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The Financial Crisis and the Money Supply Chain
Three types of flows [underly] supply chain management: material, information, and money. Most disruptions (for example, a tsunami, a labor strike, or theft) affect material flows from suppliers to their customers. Material flow disruptions are often coupled with disruptions in the information flow. In contrast, a financial crisis disrupts the flow of money and credit, which affects the ability of consumers to purchase goods from retailers and of manufacturers to purchase parts and products from suppliers. Thus, whereas many disruptions affect supply, a financial crisis affects demand as well.
A disruption in demand
Whereas physical disasters usually have an obvious geographic epicenter, the financial crisis created more widespread uncertainty. At first, companies didn't know the impact on demand and supply. Would there be bank runs? How far would real estate prices fall? How far would the stock market drop? How high would unemployment climb? How would consumers, customers, retailers, suppliers, and governments react to the crisis? Which suppliers, logistics companies, and retailers would fail? No one knew. With the tightening of credit and so much financial uncertainty for consumers and businesses, consumer demand fell.
The uncertainty created angst everywhere, manifesting itself in consumers' anxieties over spending. Consumers embraced frugality and sought to stretch their constrained budgets.
Paradoxically, the downturn actually created supply shortages in some industries, for two reasons. First, the increase in order cancellation rates caused suppliers to delay production. Suppliers didn't want to purchase raw materials for orders that might be canceled. They cut inventories and waited for firm orders, building a sales backlog as a "cushion." This reluctance of suppliers to commence production without firm orders (and upfront payments) caused supply shortages. Second, changing demand patterns brought shortages of (now higher-volume) lower-priced goods and private-label brands. Both [grocery chain] Shaw's Supermarkets and [office supplies retailer] Staples found that the shift from brand-name to private-label products strained the contract manufacturers making these generic products.
Frugality Disrupts Forecasting
The changes in consumers' purchasing behavior upended years of historical data used by companies for forecasting. Before the crisis, Shaw's "knew what you would have for dinner next week." The retailer, with 169 stores, used 10 years' worth of data to forecast exactly what consumers would buy and even how they would react to promotions. During the crisis, however, demand shifted so much that a survey of 342 global companies between late 2009 and early 2010 found that the top two challenges for supply chain performance were "demand volatility and/or poor forecast accuracy" (74 percent of respondents) and "lack of visibility to current market demand" (33 percent).
Along those lines, Staples said that its forecasts were no longer as accurate as they once were. Other companies experienced abrupt customer events that changed demand patterns. For makers of computers and other electronic products, such as HP (the biggest creditor of Circuit City), that meant a sudden shift of the business to other retail channels with different patterns of demand. History stopped being a good predictor for demand patterns.
Reacting to Forecast Inaccuracy
The downturn and disruption of forecast reliability forced companies to resort to reactive tactics rather than to planned strategy. Shaw's Supermarkets had neither sufficient historical data nor applicable forecasting models to estimate the new pattern of demand for the private-label products that consumers were suddenly seeking. As a result, the company had to become more nimble and short-term focused, using ad hoc communications as well as manual ordering from its suppliers. Rather than Shaw's promotions driving sales and marketing activities, consumer behavior was driving marketing—a complete reversal from the past; consequently, the company became focused on the next week, not on the next quarter.
Companies Shift to Survival Mode
"Hunkering down" for survival was the prevailing behavior of customers, suppliers, and companies in many industries. Responding to falling orders from their customers, companies cut orders to their suppliers even further, thus contributing to the "bullwhip effect." [For an explanation of this phenomenon, see the sidebar.] Interviews with 20 companies, conducted at the MIT Center for Transportation and Logistics, documented that cost cutting was the prevailing response to the crisis. Many companies slashed budgets, cut staff, and eliminated non-essential expenses. In 2009, another survey found that companies reduced supply chain costs by negotiating supplier cost reductions (75 percent of respondents), reducing inventory levels (60 percent), moving to lower-cost suppliers (44 percent) and reducing the number of suppliers (40 percent).
Smaller Shipments, Slower Modes
Cost cutting affected demand patterns for logistics in two ways. First, C.H. Robinson, a third-party logistics provider, noticed that customers wanted smaller shipments. Companies switched from using full truckload (TL) to less-than-truckload (LTL) carriers and from LTL to parcel carriers. Even though the smaller shipments cost more per unit shipped, shippers chose smaller order sizes because they were more concerned about high inventory levels and customer nonpayment risks.
Second, the financial crisis also coincided with high oil prices and growing concerns of greenhouse gas emissions, which reduced demand for faster modes. UPS and FedEx saw their customers shift from premium air service to less expensive ground delivery modes. Between 2008 and 2009, FedEx Express (air) shipments dropped nearly 5 percent but FedEx Ground shipments rose 1 percent. The total volume of international airfreight fell 25 percent. Mission-critical parts service providers noticed a decline in requested service levels: two-hour service became four-hour, and four-hour service requests became eight-hour, for example. High oil prices also motivated ocean carriers to adopt "slow steaming" to save fuel. Slow steaming delayed delivery of goods, increasing inventories in transit. The longer transit times also increased exposure to a multitude of transoceanic trade risks such as customer bankruptcies, port disruptions, and tariff increases.
The interplay of shipment size, speed, cost, and inventory created complex tradeoffs, which many companies addressed through a segmentation of their supply chains. For example, Shaw's considered lower-cost transportation modes, such as rail instead of truck. Rail was cheaper, but it took 21 days to move rail containers across the country, which increased the inventory costs. Not all products were shifted to rail; strawberries were too perishable, but hardier fruits such as Washington apples could make the rail journey. Astute companies performed frequent reassessments of transportation costs because fuel prices fell during the latter part of the recession, making trucking, at times, attractive again for more products.
Looking at the Bigger Picture Before Making Bigger Cuts
With the downturn in demand, BASF (the largest chemical company in the world) faced tough choices in operating its expensive, massive chemical plants. As a result of diminished demand, some plants were operating below economically productive volumes, and their managers wanted to shut them down in order to limit the losses. Yet BASF has many vertically integrated parts in its internal network, a strategy it calls verbund (which is German for "linked" or "integrated"). This integrated structure means that some of the most important suppliers and customers of BASF plants are other BASF plants.
Rather than analyze each plant in isolation (i.e., whether a given plant has enough direct customer demand to justify its continued operation), BASF looked at the bigger picture of its internal supply chain. Although a certain facility might have been economically unproductive on an individual basis, BASF kept the plant running if the plant made intermediate products that were used by other still-profitable parts of BASF. This was analogous to the value-at-risk calculations described in the last part of Chapter 3, in the sense that BASF was calculating the total impact of disrupting production of an intermediate chemical on all the downstream products that use that chemical, and thus on the entire company's financial performance. The company could rely on this holistic strategy because it had control over all the company's divisions for purposes of cost sharing. This is not the case for most other companies, which rely on external suppliers, some of whom may go out of business, creating shortages.
Bankruptcies in the supply chain
The disruption in the money supply, and the fall-off in demand, reverberated across global supply chains to create risks of bankruptcies everywhere. [The technology manufacturing and supply chain solutions provider] Flextronics summarized these risks in its 2009 annual report. The report stated that the company faced risks from "the effects that current credit and market conditions could have on the liquidity and financial condition of our customers and suppliers, including any impact on their ability to meet their contractual obligations." During a 2009 MIT Center for Transportation Logistics conference, corporate participants agreed that they were all struggling with both suppliers' and customers' problems.
Demand Disruption Becomes Supply Disruption
In February 2009, Edscha, a maker of automobile roof modules for convertibles, declared bankruptcy. When car sales plummeted 30 percent, supplier revenues dropped further, straining them financially.
Not only did automotive suppliers suffer greater sales declines owing to the bullwhip effect, but many suppliers are capital-intensive businesses because of large investments in tooling and equipment. Thus, many suppliers carried high debt loads and were especially impacted by the disruption in the credit markets. Edscha had suffered a loss of almost 50 percent of sales, which pushed the 1.1 billion company over the edge. In North America, nearly 60 suppliers' plants closed in the three years after 2008, with the loss of about 100,000 jobs. Bankruptcies in the automotive industry more than tripled between 2007 and 2009.
A Business Continuity Institute survey in the summer of 2009 found that 28 percent of companies had suffered a disruption caused by a financial failure of a supplier in the preceding 12 months, and 52 percent said such failures would be a major threat in the following 12 months. Manufacturing companies were especially hard hit by this type of disruption, with 58 percent of them reporting supplier financial failures. In another survey, 40 percent of respondents ranked "suppliers going out of business" among the risks that were most likely to affect their own supply chains.
Managing the Risks of Supplier Bankruptcy
During the depths of the downturn, one company said, "Supplier disruptions are now corporate risk number one. Risk management in the financial crisis is all about being very fast in reacting, since we lose millions of euros if a strategic supplier goes out of business. The faster we know that the supplier defaults, the less money we will lose."
Spending on supplier risk assessment and the frequency of reassessment increased dramatically during the crisis. For example, one automotive company went from a six-month assessment cycle to a weekly assessment for all first-tier and also some second-tier suppliers. Companies such as EMC [a provider of data storage solutions], [medical device maker] Boston Scientific Corporation, and Shaw's Supermarkets had mounting concerns about supplier quality during the downturn. They saw suppliers' capacity and staff cutbacks as a potential threat to quality; fewer people meant more knowledge gaps, more sporadic production runs, and fewer people to do quality-critical tasks like maintenance and inspections.
Financial Support of Suppliers
The precarious state of supplier finances forced some companies to offer direct support to their ailing suppliers. Edscha's bankruptcy was a shock for BMW, which needed the supplier's roof modules for its new Z4 convertible and other models. BMW said, "We had to help Edscha and try and stabilize it. We had no choice to go to another supplier, as that would have taken six months and we don't have that." Surveys found that between 9 and 12 percent of companies were providing financial assistance to suppliers.
Most companies explicitly eschewed direct investment in suppliers because of the risks and the companies' own need to conserve capital. Instead, companies helped financially struggling suppliers in a number of other ways. For example, BASF, HP, and others helped some suppliers by accelerating payments or by buying raw materials on their behalf. Other companies prepaid for tooling or other capital-intensive supplier needs if suppliers couldn't get their own credit. According to Dr. Hermann Krog, then executive director of logistics at Audi, the automotive OEM helped suppliers by agreeing to be the guarantor on some bank loans.
Jackie Sturm, vice president and general manager of Global Sourcing and Procurement at Intel, said that the company assisted suppliers in creating financial plans as well as in finding other customers or investors. In some cases, however, Intel went a step further. It provided liquidity, by lending working capital against future production. Intel Capital even took equity stakes in a few suppliers and—as it turned out—profited from those investments when the economy recovered.
Solutions for Customer Insolvency
Supplier bankruptcies weren't the only risks faced by companies; customers failed, too. For example, in 2009 alone, Flextronics "incurred $262.7 million of charges relating to Nortel and other customers that filed for bankruptcy or restructuring protection or otherwise experienced significant financial and liquidity difficulties," according to Flextronics's 2011 annual report. A customer bankruptcy might mean an indefinite delay in getting paid, if one got paid at all. A spring 2009 survey found that 7 percent of companies were providing financial assistance to customers.
Nypro, a $1.2 billion global plastic parts manufacturer, reviewed all of its "customers at risk," sometimes on a daily basis during the crisis. For some customer accounts, the company was able to insure the receivables. On accounts for which it couldn't get insurance, such as on automotive customers, the company offered early payment discounts to customers to mitigate financial default risks, thus reducing Nypro's exposure to those risky customers. Some customers paid in as few as 15 days under this program.
Compared to prior recessions, the rise of outsourcing and contract manufacturing created new customer-side risks during the 2008 financial crisis. For example, Nypro might make parts on behalf of a large low-risk firm, such as bottle caps for P&G or cell phone bodies for Nokia. But as a result of outsourcing by the original equipment manufacturer (OEM), Nypro's parts might actually be sent to a small regional co-packer or a Chinese contract manufacturer before being shipped to the OEM. This intermediary contract manufacturer was then responsible for paying Nypro. This arrangement exposed Nypro to the credit risk of the contract manufacturer, rather than the OEM. Worse, when Nypro negotiated an agreement with a big OEM like P&G or Nokia, Nypro might not even know who these contract manufacturers would be. Consequently, Nypro sought guarantees from the OEM, or enlisted its help in performing due diligence on co-packers and contract manufacturers.
Recovery: Phase 2 of the bullwhip
During the downturn, U.S. unemployment had more than doubled—reaching 10 percent in December 2009. The rate of business failures increased 30 percent from the prerecession value to 235,000 failures per quarter in March 2009. Although the world may have been staring into a financial abyss after Lehman's failure in the fall of 2008, global resilience absorbed the shock. Trillions of dollars in monetary stimulus stabilized the financial markets, and fiscal stimulus helped limit the depths of the downturn. Governments took over ailing financial institutions or agreed to take toxic assets off of banks' balance sheets. These concerted efforts by central bankers and governments prevented a deeper deflationary cycle, runs on banks, and other types of value-destruction processes that contributed to the 1930s Great Depression. Retail sales began to recover after March 2009, and by June 2009, the recession was officially over in the United States.
Risks in the Rebound
Managing during the downturn had been difficult, yet managing during the rebound wasn't easy, either. In the following 12 months, retail sales rebounded by a modest 7 percent, but imports surged 27 percent as distributors and retailers started to build inventory in anticipation of increased sales. The bullwhip was now again in effect.
To manage the recovery, USG Corp., a U.S.-based maker of construction materials with 2009 sales of $3.2 billion, used advanced planning software. When the housing bubble burst, the company cut production capacity strategically and reduced costs. As construction slowly rebounded, the company planned for careful growth and determined the optimal use of manufacturing plants for specific products and markets.
"Now, we are looking at long-term forecasts and running models five to 10 years into the future to help us determine when and what [capacity] we will need to bring back online first," said Timothy McVittie, senior director of logistics for USG Building Systems. "Finding the right balance is a big hairy beast," McVittie explained, "due to the challenge of staying lean but still meeting customer expectations." He then added, "Considering that industry demand is as low as it is, the marketplace has little patience for manufacturers who cut too deep and can no longer effectively service their customers."
Overextended Suppliers in a Fragile Economy
Companies worried about suppliers' abilities to handle a rebound; a company couldn't be poised for growth if its suppliers weren't poised for growth. EMC noted that the 2000-2001 tech industry recession had been a painful one because suppliers cut capacity too slowly. In contrast, during 2008-2009, EMC was surprised by how quickly technology suppliers reacted. DRAM memory chip capacity, for example, fell rapidly. But overly aggressive cutbacks could be just as damaging as overly cautious ones, so EMC prepared for the recovery by using contracts that required suppliers to maintain 20 percent upside capacity available. When EMC visited a supplier, it made sure that the supplier was devoting resources to EMC and that if the supplier cut capacity, it did not cut capacity devoted to EMC.
The automotive industry experienced similar effects. As automakers and other vehicle manufacturers increased their production volumes beginning in 2010, the growth strained their suppliers. Some of these suppliers grew too fast and without adequate capital. Small suppliers, especially, still didn't have access to capital, and other suppliers were too uncertain about the economy to make needed capital investments. Part of companies' concerns about these supply risks were driven by ongoing economic uncertainties such as the United States's "fiscal cliff," debt ceiling, budget sequestration battles, European sovereign debt crisis, government austerity moves, and mixed data about the robustness of the recovery.
In particular, Toyota watched for suppliers that responded to production launches with plans to work seven days a week. Although the financial results of these suppliers were impressive when judged according to traditional metrics, many were actually becoming more fragile and more risky as a result of deferred maintenance, lack of equipment renewal, and overworked employees. Around-the-clock production "immediately throws up a flag," said Toyota's North American purchasing chief Bob Young. "It means we have to visit them to understand their true condition." As the recovery progressed and Toyota North America planned to boost production, the company doubled its supplier watch-list to 40 in April 2013 from 20 suppliers in 2012.
In thinking about long-term relationships and the stability of the entire supply base, companies were looking to aid selected suppliers as needed. They were again considering tooling buys, accelerated payables, buying materials for suppliers, loans, and so forth. In one case, a large company simply bought the small supplier when the supplier ran into trouble. Honda Motor Co.'s North American purchasing chief, Tom Lake, acknowledged that Honda can't just say "more" and expect suppliers to jump. "Because so many automakers are increasing production, suppliers have to pick and choose where to make an investment."
Cash becomes king: Reducing working capital
The financial crisis created urgency and an opportunity to both reduce operating costs and free up scarce capital locked in the supply chain. One of the results was increased collaboration between companies' finance departments and supply chain organizations.
Material Flow Begets Cash Flow
Although companies' supply chain operations do not typically make financial headlines, they have three significant effects on cash flows and working capital requirements. First, DPO (days payables outstanding) are unpaid bills to suppliers and represent a de facto loan of cash from the supplier to the company. Second, DSO (days sales outstanding) are customers' unpaid bills and represent a de facto loan of cash from the company to its customers. Third, DIO (days inventory on hand) is cash tied up in inventory. Companies can reduce their working capital levels through paying suppliers later (increasing DPO), accelerating the collection of customer payments (reducing DSO), or reducing inventories (reducing DIO). A spring 2009 survey found that 55 percent of companies extended payment terms with suppliers (DPO), 25 percent worked to accelerate customer payment terms (DSO), and 44 percent worked on reducing supply chain-wide inventory (DIO) as part of their efforts to manage working capital.
Terms of Endearment: Reducing Working Capital
Prior to the financial crisis, many salespeople paid little attention to customers' payment terms. That left their companies with high DSO and high working capital requirements. The recession made companies more aware of the costs of giving away working capital via generous terms. Many of them looked to reduce DSO by improving customers' compliance with payment terms. Companies scrutinized actual payments relative to contractual payment terms, realizing that payment terms in reality were longer than specified in the contract—especially with customers strapped for cash who tried to delay payments. When Nypro compared its actual DSO to its contractual average, it found that its average contractual DSO was 52 days but the actual average payment was received 65 days after delivery. The company started focusing on chronically late customers in order to decrease this average.
Similarly, the financial crisis also led companies to scrutinize supplier payment terms. For example, in the past, Nypro let each of its plants negotiate and manage supplier payment terms, but that practice resulted in a wide range of 30- to 75-day terms. During the crisis, Nypro created global supply contracts with its top 50 suppliers and worked on lengthening its payment terms. Nypro had some success because its financial stability and reputation for consistent and timely payments made suppliers more willing to extend the terms.
Nypro's program was part of a larger effort to create a cash-neutral supply chain, adding discipline to incremental activities that might consume cash or capital. For example, Nypro started performing a capital and cash-flow analysis of all new programs, including large sales quotes, so that the company didn't take on projects or sales commitments that it couldn't afford. This analysis included the capital, inventory, terms, and ROAE (return on average equity) implications of any new program or quote. By incorporating cash and capital analyses at that level, the program managers and salespeople became aligned with the company's financial goals.
Cash neutrality also affected ongoing supply chain activities. If the company faced a unilateral increase in DSO on the customer side, it passed that increase through to the DPO and the supply side. Keeping the terms matched on both sides avoided unexpected demands for cash to support supply chain operations. Nypro also rented equipment for flexible capacity rather than buying all the equipment needed for the upside estimates of demand. That way, if demand failed to materialize, Nypro didn't have surplus capacity on its books. In total, Nypro freed up $100 million in cash from the beginning of the financial crisis to October 2009.
Too Much Junk in the Trunk: Reducing Inventory
A January 2010 survey found that 60 percent of companies had reduced their inventory levels throughout 2009. Both Church & Dwight [a manufacturer of personal care and household products] and [the apparel retailer] Limited Brands worked to become more demand-driven with leaner inventories. In fact, Church & Dwight started measuring inventory in terms of dollars rather than weeks to emphasize the financial burden of inventory rather than inventory's role as a buffer. The company reduced inventory through improved sales-and-operations-planning (S&OP) processes, tightened safety stock requirements, integrated raw materials planning, and consignment-at-vendor optimization. The company also paid special attention to slow-moving and remnant inventory, the size of which grew during the downturn, as a result of the drop in demand as well as the shifts in demand patterns. This emphasis helped improve other financial variables such as write-offs and capital tied up in warehouse space. Between 2006 and 2009, Church & Dwight reduced remnant inventory from 12 percent to between 4 and 5 percent.
Relative Credit Quality in the Supply Chain: Winning the Battle and Losing the War
Strategies to reduce working capital requirements can have unintended effects. Lengthening payment terms to suppliers meant that those suppliers' financial situations worsened. Too-low inventories of material and parts reduced a company's buffers to any supply hiccup. And low inventory of finished goods could reduce the company's level of service, straining its relationships with customers. Even tightening payment terms and cutting down on the time until the company got paid (cutting down DSO) carried a risk, especially during the downturn, that customers would demand better prices or other extra services in return for cutting DSO or take their business to suppliers who offered longer payment terms.
Advance Auto Parts (AAP), a Fortune 500 automotive retailer of parts, accessories, and maintenance items, was careful about reworking terms with suppliers. An improved, longer DPO for AAP meant a worse DSO for its suppliers. AAP saw this as a zero-sum game or worse. A company could readily optimize itself into a worse position by being too aggressive with longer DPO terms. First, if AAP's supplier had to borrow extra cash because of lengthening payments, those borrowing costs would appear in the supplier's prices. And if the supplier had a worse credit rating than AAP, then the supplier would pay more for one day of the supplier's DSO than AAP would pay for one day of its DPO. Second, longer payment terms to suppliers could increase the risk of a supplier bankruptcy. AAP devised an innovative supply chain financing program to address this issue.
AAP did very well during the crisis; although many consumers stopped buying new cars, most still had a car, and those cars needed maintenance. The maintenance needs of the aging fleet meant good times for car part retailers such as AAP. While Chrysler begged for a government bailout and slipped into bankruptcy, AAP had little trouble obtaining credit on favorable terms. The company had many small suppliers that make automotive replacement parts, including ones that supplied the struggling OEMs. Given the small size of the suppliers and the turmoil in the automotive industry, the suppliers were hurting for cash but couldn't borrow at affordable rates, if they could borrow at all.
AAP crafted a supplier financing program with some financial institutions in which the financial institution paid the supplier's invoice at a discount on quick terms—as short as 20 days. But rather than use a discount factor based on the supplier's credit rating, the program used AAP's much better credit rating. This rate was about half the one most suppliers could have gotten on their own. The result was that suppliers became willing to offer AAP significantly longer payment terms—as much as 240 days. At the end of this much-extended payment term, AAP paid the invoice amount to the financial institution.
AAP noted three key details that were needed to make the program work. First, AAP inspected incoming goods in a timely fashion to certify the invoice to the bank, making the supplier eligible for quick payment. The 20-day early payment terms reflected the minimum time that AAP needed to ensure the quality and correctness of the order. Second, careful documentation also ensured that AAP had the necessary audit trails and Sarbanes-Oxley compliance. Third, AAP worked with its outside auditor and rating agencies to ensure that the program would be counted as accounts payable and not ordinary debt on the company's balance sheet. The reasoning worked, because the financing was directly tied to transactions between AAP and the suppliers. Moreover, the supplier (not AAP) controlled the duration of the "loan" because the supplier decided when to ask the bank for the money.
The three-way financial relationships in the program helped all three participants. AAP got longer payment terms, which let the company conserve cash without incurring more debt on its balance sheet. The program also reduced AAP's supplier risks because it helped improve the financial strength of the suppliers. The supplier got paid quickly but also had flexibility to manage cash coming from outstanding receivables on favorable interest-rate terms. Suppliers were not forced to use the program or pay any fees for unused borrowing. The financial institution earned interest through the difference paid to the supplier and the amount paid by AAP. The mutual benefits of the program enabled AAP to attract several financial institutions to the program as well as a large number of its top suppliers.
When Black Swans Drop In
Some types of very rare, high-impact disruptions lead to novel responses, such as a clever way to create a beneficial relationship between a company, its cash-strapped suppliers, and risk-averse bankers. Other types of disruptions, however, have less idiosyncratic causes and more frequently felt effects. For these kinds of disruptions, companies can prepare options prior to the disruption that accelerate recovery and mitigate impact. Many of these preparations also help when some unpredictable phenomenon hurtles the company, industry, or the economy toward a crisis.
The swift contraction in demand [during the financial crisis of 2008-2009] sparked an amplified reaction in upstream supply chain activities that grew more and more extreme as the disruption in demand propagated up the chain of suppliers—a phenomenon known as "the bullwhip effect."
In a hypothetical illustration of the bullwhip effect, if a retailer sees an X percent drop in sales, it might reason that future sales will be low, too, because most forecasts are based on past experience. In addition, it might realize that its current inventories are too high if future sales continue to be low. Consequently, the retailer might cut orders to the wholesaler by, say, 2X percent (reflecting both lower future sales and a desire to decrease the high current inventory). The wholesaler, seeing the 2X percent drop in orders from the retailer, might prepare for future lower sales and too much inventory by cutting orders to [its own suppliers] by 4X percent. At each tier of the supply chain, the decline in demand sparks a bigger decline in orders from suppliers—each company reasoning that it needs to quickly cut production (to adjust to declining sales) and work off its bloated inventory.
When demand revives, the bullwhip pattern reverses as each echelon boosts ordering both to cover expected higher sales and to quickly replenish depleted inventories. Again, the effect amplifies up the chain with larger and larger order size increases upstream in the supply chain. However, because of cuts in capacity during a downturn, upstream companies take time to respond to orders. As orders flood in, lead times grow, suppliers start allocating partial shipments to customers, and customers respond by boosting orders even more in an effort to garner a greater percentage of the allocation. All of this causes significant swings in inventory and orders, such that the amplitude of the swings is larger the further upstream (and further from the consumer orders) a company is in its supply chain.
In the context of a normal economy with modest demand volatility, the bullwhip effect causes volatility to vary across the tiers of a supply chain—wholesale volumes will be more volatile than retail volumes, manufacturing volumes will be more volatile than wholesale volumes, and supplier volumes will be more volatile still. This phenomenon has been documented in consumer packaged goods industries, food, semiconductor manufacturing, and others.
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