Part I: The Quantum of WIP: "How much work-in-process is enough?"

(excerpted from The Pipeline)

“Let’s talk about the amount of work-in-process that we need or should have”, said the intrepid, results-based consultant. “Recall that we said the size and capacity of a pipeline are not the same thing. Size is defined by the amount of work-in-process it carries. Capacity is the rate of throughput – or output – in relation to the size of the pipe.

“The question becomes, how much work-in-process do we need or want? The answer is, we want only what we need. We only want what we need to produce the output, we only want what we need to utilize the capacity. If we have too much work-in-process, it is size that is wasted, size we paid to have but didn’t use. On the other hand, if we don’t have enough work-in-process, it’s dangerous, because we can’t protect the capacity of the pipeline from variation and uncertainty.

“So – how much work-in-process is enough?”

“I can speak to that question”, said the CFO. “Since RB Builders has now adopted a very disciplined business model, the company pays very close attention to its Debt-to-Equity Ratio. D/E prescribes the amount of equity, which, in turn, limits the amount of debt, primarily used to fund the level of work-in-process; I suppose you could also say the D/E Ratio tells us how much equity is required for a prescribed level of debt.

“That translates into two scenarios of how much work-in-process RB Builders can have – or should have – on its Balance Sheet.

“The first scenario is what we call “Maximum WIP”. Max WIP translates into a maximum number of units RB Builders is allowed to have under construction and a ceiling on the amount that can be outstanding under the company’s construction lines of credit. The second scenario is what we call “Necessary WIP”, which is the number of homes and the associated amount of construction debt that RB Builders should have, given its current ability to utilize its production capacity, and achieve its targeted Revenue and closings.

“The difference between Max WIP and Necessary WIP is the difference between what is currently needed and what is allowed. There is another gap, and that is the gap between Necessary WIP and what we could call “Minimum WIP”. The measure of the gap between Necessary WIP and Minimum WIP is often the gap between targeted and achieved cycle times, the gap between targeted and achieved levels of productivity, the gap between targeted and achieved utilization of production capacity.

“Necessary WIP is based on current cycle time and capacity, so one of the results of an improvement in cycle time, inventory turn, capacity utilization, and productivity is a decreasing level of Necessary WIP, towards Minimum WIP – which is obviously something we want to see.”