Demand Amplification in Supply Chain

Higher Variability in Orders Placed by Computer Retailer to Manufacturer Than Actual Sales

Lee, H, P. Padmanabhan and S. Wang (1997), Sloan Management Review

Increasing Variability of Orders Up the Supply Chain

Lee, H, P. Padmanabhan and S. Wang (1997), Sloan Management Review

The Bullwhip Effect and its Impact on the Supply Chain

• Consider the order pattern of a single color television model sold by a large electronics manufacturer to one of its accounts, a national retailer.

Point-of-sales Data-Original

POS Data After Removing

Promotions

The Bullwhip Effect and its Impact on the Supply Chain

POS Data After Removing Promotion & Trend

The Bullwhip Effectand its Impact on the Supply Chain

We Conclude ….

• Order variability is amplified up the supply chain; upstream echelons face higher variability.

• What you see is not what they face.

What are the Causes….

• Promotional sales– Forward buying

• Volume and transportation discounts– Batching

• Inflated orders– IBM Aptiva orders increased by 2-3 times

when retailers thought that IBM would be out of stock over Christmas

– Motorola cell phones

What are the Causes….

• Single retailer, single manufacturer.– Retailer observes customer demand, Dt.

– Retailer orders qt from manufacturer.

Retailer ManufacturerDt qt

L

What are the Causes….

• Promotional sales• Volume and transportation discounts• Inflated orders• Demand forecasting

– Order-up-to points are modified as forecasts change – orders increase more than forecasts

• Long cycle times– Long lead times magnify this effect

What are the Causes…. • Single retailer, single manufacturer.

– Retailer observes customer demand, Dt.

– Retailer orders qt from manufacturer.

Retailer ManufacturerDt qt

L

How big is the increase?

• Suppose a P period moving average is used.

2

2221

)(

)(

P

L

P

L

DVar

qVar

Var(q)/Var(D):For Various Lead Times

L=5

L=3

L=1

0

2

4

6

8

10

12

14

0 5 10 15 20 25 30

L=5

L=3

L=1

Consequences….

• Increased safety stock

• Reduced service level

• Inefficient allocation of resources

• Increased transportation costs

Multi-Stage Supply Chains

• Consider a multi-stage supply chain: – Stage i places order qi to stage i+1.

– Li is lead time between stage i and i+1.

RetailerStage 1

Manufacturer Stage 2

Supplier Stage 3

qo=D q1 q2

L1 L2

Multi stage systems

• Centralized: each stage bases orders on retailer’s forecast demand.

• Decentralized: each stage bases orders on previous stage’s demand

2

2

11

221

)(

)(

P

L

P

L

DVar

qVar

k

ii

k

iik

k

i

iik

P

L

P

L

DVar

qVar

12

2221

)(

)(

Multi-Stage Systems:Var(qk)/Var(D)

0

5

10

15

20

25

30

0 5 10 15 20 25

Dec, k=5

Cen, k=5

Dec, k=3

Cen, k=3

k=1

The Bullwhip Effect:Managerial Insights

• Exists, in part, due to the retailer’s need to estimate the mean and variance of demand.

• The increase in variability is an increasing function of the lead time.

• The more complicated the demand models and the forecasting techniques, the greater the increase.

• Centralized demand information can significantly reduce the bullwhip effect, but will not eliminate it.

Coping with the Bullwhip Effect in Leading Companies

• Reduce uncertainty– POS– Sharing information– Sharing forecasts and policies

• Reduce variability– Eliminate promotions– Year-round low pricing

• Reduce lead times– EDI– Cross docking

• Strategic partnerships– Vendor managed inventory– Data sharing

Example: Quick Response at Benetton

• Benetton, the Italian sportswear manufacturer, was founded in 1964. In 1975 Benetton had 200 stores across Italy.

• Ten years later, the company expanded to the U.S., Japan and Eastern Europe. Sales in 1991 reached 2 trillion.

• Many attribute Benetton’s success to successful use of communication and information technologies.

Example:Quick Response at Benetton

• Benetton uses an effective strategy, referred to as Quick Response, in which manufacturing, warehousing, sales and retailers are linked together. In this strategy a Benetton retailer reorders a product through a direct link with Benetton’s mainframe computer in Italy.

• Using this strategy, Benetton is capable of shipping a new order in only four weeks, several week earlier than most of its competitors.

How Does BenettonCope with the Bullwhip Effect?

1. Integrated Information Systems

• Global EDI network that links agents with production

and inventory information

• EDI order transmission to HQ

• EDI linkage with air carriers

• Data linked to manufacturing

2. Coordinated Planning

• Frequent review allows fast reaction

• Integrated distribution strategy

Information for Effective Forecasts

• Pricing, promotion, new products– Different parties have this information– Retailers may set pricing or promotion without

telling distributor– Distributor/Manufacturer might have new

product or availability information

• Collaborative Forecasting addresses these issues.

Information for Coordination of Systems

• Information is required to move from local to global optimization

• Questions:– Who will optimize?– How will savings be split?

• Information is needed :– Production status and costs– Transportation availability and costs– Inventory information– Capacity information– Demand information

Locating Desired Products

• How can demand be met if products are not in inventory?– Locating products at other stores– What about at other dealers?

• What level of customer service will be perceived?

Lead-Time Reduction

• Why?– Customer orders are filled quickly– Bullwhip effect is reduced– Forecasts are more accurate– Inventory levels are reduced

• How?– EDI– POS data leading to anticipating incoming

orders.

Information to Address Conflicts• Lot Size – Inventory:

– Advanced manufacturing systems– POS data for advance warnings

• Inventory -- Transportation:– Lead time reduction for batching– Information systems for combining shipments– Cross docking– Advanced DSS

• Lead Time – Transportation:– Lower transportation costs– Improved forecasting– Lower order lead times

• Product Variety – Inventory:– Delayed differentiation

• Cost – Customer Service:– Transshipment

The Effect of Lack ofCoordination on Performance

• Manufacturing cost (increases)• Inventory cost (increases)• Replenishment lead time (increases)• Transportation cost (increases)• Labor cost for shipping and receiving (increases)• Level of product availability (decreases)• Relationships across the supply chain (worsens)• Profitability (decreases)• The bullwhip effect reduces supply chain profitability by

making it more expensive to provide a given level of product availability

Obstacles to Coordination in a Supply Chain

• Incentive Obstacles

• Information Processing Obstacles

• Operational Obstacles

• Pricing Obstacles

• Behavioral Obstacles

Incentive Obstacles

• When incentives offered to different stages or participants in a supply chain lead to actions that increase variability and reduce total supply chain profits – misalignment of total supply chain objectives and individual objectives

• Local optimization within functions or stages of a supply chain

• Sales force incentives

Information Processing Obstacles

• When demand information is distorted as it moves between different stages of the supply chain, leading to increased variability in orders within the supply chain

• Forecasting based on orders, not customer demand– Forecasting demand based on orders magnifies

demand fluctuations moving up the supply chain from retailer to manufacturer

• Lack of information sharing

Operational Obstacles

• Actions taken in the course of placing and filling orders that lead to an increase in variability

• Ordering in large lots (much larger than dictated by demand) – Figure 17.2

• Large replenishment lead times• Rationing and shortage gaming (common in the

computer industry because of periodic cycles of component shortages and surpluses)

Pricing Obstacles

• When pricing policies for a product lead to an increase in variability of orders placed

• Lot-size based quantity decisions

• Price fluctuations (resulting in forward buying) – Figure 17.3

Behavioral Obstacles• Problems in learning, often related to communication in the supply

chain and how the supply chain is structured• Each stage of the supply chain views its actions locally and is unable

to see the impact of its actions on other stages• Different stages react to the current local situation rather than trying

to identify the root causes• Based on local analysis, different stages blame each other for the

fluctuations, with successive stages becoming enemies rather than partners

• No stage learns from its actions over time because the most significant consequences of the actions of any one stage occur elsewhere, resulting in a vicious cycle of actions and blame

• Lack of trust results in opportunism, duplication of effort, and lack of information sharing

Managerial Levers to Achieve Coordination

• Aligning Goals and Incentives

• Improving Information Accuracy

• Improving Operational Performance

• Designing Pricing Strategies to Stabilize Orders

• Building Strategic Partnerships and Trust

Aligning Goals and Incentives

• Align incentives so that each participant has an incentive to do the things that will maximize total supply chain profits

• Align incentives across functions• Pricing for coordination• Alter sales force incentives from sell-in (to

the retailer) to sell-through (by the retailer)

Improving Information Accuracy

• Sharing point of sale data

• Collaborative forecasting and planning

• Single stage control of replenishment– Continuous replenishment programs

(CRP)– Vendor managed inventory (VMI)

Improving Operational Performance

• Reducing replenishment lead time– Reduces uncertainty in demand– EDI is useful

• Reducing lot sizes– Computer-assisted ordering, B2B exchanges– Shipping in LTL sizes by combining shipments– Technology and other methods to simplify receiving– Changing customer ordering behavior

• Rationing based on past sales and sharing information to limit gaming– “Turn-and-earn”– Information sharing

Designing Pricing Strategiesto Stabilize Orders

• Encouraging retailers to order in smaller lots and reduce forward buying

• Moving from lot size-based to volume-based quantity discounts (consider total purchases over a specified time period)

• Stabilizing pricing– Eliminate promotions (everyday low pricing, EDLP)– Limit quantity purchased during a promotion– Tie promotion payments to sell-through rather than

amount purchased• Building strategic partnerships and trust – easier to

implement these approaches if there is trust

Building Strategic Partnerships and Trust in a Supply Chain• Background

• Designing a Relationship with Cooperation and Trust

• Managing Supply Chain Relationships for Cooperation and Trust

Building Strategic Partnerships and Trust in a Supply Chain

• Trust-based relationship– Dependability– Leap of faith

• Cooperation and trust work because:– Alignment of incentives and goals– Actions to achieve coordination are easier to

implement– Supply chain productivity improves by reducing

duplication or allocation of effort to appropriate stage– Greater information sharing results

Trust in the Supply Chain

• Table 17.2 shows benefits• Historically, supply chain relationships are based on

power or trust• Disadvantages of power-based relationship:

– Results in one stage maximizing profits, often at the expense of other stages

– Can hurt a company when balance of power changes

– Less powerful stages have sought ways to resist

Building Trust into aSupply Chain Relationship

• Deterrence-based view– Use formal contracts– Parties behave in trusting manner out of self-

interest• Process-based view

– Trust and cooperation are built up over time as a result of a series of interactions

– Positive interactions strengthen the belief in cooperation of other party

• Neither view holds exclusively in all situations

Building Trust into aSupply Chain Relationship

• Initially more reliance on deterrence-based view, then evolves to a process-based view

• Co-identification: ideal goal• Two phases to a supply chain

relationship– Design phase– Management phase

Designing a Relationshipwith Cooperation and Trust

• Assessing the value of the relationship and its contributions

• Identifying operational roles and decision rights for each party

• Creating effective contracts

• Designing effective conflict resolution mechanisms

Assessing the Value of the Relationship and its Contributions

• Identify the mutual benefit provided

• Identify the criteria used to evaluate the relationship (equity is important)

• Important to share benefits equitably

• Clarify contribution of each party and the benefits each party will receive

Creating Effective Contracts

• Create contracts that encourage negotiation when unplanned contingencies arise

• It is impossible to define and plan for every possible occurrence

• Informal relationships and agreements can fill in the “gaps” in contracts

• Informal arrangements may eventually be formalized in later contracts

Designing Effective Conflict Resolution Mechanisms

• Initial formal specification of rules and guidelines for procedures and transactions

• Regular, frequent meetings to promote communication

• Courts or other intermediaries

Managing Supply Chain Relationships for Cooperation and Trust

• Effective management of a relationship is important for its success

• Top management is often involved in the design but not management of a relationship

• Figure 17.5 -- process of alliance evolution• Perceptions of reduced benefits or

opportunistic actions can significantly impair a supply chain partnership

Achieving Coordination in Practice

• Quantify the bullwhip effect• Get top management commitment for coordination• Devote resources to coordination• Focus on communication with other stages• Try to achieve coordination in the entire supply

chain network• Use technology to improve connectivity in the

supply chain• Share the benefits of coordination equitably

Summary of Learning Objectives

• What are supply chain coordination and the bullwhip effect, and what are their effects on supply chain performance?

• What are the causes of the bullwhip effect, and what are obstacles to coordination in the supply chain?

• What are the managerial levers that help achieve coordination in the supply chain?

• What are actions that facilitate the building of strategic partnerships and trust in the supply chain?

Forecasting

Laws of Forecasting

• Three Laws of Forecasting

– Forecasts are always wrong!

– Detailed forecasts are worst than aggregate forecasts!

– The further into the future, the less reliable the forecast will be!

Forecasting

• Starting point of all Production Planning systems

• Qualitative Forecasting techniques

• Quantitative Forecasting techniques

• Decisions strive for Robustness while relying on forecasts (e.g., agile manufacturing)

Qualitative Forecasting

• Relies on expertise of people

• Delphi Method

• Usually used for technological forecasts (long term forecasts)

Quantitative Forecasting

• Causal models– Predict a future parameter (e.g., demand for a

product) as a function of other parameters (e.g., interest rates, marketing strategy).

• Time Series models– Predict a future parameter as a function of

past values of that parameter (e.g., historical demand).

Causal Forecasting

• Opening a fast food restaurant– Demand forecast?– Predictable parameters

• Population in the vicinity• Competition

– Use statistics (e.g., regression) to estimate the parameters

• Y = b0 + b1x1 + b2X2

Time Series Forecasting

• Time period i = 1,2,…..t (most recent data)• A(i): Actual observations• f(t+λ): Forecasts for t + λ, λ = 1,2,……,• F(t): smoothed estimate (current position of

the process under consideration)• T(t): smoothed trend

Time Series Model f(t+λ), λ =1,2,3,…,A(i), i =1,2,…t

Time Series Forecasting

• Moving-Average Model

• Exponential Smoothing Model

• Exponential Smoothing with a Linear Trend Model

• Winter’s Method (adds seasonal multipliers to the exponential smoothing with linear trend model)

Moving-Average Model

• Simply average the actual values to forecast future values

• Drawback-equal weights to all values

• Hence, m data points are chosen (user decides the value of m

• Higher m makes model more stable, but less responsive

• MA model ignores trends,T(t) = 0

• Model underestimates rising trend, overestimates decreasing trend

t

iAtF

t

i 1

)()(

,....,2,1),()( tFtf

m

iAtF

t

mti

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Exponential Smoothing

• Older the data point, lesser the weight

α from 0 to 1

• Lower values of α would make the model less responsive

• The model will underestimate the parameters with an increasing trend

)1()1()()( tFtAtF

,....2,1),()( tFtf

Trend Models

• Exponential smoothing with a linear trend

• Winter’s method for seasonality

Value of Information

• “In modern supply chains, information replaces inventory”– Why is this true?– Why is this false?

• Information is always better than no information. Why?• Information

– Helps reduce variability– Helps improve forecasts– Enables coordination of systems and strategies– Improves customer service– Facilitates lead time reductions– Enables firms to react more quickly to changing market

conditions.