Is Excess And Obsolete Next?

Supply chain disruptions and product shortages across manufacturing and retail have caused many people to proclaim the end of just-in-time inventory practices in favor of more just-in-case stocking. Looking at the transcripts of some recent quarterly earnings calls, we are indeed seeing some inventory build-up going on. This might be a good time to revisit the rationale for just-in-time inventory versus just-in-case, because if we aren’t careful, we could be facing a wave of what the accountants call “excess and obsolete,” the write-downs of excess inventory that often follows stocking binges.

Many modern lean manufacturing practices were developed by Toyota after World War II. They were born of an effort to catch up with the American auto industry, who benefited from extensive manufacturing scale and plentiful resources. Taiichi Ohno, an industrial engineer who is considered to be the father of the Toyota Production System (TPS), recognized that the company had to work with limited resources, and he designed a manufacturing system to operate within the company’s constraints. Rather than making large batches of parts at a time, he sought to produce them at a rate that matched demand. Just-in-time was inspired by observing an American supermarket, where a customer took the desired amount of goods from the shelf and the store restocked with just enough to fill the space.

The most important consideration in the Toyota Production System (TPS) is the complete elimination of waste, and Ohno identified excessive production resources, overproduction, excessive inventory, and unnecessary capital investment as foremost. Overproduction led to excess inventory, and created the need for more workers, equipment, floor space and activities to manage inventories. Worst of all, it tied up cash and incurred the risk of write-offs. Defects or design changes were particularly problematic if there was a large inventory of parts on hand or in the pipeline, because it meant they had to be reworked or scrapped. TPS was developed over many years, and techniques such as just-in-time and production smoothing were developed through much trial and error and continuous improvement.

Western companies first began to understand TPS as a fundamentally different and better approach to production in the 1980s. Perhaps it was the times. R.C. Estall writing in the journal Area in 1985 commented, “current high interest rates, fiercely competitive markets and low profit margins have made inventory management a much more serious matter for manufacturing firms.” He went on to describe just-in-time as “a more lasting possibility of major cost reduction,” citing the potential for reducing cash tied up in inventory. He pointed out that in 1984, General Motors had 3,500 suppliers compared to 225 for Toyota, and carried five days of inventories valued in 1982 dollars at $5 billion. Toyota, in contrast, had perfected a system in which parts for its assembly lines might be delivered daily or several times a day. Much less cash tied up in inventory meant lower production costs which could be passed on to consumers in the form of lower prices.

American companies slowly adopted TPS over the next two decades, slowed by the cultural changes and shifts in mindset that were necessary to a successful implementation. But by the early 2000s, almost every production facility around the world, making everything from cars to phones to consumer packaged goods had adopted elements of TPS under the banner of “lean production” or their own named production system versions. And in many instances, they put long logistics links into their supply chains, for example sourcing auto parts from China to go into vehicles assembled in North America, because those distant sources offered more attractive prices.

Supplier Geography

When Ohno designed TPS, most of Toyota’s suppliers were geographically close. As the company expanded production globally, it also worked hard to ensure that logistics processes would support its production flow. Just-in-time assembly requires strictly scheduled deliveries – a low inventory “pull” system with high frequency, small lot size parts deliveries. For its North American assembly operations, this meant a large, flexible trucking network with dedicated routes. In recent years the company has put increased focus on managing this network so that it could respond quickly to changes, trying to both meet customer demand and minimize supply chain risks. This also included a focus on supplier location, something that is intimately intertwined with logistics planning. Around 75% of material destined for its network of North American factories is sourced in North America, with a heavy concentration in Midwestern states near its major facilities including Kentucky, Ohio, Michigan, the southeast, and southern Ontario. But this doesn’t mean Toyota carries no inventory. It carries strategic levels for things like the microchips used in cars, a lesson it learned after the East Japan earthquake and tsunami in 2011. Notably, Toyota surpassed General Motors in vehicle deliveries last year, thanks largely to comparatively better supply chain management.

Recently many people have been talking about the end of just-in-time, and a shift to more just-in-case, meaning the holding of more inventory. How we feel about this inventory build-up should depend on which sector we are looking at. Many manufactures have been struggling with logistics delays and parts shortages, so having more material on hand can make a lot of sense, especially if it comes off a long supply line from China. But forces like the semiconductor chip shortage have driven a lot of just-in-case ordering. I think a significant part of this is double-ordering, though no one likes to admit they are doing that. In supply chain vernacular, this is called “shortage gaming,” a well-known phenomenon that generally doesn’t have a happy ending. In consumer products and retail distribution, the argument is that sell-through of goods are high, and retail inventories are at historic lows. Yet some retailers have reported higher inventories in stores during their recent earnings calls.

We should not forget the original rationale for just-in-time: catch quality problems early before you have a lot of defective parts made, lessen the risk of obsolescence (especially in fast moving industries), don’t waste space storing and managing all that inventory, lessen the amount of cash tied up. We currently see a lot of construction of new warehouse space, a lot of hiring to staff them, and congestion slowing the flow of goods from ports to clogged distribution centers. Remember in the case of ocean container shipping in the eastbound Trans-Pacific trade lane, if there are 100+ ships waiting to unload off the ports of Los Angeles and Long Beach, that means a lot of inventory headed our way. If an average ship unloads 4,000 40 foot boxes (known as forty-foot equivalent units or FEUs), that means 400,000 containers full of auto parts, toys, clothing, shoes, exercise equipment and other merchandise that are eventually going to hit our shores. Hmmm … that’s a lot of stuff, and a lot of cash tied up, especially post the peak holiday season. At low interest rates, tying up cash is less of a problem. If the economy slows for whatever reason, say from higher interest rates, that could mean a lot more excess and obsolete as companies everywhere try to reduce the inventory lines on their balance sheets and generate cash. That could be pretty exciting!