Little's Law:

Relating Average Flow

Time, Throughput,
and Average Inventory
Doç. Dr. Bülent Sezen

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Average Flow Time, Throughput,
and Average Inventory
1. On average, how much time does a typical flow
unit spend within process boundaries?
The answer is the average flow time T.

2. On average, how many flow units pass through

the process per unit of time?
The answer is the throughput R.

3. On average, how many flow units are within

process boundaries at any point in time?
The answer is the average inventory I.

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 Little's Law
 In a stable process, there is a
fundamental relationship among these
three performance measures.

 This relationship is known as Little's law,

which states that average inventory
equals throughput times average flow
time:

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 why Little's law must hold?
 Let us mark and track an arbitrary flow unit.

 After the marked flow unit enters the process

boundaries, it spends T time units before departing.

 During this time, new flow units enter the process at

rate R.

 Thus, during the time T that our marked flow unit

spends in the system, R x T new flow units arrive.

 Thus, at the time our marked flow unit exits the

system, the inventory is R x T.
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 Example
 In an airport security checkpoint, average
queue size I = 17.5 passengers, while
throughput is R =600 passengers per
hour = 10 passengers per minute.

 To determine the average time spent by a

passenger in the checkpoint queue, we
use Little's law, I = R x T and solve for T:

(On average, a passenger spends 1.75 minutes at the

security checkpoint)
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 implications of Little's law
1. Of the three measures of
performance, a process manager
need only focus on two measures
because they directly determine the
third measure via Little's law.

2. For a given level of throughput in

any process, the only way to reduce
flow time is to reduce inventory and
vice versa.
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 Material Flow
 A fast-food restaurant processes an
average of 5,000 kilograms (kg) of
hamburgers per week.

 Typical inventory of raw meat in cold

storage is 2,500 kg.

 The process in this case is the restaurant

and the flow unit is a kilogram of meat.

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 Material Flow..
Throughput R = 5,000 kg/week
and
Average inventory I = 2,500kg

Therefore, by Little's law:

Average flow time T = I/R =2,500/5,000 = 0.5 weeks

In other words, an average kilogram of meat spends

only half a week in cold storage. (is it fresh?)

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 Customer Flow
 The cafe Den Drippel in Ninove, Belgium, serves
on average 60 customers per night.

 A typical night at Den Drippel is long, about 10

hours.

 At any point in time, there are on average 18

customers in the cafe.

 These customers are either enjoying their food

and drinks, waiting to order, or waiting for their
order to arrive.

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 Customer Flow..
 We would like to know how long a customer spends
inside the restaurant.

 In this example, the process is the cafe, the flow

unit is a customer, and we know that:

Throughput R = 60 customers/night

Since nights are 10 hours long,

R = 6 customers/hour
and
Average inventory I = 18 customers

Average flow time T =I/R =18/6 =3 hours

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 Job Flow
 A branch office of an insurance company
processes 10,000 claims per year.

 Average processing time is three weeks.

 We want to know how many claims are being

processed at any given point.

 Assume that the office works 50 weeks per year.

 The process is a branch of the insurance

company, and the flow unit is a claim.

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 Job Flow..
Throughput R = 10,000 claims/year
and
Average flow time T =3/50 year

Thus, Little's law implies that:

Average inventory I =R x T =
10,000 x 3/50 = 600 claims

On average, then, scattered in the branch are 600

claims in various phases of processing:
waiting to be assigned, being processed, waiting to be sent
out, waiting for additional data, and so forth.

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 Cash Flow
 A steel company processes $400 million of
iron ore per year.

 The cost of processing ore is $200 million

per year.

 The average inventory is $100 million.

 We want to know how long a dollar spends

in the process.
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 Cash Flow..
 The value of inventory includes both ore
and processing cost.

 The process in this case is the steel

company, and the flow unit is a cost
dollar.

 A total of $400 million + $200 million

=$600 million flows through the process
each year.

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 Cash Flow..
Throughput R = $600million/year
and
Average inventory I =$100 million

We can thus deduce the following information:

Average flow time T =I/R =100/600 =1/6 year =2

months

On average, then, a dollar spends two months in

the process.

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 Cash Flow..
In other words, there is an average lag of
two months between the time a dollar
enters the process (in the form of either raw
materials or processing cost) and the time it
leaves (in the form of finished goods).

Thus, each dollar is tied up in working

capital at the factory for an average of two
months.

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 Cash Flow (Accounts
Receivable)
 A major manufacturer sells $300 million worth of
cellular equipment per year.

 The average amount in accounts receivable is

$45 million.

 We want to determine how much time elapses

from the time a customer is billed to the time
payment is received.

 In this case, the process is the manufacturer's

accounts-receivable department, and the flow
unit is a dollar.

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 Cash Flow (Accounts
Receivable)..
Throughput R = $300 million/year
and
Average inventory I =$45 million

Thus, Little's law implies that

Average flow time T =1/R =45/300 year =0.15 years
=1.8 months

On average, 1.8 months elapse from the time a

customer is billed to the time payment is received.

Any reduction in this time will result in revenues

reaching the manufacturer more quickly.
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 Service Flow
(Financing Applications at Auto-Moto)
 Auto-Moto Financial Services provides financing
to qualified buyers of new cars and motorcycles.

 Having just revamped its application-processing

operations, Auto-Moto Financial Services is now
evaluating the effect of its changes on service
performance.

 Auto-Moto receives about 1,000 loan applications

per month and makes accept/reject decisions
based on an extensive review of each application.

 Assume a 3O-day working month.

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 Financing Applications at Auto-Moto..
 Until last year (we will call "Process I"), Auto-Moto
Financial Services processed each application
individually.

 On average, 20% of all applications received

approval.

 An internal audit showed that, on average, Auto-

Moto had about 500 applications in process at
various stages of the approval/rejection procedure.

 In response to customer complaints about the time

taken to process each application, Auto-Moto called
in Kellogg Consultants (KC) to help streamline its
decision-making process.
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Financing Applications at Auto-Moto..

 KC quickly identified a key problem with

the current process:

– although most applications could be processed

fairly quickly, some took a disproportionate
amount of time because of insufficient or
unclear documentation.

 KC suggested the following changes to the

process (we will call "Process II"):

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 KC suggested the following
changes:
1. Because the percentage of approved applications
is fairly low, an Initial Review Team should be
set up to preprocess all applications.

2. Each application would fall into one of three

categories: A (looks excellent), B (needs more
detailed evaluation), and C (reject summarily).
A and B applications would be forwarded to different
specialist subgroups.

3. Each subgroup would then evaluate the

applications in its domain and make
accept/reject decisions.

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Financing Applications at Auto-Moto..
 Process II was implemented on an experimental basis.

 The company found that, on average, 25% of all

applications were As, 25% Bs, and 50% Cs.

 Typically, about 70% of all As and 10% of all Bs were

approved on review. (Cs were rejected.)

 Internal audit checks further revealed that, on average,

200 applications were with the Initial Review Team
undergoing preprocessing.

 Just 25, however, were with the Subgroup A Team

undergoing the next stage of processing and about 150
with the Subgroup B Team.

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Financing Applications at Auto-Moto..
 Auto-Moto Financial Services wants to
determine whether the implemented
changes have improved service
performance.

 Observe that the flow unit is a loan

application.

 On average, Auto-Moto Financial Services

receives and processes 1,000 loan
applications per month.

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Financing Applications at Auto-Moto..
Under Process I, we know the following:

Throughput R = 1,000 applications/month

and
Average inventory I =500 applications

Thus, we can conclude that:

Average flow time T =I/R

T = 500/1,000 months = 0.5 months = 15 days

(In Process I, each application spent on average 15 days with

Auto-Moto before receiving an accept/reject decision.)

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Now let us consider Process II:
The improved process

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 The improved process
 1,000 applications arrive per month.

 After initial review, 50% of these are rejected,

25% are categorized as Type A and 25% are
categorized as Type B.

 70% of Type A are accepted and 30% rejected.

 10% of Type B are accepted and 90% rejected.

 Thus, each month, an average of 200 applications

are accepted and 800 rejected.

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 The improved process..
 Furthermore, on average, 200 applications
are with the Initial Review Team, 25 with
the Subgroup A Team, and 150 with the
Subgroup B Team.

Thus we can conclude that for Process II

Throughput R = 1,000 applications/month

and
Average inventory I = 200 + 150 + 25 =
375 applications

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 The improved process..
Thus, we can deduce that

Average flow time T =I/R

T = 375/1,000 month = 0.375 months = 11.25days

Under Process II, therefore, each application

spends, on average, 11.25 days with Auto-Moto
before an accept/reject decision is made.

Compared to the 15 days taken under Process I,

this is a significant reduction.

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 Analyzing Financial Flows through
Financial Statements
 MBPF Inc. manufactures prefabricated garages.

 The manufacturing facility purchases sheet metal that

is formed and assembled into finished products-
garages.

 Each garage needs a roof and a base.

 We now consider MBPF Inc. and analyze its three

financial statements: income statement, balance
sheet, and the more detailed cost of goods sold
(COGS) statement for 2004.

 With an appropriate use of Little's law, this analysis

will help us understand the current performance of the
process.
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 Analyzing Financial Flows through
Financial Statements
 In 2004, MBPF operations called for the
purchase of both sheet metal (raw
materials) and prefabricated bases
(purchased parts).

 Roofs were made in the fabrication area

from sheet metal and then assembled with
prefabricated bases in the assembly area.

 Completed garages were stored in the

finished goods warehouse until shipped to
customers.
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Assessing Financial Flow Performance
 Our objective is to study cash flows at
MBPF in order to determine how long it
takes for a cost dollar to be converted into
recovered revenue.

 For that, we need a picture of process-

wide cash flows.

 The flow unit here is a cost dollar, and the

process is the entire factory, including the
finished-goods warehouse.

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MBPF Inc. Inventories and Cost of
Goods Sold (in Million $)

(L&OH: Labor and Overhead) 33

Financial Flows of MBPF Inc.

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 Assessing Financial Flow Performance..

On analyzing the cash flows, we arrive at the

following information:

Throughput R =$175.8 million/year

Average inventory I= $50.6 million

Thus, we can deduce average flow time as follows:

Average flow time T =I/R

=50.6/175.8 year
=0.288 years = 14.97 weeks

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Assessing Financial Flow Performance..

 So the average dollar invested in the

factory spends roughly 15 weeks before it
leaves the process through the door of the
finished-goods inventory warehouse.

 In other words, it takes on average 14.97

weeks for a dollar invested in the factory
to be billed to a customer.

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Assessing Financial Flow Performance..

A similar analysis can be performed

for the accounts-receivable (AR)
department.

 Let us find out how long it takes, on

average, between the time a dollar is
billed to a customer (and enters AR)
to the time it is collected as cash
from the customer's payment.

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Assessing Financial Flow Performance..

 Inthis case, process boundaries are

defined by the AR department, and
the flow unit is a dollar of accounts
receivable.

 Forthis part, we will use the income

statement and the balance sheet for
the MBPF Inc.

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Statement of Income for 2004

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Balance Sheet as of December, 31
2004

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 Assessing Financial Flow Performance..

 From Income Statement, note that MBPF

has annual sales (and thus an annual flow
rate through AR) of $250 million.

 From Balance Sheet, note that accounts

receivable total $27.9 million.

 When we analyze flows through AR, we

arrive at the following information:

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 Assessing Financial Flow Performance..

Throughput RAR =$250 million/year [Net Sales]

Average inventory IAR =$27.9 million [Receivables]

Accordingly, the average flow time through AR is

Average flow time TAR =IAR / RAR

=27.9/250years
=0.112 years =5.80 weeks

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Assessing Financial Flow Performance..

In other words, after

a sale is made,
MBPF must wait on
average nearly
six weeks
before sales dollars
are collected from
the customer.

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Assessing Financial Flow Performance..
 Finally, the same analysis can be done for
the accounts-payable (AP)-or purchasing-
process at MBPF Inc.

 Recall that MBPF purchases both raw

materials and parts.

 Let us find out how long it takes; on

average, between the time raw material or
parts are received and the supplier bills
MBPF (and the bill enters AP) to the time
MBPF pays the supplier.
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Assessing Financial Flow Performance..
 In this case, process boundaries are
defined by the AP department, and the
flow unit is a dollar of accounts payable.

 From Cost of Goods Sold Table, note that

MBPF spends $50.1 million on raw
materials and $40.2 million on purchased
parts per year.

 The annual flow rate through AP is

therefore $50.1 + 40.2 = $90.3 million.

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 Assessing Financial Flow Performance..
 The balance sheet shows that the average
inventory in purchasing (accounts payables) is
$11.9 million.

 Letting the subscript AP denote accounts payable,

we can use Little's law to determine the average
flow time through AP department:
TAP =IAP / RAP
= 11.9 / 90.3
=0.13 years =6.9 weeks

In other words, it takes MBPF on average 6.9 weeks

to pay a bill.

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 Cash-to-Cash Cycle Performance
 Overall, there is an average lag of about 21 weeks (15
weeks in production and 5.8 weeks in AR) between the point
at which cost dollars are invested and the point at which
sales dollars are received by MBPF.

 We call this time of converting cost dollars into sales (21

weeks) the cost-to-cash cycle for this process.

 Yet MBPF only pays for the cost dollars it invests in the
form of purchased parts and raw materials after 6.9
weeks.

 Its total "cash-to-cash" cycle therefore is

21 - 6.9 =14.1 weeks

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 Targeting Improvement with
Detailed Financial Flow Analysis
 To identify areas within the process that can
benefit most from improvement, we need a more
detailed flow analysis.

 We now consider detailed operations by analyzing

dollar flows separately through each of the
following areas or departments of the process:
– raw materials, purchased parts, fabrication, assembly,
and finished goods.

 The flow unit in each case is a cost dollar.

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Detailed Financial Flows

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 Detailed Financial Flows..
 For each department, we obtain
throughput by adding together the cost of
inputs and any labor and overhead (L&OH)
incurred in the department.

 So, the throughput rate through

fabrication is
$50.1 million/year in raw materials
+ $(60.2million in labor and overhead
= $110.3 million/year

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 Detailed Financial Flows..
 The throughput through the assembly area
is

$110.3 million/year in roofs

+ $40.2 million/year in bases
+ $25.3 million/year in labor and overhead
=$175.8 million/year

 By analyzing the various flows through

these four stages, we find the flow times
for a cost dollar through each department.

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flow times for a cost dollar through
each department

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 Detailed Financial Flows..
 Working capital in each department includes the
amount of inventory in it.

 Flow time in each department represents the

amount of time a cost dollar spends, on average,
in that department.

 Reducing flow time, therefore, reduces MBPF's

required working capital.

 Knowing this principle, we are prompted to ask,

In which department does a reduction of flow
time have the greatest impact on working
capital?
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 Detailed Financial Flows..
 Because inventory equals the product of flow
time and throughput, the value of reducing flow
time, say, by one week in any department is
proportional to its throughput rate.

 For example, because throughput through the

finished-goods warehouse is $3.38 million per
week, reducing flow time here by one week saves
$3.38 million in working capital (inventory).

 But because the throughput rate through

purchased parts is only $0.77 million per week, a
one-week reduction in flow time saves only $0.77
million in working capital.

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 Detailed Financial Flows..
 Foreach department, we plot
throughput on the vertical axis and
flow time on the horizontal axis.

 Eachdepartment corresponds to a
rectangle whose area represents the
inventory in the department:

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Representation of Inventory Values

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 Detailed Financial Flows..
 Typically, the throughput increases as we go from
inflows through the process and end with
accounts receivable because it reflects value
added.

 Observe in Figure that a one-week reduction flow

time has the largest impact in the AR department
because the rectangle for AR represents a flow
rate of $5 million per week, which is highest.

 Thus, reducing the flow time in AR by one week

would free up $5 million!

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 Detailed Financial Flows..
 The smallest possible impact of a one-
week reduction would be in the purchased
parts department; the rectangle in Figure
that represents it is the shortest and has a
flow rate of only $0.77 million.

 With a flow time of 11.12 weeks, however,

the purchased parts department offers the
greatest potential to decrease flow time
itself.

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Inventory Turns (Turnover Ratio)
 In addition to the average level of inventory
and the average flow time, practicing
operations managers, accountants, and
financial analysts often use the concept of
inventory turns or turnover ratio to show how
many times the inventory is sold and replaced
during a specific period.

 In the accounting literature, inventory turns is

defined as the cost of goods sold divided by
average inventory.

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 Turnover Ratio..
 The cost of goods sold during a given period
is nothing other than throughput, expressed
in monetary units.

 Therefore, in our broader view of inventory,

inventory turns, or turnover ratio, is defined
as the ratio of throughput to average
inventory.

Inventory turns =R / I

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 Turnover Ratio..
But we can use Little's law, I = R x T,
to come up with an equivalent
definition of inventory turns as follows:

Inventory turns = R/I

= R/(R x T)
(R cancels out)
=1 / T
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 Turnover Ratio..
 In other words, inventory turns is the
reciprocal of average flow time and thus is
a direct operational measure.

 This directly shows why high turns are

attractive: a company with high inventory
turns has small flow times and thus is
quicker at turning its inputs into sold
outputs.

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 Turnover Ratio..
 To derive a meaningful turnover ratio, we
must specify the flow unit and measure
inventory and throughput in the same
units.

 Some organizations measure turns as the

ratio of sales to inventory.

 This measure has a drawback in that sales

(a measure of throughput) are expressed
in sales dollars but inventory is measured
in cost dollars.
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 Turnover Ratio..
 A better way to calculate turns is the ratio
of cost of goods sold (COGS)- labor, materials,
and overhead expenses allocated to the products- to
inventory because both are measured in
cost dollars.

 Measuring turns as the ratio of sales to

inventory can lead to erroneous
conclusions when measuring process
performance.

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 Example
Let us return to the MBPF financial statements to
analyze inventory turns.

We will use cost dollar as the flow unit and

designate the factory and the finished-goods
warehouse as the process:

Turns =Throughput/Inventory
= ($175.8/year) / $50.6 = 3.47/year

In other words, during one year MBPF Inc. sells and

thus replenishes its average inventory about
three times.

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