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What is the bullwhip effect, and does it impact firms’ profits?

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Opher Baron

Variations in demand can have big implications for businesses. When retail stores experience high levels of consumer demand and decide they need to order additional product to meet it, the effect does not end there. It also impacts warehousing, distribution and manufacturing. This phenomenon is called the bullwhip effect, because it becomes increasingly strong as you move further away from the source of the demand. Supply chain managers have long assumed that the bullwhip effect has major financial repercussions, but empirical research from Rotman professors Opher Baron, Jeffrey Callen, and their collaborator Dan Segal shows that for individual firms, the effect does not actually affect the bottom line.

A bullwhip’s movement starts with a flick of the wrist, but grows ever larger as it moves down the whip. The bullwhip effect in operations management works in a similar way. When there are small variations in demand at the retail level, stores order more product so they can meet that demand. This has a knock-on effect for the warehouse and distribution facilities that supply the store. In turn, warehouses order even more product for their own supplies, and manufacturing facilities will face a burden that is larger still, as they produce the additional products for all involved.

The bullwhip effect can lead to excess inventory and production. It is a major area of study in operations management, and companies have increased data sharing to better cope with the way these fluctuations in demand move through the supply chain. In recent decades, strategies to manage it have driven considerable innovation in supply chain management.

“Imagine that you run a brewery, and need to make 400 beers. It will be cheaper for you to produce 100 beers a week for four weeks in a row, than to produce 400 in a single week. This is because there are costs associated with producing so much at one time,” says Baron, a professor of operations management.

“You need more production capacity, and a bigger warehouse to store the items. Logistics will be more expensive because there is more that needs to happen in less time. And in operations management, these are all very big things. Increased variability is costly, there is no question about that.”

But despite the costs associated with accommodating demand variability, in a recent study, the researchers found that the profits of individual firms are not negatively affected.

“If there is a lot of bullwhip effect, you would think that profitability should decrease, because costs have increased,” says Baron. “But we found that there is no significant relationship between the strength of a firm’s bullwhip effect, and its profitability.”

The study examined nearly fifty years of data from firms in the retail, extraction, manufacturing and wholesale sectors. It looked at more than 4,000 firms for which the researchers had 24 consecutive quarters of accounting and market data. The researchers found that the volatility created by the bullwhip effect was less than the volatility of the sector as a whole, or what a sector might normally experience as a result of day-to-day operations.

“There is an art to doing this. If one firm sells eggplants, and another firm sells motorcycles, it is very hard to control for the variability in demand. But with the most sophisticated control that we and our referees could come up with, there was no significant correlation between the size of the bullwhip effect and the profitability of a firm,” says Baron.

These findings, which were recently published in the International Journal of Production Economics, are counterintuitive, and somewhat controversial in the field. Baron notes that it took about 10 years to get the research published, and that many experts in operations management might initially attribute the findings to the considerable progress that has been made in managing the bullwhip effect in recent decades.  

But Baron and his co-authors looked at data dating back to 1974, and the findings were consistent. The same held true when the researchers studied economic shocks that would have created sudden fluctuations in demand, such as the Fukushima nuclear disaster in Japan, the Great Financial Crisis, and the dot-com bubble. The reason behind the results could be that firms benefit from the bullwhip effect in some way.

“A company might be able to use some level of bullwhip to streamline the way they manage inventory or other processes,” says Baron.

But he also cautions against drawing sweeping conclusions. Even though the bullwhip effect does not directly impact the overall bottom line of a single company, it could have other negative consequences. It could impact relationships with other firms or place a heavy burden on certain departments or divisions within an individual organization.

And critically, the findings might not hold true when examining the bullwhip effect for entire supply chains. Baron’s analysis looked at individual firms, and data is less readily available for complex supply chains that involve multiple organizations. And even though data sharing between companies has improved, it might not be possible to optimize operations in quite the same way, when there are multiple firms involved.

But for individual firms, the findings suggest that they might actually want to have some level of bullwhip effect. Baron argues that it could help businesses grow, though more research would be needed to say that for certain.

“Our findings demonstrate that the bullwhip effect that each company creates internally has little if any effect on its financial performance- profit or stock returns,” says Baron. “Could it be that even the impact of the bullwhip on the financial performances of entire supply chains is insignificant as well? This question remains unanswered.”

Opher Baron is a professor of operations management at the Rotman School of Management.
Jeffrey Callen is a professor of accounting at the Rotman School of Management.
Dan Segal is a professor of accounting at the Arison School of Business Administration.