Winter 2011 / Issue 65 (originally published by Booz & Company)

Taming the “Bullwhip Effect” in Supply Chains

How upstream companies can hedge the risks from demand cycles.

Title: Systematic Risk and the Bullwhip Effect in Supply Chains
Authors: Nikolay Osadchiy (Emory University), Vishal Gaur (Cornell University), and Sridhar Seshadri (University of Texas at Austin)
Publisher: Self-published
Date Published: July 2011

Big shifts in demand are the bugaboo of any supply chain. All players do their best to avoid gluts and shortages in inventory, and companies higher up the chain are particularly wary of the sting that comes from the bullwhip effect: the amplified impact of a big increase or falloff in orders as it moves upstream from the consumer to the original supplier. This paper identifies another pressure point affecting upstream companies, but also a way to lessen the pain.

Two components determine variations in demand, the authors note. One, systematic risk, consists of factors that affect the broad economy, for example, interest-rate spikes and recessions. The other, idiosyncratic noise, is specific to an industry or a company, and includes sudden shifts in consumer taste and shipment delays. Idiosyncratic noise can generally be addressed by operational hedging in everything from product diversification to building factories with flexible capacity. But in times like the recent Great Recession, operational hedging loses much of its effectiveness. Thus, financial hedging (offsetting risks using traded instruments) is also needed.

How much of each form of hedging is appropriate? The authors provide a broad answer: “The degree of systematic risk increases substantially from retailers to wholesalers to manufacturers.” Put another way, the more upstream a company is, the more likely it is to face shifts in demand that can be offset, in part, through financial hedging.

The researchers analyzed monthly sales numbers from the U.S. Census Bureau from 1992 through 2007, combined with price-adjusted data from the Bureau of Economic Analysis and market returns from the Center for Research in Security Prices. They used sales as a proxy for demand, defining systematic risk in terms of the relationship between sales uncertainty and broad stock market performance.

The authors attribute the increase in upstream systematic risk to the fact that supply chains are really supply webs. The higher up the chain a company is, the more customers it serves and the more orders it receives. As the size of the aggregate order increases, so does its correlation with market performance. Order aggregation is analogous to the bullwhip effect, the researchers say, and reinforces the whip’s impact as it, too, travels up the chain.

Although uncertainty about demand is highest for manufacturers, the authors write, “our results imply that manufacturers have a way out because they also have the highest ability to hedge their risk using financial instruments.”

Bottom Line: The degree of risk related to demand variance increases upstream along the supply chain. To reduce their exposure, firms at the upper level are advised to engage in financial hedging.

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