The Bullwhip Effect and Your Supply Chain Consider an old stock trader's approach to taming volatility.

By Brent Misso

Opinions expressed by Entrepreneur contributors are their own.

If you own a business, then you might be aware of the bullwhip effect, which is an important supply chain phenomenon first noted by MIT systems scientist Jay Forrester. Even if you have never heard of this effect, perhaps you are familiar with the beer distribution game, which is an experiment designed to show the dynamics of managing a supply chain.

As you probably know, supply-chain management is a crucial aspect of running a product-oriented business, but projections can be difficult at best. And thus at some level dealing with supply chains can become an art form as much as a science.

Related: From Shipping to Packaging, 3 Creative Ways to Improve Your Supply Chain

To put the bullwhip effect in simple terms, in looking at businesses further back in the supply chain, inventory swings in larger and larger "waves" in response to customer demand (the handle of the whip), with the largest "wave" of the whip hitting the supplier of raw materials.

Since this is the case, suppliers of raw materials see the greatest demand variation in response to changing customer orders or demand. As a result of the effect, supply-chain participants have learned to build and maintain a buffer of inventory or "safety stock" to allow for such swings in orders. But, despite knowledge of the effect, the bullwhip still gives businesses fits.

Related: Tips on How to Make Your Supply Chain More Environmentally Friendly

What causes the bullwhip effect? There are numerous reasons cited for this phenomenon. First of all, there are the more obvious operational factors, some of which you have probably experienced firsthand either through the beer game, or through managing your own business

For example, lead time issues are a common supply-chain challenge. As participants often learn in the game, two overdue shipments arrive about the time customer demand has dried up. Ouch! But aside from the well-researched operational factors, supply chains are also clearly influenced by human behavior.

Human behavior in relation to perceived risk is a particularly interesting topic for me, not only from a business perspective, but also more broadly in terms of financial-market behavior. I have been an active trader for many years, so I am constantly thinking about the forces at work in volatile market action.

Related: When It Comes to Investing in the Stock Market, Timing Is Everything

Over the years, I have made some observations about decision-making and emotion in markets, and I think there is something of value here when facing the bullwhip effect.

First of all, fear is a significant motivating factor in human behavior, and the stock market will demonstrate the full force of this fact in brutal action. Let's face it, stocks generally go down much faster than they go up and especially in tough market conditions rocked by panic selling. The fear of loss, or of being wrong, is also a key human factors issue with supply-chain management.

Supply-chain managers who can calmly make decisions and act according to a plan while competitors panic, do nothing or become too greedy, should perform well within their sector. People who act out of fear or greed along with the herd of reactive people in the marketplace will often be wrong, will not benefit and may do real harm to their business.

This "fear factor" builds upon a second issue, which has to do with decisions under seemingly ambiguous and anxiety-provoking circumstances. For generations, people have wracked their brains trying to find market, commodity and equity "bottoms," or the point at which it is time to buy and "go long."

Related: Lead From a Place of Confidence, Not Fear

While I certainly haven't perfected market timing, and I would never try to do so, I have observed that it is most advantageous and less risky to add small blocks to a core position when everyone else is afraid and selling at any price. Buying into a "whipsaw" market, let alone a plummeting market, can really test your metal. But, contrarian thought and measured action over time can help mitigate risk and make money while others flounder or are crushed by the herd behavior.

With the bullwhip effect, which models herd behavior, it may be useful to face supply-chain risk and decision-making like an old stock trader. Pressing past nervous indecision, the effective manager will stoically acquire some inventory while others sit on their hands or take drastic discounting or liquidation measures due to slack demand.

When product demand picks up, those that maintained their "safety stock" and then added cheap inventory on "dips" will benefit from favorable margins on a small bump up in demand. Such positioning allows one to take a chunk of the competition's sales while they remain underwater on their ill-timed, high-priced inventory purchases.

A contrarian stance isn't about blindly doing the opposite. Rather, it is about using psychology to gain leverage from understanding typical group behavior, such as that we see with the bullwhip effect. It also about dealing with your own emotions and actions within market forces.

When it makes sense, based upon customer and supplier data, as well as sound logistical planning and experience, taking a contrarian approach offers a hedging strategy that will tame volatility and make the bullwhip effect work for you.

Related: The Data-Driven Company That Accomplished Very Little

Brent Misso

Business Owner

Brent Misso has taught at the University of Wisconsin, Arizona State and Oregon State and worked in organizational development and training in the tech sector. His firm, EBM Research and Systems, helps people to learn and work better with other humans and systems technologies.

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