COPQ Training Materials

SYSTEMS Quality Consulting 1

Cost of Quality as a Driver for

Continuous ImprovementPresented by

Roger E OlsonPartner


Agenda

1. Linking Quality Improvement to Profits2. Cost of Quality Definitions and Types 3. Understanding Cause and Effect in

COQ Measurements4. Establishing COQ Baseline5. Cost Driver Analysis


History/Background of COQ

• Joseph Juran first discussed cost of quality analysis in 1951 in the first edition of Quality Control Handbook

• Armand Feigenbaum identified the four cost categories in 1956 in “Total Quality Control” in the Harvard Business Review, Vol. 34, No 6



Armand Feigenbaum’s original categories• Cost of Control

– Prevention costs– Appraisal (i.e., inspection) costs

• Costs of Failure of Control– Internal defect costs– External defect costs



• The Quality Cost Committee was established by the then ASQC in 1961

• Philip Crosby, a former CEO, popularized the concept of COQ with his book Quality is Free in 1979

• The current revisions of ISO 9000, QS-9000 and AS9100 reference the use of COQ in quality improvement



Crosby’s categories• Price of Conformance (POC/COC)

– Prevention costs– Appraisal costs

• Price of Nonconformance (PONC/CONC)– Internal defect costs– External defect costs


Deming, Juran, Crosby on COQ

• Deming – the cost of nonconformance, and the resulting loss of good will, is so high that measuring it is not necessary

• Juran – as defect prevention increases, the cost of scrap/rework decreases faster. Need to know where to look

• Crosby – money is the language of management, you need to show them the numbers

(Philosophy)


Juran and Crosby on COPQ

The cost of poor quality (COPQ = PONC):• “COPQ is the sum of all costs that would

disappear if there were no quality problems.”- Juran

• “You can easily spend 15 - 30% of your sales dollars on PONC.” - Crosby

• “In most companies the costs of poor quality runs at 20 - 30% of sales.” - Juran


Something to Think About…

• Net profits for many companies is less than 5% of sales

• COPQ on the average is 17% of sales• Total COQ on the average is 25% of sales• COPQ is some companies is as high as 40%

of sales• COPQ is typically 3 to 6 TIMES as large

as profits


Example 1

Paper Mill – April 2004 Report to New CEO• Sales: $220,000,000 (460 employees)• POC: $7,600,000• PONC: $35,300,000• COQ: $42,900,000• EBITDA: $12,678,000• Net Profit: $3,150,000


Example 1

Paper Mill – April 2004 Report to New CEO• Sales: $220,000,000• POC: $7,600,000 (>90% appraisal)• PONC: $35,300,000• COQ: $42,900,000• EBITDA: $12,678,000• Net Profit: $3,150,000• Net Profit/Sales = 1.43%

3X 11X


Example 1

Paper Mill – April 2004 Report to New CEO• Sales: $220,000,000• POC: $7,600,000• PONC: $35,300,000• COQ: $42,900,000• EBITDA: $12,678,000• Net Profit: $3,150,000• Net Profit/Sales = 1.43%

~ 5X


Example 2a

Transportation Industry Supplier (1998)• Sales: $130,000,000 • COC: $4,400,000 (92% appraisal)• COPQ: $18,500,000• COQ: $22,900,000• EBITDA: $6,531,000• Net Profit: $2,050,000

3X 9X

• Net Profit/Sales = 1.57%


Example 2b

Transportation Industry Supplier (2003)• Sales: $185,000,000 • COC: $8,600,000 (45% appraisal)• COPQ: $8,100,000• COQ: $16,700,000• EBITDA: $19,900,000• Net Profit: $6,650,000

0.5X 1.2X

• Net Profit/Sales = 3.6%


Don’t Let Poor Quality Costs Eat Your Profits!

COPQ

Profits


1. Linking Quality Improvement to Profits

• Background of Quality Costs• Evolution of Quality• Traditional vs Value Driven Quality Strategy


What is Quality?

Quality is “fitness for use”

(Joseph Juran)

Quality is “conformance to requirements”

(Philip B. Crosby)

Quality of a product or service is its ability to satisfy the needs and expectations of the customer


““Inspection with the aim of finding the bad ones Inspection with the aim of finding the bad ones and throwing them out is too late, ineffective and and throwing them out is too late, ineffective and

costly. Quality comes not from inspection but costly. Quality comes not from inspection but improvement of the process.improvement of the process.””

Dr. W. Edwards DemingDr. W. Edwards DemingFounder of the Quality EvolutionFounder of the Quality Evolution


All quality improvement of a lasting nature occurs as the result of a project. Joseph Juran


Traditional “Strategy”

• Historically, organizations tend to treat strategic planning and quality improvement planning as two separate and unrelated activities

• Strategic planning tends to be regular and scheduled, but with no follow up

• Continuous improvement is not a process, it happens randomly, with no connection to the “big picture”


Value Driven Quality Strategy

• Starts with a focus on the customer• Organizations treat strategic planning and

quality improvement planning as an integrated activity

• Strategic planning is a function of need, not the calendar

• Continuous improvement is a process, it happens regularly, with a connection to the “big picture”


Cost of Quality Definitions and Types

Total Quality Costs represent the difference between the actual (current) cost of a product or service and what the reduced cost would be if there were no possibility of substandard service, failure to meet specifications, failure of products, or defects in their manufacture.

Campanella, Principles of Quality Costs


Prevention

The costs of all activities specifically designed to prevent poor quality in products or services. Examples include:

• Quality planning• New product reviews• Quality education

• Process capability evaluations• Supplier capability surveys• Quality improvement projects

These are all planned, proactive activities


Income StatementIncome

Sales $4,100,000Returns ($105,000)

Income $3,995,000

Cost of Goods SoldLabor $960,600Materials $1,118,000

COGS $2,078,600Expenses

Salaries $483,800Services $98,400Depreciation $194,340Training $3,300Supplies $36,900Interest $61,500Rent $287,000Accounting $24,600Legal $28,200Office Supplies $16,400Travel $28,700Licenses/Certification $12,300Meals and Ent. $15,300Advertising $82,000Sales Shows $41,000Repairs $44,600Telephone $20,500Utilities $36,900

Expenses $1,515,740

Profit $400,660

Hidden Quality Costs

Prevention Costs

• Quality Planning $4,000

• Engineering design $10,000

• Quality Training $2,000

• Preventive maint. $4,000

$20,000

$20,000


Prevention

In the ideal situation, prevention costs will be the largest portion of the Total Cost of Quality.

Typically, prevention is less than 10% of TCOQ

It should be over 70%!


Appraisal

The costs associated with evaluating or auditing products or services to assure conformance to quality standards and performance requirements. Examples:

• Incoming inspection/test• Calibration of inspection/test equipment• Final inspection/test

These are all planned activities



Sales $4,100,000Returns ($105,000)

Income $3,995,000




Expenses $1,515,740

Profit $400,660


Appraisal Costs

• Inspector wages $40,000

• In-process inspect $75,000

• Quality audits $20,000

• Calibration services $40,000

• Supplies $15,000

• QC floorspace $50,000

• Regulatory approval $10,000

$250,000

$250,000


Appraisal

Appraisal costs should be the second largest category, but should not exceed prevention costs.


Internal Failures

All costs resulting from products or services not conforming to requirements or customer/user needs which occur beforedelivery/shipment of product, or the furnishing of a service. Examples include:• Scrap/rework• Reinspection/retesting• Material Review Board

These are non-value added and reactive



Sales $4,100,000Returns ($105,000)

Income $3,995,000




Expenses $1,515,740

Profit $400,660


Internal Failure Costs

• Labor (rework) $110,000

• Materials (rework) $95,000

• Eng. redesign $30,000

• Failure analysis $20,000

• Software fix $40,000

• Fire loss – equip. $70,000

• Rework space $35,000

$400,000

$400,000


Internal Failures

• The goal is to identify all internal failures and resultant costs, and then systematically identify and eliminate root causes until internal failure costs are eliminated.

• Remember, all firefighting is a the result of a failure!


External Failures

All costs resulting from products or services not conforming to requirements or customer/user needs which occur after delivery/shipment of product, or the furnishing of a service.


External Failures - Examples

The costs incurred when the customer finds the failure– Processing customer complaints– Field repairs– Recall costs– Returned goods– Processing returned materials– Warranty costs– Loss of reputation– Penalties– Customer incurred costs These are non-value added



Sales $4,100,000Returns ($105,000)

Income $3,995,000




Expenses $1,515,740

Profit $400,660


External Failure Costs

• Returns $105,000

• Labor $60,000

• Materials $40,000

• Consulting Services $37,000

• Legal $25,000

• Travel $15,400

• Meals & Entertain $3,000

• Repairs $44,600

$330,000

$330,000



Sales $4,100,000Returns ($105,000)

Income $3,995,000




Expenses $1,515,740

Profit $400,660

Prevention: $20,000Appraisal: $250,000COC $270,000

Int. Failure: $400,000Ext. Failure: $330,000COPQ $730,000

COPQ/Sales = 18.3%



Sales $4,100,000Returns ($105,000)

Income $3,995,000




Expenses $1,515,740

Profit $400,660

Prevention: $20,000Appraisal: $250,000COC $270,000

Int. Failure: $400,000Ext. Failure: $330,000COPQ $730,000

TCOQ $1,000,000(TCOQ/Sales = 24.4%)


TCOQ Summary

Sales: $4,100,000Profit: $400,660

COC/Sales = 6.5%COPC/Sales = 17.8%TCOQ/Sales = 24.4%

COPQ/Profit = 1.8TCOQ/Profit = 2.5

Prevention: $20,000 (2%)Appraisal: $250,000 (25%)COC $270,000 (27%)

Int. Failure: $400,000 (40%)Ext. Failure: $330,000 (33%)COPQ $730,000 (73%)

TCOQ: $1,000,000 (100%)


PONC

POC

Over time, PONC is reduced to 1/10 - 1/20 of its original level

POC is increased initially,then slowly decreased over time

But, POC never goesaway completely

Year 1 Year 2 Year 3 Year 4 Year 5

Price of Conformance and Price of NonconformanceOver Time

Tota

l Cos

t of Q

ualit

y


PONC

POC

Year 1

Tota

l Cos

t of Q

ualit

y

THE Barrier to Reducing COPQ

You must INCREASEthe POC, mostlyPrevention costs, BEFORE COPQ will start to drop.


Prevention

Appraisal

Failure

Time

Cos

tsSpending more on

prevention will reduce appraisal and failure

costs over time


In the Beginning COQ Category Maturity~65% Failure <10%~25% Appraisal <20%<10% Prevention >70%

How the Percentages Should Change Over Time

PreventionAppraisal

Failure

% of Total COQ



• A survey by the Illinois Manufacturers’Association revealed a 400% margin of error in cost of poor quality assessments.

• Companies initially reported an average of 6%cost of poor quality (6% of sales).

• A later, in-depth assessment showed the average to be closer to 25% (25% of sales).

• The Survey Conclusion: 75% of the cost of poor quality is hidden, and not obvious!



• Over 70% thought their organizations COPQ was less than 10 percent of sales

• Twenty-seven percent admitted they had no idea what their companies COPQ was

• One of the conclusions of those conducting the survey: “too many people still do not understand the relationship between cost and quality”

Results of an ASQ survey of CEOs:


Failu

re C

o sts

Process Time

Prevention

Component

Subsystem/Assembly

Final Inspection

Receiving Inspection

Litigation loss

Field Failure/Repair

$1

$10

$100

$1000

$10,000

Failure costas a functionof detectionpoint inprocess

Artificial HipInternal

External


Why Study Cause and Effect and COQ?

A key finding in a four-year study* for the Institute of Management Accountants, of more than thirty industry leaders, is the importance of understanding the cause and effect relationship among strategy, quality, productivity, profitability and competitiveness.

* Atkinson, Hamberg and Ittner, Linking Quality to Profits, 1994


Understanding Cause and Effect in COQ Measurements

The study found that without exception the successful companies in the study based quality related decisions on a clear understanding of the cause-and-effect relationship between the goals they wanted to accomplish and the step required to achieve those goals.

Atkinson, Hamberg and Ittner, Linking Quality to Profits, 1994


The High Level Cause and Effect View

Effective Quality Improvement

Higher Quality

Increased Productivity

Increased Profitability

Increased Competitiveness

Which Leads to

Which Leads to

Which Leads to

Which Leads to

It allStartsHere!


Any Similarity?

Effective Quality Improvement

Higher Quality




Which Leads to

Which Leads to

Which Leads to

Which Leads to


The Problem Is…..

When Senior ManagementDoesn’t Understand

High QualityLeads to




Which Leads to

Which Leads to


The Cause and Effect Framework

Step 1. The quality process embraces the strategic vision and goals of top management, aligning the objectives and priorities of the quality process and the business.




Step 2. Improvement projects are chosen on the basis of improving profitability and customer satisfaction by eliminating the high payback root cause of poor quality and the related nonvalue-added activities and waste. (We will look at how to do this in a later chapter – Cost Driver Analysis)




Step 3. Productivity gains from higher quality are trapped and held by making the organizational alterations necessary to eliminate nonvalue-added activities and waste. This means we have to institutionalize process improvements. We need to monitor and measure those processes to insure the gains don’t go away.




Step 4. Profitability gains from higher productivity are trapped and held by redeploying resources from nonvalue-added activities into value-added activities. Note: Most companies are not good at this step!



Short-Term Cost of Quality and Total Quality Management (Quick Fix)

2. Fewer people todo same work-

false improvements!

5. Poor quality

1. Cut budget

3. More errorsAnd rework

4. Totalcosts

increase

Pacific Bell Cost of Quality Handbook, 1992


Long-Term Cost of Quality and Total Quality Management

2. Teams improve processes and productivity

5. Improved qualityAnd profitability

1. Invest inquality

improvement

3. Fewer defects and rework

4. DecreaseIn

Totalcosts

Pacific Bell Cost of Quality Handbook, 1992


Establishing COQ Baseline

• Two Approaches• Advantages and Disadvantages of each

approach• Getting started


Two Approaches

• Ad-hoc informal system– Purpose is to quickly get a good estimate of

how large TCOQ and COPQ are– Output is TCOQ report for a point in time

• Formal Cost of Quality System– Permanent feature of management reporting

and decision making system– Provides detailed ongoing reports


Ad-hoc informal system

• Cross functional team• Meets for two weeks to two months and

then disbands• Reviews existing quality, defect, rework

reports• Conducts interviews to assess extent of

failure costs• Reports on TCOQ and COPQ as of a

given date


Advantages and Disadvantages of an Ad-hoc informal system

• Advantages– Can have report in two to four weeks– Less cost than formal system

• Disadvantages– Typically underestimates COPQ and does not

get managements attention


Formal COQ System

• Cross functional team• Involves finance department• Requires training of all employees on cost

of quality concepts• Requires ongoing data collection efforts


Advantages and Disadvantages of a Formal COQ System

• Advantages– Data is very accurate– Root cause analysis and problem solving is

easier• Disadvantages

– Slower to get first report– Adds infrastructure (costs) although these will

be more than offset IF COQ projects are successful


Starting a COQ Program

• Senior management support is critical for either approach

• Senior management must be open to the possibility that COPQ is large (Why?)

• COQ programs cannot be started from the bottom up (Why?)


Starting a COQ Program

1. Determine level of detail to be included1. Level 1 Assessment deals with internal and

external failures only2. Level 2 Assessment adds appraisal costs3. Level 3 Assessment adds prevention costs


COQ Assessment Problems

• When ongoing periodic assessments are made, the cost of poor quality may continue to increase over the first 2-3 years, due to assessment team members getting better at identifying poor quality costs

• The first assessment may identify far more improvement than the organization can handle


Potential COQ Assessment Problems

• Avoid the expectation that a cost of quality assessment solves any problems – it is a data gathering exercise

• Level 1 assessments are most useful when used to identify significant opportunities for savings, to avoid drowning in minutia


The COQ Challenge

• Many COQ costs appear to be appraisal, but when you dig deeper, they are only there because some process is not working right.

• Some COQ costs are currently seen as not related to COQ.

• Remember: “ COPQ is the sum of all costs that would disappear if there were no quality problems.” -Juran


For every cost, and cost category, be willing to ask this question: “If all of our processes (admin and manufacturing) produced the correct results the first time, would this cost still be here?”


1. Linking Quality Improvement to Profits2. Cost of Quality Definitions and Types 3. Understanding Cause and Effect in COQ

Measurements4. Establishing COQ Baseline5. Cost Driver Analysis


Cost Driver Analysis

• Definition• Methodology• Root Cause Analysis• Percent Allocation and Cost• Add Common Root Cause Costs



1. For each failure there is a root cause2. Causes are preventable3. Prevention is always cheaper

The underlying beliefs:



What is it?A powerful technique that integrates the

problem solving tools of the quality process with the poor-quality cost assessment.


Cost Driver Analysis-How To

1. Determine the root cause of the poor-quality costs

2. Identify the activity percentages and calculate the cost of poor quality related to each root cause


Cost Driver Analysis-How To

3. Combine the financial impacts of common root causes to determine the total financial impact of the root cause

4. Perform a cost-benefit analysis for the high financial impact root cause to determine the financial payback


Internal Failure costsScrap $66,500 14.9Repair $1,900 0.4Rework $2,500 0.6Failure analysis $4,000 0.9

Total Internal Failure costs $74,900 16.8

External Failure costsFailures - manufacturing $14,500 3.2Failures - Engineering $7,350 1.6Penalties $198,714 44.4Failures - Sales $4,430 1.0Warranty charges $31,750 7.1Failure analysis $7,600 1.7

Total External Failure costs $264,344 59.1

Total Quality Costs $447,144 100


Penalties Incorrect shipments

Late shipments

Partial shipments

Poor-Quality-Cost Element

Cost Drivers


Identify the Percentages

Penalties

Partial Shipments$198,714

80%

15%

5%

$198,714X 80%

$158,971



Penalties

Partial Shipments

ExcessiveDowntime

$198,714

80%

15%

5%

90%

10%

$198,714X 80%

$158,971X90%

$143,074



Penalties

Partial Shipments

ExcessiveDowntime

ToolBreakage

$198,714

80%

15%

5%

90%

10%

75%

15%

$198,714X 80%

$158,971X90%

$143,074X75%

$107,306



Penalties

Partial Shipments

ExcessiveDowntime

ToolBreakage

Hard Spots inRaw Material

$198,714

80%

15%

5%

90%

10%

75%

15%

95%

5%

$198,714X 80%

$158,971X90%

$143,074X75%

$107,306X95%

$101,940

$101,940


Identify the Root Cause

Penalties

Partial Shipments

ExcessiveDowntime

ToolBreakage

Hard Spots inRaw Material

Root Cause of Poor Quality

Poor-Quality-Cost Element


Last Thoughts


Failure To Include White Collar Costs

Prominent quality experts maintain that the inability of COQ systems to accurately capture white-collar costs and indirectquality costs is a fatal shortcoming and probably the single most frequently found reason for failure.


Failure To Include White Collar Costs

Examples:• Disruption of operations due to out of

conformance purchases and production• Excessive inventory levels maintained to

accommodate poor quality• Poor quality related schedule changes• Opportunity costs of lost consumer goodwill


Need to have a “CoQ Process”

• “Doing” Cost of Quality needs to be more that just data collection and analysis

• Need to create a process that takes Cost of Quality data and turns it into actions that results in lower Cost of Poor Quality (PONC/CONC)


The COQ Process

1. Commitment2. COQ Team3. Gather data (COQ assessment)4. Pareto analysis5. Determine cost drivers6. Process Improvement Teams7. Monitor and measure8. Go back to step 3

TypicallyMissing


“Wished I had understood that Cost of Quality stuff better”


Key Points

• COPQ is big, usually 15-20% of sales!• COPQ is usually 3-5X profits, can be 10X.• Understanding poor cost of quality drivers is the

key to understanding the right project to work on.• Must capture white collar/indirect COPQ costs.• Prevention/Appraisal costs have to go up, before

overall COQ can go down. There are no exceptions to this!


Questions


SYSTEMS Quality ConsultingTraining and ConsultingISO 9001 ISO 14001

Lean Manufacturing Six Sigma

www.systemsquality.com909-484-7545

COPQ Training Materials

Documents

Transcript of COPQ Training Materials