StrategicManagementJournal, Vol.

15, 167-178(1994)

CHAOSTHEORYAND STRATEGY:
THEORY,

I APPLICATION.
DAVIDLEVY
AND MANAGERIAL
IMPLICATIONS
Department of Management, lJniversity of Massachusetfs- Boston
Boston, Massachusetts, U.S.A.

This paper argues that chaos theory provides a useful theorectical framework for
understanding the dynamic evolution of industries and the complex interactions among
industry actors. It is argued that industries can be conceptualized and modeled as complex,
dynamic systems, which exhibit both unpredictability and underlying order. The relevance
of chaos theory for strategy is discussed, and a number of managerial implications are
suggested. To illustrate the application of chaos theory, a simulation model is presented
that depicts the interactions between a manufacturer of computers, its suppliers, and its
market. The resuhs of the simulation demonstrate how managers might underestimate the
costs of international production. The paper concludes that, by understanding industries as
complex systems, managers con improve decision making and search for innovative
solutions.

INTRODUCTION firm behavior in turn can alter the structure of

One of the enduring problems facing the field
of strategicmanagmentis the lack of theoretical
tools available to describe and predict the
behaviorof firms and industries.For example,
even if we know that oligopolisticindustriesare
likely to experienceperiodsof stabilityalternating
with periods of intense competition, we do not
know when they will occur or what will be the
outcome. Similarly, it is almost impossibleto
predict the impact of the advent of a new
competitor or technology in an industry. The
fundamentalproblem is that industriesevolvein
a dynamicway over time as a result of complex
interactionsamong firms, government, labor,
consumers, financial institutions, and other
elementsof the environment. Not only does
industry structure influence firm behavior, but
Key words: Chaostheory, simulation,international,
supply chain
an industry and the contours of competition.
Existing theoretical models, however, tend to
assume relatively simple linear relationships
without feedback.Indeed,manystrategictheories
attempt to classify firms and industries and to
describe appropriate strategiesfor each class;
examplesinclude the Boston ConsultingGroup
matrix for resource allocation and Bartlett's
classificationof international strategies(Bartlett
and Ghoshal,1989).Although thesemodelsare
basedon recurrent patternsthat we recognizein
the real world, there are usually far too many
exceptionsfor the modelsto havemuchpredictive
value.
Chaostheory, which is the study of nonlinear
dynamic systems, promises to be a useful
conceptualframework that reconcilesthe essen-
tial unpredictabilityof industrieswith the emer-
genceof distinctivepatterns(Cartwright,1991).
Although chaostheory was originally developed
in the contextof the physicalsciences,Radzicki
(1990) and Butler (1990) amongstothers have

-2095t94tB01.67
ccc 0143 -r2
@)1994by JohnWiley & Sons,Ltd.
 168 D. Levy

noted that social, ecological, and economic have confoundedmathematiciansfor years. A

systemsalsotend to be characterized by nonlinear similar problem afflicts someonewho is trying
relationships andcomplexinteractionsthat evolve to calculate the path of an object in the
dynamicallyover time. This recognitionhas led gravitationalpull of two or more bodies.While
to a surgeof interestin applyingchaostheory to we canusesimpleNewtonianequationsto predict
a numberof fields,includingecology(Kauffman, the orbits of planetsaroundthe sun with a high
l99l), medicine(Goldberger,Rigney and West, degreeof accuracy,the mathematicsinvolvedin
1990) internationalrelations (Mayer-Kressand the caseof two or more 'suns'becomeintractable.
Grossman,1989),and economics(Baumol and The problem can be illustratedon a terrestrial
Benhabib, 1989; Kelsey, 1988).t Despite the level by observingthe motion of a simpletoy, a
apparentapplicabilityof chaostheoryto the field metal ball suspended over two or more magnets.
of businessstrategy',there has been surprisingly The ball will tracea seriesof patternsthat never
little work in this area. exactlyrepeatthemselves, and yet aie not totally
This paperintroducesreadersto chaostheory, random.
and discusses its relevanceto the socialsciences The paradox here is that the motion of the
in generaland to aspectsof strategyin particular, metal ball is driven by the same Newtonian
including planning and forecasting, and the equationsas the well understoodcaseof a single
impact of changeon firms and industries.The gravitationalattractor.If we knew preciselythe
applicationof chaostheoryto a business situation original location, speed, and direction of the
is illustrated using a simulation model of an ball, we ought to be able to predictits path with
internationalsupply chain. The model, which is a reasonabledegree of accuracy. How is it
based on the author's researchinto the supply that deterministic systems can give rise to
chain of a California-based computercompany, unpredictability?The explanation is that tiny
depicts the complex interactionsbetween the variationsin the motion of the ball are magnified
firm, its suppliers,andits markets.The simulation every time it swingsby one of the magnets.It
resultsillustrate the managerialimplicationsof is a combination of this divergenceand the
applyingchaostheory to strategicmanagement. repeatedinteractionsthat give rise to 'chaotic'
The model demonstrateshow small disruptions behavior. Mathematically,chaotic systemsare
to the supply chain interact to make the chain representedby differentialequationsthat cannot
highly volatile, imposingsignificantcostson the be solved,so that we are unableto calculatethe
organization.Although forecastingis very difficult stateof the systemat a specificfuture time 't'.
in the supply chain, distinct patterns emerge At the limit, chaoticsystemscan becometruly
which are useful for managers.The simulation random. A toss of a coin or the roll of a die
also shows that by understandingthe supply are, in theory, deterministicsystems,but yield
chainas a complexdynamicsystem,it is possible more or less random outcomes.Not only is it
to identify managerialapproachesthat lower the impossibleto toss a coin twice in exactly the
cost of operatingthe supplychain. sameway, but on each toss the coin is subject
to slightly different air currents, themselvesa
result of turbulent air flow (Ford, 1983).
AN INTRODUCTION TO CHAOS To overcomethe problem of intractablediffer-
THEORY ential equations,researchers usuallymodel sys-
tems as discrete difference equations, which
Chaostheory is the studyof complex,nonlinear, specifywhat the state of the systemwill be at
dynamic systems.The field was pioneered by time 't* 1' given the stateof the systemat time
Lorenz (1963), who was studying the dynamics 't.' Computer simulationscan then be used to
of turbulent flow in fluids. Although we all seehow the systemevolvesover time.
recognizethe swirlsand vorticesthat characterize One of the major achievements of chaostheory
turbulentflow, the complexitiesof turbulentflow is its ability to demonstratehow a simpleset of
deterministicrelationships canproducepatterned
t See also special issues of. Journal yet unpredictableoutcomes. Chaotic systems
of Economic Theory,
40(1), 1986, and Journal of Economic Behavior and Organiza- never return to the same exact state, yet the
tion,8(3), 1987. outcomesare boundedand createpatternsthat
 Chaos Theory and Strategy t69

embody mathematicalconstants(Feigenbaum, reflectvery complexunderlyingrelationships that

1983).It is the promiseof findinga fundamental include the interaction of several potentially
order and structurebehind complexeventsthat chaotic systems;crop prices, for example, are
probablyexplainsthe greatinterestchaostheory influenced by the interaction of economic and
has generatedin so many fields. weathersystems.The searchfor a simpleset of
equationsto explain complex phenomenamay
be a futile attempt to construct grand 'meta-
Chaostheory and the social sciences
theory,' a projectthat is rejectedin the postmod-
Proponentsof chaostheory enthusiastically see ern paradigm. The applicationpresentedhere
signsof it everywhere,pointing to the ubiquity usesa different approach;field study researchis
of complex,dynamicsystemsin the socialworld used to derive a set of relationships among
and the resemblance betweenpatternsgenerated variables and the influence of external systems
by simulatednonlinear systemsand real time is modeledprobabilistically,a methodsuggested
series of stock exchangeor commodity prices. by Kelsey(1988).
From a theoreticalperspective,chaostheory is Social and physicalsystemsalso differ in the
congruouswith the postmodernparadigm,which source of unpredictability. In the physical
questionsdeterministicpositivismas it acknowl- world, unpredictability arises due to many
edgesthe complexityand diversityof experience. iterations, nonlinearity, and our inability to
While postmodernismhas had a profound influ- definestartingconditionswith infinite precision.
ence on many areas of social scienceand the In the social world, far less accuracy is
humanities,it hasbeenneglectedby organization possiblein definingstartingconditions,and the
theoristsuntil very recently(Hassardand Parker, specificationof the system structure itself is
1ee3). much lessprecise.
Despiteits attractions,the applicationof chaos A final difference is that physical systems
theory to the socialsciences is still in its infancy, are shapedby unchanging naturallaws,whereas
and there are thosewho think that expectations social systemsare subject to intervention by
are too high (Baumol and Benhabib, 1989). individualsand organizations.Investigationsof
Although real life phenomenamay resemblethe economictime seriesby chaos theoristshave
patternsgeneratedby simplenonlinearsystems, usually assumedthat relationshipsamong eco-
that does not mean that we can easily model nomic actors are fixed over time. In reality,
and forecast these phenomena; it is almost methods of stabilizing the economy have
impossibleto take a set of data and determine changed from the use of the gold standard
the system of relationshipsthat generatesit and balanced budgets to Keynesian demand
(Butler, 1990). In fact, there is considerable managementand, later, to monetaristcontols.
debate in the economicsand finance literature Human agency can alter the parametersand
about how one tests a data seriesto determine very structures of social systems, and it is
if it is chaotic or simply subject to random perhapsunrealisticallyambitiousto think that
influences(Brock and Malliaris, 1989; Hsieh, the effects of such intervention can be endo-
1991). Moreover, it is important to recognize genized in chaotic models.2 Nevertheless,
that many systemsare not chaotic, and that chaotic models can be used to suggestways
systems can transition between chaotic and that people might interveneto achievecertain
nonchaoticstates.Chaostheory is perhapsbetter goals. The application presented here, for
seen as an extension of systemstheory (Katz example,showshow managementcan reduce
and Kahn, 1966;Thompson,1967)into the realm the volatility of the supply chain to improve
of nonlinear dynamics rather than as a total performance.
paradigmshift.
It is possible that the applicationof chaos
theory to socialsciencehas been constrainedby 2 To some extent, the distinction between endogenous and
the fact that it has developed in relation to exogenous variables in a model is one of convenience; a
physical systems,without taking into account factor that is exogenous in a simple model might become
endogenous in a more complex and comprehensive one.
fundamentaldifferencesbetween physical and Exogenous factors can be included as random variables in
socialscience.In the socialworld, outcomesoften chaotic systems for modeling purposes (Kelsey. 1988).
170 D. Levy
RELEVANCE OF CHAOS THBORY TO
STRATEGY
To understandthe relevanceof chaostheory to
strategy,we need to conceptualizeindustriesas
complex, dynamic, nonlinear systems. Firms
interact with each other and with other actorsin
their environment,suchas consumers,labor, the
government, and financial institutions. These
interactions are strategic in the sense that
decisionsby one actor take into accountantici-
pated reactions by others, and thus reflect
a recognition of interdependence.Although
interfirm behavior has been modeledformally in
economicsand businessstrategy using game
theory (Camerer, I99L), these models tend to
presumethe emergenceof equilibrium and do
not adequately reflect industry dynamics. As
Porter (1990) emphasizes,the evolution of
industriesis dynamicand path dependent:corpor-
ate (and country-level) capabilities acquired
during previous competitive episodesshape the
contextfor future competitivebattles.Moreover,
the accumulationof competitive advantagecan
be self-reinforcing,suggestingat least one way
in which industriesare nonlinear. If industries
do behave as chaotic systems,a number of
implicationsfor strategycan be drawn.
Long-term planning is very difficult
In chaotic systems,small disturbancesmultiply
over time becauseof nonlinearrelationshipsand
the dynamic,repetitivenatureof chaoticsystems.
As a result,suchsystemsare extremelysensitive
to initial conditions, which makes forecasting
very difficult. This is a problem that has
confronted meteorologiststrying to model the
weather: the fundamentalproblem is trying to
use finite measurementsin an infinite world.
A related problem is that as systemsevolve
dynamically,they are subject to myriad small
random(or perhaschaotic)influencesthat cannot
be incorporatedinto the model.
Formulatinga long-termplan is clearly a key
strategictask facing any organization.People
involved in planning,whether in business,eco-
nomics,or someother area,have alwaysknown
that modelsare alwaysjust models,that forecasts
are uncertain,and that uncertaintygrows over
time. Nevertheless.our conventionalunderstand-
ing of linearmodelsand the influenceof random
errors would lead us to think that better models
and a more accurate specificationof starting
conditionswould yield better forecasts,useful
for perhapsmonths if not years into the future.
Chaos theory suggestsotherwise; the payoff in
terms of better forecasts of building more
complexand more accuratemodelsmay be small.
Similarly, we cannot learn too much about the
future by studyingthe past: if history is the sum
of complex and nonlinear interactionsamong
peopleand nations,then history doesnot repeat
itself. Concerningurban planning, Cartwright
(1991)has noted that we have to acknowledge
that 'a completeunderstandingof some of the
thingswe plan may be beyondall possibility.'
The notion that long-termplanningfor chaotic
systems is not only difficult but essentially
impossiblehas profound implicationsfor organi-
zations trying to set strategy based on their
anticipationof the future. Rather than expend
large amountsof resourceson forecasting,stra-
tegic planning needs to take into account a
number of possible scenarios.Moreover, too
narrow a focus on a firm's core products
and markets might reduce the ability of the
organizationto adapt and be flexible in the face
of change. The proliferation of joint-ventures
and the acquisition by large firms of stakes
in entrepreneurialenterprisescan perhaps be
understoodas attempts to keep a foothold in a
number of potential scenariosin the face of
uncertaintyand acceleratingchange.
Industries do not reach a stable equilibrium
The traditional approachto understandingthe
influenceof industry structure on firm behavior
and competitive outcomes has been derived
from microeconomics,with its emphasis on
comparativestaticsand equilibrium.More recent
applicationsof game theory have attempted to
accountfor interactionsamongsmall numbersof
firms (usuallytwo), yielding predictionsabout,
for example, investmentsin R&D or plant
capacity to seize first-mover advantages.Even
the most complexgame theoreticmodels,how-
ever, are only considereduseful if they predict
an equilibrium outcome. By contrast, chaotic
systemsdo not reacha stableequilibrium;indeed,
they can never passthrough the sameexactstate
more than once. If they did, they would cycle
endlesslythrough the same path becausethey

are driven by deterministic relationships.The
implicationis that industriesdo not 'settle down'
and any apparentstability, for examplein pricing
or investmentpatterns,is likely to be shortlived.
Chaos theory also suggeststhat changesin
industrystructurescanbe endogenous.Corporate
decisionsto enter or exit the market, or to
developnew technologies,alter the very structure
of the industry, which in turn influencesfuture
firm behavior. One of the most provocativeand
controversialelements of chaos theory is that
chaotic systemscan spontaneouslyself-organize
into more complexstructures(Allen, 1988).The
notion has been applied to biological evolution
(Laszlo, 1987) as well as to economicsystems
(Mosekildeand Rasmussen, 1986).In the context
of businessstrategy,the conceptcould potentially
be applied to the evolution of complexorganiza-
tional relationshipssuch as long-term contracts
and technical cooperation with suppliers, and
hybrid forms of organizationalcontrol such as
joint ventures.Chaostheory suggeststhat new,
more complex organizationalforms will appear
more frequently than if they were simply the
result of random mutations.
Dramatic changecan occur unexpectedly
Traditional paradigmsof economicsand strategy,
which are generally based upon assumptionsof
linear relationshipsand the use of comparative
static analysis, lead to the conclusion that
small changesin parametersshould lead to
correspondinglysmall changesin the equilibrium
outcome.Chaostheoryforcesusto reconsiderthis
conclusion.Large fluctuationscan be generated
internally by deterministicchaoticsystems.Mod-
els of population growth based on the logistic
differenceequation illustrate how sudden,large
changesin population levels can arise from the
dynamics of the system rather than from the
influenceof external shocks(Radzicki, 1990).3
Similarly, if economic systemsare chaotic then
we do not need to search for wars or natural
3 The logistic difference equation has the form:
P,*t : P, * R* (1-P,)
P, a fraction between 0 and 1, representsthe population
level as a proportion of the maximum carrying capacityof
the environment.R is the growth rate from one cycle to the
next. Populationgrowth is constrainedby the factor 1-P,,
which can be understoodas a resourceconstraint.
Chaos Theory and Strategy I7t
disastersto accountfor economicdepressionsor
a crashin the stock market.
The size of fluctuations from one period to
the next in chaotic systemshave a characteristic
probability distribution (Bak and Chen, 1991).
Under this distribution, large fluctuationsoccur
more frequently than under the normal distri-
bution, suggesting that managersmight underesti-
mate the potential for large changesin industry
conditionsor competitors'behavior.
Small exogenousdisturbancesto chaotic sys-
temscan alsocauseunexpectedlylargechanges.
The implication for businessstrategyis that the
entry of one new competitoror the development
of a seeminglyminor technologycan have a
substantialimpacton competitionin an industry.
An examplethat comesto mind is the way Dell's
mail order strategy in the personal computer
industry forced other companiesto reduce their
prices and reexaminetheir traditional high-cost
salesand servicechannels.
Short-term forecastsand predictions of patterns
can be made
Although the unpredictabilityand instabilityof
chaotic systemshas been emphasized,there is
also a surprising degree of order in chaotic
systems. Short-term forecasting is possible
becausein a deterministicsystem, given the
conditions at time 't,' we can calculate the
conditionsat time 't+1.' A carefullyconstructed
simulation model of a complex system with
accuratelyspecifiedstarting conditionscan yield
useful forecastsat least for severaltime periods.
Weather forecastsbased on sophisticatedcom-
puter modelsusingmeasurements from thousands
of points around the globe do provide useful
forecastsfor a few days,which is usuallysufficient
for purposessuch as hurricane warnings. If we
imaginethat strategicdecisionsin companiesare
made on a monthly or even annual cycle, then
industry simulation models might be able to
make useful predictionsover a time horizon of
severalmonths or possiblyyears.
Another feature of chaotic systemsthat lends
them a degreeof order is that they are bounded;
outcomevariablessuchpricing or investmentsin
new capacityfluctuatewithin certain boundsthat
are determined by the structure of the system
and its parametersbut not its initial conditions.
In the context of businesstrategythese bounds
t72 D. Levy

might be set by feedback loops such as the betweencountries,betweenfirms in an industry,

entrance of new firms or antitrust action by or even betweendepartmentsin a firm.
the government in response to monopolistic
conditions.
Although we cannot forecastthe precisestate Guidelinesare neededto cope with complexity
of a chaotic systemin the longer term, chaotic and uncertainty
systems trace repetitive patterns which often 'Strategy'can refer to a set of guidelinesthat
provide useful information. According to Rad- influence decisions and behavior. It is the
zicki (1990),deterministicchaos'is characterized complexityof strategicinteractions,whether in
by self-sustainedoscillationswhose period and chess, soccer, or in business,that makes it
amplitude are nonrepetitive and unpredictable, essentialto adopt simplifying strategiesto guide
yet generatedby a systemdevoidof randomness.' decisions;even the most powerful computersare
For example, while we do not know exactly unable to track all possiblemovesand counter-
where or when tornadoes and hurricanes will movesin a chessgame. General Electric'swell
strike, we do know what conditionslead to their known strategyof being numberone or number
occurrence, when and where they are most two in every industry in which it participatesis
frequent,and their likely paths.In a similarway, a simple example of a guideline which may be
we know that oligopolistic industriestend to generally useful but is not always optimal in
alternatebetweenperiodsof intensecompetition every situation. We need general guidelines
andperiodsof morecooperativebehavior,though becauseit is impossibleto specify the optimal
we do not know when an industry will make the courseof action for every possiblescenario.
transitionfrom one state to another.To give a It is important to distinguish the guidelines
third example,we know that the economycycles and patternsof behavior that constitutestrategy
through recessionsand booms,though we cannot from the underlying rules of the game. In a
predict very well the depth or duration of a game of chess,for example, knowing the rules
particular recession (Butler, 199). Observing for playing the game does not necessarilygive
patterns is especiallyuseful if we can associate one insights into strategiesfor successfulplay.
different phasesof the systemwith other charac- One can only learn thesestrategiesafter experi-
teristics;for example,thereis a strongrelationship encing the complexitiesof interactions on the
betweenbusinesscyclesand other variablessuch chessboard. Indeed, becauseof the complexity
as demand, interest rates, the availability of of strategicinteractions,one does not always
credit, vendor lead times, and the tightnessof know why a particular strategyis successful.
the labor market. While the complexity of industry systems
An intriguing aspectof the patternstraced by dictatesthe needfor broadstrategies,the dynamic
chaotic systemsis that they are independentof natureof chaoticsystemsmandatesthat strategies
scale;in other words, similarpatternsare traced adapt.As industrystructuresevolveand competi-
by a systemwhateverhorizon is usedto view it. tors changetheir strategies,a firm clearly needs
Economic time series often appear to display to changeits own guidelinesand decisionrules.
this property.Stockprices,for example,displaya The problem here is that there is no simple way
remarkablysimilarpatternwhetherone observes of deriving optimal strategiesfor a given system.
daily changesover 1 year or minute-by-minute Indeed, in a complexsystemthe best strategies
changesover a day. These imagesof patterns might achievegoals indirectly and even appear
within patterns are termed fractals when they counter-intuitive. The bestwayto improvequality
are generatedby chaotic systems.In the natural is not necessarilyto check every product several
world, fractalscanbe found in manyphenomena, times: it may be to improve labor relationsand
from the shapeof coastlinesto ice crystals.The thus gain labor's cooperationin finding waysto
implicationsfor businessstrategyare not entirely reduce defects. IBM's decision in 1981 to
clear. One interpretationis that previousexperi- let other 'clone' manufacturersuse the DOS
encesin an industry are likely to recur on a operatingsystemfor personalcomputershelped
much larger scale. A second interpretationis competitors but also indirectly helped IBM to
that similar patterns of behavior might be build market share by creating the industry
expected whether one examines competition standard.
 Chaos Theory and Strategy t73

In order to understandindirect or counter-

I/ENDoRS
intuitive meansto an end, a systemneedsto be I I I
understood as a whole. If systems are very I | !l
t
complex, then simulation models might pronl t l
J i I
helpful in finding the most effective way to cor{poNENT
achieve a goal. The example discussed later in Il{\tBNtclRY vs. TARGETINv. iI
this paper illustrateshow the best way to cut I

inventoryin a supplychainmight be to reduce I i i

disruptions to the chain rather than shorten lead
trmes.
SIMULATION OF AN INTERNATIONALI
SUPPLYCHAIN I i,
v !
Thesupplychainasacomp|exdynamicsystem_qIqI!{- >
The simulation of an international supply chain
demonstrateshow chaos theory can be applied
to the understandingof a real managerialissue.
The exampleis drawn from the author'sresearch
into the costs of coordinating the international
supply chain of a personal computer company
called California Computer Technology(CCT).4
Following Eisenhardt (1989), a case approach
was usedto build and test theory in an iterative
manner.
The researchled to a conceptualizationof the
supply chain as a complex, dynamic, nonlinear
system.The systemis subject to externaldisrup-
tions, and the stagesof the chain are linked by
flows of goods and information, with time lags
and feedback mechanisms.The complexity of
interactionsalong the supply chain is such that
one cannot easily predict how the system will
operateunder variousconditions,but a computer
model of these processes can simulate the
outcome (Lant and Mezias, 1990; Morecroft
1984).Figure 1 is a simplified representationof
CCT's supply chain, showingin schematicform
the flows of goods and information within the
model. Solid lines represent flows of goods,
dotted lines flows of information.
In reality, supply chainsare often much more
complex than this. CCT, for example, has
hundredsof vendors,three productionsites,and
distributors and warehousesin many countries.
Corporate headquarter functions interact with
vendors, the field sales organization, and the
productionsites.Nevertheless,the diagramdoes
a The name of the company has been disguised to prorecr uncertainty, The linkages themselves are also
proprietary information.
TARGETcoMPoNENT<--- I
II TNvENToRY i
v i
!
I nnooucrroN l<----- pRoDucrron <-----!
SCHEDULE !
iI
!
INI|ENSORY VS. TARGBT INV. !
^ l
t l
, !
I
TARGET SYSTEI,i INV.
a l
!
't l
l
i
Figure1. A Modelof CCT'ssupplychain
capturethe essenceof the supplychain. Materials
move along the chain in one direction, gaining
value at eachstage.Information is exchangedin
both directions among the organizationsalong
the chain. This simple representationis very
useful in analyzing the potential sources of
coordination costs in a supply chain and the
impact of geographicallyseparatingstagesof the
chain. It is also valuable as a tool for designing
strategiesthat improve the performance of a
supplychain.
There are two important dimensionsto this
system, uncertainty and time relationships.
Rather than performing as a stable, ready state
system, each stage of the chain is potentially
subject to disruptions, or 'shocks.' Demand
fluctuatesin an unpredictableway, production
problemscan affect output, and suppliersdo not
always deliver on time. When demand and
production are rising, delivery and production
problems are more likely. As a result of the
uncertainty at each stage, flows of materials
and finished systemsfluctuate in volume, and
inventoriesneed to be adjustedto cope with the
subject to disruption. Shipments and communi-
174 D. Levy

cation can be delayed, and information can be INVENTORY TO DEMANDRATIOFOR lOO MONTHS
misunderstood.
A secondimportant dimensionof the supply o
chain system is the time relationship among Z .
=
the stages. As a result of the time lags in u, o
communication,production, and distribution,a -
disruptionto one elementgeneratesa sequence zF
O 2
of changesin other parts of the system. For =
example, demand fluctuationscausechangesin F
salesforecasts,productionschedules,and order Fz ' I
UJ

to vendors. Disruptionsoriginatingin any one z

o
part of the system,in effect, propagateforwards
and backwardsalong the chain. Disruptionscan
interact; for example, a production problem t too
,,"r,"iir"r,
could occur in a month when demand was
unexpectedlyhigh, causingsome demand to go Figure2. Simulated inventory levels,
productshipped
unmet. from Singapore to U.S.
A number of researchersinvestigatingaspects
of the supply chain have recently turned to
simulationmodels,most of which attemptto find outcomes.CCT's managersdid not expect this
cost-minimizing solutionsusinglinearor nonlinear volatility, becausethe strategicdecisionto source
programming(e.g., Breitman and Lucas, 1987; from Singaporewas taken using cost estimates
Cohenand Lee, 1989;Hodder and Jucker,1985; that assumeda stablesupplychain. In fact, the
Hodder and Dincer, 1986). These models do instability of the chain imposed substantial
not, however,deal adequatelywith uncertainty unexpectedcosts on CCT, primarily related to
in a dynamic,multiperiodsetting. the expense of using air-freight to expedite
The simulationmodel developedfor this study shipments,the opportunitycostof lost sales,and
is describedin more detail in the Appendix and the costof holdingexcessinventories.In addition,
in Levy (1992). The model assumesa set of CCT incurred expensesrelating to the communi-
decisionrules and linkagesamong the stagesof cation and managerialtime neededto manage
the supply chain, which are used to determine the unstable supply chain. These costs were
the production plan and other variables each all underestimatedbecausemanagersdid not
month. Each stageof the supplychainis subject appreciate the impact of complex interactions
to random fluctuations,and the chain evolvesin alongthe supplychain, and tendedto treat each
a dynamic fashion from month to month. disruptionas a one-timeevent.
The simulation does reveal some patterns
Resultsand implications within the fluctuating inventory levels. Peak
inventory levelsare reached,on average,every
Figure 2 shows simulated inventory levels over 5 months,thoughthe numberof monthsbetween
a period of lffi months based on a version of peaks varies from 21 months; the system is
the model representingproduction in Singapore clearly aperiodic. Moreover, there is a relation-
for the U.S. market, which entails 30 days ship between the average time between peak
shippingtime. Inventory levels are expressedas inventory levels and shippingtime: when pro-
a proportion of monthly demand,and negative duction is available for sale the same month
valuesindicatethat demandcannotbe met from (representing productionin the U.S. for the U.S.
inventorythat month. market), averagetime betweenpeak inventory
The most obvious feature of the graph is levels falls to around 4 months. Note also that
the volatility of inventory levels. These large inventorylevelsare lessvolatile and that peaks
fluctuationsillustrate well how relatively small are lower, as would be expectedwhen delivery
disruptionsto the supply chain can interact with times are shorter.
organizationaldecisionprocessesand lead times As well as illustrating the volatility of the
in the systemto producelarge and unpredictable supplychain and its associated costs,the model

TO DEMANDRATIOFOR1OOMONTHS
INVENTORY
2.e
2.6
2.4
2 2-z
tr 1.9
o
..8
J 4.4
F 1.2
6 1
= o'o
t o.B
O o..r
z 0.2
llj
7 -o.z
-0.4
-o.3
-o.8
TIME (MONTHSI
Figure 3. Simulated inventory levels, product made
and sold in U.S.
can be used to guide decisions concerning
production location, sourcing, and optimum
inventory levels. Used for this purpose, the
simulation model demonstrateshow complex
systemsneed to be understoodas a whole, and
how goals can be achievedthrough indirect and
nonobviousmeans.For example,the simulation
model enablesthe cost of offshore sourcing to
be estimatedin termsof the incrementalinventory
neededto maintain demandfulfillment at some
specifiedlevel. It was estimatedthat in order to
maintainan averagelevel of 95 percentdemand
fulfillment when sourcingfrom Singaporerather
than California for the U.S. market, average
systeminventory levels would have to increase
by more than 2 months of sales.
The underlying order in the supply chain
systemcan be glimpsedin Figure 4. The X-axis
showsthe value of a parameterrepresentingthe
standard deviation of the monthly percentage
change in demand, a measure of demand
instability. The range of values was chosen to
reflect the instability observed for CCT's pro-
ducts. The Y-axis showsthe averageproportion
of demand that could not be fulfilled over 100
iterationsof a 36-monthperiod.
There appearsto be a thresholdbeneathwhich
demand instability does not have a significant
effect;in this region,the systemdoesnot exhibit
chaos.Oncethe instabilityparameterapproaches
0.1, the proportionof demandunfulfilledbegins
to rise rapidly but smoothly and exceeds10
Chaos Theory and Strategy 175
o.1t
2 o'r
= o.oe
uJ
!lr, o . o .
=l o.07
u-
j 0.08
l.L
Z o.os
f
o.or
$
f o.o,
ul
f, o.o"
0.01
STD. DEV. OF MONTHLY % CHANGE IN DEMAND
Figure 4. Impact of demand stability on unfulfilled
demands
percent of demand for products with the most
unstabledemand.
While the simulationmodelillustratesthe costs
and difficultiesof an unstablesupply chain, it
also suggestsapproachesto solving these prob-
lems. The simulation model could be used to
determineoptimal inventorylevelsfor different
productsand components,and to identify those
which need to be manufacturedlocally, based
on the level of volatility associatedwith them.
Although CCT's managers had always been
awarethat unstableproductsshouldbe produced
locally,they tendedto underestimate thesecosts.
The simulationprovided a tool to analyzemore
preciselywhich productswere stable enoughfor
offshore manufacture.
Another approach,using the insight gained
from Figure 4 above, would be for managers
to attempt to improve the accuracy of sales
forecastingin order to reducethe costof offshore
manufacture.Similarly, managerscould try to
reducedisruptionsto the supplychainfrom other
sources,by working with suppliers to improve
quality and reducelead times, and by reducing
the occurrenceof internal productionproblems.
Volatility can also be reducedby interveningat
the boundaries of the system to change its
structure.CCT, for example,has participatedin
the widely observedtrend toward fewer suppliers.
Using thesetechniques,managementcould sim-
plify and stabilizethe system,possiblymakingit
nonchaotic.
It should be noted that the approachesto
176 D. Levy
managingcomplexsystemsdescribedabove con-
stitutekey elementsof leanproduction(Womack,
Jones, and Roos, 1990). Lean production can
thus be conceptualizedas a way to simplify and
reduce the varianceof complex dynamic supply
chain systems, making their behavior more
predictable.Indeed, this researchsuggeststhat,
contrary to the prevailing notion that lean
production methodsconstraininternational pro-
duction (Hoffman and Kaplinsky, 1988; Jones
and Womack, 1985), lean production could
actually facilitate international operations by
reducingvolatility along the supply chain.
CONCLUSIONS
Chaos theory is a promising framework that
accountsfor the dynamic evolution of industries
and the complex interactions among industry
actors. By conceptualizingindustries as chaotic
systems,a number of managerial implications
can be developed. Long-term forecasting is
almost impossible for chaotic systems, and
dramatic change can occur unexpectedly;as a
result, flexibility and adaptivenessare essential
for organizationsto survive.Nevertheless,chaotic
systemsexhibit a degreeof order, enablingshort-
term forecastingto be undertakenand underlying
patterns can be discerned. Chaos theory also
points to the importanceof developingguidelines
and decisionrules to cope with complexity, and
of searchingfor nonobviousand indirect means
to achievinggoals.
The simulation model presentedhere demon-
stratesthat chaostheory haspracticalapplication
to issuesof businessstrategy. The simulation
illustrates how managementcan underestimate
the impact of disruptions to an international
supplychain,generatingsubstantialunanticipated
costs. It also demonstrateshow management
might intervene to reduce the volatility of the
supply chain and improve its performance, by
reducingthe extent of disruptionsand changing
the structureof the supply chain system.
APPENDIX
The supply chain was simulatedusing a spread-
sheet model, with columns representing the
variables in the system, and rows representing
successivemonths. In order to model the
stochastic natureof the supplychain,a simulation
packagecalled 'RISK'was used,which allowsa
variety of probability distributionsto be assigned
to each cell of the spreadsheet.Actual data
and decision criteria from CCT were used to
determine the structure of the model and the
rangeof valuesto be usedfor variousparameters.
For example, monthly bookings data revealed
that the level of bookingseach month could be
modeledby taking the previousmonth'sdemand
plus a percentagechange that was a normally
distributedrandom variablewith mean zero.
Three sets of input parameterswere used for
the model. The first set representsthe level of
disruptionsaffectingdemand,supplierdeliveries,
and production. The second set representsthe
target levels of system and component inven-
tories. The standardvaluesfor thesewere set at
half a month's salesfor systems,excludingany
inventory in transit, and 1 week's productionfor
components.The third group of input parameters
representsthe impact of distance on shipping
time for finishedgoods, and of different vendor
lead times. The main output variables of the
systemwere the levelsof systemand component
inventoriesand the level of demand fulfillment.
Using these parameters,the model simulatesa
36-monthtime period. The model beginsat time
zero with a nominal level of demand and
production of 100 units, but thesevaluesevolve
over time. The simulation packageenablesthe
spreadsheet to be recalculateda specifiednumber
of times. On eachiteration,the entire 36-month
spreadsheetis recalculatedwith a new set of
random numbers. A large number of iterations
can thus be used to build up a probability
distribution for these output variables and to
calculate a mean (expected)value. The results
presentedhere were obtainedusingone hundred
iterations for each simulation. Each simulation
of lffi iterationswas run using a different set of
input parameters.A list of variablesrecalculated
on a monthly basisis given in the Appendix.
Three main performancemeasureswere cap-
tured as output variables.Average system and
average component inventory levels over 100
iterationsof the 36-monthperiod were expressed
in terms of months' sales.Demand fulfillment
was measuredby summingthe total number of
units of demandwhich could not be met due to
inadequateinventory,and dividing this total by

total demandto give a ratio indicatingunfulfilled
demand.
The effect of distanceon shipping times and ENDING
of different vendor lead times was modeled by SYSTEM INV:
using different versionsof the basic model. The
simulationsusedfor this paper used a version in
which production in Singaporeis available for
sale in the U.S. the following month (i.e., 30
daysto ship and clear customs)and vendor lead
times are 60 days.
VARIABLES RECALCULATED ON
MONTHLY BASIS FOR SIMULATION
MODEL
ACTUAL Demand for systems each
DEMAND: month was equal to the
previous month's demand
plus a random percentage
change.
ACTUAL Salesof systemseachmonth
SALES: wereequalto demandunless
constrainedby lack of inven-
tory.
SALES The best sales forecast for
FORECAST: the next month was the
previous month's demand,
as no trend was built into
demand fluctuations.
ENDING The level of component (or
COMP. INV.: material) inventory each
month was the level the
previous month plus deliver-
ies from vendors less what-
ever was consumedin pro- ""flt.t"tiJtilbn"r (1991).
duction.
TARGET The target level of compo-
COMP. INV.: nent inventorywas adjusted
each month to equal a pro-
portion of the current sales
forecast.
ORDERS Orders to vendors were
TO VENDORS: basedon the salesforecast,
the production schedulefor
the following month, and a
comparison of actual with
target component inventory
levels.
DEL. FROM Deliveries each month
VENDORS: equalled orders placed 1. or
2 months previously,
Chaos Theory and Strategy I77
depending on the version,
lessa random percentage.
Systeminventory at the end
of each month was equal to
the inventory the previous
month less sales plus pro-
duction the same or the
previous month, depending
on the model version.
TARGET The target level of system
SYSTEM INV: inventorywas adjustedeach
month to equal a proportion
of the currentsalesforecast.
PRODUCTION The production plan for the
PLAN: following month was based
on the sales forecast,
adjusted for the difference
betweenactual and planned
systeminventory.
ACTUAL System production each
PRODUCTION: month was equal to the
production plan of the pre-
vious month, lessa random
percentage,and constrained
by the availabilityof material
inventory.
UNFUL. Unfulfilled demandequalled
DEMAND: monthly demand less
monthlv sales.
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