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Taming the bull: How understanding the bullwhip effect can help you cut down losses

22 Nov, 2022 | Business Tips

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A critical segment of a company’s inventory management system is maintaining an optimum stock level. Companies maintain a specific sales-to-inventory level ratio depending on several factors, including the lead time to receive products and product consumption. A higher ratio indicates the company might be overstocking on goods, and a lower ratio can mean that the company was not stocking enough items to fulfill customer demand. In both scenarios, the company might suffer financial and reputational damages. One of the causes of over/understocking can be the bullwhip effect. So, what is the bullwhip effect? And how can DEAR Systems inventory management software help you prevent it?

What is the bullwhip effect?

When a retailer miscalculates demand for its products by a small percentage, it results in a much broader effect on the manufacturer. This phenomenon is called the bullwhip effect.The bullwhip (also known as whiplash or whipsaw) effect is a supply chain phenomenon where a slight demand fluctuation at the retail level causes a significant rise in demand as it moves up the supply chain to wholesale, distribution, and manufacturing levels.

Logistics executives at Procter & Gamble (P&G) observed this phenomenon in the order pattern of their product PampersⓇ diapers in the 1990s and coined the term “the bullwhip effect.” They observed that although the babies used a constant amount of diapers every week, the retailers’ orders varied every week. Sometimes they were too high and other times too low. The same order pattern was followed by the distributors. However, the variation in orders from the distributors was higher than the variation of retail orders. This led to even higher variation in the P&G’s own orders from their suppliers. Since then, many studies have been conducted on the subject.

Have you ever observed a person operating a whip? A slight movement of their wrist can cause the whip to form a wide, forceful arc. A whiplash is the flexible part of the whip. Just like the whiplash, the bullwhip effect causes a significant demand fluctuation if there is the slightest change in the retail sector. Typically, the supply chain stages are purchasing raw materials, manufacturing, distributing, wholesale, retail sale, and delivering to consumers. An untrained observer won’t consider individual consumers and retailers as the one having any say in the quantity manufactured. However, the fact is, a manufacturer would depend on the consumer demand data obtained from the retailers to plan production.

A simple judgmental error on the part of a retailer can result in a ripple effect. The mistake will snowball into a massive issue. If the retailer overestimated the demand and ordered a bit more, it might result in a huge increase in the production of the product. On the other hand, if the retailer underestimated the demand and ordered fewer items, the manufacturer might consider it a cue to put a break on the production. This bullwhip effect can result not only in the overstocking of the products but also understocking.


An example of the bullwhip effect

Let’s understand the concept of bullwhip with an example. Company X manufactures butter and sells 100 packs in a given period. Now, usually, the demand for butter is pretty consistent throughout the year. Company X collects data from the distributors, who in turn get their data from the wholesalers and the wholesalers have their data from the retailers.

Company Y also manufactures butter, and there is a temporary short supply of their butter in the market. The customers of company Y will buy company X butter for the period. This will increase the sale of company X butter from 100 packs to 125 packs. The retailers might think this increased demand will last and want to stock it for the next period. Therefore, they will order 130 packs.

The wholesalers who cater to ten such retailers will order 1400 packs to create a comfortable buffer. Similarly, the distributor and the manufacturer will also store in excess to be on the safe side. Thus, the production of butter in company X will skyrocket. However, in the next period, the situation might be different, resulting in overstocking butter X in every part of the supply chain. This is a classic case of the bullwhip effect.

The exact opposite will happen if the retailer underestimates its demands. Suppose Company Y has a discount on its butter. Then the consumer might prefer to buy butter Y instead of X for that period. This will lead to decreased demand for butter X. The retailers might underestimate the demand for the next period and order a reduced quantity of 75 packs instead of 100 packs. The wholesaler, in turn, would order just 700 packs for ten such retailers. Consequently, the production of the butter will decrease considerably leading to shortages. In that case, the company would face understocking issues.


How does the bullwhip effect affect your business?

The bullwhip effect negatively impacts the company’s business, financially and otherwise. Let’s look at some of the most profound effects of the bullwhip effect:

Enhanced storage costs

When a company manufactures goods beyond what it can sell in a reasonable time, it must store the overstocked goods for a more extended period. The longer you hold your inventory you incur enhanced costs, including:

  • The additional cost of capital investment in the goods,
  • The extra space required for the goods, and
  • The enhanced labor cost for keeping up the quality of products.

These costs will dent the finances of the company. On the other hand, if the bullwhip effect has led to understocking of goods, the company will suffer a loss of turnover. It will lose potential profits.

Increased efforts to sell the goods

The company must make increased efforts to sell the overstocked goods. Due to the bullwhip effect, it has to employ people to dispose of the goods. Sometimes when the goods have a short expiration date, the company might have to sell the goods at a discount. An additional cost of advertising and marketing might be required to sell the extra load of goods.

Damage and loss of goods

When the goods are stored for longer, the possibility of damage increases. Some products have expiration dates and can’t be used/sold after that date. The company would have to dispose of such goods if it can’t sell them in time. Additionally, some items may no longer be trendy or may have been replaced by a better version. Even after discounts, these products might be nearly impossible to sell, and the company might face issues getting rid of them.


How can DEAR Systems help you prevent the bullwhip effect?

If you have faced the bullwhip effect in your business, you know how difficult it is to get back on your feet after the phenomenon. You can take steps to prevent the bullwhip effect by employing DEAR Systems inventory management software.

One of the most important ways in which the DEAR Systems software helps you prevent the bullwhip effect is by helping you make accurate forecasts. The bullwhip effect is often triggered by an inaccurate forecast. DEAR Systems’ state-of-the-art software gives you accurate insights into the future.

Moreover, data trends represented through charts and graphs can help a manager spot inaccuracies instantly. DEAR Systems offers a clear graphical representation of the business data to help you pinpoint erroneous data. Let’s look at how DEAR systems can help.

Data collection

A company needs to ace both internal and external communications to prevent the bullwhip effect. Internal communication is the conversation between the company’s members, and external communication is the company’s conversation with outsiders. An automated inventory management system can help ensure both types of communication are effective. For example, with automation, retailers’ orders are automatically updated on the integrated system for suppliers to access. With DEAR automation the suppliers can receive purchase emails and start the supplying process. Additionally, communication among different departments of a company is vital in the inventory management process. A minor miscommunication can lead to significant effects on the outcome. For example, consider a case where a company is using paper requisition slips, and a factory foreman writes a requisition slip for 1000 liters of oil and passes it on to the purchasing department. However, the purchasing department makes a mistake in reading the requisition slip and orders 1600 liters of oil from the supplier. Then the company would be left with an overstock of 600 liters of oil. This oil will incur carrying cost for an extended period of time. If the product has a shorter shelf life, the company might face issues in disposing of the extra items ordered. An automated system reduces the likelihood of these types of errors.

The automation features of DEAR Systems inventory management software can give every employee access to information when they need it. This information helps all your internal stakeholders make correct decisions at the right time. Moreover, DEAR Systems has a B2B portal to communicate effectively with other businesses. It helps the company collect data from different sources and merge them for decision-making. With more information that is accurate, you and your employees will be able to make better forecasts.

Real-time visibility

Real-time visibility is crucial in making inventory and manufacturing decisions for a company. You need to know how much of an item is in stock at any given time to make ordering predictions and decisions.  Real-time visibility helps you avoid the bull-whip effect. Additionally, DEAR Systems inventory management software offers integrations with other software, including ERP, accounting, marketing, and specialized forecasting software, so every team can make accurate forecasts.

Minimize price fluctuations

Reducing price fluctuations can help reduce your chances of experiencing the bullwhip effect. One way to reduce price fluctuations is to ensure you know exactly how much it costs to produce your product. With DEAR Systems’ job costing feature, you know how much every job costs, so you can set stable prices.

Bring down the lead time

Lead time refers to the time it takes for a product to reach your premises after you place the order. When the lead time is higher, there are more chances of misjudging the demand for the product. Reducing the lead time can help the company move closer to the market sentiment.

You can track the real-time location of goods and identify bottlenecks using the DEAR Systems inventory management system. Another way to reduce lead time is to integrate order fulfillment software, such as TrueCommerce, SPS Commerce, or Crossfire EDI, with your inventory management system.

Incorporate materials requirements planning (MRP) in your system

Materials Requirements Planning (MRP) considers demand from sales and supply from stock on hand, transfers, production, assembly and suppliers to generate supply management suggestions.

MRP and supply chain management features allow you to incorporate your supply chain strategies into DEAR inventory management. Use MRP to compare actual and forecasted sales demand with available and potentially available stock supplies, then determine when products should be produced in-house, bought from suppliers, and delivered from distribution centers.


Final thoughts on the bullwhip effect

The consequences of the bullwhip effect can prove very expensive for the company as it faces either overproduction or underproduction. DEAR Systems can help you prevent your company from the bullwhip effect by automating your inventory management and using the software to forecast demand accurately.

Book a call with our experts to know your software better.


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