The Bullwhip Effect

Originally written in July 2018

The bullwhip effect is a phenomenon where changes in downstream demand are magnified as the information travels imperfectly up the supply chain, causing serious inefficiencies across the entire channel.

Financial investment cycles in commodity industries tend to reflect long-term bullwhip effects, where they are called the capital cycle.

In Supply Chains

A small flick of the wrist (a shift in point of sale demand) can cause a large motion at the end of the whip (manufacturer’s response). In supply chains, the bullwhip effect is often attributable to two root causes:

• Disorganization lack of communication between counterparties, heuristic demand estimation
• Misaligned incentives constrained ordering (minimum thresholds, fixed-period arrangements, etc.), special customer promotions (free returns, discounts)

Forrest’s commentary notes that participants affected by the Bullwhip effect often make an error of fundamental attribution, emphasizing internal shortcomings like ineffective employees over external factors like those above.

In Commodity Industries

The bullwhip effect can feature prominently in the competitive dynamics of commoditized industries, where a few suppliers sell an undifferentiated product.

Bullwhip effects are significant in commodity industries where there is a long delay between demand signal and supply response and demand is highly-cyclical. Examples include semiconductors, housing, and natural resources.

The general pattern:

1. Demand rises, increasing prices and profit
2. Suppliers increase capacity to capture more profits
3. Supply rises above demand, decreasing prices and profits
4. Supply is reduced via distress until the demand again inflects over supply and the cycle repeats

The Capital Cycle

Because of long-term bullwhip effects, commodity industries companies are difficult to value. This adjacent financial phenomenon to the supply-chain bullwhip effect is called the capital cycle.

The capital cycle is caused by investor optimism about future returns in an under-supplied industry. Invested capital follows supply response, which follows cyclical demand. This second-order investor/supplier/demand relationship causes significant volatility in valuations.

As suggested by the chart below, the capital cycle is a clear example of extrapolation bias.

Solutions

Holistic systems thinking is an effective antidote to bullwhip effects in the supply chain as well as handling complex adaptive system behavior in general.

Specifically, managers can:

1. “Spotlight” the problem, discussing it directly to employees and counterparties
2. Improve the inventory planning (supply) and consumer forecast (demand) process by measuring it
3. Minimize artificial barriers and skewed incentives such as operational inefficiencies (logistics) and unstable pricing (everyday low prices, less promotions, better governance in shortage situations)

Further Reading

From this series:

• The Hype Cycle (August 2018)
• Second Order Effects (upcoming)
• Spotlighting (upcoming)

External:

• MIT professor and economist Jay Forrester first described the bullwhip effect in the 1960’s
• Thinking in Systems: a Primer by Meadows (goodreads) is a readable introduction to handling complex adaptive system behavior in general. In the book’s vocabulary, bullwhip effects are an example of a feedback loop
• For more on the bullwhip effect in financial analysis, see Capital Returns: Investing Through the Capital Cycle (goodreads) by value investor Marathon Asset Management
• Adaptation in markets and industries is a feature of David Tepper’s investment process (25iq)
• Cyclical adaptive effects also occur in even more long-term macroeconomic systems, such as the debt cycle
• Byrne Hobart on Bullwhip Effects [substack]

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