Schedule a talk with one of our advisors to learn more about Summitry and how we can help you get a foothold on your financial life.
Adam Govani, CFP®
The last eighteen months have brought to light many mundane topics that suddenly had great personal relevance – how many average people read about cold chain logistics and syringe supplies before 2020?
In keeping with this theme, the unglamorous crisis du jour has become the global supply chain. There is an avalanche of news predicting a holiday bereft of toys. Even Susan Walker is considering giving up on Christmas.
These fears are perfectly reasonable. There have been well-documented structural issues in the supply chain, many of them without a clear resolution in sight. At this point, it would be repetitive to re-hash the excellent work of journalists that have documented:
While this list is not exhaustive, we believe it cover some of the most pressing structural issues affecting the supply chain. However, a systems breakdown is about human interaction and there is a dearth of coverage about how the supply chain is as much a human problem as a structural one. After all, watching adults fight over pallets of toilet paper suggests that the problem is bigger than congested ports and truck drivers.
In 1961, an MIT professor by the name of Jay Wright Forrester collaborated with General Electric’s household appliance division to tackle a vexing problem . It would seem a manufacturing titan like GE would have excellent visibility into necessary production and should be able to adjust output to meet demand. In fact, the opposite was true: factories struggled with wild swings in orders month-to-month, oscillating between massive over- and under-capacity. This problem was not exclusive to GE; rather it was endemic problem faced by manufacturers.
It seems improbable that the demand for say, toasters, would change dramatically month-over-month. So how was GE so consistently missing the mark? Forrester’s research led to the eponymous “Forrester effect,” commonly referred to as the “bullwhip effect.” Forrester later turned his research into a game played by MIT business students to this day, called the “Beer Game.” Turns out, a college game about beer goes a long way in explaining our current supply chain woes.
In a simplified version of the game, imagine a team with four members:
We can use the more topical example of toilet paper in lieu of beer. The goal of the game is to respond to changes in consumer consumption by both matching demand and avoiding excess inventory (which is a cost to a real business). The premise is not that complicated, but the results can be surprising.
Imagine a retailer that begins to see a spike in toilet paper sales in early March of 2020. In response, the retailer must decide how to place their next order from their wholesaler. The retailer might increase their order by 10%, accounting for increased demand, extra inventory, and the delay between placing and receiving an order. The wholesaler sees this order, and with no context, must make the same decision. The wholesaler may increase their distributor order by 15% to account for future demand uncertainty, extra inventory – many of the same considerations as the retailer.
There is clearly a pattern emerging here. At each point in the supply chain, actors have to make future demand forecasts. As these changes echo through the supply chain, errors in judgment can cause vast magnifications. By the time the original 10% order trickles down to the manufacturer, the manufacturer may respond to downstream demand increases by increasing production 30%. Thus the term “bullwhip effect,” in the image of a cowboy whose slight flick of the wrist can cause a powerful crack of the whip.
Understandably, there are factors that can make this magnification even worse. Long lead times, greater volatility in demand, and other forms of uncertainty (say, a global pandemic) make forecasting future demand that much more difficult. This ordering creates artificial demand and can lead to excess inventories, product scarcity, and rising prices. Imagine a supermarket with an entire warehouse stocked to the brim with far too much toilet paper, while its competitor down the street can barely keep their shelves stocked. Now extrapolate that supermarket to the global supply chain for everything from pool chlorine tablets  to Pelotons.
The upshot of this post is that it would be prudent to take the doom-and-gloom predictions with a big grain of salt. It is easy to see how incentives skew in favor of over-ordering in the face of uncertainty, creating artificial demand and perceived scarcity. More importantly, it shows how a group of people, each acting rationally, can lead to highly irrational outcomes. The structural issues facing the supply chain will resolve themselves in time (capitalism has a way of solving these things) and excess inventories will normalize. While this may cause a bullwhip effect in reverse direction (i.e. decreasing demand) it would be a healthy sign that we are in the process of moving back towards a healthy equilibrium.
Human nature may not change, but a better understanding of it can help us act rationally in times of uncertainty. In the meantime, we are left wondering: what did they do with all that toilet paper?
Interested in more insights like this? Contact us today!
*A distributor buys from manufacturers and sells to wholesalers, while wholesalers then sell to retailers.
GET THE NEXT SUMMITRY POST IN YOUR INBOX:
MORE INSIGHTS AND RESOURCES
Schedule a talk with one of our advisors to learn more about Summitry and how we can help you chart a path for your financial future.
Advisor Group Manager