Inventories in the Economic Recovery: Caterpillar Snaps the Bullwhip
Submitted by Businomics Blog
The recession is the time to cut inventories. The recovery is the time to re-stock. First, though, you have to make sure that your vendors are up to the challenge. The Wall Street Journal recently ran an excellent front page story about Caterpillar Inc. entitled, “’Bullwhip’ hits firms as Growth Snaps Back.” The so-called Bullwhip effect is the cyclical inventory swing, which I describe in more detail in my book, Businomics. In the recession, three forces reduce orders from vendors:
- With a lower level of sales, there is less ordering to replace recently-sold merchandise.
- At a lower level of sales, an inventory-sales ratio targets dictates lower inventories.
- Many companies lower their inventory-sales ratio target to conserve working capital.
When the economy begins to recover, the opposite happens. One dollar’s worth of sales first triggers one dollar’s worth of orders from the supplier. Then the higher sales level triggers a few additional cents worth of orders due to the higher average sales level. Finally, the company realizes that having inventory in stock is a competitive advantage, and it now has adequate cash, so it raises its inventory-sales target. The swing in inventories is highly disproportionate to the underlying change in sales.
(I’ve previously written about how tight inventories can cost businesses both immediate sales as well as customer loyalty, and I think the inventory swing across the economy will have a large impact on economic growth in 2010.)
Caterpillar anticipated this bullwhip effect in its own operations and had the wisdom to wonder if its vendors would be able to deliver increased shipments. Now let’s talk about how a company whose CEO is a Ph.D. in economics handles this challenge. The Journal reports,
“…Caterpillar took the unusual step late last year of visiting with key suppliers to ensure they had the resources to quickly boost output. In extreme cases, the equipment maker is helping suppliers get financing.“
This is a genuine challenge. I’m hearing stories of businesses that cannot get the materials they need from their vendors. The reasons are various, but all tie to the recession. The vendor may lack the working capital needed to buy raw materials and pay newly re-hired workers. Caterpillar is wise to help its vendors with financing. Trade credit usually helps vendors with their raw material costs, but companies battered by the recession may have to pay cash up front from their nervous and cash-poor suppliers. Labor, of course, has to paid promptly. Even if the vendor has adequate working capital, it may have laid off workers with key skills, and it may have deferred maintenance on some of its equipment. A corporate buyer typically talks to a sales representative, who is not inclined to report potential problems with deliveries. The conversation with vendors has to be elevated to higher level officers knowledgeable about the companies finances and operations. Caterpillar also inquired about their vendors’ exposure to the automobile industry, a key risk to survival in this economic climate.
If your company depends on its vendors, read the entire Wall Street Journal article. Then start a program to meet with your critical vendors. (Personal plug: I have been talking to businesses about business strategy in the recovery, and I can help firms that want to engage in their own recovery readiness assessment, or want to make sure their vendors are ready.)
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