Structural causes of the bullwhip: demand forecast updating.

1CV30 –Supply Chain Management.

Fall 2016
September 6, 2016

1 Introduction
In this document we will prove that updating of demand forecast information induces the bullwhip
effect. We will do so by deriving the expression for the bullwhip as the variance of orders divided by
variance of demand for a specific, single-echelon system. This particular system is based upon an order-
up-to policy (also, base-stock policy) and updates the expectations of demand through a moving average
forecast. Additionally, we assume an i.i.d stationary demand stream although the results also hold for
more complex forms of stationary demand.

2 Ordering policy
We consider a simple policy where the order-up-to level, yt is given by:

yt = L.D̂t , (1)

where L is the lead time and D̂t is the expected demand at time t (so the forecast of demand at time t.
Let’s assume that the sequence of events is such that in each period, t, a single retailer (you!) observes
his (or her) inventory level and places an order, q , to a single manufacturer. After the order is placed,
the retailer observes and fills customer demand for that period, denoted by D. Any unfilled demands
are backlogged. There is a fixed lead time between the time an order is placed by the retailer and when
it is received at the retailer, such that an order placed at the end of period t is received at the start of
period t + L.
This means that, every period, the decision maker will place orders to its supplier so that, immedi-
ately after ordering, the inventory position equals the expected lead time demand. Remember that the
inventory position equals the on-hand stock plus the in-transit stock, minus the backlog.
Thus, we can express the order placed at time t as:

qt = yt − yt−1 + Dt−1 , (2)

which, by substituting Eq (1) we can write as:

qt = L.D̂t − L.D̂t−1 + Dt−1 , (3)

We now need to gather some information about the demand process and the forecast of demand.

3 Demand and forecast

In this example we will consider any i.i.d stationary demand stream. We can write it as

Dt = µ + t , (4)

where µ is a constant and the stochastic error term, t is an i.i.d process with a mean of 0 and a standard
deviation of σe . Since demand is stationary, its mean is constant through time,

E(D) = µ (5)

1
 To forecast demand, we will use a very simple moving average process; that is, our expected future
demand equals the average of the last N demand observations, where N is an arbitrary positive integer.
Formally:
PN
Dt−i
D̂t = i=1 . (6)
N
Note that the mean of the actual demand process is stationary, while our demand expectation will
change over time. This is the key insight that allows us to understand why keeping a forecast will
generate a bullwhip.

4 Variance of demand
To calculate the variance of demand, we will make use of a series of well known formulas from your
statistics courses:

VAR(aX ) = a2 VAR(X ), (7)

2 2
VAR(aX ± bY ) = a VAR(X ) + b VAR(Y ) ± 2abCOV (X , Y ). (8)

The easiest way to derive the variance of demand is by noticing (using Equation 4) that:

VAR(Dt ) = VAR(µ) + VAR(t ) + 2COV (µ, t ), (9)

Because µ is a constant, and µ and  are independent, we can rewrite the above as

VAR(Dt ) = VAR(t ). (10)

In other words, the variance of demand is constant and is equal to the variance of the error term.

5 Variance of orders
Substituting the expression for demand expectation (From Eq 6) into Eq (3), we get:
N N
L X L X
qt = Dt−i − Dt−i−1 + Dt−1 , (11)
N i=1 N i=1
N
L X
qt = (Dt−i − Dt−i−1 ) + Dt−1 , (12)
N i=1
L
qt = (Dt−1 − Dt−N −1 ) + Dt−1 , (13)
N
 
L L
qt = 1 + (Dt−1 ) − Dt−N −1 . (14)
N N
Now that we have expressed the orders as a function of demand, we can use Eq (8) to express the variance
of orders as a function of the variance of demand:
 2  2   
L L L L
VAR(qt ) = 1 + VAR(Dt−1 ) + VAR(Dt−N −1 ) − 2 1 + COV (Dt−1 , Dt−N −1 ).
N N N N
(15)

Because by our assumption demand is i.i.d, the last term is equal to zero, and this equation simplifies
to:
 2  2
L L
VAR(qt ) = 1 + VAR(Dt−1 ) + VAR(Dt−N −1 ) (16)
N N
Because the demand is stationary, the variance does not depend on time, so we can drop the sub-indexes:
 2  2
L L
VAR(q) = 1 + VAR(D) + VAR(D). (17)
N N

2
Now, we have completely described the variance of orders in terms of the variance of demand. What’s
left now is just algebra:
 2  2
VAR(q) L L
= 1+ + (18)
VAR(D) N N
2L 2L2
=1+ + 2. (19)
N N
VAR(q)
Remember that by definition, the bullwhip of a system is BW = VAR(D) , which means that Eq (19)
gives us the bullwhip for our system:

2L 2L2
BW = 1 + + 2. (20)
N N
Note that, because lead times are always positive and N is a positive integer the second and third terms
of the right hand side of Eq (20) are always positive, which implies that BW ≥ 1. This completes the
proof.