What it means
Almost every business-to-business market runs on derived demand. Packaging demand comes from the products packaged, machine tool demand comes from the goods those tools make, and demand for accountants, drivers and software engineers comes from the activity their employers are pursuing.
Labour is the classic case: no employer wants staff for their own sake, only for what the staff produce. The commercial consequence is that your demand signal arrives late and arrives amplified.
Late, because you find out about the end market's slowdown only when your customer revises orders; amplified, because customers cut orders by more than their own sales fell while they run down existing stock. That amplification running up a supply chain is known as the bullwhip effect.
This changes how forecasting should be done. Instead of extrapolating your own order history, you track the end market directly: housing starts if you sell fittings, vehicle production schedules if you sell components, advertising spend if you sell creative services.
Companies that monitor the end market usually see turning points one or two quarters before those that watch only their own order book. It also shapes pricing power and risk.
A supplier whose demand is derived from a single end market, or worse from a single customer, has very little negotiating leverage and inherits all of that market's volatility. Diversifying across end markets that do not move together is generally more valuable than winning one more customer in the market you already serve.
There is a useful nuance about elasticity. Where the input is a small part of the end product's cost, derived demand tends to be relatively insensitive to the input's own price, because a buyer will not redesign a car to save a few dollars on a fastener.
Where the input is a large share of cost, the opposite holds, and price rises are resisted hard.
In practice
Real-world examples.
Example
A carton manufacturer supplies a soft drinks brand, and its production plan is built directly from the brand's promotional calendar rather than from its own sales history. When the brand delays a summer campaign by six weeks, the carton plant reschedules two production lines before a single order is formally changed.
Example
A logistics recruiter finds that demand for warehouse staff tracks online retail order volumes almost exactly. She monitors weekly parcel volume data as her leading indicator and starts building a candidate pipeline before her clients call.
Example
A software firm sells case management tools to mortgage brokers, so its licence renewals depend on housing transaction volumes. When transactions slow, brokers consolidate and licence counts fall, even though the software itself has not become any less useful.
Formula
Calculation
Derived demand (units) = End-product demand x Input units per end product
Revenue from derived demand = Derived demand units x Price per unit
A tyre manufacturer supplies a vehicle assembler that plans to build 240,000 cars a year, fitting four tyres plus one spare, so five tyres per car. Derived demand = 240,000 x 5 = 1,200,000 tyres. At $85 a tyre, revenue = 1,200,000 x $85 = $102,000,000.
Car sales then fall 15%, so the assembler builds 240,000 x 0.85 = 204,000 cars. Derived tyre demand falls to 204,000 x 5 = 1,020,000 units and revenue to 1,020,000 x $85 = $86,700,000, a drop of $15,300,000. The profit effect is harsher still: with a variable cost of $55 a tyre, contribution per unit is $30, so total contribution falls from 1,200,000 x $30 = $36,000,000 to 1,020,000 x $30 = $30,600,000. Against fixed costs of $22,000,000, profit falls from $14,000,000 to $8,600,000, a decline of about 39% caused by a 15% fall in a market the tyre maker does not sell into.Case study
Seen in the real world.
Ironvale Fasteners is an illustrative and entirely fictional maker of specialist bolts used in wind turbine assembly. Roughly 70% of its revenue came from three turbine manufacturers, and its sales forecast had always been built by taking last year's shipments and adding a growth percentage.
When a subsidy scheme in its main export market was allowed to expire, turbine orders slowed sharply, and Ironvale's customers cut their fastener orders by considerably more than their own output fell because they were also running down safety stock. The company was carrying a full order book one quarter and a half-empty factory two quarters later, having had no independent warning at all.
Afterwards the fictional company rebuilt its forecasting around end-market indicators: announced turbine installations, subsidy policy timetables and its customers' published order backlogs. It also began targeting the marine and heavy construction markets, on the reasoning that a business living on derived demand should at least derive it from more than one place.
Watch out
Common mistakes.
- Forecasting from your own order history when your demand is derived, which guarantees you see turning points only after your customers have already acted on them.
- Reading a sudden order cut as a loss of market share, when it is often a customer destocking in response to a modest change in their own end market.
- Measuring customer concentration by name while ignoring end-market concentration, so a supplier with eight customers all serving one industry believes it is diversified.
Questions
People also ask.
Is labour demand a form of derived demand?
Yes, and it is the textbook example: employers hire because of demand for what the workers produce, not for the work itself.
Why do input suppliers see bigger swings than their customers?
Because customers adjust inventory as well as production, so a small change in end demand becomes a larger change in orders as it moves up the chain.
How can a business reduce derived demand risk?
By serving several end markets that do not move together, by watching leading indicators for those markets, and by keeping a cost base flexible enough to absorb sharp swings in volume.
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