The Beer Game - Small Changes, Big Effects

I enjoy talking to business owners about how I can help them to increase profit and one of the techniques that I use is to show how small changes in what they do can have such a big effect on their bottom line.

If you simplify business, there are only three ways in which you can improve your profit:

1. You can sell more
    
2. You can sell at a higher price
    
3. You can reduce your costs

An Exciting Example

Imagine you run a business with £1 million sales which makes £40k profit after paying you a fair salary for your time and effort. The average margin you make is 40% but your overheads reduce your final return on sales to 4% which is around the average level.

Just changing each of those factors by a 1% improvement an extra £23k of extra profit or an increase of 57.5%.

To talk you through it step by step:

A 1% increase in sales prices with no reduction in volume will increase your profit by £10k (1% of 1,000k) with no changes in costs.

A 1% reduction in your costs will save you £9k (total costs are £960k so 1% is £9.6k which I rounded down).

A 1% increase in your sales volumes means your sales increase by £10k so the 40% margin means £4k extra profit.

The overall effect = £10k + £9k + £4k = £23k

Do you think that you could do just 1% better in each of these areas? Perhaps increase your leads by 1% of convert 1% more of your leads into orders?

This is an exciting way to look at business improvement and shows that small changes can have big effects.

A Scary Example

Unfortunately the same logic works if things get worse and a 1% worsening of those three profit drivers would cost in this example, the same £23k, or would more than halve the profit.

So my question to you is:

"Do you have the information systems in place to tell you if things are getting better by 1% or worse by 1%?"

If you don't, you can't correct problems in the early stages before they become entrenched and you can't take full advantage of unexpected opportunities.

So at what stage do you think your information systems start flagging up issues if not at the 1% level which could increase or decrease your profits by 50%.

At the 2% level which could wipe out the profit or double it?

At the 5% level when your business is going through wild swings or even bigger than that?

My Purpose In Explaining These Business Dynamics

It is not to promote a new information system or accountancy service (but you may want to talk to your accountant about designing key performance indicators or if you are a bigger business, consider appointing a part time Finance Director).

Instead I want you to understand why small changes in the economy and a concept called the product life cycle can have such a big effect on your business.

Both will be the subjects of separate articles on the blog but as talk continues about whether the UK and the US will have recessions (definitions differ), you need to start thinking about the possible consequences on your business.

The Beer Game

The Beer Game was first developed (by Jay Forrester I think) at the Massachusetts Institute of Technology in the sixties and is a simulation I have used in workshops to show that by making rational decisions, we can become victims of the system.

It works along similar ideas to chaos theory where a butterfly flapping its wings may cause a tornado:

"The flapping of a single butterfly's wing today produces a tiny change in the state of the atmosphere. Over a period of time, what the atmosphere actually does diverges from what it would have done. So, in a month's time, a tornado that would have devastated the Indonesian coast doesn't happen. Or maybe one that wasn't going to happen, does." (Ian Stewart, Does God Play Dice? The Mathematics of Chaos, pg. 141)

It is a shame we can't play the beer game in a workshop environment but I have found a computer simulation prepared by major consultancy firm AT Kearney and Matthew Forrester on the MIT website (click here).

There is a full description of the Beer game in Peter Senge's seminal book "The Fifth Discipline: The Art & Practice of the Learning Organisation" which was my first introduction to both the beer game and systems thinking about fifteen years ago.

You can buy the book from Amazon UK or USA

I must do a full review although the book has been revised since my battered, much thumbed copy was printed.

A Simple Explanation Of Beer Game

Imagine a three stage supply chain, retailer, wholesaler and factory.

Each holds stock (inventory) to cope with minor fluctuations in short term demand and any unexpected delays in new supply coming in.

There is a time delay between ordering new beer and receiving it.

Each business wants to maximise profit and in particular wants to meet customer demand when it arises.

The retailer starts seeing an increase in demand from customers so orders more from the wholesaler.

The wholesaler sees extra demand from all the retailers in their area and is delighted to supply the extra from stock and orders more from the factory.

The retailer continues to sell more, so decides to not just order at the replenishment level but to increase their stock, just in case they sell out.

The wholesaler sees this surge in demand and again supplies from stock which is now scarce and orders more from the factory.

The retailer continues to sell more at the new level but doesn't receive the expected supply from the wholesaler who has now run out. This worries the retailer who decides that "to be on the safe side" they will increase their order some more.

This goes on through some more cycles, where first the supply chain is stripped of all the beer but then, as supplies come through, it is overwhelmed. Everyone suddenly has far too much.

The retailer stops ordering but continues to sell, the wholesaler stops selling and ordering and with massive amounts of cash tied up in stock/inventory, starts worrying about their survival, the factory sees no orders coming through from the wholesalers and when it makes enquiries, it discovers that there won't be any orders at current rates for months. Layoffs and plant closures begin.

The story of the beer game works best in simulations when you are making the decisions but the description in "The Fifth Discipline" describes the logic much better than I have.

The trigger was a doubling of demand because a pop song named the beer but the system should have been easily able to cope. It couldn't because of the time delays in the process and the mis-information that was passed backwards along the supply chain.

An Example From My Own Past

I have told the story a few times of when I was Finance Director of a manufacturing business in the West Midlands in the early nineties and we hit the recession which particularly affected the building industry which was the sector we served.

I have never seen big monthly profits (of over £100k) turned into masses of red ink so quickly. We were hit on three sides:

1. Our sales volumes dropped sharply
    
2. We found ourselves caught in a price war on nearly all our products and our prices were cut and cut again. Our competitors say we caused it, we said they did.
    
3. Our costs increased as our production volumes shrank mush faster than our sales.

It's that last factor that I want to explain here because we had our own beer game going on.

Our stock policy at that time was to hold say 4 weeks worth of stock based on an average weekly sales rate calculated over the last three calendar months.

So imagine a product which had weekly sales of 1,000 units based on selling 13,000 over the previous 13 weeks and therefore had a stock target of 4,000 units.

Month 1

Then one month we sold an average of 800 per week but we made 1,000.

So at the end of the month we had stock of 4,800 (= 4,000+ 4,000 -3,200)

Our sales over the last 13 weeks reduced to 938 (= 13000 - 4000 + 3200)

Our new stock target was 3,752 (4 x 938)

So our new production target for the month was only 2704 (based on expecting to sell 3,752 in the next 4 weeks and reducing our stock from the actual 4,800 to the new target of 3,752).

Our production was therefore reduced from 4,000 to 2,704, a 32.4% reduction when sales had only reduced by 20%.

Month 2

Sales carried on at 800 per week which unfortunately was lower than the production forecast had assumed of 3752.

Stock was now 5,352 (4,800+3,752-3,200)

Sales over the last 13 weeks were now 11,400 (13,000 - 4,000 - 4,000 + 3,200 + 3,200), our expected average weekly sales used for planning was 877 (based on 11,400 / 13 weeks).

This meant that our new stock target was 4 weeks at 877 = 3,508

Our new production target was the expected sales less the stock reduction = 3,508 -(5,352-3,508) = 1,664.

In two months, our expected production of this product (and all the others) was down from 4,000 to 2,704 to 1,664 - a drop of 58% from normal levels when sales were down 20%

Can you see the exaggerated effect that the Beer Game was having and we thought we were behaving rationally!

It turned out that sales didn't drop by 20%, our customers, the electrical wholesalers were doing just what we were doing, they were reacting to reduced orders from their customers by cutting back on the stock they carried.

But we didn't know that at the time. We had expected a reduction and official building industry forecasts indicated that new builds were going to be down by around 10% that year.

If the industry was down by 10% but we were down by 20%, it must be because of those ****** we were competing against who had slashed prices. We had to protect what we had so we reduced our prices.

When our customers had finished their de-stocking, they needed to re-order to meet ongoing demand but our stocks were now so low we couldn't cope. Our service suffered.

Our production planning system responded but guess what, it over-responded and we went from short time working and lay-offs to extended shifts and high overtime premiums.

Our employees must have thought the management were idiots.

If Only We Had Understood The Beer Game

In 1991 I hadn't read "The Fifth Discipline". I had never heard of the beer game.

But if I had, it could have saved a lot of money and a lot of unpleasant times as we struggled and failed to cope with the extreme fluctuations we were seeing in our production planning and stock control system.

The upside was that the problem became the central issue for the company and responsibility was taken away from the Operations Director and passed to me. Since then, I have been fascinated by systems thinking and stock control issues.

Stories From My Personal Life

Have you noticed what happens if you hear on the News on the radio or television that crops have failed and there could be a shortage?

Everyone wants to buy, troops off to the supermarkets and buys three extra units. Demand shoots through the roof and creates a genuine shortage.

I remember in my teens, there was a sugar shortage and the supermarket shelves were cleared. We didn't have any and I've never taken sugar in my tea or coffee since.

A few years ago, we had a petrol shortage in the UK. Petrol station after petrol station was dry and those that weren't had long queues of cars with motorists prepared to wait two or three hours to make sure that there tanks were full.

The authorities said that there was no shortage. The motorists knew different because they created the shortage. Every tank was kept filled to the brim and if you drove 50 miles, it was natural to want to fill up again.

Lessons To Learn From The Beer Game

1. Understand the way your "system" reacts to fluctuations and beware of automating too far. Once you become aware of the biases you have to use judgement rather than just calculations.
    
2. Shorten the lead times. One of the main causes of extreme fluctuations is the time lag between action and reaction.
    
3. Improve your market intelligence and share that intelligence with other parts of the chain. In the Beer Game explained in "The Fifth Discipline", market demand doubled one week because of a pop song and then stayed constant at that new level. If the players had known the true facts, rather than reacting emotionally to the shortage, their decisions would have been different and brought the system back into a steady state much faster.

It Is How You Adapt That Matters

"It's not the strongest nor most intelligent that survive. It is the one most adaptable to change." (Charles Darwin)

To Your Success

Your Profit Coach

Paul Simister

Business coaching for customer focused entrepreneurs

Comments

[Increase profit]

Thanks a lot! Its really nice and interesting.