Cracking the bullwhip

The Wall Street Journal had an article about how Caterpillar is managing the shift from recession to growth (‘Bullwhip’ Hits Firms as Growth Snaps Back, Jan 27).  A large part of the article revolves around the bullwhip effect.  Here is how my colleagues (including my dean) define the bullwhip effect in their textbook:

Bullwhip effect The phenomenon of upstream variability magnification that indicates a lack of synchronization among supply chain members.

Here is what the article says about it:

Caterpillar Inc. recently told its steel suppliers that it will more than double its purchases of the metal this year—even if the company’s own sales don’t rise one iota. In fact, the heavy-equipment maker has been boosting orders to suppliers for everything from big tires and hydraulic tubes to shatterproof glass.

How is that possible? Chalk it up to the “bullwhip effect,” which is reverberating across the U.S. economy. This phenomenon occurs when companies significantly cut or add inventories. Economists call it a bullwhip because even small increases in demand can cause a big snap in the need for parts and materials further down the supply chain.

The bullwhip has broad implications now as companies rush to fill orders while also restocking warehouse shelves. It touches everyone from retailers to the industrial companies that supply the grease, bolts and coal needed to churn out more products. The manner in which companies, large and small, respond to market shifts determines which ones emerge first from the slump and start growing again.

So the image to have in mind here is Indiana Jones keeping the bad guys at bay with just a strip of leather. A small move at the wrist causes a big swing at the end.  The classic story is Pampers diapers.  The end consumer uses the product at a pretty constant rate.  However, when P&G looked at the orders they were getting from retailers and distributors, they saw significant variability.  When they looked upstream at the orders they placed on their suppliers, these were even more variable.  The research that put the term on the map for the supply chain community was an article by Hau Lee, Paddy Padmanabhan and Jin Whang (these were profs of mine in grad school so I am obliged to mention all of them). Their work dates from the early 90’s and reappears every now and then (check out this article from the McKinsey Quarterly).  Given this existing work, it begs the question of whether the Wall Street Journal got it right.

I’m not 100% convinced it did.  What most people — both researchers and supply chain managers in practice — focus on is variation over time.  The issue that causes concern is that firms in supply chain are dealing with variability that is not really there and that they don’t realize this.  Variability makes planning in a supply chain hard.  If firms don’t realize what is driving that variability, they may take costly, unnecessary actions.   For example, a firm selling plastic for P&G’s diapers had to learn to deal with wide swings in orders when it could have been avoided with better joint planning.  On the other hand, a firm selling lawn equipment to Home Depot has to live with wide swings in orders but they know it’s coming and why.  No amount of better coordination is going to make those swings in orders go away.

I think that Caterpillar is closer to the latter story.  Everyone knows that we have been in a recession.  Everyone has heard that we may be coming out of it.  A Cat supplier should not be surprised if orders pick up and they should anticipate that volumes jump around a lot until everyone figures out just how strong the recovery is.  This not to say that this transition will be easy.  What the article makes clear is that Caterpillar’s supply base has been potentially crippled by the depth of the recession and restrictions on lending:

Many are smaller companies hurt by the credit crunch as they continue to have difficulty obtaining loans.  A flow of new orders to suppliers could encourage banks to start lending to them more freely. But if that doesn’t happen quickly, there could be bottlenecks and shortages as suppliers miss shipments or turn away orders because they can’t afford to buy the materials or hire more workers to do the job. Prices could spike. …

“Many of these smaller companies have breached their bank covenants,” says Steve Wunning, the Caterpillar group president, who is among other things responsible for purchasing and led the recent meetings with suppliers. “When they come in and say they need to borrow more money because they’re hiring people and buying more material, what are these banks going to say? They’re probably going to say, ‘Wait a minute.’ ”

To smooth the way, Caterpillar this month unveiled a program that allows suppliers to borrow money from a bank, against their receivables, at a favorable interest rate. This means they can tap the loan funds within five days of delivery of goods to Caterpillar—as opposed to a typical 60-day wait.

In the best of times, a rapid ramp up in demand can run into speed bumps.  For example, some have argued that Toyota was slow to implement its recent recall because they simply need time to make enough replacement parts  (What another recall means for Toyota, Marketplace, Jan 22).  But for many suppliers these aren’t the best of times and the loans or lines of credit that would usually grease the wheels are simply not available.  So I see this story being much more about how a large firm can help smaller suppliers transition out of the recession, a story that is also playing out in the auto industry.  (Also, the McKinsey Operations Extranet has an interesting article this week on managing supplier defaults.)

A final point from the article, as it ramps up from the recession, Caterpillar is also shifting its production and sales strategies to reduce variability in sales:

Caterpillar is also changing how it sells its products. The company offers a dizzying array of features, and until now, that complexity often led to delays in delivering machines to customers. Customers love the variety, but were often frustrated by delivery delays.

Mr. Wunning, the group president, says Caterpillar is replacing this with a “lane strategy.” The first “lane” is made up of machines that contain the most commonly requested features and typically will be kept in stock by dealers and at Caterpillar staging facilities around the country. At the other extreme is lane four, custom machines that take six months or more to build and deliver.

The implication for Caterpillar and its suppliers is clear: Many customers who would normally order a unique machine will instead opt for something readily available once they learn the lane-one machine is close to what they want and can be delivered fast. This in turn makes it easier to set production schedules.

This over the long haul might reduce the bullwhip effect in Caterpillar’s supply chain if customers are willing to settle for more standard configurations.