Revisiting the JIT Paradigm
Introduction
Many manufacturers, retailers and suppliers have placed great emphasis on JIT - just in time inventory management. At its core, JIT is a means to eliminate waste of all kinds in the production process, to improve product quality, and identify inefficient processes. To date, there's little dispute that JIT management has improved companies' bottom lines; by most accounts, JIT practices have saved manufacturers billions of dollars.
However, while JIT offers the potential to create significant savings for firms, it can be easily misapplied. Just as re-engineering has become a euphemism for downsizing, in practice JIT programs are implemented to reduce inventory and thus free up capital. While it is true that JIT can indeed save firms money and improve efficiency, JIT programs can expose firms to costly production disruptions and failures to meet customer demands. It must be recognized that there are costs as well as benefits to JIT management, and both have changed significantly over the past few months.
As is so often the case when management concepts are misapplied, a backlash eventually occurs in the concept's acceptance. JIT may have reached its apex and could be ready to swing back. Manufacturers should reconsider their inventory policies as the cost of inventory falls, internationalization grows, and costly supply chain disruptions continue to increase. In short, management should take a second look at how it implements JIT.
The Origins of JIT
The origins of JIT come from the automotive industry, when Taiichi Ohno and Shigeo Shingo developed the "Toyota Production System," which was later to become known more generally as JIT. JIT's promise of inventory reduction became a major focus for American businesses in the '80s, when Japan's economy and businesses were thriving, and in many respects, overtaking American business in efficiency of production and quality of products. One of the major contributors to the Japanese success was the lower cost structure achieved through aggressive management of inventory levels. At the time, interest rates were at all-time highs, with the prime lending rate topping 20 percent, and the cost of holding inventories was astronomical. Burdened by excessive inventories and skyrocketing interest rates, U.S. manufacturers could not afford to compete with Japanese firms that were "leaner and meaner." JIT programs abounded throughout the '80s and '90s, with a steadily growing following.
JIT 101: The Basics
JIT focuses first and foremost on the elimination of waste and non-value added activities of all kinds in production, including unnecessary product movement. JIT proponents point to two sources of inefficiency arising from inventory. First, excessive inventory is a wasteful use of capital that could be used in more productive ways. This waste has been a primary focus of practitioners who have implemented JIT programs.
But just as important to the advocates of JIT is the notion that excess inventories hide production process inefficiencies and allow them to persist. Variability of any kind in the production process - such as tolerances for product standards or volatility in production or delivery times - is considered a signal of waste. JIT programs reduce inventories to expose process inefficiencies and force their elimination. However, strictly reducing inventories without resolving underlying production problems and other sources of variation will simply result in product and material shortages, production line stoppages, and missed sales opportunities.
This does not mean that holding excessive inventory is better; rather, that managers should reevaluate the feasibility of eliminating the variability that gives rise to the need for inventories in the first place. In particular, the role of distribution and supply chain logistics is growing more important. The focus on reduced inventories, while well intentioned and rational, has driven the need for reduced lot sizes and faster delivery times beyond what is optimal or advisable under the current business climate. Simply put, inventory reduction for its own sake may be costing producers far more than they realize.
The Cost of Inventories
A major determinant of the cost of holding inventory is the prevailing real interest rates that directly affect the firm's cost of capital. If Caterpillar holds an average of 1,000 engines in its warehouse, and each engine costs $10,000 to build, and the real interest rate was seven percent, then Caterpillar loses $700,000 a year in foregone interest - not to mention the costs involved in physically storing the engines. In the early '80s real interest rates for firms like Caterpillar were at historic levels, dramatically increasing the opportunity costs of holding inventory. Today, we are experiencing the lowest interest rates since WWII, allowing firms to hold larger stocks of inventory more economically.
To be sure, the cost of holding inventory is a function of many things other than interest rates. By most estimates, the annual cost of inventory has hovered in the 25 percent range. Although insurance, taxes, shrinkage, spoilage and obsolescence, warehousing, and administration are important considerations, the cost of money is still a full quarter of the total cost of inventory. In the last year, the cost of money for most firms has fallen substantially. Although every industry faces unique costs of inventory holding, recent interest rate decreases are a large reduction in the total cost of holding inventory.
Since the opportunity cost of capital plays such a large role in the cost of holding inventory, the recent decline in interest rates has dramatically lowered the opportunity cost of holding inventory for everyone. As interest rates hit record lows, U.S. manufacturing is beginning to hold more inventories, as we would expect.
Internationalization's Impact on JIT Programs
As Japanese companies implemented JIT programs, they benefited from Japan's compact geography and largely closed economy that makes for relatively low transportation expenses. The United States does not share that luxury, and domestic JIT programs are generally subject to substantially higher transportation costs. The impact of NAFTA and globalization only increases the distances between suppliers as production is shifted to countries with lower real cost of labor and more favorable exchange rates.
The sources of cost have changed. Imports from Mexico and Canada have accelerated since the passage of NAFTA. Perhaps more importantly, imports have doubled as a percentage of GDP over this time frame. This rapid change has lowered the costs of physical production but increased the importance of transportation costs.
Balancing JIT and Transportation Costs
While the value and price of inventory costs as a percent of GDP have fallen over the last 10 years, transportation expenditures have gradually risen. Inventories and transportation can be employed as substitute factors of production by hold inventories where they will be needed, or by paying higher transportation costs to get them there in an expedited fashion. As illustrated in Figure 1, the savings from JIT programs are often diverted towards increased transportation budgets.
Figure 1 - Inventory cost savings have been offset by transportation cost increases.
As transportation costs become a larger component of final costs, they must be considered in tandem with inventory cost considerations. While JIT depends heavily on the ability to reduce lot sizes, ironically, the transportation cost per unit of each lot grows appreciably as the lot size shrinks. From economies of scale, the cost of transportation per unit rapidly decreases as shipment size increases. Hence, shippers are faced with a transportation calculus that can become quite complicated.
With the steady internationalization of production, subassembly facilities become more far-flung and the costs of transportation of each lot inescapably grow. Small lot sizes further exacerbate this problem, and JIT programs are significantly challenged to deal with the competing forces of low inventories in the face of growing transportation costs.
It is widely reported that shippers and receivers expect faster, smaller, more reliable transportation. Speed and reliability come at a price, however; Figure 2 shows representative transportation costs by mode. Clearly, slower forms of transportation are significantly less expensive per unit. An increased shipment lots size drives what is equivalent to a massive quantity discount in transportation costs. The relevant question that must be continuously asked by a firm is whether reduced inventories justify the increased transportation costs? When inventory costs are low and transportation distances are far, more than likely the answer to the question is "no."
Figure 2 - Representative Transportation Costs by Mode
Environmental Variability
One of the tenets of JIT is to eliminate the kinds of variability that give rise to the need for inventories. However, the elimination of variability is often excessively costly or impossible. More demanding production and delivery schedules generally require increased attention and resources to execute, which affect the cost. Exposure to physical anomalies expands as shipment distances grow and safety stock continues to fall.
Some variability is inescapable and some major events are unpredictable. Even in the past decade, we have witnessed natural, political, and financial disruptions that have fouled many supply chains. For example, earthquakes, floods, hurricanes, and blizzards have regularly hampered product deliveries. Prolonged Teamster and UPS strikes, supplier and carrier bankruptcies, and rail mergers have stopped many product pipelines. Wars, coups, terrorist events, changes in trade policy, and border-crossing restrictions have made delivery of goods and services more problematic. JIT practitioners are at the mercy of these disruptions.
Examples of affected producers abound. Recently, Ford and GM had to shut down plants, losing thousands of units of production, as their parts supply chain was disrupted by terrorist attacks on the United States. Conversely, Harley Davidson has stockpiled critical parts to avoid $56,000 per hour assembly line outage costs. High-tech companies like AMD have been hampered by reduced and delayed international air cargo services. Even Dairy Queen has had difficulty procuring critical ingredients due to border crossing delays from Canada.
Technology as a Solution
The Internet has allowed suppliers and buyers to collaborate on forecasts and to better manage unplanned events. The problem of information flow has been so well addressed that physical flow problems have become the limiting factor. Simply put, knowing where a component is does not replace its physical presence on the assembly line. Information helps manage excesses and exceptions, but does not replace on-hand inventory.
Symptoms of a JIT Problem
JIT programs that have exceeded optimum level of inventory reduction may exhibit
some of the following telltale symptoms:
• Inventory reductions have not resulted in anticipated financial gains, or
initial gains have diminished or reversed
• Increased missed sales due to stock-outs
• Increased production line stoppages due to shortages of raw materials or parts
• Higher transportation costs per unit
• Reliance on expedited parts runs
• Growing expenses for logistics management services, personnel, or technology
• Massive software installations for supply chain and inventory management,
with dubious returns.
Recommendations
Shigeo Shingo, co-developer of Toyota's JIT system, said that "inventory is evil." As an enabler of inefficiency and waste, inventory is just that. However, Shingo's statement has been largely taken out of context and often misapplied in practice.
Although inventories are indeed an "evil," they are also a necessary one. Just like an insurance policy, inventory protects producers against unpredictable demand fluctuations and breakdowns in the supply chain. As the cost of the inventory "insurance policy" falls, the rational businessperson should purchase more insurance.
Increased inventory may be more than just the regrettable necessity of insurance
against uncertainty. Clearly, increased inventories also allow for lower-cost
modes of transportation. Modified inventory strategies can be coupled with progressive
concepts, such as "forward storage," in which product is stored closer to the
end customer, or "product transformation centers," at which final assembly options
and customization takes place. Increased inventories may result in improved
final delivery times, ability to customize in a make-to-order environment, and
ultimately the ability to meet customer demand. Companies should not become
too enamored with JIT's lean inventory methods before fully considering these
factors:
• The cost of holding inventory has fallen while transportation expenditures
have risen
• The distance traveled for inventory has increased, which increases both
total transportation cost and the fixed cost of each lot produced
• Variability is inherent in supply systems, and the need to buffer against
this variability is clear
As economic conditions change, so should logistics strategies. At this juncture,
a rational review of transportation and inventory costs may be in order for
much of the U.S. manufacturing sector.
