How to Reduce Inventory Costs with a Just-in-Time Inventory System
Manufacturers and distributors need to have inventory available to ensure a steady flow of goods to producers and consumers. Selling inventory also keeps a steady flow of capital coming into your business. However, handling and storing materials can be costly.
How Can Your Manufacturing or Distribution Business Reduce Inventory Costs?
When considering the costs of housing inventory, it is important to distinguish between value added activities and non-value added activities.
- Value added activities add value to a product or service at a given stage in the production cycle or supply chain; customers are willing to pay for value added activities because they make the product or service better
- Non-value added activities increase the final cost of the product or service, but do not increase the value to the customer
The cost of warehousing inventory is a non-value added activity. Upon receiving merchandise, your customer’s only concern is, “Does it work and is it going to perform the function for which it was purchased?”
Just-in-time (JIT) purchasing and just-in-time production help combat these undesirable, non-value added inventory costs. These demand-pull inventory systems are applied by requiring that raw materials arrive in your warehouse exactly as they are needed for production or distribution. The goal of JIT systems is to eliminate all non-value added activities.
The Benefits of Just-in-Time Inventory Systems
JIT purchasing and productions systems offer many advantages over traditional systems, such as:
- Lower investment in inventory
- Reduced space required to store inventory
- Reduced risk of defective and obsolete inventory
- Reduced manufacturing costs
- Simplification of your costing system (all goods sold / produced will flow to the cost of goods sold since inventory is sold and produced only when needed)
The primary benefit of a JIT purchasing or production system is the reduction of inventory … ideally to zero. Reducing inventory will decrease the cost of handling and storing materials. It will also free up space that can be used for more cost effective activities.
The Supply Chain Crisis and Impact on Just-in-Time Inventory Systems
Despite the multiple benefits of JIT systems, recent history has shown that this method has its challenges.
When the COVID-19 pandemic hit the United States in 2020, consumer demand for goods skyrocketed. Despite this, the availability of skilled labor declined through 2020 and 2021. The labor shortage, combined with unpredictable disruptions in the supply chain, meant manufacturers and distributors couldn’t obtain inventory fast enough to meet consumer demand. As a result, JIT systems started to fail for some businesses.
If you choose to implement a JIT system in today’s market, it's important to understand the tradeoff between risk and resilience. With JIT systems, there is a notable risk that you might not be able to get inventory fast enough to meet consumer demand.
In today’s environment, it’s important to maintain a safety stock of inventory. Safety stock is extra quantities of specific items that you purchase in case that item goes out of stock in the future. Think of it like setting up an emergency fund for your finances. To figure out the quantity of safety stock you’ll need, you need to determine the number of products sold per day and multiply it by the number of days’ worth of safety stock you think you’ll need. Be sure to factor in variables such as lead-time and seasonal demand.
While safety stock will require increased investment in inventory, increased storage and handling, and a reduction in liquidity, it can save your company the headache of trying to purchase items at higher costs (due to demand) or finding replacements if supply chain issues become a problem.
JIT systems can be a great way to increase profitability and preserve cash flow, especially when markets are stable. However, it’s important to keep in mind the risk and resilience trade off and keep a safety stock supply to protect your business.
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This post was originally published in July 2013 and has been updated for accuracy and comprehensiveness.
Published on December 16, 2021