JIT savings – myth or reality? – just-in-time management
The just-in-time management philosophy is not new to manufacturers. Though it was initially developed and justified on cost reduction and quality improvement dimensions, managers today have extended its definition to mean the “elimination of waste” in the manufacturing process. This includes any non-value-added activities in the production process.
In this article, we challenge the measurement of the dollar benefits of JIT manufacturing and offer the admonition that blindly following the JIT caravan may lead to benefits that are only a mirage. Specifically, we address the issue of lot-size reduction associated with JIT shipments to customers and assert that, unless changes in the accounting and financing of inventories are made concurrently with changes in production, inventory cost savings are only a illusion.
The JIT Paradigm
Just-in-time manufacturing techniques have become the conventional wisdom of manufacturers all over the world. The success of Japanese manufacturers in the global economy in the 1980s has been attributed to this system. Indeed, JIT encompasses various types of activities; Sakakibara, Flynn, and Schroeder (1993) provide a framework and measurement instrument for JIT manufacturing that includes initiatives as varied as setup time reduction, equipment layout, training, and accounting adaptation to JIT.
Pundits often claim that JIT benefits are more apocryphal than real. The basis for this argument has been that a downstream manufacturer merely displaces its inventory-holding requirements to upstream suppliers, thereby decreasing its own costs while increasing supplier costs. Although this statement may be true, the astute supplier will use the information obtained from its customers to alter its production system and thereby lower its costs. Subsequently, that supplier will work with its own suppliers backward through the supply chain, eventually resulting in reduced system costs.
Still, even with this coordination throughout the supply chain, the benefits of JIT may not be realized unless financing and operational decisions are addressed. The point of the three examples that follow is that, when costs are fixed and cash-flow changes do not accompany changes in production scheduling, savings from inventory reduction are often overestimated.
The Receivables Myth
Consider the following visit of the authors to an automotive OEM (Original Equipment Manufacturer) supplier. As we walked through the plant, we could not help admiring how neat and clean the shop floor was. We were also intrigued by the amounts of vacant space stacked with empty bins. When we asked our host about this, she proudly replied, “Oh, this is the result of the JIT program we instituted a year ago. We have succeeded in reducing finished goods inventory levels from five days to one day as a result. Of course, we now have to machine smaller batches of the components before assembly, but we figured the savings in inventory holding costs more than offset the additional expense of performing more frequent setups. The program has been very successful.”
This description sounded like a textbook example of the advantages of JIT, so we pressed our host further: “How does your customer pay you?”
“Why, they pay us by check every 15 days. Our payment terms are net 15.”
“You mean every 15 days you receive a check for shipments made 15 days or more earlier?”
“Sure, they do try their best to get some additional float, but then who doesn’t? Why do you ask?”
If Cash Is King…
Managers are constantly bombarded by the notion that cash flow is what really matters. MBA students are often implored: “When in doubt, do a spreadsheet and look at the cash flows.” Cash flow analyses are quite easily performed for macro financing and investing decisions. But evaluating the cash flow impact of micro operating level decisions is not as easy. Functional walls in many organizations prevent the effects of these decisions from being traced, so managers, by necessity, evaluate operating decisions based solely on how they affect those managers’ immediate areas of influence.
To do this, managers are forced to use a proxy for cash flows. When analyzing production and inventory management decisions (based on traditional EOQ models), for instance, managers use material flows as a proxy for cash flows and hope that by minimizing inventory levels they will be able to optimize cash flows. Although Cavinato (1988) addresses the issue of cash flow, he does not explicitly relate it to production lot-sizing decisions.
… JIT Is an Impostor to the Throne
Take the example of the investment made by an OEM supplier to introduce a JIT manufacturing system. Management anticipated that the investment required to increase the flexibility of the equipment would be offset by the resulting reduction in inventory holding costs. But the company did not realize the majority of these savings. Here’s why:
Alpha Corporation machines several types of steel components that are packed in “kits” before they are shipped to customers. Beta Corporation is its principal customer and accounts for about 85 percent of total sales. Before they were bitten by the JIT bug, manufacturing managers attempted to maximize machine use by running large lot sizes. The plant would build up the finished goods inventory for five days, and at the end of the fifth day the finished goods would be shipped to Beta.
Then somebody proposed reducing the finished goods inventory by increasing the flexibility of the plant so Alpha would be able to manufacture smaller batch sizes and ship the finished kits to Beta on a daily basis. Of course, some investment would be necessary to retool, buy new fixtures, and modify the process. But management calculated that this investment would be more than paid for by the savings the company would realize by reducing inventory holding costs. These costs had been calculated by the controller’s crew to run to about 30 percent of the dollar value of the inventory on hand. Half was attributable to the cost of capital tied up in the inventory, the other half to warehouse depreciation and maintenance. Warehouse costs were fixed 0nanagement was unlikely to sell or lease the space), but capital costs would be saved as inventory levels went down.
Alpha billed its customers in payment terms of net 15 days. The assumption employed while calculating inventory holding cost savings was that if Alpha made daily shipments to its customers it would receive a check every day for a shipment made 15 days before. If this assumption was correct, then the cost-of-capital savings would have indeed materialized as Alpha had expected. But Alpha failed to consider the accounting systems in place at Beta Corporation. Beta had a practice of making out a check to its suppliers every 15th day only. Processing payments on a daily basis was too cumbersome, it claimed. Every 15th day the accounting department at Beta would consolidate all accounts payable that were 15 days or more overdue and process a single payment to the supplier (in this case, Alpha). Because of this feature in the payables-management system at Beta, Alpha ended up not realizing any cost-of-capital savings at all. It merely changed one asset (finished goods inventory) for another (accounts receivable), and the net cash flow impact was zero. As Saul Migini, Jr., president of the National Association of Credit Management, says, “A sale is not a sale until you collect the money” (Selz 1994). Minor savings did accrue because less physical space was now needed to store the inventory, although the opportunity cost for warehouse space was negligible. Alpha had the possibility of realizing savings by working with its own suppliers, but had not yet done so.
Figure 1 shows the finished goods inventory buildup and depletion pattern under three scenarios of shipping patterns, assuming constant production and demand of $12,000 per day. The three scenarios assume product shipment cycles of five days, three days, and one day, respectively. Finished goods inventory levels decline as the company ships more frequently. Figure 2 shows the receivables patterns under the same three scenarios. As the shipment frequency increases, accounts receivable accrue more quickly. Figure 3 plots what happens to the sum of accounts receivable and finished goods inventory. Note that the three scenarios are identical when the sum of these two assets is compared.
Unless the payment terms are changed concurrently with the shipping cycle, the increased shipping frequency brings no opportunity cost benefits. True, there is less “stuff” sitting around and so less chance for theft, loss, spoilage, or breakage. Nevertheless, it would be incorrect to use the opportunity cost of capital in holding-cost calculations to measure the effects of inventory reduction.
A Saucy Example
Another illustration of this cash flow principle is the company that makes a famous hot sauce used to enhance the flavor of food. Every year, seeds are planted in January and grown in greenhouses until April, when the seedlings are transplanted to the field. In the fall, the peppers are ready to be picked. The day they’re picked, the peppers are crushed, a little salt is added, and the mixture is put into barrels for aging. After the mash has fermented (usually three to six months), the barrels are shipped to warehouses, where the mash is aged for three more years, the barrels opened, and the salty pepper juice drained off. The remaining mash is mixed with vinegar and salt in tanks for about four weeks. Afterward, the seeds are strained off, and the sauce is ready to be pumped to filling lines for bottling.
When the company set about deciding the lot sizing of various bottle sizes, the question arose as to the appropriate holding cost after the bottles were filled, packed, and sent to warehouses. Should the cost of the sauce be included in the inventory calculations? Figures 4, 5, and 6 represent the physical flow of goods through the system. Again, we compare three scenarios: one-month, three-month, and six-month production cycles. Demand is assumed to be constant and equal to 1,000 barrels of sauce per month. Figure 4 shows the total amount of sauce in barrels, assuming that 12,000 barrels are put in inventory in months 1, 13, and 25. The total barrel inventory is depicted in Figure 4; with monthly production runs, the sauce is depleted in smaller steps than with the three- or six-month production runs. Figure 5 shows the inventory in bottles; we might conclude that monthly runs are better, because we have significantly less inventory on hand than if we have six-month runs. Looking at the total investment in sauce in Figure 6, however, we see that the total inventory investment is unchanged for the three production cycles.
The key is that the decision to transfer the sauce from barrels to bottles is not associated with any direct cash flow implications. Sauce inventory is a constant, independent of the bottling decision. Therefore, JIT initiatives should not use the full cost of the finished product in calculating the benefits of inventory reduction. Clearly, JIT initiatives will have benefits associated with them in terms of purchased parts (bottles, caps, packaging) but not the sauce itself. In this case, though, because the supply chain is three years long (the aging time for the sauce), JIT benefits can not be pushed to “suppliers” (the barrels).
Be Careful to Consider Out-of-the-Box Solutions
Let us now consider an example in which the benefits of JIT are actually greater than they might seem to be at first glance. A niche paper manufacturer provides uncoated writing, text, and cover papers to the premium communications market. In the basic paper-making process, cotton and wood are broken down into their cellulose fibers in a solution made up of more than 99 percent water; this fiber solution is then dried and pressed together to form a single sheet of fiber-interlocked paper.
Paper machines make paper as wide as 104 inches that comes off in rolls with diameters of 29 to 40 inches. These huge “parent” rolls are then sliced into narrower rolls that can be mounted on the back end of the finishing machines that produce the final product. The company had traditionally kept five to six weeks of finished goods in stock. It replenished its warehouse as needed by scheduling the paper machines to run the various grades of paper, then cutting all of the paper into the final product. The paper machines were scheduled by grade of paper, according to a preset, fixed interval of time. These types were run once every two, four, or eight weeks, depending on the relationships among setup cost and time, demand, and annual holding costs. Finishing involved cutting the large rolls to the smaller SKU (stock keeping unit) size, then placing the finished product in boxes or on pallets.
Historically, the bottlenecks were the paper machines, which were run as close to 100 percent utilization as possible and the paper sent to finishing immediately after. Finishing capacity and labor were a fixed cost. By the logic of our previous two examples, there was no incremental cost in finishing the paper immediately, because total investment in paper was unaffected. An argument similar to the previous two examples had historically been made to show that the sum of work-in-progress (WIP) and finished goods was constant, irrespective of the finishing schedule. The finishing stage in this instance can be thought of as the bottling stage in our sauce example. Finishing merely converted one type of asset–rolls–into another–cut paper. Because finishing costs were fixed, and the difference in storage costs was negligible, no incremental cash flows were associated with the cutting process. We might conclude, therefore, that no benefit is accrued from a JIT finishing process.
This analysis, however, is not complete, and the conclusions would be incorrect because of possible savings in safety stock inventory. The product structure for the company was such that there were only 10 or 15 types of parent rolls, but almost 1,500 final SKUs. A tremendous savings in finished goods inventory could be had by stocking paper at the parent-roll stage, not at the final SKU stage. This occurs because if paper is stored in its most flexible form, the parent roll, the same rolls can provide protection against excess demand for many different products. Given enough flexible capacity, the total inventory could be reduced significantly by stocking paper in the generic parent roll state rather than in the specific SKU, cut-paper state.
This JIT provision of products through a finish-to-order system would require sufficient capacity at the finishing stage. The extra capacity cost would be more than offset by the reduction in inventory. The lesson here is that, even though the cost of holding the inventory at the different stages (WIP and finished goods) would be the same, the total amount of inventory needed if parent rolls rather than SKU were stocked would be significantly lower. Cash flow savings would accrue because current safety stock in cut paper could be reduced, resulting in a one-time decrease in working capital investment. By instituting the convert-to-order system, the cash required to provide similar service levels would be significantly reduced. The caveat here is that, in addition to examining cash flows, a company should continually explore ways to improve the operating system.
We have offered three examples showing that, in addition to examining the physical flow of materials through a factory, companies need to look at the flow of cash through the organization to make well-informed inventory decisions. Though JIT offers an improved look at the factory, companies may, if they do not simultaneously look at cash-flow measures, have suboptimal systems. Barriers between functional areas–in this case, accounting, finance, and operations–must be removed for organizations to make the best decisions.
J. Cavinato, “What Does Your Inventory Really Cost?” Distribution, March 1988, pp. 68-72.
H. Gleckman, “A Tonic for the Business Cycle,” Business Week, April 4, 1994, p. 57.
H.L. Lee and C. Billington, “Managing Supply Chain Inventory: Pitfalls and Opportunities,” Sloan Management Review, Spring 1992, pp. 65-73.
S. Sakakibara, B. Flynn, and R. Schroeder, “A Framework and Measurement Instrument for Just-in-Time Manufacturing,” Journal of Operations Management, 2, 3 (1993): 177-194.
W.L. Sartoris and N.C. Hill, “Innovations in Short-Term Financial Management,” Business Horizons, November-December 1989, pp. 56-64.
M. Selz, “Big Customers’ Late Bills Choke Small Suppliers,” Wall Street Journal June 22, 1994, p. B1.
E.R. Sims, Jr., “Material Flow Is Money Flow-,” Industrial Engineering, August 1990, pp. 18-19.
M.W. Tucker and D.A. Davis, “Key Ingredients for Successful Implementation of Just-in-Time: A System for All Businesses,” Business Horizons, May-June 1993, pp. 59-65.
Jitendra Chhikara is a manager of financial business planning and analysis at AT&T Universal Card Services in Jacksonville, Florida. Elliott N. Weiss is an associate professor of business administration at The Darden School of the University of Virginia in Charlottesville,
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