The Cost of Quality

As summer comes to a close and we observe the "back to school" activities around us, I thought it would be appropriate to engage in a slightly more academic, albeit highly practical, activity that can help take your business to the next level of performance. It involves finding out just how much money your company wastes due to poor quality, inefficiencies, defects, rework and other no-value-added activities.

It's called a Cost of Quality assessment.

Several issues ago, I introduced the Cost of Quality analysis as a measurement used to make people, particularly managers, aware of the financial impact of poor quality. This analysis helps identify opportunities to improve profitability without having to increase sales. It can typically uncover cost savings opportunities equivalent to 20 percent of total sales in manufacturing businesses and 30 percent of total expenses in service businesses. Interested in determining the opportunity in your business? Here's how.

Determining the Cost of Quality starts with understanding the essential elements: the Cost of Nonconformance, error-free costs, Cost of Conformance and Cost of Lost Opportunity.

Cost of Nonconformance (CONC) represents what it costs to do things wrong. This is often referred to as the measurement of quality. Examples of CONC include expenses relating to customer returns, warranty work, useless reports, redundant paperwork, reprocessing, rework, customer complaint handling, unplanned service and excess inventory.

CONC is the cost of wasted time, money and effort -- costs that can be avoided. As I had mentioned earlier, it is not unusual for the CONC to make up a significant part of overall operating expenses.

Error-Free Costs are the expenses incurred from operating processes and activities without mistakes. Planned labor, material and other resources utilized to generate your business products or services would be included.

Cost of Conformance (COC) is the cost of doing things right the first time. It covers all the things done to make sure business activities are done correctly, meeting all customer and business needs. Unlike error-free costs, COC includes only expenses for special efforts taken to ensure that things are done correctly. Examples include costs associated with reviewing order entries for keypunch errors, proofing documents, product inspection and testing, training, preventative maintenance on equipment and time associated with planning meetings.

Cost of Lost Opportunity, on the other hand, isn't money being spent. It's money that isn't being made. When a company is unable to satisfy a customer, it will often lose some or all of that customer's business. The lost opportunity represents the profit a company doesn't make because of the customers it loses due to lack of product and service quality.

Now that we understand these elements, we can begin to construct the Cost of Quality in an organization. It is calculated by adding up the CONC, the COC and the Cost of Lost Opportunity.

Cost of Quality = Cost of Nonconformance + Cost of Conformance + Cost of Lost Opportunity

The goal is to minimize the total cost of quality. By doing so, companies can minimize the total operating expenses for any given level of sales and activity.

Here is how a company's Total Cost of Quality may be affected by investing and committing to doing things right the first time:

As your company invests time and money to do thing right the first time, the COC increases. Waste due to poor quality then decreases -- therefore, the CONC decreases, and so does the Cost of Lost Opportunity.

As high quality in all business activities becomes a part of habit and routine, the company spends fewer dollars to ensure quality. Employees then internalize the new way of doing business, and the COC decreases.

The Best Part

Because of these efforts, the total Cost of Quality decreases. Total operating expenses decrease, and profit increases.

The goal is to minimize the total expenses in the company by focusing on minimizing CONC. An excellent starting point is to conduct a Global Cost of Quality Analysis. This can tell you what your COC and CONC are. This high-level approach can take very little time with the involvement of the right people, and information provided by your company's chart of accounts and current financial statements.

Step 1: Go line by line down through your chart of accounts and determine which ones relate directly to COC or CONC. Then write COC or CONC next to each such account. For example, if you had an account for product returns, label it CONC. If you have inspection or quality control and there is an account for this, label it COC. At this point, we are looking for whole accounts that fit neatly into the COC or CONC categories.

Step 2: Consider who may be involved in activities that relate primarily to either COC or CONC. A safety trainer is a good example of COC. His/her salary and benefits would fall into this category. Good examples of CONC include employees dedicated to expediting, rework, customer returns or complaints.

Step 3: Look at activities that one or more employee(s) perform as a part of the job that relate to COC or CONC activities. Let's say that a number of orders delivered to customers each month was wrong or incomplete. For each incomplete order, there are a number of steps that must be performed to make it right. Consider the labor and resources consumed to make this order right. This could include time spent by a customer service representative, time spent returning an order and reprocessing the corrected order. By considering the time and resources used in these activities, we can understand the total CONC associated with a wrong or incomplete order. A seemingly small issue such as an incorrect shipment can easily cost a company hundreds of dollars to rectify once all costs are considered.

Step 4: In some situations, you can determine the cost of an activity from start to finish and come up with a standard price for it. In our previous example, you may determine that for each wrong or incomplete order it generally costs $100 for time and other resources. You can now use this standard cost and multiply it by the total number of occurrences to come up with a total CONC.

Step 5: The last technique involves understanding what an activity should cost in the best case scenario and comparing current performance with this target. If industry comparisons or benchmarks are available, use them to compare your company's performance in a specific area with the best in the industry. The costs associated with the difference between your performance and the best performance represent CONC.

Total all of the identified CONC and COC using the previous techniques to identify the total cost of conformance and nonconformance in your business.