The bullwhip effect: How to contractually minimize its impact through collaboration in the production chain

Introduction

The bullwhip effect – an explanation of the phenomenon

Increases in the price of energy, foodstuffs and services have caused the already high inflation rate in Canada and the United States to rise in February 2022 to 7.9 per cent in the U.S. and 5.7 per cent in Canada, and disruptions in the oil and commodities markets due to the conflict in Ukraine will likely accentuate the upward pressure on prices. The economic recovery in the wake of the COVID-19 pandemic has created numerous supply chain problems in many sectors. While there are multiple causes for current supply chain issues, the bullwhip effect has exacerbated the problem. The buying habits of consumers having varied with the impact of successive waves of the pandemic, the bullwhip effect is a top-of-mind issue for supply chain managers. In order to better manage the impacts of the bullwhip effect, it is possible to contractually facilitate collaboration in the supply chain to better determine actual demand and minimize its effects.^[1]

The bullwhip effect is a consequence of a supply chain inefficiency related to demand forecasts. The bullwhip effect increases variations in suppliers' inventory by a multiplier effect in the supply chain as a result of changing consumer demand. The bullwhip effect is described as "the tendency of high-volume orders to amplify actual demand, and the consequent impact of this amplification on the supply chain."^[2]

By way of example, an automobile dealer will tend to want to increase its inventory of electric vehicles if it notes that sales of such vehicles are increasing rapidly. If the dealer substantially increases its monthly orders and other dealers follow suit at the same time, the manufacturer of the electric vehicles will have difficulty filling the orders. Eventually, the manufacturer's suppliers will also have to deal with a series of orders that appear to be greater than the actual demand.

How to minimize the bullwhip effect contractually

In the case of distribution contracts and contracts for the purchase and sale of products, the buyer and seller determine the terms governing the purchase and sale of the products covered by the contract. The contract will normally specify the nature of the products sold, the sale price, the delivery timeline and the ordering mechanism. In order to promote collaboration in the supply chain, there are several collaborative models that can be integrated contractually in the production chain, namely (i) an information-sharing model whereby the buyer and seller exchange information on sales and sales forecasts, (ii) an inventory-management model whereby the seller manages the buyer's inventory and undertakes to replenish it, and (iii) a synchronized supply management model whereby the seller handles operational management of the buyer's inventory and integrates the latter's production chain into its own.^[3]

According to Holgado de Frutos et al.,^[4] the information that should be shared between the parties varies with the type of production-chain collaborative model as follows:

Thus, the exchange of such information pursuant to the model preferred by the parties should be agreed to contractually in order to consolidate collaboration in the supply chain.

An example of collaboration pursuant to the first collaborative model consists of contractually obligating the buyer to provide monthly and annual sales forecasts to the seller so the latter knows what the buyer's short-term and mid-term order projections are. The seller and buyer may then contractually agree that only the monthly projection for the coming month will constitute a firm order on the buyer's part, and that the buyer's mid-term firm orders may fluctuate by a predetermined percentage. For its part, the seller undertakes to maintain a certain level of inventory at all times. By having the buyer's forecasts in hand, the seller can manage its suppliers and avoid disruptions in the supply chain by having a short- and mid-term grasp of its buyers' needs.

In the context of this collaborative process, several factors contribute to the success of supply chain collaboration, including the designation of a contact person for both the buyer and the seller who has access to accurate information, the regular sharing of information and performance indicators by the parties, and the alignment of the parties' objectives.^[5]

In addition to the collaboration clauses and depending on the type and extent of shared information, clauses pertaining to confidentiality, cyber security and protection of information should be included in the contract. In the case of confidentiality clauses, particular attention must be paid to the scope of the definition of confidential information to ensure that it covers shared information specific to each relationship. In addition, regarding cyber security, high standards of IT security, confirmed among other things by external audit reports, could be required by the buyer in order to obtain guarantees concerning the protection of the shared information. Finally, clauses on the notification and management of any cyber security incident should be negotiated between the buyer and the seller in order to provide for a response protocol and the sharing of risks between the parties.

Ultimately, the difficulties related to production chains will lead some corporations to accumulate inventory as the economic cycle progresses. If inventory-related collaborative measures do not allow a slowdown to be anticipated, certain clauses may be added to minimize the risks of default of payment to the sellers. Clauses providing for shorter payments, the buyer taking out insurance against its credit risk, or the seller taking security on delivered products, are options that can be negotiated by the seller.

It should be noted that buyers and sellers contractually sharing information vertically must ensure that they comply with the antitrust legal obligations and import-export rules of the countries where they do business.

Conclusion

The optimal level of collaboration between a buyer and a seller is not determined in advance, and the parties must evaluate which information involving their production chain is to be shared contractually. In the current context of supply chain disruptions, it is in the interest of both sellers and buyers to ensure that their production chain operates efficiently. Collaboration in the production chain can reduce the impacts of the bullwhip effect, reduce production-chain related uncertainties and optimize the flow of transactions.

Should you have any specific questions about this article or would like to discuss it further, you can contact the authors or a member of our Corporate Commercial Group.