Have You Experienced a Demand Disruption?

Many companies have mature programs in place to manage the risk of supply disruptions, but are you prepared for a significant change in demand?

In preparation for a 2017 talk, I did a survey of the risks identified by products and services companies in the 1A Risks statements in their SEC 10-K filings.  Supply disruptions, while not the most frequently mentioned risk, were the only risk mentioned by every company in the survey.  It’s safe to say that supply disruptions are a constant concern for Boards, CEO’s, and Supply Chain leadership teams.  But what about a disruption to demand?  Particularly one that causes a sudden and significant increase in demand?  Recent experience during the COVID-19 pandemic has indicated that few companies have thought about, or are ready for such a disruption.

A supply disruption is an event that constrains the ability of a company to produce or deliver product to customers.  A shortage of a key raw material, downtime on a critical production resource, and severe weather that impacts transportation are all potential sources of a supply disruption.  But what then is a demand disruption?  A demand disruption is an event that causes a sudden and significant change in customer demand patterns that exceeds the ability of the supply chain to respond.  While both increases and decreases in demand can be considered to be disruptive, I will focus this discussion on increases.

A sudden increase in demand?  Most companies would say that’s a good problem to have.  However, when the increase is large enough to be disruptive, it comes with a host of problems.  To begin with, one company’s demand disruption is almost certainly a supply disruption for that company’s customers.  If demand increases to the point where it exceeds the capacity of the supply chain, then some portion of demand will not be met, or not met in a timely fashion.  Customers will see this as a disruption to their supply and respond accordingly.  A demand disruption then has the potential to drive increased costs through premium transportation, overtime, and potential contractual penalties.  Not to mention the impact on customer relationships.

What distinguishes a demand disruption from a supply disruption is the source.  In a demand disruption, the supply chain is operating normally, and at normal levels of demand there would be no issue.  To be a demand disruption, the primary cause of the disruption must be a change in the underlying demand patterns absent of any disruption to the impacted company’s supply.  The COVID pandemic has created a number of demand disruptions, both directly and indirectly.  It doesn’t take a global pandemic to create a demand disruption, but these are illustrative of how disruptions occur.

How Could We Run Out of Toilet Paper?

Everyone is familiar with the toilet paper shortages that occurred during the pandemic, but few people really understand what caused them.  In simple terms, there are two kinds of toilet paper: Consumer, or what you buy for home use, and Commercial, or what you find in public and office restrooms.  When large numbers of people began to work from home during the pandemic, it created a significant shift in the mix of toilet paper consumption, with volume shifting from commercial to consumer grade. Overlaid on top of this was a spurt of panic buying (no one wants to run out of toilet paper!).  While the panic buying was transitory, the change in product mix could be expected to last as long as people continued to work from home – and in proportion to the number of people working from home.  This became an issue because different production assets are used to produce consumer vs. commercial grades and they are packaged differently.  So while there was excess supply of commercial toilet paper, production of consumer toilet paper could no longer keep up with demand.  The resulting supply shortages then were not the result of any supply side disruption – paper mills were producing as much as they could – but due to the sudden and sharp increase in demand for the consumer product.

The Backup Supplier Fallacy

When I ask people about their strategies for maintaining supply continuity, often the first one mentioned is having a backup supplier.  This is of course a valid strategy, but only in the right circumstances. When a supplier fails, the customers of that supplier will move to alternative suppliers.  In a highly fragmented supply base this is barely noticed.  However, as the supply base becomes more concentrated the ripples created by the failure of any one supplier grow larger and larger.  An example is the 2016 bankruptcy of Hanjin, the Korean container shipping line.  Given Hanjin’s size and market share in a concentrated supply market, Hanjin’s failure disrupted demand for all of the remaining lines as shippers sought container bookings from other lines.  Having a contract with another shipping line was of little value as every carrier had more demand than they had the capacity to support.  The result was delays of several weeks added to container transit times, and steep prices increases.  Ultimately, higher prices and time allowed the industry to reach a new equilibrium that once again balanced supply and demand.  The key learning here is that a backup supplier is only effective to the extent that they have the capacity to absorb the incremental demand created by a disruption elsewhere.

Bankruptcies, strikes, and other factors that eliminate a supply source, even temporarily, can cause a demand disruption for alternative sources.  This happened many times in the early stages of the COVID-19 pandemic as factories were idled.  To the extent that alternative sources were available and still operating, those companies experienced demand disruptions.

The Chip Bullwhip

In their 1997 article, The Bullwhip Effect in Supply Chains[1], Lee et al described how variability can increase as demand propagates upstream in a supply chain.  This can create significant inefficiencies, but what happens when the effect is to increase demand beyond the capacity of the supply base?  Demand variability of significant magnitude can lead to demand disruptions.  This is particularly true when the supply base is highly capital intensive as the required capital investment acts as a disincentive to having excess capacity available to buffer surges in demand.

There is perhaps no better example of this than the current semiconductor chip shortage.  Semiconductor fabs are extremely capital intensive, costing billions to build.  This has led both to a high level of concentration in the supply base (five major players) and to production economics that incent running at capacity 24×7.  As an added complication, much of the output of these companies is unique customer devices produced on a make-to-order basis.  Producing to stock on these devices is high risk if it’s an option at all. When COVID related shutdowns began in March, 2020, customers cut their forecasts and orders for semiconductors.  Semiconductor output dropped, and in many cases capacity went unused.  But homebound consumers continued to buy, and at increased levels.  With extra money in their pockets from not traveling and not eating out, and new needs like laptops to allow their children to attend school virtually, consumer spending on technology surged.  By summer, semiconductor companies were seeing demand at pre-pandemic levels, and by fall of 2020 demand began to exceed the capacity available to support it.  Now, had demand remained constant throughout the year there would likely have been no issue, at least in 2020.  But the bullwhip which first pulled demand down and then up led to lost output and thus a loss of effective capacity.  Perhaps the industry most impacted by the chip shortage is the auto industry.  Unlike consumer electronics, many auto plants were closed for extended periods of time and forecasts and orders for semiconductors followed suit.  By the time that automotive plants began to reopen and place new orders, the available capacity in semiconductor fabs was fully utilized in support of other industries.  This only added to the demand disruption that was already in full swing.  As the last industry to restore demand, the auto industry has been bearing the brunt of chip shortages.

Now, interestingly enough, companies that supply raw materials to the semiconductor industry have seen a smaller magnitude of change in their demand.  This is because the capacity constraints of their customers act as a damper on the bullwhip.  As a general rule, while variability increases further upstream in the supply chain, capacity constraints often have a dampening effect on that variability.

[1] Lee, Hau L, Padmanabhan, V, and Whang, Seungjin; The Bullwhip Effect in Supply Chains; MIT Sloan Management Review, Spring 1997

Managing a Demand Disruption

While many see a sudden increase in demand as a good problem to have, it is a problem nonetheless.  How a company interprets and responds to a change in demand can have a significant impact on operating costs and customer good will.  It also creates a significant risk of trapping cash in unneeded inventory or capital equipment.  To successfully navigate a demand disruption, companies should focus on three areas: understanding the demand, managing customer relationships, and maximizing output.

Why?

The first step in navigating a demand disruption is to understand what happened and how events are shaping demand. Understanding begins with asking a lot of, “why”, questions to get to the root cause of the change.  Once you know what happened and how customers responses to events are shaping demand, you can move on to the other critical questions.  The first of these is, “Is the change temporary, or does it single a transition to a new equilibrium?”  In the case of pandemic demand for toilet paper, the change in demand was caused by people working from home instead of in an office environment.  At some point, people will return to the office, although some portion of the population may transition to some level of working from home permanently.  The return to the office is not likely to happen overnight, and forecasts of future demand should reflect a gradual transition back to something like the historical mix.  In the Hanjin bankruptcy example cited earlier, the change is permanent. But it should be expected that the market will gradually return to a new equilibrium as the remaining competitors add capacity until supply approximates demand.  The duration of the change is a key consideration in determining how to properly respond.  A short term change likely does not justify significant capacity investments to increase output as the incremental capacity will quickly be idled.  However, a permanent change with an opportunity to capture long term market share gains may justify investment.

When customers are faced with a shortage of supply, they may attempt to game the system by inflating orders and forecasts in the hopes that this will give them a larger allocation.  This behavior can significantly distort the demand signal, leading to incorrect decisions about production plans or capacity investments.  The second part of understanding demand is to relentlessly scrub customer orders and demand forecasts to understand what is the real demand signal and what is fluff.  This is best approached from a variety of angles, such as looking at historical demand, market size and market share, and other indicators to develop a consensus on a reasonable estimate of demand. In this exercise it is often useful to identify upper and lower bounds as opposed to a single number.  When supply ultimately begins to catch up to demand, the additional demand created by gaming will quickly evaporate, potentially leaving piles of inventory or idle production lines in its wake if not handled properly.

Managing Customer Relationships

During a demand disruption demand exceeds available supply.  Customers will experience this as a supply disruption that negatively impacts their business.  Managing customer relationships during this time is key.  From a supply chain perspective, the key customer relations question is who gets what when.  In other words, allocation. Companies should implement an allocation process well in advance of any disruption to demand.  This may be an extension of the process used during routine backorders, but modifications are needed to address the scope, scale, and likely duration of a demand disruption.  Having the process in place allows for an agile response that can begin when the potential for disruption first appears on the horizon.

A good allocation process involves Supply Chain working closely with the Commercial team to understand the available tradeoffs and implications on both operations and customers.  The process should allow for evaluation of various allocation schemes and priorities and must be able to address customer shortage gaming behaviors. Key considerations are maintenance of current customer relationships and commitments vs. opportunities to grow volume and market share.  Finally, the process must consider the inevitable escalations from customers to senior executives and how these requests will be resolved.

Maximize Volume

When demand exceeds supply, the natural response is to try to increase supply.  In the long term, it’s possible (but not necessarily prudent) to add capacity to restore the supply-demand balance.  In the short term however it’s critical to consider all avenues to increase output with existing capacity. This can happen through adding shifts or increasing overtime, but it’s important to also consider more radical approaches. During the pandemic, certain food producers increased output by temporarily slashing their SKU portfolio and focusing on the highest volume products only – for example, stopping the production of ziti noodles to produce more spaghetti.  The specific tradeoffs available will vary widely by company and production technology, but radical moves such as this must be considered in the face of a significant demand disruption

Conclusion

Prior to the pandemic, the concept of a demand disruption was largely outside of the vocabulary of many supply chain professionals.  However, the pandemic has brought this into sharp focus with most of us feeling the impact of demand disruptions in toilet paper, pasta, and other grocery staples.  But you don’t need a global pandemic to create a demand disruption.  Bankruptcies, natural disasters, and the