Just in time

McDonald's, a guide to the benefits of JIT

Just-in-Time (JIT) inventory is the big thing right now in operations.  This, along with
lean operations and six-sigma are the buzz words being talked most about.  But what
exactly is the deal with JIT operations?
First of all, JIT is a form of providing supplies for customers, as the name suggests,
just in time.  For example, Dell, whom I wrote about, has become famous for its JIT
model which involves not even being in possession of the raw materials needed to
fulfill an order until that order is placed and yet they are still capable of filling orders
in a short period of time.
McDonald's is another example of a JIT system wherein McDonald's doesn't begin to
cook (well, I should probably say reheat and assemble what may or may not be actual
food) its orders until a customer has placed a specific order.
What used to be the case was McDonald's would pre-cook a batch of hamburgers and
let them sit under heat lamps.  They would keep them for as long as possible and
eventually discard what couldn't be sold.  The only way to get a fresh hamburger
under the old system was to make a special order.  Now, due to more sophisticated
burger-making technology (including a record-breaking bun toaster), McDonald's is
able to make food fast enough to wait until it's been ordered.
What both of these firms do is they provide a customer with their order as fast as
possible while having the finished product sitting in inventory for as short as possible.

What are the benefits for McDonald's?

The major benefits for McDonald's are better food at a lower cost.
Let's stop here for a second to drive home a very important point: Whenever you can
implement something that allows you to raise quality AND lower costs, you should
definitely look into implementing that practice.  Unless illegal, immoral, socially
irresponsible, or likely to drive down demand (which is unlikely considering quality is
being improved), you are probably going to want to implement this practice.  Back to
McDonald's.
McDonald's has found something that allows them to improve quality and lower
costs.  Let's take a look at how it does both.
Improved Quality
I think benefits of a better tasting burger should be fairly apparent.  Unless of course
you prefer aged burgers, the fresher burger is going to be higher quality if made fresh
just for you.
The less obvious benefit is the higher quality customer service that arises from the JIT
burger assembly.  When McDonald's waits for you to order the burger, they do a few
things to improve customer service.  First of all, when you place a special order, it
doesn't send McDonald's into a panic that causes huge delays.
Now that McDonald's is in the practice of waiting until you order a burger until they
make it, they don't freak out when they have to make a special order fresh just for
you.  This higher quality customer service is subject to McDonald's ability to actually
produce faster.  Without this ability, McDonald's ordering costs would be sky-high
because the costs associated with ordering would be the loss of customers tired of
ordering fast food that really isn't fast.
Second, JIT allows McDonald's to adapt to demand a little bit better.  Seemingly,
lower inventory levels would cause McDonald's bigger problems in a higher demand
because they wouldn't have their safety stock.  However, because they can produce
burgers in a record time, they don't have to worry about their pre-made burger
inventories running out in the middle of an exceptionally busy shift.
Lower Costs
The holding costs for burger parts (beef, cheese, buns, whatever other garbage they
put on their burgers) are fairly high because of their spoilage costs.  Frozen ground
beef that's good today might not be so good in a few months.  Once cooked, the same
ground beef's spoilage rate shoots through the roof.  Instead of having a shelf life of
months or weeks, the burger needs to be sold within 15 minutes or so.  The holding
costs go from roughly 20% per week to 100% per hour.
In other words, under McDonald's old system, they produced at a level that gave them
high inventories so that food would be available fast, which is the main benefit of fast
food.  Unfortunately, food that was unsold after a short period of time was scrapped. 
Food that was sold was forced to be sold at a higher price in order to absorb the scrap
costs of unsold food.  Ultimately this meant higher costs for McDonald's.
For McDonald's, the benefits of JIT are fairly clear.  For Dell, it was the same way. 
So what is it that both of these firms have in common, and ultimately, when is JIT a
good system to implement?
Why JIT
Economic Order Quantity Savings
A large benefit of JIT is that it reduces the total cost of ordering and holding
inventory.  Let's quickly recap three firms that have achieved this and how they did
so.
Dell and McDonald's
High holding costs are the nature of the computer and fast food industries.  JIT system
allowed them to exploit the savings that were realized by holding less inventory.
Wal-Mart
Instead of having particularly large holding costs, Wal-Mart recognized that they were
in a position to make ordering costs very small.  Because of their importance to their
suppliers, along with their software made affordable through economies of scale,
Wal-Mart has made ordering a very small percent of their overall costs.  By lowering
ordering costs, Wal-Mart has made ordering small batches with greater frequency a
profitable reality.
High holding costs and low ordering costs are the factors that drive JIT.  Generally,
it's the ability to lower ordering costs that make it a feasible solution.  McDonald's
and Dell were both slaves to the high holding costs.  It was just the nature of their
industry.  The solution for them was that while they couldn't lower holding costs, they
could lower ordering costs.  Wal-Mart didn't even have particularly high holding
costs, but they realized it would be profitable to lower ordering costs which led to
high holding costs as a ratio of holding costs to ordering costs.
What McDonald's, Wal-Mart, and Dell have in common is very high holding costs in
comparison to their ordering costs.  Ultimately, this, coupled with the ability to lower
safety stock, is when JIT is effective.  EOQ determines how much you should order
and there are two factors that drive economic order quantities down: low ordering
costs and high holding costs.  Depending on the product and the industry, one or both
of these qualities may exist in your operations.  If they do, JIT may be right for you. 
Without the ability to make ordering costs low as a percentage of holding costs then
there is no need for JIT.  In fact, the increased frequency in ordering will result in cost
increases.
Safety Stock Reductions
The other aspect of JIT is the drastic reduction in safety stock.  My previous article on
safety stock discussed the two reasons safety stock exists:  variability in demand and
variability in lead times from suppliers (in McDonald's case, the supplier is the
internal production process).
It is because of this variability that safety stock exists in the first place.  What JIT
does is tries to reduce the lead times and variation in lead times in order to help
reduce safety stock.  Let's revisit the safety stock formula to figure out why this is:

Safety Stock:  {Z*SQRT(Avg. Lead Time*Standard Deviation of Demand^2 + Avg.

Demand*Standard Deviation of Lead Time^2}
The first term is Lead Time*Standard Deviation of Demand^2.  This is the inventory
needed to account for fluctuations in demand during the lead time.  If lead time is
shorter, which JIT tries to accomplish, then this part of the safety stock is smaller, this
lowering safety stock inventory.
Wal-Mart and Dell accomplished this by using better software and communication
with their suppliers.  McDonald's accomplished this by creating a system that allowed
a faster burger production (remember, McDonald's lead times are internal).
The second term is Avg. Demand*Standard Deviation of Lead Time^2.  This is the
inventory needed to fill demand because of lead time variance.  If lead time has no
variance or is reduced then this term can be eliminated or at least reduced.  Again, this
is what JIT try to accomplish.
Wal-Mart accomplishes this by demanding it, Dell by working with suppliers, and
McDonald's by standardizing production.
In order to accomplish the tasks of shortening lead times and reducing their variances,
a considerable amount of work needs to be done with suppliers/internal operations. 
For some firms this is worth the trouble, for others, it is not.
Conclusively, there are two major parts to JIT inventory operations: lowering the ratio
between ordering costs and holding costs and shortening lead times.  What results is a
firm with such high holding costs that ordering very small batches very frequently is
the most profitable solution.  This eliminates average inventory above the safety stock
level.  Then, if lead times and lead time variability can be decreased, safety stock can
be decreased.  The result is inventory coming in as it needs to come in.  In other
words, it comes in just-in-time.
November 08, 2005 in Case Studies, Just-in-Time | Permalink| Comments (1)
October 17, 2005
The Risks of Being Just-In-Time
The following is a guest article written by Nick Koletic, an economics specialist at
UCLA.  In addition to giving a brief background on Just-In-Time inventory system’s
benefits, the article’s main focus is the risks that JIT systems face.
Just-In-Time inventory (JIT) is part of a production system whereby a firm vastly
reduces inventory from its production processes so that utilization of production
inputs and delivery of finished products are accomplished without incurring
significant holding costs.  While JIT inventory systems are quite attractive for this
reason, they are a double-edged sword. And though a JIT system might even be a
necessity given the inventory demands of certain business types, its many advantages
are realized only when some significant risks to healthy inventory management are
mitigated.
JIT systems have several cost-cutting advantages.  As Charles mentioned in his Dell
Computer case study, JIT inventory systems, a “financial imperative” for Dell, can
radically reduce holding costs.  In the case of Dell Computers, this meant that the
fewer finished computers Dell holds in inventory, the less money they lose per
computer as they “rot” on a shelf.
In addition to these significant cuts in depreciation costs, which for Dell can be up to
1 percent per computer per week, JIT inventory can also cut storage costs.  One can
imagine how Toyota, a pioneer of JIT systems, might save on storage costs as their
finished computers and cars no longer sit idle in warehouses awaiting customers.  And
these storage cost savings apply not only to these finished goods, but also to parts that
Toyota might use as inputs in production.  These inventories are kept at a minimum
through JIT systems as parts are ordered as needed.
JIT systems also cut delivery costs as finished products are shipped to where they are
in demand.  Shipping the same quantity of a product to different retail outlets, for
example, might not make much sense if the demand for that good is significantly
greater at one location relative to another.  This approach to delivery cost savings also
facilitates decreases in aforementioned holding costs by not overstocking certain
locations with a product.  The same principle holds for inputs in production; parts are
not delivered and held at production centers where they might lay idle.
Some positive externalities may also result from a firm’s decision to implement a JIT
system.  Suppliers of such a firm, for example, might then be able handle larger orders
but fulfill them with smaller shipments.  That is to say that for any given order size,
supplying a customer that utilizes JIT is typically easier to do because individual
shipments tend to be smaller for these customers and thus tend to be less demanding
of the supplier.  So it might be possible for suppliers, merely by the nature of their
customers’ JIT system, to greatly expand their ability to fill larger orders without
having to increase production capacity.
Several factors, however, make JIT systems a risky proposition.  A key concern here
is the extent to which firms are dependent upon particular suppliers under such an
inventory system.  For example, if a firm were to commission a highly proprietary
product to a single supplier (single suppliers being common in JIT), a JIT inventory
system would put such a firm at an even higher risk of rip-off on behalf of the
supplier because the firm would have no immediate inventory to buffer an
interruption of supply.  Such an interruption of supply might be so costly that the firm
might just allow the supplier to overcharge the firm up to the cost of this interruption. 
This rip-off cost might completely cancel out or even exceed the savings that drove a
firm to utilize a JIT inventory system in the first place.
Even more dangerous are internal issues that might lead single suppliers to be unable
to fulfill a firm’s orders.  In this case, the firm has no option but to incur the costs of
an interruption of its production input supply.  Internal issues might include, say,
labor strikes on behalf of the supplier’s employees in which labor unions could hold
the supplier for ransom up to the amount of its pending orders, again leading to an
interruption of the firm’s supply of production inputs.  But internal issues can mean a
host of things (and no, I'm not talking about a Webhost) that prevent a firm’s supplier
from supplying.  The point is that by facilitating the interconnectedness between
businesses, JIT inventory systems increases the risk that problems or failures on one
end of the production chain might be felt on another end.
However, these risks associated with JIT inventory systems may be ameliorated to a
certain extent.  Indeed, the evolution of the organization of firms has already taken
many of these risks into account, particularly with respect to rip-offs.  For example,
firms that might otherwise commission highly proprietary products to a handful of
suppliers usually either produce these items themselves or in fact own the suppliers
that do so in order to prevent price-gouging from occurring.
If in-house production or a supplier buy-out is not a feasible option, firms still have
other common-sense ways of preventing these risks.  A firm might have to really
scrutinize the integrity of their suppliers not only in terms of their trustworthiness but
also in terms of the health of their business; contracting with a supplier at risk of
going out of business makes little business sense in general, but firms with JIT
systems are and should be even more acutely aware of these scenarios.  Taking it a
logical step further, a firm might contract with several suppliers in order to lessen the
harm done by any one of them failing to supply.   Furthermore, for the risk-averse
firm, short-term and non-exclusive contracts with suppliers might also be attractive as
they provide both insurance and punishment against a supplier’s “misbehavior”.   A
supplier would have less incentive to misbehave and the firm would have more
recourse under such an arrangement.
Just-In-Time inventory systems provide for an attractive, cost-cutting production
system as long as risks are weighed and mitigated.  Preventative measures introduced
here are by no means meant to be an exhaustive list of how firms should approach
these risks, but rather are suggestions to the preliminary considerations firms should
make in implementing a successful Just-In-Time inventory system.
October 17, 2005 in Just-in-Time | Permalink | Comments (0)
September 26, 2005
Dell Computers: A Case Study in Low Inventory
When managers discuss low inventory levels, Dell is invariably discussed. Hell, even I've mentioned
Dell on this site. So why all the commotion? Has their low inventory REALLY helped out that much?
In short, yes. This article is primarily going to discuss how much it helped. This article will not discuss
how they achieved such high inventory turns using a state of the art just in time inventory system.
Reasoning behind need for lower inventory

The first thing that needs to be discussed is why low inventory has such a great effect on Dell's overall
performance. The reason is quite simple: computers depreciate at a very high rate. Sitting in inventory,
a computer loses a ton of value. 
As Dell's CEO, Kevin Rollins, put it in an interview with Fast Company: 
"The longer you keep it the faster it deteriorates -- you can literally see the stuff rot," he says. "Because
of their short product lifecycles, computer components depreciate anywhere from a half to a full point a
week. Cutting inventory is not just a nice thing to do. It's a financial imperative." 
We're going to assume that the depreciation is a full point per week (1%/week) and use that to
determine how much money high inventory turns can save Dell. 
This means that for every 7 days a computer sits in Dell's warehouses, the computer loses 1% of its
value. Ok, now that we know how much Dell loses for each day, let's take a look at some of Dell's data
over the past 10 years that I pulled fromwww.themanufacturer.com 
What I got from this was the inventory turns. An inventory turn, as this website successfully describes
it, is "cost of goods sold from the income statement divided by value of inventory from the balance
sheet". Typically, this is turned into a value showing how many days worth of inventory a firm has by
dividing inventory turnover by 365. I divided the inventory turnover by 52 in order to show how many
weeks worth of inventory Dell holds. 
Here are the results:
Dell’s Inventory Turnover Data 
Year      Inventory Turnover         Week's Inventory
1992      4.79                                10.856
1993      5.16                                10.078
1994      9.4                                  5.532
1995      9.8                                  5.306
1996      24.2                                2.149
1997      41.7                                1.247
1998      52.40                               0.992
1999      52.40                               0.992
2000      51.4                                1.012
2001      63.50                              .819 
Key point to notice here is that Dell was carrying over 10 weeks worth of inventory in 1993. By 2001,
Dell was carrying less than 1 week's worth of inventory. This essentially means that inventory used to
sit around for 11 weeks and now it sits around for less than 1 week.
So what does this mean for Dell?
Remember, computers lose 1 percent of their value per week. This isn't like the canned food industry
where managers can let their supplies sit around for months before anyone bats an eye. Computers
aren’t canned goods, and as Kevin Rollins of Dell put it, computers “rot”. The longer a computer sits
around, the less it is worth. 
That said, due to depreciation alone, in 1993 Dell was losing roughly 10% per computer just by
allowing computers to sit around before they were sold. In 2001, Dell was losing less than a
percent. Based on holding costs alone, Dell reduced costs by nearly 9%. 
Since 2001, Dell has continueed to lower inventory. Looking at their latest annual reports, day's
inventory has dropped by approximately a day. 
Hopefully this article provided you with a practical example that demonstrates the positive effects
lower inventory can have on a firm's overall costs. For more information regarding lawyers in the
Texas area, check out Dallas Fort Worth trucking accident attorney. For more basic information
regarding holding costs, please read A Simplified Look at the Pros and Cons of Inventory.