Total Corporation is considering implementing a JIT production system. The new system would reduce current average inventory levels of $2,000,000 by 75% but would require a greater dependency on the company’s core suppliers for on-time deliveries and high-quality inputs. The company’s operations manager, John Chan, is opposed to the idea of a new JIT system. He is concerned that the new system will be too costly to manage, will result in too many stock outs, and will lead to the layoff of his employees, several of whom are currently managing inventory. He believes that these layoffs will affect the morale of his entire production department. The plant controller, Stephen Li, is in favour of the new system, due to the likely cost savings. John wants Stephen to rework the numbers because he is concerned that top management will give more weight to financial factors and not give due consideration to nonfinancial factors such as employee morale. In addition to the reduction in inventory described previously, Stephen has gathered the following information for the upcoming year regarding the JIT system:
• Annual insurance and warehousing costs for inventory would be reduced by 60% of the current budgeted level of $350,000.
• Payroll expenses for current inventory management staff would be reduced by 15% of the budgeted total of $600,000.Additional annual costs for JIT system implementation and management, including personnel costs, would equal $220,000.
• The additional number of stock outs under the new JIT system is estimated to be 5% of the total number of shipments annually. 10,000 shipments are budgeted for the upcoming year. Each stock out would result in an average additional cost of $250.
• Total’s required rate of return on inventory investment is 10% per year.
Required:
a) From a financial perspective, advise whether Total Corporation should adopt the new JIT system.
b) Advise Stephen Li whether he should rework the numbers.
c) Advise how Stephen Li could manage John Chan’s concern.