SATURDAY, NOVEMBER 25, 2017
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Implementation Financial Analysis What Belts Should Know About the Cost of Poor Quality

What Belts Should Know About the Cost of Poor Quality

Of all the activities and tools used in the Measure phase of DMAIC, the thing many Belts struggle with the most is the cost of poor quality (COPQ), or the cost associated with the quality of a work product. Belts need to understand what COPQ includes, and what it does not, so they can determine and justify projects, and gain buy-in for efforts based on financial findings.

What Is the Cost of Poor Quality?

COPQ includes:

  • Those costs generated as a result of producing defective material.
  • The cost involved in fulfilling the gap between the desired and actual product or service quality.
  • The cost of lost opportunity due to the loss of resources used in fixing the defect, including all the labor cost, rework cost, disposition costs and material costs that have been added to the unit up to the point of rejection.
  • A portion of the appraisal cost if there is an inspection point.

COPQ does not include detection and prevention cost.

Other Cost Acronyms

One reason Belts may find COPQ confusing is that it is not the only cost acronym. Therefore, it is also helpful to know the meaning and similarities of these other acronyms:

  • Cost of Quality (COQ): This is the amount of money a business loses because its product or service was not done right in the first place. From fixing a warped piece on the assembly line to having to deal with a lawsuit because of a malfunctioning machine or a badly performed service, businesses lose money every day due to poor quality. For most businesses, this can run from 15 percent to 30 percent of their total costs. As defined by Philip B. Crosby in his book Quality Is Free (McGraw-Hill, 1979), COQ has two main components: cost of conformance and cost of non-conformance.
  • Cost of Conformance (COC): This is the total cost of ensuring that a product is of good quality. It includes costs of quality assurance activities such as standards, training and processes, and costs of quality control activities such as reviews, audits, inspections and testing. COC represents an organization’s investment in the quality of its products.
  • Cost of Non-conformance (CONC): An element of COQ representing the total cost to the organization of failure to achieve a good quality product, CONC includes both in-process costs generated by quality failures – particularly the cost of rework – and post-delivery costs including further rework, re-performance of lost work (for products used internally), possible loss of business, possible legal redress and other potential costs. This is similar to COPQ.

When Cost of Poor Quality Matters

A primary element of an effort or project is estimating the financial value to justify it. Some practitioners justify and report projects with a soft savings undertone, meaning there is an inherent value that is understood to be good for the business but may be difficult to quantify. Other practitioners, however, are required to show a financial impact to the bottom line before starting a project. In this situation, using a COPQ or CONC metric can be beneficial. Rather than focusing on how much a single project will achieve in value, practitioners can track the metric value on a monthly basis to compare performance with the prior year’s costs. For example, while working on a project to reduce staff turnover may be difficult to validate financially, especially in a short time frame, the work can feed into reducing COPQ costs for human resources, such as relocation expense for new employees and costs for processing exit interviews.

Green Belt Involvement

Green Belts should be provided with a way to identify costs being incurred by the organization to ensure products or services delivered are acceptable in the eyes of the customer. They should learn about identifying COPQ in the Define phase. This step allows the Champion to both quantify and measure the impact of process improvement activities in a way that translates those impacts to the bottom line. During the Measure, Analyze and Improve phases, the Green Belt can discover additional savings opportunities.

Using COPQ Numbers to Gain Buy-in

Two processes that have the same defect measure may seem equal. However, after calculating COPQ, a practitioner may find the dollar impact of one process may be much greater than the dollar impact of the other. COPQ numbers are understandable without Lean and Six Sigma training because they are in dollars. This helps gain buy-in from the team for improvements and enables the team to identify major opportunities for cost reduction and revenue. Because most project justification is based on measurable performance, COPQ benefits can be itemized and validated by the finance area. In short, using COPQ:

  • Quantifies the size of the quality improvement in financial terms.
  • Prioritizes project opportunities and monitors project progress in terms of financial impact.
  • Identifies sources of financial impact, including improving efficiencies, reducing cost and avoiding cost.
  • Establishes the financial baseline/current process cost, developed from historical financial experience and data.

Ways to Measure Financial Benefits of High Quality

Avoiding the costs associated with poor quality can lead to financial benefits. Three classifications are used to measure these benefits:

Hard Dollar Financial Impact

Hard savings or hard dollar financial impacts are Lean and Six Sigma project benefits that allow organizations to do the same amount of business with less employees (cost savings) or handle more business without adding people (cost avoidance). These are referred to as hard savings, and have typically shown:

  • Reduced error rate resulting in the elimination of rework.
  • Reduced error rate resulting in the reduction of claims.
  • Expedited collection of claims.
  • Faster speed to market, resulting in a more competitive product or service.

Soft Dollar Financial Impact

Soft savings are benefits such as reduced time to market, cost avoidance, lost profit avoidance, improved employee morale, enhanced image for the organization and other intangibles that may result in additional savings to the organization, but are harder to quantify. Soft savings have typically shown:

  • Reduced time needed to process, resulting in a savings of staff hours dedicated to the task.
  • Elimination of steps or functions in a workflow.
  • Improved processing, facilitating workflow in other areas.
  • Development of best practices useful in other areas.
  • Increased client satisfaction through improved turnaround time, error-free deliverables and improved communication.

Cost Avoidance

Simply stated, cost avoidance refers to avoiding the costs in the first place.

Using the Financial Aspect of Costs Within DMAIC

The financial side of determining and using the COPQ can usually be related to the individual phases of DMAIC in the following manner:

  • Define: Determine financial model and estimate financial impact
  • Measure: Calculate current process cost and/or initial COPQ and establish preliminary financial benefit targets
  • Analyze: Refine the financial opportunity
  • Improve: Perform cost-benefit analysis
  • Control: Verify financial opportunity realized
  • Realization: Track actual project performance for 12 months and validate financial benefits as part of control plan

For practitioners preparing to report on COPQ through a cost-benefit analysis in the Improve phase, the following template may serve as a model (Table 1).

Table 1: Cost-benefit Analysis Template
CostsOne-timeAnnual
Current annual process cost
Improved annual process cost
Difference (savings) or cost
 $104,736
$50,000
($54,736)
Cost to implement:
– Software upgrade (adjustment to ranger software)
– Training (28 hours x $57 an hour)
Total cost to implement
$2,000
$1,596
$3,596
 
BenefitsOne-timeAnnual
Annual process cost savings: soft savings from efficiency ($54,736)
Annual customer savings: reduce uplift (provide details on calculation and assumptions) ($30,000)
Other, non-quantifiable benefits (COPQ)
– Reduce risk to customers by increasing price certainty
– Increase customer satisfaction with collateral processing
– Improve organization reputation
 N/A
Total Benefits ($84,736)
Net Cost/Benefit$3,596($84,736)

The Iceberg Effect

COPQ is sometimes also known as the iceberg because when people view an iceberg, they usually see only the tip. Providing a poor quality product also carries hidden risks, which should be included when calculating COPQ. This concept is illustrated in Figure 1.

Figure 1: Cost of Poor Quality - The Iceberg Effect

Figure 1: Cost of Poor Quality - The Iceberg Effect

Avoid Poor Quality at All Costs

Financial analysts have estimated that COPQ typically amounts to 5 percent to 30 percent of gross sales for manufacturing and service companies. Even non-profit organizations have similar numbers as a part of their bottom-line operations. Reducing COPQ may have the power to transform marginally successful companies into profitable ones. Yet many managers do not even know what their company’s COPQ is.

All levels of management, however, recognize that quality is an absolute necessity to survive and succeed in today’s business environment. Therefore, understanding and determining COPQ are imperative to the success of an organization. In addition, COPQ provides quality management teams with the leverage necessary to support their process improvement efforts in the absence of hard dollar and/or easily quantifiable financial calculations.

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Comments

S.Coleman

Excellent explanation and advocacy for an area some execs still see as fuzzy. I am working to bring “Quality Management” concepts into a higher education environment: it’s a challenge. This article will help inform them.

Reply
D. Renner

Excellent article! Simply the fact that some companies call this ‘cost of production quality’ rings a bell. Quite often it is mistakenly described as the cost to achieve a certain level of quality but it is in fact nothing but a nice phrase for poor quality produced during the first attempt. This article is very educational.

Reply
Chris Seider

I thought I had posted this….

That Fig 1 looks awfully familiar. :)

Reply
Rajives Singh

Brilliant explanation and written outstandingly. With so much information readily available yet so many organisation fail due to COPQ in their products and services.

Reply


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