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Just-in-time production (JIT) is a business strategy in which a manufacturer produces each item as it is ordered, rather than keeping an extensive amount of surplus products on hand. The chief benefit of the strategy is that it allows businesses to ensure that there is always a buyer for any item produced, keeping inventories low. If there are no customers wanting to purchase an item, production stops.
Key Takeaways
- Just-in-time (JIT) is a production strategy in which a company only produces an item after a buyer has made an order, therefore keeping inventories low.
- Lower inventories make a company look more efficient and also boosts the return on total assets (ROTA), a key measure of how well a company uses funds to boost profits.
- JIT allows companies to spend less on parts and labor, as well as limit the risk of items losing value from sitting around too long.
Why Low Inventories Matter
The JIT production process means inventory levels are kept to a minimum. A low inventory figure on the balance sheet means a higher inventory turnover ratio, making the company look more efficient. The inventory turnover ratio is a metric used in corporate finance to estimate how efficiently a company is selling its products.
By dividing the total cost of goods sold (COGS) by the average inventory over a given period, the inventory turnover ratio reflects the number of times the company has sold its total average inventory. A company with little to no inventory has a much higher ratio than a company with equivalent COGS expenses that utilizes a more anticipatory production strategy.
High inventory turnover ratios are considered a good sign of operational efficiency, effective purchasing management, and productive use of advertising and promotional campaigns aimed at generating sales.
How the JIT Strategy Boosts Profitability
The JIT production strategy has an important effect on other measures of corporate efficiency and profitability. Lower inventory means a reduced total asset figure on the balance sheet, all else being equal. This translates directly into a higher return on total assets (ROTA) ratio. The ROTA ratio divides a company’s earnings before interest and taxes by its total assets to determine how effectively the business’s operational model utilizes invested funds to generate profit.
The asset turnover ratio is another efficiency ratio that reflects a company’s ability to generate revenue by dividing net sales by average assets for a specific time period. Decreased inventory means a smaller denominator in both these formulas, leading to healthier ratios across the board.
JIT Means Lower Costs For Materials and Labor
Apart from the improvement in comparative metrics, the JIT production strategy is advantageous to a company’s profitability in many other ways. Sales-contingent production means lower costs for both raw materials and labor. If a business is not looking to produce a backlog of goods for sale, it need only purchase those materials required for items that have already been ordered, leading to a reduction in COGS.
Labor expenses are also reduced since the number of man-hours needed to fulfill orders is likely lower than would be required for full-time production. On-demand production means fewer items sitting on shelves depreciating in value if sales take a downturn, and the risk of losing money if a product becomes obsolete is virtually eliminated. While many companies must invest capital in large warehouses to store products for sale, minimal inventory means almost nonexistent storage expenses. The reduction of these key production and operational expenses means higher gross and operational profits, which directly contribute to a healthier bottom line.
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Image and article originally from www.investopedia.com. Read the original article here.