SUNDAY, OCTOBER 21, 2018
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Implementation Financial Analysis Ask the Expert: The Topic – Six Sigma and Return on Investment

Ask the Expert: The Topic – Six Sigma and Return on Investment

John Lopez-Ona
President
Six Sigma Qualtec
Princeton, New Jersey, USA

Q: Why do you think people hear stories about companies failing to achieve adequate return on their Six Sigma investment?

A: We hear stories about these failures because they occur. The question is why do they occur? One significant reason a program doesn’t achieve targeted returns is a lack of senior management commitment. Invariably when this is lacking, the initiative becomes a training exercise characterized by poorly conceived or poorly supported projects rather than a plan to drive business results with projects based on relevant business cases. Training is expensive. A big expense with no focus on results yields little or no returns.

If I were tasked with a Six Sigma project which management wasn’t fully supporting, I’d scale back my expenses to match to the number of good projects I could convince well-intentioned Champions to support. By driving results on those projects while maintaining low expenses, I’d ensure a high return on investment which I would market internally to gain the senior support needed to ensure success of a larger expenditure.

Q: How do you measure return on investment (ROI) in a Six Sigma initiative?

A: The return on any investment compares the costs, or investment, over time to returns over time, discounted by a risk-adjusted rate to take into account the value of money over time. Due to the tremendous impact of Six Sigma, the most sensitive variable in this calculation is the returns, and not the costs.

Returns can be segregated into hard and soft savings. Hard savings are those that are more easily traceable to actual cash, like reduced waste or headcount reductions. Soft savings are those that are less “bankable” like reductions in cycle times. While hard savings calculations are pretty much the same from project to project and company to company, there is tremendous room for interpretation with soft savings. Common and simple errors in calculating soft savings are things like counting gross sales improvements rather than the net from sales, or measuring working capital reductions rather than the reduced financing costs. But even with all the room for interpretations and mistakes in soft savings, not to develop an accepted methodology for assigning value would disregard a significant source of benefits.

Whether hard or soft, one interesting observation is that few organizations calculating returns differentiate between one-time and recurring savings. Recurring savings obviously are worth a multiple of one-time savings and should be counted by calculating the present value of the related cash flows over the time period they recur. I think organizations don’t do this in the interest of being conservative, but they don’t realize how conservative it is.

However, the greatest difficulty in measuring ROI in any performance improvement initiative is assigning value to non-cash-yielding improvements, like if the initiative boosts sales growth rates or advances the company’s competitive position. 
 
These kind of improvements can impact a company’s intrinsic value, thus creating shareholder value well in excess of any project savings. To assign value to such improvements, one must look to more sophisticated valuation theories such as Economic Value Analysis, which addresses shareholder value in a more significant way.

Q: What are the critical success factors in achieving a satisfactory ROI?

A: The most critical success factor is project selection.

If ROI is your objective, you have three variables with which to maximize it – lower the investment, raise the annual returns, or reduce the time in which gains are achieved. The most sensitive variable is raising targeted returns. Returns are a function of many interrelated variables. Some of these are the quality of the training event, the quality of the candidates, senior management support and the size of the opportunity. But I would argue that the most sensitive variable is the selection of projects.

The success of projects is most dependent on alignment to the company’s initiatives, assuming the initiatives have been correctly aligned to stakeholder concerns. In its simplest form, the initiative could be cost savings. Of course, once again, targeting strategic goals that redefine the company can have a much greater effect on the returns on an initiative.

A good program will hit enough hard savings projects to achieve an acceptable ROI, move to goals with even greater impact, such as revenue projects that can change the company’s growth rate, and finally, move to goals aimed at redefining the company’s competitive position.

Q: In this tough economic climate, why should companies spend money on Six Sigma?

A: Quite simply, there are few investments that can provide the same rate of return. However, once the low hanging fruit is harvested, the success of the implementation becomes more about alignment to the right problems – and that is a more difficult objective.

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Comments

ripstaur

Good stuff! There are a couple of other very good but rarely used methods for estimating savings up front, and tracking them going forward. Throughput accounting has been around for a while, and represents a more accurate way to represent actual in-systems costs. Another paradigm, based on the Taguchi loss functions, enables you to quantify current costs of production and estimate cost savings due to operating on target at reduced levels of variation. There are two good resources on this: “The Process Evaluation Handbook” and the more recent “Reducing Production Costs;” both are by Don Wheeler at SPC Press.

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