That's a lot of SKUs!

« May 2006 | Main | September 2006 »June 22, 2006

Clearing up some misconceptionsSaturday morning, surfing the internet a little bit, figure I'll check out what my colleagues are writing about.  Much to my delight, I stumble across what seems to be a well-written artcile about JIT and EOQ.  Man was I wrong.  What surprised me the most was that this article seems to come from credible writers. So, instead of writing about a great article, I'd like to write about the shortcomings of it in an effort to further dissipate misconceptions regarding ordering optimization.

JIT vs. EOQ???First of all, the article I read turned out to be a JIT vs. EOQ article.  This should have been my first indication that something was wrong because JIT is NOT an alternative to EOQ, but rather an ordering method that grew out of a solid understanding of EOQ.  EOQ being an alternative to JIT is the first major misconception I'd like totackle.As I mentioned, EOQ is not an alternative to, JIT.  EOQ stands for economic order quantity and is a formula for determining the optimal quantity that should be ordered in order to minimize the sum of holding costs and ordering costs.  Essentially, it is the perfect balancing point in which if you order more frequently, although you are saving money in holding costs (the costs of carrying inventory), you are incurring more costs spent on ordering that you save in reduced holding costs.  So really you are looking to reduce two factors as much as possible:  ordering and holding.  (Basically an ordering theory based on the Law of Diminishing Returns).

JIT, or just-in-time inventory, is exactly the same.  The goal of JIT is to reduce the sum of ordering costs and holding costs.  However, JIT is used in cases where holding costs are so high that the EOQ is a very small amount.  Therefore, it is more economical to order just-in-time than it is to order large amounts very rarely.

Basically, JIT is what happens when the ratio of holding costs to ordering costs becomes so high that the formula for EOQ dictates ordering be performed so frequently that it becomes worthwhile to order as needed.

This can happen in two ways:

1.  Holding costs are naturally so high (such as in the computer industry) that the holding cost to ordering cost ratio results in an EOQ that leads to to JIT.

2.  Ordering becomes so cheap (such as the way in whichWal-Mart uses EDI) that the ratio of holding costs to ordering costs results in EOQ that leads to JIT.Either way, EOQ drives companies towards JIT because the quantity that is most economical is so small that savings can be achieved through small batches on a very frequent, or just-in-time basis.

That said, I'll say it one more time.  JIT and EOQ are not opposing models.  If you are looking for a different model, I'd recommend the news vendor model...not that it's necessarily better for you, but it is a different model with different applications.

Common Misconception #2

Inventory needs to be reduced to reduce space used in the warehouse.

While it's true that inventory takes up space, it's wrong to think this is the only cost (which the article I read focuses on as reducing holding costs).  The reality is that rent is rarely the source of high holding costs.  For automotive manufacturers such as Toyota, space is an issue, because cars are pretty damn big.  But for Intel, the true holding cost is how quickly the chips lose value.  The longer they hold on to the chips, the less they're worth.  Literally their chips and other computer parts can lose 1 point a week in value.  There are loan sharks out there that charge less than that.Bottom line: rent is only one of the many factors that determine holding costs.

So, where's this article?  Well I decided not to embarrass the site it came from, nor bless them with an web traffic...oh yeah, and I wrote this article a month ago and forgot to put the link in...sorry guys.