With major retailers stuck with unprecedented inventory levels, companies need to assess their inventory levels. While companies were busy buying up goods to meet pent-up demand and ease their supply chain, manufacturers began forecasting, and making, more goods to meet future demand. While prior performance does not predict future performance, the economic good times and easy cash of 2020 and 2021 seemed to point toward continued growth for demand.
However, as the Fed begins tightening up their policy, and other economic factors erode consumer confidence and demand, companies are beginning to feel the bullwhip effect.
What is the bullwhip effect?
According to TechTarget, the bullwhip effect is a supply chain issue where small demand fluctuations at the retail level cause increasingly larger demand changes at the manufacturer and raw material supplier levels.
Using an example, a retailer who is reacting to surging demand for a good asks Manufacturers A and B for 100 widgets. Manufacturer A can sell 75 widgets, while B can sell 50 widgets. Both manufacturers see an increase in demand for their widgets and both order 100 more Component X from their supplier. Seeing this increase in demand for Component X, the supplier produces 400 of Component X to be safe. In doing so, the supplier takes out a line of credit to ramp up production of Component X anticipating the additional sales will pay down the credit and bring in extra profit.
As we can see, the request for 100 widgets leads to the production of 125 widgets, which leads to a request of 200 Component X, and leads to the production of 400 Component X. As retailers are currently observing, they have overestimated demand, and are now working to reduce inventory leading to waste and excess inventory at all levels of the supply chain.
If the bullwhip continues, the market will rapidly fluctuate between highs and lows. These cyclical highs and lows can cause large swings in supply and demand leaving inventory, cash flow, and sales vulnerable.
Managing the bullwhip effect
There are two major effects of the bullwhip effect that companies need to manage.
Rising inventory levels during the bullwhip trough drag down the balance sheet as inventory levels rise. Depending on the duration of the trough, inventory may become obsolete and be written off. If that inventory was purchased on credit, companies face the cash flow burden of paying down that credit with revenue unassociated with the inventory, dragging down margins elsewhere.
As production gears down during the trough, the company is unable to meet rising demand during the highs of the bullwhip and misses out on sales during the upturn in demand. Additionally, the company could be poorly positioned if market conditions cause a spike in demand despite being in a bullwhip trough. Thus, missing out on crucial sales during an economic downturn.
Managing these effects relies on an accurate assessment of your current inventory and a reasonably accurate forecast of future demand factoring in the bullwhip effect.
What can companies do?
You can start by accurately assessing your inventory levels. Begin with this checklist that identifies:
- Current inventory on-site or in the warehouse
- Inventory in transit (truck, rail, ship, air, etc.)
- Inventory ordered and awaiting transit
- All outstanding purchase orders and verify their accuracy
Once you have an idea of what inventory is on the shelf, or eventually will be, you can then begin forecasting how much of the future demand will use that inventory. Talk to customers and vendors to get a better idea of what is really occurring in the marketplace. Having a view of what is upstream and downstream will help highlight any variability resulting from the bullwhip effect.
Rolling forecasts can help determine appropriate inventory levels for the next several quarters. Create an acceptable range of inventory to mitigate an economic downturn while still allowing the company to take advantage of any upticks in demand. Work with your team to devise a plan that can help ensure you have right-sized inventory for various scenarios. You may also want to consider how you are costing your inventory to ensure you’re minimizing the downsides of the bullwhip troughs.
Finally, ensure your cash flow and balance sheet can handle this range of scenarios. Talk to your advisors to determine if any actions need to be taken in preparation of certain contingencies or conditions being met (loan conditions, etc.). Being proactive now can help ease the burden when things are going poorly in the future.