November 08, 2005

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.

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Comments

I think this is a really good overview of JIT and the benefits it can bring a firm. Dell, McDonald's, and Walmart have the resources to implement big JIT systems. I'd be interested to see if you have any advice for small businesses looking to implement JIT.

Posted by: acts_as_flinn | Aug 11, 2006 11:33:33 PM

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