Inventory Management Review

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.

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.

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 from www.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.