Recently, major U.S. retailers were caught with too much inventory and were being forced to heavily discount to liquidate it. It was the result of the Bullwhip Effect, which represents a distortion of information up the supply chain where upstream suppliers build too much due to a nonrecurring spike in demand. Could the Bullwhip Effect be happening in the residential HVAC market?
To understand the Bullwhip Effect, recall the Indiana Jones movies. Jones would make a small flick of his wrist holding the bullwhip, and the variation of the whip would increase as it moved towards the tip. Just as the whip moves up and down across its length, so the inventory in a supply chain can range from overstocked to empty shelves.
The Bullwhip Effect was first identified by Proctor & Gamble analysts as they studied demand fluctuations in Pampers. The number of babies and use of diapers were believed to be fairly steady, yet each step along the supply chain resulted in greater distortions. The P&G analysts determined that this occurred when a retailer ordered extra diapers above replacement inventory or reordered in batches. Seeing the jump in demand, the wholesaler stepped up their orders even more, which then resulted in the manufacturer producing even more. What may have been a temporary jump in demand generated an overreaction at each stage of the supply chain and was seen, not as a temporary jump, but a permanent shift in demand.
Eventually, the overreactions result in excess inventory that must be liquidated or written off. Retailers are currently experiencing a Bullwhip Effect from consumers splurging government stimulus money during COVID lockdowns. Retailers were running out of inventory and pumping out orders for more. Now that people are returning to work and inflation is spiking, demand is dropping and the inventory is piling up.
Retail has clearly been impacted by the Bullwhip Effect, but it’s not the only industry to feel its impact. Now, it appears the Bullwhip Effect might also show up in residential HVAC.
Did Residential HVAC Demand Temporarily Spike?
At the start of COVID, HVAC manufacturers dramatically cut their demand forecasts. Fortunately, demand for residential products did not abate. First, 2005 was the record shipment year for residential air conditioners and heat pumps in the history of the industry. With a 15-year average for equipment, 2020 was projected to be a new record for replacements. Next, 2019 experienced a late summer for much of the country. Around half a million units were deferred into 2020.
The demand was present, but would people buy? People were staying home due to COVID. The layoffs that decimated employment in hospitality, travel, food service, retail stores, and personal services primarily affected renters. Most homeowners were salaried and able to work from home. With reduced options for their disposable incomes, people put money into their homes.
As COVID wore on, demand for suburban and even rural housing picked up. People wanted out of congested urban apartments and condos. Housing starts jumped from their COVID trough and started accelerating.
The result was 2020 was a record year for the residential market. COVID did impact demand, resulting in deferred replacements into the first half of 2021, which surpassed 2020.
Manufacturers had trouble getting computer chips. They had trouble sourcing certain types of resin. Evaporators were in short supply. COVID was affecting production. Manufacturers were building everything they could. Distributors were buying everything they could. Contractors, including those who rarely stocked, were stocking everything possible. What could go wrong?
The Shipment Cliff
From 2005 through 2009, the residential air conditioning industry contracted 40%. This contraction is the Shipment Cliff. It is based on history, so the residential end of the business cannot avoid it. There are signs that it is already impacting the industry.
Courtesy of AHRI
In 2021, manufacturers began rolling out a wave of price increases. Prices increased 20% on average and for once, contractors were pretty good about passing the price increases along. Without doing anything different, sales jumped 20%.
This year, more price increases were announced. Everyone seems happy with the state of the industry. And yet, there are signs that the Shipment Cliff is starting to affect the replacement market. Shipments in the latter half of 2021 were actually fairly flat compared to 2020. Contractors, when pressed, have noted that installations are down on an apples-to-apples basis. However, thanks to the price increases, contractors are charging more and doing less, so profits are up.
The robust housing market clouds the shipment data. Residential new construction is strong, but there are signs that interest rate increases are starting to impact new home buyers.
The Bullwhip Effect
As surprising as it seems, when you combine the Shipment Cliff with a reduction in housing starts, HVAC manufacturers and distributors could very well find themselves with the excess inventory from the Bullwhip Effect in late 2022 or 2023. If this happens, expect select discounting to quietly occur, along with special promotions. This will still be a profitable year for manufacturers if the Bullwhip Effect takes place — just less so.
The Strategy for Contractors
Contractors who had been buying up every piece of equipment they could might want to start reducing inventory levels. Certainly contractors should ensure they sell off any of the equipment that will be banned next year. Do that first and fast.Contractors are advised to work with their supplier territory sales managers to achieve the right balance of inventory on hand, reducing inventory where distributor levels are holding. If the industry does become overbuilt, contractors should be alert for discounts.