The Bullwhip Effect in Distorted Market could Once again Wreak Supply Chain Havoc

Virtually everyone, it would seem, is aware of the on-going global shortage of microchips, causing disruptions in many product sectors.

Supply Chain Digest Says...   Sheffi says this scenario is in fact playing out in the semiconductor industry, where over-ordering is widespread. What do you say? Click here to send us your comments   Click here to see reader feedback

What’s obvious is the impact the shortage is having on manufacturers of product such as automobiles and appliance, as evidenced in the former case by near empty auto dealer lots and long waits for new cars.

Much less obvious is the possibility the chip shortage will precipitate an economic recession, via the well-known “Bullwhip Effect.”

So says Dr. Yossi Sheffi, a professor at MIT and author of many books related to supply chain management, writing a guest column this weekend on the thenationalnews.com web site.

First, how did we get here? Sheffi notes at after a severe economic contraction in Q2 2020 due to the start of the pandemic (the US economy fell a record 33% in the quarter), governments began to implement various stimulus progress, while stay at home lifestyles juiced demand for products instead of going out to eat or taking vacations. Today, a significant percent of products also need microchips, sometimes as many as several dozens in high end car models.

As a result, demand for chips soared, above that which would have been the levels without the pandemic, even as chip makers were often battling their own labor challenges. Delays in both ocean and air shipping exacerbated the existing supply-demand imbalance.

“Product shortages continue to plague markets today, and it will take some time before the supporting supply chains stabilize,” Sheffi says.

But we know most of that. What a lot more of us don’t know is that this scenario and a likely impact of the Bullwhip Effect could lead to a real economic slowdown.

The Bullwhip Effect (first identified at MIT in the 1960s), in great simplification, describes how lack of information leads companies to over and under order based on false signals, and how this behavior flows back through the supply chain, leading to poor and costly inventory management.

And Sheffi says it is likely happening right now in the chip-related supply chain.

“As today’s product manufacturers struggle to keep up with demand as well as unrelenting supply uncertainties, they often over-order, assuming that only a fraction of their orders will actually be fulfilled,” Sheffi says, adding that “They also assume that current demand will continue and grow.”

This starts a ripple effect, as the next link back in the supply chain, perhaps a parts distributor, receives an inflated order, inflates it further, and passes it to another supplier, etc.

“By the time the order reaches small, sub-tier suppliers deep in the supply chain, it has become grossly proportioned,” Sheffi notes.

(See More Below)

Sheffi says this scenario is in fact playing out in the semiconductor industry, where over-ordering is widespread. He says he has heard of manufacturers threatening to sue suppliers that do not fulfill their orders.

But at some point demand will return to more normal levels. When that happens, many companies will be left with inventories of products they can’t sell and parts they can’t use. Sheffi says the situation will deteriorate further as some companies stop ordering anything for a while.

So output will slow, perhaps to recessionary levels. Many enterprises will fail, thereby deepening the recession.

This in a different way happened in the recession that started in 2008.

“The bullwhip played out across a broad swathe of industry during that period, and the subsequent downturn caused manufacturers to cut inventories by 15% as their sales declined by some 30%,” Sheffi notes.

Sheffi concludes with this warning: “As companies today grapple with shortages of parts and components, they should be aware of how the underlying causes of these shortages aided by the Bullwhip Effect could cause markets to pivot - and prepare for the worst.”

Any reaction to this Sheffi's perspective? Let us know your thoughts at the Feedback section below.