August 2003 | Commentary | Viewpoint

Is It Time to Jettison JIT?

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Manufacturers, retailers, and suppliers have come to rely on Just In Time inventory management, or JIT, as a way to reduce costs and improve efficiency. There is no doubt that JIT management has improved companies' bottom lines and saved manufacturers billions of dollars.

While JIT offers the potential to create significant savings for firms, it is far from being the panacea promised by some of its advocates. Just as reengineering became a euphemism for downsizing, in reality many firms implement JIT regimes with a primary goal of reducing inventory in order to free up capital.

Poorly-conceived JIT programs, however, can expose firms to costly disruptions in production and failures to meet customer demands. There are costs as well as benefits to just-in-time management, and both have changed significantly in the recent past. Inventory reduction for its own sake may be costing producers far more than they realize.

The Cost of Inventory is Falling

A major determinant of the cost of holding inventory is the prevailing real interest rate, which reflects the firm's opportunity cost of capital. Every dollar of input inventory held in the warehouse represents one less dollar earning interest in the bank or, more likely, one more dollar that the firm has to borrow in the market.

In the early 1980s, real interest rates were at historically high levels, dramatically increasing the opportunity cost of holding inventory. With interest rates hovering near levels last seen in the 1950s, firms can manage to hold larger stocks of inventory more economically.

Further, the increasing globalization of the world economy also reduces the dollar value of work-in-process inventories. As production shifts to relatively low-cost developing countries, the cost per unit and total capital invested in intermediate product falls, reducing the corresponding inventory holding costs.

Transportation Expenditures Have Risen

Transportation costs must be considered in tandem with inventory cost considerations when making logistical decisions. While the increasing globalization of the world economy has reduced the capital tied up in inventories, it has increased the distances product is shipped. Accordingly, the proportion of transportation costs as a percent of total costs has risen.

Further, the advisability of JIT depends heavily on the ability to reduce lot sizes, causing shippers to demand faster, smaller, more reliable transportation. Shippers are required to substitute modes such as less-than-truckload and air freight for more economical modes such as full truckload and rail to support JIT's exacting standards for low inventories and precision delivery windows.

Speed and reliability come at a price, however; the transportation cost per unit of each lot grows appreciably as the lot size shrinks. Slower forms of transportation are significantly less expensive per unit. The relevant question that firms must continuously ask is whether reduced inventories justify the increased transportation costs.

As a result of these trends in the United States, inventory expense reductions have been largely offset by longer shipment distances and shifts to more expensive modes of transportation. While inventory costs as a percent of GDP have fallen over the last 10 years, transportation expenditures have gradually risen despite falling transportation prices.

Variability is Inescapable

One of the central tenets of JIT is the need to eliminate variability of all kinds that gives rise to the need for inventories. However, more exacting production, and its accompanying need for more precise delivery schedules, requires increased investment in technology, personnel, and transportation assets to execute, increasing the cost of logistics management. At some point it becomes too costly to eliminate additional variability.

The internationalization of production exacerbates the problem. For example, the recent West Coast port strike dramatically affected Asian imports, and the increased scrutiny of imports following the Sept. 11 disaster wreaked havoc with Michigan auto plants, which depend greatly on Canadian suppliers.

In these cases, supply chain variability is simply inescapable. JIT practitioners are more subject to such frequent and unavoidable disruptions. The important point is that there is no reason to believe that these sorts of disruptions are abating in any way.

JIT programs that have exceeded the optimum level of inventory reduction will exhibit some of the following telltale symptoms:

  • Increase in missed sales due to finished goods stock-outs.
  • Increase in production line stoppages due to shortages of raw materials or intermediate parts.
  • Increase in embedded transportation costs per unit from more frequent or longer-distance small-lot shipments.
  • A growing reliance on expedited parts shipments.
  • Increase in expenses for logistics management services, personnel, or technology.
  • Dubious returns on supply chain and inventory management software installations.

Too Much JIT?

Just like an insurance policy, inventory protects producers against unpredictable demand fluctuations and breakdowns in the supply chain. As the cost of inventory falls, companies should buy more insurance, especially as the events we insure against with extra inventory show no signs of receding.

Increasing inventory gives the firm more than just insurance against supply disruptions. Larger inventories also allow for lower-cost modes of transportation, creating immediate savings.

Firms that employ JIT should carefully examine how the relative costs and benefits of the practice have changed, and reconsider the extent to which it is used. Firms should not become too enamored with JIT and lean inventory methods without fully considering the ramifications of these programs.

As economic conditions change, so should manufacturers' assessment of their logistics strategies. A review of the transportation and inventory cost trade-off may be in order for much of U.S. manufacturing.

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