There is a business concept called the Whiplash Effect. The concept is that the further back in the supply chain a company is, the greater the volatility in demand it experiences. This is due to the use of inventory by the members of a supply chain. As an illustrative example, consider a retailer of personal computers. This retailer will experience some volatility in customer demand and so will maintain some inventory. Then depending on demand and the retailers forecasting of future demand, they will order batches of new inventory from a wholesaler. The problem is that the volatility in customer demand experienced by each retailer, and the forecasting of each retailer, is partially correlated. This means that the wholesaler experiences even greater volatility in customer demand. As we progress backwards down the supply chain the volatility becomes more and more pronounced. So the PC manufacturers experience greater volatility again, and a company such as Intel producing components for a PC will experience significant volatility in demand. Therefore when there is a downturn in customer demand experienced by a retailer, the process of them reducing their inventory and ordering less, and the exact same thing occurring at every level of the supply chain causes a Whiplash Effect for suppliers at the end of the supply chain.
I’ve been considering a couple of trends and wondering if a contributing factor of the current recession is a significant Whiplash Effect. The first trend is the speed of information in the supply chain with new internet based business-to-business inventory ordering systems. I assume that in the past, inventory management reacted slower to changes in demand and therefore this would mute the whiplash. The second trend is the discretionary proportion of our income. When I was reading The great crash the author discussed that the people who lost money in the 1929 stock market crash tended to have a high proportion of discretionary income. The problem with this is that unlike normal expenses, consumers can quickly choose to cut back on spending discretionary income. As the discretionary proportion of our income has been growing over many decades, I wonder if a greater proportion can result in more volatility in consumer demand. If there is a concerted change in consumer spending behaviour, this would result in a significant whiplash.
Some of the most alarming data points currently in the media have come out from consumer-electronic companies and car manufacturers in Japan and Taiwan. High-definition plasma TVs, GameBoys, and new cars are discretionary spending, and therefore consumers in the USA and Europe can quickly stop spending on these items. Then, with the improvement in inventory management within the supply chain, I wonder if this reduced customer demand has caused the biggest ever whiplash effect for these manufacturers.
One parting thought. If this is a contributing factor, then we should note that the whiplash works both ways. When a feeling of optimism returns, there will be concerted discretionary spending by consumers and every member of the supply change will react quickly to rebuild inventories. And there could be sudden unprecedented demand at the bottom of the supply chain.