What happens when suppliers mistake a spike in orders for real demand
Article (below the introduction) by Eliyahu Goldratt, september 2010. © Eliyahu M. Goldratt, 2010. Published on this website with permission
In his article The power of cause and effect: the effects continue, Eliyahu Goldratt, the founder of the Theory Of Constraints, explains what happens when companies don’t react to real market changes, but to (exaggerated) fluctuations in the amount of orders placed by what is only the next link in their supply chain.
Due to the economic recession, sales of electronic consumer goods dropped by as little as 2 to 3 percent at the end of 2008. However retailers, afraid to be left with inventory, decided to sell the goods on their shelves first, and therefore drastically reduced the amount of new orders in the first four months of 2009.This overreaction was passed on by the electronic consumer goods industry to their electronic components suppliers (link three in the supply chain), who faced an unprecedented drop in orders by 50%, Goldratt explains.
A kind of bull-whip effect, but in this case not driven by uncertainty but by fear! Around April 2009, the retailers regained their confidence in the market and started to increase the amount of orders, not only to meet customer demand, but also to replenish their stock. As a result, the next cycle of exaggeration and overreacting now threatens to begin: The electronic components suppliers can’t keep up with the current spike in demand, and therefore they think they should invest in extra capacity. According to Goldratt, that is the worst thing they can do. In the end that will not only leave them with overcapacity, also the prizes for their products will drop. Read Goldratt’s article below!
In January 2009, the electronics component industry, facing an unprecedented drop in orders in December 2008 (by 50%) had planned to immediately react with a massive cut of its workforce. A proper analysis done at that time, (The power of cause and effect no.1, written in January 2009) revealed that this expected reaction was not needed and that it would lead to grave consequences.
Unfortunately, most electronics component manufacturers did lay people off - only to face, less than three months later, a surge in demand. All the signs indicate that these companies are now about to make a similar mistake which will lead to even graver consequences.
Drop in demand
In December 2008 the drop in demand for the component manufacturers was not a result of a drop in consumer demand for electronic consumer goods. As a matter of fact, in all the major markets of the world the dollar value of purchases of electronic consumer goods did not drop by more than 2 to 3 percent, and in terms of units sold actually increased. Rather, the drop in demand for the components manufacturers was an unavoidable result of retail’s reaction to the media’s frantic declarations of an economic recession.
Retailers, trying to avoid being stuck with surplus inventories (which in the case of electronics consumer goods will shortly become obsolete inventories) naturally took immediate actions to reduce their inventory levels. Which meant a drastic reduction in the amounts ordered by retailers.
For those who realized that the drop had nothing to do with an actual drop in consumer demand, it was apparent that once retailers reduced their inventories the demand would jump back to the pre-economic-scare levels. Since the retailers (together with the wholesalers) are holding about three to four months of inventories it was obvious that around April 2009 the demand on component manufacturers would return to normal. That was exactly what actually happened.
Alas, during the first half of 2009, not only the retailers reduced their inventories, the electronics assembly companies did it as well.
When the scare was over and companies (retailers as well as electronic assemblies) had adjusted to the new reality they naturally wanted to gradually restore their inventories to the proper level; their orders reflected not just their current consumption but also the quantities needed to rebuild inventories to their normal levels.
But, rebuilding inventories is governed by different factors than reducing inventories. The speed at which inventories can be reduced is governed by the rate of clients’ purchasing. The speed at which inventories can be increased is governed by the amount of excess capacity the vendor has. Even if we assume that by mid 2009, electronic component manufacturers had succeeded to bring their capacity back to 2008 levels (and considering the time it takes to hire and train people, this is a very optimistic assumption) it means that, on average, the electronic component manufacturers had no more than 15% excess capacity.
With this amount of excess capacity to refill even two months of inventory will take more than a year. The problem is that during that time, when the orders are inflated to reflect the need to increase inventories, the demand is higher than the capacity available; vendors have - for all practical purposes – bottlenecks. When a vendor has a bottleneck, any upward fluctuation in demand translates into longer lead times to satisfy client orders. Any increase in supply lead time causes the client (electronics assembly) to realize that it should further increase its inventories.
This phenomena opens the gates to inflated internal demand (orders from assembly to components) when actually the external demand (purchases by consumers) is relatively stable. Does it happen? Do we witness a surge in internal demand?
Scramble for parts
A recent article published in the Wall Street Journal entitled: ‘From snowmobiles to cell phones, a scramble for parts’, reports on ongoing shortages of electronic components that has been intensifying since the beginning of the year (2010).
The most alarming fact reported in this article is that recently the supply lead time has elongated from ten weeks to twenty weeks. This phenomenon ensures that in the near future electronic assembly companies will continue to increase their inventories and the component manufacturers will become more and more confident that future demand is on the upswing.
Not being able to supply all the demand and being under increased pressure from impatient clients will, no doubt, lead component manufacturers to the conclusion that continuing to operate with the existing level of capacity is limiting the profit that they can realize today. Moreover, since it also endangers their market share it is limiting the profit they will be able to make tomorrow. There is little doubt that, in the current frame, very few components manufacturers are not contemplating to heavily invest in increasing their capacity and many have already approved the needed investments.
The problem is, of course, that the demand is not real. It’s not a demand driven by consumer purchases; consumer purchases of electronics consumer goods have remained relatively stable in the last two years. It is a demand driven by the supply chain internal adjustments.
Once again companies that are participating in the supply chain ignore the most fundamental rule: as long as the end consumer hasn’t bought, no one in the supply chain has really sold. But, this time the mistake, if not stopped now, will have much graver and more long-lasting ramifications.
It takes time to significantly increase capacity; to open new plants. These efforts have already started. It stands to reason that within one, or a maximum of two years, the new capacity will be operational.
What must happen then? The additional capacity will collapse the delivery lead times. When lead times plummet, clients quickly reevaluate the amount of needed inventory and readjust the levels downward accordingly.
Readjusting the inventory level downward will have an immediate and drastic impact on the quantities ordered, and as a result supply lead time will shrink further.
From the above cause and effect logic it is clear that once the new capacity will be operational the strong demand that we witness now will, in almost no time, vanish. We’ll swing into a period where the increased supply will be much higher than demand. And we all know what will happen then; prices will drop.
Exactly when their investments (their expansion plans) have been completed, those companies will face a reality where, not only the demand vanishes but also prices drop.
The problem is that not only those companies that have confused internal, supply-chain demand with consumer demand will suffer. The problem is that also companies that analyzed the situation properly and resisted the temptation to invest in more capacity will also suffer. They will suffer from the resulting too low prices. The increase in capacity of their less analytical competitors will also erode their prices, and significantly lower prices are poison to profitability.
Convincing competitors to refrain from investing now in additional capacity should be the number one concern of any component manufacturer. I think that there is only one effective way to convince competitors to freeze their investments in additional capacity, and that is to convince them that instead of investing heavily in more expensive capacity that will only become productive a year or more from today, it is possible, within weeks, to reveal much more capacity from existing operations.
I urge consumer electronics manufacturers who have done so to reveal their actual achievements: to release into the public domain, and particularly to their competitors, the details of what they have done, the time that it took to increase production and the magnitude of the increase.
> Read also: Goldratt's article "Standing on the Shoulders of Giants" about the interrelationship of the Toyota Production System and TOC
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