Forthcoming in The Bullwhip Effect in Supply Chains. O. Carranza and F. Villegas, (eds.) Palgrave McMillan.

Operational and Behavioral Causes of Supply Chain Instability

*

John D. Sterman
Sloan School of Management
Massachusetts Institute of Technology
Cambridge, MA 02142
jsterman@mit.edu
web.mit.edu/jsterman/www

The central core of many industrial companies is the process of production and distribution. A recurring problem is
to match the production rate to the rate of final consumer sales. It is well known that factory production rate often
fluctuates more widely than does the actual consumer purchase rate. It has often been observed that a distribution
system of cascaded inventories and ordering procedures seems to amplify small disturbances that occur at the retail
level... How does the system create amplification of small retail sales changes?... [W]e shall see that typical
manufacturing and distribution practices can generate the types of business disturbances which are often blamed on
conditions outside the company.
Jay W. Forrester (1961) Industrial Dynamics, p. 22
Supply chain instability is a pervasive and enduring characteristic of market economies.
Production, inventories, employment, revenue, profit and a host of other indicators fluctuate,
irregularly but persistently, throughout the economy, in industries from A to ZAircraft to Zinc
(e.g., W. Mitchell 1971, Zarnowitz 1985, Sterman 2000). Supply chain instability harms firms,
consumers, and the economy through excessive inventories, poor customer service, and
unnecessary capital investment. Instability in employment erodes skill and worsens labor-
management relations. Volatility in revenue and profit increases risk and raises the cost of
capital. Instability diverts leadership attention from the design of successful new products and
strategies to firefighting and crisis management.
Despite the undoubted benefits of the lean manufacturing and supply chain revolutions of the
past decade, supply chain instability continues. Examples include record inventory write-offs,
excess capacity, price cuts, layoffs, and bankruptcies in computers, semiconductors,
telecommunications, and other high-tech industries after 2000, and waves of zero-interest
financing, employee discounts for all, and cash-back incentives accompanying surplus inventory
in the automobile market.
Supply chain instability is often described as the bullwhip effect, the tendency for variability to
increase at each level of a supply chain as one moves from customer sales to production (Lee et
al. 1997, Chen et al. 2000). While amplification from stage to stage is important, supply chain
instability is a richer and more subtle phenomenon. The economy, and the networks of supply

*
I acknowledge the contributions of Ed Anderson, Octavio Carranza, Rachel Croson, Gokhan Dogan, Karen
Donohue, Paulo Gonalves, Elena Katok, and Rogelio Oliva. Financial support provided by the Project on
Innovation in Markets and Organizations at the MIT Sloan School.

11/30/05 2
chains embedded within it, is a complex dynamic system and generates multiple modes of
behavior. These include business cycles (oscillation), amplification of orders and production
from consumption to raw materials (the bullwhip), and phase lag (shifts in the timing of the
cycles from consumption to materials). High product returns and spoilage are common in
industries from consumer electronics to hybrid seed corn (Gonalves 2003). Many firms
experience pronounced hockey-stick patterns in which orders and output rise sharply just prior to
the end of a month or quarter as the sales force and managers rush to hit revenue goals. Boom
and bust dynamics in supply chains are often worsened by phantom ordersorders customers
place in response to perceived shortages in an attempt to gain a greater share of a shrinking pie
(T. Mitchell 1923, Sterman 2000, ch. 18.3, Gonalves 2002, Gonalves and Sterman 2005).
What are the causes of supply chain instability? Why does supply chain instability persist,
despite the lean revolution and tremendous innovations in technology? What can be done to
stabilize supply chains and improve their efficiency?
Here I describe the origins of supply chain instability from a complex systems perspective. The
dynamics of supply chain networks arise endogenously from their structure. That structure
includes both operational and behavioral elements. Operational causes refer to the physical and
institutional structure. Physical structure includes the placement of inventories throughout the
network of suppliers and customers and time delays in production, order fulfillment,
transportation, and so on. The institutional structure includes the degree of horizontal and
vertical coordination and competition among and within firms, the availability of information to
each organization and department, and the incentives faced by each decision maker. Behavioral
causes encompass the mental models of the decision makers, including their attitudes,
attributions about other actors, and the heuristics and routines they use to interpret the
information they have and make decisions such as production, capacity and pricing.
The operations management literature emphasizes the physical and institutional structure,
assuming decision makers are rational agents who make optimal decisions given their local
incentives and the information available to them. For example, the bullwhip can arise from
rational behavior if there are quantity discounts that encourage bulk purchases. However, supply
chain instability is also, and crucially, a behavioral phenomenon. The mental models and
decision rules people use to manage supply chains are far from optimal. Decision makers are, at
best, boundedly rational, typically relying on mental models that grossly simplify the
environment, incorporate few feedback processes, ignore or underestimate time delays, and fail
to account for key stock and flow structures. The same bounds on rationality slow learning,
enabling supply chain instability to persist. I review the extensive experimental and field data
documenting these misperceptions of feedback and discuss how they can be overcome.

11/30/05 3
Oscillation, Amplification, and Phase Lag
Exhibit 1 shows industrial production in the US. The data exhibit several modes of behavior.
First, the long-run growth rate of manufacturing output is about 3.4%/year. Second, as seen in
the bottom panel, production fluctuates significantly around the growth trend. The dominant
periodicity is the business cycle, a cycle of prosperity and recession of about 35 years in
duration, but exhibiting considerable variability.
The amplitude of business cycle fluctuations in materials production is significantly greater than
that in consumer goods production (exhibit 2). The peaks and troughs of the cycle in materials
production also tend to lag behind those in production of consumer goods. Typically, the
amplitude of fluctuations increases as they propagate from the customer to the supplier, with
each upstream stage tending to lag behind its customer. These three features, oscillation,
amplification, and phase lag, are pervasive in supply chains.
Oscillation, amplification, and phase lag are even more pronounced in specific industries. The
top panel in exhibit 3 shows the petroleum supply chain (the figures show the annualized growth
rate; all monthly data are shown as 12-month centered moving averages to filter out the high-
frequency month-to-month noise). Oil and gas drilling activity fluctuates about three times more
than production, imposing large boom and bust cycles on suppliers of drill rigs and oil field
services. The middle panel shows the machine tool industry. Fluctuations in economic growth
lead to much larger swings in motor vehicle sales. During recessions, sales fall as people keep
old cars longer, causing unanticipated inventory accumulation and forcing even larger production
cutbacks. The automotive industry generates a large share of total machine tool orders. During a
production downturn, the auto companies postpone or cancel their capital investment plans,
causing even larger drops in the orders they place for machine tools. During the next upswing
they scramble to build capacity and orders surge. The phase lag between vehicle production and
the induced changes in machine tool orders is clearly visible. The bottom panel shows the
semiconductor industry. Semiconductor production is at the upstream end of the computer and
electronics supply chain and fluctuates far more than industrial production as a whole.
Prior research offers two categories of explanation for the bullwhip effect, each motivating
distinct recommendations to dampen it. The first category focuses on operational causes of the
problem, such as production lags and order processing delays, procedures for demand
forecasting, order batching to take advantage of scale economies or quantity discounts, rational
responses to product shortages, and price fluctuations caused by promotions. Many of these
were documented and modeled by Forrester (1958, 1961); see also Lee et al. (1997). Techniques
to eliminate them are now an important part of the tool kit for supply chain design (e.g., Simchi-
Levi et al. 1999).

11/30/05 4
The second category, first introduced by Forrester (1958, 1961), emphasizes behavioral causes of
instability. Behavioral explanations emphasize the bounded rationality of decision makers,
particularly the failure to account for feedback effects, accumulations, and time delays. Studies
in dynamic decision making consistently show that people do not understand the stock and flow
structure of systems and do not adequately account for time delays, feedbacks, and nonlinearities
(Booth Sweeney and Sterman 2000, Drner 1996, Brehmer 1992). Specifically, people tend to
place orders based on the gap between the target level of inventory and their current, on-hand
stock, while giving insufficient weight to the supply line of unfilled orders (the stock of orders
placed but not yet received). Supply line underweighting is sufficient to cause the instability
observed in both experimental and real supply chains (Sterman 1989a, 2000).
Supply chains are of course not restricted to manufacturing or even management settings.
Service industries such as insurance have supply chains for recruiting customers, writing
policies, and processing claims (Anderson and Morrice 2005, Fitzsimmons et al. 2003). Labor
supply chains provide employees through processes of vacancy creation, recruitment, and
training; product development provides new products through requirements definition, high-level
design, detailed design, testing, and so on. Even the supply of glucose providing the energy
required for your metabolic activity is the output of a supply chain encompassing food
consumption, insulin synthesis, glucose metabolism and waste excretion (see Sturis et al. 1991
for a system dynamics model of the human glucose-insulin system). Like manufacturing supply
chains, these systems include multiple time delays and are prone to instability and oscillation.
The Stock Management Problem
Supply chains consist of networks of firms, each receiving orders and adjusting production and
production capacity to meet changes in demand. Each link in a supply chain maintains stocks of
materials and finished product. To understand the behavior of a supply chain and the causes of
instability, it is first necessary to understand the structure and dynamics of a single link, that is,
how an individual firm manages its resources as it attempts to balance production with orders.
In such stock management tasks, managers seek to maintain a stock (the state of the system) at a
particular target level or within an acceptable range. Stocks are altered only by changes in their
inflow and outflow rates. Typically, the manager must set the inflow rate to compensate for
losses and usage and to counteract disturbances that push the stock away from its desired value.
Usually there are lags between the initiation of a control action and its effect and lags between a
change in the stock and the perception of that change by the decision maker. The duration of
these lags may vary and may be influenced by the managers own actions.
Stock management problems occur at many levels of aggregation. At the level of a firm,

11/30/05 5
managers order parts and raw materials to maintain inventories sufficient for production to
proceed at the desired rate. They must adjust for variations in the usage of these materials and
for changes in their delivery delays. At the individual level, you regulate the temperature of the
water in your morning shower, guide your car down the highway, and manage your checking
account balance. At the macroeconomic level, the US Federal Reserve seeks to manage the
stock of money to stimulate economic growth and avoid inflation, while compensating for
variations in credit demand, budget deficits, and international capital flows.
The stock management control problem can be divided into two parts: (1) the stock and flow
structure of the system and (2) the decision rule used by the managers to control the acquisition
of new units (Exhibit 4). Consider first the physical structure. The stock to be controlled, S, is
the accumulation of the acquisition rate AR less the loss rate LR:

!
S = (AR LR)dt " (1)
Losses include any outflow from the stock and may arise from usage (as in a raw material
inventory) or decay (as in the depreciation of plant and equipment). The loss rate must depend
on the stock itselflosses must approach zero as the stock is depletedand may also depend on
other endogenous variables X (e.g., prices, marketing campaigns, competitor responses) and
exogenous variables U (e.g., weather). Losses may be nonlinear and may depend on the age
distribution of the stock:
LR = f(S, X, U) (2)
In general the decision maker cannot acquire units directly; rather there is a time delay between
ordering units and delivery. Hence there is a supply line of unfilled ordersthe stock of orders
placed but net yet received. The supply line accumulates the Order Rate, OR, less the
acquisition rate:

!
SL = (OR AR)dt " (3)
In general, the acquisition of new units involves time delays (e.g., the time required to fill orders,
fabricate subassemblies, or build capital plant). Hence acquisition depends on the supply line
and the average Acquisition Lag, !.
AR = L(SL, !) (4)
where the lag functional L(
.
) denotes a material delay. The acquisition lag ! is itself endogenous.
The acquisition of new units requires resources: Production requires labor and equipment;
deliveries require materials handling systems and transportation resources. These resources may
themselves be dynamic and endogenous. The resources available at any moment impose
capacity constraints. The acquisition lag ! depends on the supply line relative to the capacity of
the process to delivery, which in turn depends on other endogenous and exogenous variables.

11/30/05 6
Often, the average acquisition lag is relatively constant up to the point where the required
acquisition rate exceeds the capacity of the process, as for example when the desired
construction rate for capital plant exceeds the capacity of the construction industry. The
acquisition lag can also be influenced by management, as when a firm speeds construction
through overtime, or expedites materials procurement by paying premium freight. Thus the
acquisition lag depends on the supply line and these other endogenous and exogenous variables:
! = f(SL, X, U) (5)
When the acquisition rate is constrained by the capacity of the supplier the actual delivery time
for items in the supply line rises, causing deliveries to be delayed and product to be rationed
among competing customers. The consequences of such rationing are discussed below.
The stock management structure is quite general. The system is nonlinear (nonlinearities arise
from nonnegativity constraints and capacity limits on acquisition). There may be arbitrarily
complex feedbacks among the endogenous variables, and the system may be influenced by a
number of exogenous forces, both systematic and stochastic. Exhibit 5 maps common examples
into the generic form. In each case, the manager must choose the order rate over time so as to
keep the stock close to a target. Oscillation and instability are common in these systems.
In most realistic stock management situations the complexity of the feedbacks among the
variables precludes the determination of the optimal strategy. The order decision model
proposed here assumes that managers, unable to optimize, instead exercise control through a
locally rational heuristic. The model thus falls firmly in the tradition of bounded rationality as
developed by Simon (1982), Cyert and March (1963), and others. Cognitive limitations are
recognized, as are information limitations caused by organizational structures such as task
factoring and subgoals (for a discussion of local rationality in the context of simulation models
see Morecroft 1983, 1985 and Sterman 2000).
The hypothesized decision rule utilizes information locally available to the decision maker and
does not presume that the manager has global knowledge of the structure of the system.
Managers are assumed to choose orders so as to: (1) replace expected losses from the stock; (2)
reduce the discrepancy between the desired and actual stock; and (3) maintain an adequate
supply line of unfilled orders. To formalize this heuristic, first observe that orders in most real-
life situations must be nonnegative:
1

OR = MAX(0, IO) (6)

1
Order cancellations are sometimes possible and occasionally exceed new orders (e.g. the U.S. nuclear power
industry in the 1970s, telecommunications equipment in 2001). Cancellations are subject to different costs and
administrative procedures than new orders and should be modeled as a distinct outflow from the supply line rather
than as negative orders.

11/30/05 7
where IO is the indicated order rate, the rate indicated by other pressures.
The indicated order rate is based on the anchoring and adjustment heuristic (Tversky and
Kahneman 1974). Anchoring and adjustment is a common strategy in which an unknown
quantity is estimated by first recalling a known reference point (the anchor) and then adjusting
for the effects of other factors which may be less salient or whose effects are obscure, requiring
the decision maker to estimate these effects by what Kahneman and Tversky (1982) call mental
simulation. Anchoring and adjustment occurs a wide variety of decision-making tasks (Plous
1993). Here the anchor is the expected loss rate L
e
. Adjustments are then made to bring the
stock and supply line in line with their desired levels:
IO = L
e
+ AS + ASL (7)
where AS, the Adjustment for the Stock, corrects discrepancies between the desired and actual
stock, and ASL, the Adjustment for the Supply Line, corrects discrepancies between the desired
and actual supply line.
Why does the order rate depend on expected losses rather than the actual loss rate? The sales of
a company right now cannot be measured. Instead sales are accumulated over some interval of
time such as a week, month, or quarter. The reported sales rate is the average over the reporting
interval, and sales right now usually differ from the average over the interval. Even in a supply
chain with bar code scanning or RFID, the reported flows always differ from their instantaneous
values. Further, the more frequently sales data are reported, the more high-frequency noise they
contain. Managers seeking to determine whether a change in orders is a temporary blip to be
quickly reversed or a trend requiring changes in production, employment, and capital investment
must therefore wait until more data become available, creating additional delay between data
reporting and action. Indeed, the more frequently data are sampled and reported, the more noise
they will contain, and the longer the decision maker must wait before being able to separate
signal from noise.
Forecasts of the loss rate (e.g., shipments from inventory) may be formed in various ways.
Common forecasting methods include moving averages, exponential smoothing, and trend
extrapolation. Even when apparently sophisticated market research methods and econometric
models are used, forecasters tend to massage the data in such a way that the resulting forecasts
are often indistinguishable from simple smoothing and extrapolation (Sterman 1987).
The bottom of Exhibit 4 shows the feedback structure of the ordering heuristic. The adjustment
for the stock AS creates a negative feedback loop that regulates the stock. For simplicity the
adjustment is linear in the discrepancy between the desired stock S* and the actual stock:
AS = "
S
(S* S), (8)

11/30/05 8
where the stock adjustment parameter "
S
is the fraction of the discrepancy ordered each period.
The adjustment for the supply line is formulated analogously as
ASL = "
SL
(SL* SL), (9)
where SL* is the desired supply line and "
SL
is the fractional adjustment rate for the supply line.
The desired supply line in general is not constant but depends on the desired throughput #* and
the expected acquisition lag !
e
:
SL* = !
e
#*. (10)
By Littles Law, the longer the expected delay in acquiring goods or the larger the throughput
desired, the larger the supply line must be. For example, if a producer wishes to add 10,000
widgets per week to finished inventory and production requires 8 weeks, there must be 80,000
widgets in various stages of work in process inventory to ensure an uninterrupted flow of
production. The adjustment for the supply line creates a negative feedback loop that adjusts
orders so as to maintain an acquisition rate consistent with expected throughput and the
acquisition lag. Without such a feedback production would be initiated even after the supply line
contained sufficient orders to correct stock shortfalls, producing overshoot and instability (as
shown below, this is precisely what happens). The supply line adjustment also compensates for
changes in the acquisition lag. If the acquisition lag doubled, for example, the supply line
adjustment would induce sufficient additional orders to restore the desired throughput. As in the
formation of expected losses, there are a variety of possible representations for !
e
and #*,
ranging from constants through sophisticated forecasts (Dogan and Sterman 2005). In particular,
it takes time to detect changes in delivery times. Customers often do not know that goods they
ordered will be late until after the promised delivery time has passed. Hence changes in !
e
tend
to lag changes in the actual acquisition lag.
Behavior: The Endogenous Emergence of Instability
The simple stock management structure yields important insight into the sources of amplification
observed in supply chains. To illustrate, exhibit 6 shows the policy structure diagram for a
simple model of a manufacturing firm operating a make-to-stock system. The structure is an
example of the general stock management structure described above. The firm maintains a stock
of finished inventory and fills orders as they arrive. Production takes time. The stock of WIP
(work in process) is the supply line. WIP is increased by production starts and decreased by
production. A key decision for the firm is production scheduling: managers must set production
starts to replace expected losses from inventory (shipments), keep inventory at an appropriate
level to provide good customer service, and maintain an adequate supply line of WIP inventory
to do so. If inventory is inadequate, some items will be out of stock and shipments fall below

11/30/05 9
orders, degrading customer service (in this initial model I assume customers are delivery
sensitive; unfilled orders are lost to competitors). The firm adjusts production starts to move the
levels of inventory and WIP toward their desired levels. Exhibit 7 shows illustrative parameters.
The manufacturing cycle time, from the receipt of raw materials to the completion of finished
product, is set to 8 weeks. To provide excellent customer service, the firm seeks to maintain
inventory coverage of four weeks. They attempt to correct gaps between desired and actual
inventory in 8 weeks ("
S
= 1/8 of the gap per week) to smooth production and minimize costly
swings in output, and correct gaps between the desired and actual level of WIP inventory over
two weeks ("
SL
= 1/2 of the gap per week). Exponential smoothing of actual orders, a widely
used method, forms the demand forecast.
To illustrate how supply chain instability arises endogenously through the interaction of a firms
own structure and policies, in this initial model demand is exogenous and materials, plant,
equipment and labor are assumed to be ample so the production process is uncapacitated. Hence
the lag between production starts and completion is constant (these and other simplifying
assumptions are relaxed in Sterman 2000 and Gonalves et al. 2005). The resulting dynamics
arise entirely within the firm itself as it manages its inventories and production.
2

Exhibit 8 shows the firms response to an unanticipated 20% step increase in customer orders
(the initial customer order rate is 10,000 widgets per week). The firm is initially able to fill
nearly all the incoming orders, despite the increase. However, since production continues at the
initial rate of 10,000 widgets/week, inventory falls. As inventory falls, so too does the firms
ability to ship. Shipments drop below orders, causing the firm to lose business (and its
reputation as a reliable supplier). The growing gap between desired and actual inventory forces
desired production above expected orders. The quantity of work in process required to meet the
higher production goal also grows, opening a gap between the desired and actual level of WIP.
Desired production starts therefore rise even more than desired production.
As time passes the firm recognizes that the change in demand is not a mere random blip and
gradually raises its demand forecast. As expected orders rise, so too does desired inventory,
further increasing the gap between desired and actual inventory and further boosting desired
production. Though customer orders jump 20%, production starts peak more than 42% higher
than the initial rate about 4 weeks after the shock. A useful measure of supply chain instability is
the amplification ratio, defined as the ratio of the maximum change in the output to the
maximum change in the input. The amplification ratio for production starts is 42%/20% = 2.1.

2
The model is fully documented in Sterman (2000), Chapter18, and is available at
www.mhhe.com/business/opsci/sterman/models.mhtml; file <widgets>.

11/30/05 10
A 1% increase in desired capacity induces a peak surge in production starts of more than 2%.
The rapid increase in production starts soon fills the supply line of WIP, but production lags
behind. Production does not surpass shipments until more than 6 weeks have passed; until then
inventory continues to fall even as desired inventory rises. Inventory stops falling when
production first equals shipments. The system is not yet in equilibrium, however, because of the
large gap between desired and actual inventory and between orders and expected orders.
Production eventually rises above shipments, causing inventory to grow. Production falls back
as inventory reaches the new, higher desired level. The peak of production comes about one-
quarter year after the change in orders, far longer than the eight week production delay.
The simulation reveals several fundamental aspects of supply chain behavior. First, the
production delay means additions to finished inventory continue at the original rate long after
demand changes. When shipments unexpectedly rise an initial drop in inventory is inevitableit
is a fundamental consequence of the physical structure of the system. Second, an increase in
demand means the firm must increase the inventory it carries to maintain adequate coverage and
good service. The firms inventory falls at the same time it seeks to hold more.
Second, amplification of the demand shock is unavoidable. The only way to increase inventory
back to its initial level is for production to exceed shipments. Production must overshoot the
shipment rate long enough and by a large enough margin to build inventory back to its initial
level. Production starts must overshoot orders even more to build inventory to the new desired
level, and still further to build WIP up to a level consistent with the higher throughput rate.
Third, amplification is temporary. In equilibrium, production starts rise precisely as much as
demand. But restoring inventory and then building inventory and WIP to their desired levels
requires a transient increase in production starts above demand. The temporary overshoot of
production starts is then passed upstream to suppliers through orders for materials. Though final
demand does not overshoot, suppliers face a boom and bust in the orders they receive.
Fourth, changes in production starts must lag the change in customer orders. The inventory gap
reaches its maximum about when inventory reaches its minimum. Inventory bottoms out only
after production has finally risen enough to equal shipments, an event that must lag the change in
orders. Like amplification, this phase lag, characteristic of many real supply chains, is a
fundamental and inevitable consequence of the physical stock and flow structure.
The stock management structure thus explains why supply chains generate amplification and
phase lag. Given the structure of the system (in particular, production delays and forecast
adjustment delays), production and production starts must overshoot, amplify, and lag
unanticipated changes in demand, no matter how rational the managers of the firm may be.

11/30/05 11
While the amount of amplification and length of the phase lag depend on the parameters, their
existence does not. Less aggressive stock adjustments would reduce amplification, but lengthen
the time required to restore inventory to the desired level, thus harming customer service.
The model developed so far constitutes a generic model of a firms manufacturing process. An
industry supply chain can be modeled by linking several of the single firm models together.
Each member of the supply chain is then represented by the same structure, though of course the
parameters can differ. The generic modules can be linked in an arbitrary network to capture the
structure of an industry or economy, including multiple suppliers, competitors, and customers.
To illustrate, consider a supply chain consisting of two firms (or units within a vertically
integrated firm). As before, the customer order rate received by the downstream firm (the
producer) is exogenous. The model has been augmented to include backlogs of unfilled orders
and an explicit stock of raw materials. The upstream (supplier) firms orders are determined by
materials orders placed by the downstream firm. Deliveries to the downstream firm depend on
the suppliers ability to ship. As is common, the producer does not share its point of sale data, or
data on its inventory and WIP levels, with the supplier. For both firms capacity is again assumed
to be ample and never constrains production. For purposes of exposition, the parameters of the
two firms are assumed to be identical.
3

Exhibit 9 shows the response of the linked model to a 20% step increase in customer orders.
Performance is far worse than the case where materials can be acquired fully and without delay.
The producers materials orders reach a peak of about 18,000 units/week, an amplification ratio
of 4.1. Though customer demand does not fluctuate, the supplier is whipsawed through large
amplitude fluctuations. The delivery of materials to the supplier reaches a peak of more than
28,000 units/week, an amplification ratio relative to customer orders greater than a factor of nine.
The surge in orders received by the supplier causes a severe inventory shortage at the supplier,
boosting the suppliers delivery lead time to a peak 75% greater than normal. Those shortages
constrain the downstream firms ability to produce, degrading customer service.
The transient surge in orders for materials placed by the downstream firm compounds the
suppliers problems. Though the supplier smooths incoming orders to filter out short-term
fluctuations, the suppliers forecast of orders significantly overshoots the final equilibrium.
Because information is not shared, the supplier does not know final sales and cannot tell which
orders reflect an enduring change in consumer demand and which reflect temporary inventory
and supply line adjustments. Consequently, the supplier first finds itself with far too little

3
Full documentation is provided in Sterman 2000, chapter 18; the model, <W2Stage_w_DD_FB.mdl> is available
at www.mhhe.com/business/opsci/sterman/models.mhtml.

11/30/05 12
inventory and materials, and aggressively boosts production. But just as the tap begins to flow,
orders received from the producer fall, leaving the supplier with huge surplus stocks and forcing
supplier production starts far below producer orders. The delays and stock adjustments cause
supplier production to be nearly completely out of phase with producer orders. Supplier output
reaches its peak just about the time incoming orders fall to their low point.
The simulated supply chain, though it represents only two links, exhibits all three phenomena
observed in real supply chains: oscillation, amplification, and phase lag. Most important, these
attributes arise endogenously. The supplier experiences oscillation in output even though the
external environment does not oscillate at all. The dynamics emerge from the interaction of the
physical structure of the supply chain with the bounded rationality of the managers.
Of course, the step increase in customer demand is not realistic. The step is analogous to striking
a bell with a single tap of the clapper. The step in demand suddenly knocks the system out of
equilibrium, allowing us to observe how the system responds to a single shock. In the real
world, of course, supply chains are not struck once but are continuously perturbed by changes in
customer orders (and random variations in other key rates, such as production and materials
deliveries). These random shocks constantly knock systems out of equilibrium, eliciting a
characteristic response determined by their feedback structure. Exhibit 10 shows the response of
the two-firm model when customer orders vary randomly around a constant value. The random
shocks in customer orders cause the supply chain to ring like a bell. The rate at which the
supplier acquires raw materials fluctuates with much larger amplitude and much longer period
than the changes in customer orders. The standard deviation of customer orders is less than 5%,
but the standard deviation of the suppliers materials acquisition rate is more than seven times
greater. And while most of the random fluctuation in customer orders consists of day-to-day or
week-to-week variations, the response of the supply chain is a longer cyclethe system
resonates at a characteristic frequency determined by its structure.
The purpose of inventory is to buffer the system against unforeseen fluctuations in demand. The
simulated supply chain does a good job of absorbing the very rapid random fluctuations in
customer orders. However, management policies significantly strengthen the slower variations
in demand, leading to persistent, costly fluctuations. These fluctuations are progressively
amplified by each stage. The system selectively attenuates high-frequency variations in demand
while amplifying low frequencies. As seen in the petroleum, machine tool and semiconductor
industries (Exhibit 3), small perturbations in final demand cause huge swings upstream.
Evidence from the lab and field
A large number of experimental and field studies document the bounds on rationality and

11/30/05 13
dysfunctional behavior of managers in supply chains and other dynamically complex systems.
Indeed, the evidence shows that the behavior of even experienced managers is often less rational
than assumed in the models above.
The Beer Distribution Game is a role-playing simulation of a supply chain originally developed
by Jay Forrester in the late 1950s to introduce managers to the concepts of system dynamics and
computer simulation.
4
Since then the game has been played all over the world by tens of
thousands of people ranging from high school students to supply chain professionals and chief
executive officers. The game is also used extensively in experimental studies of dynamic
decision making and supply chain management (e.g., Sterman 1989a, Chen and Samroengraja
2000, Croson and Donohue 2002, 2003, Croson et al. 2005, Steckel, Gupta and Banerji 2004,
Wu and Katok 2005, Dogan and Sterman 2005, Oliva and Gonalves 2005).
The game is played on a board portraying a typical supply chain (Exhibit 11; many universities
and experimental studies use computer implementations). Markers and chips represent orders for
and cases of beer. Each brewery consists of four sectors: retailer, wholesaler, distributor, and
factory (R, W, D, F). One person manages each sector. A deck of cards represents customer
demand. Each week, customers demand beer from the retailer, who fills the order out of
inventory. The retailer in turn orders beer from the wholesaler, who ships the beer requested
from wholesale stocks. Likewise the wholesaler orders and receives beer from the distributor,
who in turn orders and receives beer from the factory. The factory produces the beer. At each
stage there are order processing and shipping delays. Each sector has the same structure.
The players objective is to minimize total costs for their company. Inventory holding costs are
usually set to $0.50 per case per week, and stockout costs (costs for having a backlog of unfilled
orders) are $1.00 per case per week. The task facing each player is a clear example of the stock
management problem. Players must keep their inventories as low as possible while avoiding
backlogs. Incoming orders deplete inventory, so players must place replenishment orders and
adjust their inventories to the desired level. There is a delay between placing and receiving
orders, creating a supply line of unfilled orders.
5

The game is far simpler than any real supply chain. There are no random eventsno machine
breakdowns, transportation problems, or strikes. There are no capacity constraints or financial
limitations. The structure of the game is visible to all. Players can readily inspect the board to

4
Instructions and materials are available from the System Dynamics Society at <systemdynamics.org>. Many firms
have customized the game to represent their industry.
5
Minimum costs are obtained when inventory is zero, but when incoming orders are uncertain and backlogs are
more costly than inventories, it is optimal to set desired inventory to a small positive number.

11/30/05 14
see how much inventory is in transit or held by their teammates, essentially creating the full
information sharing firms in the real world still struggle to achieve. The game is typically played
with a very simple pattern for customer demand. Starting from equilibrium, there is a small,
unannounced one-time increase in customer orders, from 4 to 8 cases per week.
Despite the simplicity of the game, people do extremely poorly. Among first-time players
average costs are typically an astonishing 10 times greater than optimal. Exhibit 12 shows
representative results. In all cases customer orders are constant (except for the small step
increase near the start). In all cases, the response of the supply chain is unstable. The
oscillation, amplification, and phase lag observed in real supply chains are clearly visible in the
experimental results. The period of the cycle is 20-25 weeks. The average amplification ratio of
factory production relative to customer orders is a factor of four, and factory production peaks
some 15 weeks after the change in customer orders.
Most interesting, the patterns of behavior generated in the game are remarkably similar (there
are, of course, individual differences in magnitude and timing). Starting with the retailer,
inventories decline throughout the supply chain, and most players develop a backlog of unfilled
orders (negative net inventory). In response, a wave of orders moves through the chain, growing
larger at each stage. Eventually, factory production surges, and inventories throughout the
supply chain start to rise. But inventory does not stabilize at the cost-minimizing level near zero.
Instead, inventory significantly overshoots. Players respond by slashing orders, often cutting
them to zero for extended periods. Inventory eventually peaks and slowly declines. These
behavioral regularities are all the more remarkable because there is no oscillation in customer
demand. The oscillation arises as an endogenous consequence of the way the players manage
their inventories. Though players are free to place orders any way they wish, the vast majority
behave in a remarkably uniform fashion.
Analyses of the beer game and related experiments (Sterman 1989a, b; Diehl and Sterman 1995)
show why. In brief, participants tend to place orders without regard to the supply line of unfilled
orders. The only thing most players care about is whether there is enough inventory right now.
Ignoring the time delays creates oscillation and instability, and raises costs far above potential.
To understand the role of the supply line adjustment in the origin of oscillations more formally I
estimated the parameters of the stock management decision rule for a large sample of players in
the beer game. To do so, I assumed that the desired stock S* and desired supply line SL* are
constant.
6
Defining $ = "
SL
/"
S
and S = S* + $SL*, collecting terms, and allowing for an
additive disturbance term % yields

6
Dogan and Sterman (2005) relax the assumption of constant desired stocks, finding no significant change in results.

11/30/05 15
OR = MAX(0, L
e
+ "
S
[S S $SL) + %] (11)
Note that since S*, SL*, "
S
and "
SL
are all ! 0, S ! 0. Further, subjects are unlikely to place
more emphasis on the supply line than on inventory itself: the supply line does not directly affect
costs nor is it as salient as inventory. Therefore it is probable that "
SL
" "
S
, meaning 0 " $ " 1.
Thus $ can be interpreted as the fraction of the supply line subjects take into account. If $ = 1,
managers give the supply line as much weight as inventory on hand. If $ = 0, goods on order are
ignored. It is easily shown that the optimal value of $ is one: managers should fully account for
both on-hand and on-order inventory when placing new orders. Failure to count the supply line
of on-order inventory means managers attempting to correct an inventory shortfall would
continue to place orders even after sufficient goods to fully correct the problem are in the supply
line. Inventory would overshoot the desired level, leading to oscillation and high costs.
While it is folly to ignore the supply line the estimation results show this is precisely what
happens. The decision rule in eq. (11) explains 71% of the variance in the order decisions of the
subjects (Sterman 1989a). The estimated parameters showed that most were using grossly
suboptimal cue weights. The average weight on the supply line was only 0.34. Only 25% of the
subjects considered more than half the supply line and the estimated value of $ was not
significantly different from zero for fully one-third. Exhibit 13 compares simulated and actual
behavior for the factory in an actual game. The estimated stock adjustment rate "
S
is 0.80
weeksthe player reacted aggressively to inventory shortfalls, ordering nearly the entire
inventory shortfall each week. At the same time, the subject completely ignored the supply line
($ = 0). Because it takes 3 weeks to produce beer ordered today, the player ordered nearly three
times more than needed to correct the inventory shortfall. Aggressively reacting to current
inventory while completely ignoring the supply line leads to severe instability and high costs.
These results have been repeatedly confirmed by subsequent experiments, and alternative
explanations have been tested and ruled out. The standard protocol for the beer game eliminates
most of the operational explanations for amplification cited in, e.g., Lee et al. (1997), including
order batching (because there are no fixed ordering costs or quantity discounts), gaming in
response to shortages (because each player orders from and ships to only one supplier and
production capacity is infinite), and promotions or forward buying (because prices are fixed and
customer demand is exogenous). However, in the standard game players do not know the pattern
of customer demand, so it is possible that the bullwhip arises from the way subjects forecast
demand. Croson and Donohue (2002, 2003) tested this possibility by running the game (in a
computerized implementation) so that demand was a stationary, uniform random process,
varying from 0 to 8 cases/week. Further, all subjects were informed of the demand distribution
in advance. The results were nearly identical to the standard game with unknown demand.

11/30/05 16
Subjects generated oscillation, amplification, and phase lag. Estimation of the subjects
decisions showed that they ignored the supply line much as in the original experiment.
It may still be objected that subjects did not know the realization of demandif they had perfect
information on actual demand, rather than only its distribution (e.g., by making point of sale data
available throughout the system), then the bullwhip would disappear. To test this possibility
Croson, Donohue, Katok and Sterman (2005) made customer demand completely constant at
four cases per week, and all players were publicly informed of this fact in advance. When
demand is constant and known to all, and with initial inventory set at the cost minimizing level,
there should never be any bullwhip effect. Surprisingly, however, among more than 250
subjects, amplification, oscillation and phase lag were pervasive. Estimation results showed
subjects significantly underweighted the supply line much as in the original study. Supply line
underweighting and the resulting instability persisted even when subjects were allowed to play a
second time. Exhibit 14 shows a typical second game. Demand is constant at four cases/week,
publicly announced to all players in advance, and subjects were paid in proportion to their profit.
Nevertheless, the classic pattern of oscillation, amplification, and phase lag is clearly visible.
Indeed, the amplitude of the cycle is still growing after nearly 50 weeks.
The tendency to ignore feedbacks and time delays is robust to information availability,
incentives, opportunities for learning and the presence of markets (Sterman 1989b; Diehl and
Sterman 1995; Brehmer 1992, Kampmann and Sterman 1998, Bakken 1993, Paich and Sterman
1993). In the standard beer game supply line information is not displayed; subjects must keep
track of the supply line themselves. Many people assume that providing supply line information
would eliminate the problem. However, in Sterman 1989b, Diehl and Sterman (1995), and
Kampmann and Sterman (1998) the supply line was made as prominent in the information
display as the inventory level, yet subjects ignored it anyway. Our mental models condition the
cues we use in decision-making. Subjects who dont recognize the presence of a time delay or
understand its function in the system are unlikely to account for it even if the information needed
to do so is available. Another critique relates to learning: perhaps first time players make these
errors, but surely people would rapidly learn to recognize and account for the supply line.
Unfortunately the experimental evidence shows this is false. Diehl and Sterman (1995), Wu and
Katok (2005), Paich and Sterman (1993) and Croson et al. (2005) show that learning from
repeated play in the beer game and related dynamic decision making tasks is slow and uneven.
People often learn false and harmful lessons. Performance remains significantly below optimal
even after the equivalent of years or decades of simulated experience.
Many players find these results disturbing. They argue that they took a wide range of
information into account when placing orders and that their subtle and sophisticated reasoning

11/30/05 17
cannot be captured by a model as simple as equation 11. After all, the decision rule for orders
only considers three cues (incoming orders, inventory, and the supply line)how could it
possibly capture the way people place orders? Actually, players behavior is highly systematic
and is explained well by the simple stock management heuristic. People are often surprised how
well simple decision rules can mimic their behavior.
In fact, one of the games shown in Exhibit 12 is a simulation, not actual play. Each players
orders are generated by the decision rule in equation 11. The parameters of the rule, for all four
players, were set to the average values estimated in Sterman (1989a). A small amount of random
noise was added to the order rate. Which is the simulation?
7

Why Do We Ignore the Supply Line?
The beer game clearly shows it is folly to ignore the time delays in complex systems. Consider
the following situation. Your car is stolen and never recovered. Insurance settlement in hand,
you visit a dealer and select a new car, but the model you want is not in stockdelivery will take
4 weeks. You pay your deposit and leave. The next morning, noticing that your driveway is
emptyWheres my car!you go down to the dealer and buy another one. Ridiculous, of
course. No one would be so foolish as to ignore the supply line. Yet in many real life situations
people do exactly that. Consider the following examples (Exhibit 5 shows how they map into
the stock management structure):
You cook on an electric range. To get dinner going as soon as possible, you set the burner
under your pan to high. After a while you notice the pan is just hot enough, so you turn the
heat down. But the supply line of heat in the glowing coil continues to heat the pan even after
the current is cut, and your dinner is burned anyway.
You are surfing the worldwide web. There is no response to your last mouse click. You click
again, then again. Growing impatient, you click on some other buttonsany buttonsto see
if you can get a response. After a few seconds, the system executes all the clicks you stacked
up in the supply line, and you end up far from the page you were seeking.
You arrive late and tired to an unfamiliar hotel. You turn on the shower, but the water is
freezing. You turn up the hot water. Still cold. You turn the hot up some more. Ahhh. Just
right. You step in. A second later you jump out screaming, scalded by the now too-hot water.
Cursing, you realize that, once again, youve ignored the time delay for the hot water to heat

7
Simulated orders were generated by eq. 11 with the average parameters found in Sterman (1989a): S = 17 units,
"
S
= 0.26/week, and $ = 0.34. L
e
t
was formed by first-order exponential smoothing of the incoming order rate with
smoothing time constant & = 1.82 weeks. The error term %
t
~ N(0, '
2
) with ' set to the mean of the standard errors
of the estimated equation over the sample.

11/30/05 18
the cold pipes and get to your shower.
You are driving on a busy highway. The car in front of you slows slightly. You take your foot
of the gas, but the distance to the car in front keeps shrinking. Your reaction time and the
momentum of your car create a delay in responding to changes in the speed the car ahead. To
avoid a collision, you have to slam on the brakes. The car behind you is forced to brake even
harder. You hear the screech of rubber and pray you wont be rear-ended.
You are young, and experimenting with alcohol for the first time. Eager to show your friends
you can hold your liquor, you quickly drain your glass. You feel fine. You drink another.
Still feeling fine. You take another and another. As consciousness fades and you fall to the
floor, you realizetoo latethat you ignored the supply line of alcohol in your stomach and
drank far too much.
8

Few of us can say weve never burned our dinner or been scalded in the shower, never drunk too
much or braked hard to avoid a collision.
Recognizing and accounting for time delays is not innate. It is behavior we must learn. When
we are born our awareness is limited to our immediate surroundings. Everything we experience
is here and now. All our early experiences reinforce the belief that cause and effect are closely
related in time and space: When you cry, you get fed or changed. You keep crying until mother
or father appears, even when you hear your parents say, Were coming (that is, despite
knowledge that your request for attention is in the supply line). As all parents know, it takes
years for children to learn to account for such time delays. When my son was two he might ask
for a cup of juice: Juice please, Daddy. Coming right up, Id say, taking a cup from the
shelf. Though he could see me getting the cup and filling it up, hed continue to say, Juice,
Daddy! many timesever more insistentlyuntil the cup was actually in his hand.
Learning to recognize and account for time delays goes hand in hand with learning to be patient,
to defer gratification, and to trade short-run sacrifice for long-term reward. These abilities do not
develop automatically. They are part of a slow process of maturation. The longer the delay and
the greater the uncertainty in seeing the results of our corrective actions, the harder it is to
account for the supply line. More subtly, our childhood experiences reinforce the idea that there
is no cost to ignoring the supply line. Though my son may have said Juice, Daddy ten times
before I could fill his order, I brought him only one cup. He didnt take the supply line into
account, but I did. In that situation, there is no cost to overordering, while patience might not
work (dad might get distracted and forget to bring the juice; others might get fed while the one

8
Tragically, young people die every year from alcohol poisoning induced by aggressive drinking and failure to
account for the supply line of alcohol theyve already ingested.

11/30/05 19
who accounts for the supply line goes hungry). What is adaptive and evolutionarily
advantageous for the individual is dysfunctional for modern social systems where there is no
central authority to account for time delays and prevent overordering.
One might argue that by the time we become adults we have developed the requisite patience and
sensitivity to time delays. There may be no cost to demanding juice a dozen times, but surely
when the stakes are high we would quickly learn to consider delays. You dont burn yourself in
your own shower at homeyouve learned where to set the hot water faucet to get the
temperature you like and to wait long enough for the water to warm up. Most people soon learn
to pay attention to the supply line of alcohol in their system and moderate their drinking. The
conditions for learning in these systems are excellent. Feedback is swift and the consequences of
error are highly salient (particularly the morning after). There is no doubt in either case that it
was the way you made decisionsthe way you set the faucet or drank too fastthat caused the
problem. These conditions are usually not met in business, economic, environmental, and other
social systems. Cause and effect are obscure, creating ambiguity and uncertainty. The dynamics
are far slower, and the time required for learning often exceeds the tenure of individual decision
makers. Ignoring time delays is also sometimes rational for the individual. In a world of short
time horizons, of annual, quarterly, or even monthly performance reviews, the incentives people
face often mean it is rational for them to be aggressive and ignore the delayed consequences of
their actions (of course, those short evaluation time horizons themselves reflect failure by the
principals to understand the time delays between the actions of their subordinates and outcomes).
The economist Albert Aftalion recognized in the early 1900s how failure to account for the time
delays could cause business cycles. Using the familiar fireplace as an analogy, his description
explicitly focuses on the failure of decision makers to pay attention to the supply line of fuel:
If one rekindles the fire in the hearth in order to warm up a room, one has to wait a while
before one has the desired temperature. As the cold continues, and the thermometer
continues to record it, one might be led, if one had not the lessons of experience, to throw
more coal on the fire. One would continue to throw coal, even though the quantity
already in the grate is such as will give off an intolerable heat, when once it is all alight.
To allow oneself to be guided by the present sense of cold and the indications of the
thermometer to that effect is fatally to overheat the room.
9

While Aftalion argued that the lessons of experience would soon teach people not to continue
to throw coal, he argued that business cycles in the economy arose because individual
entrepreneurs focused on current profitability and failed to account for the lags between the
initiation of new investment and its realization, leading to collective overproduction. Yet even if
individuals cant learn effectively, shouldnt the discipline imposed by the market quickly weed

9
Quoted in Haberler (1964) pp. 135136.

11/30/05 20
out people who use suboptimal decision rules? Those who ignore the supply line or use poor
decision rules should lose money and go out of business or be fired, while those who use
superior decision rules, even by chance, should prosper. The selective pressures of the market
should quickly lead to the evolution of optimal decision rules.
To the contrary, learning and evolution in real markets appear to be slow, despite decades of
experience and the huge sums at stake. Part of the problem is lack of information. Individual
firms frequently do not share full information on their incoming orders, inventories, WIP, and
supply lines with their supply chain partners or competitors, many of whom are ordering from
the same suppliers. Part of the problem is a mismatch in time horizons, with managers evaluated
over periods much shorter than the time required for the full impacts of their decisions to
manifest. The tenure of individual managers is often short relative to the time frame over which
supply chain dynamics unfold. Expertise is diluted by the entry of new firms and new managers
who lack experience. Part of the problem is the narrow boundary of the mental models used by
many managers. Many firms view themselves as small relative to the market and treat the
environment as exogenous, thereby ignoring all feedbacks from prices to supply and demand.
The individual firm may not know or give sufficient weight to the supply lines of all firms in the
industry or the total capacity of all plants under construction. Firms tend to continue to invest
and expand as long as profits are high today, even after the supply line of new capacity under
construction is more than sufficient to cause a glut and destroy profitability. Each investor takes
market conditions as exogenous, ignoring the reactions of others. Field study of the telecom, real
estate, shipbuilding and other industries document the failure to consider these feedbacks and the
supply lines of capacity under construction (e.g. Sterman 2000, Shi 2002).
Instability and Trust in Supply Chains
It is worth pausing to consider the effect of supply chain instability on the beliefs and behaviors
of managers in the different firms. In the unstable world illustrated by the simulations and data
shown here, trust among partners in a supply chain can rapidly break down. Downstream firms
find their suppliers to be unreliable. Delivery quotes will often not be met, and producers too
often find suppliers place hot selling products on allocation (where each customer receives less
than their full order due to a shortage of supply). In turn, suppliers find the ordering patterns of
their customers to be volatile and capricious. Forecasts of incoming orders are rarely correct and
always changing. As shown in exhibit 9, the suppliers forecast of incoming orders (the
expected order rate) reaches its peak just as actual incoming orders fall below their equilibrium
level and begin to approach their minimum. Before long, the forecasts, which are typically
produced by the sales and marketing organization, lose all credibility with the production and
operations people. The marketing organization, in turn, complains that unreliable production

11/30/05 21
makes forecasting, not to mention selling, difficult. The endogenous instability caused by the
structure of a supply chainin particular, managements own policiescan breed blame and
mistrust within and between firms in a supply chain.
Blame and mistrust then feed back to worsen the instability in a vicious cycle. One common
manifestation of such distrust is the phenomenon of phantom orders or lead-time gaming.
During upswings in demand, suppliers are unable to boost production fast enough to keep pace.
Product becomes scarce, and customers are placed on allocation. Customers often respond to
longer delivery times and unreliable supplier deliveries by increasing their desired inventory
levels, ordering farther ahead, and placing multiple orders through different distributors. Such
hedging is particularly likely when the supplier serves multiple customers. Suppose the supplier
runs short of product and places the customers on allocation: Each will only receive, say, 80%
of its order. Customers are likely to respond by ordering 125% or even more of what they
actually require. Firms that fail to play this allocation game will likely lose market share to their
aggressive competitors.
Contrary to basic economic intuition, scarcity causes an increase in demand as each customer
scrambles to get a bigger slice of the shrinking supply pie. The result is a positive feedback loop,
a vicious cycle of scarcity, increased orders by customers desperate to gain a larger share of
available supplies, and still longer delivery times and smaller allocations. Suppliers,
experiencing a huge increase in demand just when supplies are tightest, scramble to add capacity
and expedite production. Once they succeed, however, delivery times return to normal and
allocations are increased. Customers, now able to get product quickly, cancel the phantom
orders they placed, leaving the supplier with excess inventory, excess capacity, and large losses.
Phantom orders played a major role in the overshoot and collapse of the telecommunications
equipment supply chain in the late 1990s, causing record losses, layoffs, and stock price declines
at firms such as Lucent, Nortel, Cisco, and JDS Uniphase (Gonalves 2002, Shi 2002).
On the surface, it appears that the supplier bears most of the excess costs created by phantom
orders. However, these costs must eventually be passed on to the downstream firms in higher
prices or poor customer service and product quality. Firms have a strong incentive to improve the
stability of their suppliers. Nevertheless, the parochial, local incentives facing individual
functions and firms often lead to actions that degrade the stability of the entire supply chain.
Why would customers place phantom orders when doing so is ultimately harmful to both their
suppliers and themselves? Phantom orders are locally rational. To ensure delivery of needed
goods, the purchasing department must maintain a supply line proportional to the delivery delay.
Failure to respond to changes in lead times could result in costly accumulation of excess

11/30/05 22
inventories, or, worse, shortages that could shut down production. The mental models of the
purchasing managers in downstream firms typically treat supplier lead times as outside their
control. Each firm reasons that it is responsible for only a small part of the suppliers total
demand, so changes in its orders wont affect supplier lead times. Organizational routines such
as updating the supplier lead time assumptions of the materials requirement planning system
based on recent delivery experience implicitly presume that the resulting changes in materials
orders wont affect supplier lead times. But when all customers act in a similar fashion a vicious
cycle (positive feedback loop) is closed. The mismatch between the mental models of the
supplier, in which lead times are exogenous, and the actual situation, in which lead times are
strongly affected by the ordering behavior of the downstream firms, further degrades supply
chain performance and reinforces the view of the different organizations that their partners are
unpredictable and untrustworthy.
What can be done? There are now many useful tools to redesign supply chains for improved
stability, agility and efficiency (Simchi Levi et al. 1999). These include changes to the physical
structure (lean manufacturing, platform-based product architectures, multi-modal transport,
third-party warehousing) and changes in information technology (point of sale data, ERPs,
RFID, etc.). Yet the continued oscillation and amplification, boom and bust, in high tech, real
estate, shipbuilding, automobiles, and other industries suggests that these technical solutions are
not sufficient to eliminate supply chain instability. Enduring, comprehensive improvements
require managers to address the behavioral causes: improving mental models and redesigning
decision making processes to recognize the interdependencies, feedbacks, time delays, and other
elements of dynamic complexity in modern organizations. While space does not permit
description, the list of successful examples is growing (e.g., Sterman 2000, Ch. 11.6, 18.3).
Summary
Supply chains are fundamental to a wide range of systems and many exhibit persistent
instability. Every supply chain consists of stocks and the management policies used to manage
them. These management policies are designed to keep the stocks at their target levels,
compensating for usage or loss and for unanticipated disturbances in the environment. Often
there are important delays between the initiation of a control action and the result, creating a
supply line of unfilled orders.
This paper developed a generic model of the stock management structure and showed how it can
be customized to various situations. The model was used to explain the sources of oscillation,
amplification, and phase lag observed in supply chains. Supply chain instability arises from both
operational and behavioral causes. Field and experimental studies show that people often fail to

11/30/05 23
account for the feedback effects of their actions and ignore important time delays. These
misperceptions of feedback are robust to incentives, experience, information availability, and the
presence of market institutions. Experimental studies show clearly that supply chain instability
remains even after all operational causes such as quantity discounts are eliminated. Instability is
a behavioral phenomenon arising from the failure to account for feedbacks, time delays, and the
supply line of unfilled orders.
There is no single cause for the failure to account for feedback, time delays and the supply line.
A range of factors, from information availability to individual incentives, all contribute. But
behind these apparent causes lies a deeper set of behavioral causes, causes rooted in our
imperfect mental models and poor inquiry skills. True, the supply line is often inadequately
measured, but if people understood its importance they would invest in data collection and
measurement systems to provide the needed information. True, compensation incentives often
encourage people to ignore the distal and delayed consequences of todays actions, but if
managers and shareholders understood the structure and dynamics of the market they could
redesign incentives so their agents would focus on long-term performance. Our mental models
affect the design of our institutions, information systems, and incentive schemes. These, in turn,
feed back to our mental models. The failure to account for the supply line reflects deeper defects
in our understanding of complex systems. Failure to understand the role of time delays worsens
the instability we face and leads to more surprisesusually unpleasantstrengthening the belief
that the world is inherently capricious and unpredictable, slowing learning, and further
reinforcing the harmful short-term focus. Innovative managers who redesign the physics of their
systems, their information systems, and, most importantly, the mental models guiding decision
making and strategy are creating breakthrough improvements in performance.
References
Anderson, E., C. Fine, G. Parker 2000. Upstream Volatility in the Supply Chain: The Machine
Tool Industry as a Case Study. Production and Operations Management. 9(3): 239-261.
Anderson, E., and D. Morrice 2005. Stochastic Optimal Control of Centralized Staffing and
Backlog Policies in a Two-Stage Customized Service Supply Chain. Forthcoming in
Production and Operations Management.
Bakken, B. 1993. Learning and Transfer of Understanding in Dynamic Decision Environments.
PhD thesis, MIT Sloan School of Management, Cambridge, MA 02142 (unpublished).
Booth Sweeney, L. and J. Sterman 2000. Bathtub Dynamics: Initial Results of a Systems
Thinking Inventory. System Dynamics Review 16(4): 249-294.
Brehmer, B. 1992. Dynamic decision making: Human control of complex systems. Acta
Psychologica 81, 211-241.

11/30/05 24
Chen, F. and R. Samroengraja 2000. The stationary beer game. Production and Operations
Management. 9(1), 19-30.
Chen, F., Z. Drezner, J. K. Ryan, and D. Simchi-Levi. 2000. Quantifying the bullwhip effect:
The impact of forecasting, lead times, and information. Management Science. 46(3) 436-443.
Croson, R. and K. Donohue. 2002. Behavioral causes of the bullwhip and the observed value of
inventory information. Working paper, Carlson School, University of Minnesota.
Croson, R. and K. Donohue. 2003. Impact of POS data sharing on supply chain management: An
experimental study. Production and Operations Management. 12(1) 1-11.
Croson, R., K. Donohue, E. Katok, J. Sterman 2005. Order Stability in Supply Chains: The
Impact of Coordination Stock. MIT Sloan School of Management Working Paper No. 4513-04.
Available at web.mit.edu/jsterman/www.
Cyert, R. and J. March 1963/1992. A Behavioral Theory of the Firm. Englewood Cliffs, NJ:
Prentice Hall, 2nd ed. Cambridge, MA: Blackwell.
Diehl, E. and J. D. Sterman. 1995. Effects of feedback complexity on dynamic decision making.
Organizational Behavior and Human Decision Processes. 62(2) 198-215.
Dogan, G. and J. Sterman 2005. When less leads to more: Phantom ordering in the beer game.
Proceedings of the 2005 International System Dynamics Conference, Boston, MA.
Drner, D. 1996. The Logic of Failure. New York: Metropolitan Books/Henry Holt.
Fitzsimmons, J., E. Anderson, D. Morrice, and G. Powell. 2003. Managing Service Supply
Relationships. International Journal of Services Technology Management. 5(3): 221-232.
Forrester, J., 1958. Industrial dynamics: A major breakthrough for decision makers. Harvard
Business Review. 36 37-66.
Forrester, J. 1961. Industrial Dynamics. MIT Press, Cambridge, MA.
Gonalves, P. 2002. When do minor shortages inflate to great bubbles? Proceedings of the 2002
International System Dynamics Conference. System Dynamics Society: Albany, NY.
Gonalves, P. 2003. Investigating the Causes of Seed Returns in the Agribusiness Industry,
Proceedings of the 2003 International System Dynamics Conference. System Dynamics
Society: Albany, NY.
Gonalves, P., J. Hines, and J. Sterman 2005. The Impact of Endogenous Demand on Push-Pull
Production Systems. System Dynamics Review, forthcoming.
Gonalves, P. and J. Sterman. 2005. Overordering Games in Supply Chains. Proceedings of the
2005 International System Dynamics Conference. System Dynamics Society: Albany, NY.
Haberler, G. 1964. Prosperity and Depression. London: George Allen and Unwin.
Kahneman, D. and A. Tversky, 1982. The Simulation Heuristic, in Kahneman, D. et al.
Judgment Under Uncertainty: Heuristics and Biases, Cambridge University Press, Cambridge.
Kampmann, C. and J. D. Sterman. 1998. Do markets mitigate misperceptions of feedback in
dynamic tasks? Working paper, Sloan School of Management, MIT.
Lee, H., P. Padmanabhan and S. Whang, 1997. Information distortion in a supply chain: The

11/30/05 25
bullwhip effect. Management Science. 43 546-558.
Mitchell, T. W., 1923. Competitive Illusion as a Cause of Business Cycles, Quarterly Journal of
Economics, 38, 631-652.
Mitchell, W. C., 1971. Business Cycles and their Causes, Univ. of California Press, Berkeley.
Morecroft, J., 1983. System Dynamics: Portraying Bounded Rationality, Omega, 11, 131-142.
Morecroft, J., 1985. Rationality in the Analysis of Behavioral Simulation Models, Management
Science, 31, 900-916.
Oliva, R. and P. Gonalves. 2005. Behavioral Causes of Demand Amplification in Supply
Chains: Satisficing Policies with Limited Information Cues. Working paper Mays Business
School, Texas A&M University, College Station, TX.
Paich, M. and J. Sterman 1993. Boom, Bust, and Failures to Learn in Experimental Markets.
Management Science 39(12) 1439-1458.
Plous, S. 1993. The Psychology of Judgment and Decision Making. New York: McGraw Hill.
Shi, S. 2002. Phantom Orders Roil Ciscos Supply ChainA System Dynamics Study of
Networking Equipment Industrys Supply Chain. Unpublished masters thesis, MIT,
Cambridge, MA.
Simchi-Levi, D., Kaminsky, P. and Simchi-Levi, E. 1999. Designing and Managing the Supply
Chain. McGraw-Hill, New York.
Simon, H. A., 1982. Models of Bounded Rationality. The MIT Press, Cambridge MA.
Steckel J., S. Gupta & A. Banerji. 2004. Supply chain decision making: Will shorter cycle times
and shared point-of-sale information necessarily help? Management Science. 50(4) 458-464.
Sterman, J. D. 1987. Expectation Formation in Behavioral Simulation Models. Behavioral
Science 32: 190-211.
Sterman, J.D. 1989a. Modeling managerial behavior: Misperceptions of feedback in a dynamic
decision making experiment. Management Science. 35 321-339.
Sterman, J. D. 1989b. Misperceptions of feedback in dynamic decision making. Organizational
Behavior and Human Decision Processes. 43(3) 301-335.
Sterman, J. D. 2000. Business Dynamics: Systems Thinking and Modeling for a Complex World.
McGraw-Hill, New York.
Sturis, J., K. Polonsky, E. Mosekilde, and E. Van Cauter (1991) Computer model for
mechanisms underlying ultradian oscillations of insulin and glucose, American Journal of
Physiology 260 (Endocrinol. Metab. 23): E801-E809.
Tversky, A. and D. Kahneman, 1974. Judgment Under Uncertainty: Heuristics and Biases,
Science, 185 (27 September), 1124-1131.
Wu, D. and E. Katok. 2004. System-Wide Training and Coordination, the Impact of Learning on
the Bullwhip Effect: An Experimental Study, Penn State Working Paper.
Zarnowitz, V. 1985. Recent work on business cycles in historical perspective: a review of
theories and evidence, Journal of Economic Literature, 23(2), 523-580.

11/30/05 26
0
25
50
75
100
125
1950 1960 1970 1980 1990 2000
U
S

I
n
d
u
s
t
r
i
a
l

P
r
o
d
u
c
t
i
o
n
(
1
9
9
7

=

1
0
0
)

80
90
100
110
120
1950 1960 1970 1980 1990 2000
I
n
d
u
s
t
r
i
a
l

P
r
o
d
u
c
t
i
o
n

R
e
l
a
t
i
v
e

t
o

T
r
e
n
d

(
T
r
e
n
d

=

1
0
0
)

Exhibit 1. Top: Industrial production in the US, 1946-2005 (source: US Federal Reserve, series
B50001). Bottom: Detrended industrial production showing fluctuations in the US
manufacturing sector.


80
90
100
110
120
130
1950 1960 1970 1980 1990 2000
I
n
d
u
s
t
r
i
a
l

P
r
o
d
u
c
t
i
o
n

R
e
l
a
t
i
v
e

t
o

T
r
e
n
d

(
T
r
e
n
d

=

1
0
0
)
Consumer
Goods
Materials

Exhibit 2. Oscillation, amplification, and phase lag in the aggregate supply chain (Source: US
Federal Reserve, series B51000 and B53000, each detrended by the best fit exponential).


11/30/05 27
-50
-25
0
25
50
1975 1980 1985 1990 1995 2000 2005
F
r
a
c
t
i
o
n
a
l

G
r
o
w
t
h

R
a
t
e

(
%
/
y
e
a
r
)
Oil and Gas
Well Drilling
Oil and Gas
Production


-60
-40
-20
0
20
40
60
80
1970 1975 1980 1985 1990 1995
F
r
a
c
t
i
o
n
a
l

G
r
o
w
t
h

R
a
t
e

(
%
/
y
e
a
r
)
Machine Tool
Orders
Motor
Vehicle
Sales
GDP

-20
0
20
40
60
1955 1965 1975 1985 1995 2005
F
r
a
c
t
i
o
n
a
l

G
r
o
w
t
h

R
a
t
e

(
%
/
y
e
a
r
)
Semiconductors
Industrial Production

Exhibit 3. Oscillation, amplification, and phase lag in supply chains
Top: Oil and gas drilling fluctuates far more than production. The graph shows 12-month
centered moving averages of the annualized fractional growth rate calculated from the monthly
data. Source: US Federal Reserve, series G211 and N213111.
Middle: Orders for machine tools fluctuate far more than the production of their major customer
(the auto industry). Graph shows annual growth rates. Source: Anderson, Fine & Parker (2000).
Bottom: Semiconductor production fluctuates far more than aggregate industrial production.
Twelve-month centered moving averages of the annualized fractional growth rate calculated
from the monthly data. Source: Federal Reserve, series B50001 and B53122.

11/30/05 28


Stock
S
Order Rate
OR
-
Acquisition
Rate
AR
Loss Rate
LR
Indicated
Orders
IO
Adjustment
for Supply
Line
ASL
Desired
Supply
Line
SL*
Adjustment
for Stock
AS
Desired
Stock
S*
Expected
Loss Rate
Acquisition
Lag
Other
Endogenous
Variables
X
Exogenous
Variables
U
+
+
+
+
+
+
+
+
+
-
-
+
B
Supply Line Control
B
Stock Control
Stock and Flow Structure
Ordering Heuristic
Supply Line
SL


Exhibit 4. The generic stock management structure. The determinants of the desired supply line
are not shown (see text).

Business Dynamics DRAFT Manufacturing Supply Chains
John Sterman 11/30/05 29
System Stock Supply Line Loss Rate Acquisition Rate Order Rate Typical Behavior
Inventory
management
Inventory Goods on order Shipments to
customers
Arrivals from
supplier
Orders for goods Business cycles
Capital investment Capital plant Plant under
construction
Depreciation Construction
completion
New contracts Construction
cycles
Equipment Equipment Equipment on
order
Depreciation Equipment
delivery
New equipment
orders
Business cycles
Human resources Employees Vacancies &
trainees
Layoffs and quits Hiring rate Vacancy creation Business cycles
Cash
management
Cash balance Pending loan
applications
Expenditures Borrowing rate Loan application
rate
Cash flow cycles
Marketing Customer base Prospective
customers
Defections to
competitors
Recruitment of
new customers
New customer
contacts
Boom and bust in
customer base
Hog farming Hog stock Immature and
gestating hogs
Slaughter rate Maturation rate Breeding rate Hog cycles
Agricultural
commodities
Inventory Crops in the field Consumption Harvest rate Planting rate Commodity cycles
Commercial real
estate
Building stock Buildings under
development
Depreciation Completion rate Development rate Real estate
booms and busts
Cooking on
electric range
Temperature of
pot
Heat in coils of
range
Diffusion to air Diffusion from
coils to pot
Setting of burner Overcooked
dinner
Driving Distance to next
car
Momentum of car Friction Velocity Gas and brake
pedals
Stop-and-go traffic
Showering Water
temperature
Water temp. in
pipes
Drain rate Flow from
showerhead
Faucet settings Burn then freeze
Personal energy
level
Glucose in
bloodstream
Sugar and starch
in GI tract
Metabolism Digestion Food consumption Cycles of energy
level
Social drinking Alcohol in blood Alcohol in
stomach
Metabolism of
alcohol
Diffusion from
stomach to blood
Alcohol
consumption rate
Drunkenness

Exhibit 5. Examples of the stock management structure
Business Dynamics DRAFT Manufacturing Supply Chains
John Sterman 11/30/05 30

Production
Rate
Shipment
Rate
Production
Start Rate
Production
Scheduling
Customer
Order Rate
Stockout
Inventory
Control
B
WIP Control
Work in
Process
Inventory
Inventory
Order
Fulfillment
Demand
Forecasting
B
B


Exhibit 6. The policy structure of inventory management in a manufacturing firm

Parameter Value (Weeks)
Normal Inventory Coverage 4
Manufacturing Cycle Time (acquisition delay for inventory) 8
Inventory Adjustment Time 8
WIP Adjustment Time 2
Time to Average Order Rate (demand forecast smoothing time) 8

Exhibit 7. Main parameters for the production model
Business Dynamics DRAFT Manufacturing Supply Chains
John Sterman 11/30/05 31

9,000
10,000
11,000
12,000
13,000
14,000
15,000
0 10 20 30 40 50
W
i
d
g
e
t
s
/
W
e
e
k
Weeks
Shipments
Desired Shipments
Lost Orders

9,000
10,000
11,000
12,000
13,000
14,000
15,000
0 10 20 30 40 50
W
i
d
g
e
t
s
/
W
e
e
k
Weeks
Production
Expected
Orders
Production
Starts
Customer Orders
Desired
Production


0
1
2
3
4
5
0 10 20 30 40 50
I
n
v
e
n
t
o
r
y

C
o
v
e
r
a
g
e
(
w
e
e
k
s
)
Weeks

30,000
50,000
70,000
90,000
110,000
0 10 20 30 40 50
W
i
d
g
e
t
s
Weeks
WIP
Desired Inventory
Desired
WIP
Inventory

Exhibit 8. Response of manufacturing model to a 20% step increase in orders

Business Dynamics DRAFT Manufacturing Supply Chains
John Sterman 11/30/05 32
9,000
10,000
11,000
12,000
13,000
14,000
15,000
0 10 20 30 40 50
W
i
d
g
e
t
s
/
W
e
e
k
Weeks
Supplier
Expected
Orders
Customer
Orders
Expected
Customer
Orders

9,000
10,000
11,000
12,000
13,000
14,000
15,000
0 10 20 30 40 50
W
i
d
g
e
t
s
/
W
e
e
k
Weeks
Supplier Shipment Rate
Customer
Orders
Shipment Rate

10,000
12,000
14,000
16,000
18,000
0 10 20 30 40 50
W
i
d
g
e
t
s
/
W
e
e
k
Weeks
Shipments
Orders for
Materials
Production
Starts
Production

5,000
10,000
15,000
20,000
25,000
30,000
0 10 20 30 40 50
W
i
d
g
e
t
s
/
W
e
e
k
Weeks
Supplier Order Rate
Supplier
Material Deliveries
Supplier
Production Starts
Supplier
Production


2.0
2.4
2.8
3.2
3.6
0 10 20 30 40 50
D
e
l
i
v
e
r
y

D
e
l
a
y

(
w
e
e
k
s
)
Weeks
Supplier
Delivery Delay
Delivery Delay

0.0
1.0
2.0
3.0
4.0
5.0
0 10 20 30 40 50
I
n
v
e
n
t
o
r
y

C
o
v
e
r
a
g
e

(
w
e
e
k
s
)
Weeks
Supplier
Inventory Coverage
Inventory
Coverage
Supplier Materials
Inventory Coverage
Materials
Inventory
Coverage

Exhibit 9. Response of two-stage supply chain to a 20% unanticipated demand increase
Business Dynamics DRAFT Managing the Supply Chain
John Sterman 11/30/05 33
0
5,000
10,000
15,000
20,000
0 50 100 150 200
U
n
i
t
s
/
W
e
e
k
Weeks
Supplier Material
Delivery Rate
Customer
Orders

Exhibit 10. Response of the two-stage supply chain to random variations in customer orders

Business Dynamics DRAFT Managing the Supply Chain
John Sterman 11/30/05 34


Shipping
Delay
Shipping
Delay
Production
Requests
Incoming
Orders
Orders
Placed
Production
Delay
Raw
Materials
Used
Order
Cards
Orders Sold
to Customers
WHOLESALER DISTRIBUTOR FACTORY
Shipping
Delay
Shipping
Delay
Shipping
Delay
Shipping
Delay
Current
Inventory
Incoming
Orders
Orders
Placed
Incoming
Orders
Orders
Placed
Current
Inventory
RETAILER
Customer
Orders
Production
Delay
Current
Inventory
Current
Inventory
4 4 4 4 4 4 4

Exhibit 11. The Beer Distribution Game

The game is a role-play simulation. Each player manages one of the links in the distribution chain from Retailer to Factory. In the
game, chips of various denominations represent cases of beer and move through the supply chain from Raw Materials to Customers.
Customer orders are written on a deck of cards. Each week players place orders with the supplier on their left and the factory sets the
production schedule. The orders, written on slips of paper, move upstream (left to right). The initial configuration is shown.
Business Dynamics DRAFT Managing the Supply Chain
John Sterman 11/30/05 35
0 10 20 30
C
a
s
e
s
/
W
e
e
k
0
0
0
0
Team 1

0 10 20 30
Team 2
0
0
0
0

0 10 20 30
Team 3
0
0
0
0

0 10 20 30
Team 4
0
0
0
0

0 10 20 30
Team 5
F
R
W
D
0
0
0
0

0 10 20 30
C
a
s
e
s
Team 1
0
0
0
0

0 10 20 30
Team 2
0
0
0
0

0 10 20 30
Team 3
0
0
0
0

0 10 20 30
Team 4
0
0
0
0

0 10 20 30
Team 5
F
R
W
D
0
0
0
0


Exhibit 12. Typical results of the Beer Distribution Game
Top: Orders. Bottom: Net inventory (Inventory Backlog). Graphs show, bottom to top, Retailer, Wholesaler, Distributor, and
Factory. Vertical axis tick marks denote 10 units. Note the characteristic oscillation, amplification, and phase lag as the change in
customer orders propagates from retailer to factory.
Business Dynamics DRAFT Managing the Supply Chain

John Sterman 11/30/05 36
0
10
20
30
40
0 5 10 15 20 25 30 35
C
a
s
e
s
/
W
e
e
k
Simulated
Actual
Factory Orders
(R
2
= 0.87)
Weeks

Exhibit 13. Estimated vs. actual behavior in the beer game
Factory orders for an actual player compared to estimated orders. Parameters: Smoothing time
for forecast of customer orders, 1.82 weeks; desired total stock on hand and on order, 9 cases; !
S

= 0.80, " = 0. Source: Sterman (1989b).



0
10
20
30
40
50
0 10 20 30 40 50
R Orders
W Orders
D Orders
F Orders
O
r
d
e
r
s

(
c
a
s
e
s
/
w
e
e
k
)
T5G2
Week

-100
-50
0
50
100
0 10 20 30 40 50
R Inventory
W Inventory
D Inventory
F Inventory
N
e
t

I
n
v
e
n
t
o
r
y

(
c
a
s
e
s
)
Week
T5G2


Exhibit 14. Typical experimental results when customer demand is constant and known.
Demand is 4 cases/week, and this is publicly announced to all players in advance (Croson et al.
2005). The supply chain is initialized in the optimal equilibrium with throughput of
4/cases/week and zero inventory. The data show the players second game.