ISOM 2700: Operations Management

Session 23 Bullwhip Effect

Yiwen Shen
Dept. of ISOM, HKUST

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 Introduction to Returns Contract

wholesale price retail price

w p=115
Supplier Retailer Consumers

unit production cost Demand D~N(250,125)

c=35

For every unit of unsold inventory, retailer

gets r from the supplier and returns the
inventory

• The supplier charges a fixed price w for every unit delivered to

the retailer
• For each unit of leftover inventory, the supplier collects the
leftover and pays the retailer a fixed refund r
• The supplier is now penalized for leftover inventory 2
 UV Sunglass Example

wholesale price retail price

w p=115
Supplier Retailer Consumers

unit production cost Demand D~N(250,125)

c=35

For every unit of unsold inventory, retailer

gets r from the supplier and returns the
inventory

• The production cost = 35, retail price = 115

• Recall the supply chain optimum requires a critical ratio = 0.89
• Suppose wholesale price = 60, what should be the refund level r
such that the supply chain optimum is achieved?
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 Returns Contract: Solution

• For the retailer, its overage and underage costs under the return
contract is given by
• Co = 60 - r (view r as the salvage value)
• Cu = 115 – 60 = 55

• The critical fractile of the retailer is given by

• Critical fractile = 55/(55+60 - r) = 55/(55+60-r)

• We set it to 0.89 and solve the optimal r = $53.20

• The supplier has to compensate the retailer by a lot (89% of

wholesale price) to achieve the SC optimum
• To motivate the retailer to order more (since the SC critical fractile is
relatively high) 4
 Agenda
•Bullwhip effect in supply chain

•Root causes of bullwhip effect

•Mitigation strategies of bullwhip effect

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 Variability in Supply Chain
• Consider a manufacturer of pasta in a supply chain

• It places orders on its upstream factories, and ships out pasta to

its downstream customers

• Variabilities in the upstream orders and downstream shipments

• In principle, the two variabilities should match each other as the

upstream order is determined by the downstream shipments

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 Amplification of Variability

• The variability of upstream orders is larger than that of

downstream demands
• This is seen in many industries such as manufacturing, retail,
food & beverage, and automobiles
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 Bullwhip Effect
• The variability in order is amplified when we move up through
the supply chain

• This amplification can feed on itself when the supply chain has
multiple layers: one level further amplifies its downstream levels

• Bullwhip Effect: The variability of demand at one level of the

supply chain is greater than the variability of demand at the next
downstream level

• Here we measure variability by the coefficient of variation

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 Agenda
•Bullwhip effect in supply chain

•Root causes of bullwhip effect

•Mitigation strategies of bullwhip effect

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 Bullwhip Effect: A Simplified Model

• Consider a model with one supplier and 20 retailers; each

retailer faces a daily demand following N(10, 2)
• Each retailer order once a week with the quantity equal to the
10
units sold in the previous week
 Bullwhip Effect: A Simplified Model
• We use simulation to check whether there is any bullwhip effect in the
supply chain
• First, suppose the retailer orders are evenly distributed in the week:
four on Monday, four on Tuesday, …, four on Friday

• In this case, we do not find any bullwhip effect 11

 Root Cause: Order Synchronization
• In reality, firms tend to submit orders on a particular day of the week
(e.g., Monday or Friday)
• Now suppose nine retailers submit orders on Monday, two on
Tuesday, Wednesday, and Thursday, and five on Friday

• Here we find the bullwhip effect in supply chain, which is caused by

order synchronization of retailers 12
 Root Cause: Order Batching
• In reality, firms tend to submit orders in batches, i.e., the ordered
quantity is a multiple of a batch size (e.g., save transportation cost)
• Now assume the retailer only orders when the cumulative demand
(since last order) is more than 100 units

• The bullwhip effect emerges due to order batching

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 Root Cause: Trade Promotion
• Sometimes, the supplier will also their retailers trade promotions: a
discount is available only for a short period of time
• When the discount is large enough, the retailers may buy on-deal before
their demands happen, this is called forward-buy

• The bullwhip effect emerges due to trade promotion (forward-buy) 14

 Root Cause: Overreactive Ordering
• In reality, the retailer does not know the exact distribution of its
demand --- the retailer has to infer from realized demand

• If the realized demand in a period is high, the retailer may expect

the average demand level has increased
• Then, the retailer may increase the order to the supplier
• This is called overreactive ordering

• However, if the demand eventually falls back to normal level, the

retailer will decrease the order quantity in subsequent periods

• This increases the variability in the supplier’s demand, leading to

bullwhip effect
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 Root Cause: Shortage Gaming
• For a rational retailer, it will only order as much inventory as
needed to cover the customer’s demand

• However, if the retailer knows its order cannot be fulfilled, it may

strategically inflate the order quantity
• Especially when the product is limited (on allocation)
• This can occur even when the supplier can fulfill the
retailer’s order

• This can lead to (unnecessary) increased variability for the

supplier, causing the bullwhip effect

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 Illustration: Beer Game
• Beer Game is a famous illustration of bullwhip effect
• Proposed in 1960s by MIT to show the advantage of taking an
integrated approach for managing supply chain

demand placing an order production

retailer wholesaler distributor factory

fulfilling an order

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 Agenda
•Bullwhip effect in supply chain

•Root causes of bullwhip effect

•Mitigation strategies of bullwhip effect

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 Mitigation Strategies for Bullwhip Effect
• Bullwhip effect increases the variability faced by the
suppliers in the upstream of the supply chain
• leading to challenge in inventory/capacity management and
daily operations

• Several mitigating strategies are proposed to combat the

bullwhip effect, based on its root causes identified

• These strategies require higher level of coordination and

cooperation among supply chain participants
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 Mitigation Strategies (1)
• Sharing information: providing supplier with frequent
access to customer demand data
• Collaborative planning, forecasting, and replenishment

• Smoothing product flow:

• Reduce order synchronization, e.g., schedule retailers on
different order cycles
• Reduce order batching, e.g., use smaller and more frequent
replenishment, build a distributor to supply multiple retailers

• Production smoothing: suppliers/retailers can order

inventory in advance for spikes in customer’s demand
• E.g., Thanksgiving and Christmas Holidays 20
 Mitigation Strategies (2)
• Reducing Pathological Incentives: mitigate the impact of
forward-buy and shortage gaming
• E.g., reduce large trade promotion and generous return
policy; allocate more to the retailers that sell well

• Vendor-Managed Inventory:
• The supplier, instead of retailer, decides the timing and
quantity of shipments to retailers
• The retailer shares demand data with the supplier
• Eliminate trade promotion between supplier/retailer
• Famous users: Procter & Gamble, Walmart

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