Inventory Management – Bullwhip Effect

M213 OPERATIONS MANAGEMENT BULLWHIP EFFECT Bullwhip Effect • Tendency of a player in the supply chain of a material or product in short supply to buy more than they need in the immediate future. • Logistic phenomenon named after the way the amplitude of a whip increases down its length. Why the bullwhip effect occurs? Demand Forecasting • One day, the manager of a retailer observed a larger demand (sales) than expected. • He increased the inventory level because he expected more demand in the future (forecasting). The manager of his wholesaler observed more demand (some of which are not actual demand) than usual and increased his inventory. • This caused more (non-real) demand to his maker; the manager of the maker increased his inventory, and so on. This is the basic reason of the bull whip effect. Bullwhip Effect • Businesses must forecast demand in order to properly position inventory and other resources. • Forecast are traditionally based on statistics and are rarely perfectly accurate. • Because forecast errors are a given, companies often carry inventory buffer (safety stock). Demand information is distorted as it travels within the supply chain, so that different stages have different perspectives and estimates of the chain demand. Why the bullwhip effect occurs? Lead time • With longer lead times, a small change in the estimate of demand variability implies a significant change in safety stock, reorder level, and thus in order quantities. • Thus a longer lead time leads to an increase in variability and the bull whip effect. Why the bullwhip effect occurs? Batch Ordering When using a min-max inventory policy, then the wholesaler will observe a large order, followed by several periods of no orders, followed by another large order, and so on. • The wholesaler sees a distorted and highly variable pattern of orders. • Thus, batch ordering increases the bull whip effect. Why the bullwhip effect occurs? Variability of Price • Retailers (or wholesalers or makers) offer promotions and discounts at certain times or for certain quantities. • Retailers (or customers) often attempt to stock up when prices are lower. • It increases the variability of demands and the bull whip effect.

Why the bullwhip effect occurs? Lack of supply and supply allocation • When retailers suspect that a product will be in short supply, and therefore anticipate receiving supply proportional to the amount ordered (supply allocation). • When the period of shortage is over, the retailer goes back to its standard orders, leading to all kinds of distortions and variations The Beer Game • Role-playing simulation developed in the 1960’s at MIT’s Sloan School of Management • Production and distribution of beer. – Players divide themselves into groups: Retailer, Wholesaler, Distributor, and Brewer. Weekly consumer demand simulated by a deck of cards • Retailer sells from his inventory and reorders from the Wholesaler, who sells from his inventory and reorders from the Distributor, who in turn sells from his inventory and reorders from the Brewer, who finally sells from his inventory and restocks from his production. • Order processing delays; Shipping delays • Inventory carrying costs; Stockout costs • Players base their decisions strictly on the orders they receive from their respective buyers. Consequences of the Bullwhip Effect • Lower revenues. Stockouts and backlogs mean lost sales, as customers take their business elsewhere. • Higher costs. – High carrying cost – Stockout cost – Distributors need to expedite orders (at higher shipping expenses) – Manufactures need to adjust jobs (at higher setups and changeover expenses, higher labor expenses for overtime, perhaps even higher materials expenses for scarce components. ) – All entities in the supply chain must also invest heavily in outsized facilities (plants, warehouses) to handle peaks in demand, resulting in alternating under or over-utilization. Consequences of the Bullwhip Effect • Worse quality. Quirky, unplanned changes in production and delivery schedules disrupt and subvert control processes, begetting diverse quality problems that prove costly to rectify. • Poorer service. – Irregular, unpredictable production and delivery schedules also lengthen lead time, causing delay and customer dissatisfaction. Causes of Bullwhip Effect • Demand variability, quality problems, strikes, plant fires, etc. • Variability coupled with time delays in the transmission of information up the supply chain and time delays in manufacturing and shipping goods down the supply chain create the bullwhip effect.

Causes of Bullwhip Effect 1. Overreaction to backlogs 2. Neglecting to order in an attempt to reduce inventory 3. No communication up and down the supply chain 4. No coordination up and down the supply chain 5. Delay times for information and material flow Causes of Bullwhip Effect 6. Order batching – larger orders result in more variance. Order batching occurs in an effort to reduce ordering costs, to take advantage of transportation economics such as full truck load economies, and to benefit from sales incentives. Promotions often result in forward buying to benefit more from the lower prices. 7.

Shortage gaming: customers order more than they need during a period of short supply, hoping that the partial shipments they receive will be sufficient. Causes of Bullwhip Effect 8. Demand forecast inaccuracies: everybody in the chain adds a certain percentage to the demand estimates. The result is no visibility of true customer demand. 9. Free return policies Countermeasures to the Bullwhip Effect Order Batching • High order cost is countered with Electronic Data Interchange (EDI) and computer aided ordering (CAO). – Full truck load economics are countered with third-party logistics and assorted truckloads.

Random or correlated ordering is countered with regular delivery appointments. – More frequent ordering results in smaller orders and smaller variance. • However, when an entity orders more often, it will not see a reduction in its own demand variance – the reduction is seen by the upstream entities. • Also, when an entity orders more frequently, its required safety stock may increase or decrease; see the standard loss function in the Inventory Management section. Shortage Gaming • Proportional rationing schemes are countered by allocating units based on past sales. Ignorance of supply chain conditions can be addressed by sharing capacity and supply information. – Unrestricted ordering capability can be addressed by reducing the order size flexibility and implementing capacity reservations. – For example, one can reserve a fixed quantity for a given year and specify the quantity of each order shortly before it is needed, as long as the sum of the order quantities equals to the reserved quantity. Fluctuating Prices • High-low pricing can be replaced with every day low prices (EDLP).

Special purchase contracts can be implemented in order to specify ordering at regular intervals to better synchronize delivery and purchase. Demand Forecast Inaccuracies • Lack of demand visibility can be addressed by providing access to point of sale (POS) data. • Changes in pricing and trade promotions and channel initiatives, such as vendor managed inventory (VMI), coordinated forecasting and replenishment (CFAR), and continuous replenishment can significantly reduce demand variance. Free Return Policies • Free return policies are not addressed easily. Often, such policies simply must be prohibited or limited. Vendor Managed Inventory Vendor Managed Inventory • VMI is means of optimizing Supply Chain performance in which the manufacturer is responsible for maintaining the distributors inventory levels. • The manufacturer has access to the distributors inventory data and is responsible for generating purchase orders. • Under the typical business model: – When a distributor needs product, they place an order against a manufacturer. – The distributor is in total control of the timing and size of the order being placed.

The distributor maintains the inventory plan. • Vendor Managed Inventory model – The manufacturer receives electronic data (usually EDI or via the internet) that tells him the distributors sales and stock levels. – The manufacturer can view every item that the distributor carriers as well as true point of sale data. – The manufacturer is responsible for creating and maintaining the inventory plan. – Under VMI, the manufacturer generates the order, not the distributor. VMI does not change the “ownership” of inventory. It remains as it did prior to VMI. Vendor Managed Inventory Popularized in the late 1980s by Wal-Mart and Procter & Gamble, VMI became one of the key programs in the grocery industry’s pursuit of “efficient consumer response” and the garment industry’s “quick response. ” • Successful VMI initiatives have been trumpeted by other companies in the United States, including Campbell Soup and Johnson & Johnson, and by European firms like Barilla (the pasta manufacturer). The VMI Partnership • The supplier—usually the manufacturer but sometimes a reseller or distributor—makes the main inventory replenishment decisions for the consuming organization. The supplier monitors the buyer’s inventory levels (physically or via electronic messaging) and makes periodic resupply decisions regarding order quantities, shipping, and timing. – Transactions customarily initiated by the buyer (like purchase orders) are initiated by the supplier instead. – The purchase order acknowledgment from the supplier may be the first indication that a transaction is taking place; an advance shipping notice informs the buyer of materials in transit. The manufacturer is responsible for both its own inventory and the inventory stored at is customers’ distribution centers.

Benefits of Vendor Managed Inventory 1. Improved customer service. By receiving timely information directly from cash registers, suppliers can better respond to customers’ inventory needs in terms of both quantity and location. 2. Reduced demand uncertainty. By constantly monitoring customers’ inventory and demand stream, the number of large, unexpected customer orders will dwindle, or disappear altogether. Benefits of Vendor Managed Inventory 3. Reduced inventory requirements. By knowing exactly how much inventory the customer is carrying, a supplier’s own inventory requirements are reduced ince the need for excess stock to buffer against uncertainty is reduced or eliminated. 4. Reduced costs. To mitigate the up-front costs that VMI demands, Fox suggests that manufacturers reduce costs by reengineering and merging their order fulfillment and Distribution Center replenishment activities. Benefits of Vendor Managed Inventory • While these are all potential benefits of VMI, the most important ones were not cited. 1. Improved customer retention. Once a VMI system is developed and installed, it becomes extremely difficult and costly for a customer to change suppliers. 2.

Reduced reliance on forecasting. With customers for whom a supplier runs VMI programs, the need to forecast their demand is eliminated. Pitfalls of Vendor Managed Inventory 1. EDI problems: Extensive EDI testing should be done to validate the data being sent. Is the distributor sending all the data that should be sent? Is each field populated with the correct data? 2. Acceptance: Make sure that all employees involved in the process fully understand and accept this new way of doing business. It’s not enough to just sell the concept to senior management, all employees who are involved must be willing participants. . Promotions/Events: Anything that adds or takes away from the normal ordering pattern must be properly communicated. Pitfalls of Vendor Managed Inventory 4. Customer Base: Any large customers, either gained or lost, must be communicated to the manufacturer. The distributor must guide the manufacturer on how this will effect sales. 5. Over/Obsolete Stock: An agreement must exist between the manufacturer and the distributor on what to do if an overstock does occur (or in the case of an ordering error). Also, both parties must agree on how to handle obsolete stock. . Time: Both parties involved must understand that this is a learning process. Errors will occur. You will probably not have a perfect process in place from day 1. Summary • Vendor Managed Inventory (VMI) – VMI is a continuous replenishment program in which the retailer provides the supplier with detailed information to allow the supplier to manage and replenish product at the store or warehouse level – Typically the activities of forecasting, scheduling, requisitioning and ordering are performed by the supplier. The retailer does the invoice matching and handles payment – EDI is an integral part of the VMI process Summary • Benefits of VMI – – – – – Eliminating repetitive purchasing activities Lowered costs of processing claims Reduced inventory Increased inventory turns Solidified customer-vendor relationships • VMI has its drawbacks when not implemented properly. Be aware of EDI problems, employee acceptance, and trust among the supply chain partners.