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JIT savings - myth or reality? - just-in-time management
Business Horizons, May-June, 1995 by Jitendra Chhikara, Elliott N. Weiss
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.
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