are discussed: 1) Demand forecasting, as each stage updates forecasts as new demand data is observed, can increase variability in orders placed. 2) Longer lead times magnify the effect of demand forecasting and result in larger changes to target inventory levels and more variability in orders.

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57 views

Session 15

The document discusses the bullwhip effect in supply chains. It defines the bullwhip effect as the distortion of order quantities as orders move upstream through the supply chain, resulting in increased variability. Two key causes of the bullwhip effect are discussed: 1) Demand forecasting, as each stage updates forecasts as new demand data is observed, can increase variability in orders placed. 2) Longer lead times magnify the effect of demand forecasting and result in larger changes to target inventory levels and more variability in orders.

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Term II: Supply Chain Management (SCM)

Session 15: Bullwhip Effect

Rohit Gupta
Operations Management Area
IIM Ranchi
Email: [email protected]
An important observation in supply chain management, popularly known as the bullwhip effect, suggests that demand
variability increases as one moves up a supply chain.
Empirical evidence suggests that the orders placed by a retailer tend to be much more variable than the customer demand
i.e. the actual demand observed by that retailer.
This ‘increase in variability’ propagates up the supply chain.
As a result, it distorts the pattern of orders received by distributors, manufacturers and suppliers (i.e. the upstream supply
chain agents).
This (generally increasing) distortion of order quantity as (any) order moves upstream in the supply chain is defined as
Bullwhip Effect.
How does an order moves upstream?
Let us consider a simple three-tier supplier chain consisting of one manufacturer, multiple distributors, and multiple
retailers.
The ordering of product(s) happens in the following way:
Step 1: An individual retailer’s order reaches the distributor.
Step 2: After aggregation (as the distributor supplies to a number of retailers) the distributor’s order reaches the
manufacturer.
Step 3: After aggregation (as the manufacturer supplies to a number of distributors) and finalization of the aggregate
production plan the manufacturer places her order to the respective vendors for procurement of raw materials and WIPs.
Which firm first reported about Bullwhip Effect?

The term “bullwhip effect” was coined by executives of Procter and Gamble (P&G), the company which
manufactures the Pampers brand of diapers.
These executives observed that the consumer demand for Pamper's diapers was fairly constant over time.
However, the orders for diapers placed by retailers to their wholesalers or distributors were quite variable, i.e.,
exhibited significant fluctuations over time.
In addition, even larger variations in order quantities were observed in the orders that P&G received from its
wholesalers.
This increase in the variability of the orders seen by each stage in a supply chain is the first reported case of
“bullwhip effect”.
What does this effect impact? The bullwhip effect is a major concern for many manufacturers, distributors and
retailers because the increased variability in the order process
(i) requires each facility to increase its safety stock in order to maintain a given service level,
(ii) leads to increased costs due to overstocking throughout the system, and
(iii) can lead to an inefficient use of resources, such as labour and transportation, due to the fact that it is not
clear whether resources should be planned based on the average order received by the facility or based on the
maximum order.
Understanding the Bullwhip Effect
Let us consider the case of a simple, two stage supply chain consisting of a single retailer and a single
manufacturer.
Stage 1 of Ordering:
a. The retailer observes customer demand and places orders to the manufacturer.
b. To determine how much to order from the manufacturer, the retailer must forecast customer demand.
c. Generally, the retailer will use the observed customer demand data and some standard forecasting technique
to calculate these forecasts.
Stage 2 of Ordering/ Manufacturing:
a. The manufacturer observes the retailer's demand and places orders to his supplier.
b. To determine these order quantities, the manufacturer must forecast the retailer's demand.
c. In many supply chains, the manufacturer does not have access to the actual customer demand data.
d. Therefore, he must use the orders placed by the retailer to perform his forecasting.
Observation 1: If, the orders placed by the retailer are significantly more variable than the customer demand
observed by the retailer, then the manufacturer's forecasting and inventory control problem will be much more
difficult than the retailer's forecasting and inventory control problem.
Observation 2: The increased variability will force the manufacturer to carry more safety stock or to maintain
higher capacity than the retailer in order to meet the same service level as the retailer.
Causes of Bullwhip Effect
Five main causes of the bullwhip effect are:
1. Demand forecasting
2. Lead times
3. Batch ordering
4. Supply shortages
5. Price variations
We are going to discuss Cause # 1 and 2 in detail subsequently

Cause of Bullwhip Effect – Demand Forecasting


Let us consider the previous example of a simple two stage supply chain consisting of one supplier and one retailer.
Each stage uses some form of demand forecasting to determine its desired inventory level and order quantity.
A simple order-up-to inventory policy requires each stage of the supply chain to raise its inventory level up to a given
target level in each period.
One common form of this policy is to set the target inventory level in period t, as 𝑌𝑡 and it is expressed as follows:
𝑌𝑡 = 𝜇𝑡𝐿 + 𝑧𝜎𝑡𝐿
Where, 𝜇𝑡𝐿 = an estimate of the mean demand over lead time (L)
𝜎𝑡𝐿 = an estimate of the standard deviation of the forecast errors over the lead time (L)
𝑧 = chosen parameter (by the retailer or the supplier) to meet a desired service level
Cause of Bullwhip Effect – Demand Forecasting (contd.)
Order forecasting, as expressed by 𝑌𝑡 = 𝜇𝑡𝐿 + 𝑧𝜎𝑡𝐿 , can be done by any available method of demand forecasting (moving
average, weighted moving average etc.)
Therefore, any forecasting technique can cause the bullwhip effect.
Observe that, one property of most standard forecasting methods is that the forecast is updated each time a new demand is
observed.
Therefore, at the end of each period, the retailer will observe the most recent demand, update her demand forecast based on
this demand, and then use this updated forecast to update her target inventory level.
It is this updating of the forecast and order-up-to point in each period that results in increased variability in the orders placed
by the retailer.
How to prevent Demand Forecasting based Bullwhip Effect?
If the retailer follows a simple order-up-to inventory policy in which she does not update the desired inventory level in each
period, then she would not see the bullwhip effect.
How can that be possible?
If in every period the retailer places an order to raise the on-hand inventory to the same fixed level, then the orders seen by the
manufacturer would be exactly equal to the customer demand seen by the retailer. Therefore, the variability in the orders seen
by the manufacturer would be exactly equal to the variability of the customer demand, and there would be no bullwhip effect.
Remember: This (simple) solution can not incorporate a large permanent change in customer demand (if such an event
occurs).
Cause of Bullwhip Effect – Lead Time
The lead time is defined as the time it takes an order placed by the retailer to be received at that
retailer.
Lead times can add to the bullwhip effect by magnifying the increase in variability due to the
demand forecasting.
To understand this, note that lead times increase the target inventory level, i.e., the longer the
lead time, the larger the inventory level required.
The retailer updates her target inventory level in each period (using demand forecasting), then
longer lead times will lead to larger changes in the target inventory level, and thus more
variability in the orders placed by the retailer.
For example, if the demands seen by the retailer are independent and identically distributed
(i.i.d.) from a normal distribution with mean 𝜇 and variance 𝜎 2 , then an approximately optimal
order-up-to inventory level in period t is:
𝑌𝑡 = 𝐿𝜇𝑡 + 𝑧 𝐿𝜎𝑡
Where, L = Lead time
𝜇𝑡 = Estimate of mean demand rate (i.e. demand per unit time) 𝜇
𝜎𝑡 = Estimate of standard deviation (𝜎) of demand mean demand rate (𝜇)
Cause of Bullwhip Effect – Lead Time (contd.)

Case 1: Change in mean demand, 𝜇 (and unchanged variance/ standard deviation, 𝜎)


From time period t to (t + 1),
Let us assume that (i) the estimated mean demand changes from 𝜇𝑡 to 𝜇𝑡+1 (𝜇𝑡+1 >𝜇𝑡 ).
(ii) the estimated standard deviation remains unchanged: 𝜎𝑡 = 𝜎𝑡+1 .
Then in time period (t + 1), optimal order-up-to inventory level is:
𝑌𝑡+1 = 𝐿𝜇𝑡+1 + 𝑧 𝐿𝜎𝑡+1 = 𝐿 𝜇𝑡 + ∆ + 𝑧 𝐿𝜎𝑡 , where 𝜇𝑡+1 =𝜇𝑡 + ∆𝜇 and∆𝜇 > 0
Therefore, change in order is: 𝑌𝑡+1 − 𝑌𝑡 = 𝐿∆𝜇 > 0 (Bullwhip Effect!)
Case 2: Change in standard deviation of demand, 𝜎 (and unchanged mean, 𝜇)
From time period t to (t + 1),

Let us assume that (i) the estimated standard deviation (of demand) changes from 𝜎𝑡 to
𝜎𝑡+1 (𝜎𝑡+1 >𝜎𝑡 ).

(ii) the estimated standard deviation remains unchanged: 𝜇𝑡 = 𝜇𝑡+1 .

Then in time period (t + 1), optimal order-up-to inventory level is:

𝑌𝑡+1 = 𝐿𝜇𝑡+1 + 𝑧 𝐿𝜎𝑡+1 = 𝐿𝜇𝑡 + 𝑧 𝐿 𝜎𝑡 + ∆𝜎 , where 𝜎𝑡+1 =𝜎𝑡 + ∆𝜎 and∆𝜎 > 0

Therefore, change in order is: 𝑌𝑡+1 − 𝑌𝑡 = 𝑧 𝐿∆𝜎 > 0 (Bullwhip Effect!)

Observation: When we compare the aforementioned effects i.e. changes in optimal


order-up-to inventory level(s) due to change in 𝜇 and change in 𝜎, we observe the
following:
𝑌𝑡+1 −𝑌𝑡 𝜎 ∆𝜎 𝑧
= . Therefore, if ∆𝜎 𝑧 > ∆𝜇 𝐿, we have: 𝑌𝑡+1 − 𝑌𝑡 𝜎 > 𝑌𝑡+1 − 𝑌𝑡 𝜇
𝑌𝑡+1 −𝑌𝑡 𝜇 ∆𝜇 𝐿

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