COPQ Training Materials

Cost of Quality as a Driver for Continuous Improvement
Presented by Roger E Olson Partner

SYSTEMS Quality Consulting
Agenda
1. Linking Quality Improvement to Profits 2. Cost of Quality Definitions and Types 3. Understanding Cause and Effect in COQ Measurements 4. Establishing COQ Baseline 5. 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 Feigenbaums 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
Crosbys 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

(Philosophy)
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
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
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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
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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 3X 11X EBITDA: $12,678,000 Net Profit: $3,150,000 Net Profit/Sales = 1.43%
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Example 1
Paper Mill April 2004 Report to New CEO Sales: $220,000,000 ~ 5X 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%
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Example 2a
Transportation Industry Supplier (1998) Sales: $130,000,000 COC: $4,400,000 (92% appraisal) COPQ: $18,500,000 COQ: $22,900,000 3X EBITDA: $6,531,000 Net Profit: $2,050,000 Net Profit/Sales = 1.57%
9X
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Example 2b
Transportation Industry Supplier (2003) Sales: $185,000,000 COC: $8,600,000 (45% appraisal) COPQ: $8,100,000 COQ: $16,700,000 0.5X 1.2X EBITDA: $19,900,000 Net Profit: $6,650,000 Net Profit/Sales = 3.6%
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Dont Let Poor Quality Costs Eat Your Profits!
COPQ
Profits
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1. Linking Quality Improvement to Profits
Background of Quality Costs Evolution of Quality Traditional vs Value Driven Quality Strategy
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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
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Inspection with the aim of finding the bad ones and throwing them out is too late, ineffective and costly. Quality comes not from inspection but improvement of the process.
Dr. W. Edwards Deming Founder of the Quality Evolution
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All quality improvement of a lasting nature occurs as the result of a project. Joseph Juran
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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
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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
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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
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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

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Income Statement Income Sales Returns Income Cost of Goods Sold Labor Materials COGS Expenses Salaries Services Depreciation Training Supplies Interest Rent Accounting Legal Office Supplies Travel Licenses/Certification Meals and Ent. Advertising Sales Shows Repairs Telephone Utilities Expenses
$4,100,000 ($105,000) $3,995,000
Hidden Quality Costs Prevention Costs

$20,000 Quality Planning
Quality Training Preventive maint. $4,000 $2,000 $4,000 $20,000
$960,600 $1,118,000 $2,078,600 $483,800 $98,400 $194,340 $3,300 $36,900 $61,500 $287,000 $24,600 $28,200 $16,400 $28,700 $12,300 $15,300 $82,000 $41,000 $44,600 $20,500 $36,900 $1,515,740 $400,660
Engineering design $10,000
Profit
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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%!
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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
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$4,100,000 ($105,000) $3,995,000
Hidden Quality Costs Appraisal Costs

$250,000 Inspector wages
In-process inspect Quality audits Supplies QC floorspace $40,000 $75,000 $20,000 $15,000 $50,000 $250,000
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$960,600 $1,118,000 $2,078,600 $483,800 $98,400 $194,340 $3,300 $36,900 $61,500 $287,000 $24,600 $28,200 $16,400 $28,700 $12,300 $15,300 $82,000 $41,000 $44,600 $20,500 $36,900 $1,515,740 $400,660
Calibration services $40,000
Regulatory approval $10,000
Profit
Appraisal
Appraisal costs should be the second largest category, but should not exceed prevention costs.
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Internal Failures
All costs resulting from products or services not conforming to requirements or customer/user needs which occur before delivery/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

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$4,100,000 ($105,000) $3,995,000
Hidden Quality Costs Internal Failure Costs

$400,000 Labor (rework)
Materials (rework) Eng. redesign Failure analysis Software fix Fire loss equip. Rework space $110,000 $95,000 $30,000 $20,000 $40,000 $70,000 $35,000 $400,000
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$960,600 $1,118,000 $2,078,600 $483,800 $98,400 $194,340 $3,300 $36,900 $61,500 $287,000 $24,600 $28,200 $16,400 $28,700 $12,300 $15,300 $82,000 $41,000 $44,600 $20,500 $36,900 $1,515,740 $400,660
Profit
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!
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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.
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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 These are non-value added Customer incurred costs
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$4,100,000 ($105,000) $3,995,000
Hidden Quality Costs External Failure Costs

$330,000
Returns Labor Materials Legal Travel Meals & Entertain Repairs $105,000 $60,000 $40,000 $25,000 $15,400 $3,000 $44,600 $330,000
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$960,600 $1,118,000 $2,078,600 $483,800 $98,400 $194,340 $3,300 $36,900 $61,500 $287,000 $24,600 $28,200 $16,400 $28,700 $12,300 $15,300 $82,000 $41,000 $44,600 $20,500 $36,900 $1,515,740 $400,660
Consulting Services $37,000
Profit
$4,100,000 ($105,000) $3,995,000
$960,600 $1,118,000 $2,078,600 $483,800 $98,400 $194,340 $3,300 $36,900 $61,500 $287,000 $24,600 $28,200 $16,400 $28,700 $12,300 $15,300 $82,000 $41,000 $44,600 $20,500 $36,900 $1,515,740 $400,660
Prevention: Appraisal: COC
$20,000 $250,000 $270,000
Int. Failure: $400,000 Ext. Failure: $330,000 COPQ $730,000 COPQ/Sales = 18.3%
Profit
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$4,100,000 ($105,000) $3,995,000
$960,600 $1,118,000 $2,078,600 $483,800 $98,400 $194,340 $3,300 $36,900 $61,500 $287,000 $24,600 $28,200 $16,400 $28,700 $12,300 $15,300 $82,000 $41,000 $44,600 $20,500 $36,900 $1,515,740 $400,660
$20,000 $250,000 $270,000
Int. Failure: $400,000 Ext. Failure: $330,000 COPQ $730,000
Profit
TCOQ $1,000,000 (TCOQ/Sales = 24.4%)

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TCOQ Summary
Sales: $4,100,000 Profit: $400,660 COC/Sales = 6.5% COPC/Sales = 17.8% TCOQ/Sales = 24.4% COPQ/Profit = 1.8 TCOQ/Profit = 2.5
$20,000 (2%) $250,000 (25%) $270,000 (27%)
Int. Failure: $400,000 (40%) Ext. Failure: $330,000 (33%) COPQ $730,000 (73%) TCOQ: $1,000,000 (100%)
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Price of Conformance and Price of Nonconformance Over Time

POC POC is increased initially, then slowly decreased over time But, POC never goes away completely
PONC
Total Cost of Quality

Year 1
Year 2
Year 3
Year 4
Year 5
Over time, PONC is reduced to 1/10 - 1/20 of its original level

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THE Barrier to Reducing COPQ

Total Cost of Quality POC
PONC
You must INCREASE the POC, mostly Prevention costs, BEFORE COPQ will start to drop.
Year 1
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Spending more on prevention will reduce appraisal and failure costs over time
Failure
Costs
Appraisal
Prevention
Time
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In the Beginning ~65% ~25% <10%
COQ Category Failure Appraisal Prevention

% of Total COQ
Maturity <10% <20% >70%
Failure
Appraisal
Prevention
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How the Percentages Should Change Over Time


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!
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Results of an ASQ survey of CEOs:
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
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Artificial Hip
$10,000
Litigation loss
$1000
Field Failure/Repair
Failure cost as a function of detection point in process

External
$100 $10
Receiving Inspection
Failure Costs
Final Inspection
Internal
Subsystem/Assembly Component
$1
Prevention
Process Time
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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
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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
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The High Level Cause and Effect View

Effective Quality Improvement
Which Leads to
It all Starts Here!
Higher Quality
Which Leads to
Increased Productivity
Which Leads to
Increased Profitability
Which Leads to
Increased Competitiveness
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Any Similarity?
Effective Quality Improvement
Which Leads to
Higher Quality
Which Leads to
Increased Productivity
Which Leads to
Which Leads to
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The Problem Is..

When Senior Management Doesnt Understand High Quality Leads to Increased Productivity
Which Leads to
Which Leads to
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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.
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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)
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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 dont go away.
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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!
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Short-Term Cost of Quality and Total Quality Management (Quick Fix)
1. Cut budget
2. Fewer people to do same workfalse improvements!
5. Poor quality
3. More errors And rework
4. Total costs increase
Pacific Bell Cost of Quality Handbook, 1992
57
Long-Term Cost of Quality and Total Quality Management

1. Invest in quality improvement 2. Teams improve processes and productivity
5. Improved quality And profitability
3. Fewer defects and rework
Pacific Bell Cost of Quality Handbook, 1992
4. Decrease In Total costs
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Establishing COQ Baseline

Two Approaches Advantages and Disadvantages of each approach Getting started
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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
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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
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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
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Formal COQ System

Cross functional team Involves finance department Requires training of all employees on cost of quality concepts Requires ongoing data collection efforts
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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
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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?)
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Starting a COQ Program

1. Determine level of detail to be included
1. Level 1 Assessment deals with internal and external failures only 2. Level 2 Assessment adds appraisal costs 3. Level 3 Assessment adds prevention costs
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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
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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
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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
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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?
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Cost Driver Analysis

Definition Methodology Root Cause Analysis Percent Allocation and Cost Add Common Root Cause Costs
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The underlying beliefs: 1. For each failure there is a root cause 2. Causes are preventable 3. Prevention is always cheaper
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What is it? A powerful technique that integrates the problem solving tools of the quality process with the poor-quality cost assessment.
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Cost Driver Analysis-How To

1. Determine the root cause of the poorquality costs 2. Identify the activity percentages and calculate the cost of poor quality related to each root cause
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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
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Internal Failure costs

Scrap Repair Rework Failure analysis Total Internal Failure costs $66,500 $1,900 $2,500 $4,000 $74,900 14.9 0.4 0.6 0.9 16.8
External Failure costs

Failures - manufacturing Failures - Engineering Penalties Failures - Sales Warranty charges Failure analysis Total External Failure costs $14,500 $7,350 $198,714 $4,430 $31,750 $7,600 $264,344 3.2 1.6 44.4 1.0 7.1 1.7 59.1
Total Quality Costs

$447,144
100
78
Poor-QualityCost Element Late shipments Penalties Incorrect shipments Partial shipments Cost Drivers
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Identify the Percentages

$198,714 X 80% $158,971
80% $198,714 Penalties

Partial Shipments
15% 5%
80

$198,714 X 80% $158,971 X90% $143,074
90% 80% $198,714 Penalties

Partial Shipments
Excessive Downtime
15% 5%
10%
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$198,714 X 80% $158,971 X90% $143,074 X75% $107,306
75% 90% 80%

Excessive Downtime Tool Breakage
15%
$198,714 Penalties
Partial Shipments
15% 5%
10%
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$198,714 X 80% $158,971 X90% $143,074 X75% $107,306 X95% $101,940
95% 75% 90% 80%

Excessive Downtime Tool Breakage Hard Spots in Raw Material
$101,940
5%
15%
$198,714 Penalties
Partial Shipments
15% 5%
10%
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Identify the Root Cause

Root Cause of Poor Quality Poor-QualityCost Element
Excessive Downtime Tool Breakage Hard Spots in Raw Material
Partial Shipments
Penalties
84
Last Thoughts
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Failure To Include White Collar Costs

Prominent quality experts maintain that the inability of COQ systems to accurately capture white-collar costs and indirect quality costs is a fatal shortcoming and probably the single most frequently found reason for failure.
86
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
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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)
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The COQ Process

1. 2. 3. 4. 5. 6. 7. 8. Commitment COQ Team Gather data (COQ assessment) Pareto analysis Determine cost drivers Process Improvement Teams Monitor and measure Go back to step 3
Typically Missing
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Wished I had understood that Cost of Quality stuff better

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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!
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Questions
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SYSTEMS Quality Consulting Training and Consulting ISO 9001 ISO 14001 Lean Manufacturing Six Sigma www.systemsquality.com 909-484-7545
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Cost of Quality as a Driver for Continuous Improvement

Presented by Roger E Olson Partner

SYSTEMS Quality Consulting

SYSTEMS Quality Consulting

SYSTEMS Quality Consulting

Costs of Failure of Control

Price of Nonconformance (PONC/CONC)

Deming, Juran, Crosby on COQ

SYSTEMS Quality Consulting

Juran and Crosby on COPQ

Something to Think About

Dont Let Poor Quality Costs Eat Your Profits!

SYSTEMS Quality Consulting

1. Linking Quality Improvement to Profits

SYSTEMS Quality Consulting

SYSTEMS Quality Consulting

SYSTEMS Quality Consulting

Value Driven Quality Strategy

SYSTEMS Quality Consulting

Cost of Quality Definitions and Types

These are all planned, proactive activities

$4,100,000 ($105,000) $3,995,000

Hidden Quality Costs Prevention Costs

Engineering design $10,000

SYSTEMS Quality Consulting

SYSTEMS Quality Consulting

$4,100,000 ($105,000) $3,995,000

Hidden Quality Costs Appraisal Costs

Calibration services $40,000

Regulatory approval $10,000

SYSTEMS Quality Consulting

SYSTEMS Quality Consulting

These are non-value added and reactive

$4,100,000 ($105,000) $3,995,000

Hidden Quality Costs Internal Failure Costs

SYSTEMS Quality Consulting

SYSTEMS Quality Consulting

External Failures - Examples

$4,100,000 ($105,000) $3,995,000

Hidden Quality Costs External Failure Costs

Consulting Services $37,000

SYSTEMS Quality Consulting

$4,100,000 ($105,000) $3,995,000

Prevention: Appraisal: COC

$20,000 $250,000 $270,000

SYSTEMS Quality Consulting

$4,100,000 ($105,000) $3,995,000

Prevention: Appraisal: COC

$20,000 $250,000 $270,000

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

SYSTEMS Quality Consulting

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

Prevention: Appraisal: COC

$20,000 (2%) $250,000 (25%) $270,000 (27%)

Price of Conformance and Price of Nonconformance Over Time

Total Cost of Quality

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

THE Barrier to Reducing COPQ

SYSTEMS Quality Consulting

In the Beginning ~65% ~25% <10%

COQ Category Failure Appraisal Prevention

Maturity <10% <20% >70%

How the Percentages Should Change Over Time

Something to Think About