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