January 26, 2011

Reframing Your Business Equation

The EOQ formula dates back to the Industrial Revolution and a 1913 article by Ford Whitman Harris, a self-trained engineer at Westinghouse Electric Company, in Factory: The Magazine of Management, a relic of another era. The article showed how to balance the fixed cost of ordering or producing a batch of goods with the cost of carrying the inventory between order periods. Graphically displayed with cost on the vertical axis and “lot size” on the horizontal axis, the elegantly simple solution occurs at the intersection of the upward sloping straight line (for inventory carrying cost) and the downward sloping curved line (which reflects the decreasing “setup” or “one-time ordering” costs spread over the batch size). The formula allowed a manufacturing manager to find the optimal lot size given the input parameters of per-unit carrying cost and per-batch fixed costs.

Today, many practitioners think that the EOQ embodies a way of thinking that’s no longer relevant. In reality, however, the trade-off between inventory carrying cost and setup cost remains. Taichi Ohno, father of the Toyota production system, knew that — as does anyone with a deep understanding of “factory physics.” Ohno’s innovation was to reframe the equation to solve for setup time rather than lot size.

Inspired by American grocery stores where consumers “pulled” products from a shelf that was continuously replenished, Ohno concluded that the optimal lot size was one unit. So, instead of trying to find the lot size that balanced setup cost and inventory carrying cost, Ohno sought to drive down setup cost to a low enough level to justify his ideal of a single unit for the lot size. To achieve his vision, Ohno turned to his industrial engineer, Shigeo Shingo, and challenged him to find a way to reduce a stamping press setup time of 12 hours to less than 10 minutes. Shingo and his team succeeded — and, as they say, the rest is history.

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