The bullwhip effect in supply chain management

Bullwhip effect is a theory that the farther a company gets away from the customer, the more variable the demand is. This makes no sense -- it's like saying the more stocks you have in your portfolio the more volatile it will be. What happens is not a bullwhip at all. Look -- a 5% change in demand is a 5% change in demand up the entire stream. If the front-line retailer is in line with the industry change, then that means everybody in the industry is going to see a 5% change in demand. The raw number change in demand up the supply chain is bigger, but it's still the same percentage. The producer is a bigger company to begin with, so it is equipped to handle this change to the same degree that the retailer is. Furthermore, if the 5% change at the retailer level includes some component that is specific to that one retailer, than the industry change is going to be much less than 5% - in other words less volatile. Diversification decrease volatility, because you have to look at this on a percentage basis. Looking at raw numbers, when the producer is operating at a much larger scale than the individual retailer, makes no sense.

Indeed, a quick look at the explanation for the bullwhip effect tells me that it is a fiction. The following can contribute to the bullwhip effect: overreaction to backlogs, neglecting to order in an attempt to reduce inventory, no communication up and down the supply chain, delay times for information and material flow (QuickMBA, 2010). If these are the causes, then these are the causes. It is not the change in demand that causes the inventory problems at all; it is the mismanagement of the inventory. The terminology and definition of bullwhip effect pins the blame on the change in demand when clearly it is the inventory management practices, and not the change in demand, that create this effect.

Now, vendor managed inventory can be a solution to this "bullwhip effect" if it addresses the causes. If we take at face value that change in demand is the cause, VMI does not affect that. Looking at the other causes, they relate mostly to lousy communication and mismanaged inventory policy. VMI is, if nothing else, a consistent system. The retailer provides information to the vendor, and it is the job of the vendor to manage the inventory level of the retailer. This technique is used in some fairly large companies -- a lot of grocery store distributors take this responsibility. Pepsi uses this to manage its deliveries to stores -- the reps are responsible for maintaining inventory levels, based on the demand information provided to them.

The issue with VMI is that it places the onus on managing the inventory on the vendor, which means you have to trust the vendor. If I run a convenience store, I trust Pepsi to keep my fridge full. I might trust some of my other major suppliers as well. These are well-run companies with a global track record of executing this type of system. But I do not trust any company that does not run a VMI system. If that is not what they do, then they will not be reliable as far as keeping the inventory levels up. The risk with a VMI system only increases with the number of different suppliers the company has. My little convenience store might only have a handful of suppliers, and I can ensure that they are working with me. Remember that communications is a key element of success in avoiding any inventory problems. If I have a thousand suppliers, I am going to have a hard time making sure that they are all on top of my inventory needs. Thus for many situations, VMI is not going to be useful, because you as retailer are going to struggle to keep track of all of your inventory levels.

From the producer's point-of-view, VMI is great. The vendor is in charge of ensuring inventory levels are satisfactory, and that is going to increase sales. There still needs to be a high level of communication, so that the vendor is aware of the inventory needs of the retailer. But the key point is that where inventory problems arise, communication or lack thereof is a factor, and the VMI system pretty much enforces the need for regular communication. With a formal structure for communication, the vendor and retailer are in frequent contact, eliminating one of the major causes of inventory problems.

The Ravichandran paper (2008) points out that reducing the Bullwhip Effect requires a number of different techniques. Presumably these are to tackle the numerous causes of major inventory problems. VMI improves communication and reduces the tendency of companies to underorder to clear backlogs. But it does not address all root inventory problems. Enterprise resource planning (ERP) is another tool that can help. It does more than manage inventory, but it provides a tool for the gathering and analysis of critical information that can be used in ordering, or passed along to the vendor in a VMI system. This shows the ERP is a complementary tool to VMI, but can also work on a standalone basis as well.