The Nursery Bullwhip Effect

               Have you ever heard of Michael Burry’s “Bullwhip Effect” with regards to supply chain?  It is snapping through the nursery industry and costing everyone money so we’re going to discuss it in today’s article. 

I first heard of the concept from "The Uneducated Economist" YouTube channel who introduced the phenomenon even before Michael Burry.  Speaking of which, I highly recommend this channel to anyone interested in macroeconomics, lumber futures, or the construction industry.  Simon (host) has called the Fed’s interest rate policy more accurately than anyone else for years now because he reads through all their speeches and discussions.  Great resource for the interested. 

Shortage

               Anyway, the Bullwhip Effect is a phenomenon that happens when there is not enough supply to meet demand and buyers are forced through an allocation process.  Allocation happens when the grower receives orders for more plants than they have.  In an effort to serve their customers and the company interest, the grower divvies up the plants among their customers.  Makes sense.  Shortage is the first step. 

Overordering

Buyers have a responsibility to their nurseries to secure enough products for their sales needs, so they have to get creative in how they order.  As a buyer, if you know you’re going to need 25 of a given item but keep getting about 25% of your order in allocations, you might order 100 of that plant to get your 25.  You also won’t want to put all your eggs in one basket, so might order 100 from five or six vendors to be safe. 

Even if you end up with an abundance, it’s okay because the product is so short on the market, at least you’ll never be out.  It’s a short-term strategy that works well and most nursery buyers have tried some variation of this.  Overordering is the second step. 

Overproduction

               During production planning, growers look at historical trends and analyze missed orders to capitalize on increased demand.  This makes sense for a grower, but the scope of this adjustment might surprise you.  When a product is short on the market, a grower might get fifty overorders for a key item as their customers jockey for their share of allocations.  Now, imagine those price signals sent across five or six vendors each and spread across the country.  Each of those growers attempts to meet some portion of the increased demand.  Overproduction is the third step.

Bottleneck

               I was recently talking with an experienced buyer who had placed orders for Globosa with multiple vendors.  She was caught by surprise when the confirmations came back, and she had been allocated 100% of her request from multiple growers.  She shrugged and said, “Now I’m going to have to figure out what to do with all of these Globosa.”  

               In her case, she was still planning to receive all the materials and honor her commitment to the growers, but many buyers will begin cutting orders after being confirmed more than they need.  At that point, the secured orders go to whichever growers best support the needs of the buyer, be it quality, delivery methods, or price.  This bottleneck is the fourth step.

Backup

                Most crops in the nursery industry can be maintained for 1-3 years past their prime but they never stop growing so each plant has an expiration date.  When they don’t sell through their material, growers have four options.  Maintain the crop, shift it into larger container sizes, liquidate it for cheap, or dump it.  Each of these has a cost.

 In my experience, every grower maintains the crop as long as they can in hopes of a future sale.  This increases the duration of gluts in the marketplace.  As the plants near their expiration date, about 10% of the crops are shifted into larger containers as appropriate.  70% are liquidated for cheap to recoup production costs.  The last 20% is dumped either because the quality is so bad it’s unsellable or because the grower doesn’t know the right liquidator to move it out.  Backup is the fifth step.

Shortage

               During their production planning, growers also look at plants that they’ve had to discount or dump.  The two strategies that are most often employed are either to hold the course on production quantities or cut production somewhat in favor of increasing production where there is higher demand.  It’s likely that the increase in demand that prompted the overproduction in the first place was real, but the grower miscalculated the degree thanks to this bullwhip effect. 

               Contrarians would say this is when growers should increase production to counter the market but growers who have tried typically do so while other nurseries are still maintaining or shifting their crops.  Those tactics can draw a glut out for years so upping production can be a dangerous strategy. 

               The number of nurseries staying flat or cutting production numbers makes it very probable that any adjustments will lead to future imbalances.  Any shortage will force growers to begin allocating products and potentially shorting their customers.  Shortage takes us back to the first step and the process begins again. 

Ideally, these corrections are conservative and will help stabilize the market over several years.  While that is happening, demand and overordering will break out in another cultivar and the problem inevitably begins again elsewhere. 

Possible Solutions 

               Growers and buyers both lose money during the bullwhip effect.  The current solutions inevitably produce long-term negative outcomes.  It is my belief that any long-term solution would have to benefit both parties simultaneously and work in each of theirs best interests or else the bullwhip effect will continue. 

Current Solutions:

1.       Buyers overorder and diversify their suppliers to ensure allocation needs are met.

a.       This benefits them for a few years but sends wild demand signals out into the marketplace which prompt overproduction and a glut. It’s not really their problem until the glut prompts production cuts and they can’t get the stuff again.

b.       This strategy seems necessary to support the company’s sales goals and their customers.

2.       Growers increase production to meet demand.

a.       This benefits them for a few years but the duration between propagation and sales ultimately gets them producing into a glut which will cost them in maintenance, liquidation, and dumping.

b.       Increased production seems necessary in order to support the company’s sales goals and their customers. 

Potential Solutions:

1.       Unsold crops should be destroyed instead of liquidated to protect the market.

a.       This is still reactionary, meaning it is a solution after the imbalance was already created.  It’s also expensive since dumping costs money and you sacrifice the opportunity to offset production costs through liquidation.  It would also require the participation of multiple growers.  Many growers may not be able to afford to dump their crops, so they’ll be forced to liquidate and undercut the efforts of those larger growers. 

2.       Growers should “get on the same page” with pricing so they aren’t undercutting each other.

a.       That seems like price fixing which would be illegal.  It would also artificially prop up prices and send profitability signals to other growers to increase production which undercuts the whole effort and perpetuates the glut. 

3.       Buyers should focus on consistency and not be so price conscious.

a.       Buyers are tasked with maintaining the profitability of the organization through shrewd purchasing so this would not be in their best interests.  It might also artificially reinforce high pricing which would promote further production right into a glut.

4.       Growers should use the same software to adjust production proactively. 

a.       Growers want to take advantage of market changes and sharing this sort of data would nullify everyone’s ability to perform by creating analysis paralysis.  It also creates an environment where a bully grower could corner the market on their favorite products by deliberately overproducing like a production version of playing chicken.   

               In short, I think any plan that requires total coordination or for one party to sacrifice themselves to benefit the market is a bad plan.  Nobody will do it and nobody should do it.  What we need is an incentive structure that allows growers and buyers to proactively pursue their own best interests in the reality of supply and demand. 

               I am actively developing that solution. Send me a message if you’d like to hear more.