Measuring Business Excellence

IDENTIFYING THE COST of POOR QUALITY

Lars Sörqvist
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Lars Sörqvist, (1998),"IDENTIFYING THE COST of POOR QUALITY", Measuring Business Excellence, Vol. 2 Iss 3 pp. 12 -
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 CASE STUDY

Most businesses would be happy to increase turnover by 10%, yet that is

the scale of loss through poor quality revealed by projects in Swedish
companies. And 10% may be just the tip of the iceberg. By Lars Sörqvist.

IDENTIFYING
THE COST
OF POOR
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QUALITY
ive years ago a project got under way at Stockholm's

F
REFERENCE POINTS
Royal Institute of Technology to develop an effec­
■ Company A A large
tive method of measuring the cost of poor quality. manufacturer with overseas

From its initial mapping of current methods of measurement operations and a reputation for
quality.
and working in Swedish manufacturing and service compa­ ■ Company Β Part of a

nies the project established a general model for measuring multinational looking to move
beyond ISO 9001.
the cost of poor quality. The model was described in detail in ■ Company C A large service

Measuring Business Excellence volume 1 number 2. enterprise suffering a fall-off in

quality and profitability.
To aid development the model was applied in companies. ■ Company D An electronics

Case studies carried out to test and develop principles and company hampered in its quality
initiatives by short-term priorities.
practices which emerged during the project are described ■ Company Ε A small business

here. All the companies are referred to anonymously. struggling to prioritize effectively
potential improvements.

Lars Sörqvist is a researcher at the Royal Institute of Technology in Stockholm, with responsibility for
quality. He also works as a consultant with Sandholm Associates, Djursholm, Sweden.

12 MEASURING BUSINESS EXCELLENCE VOLUME 2 NUMBER 3

 CASE STUDY
A large manufacturing
Company
business with 20,000
Α employees, annual
turnover of about SKr30
billion and plants and sales operations
in many different countries.
For most of this century Company A has
been a symbol of Swedish quality and has
enjoyed a strong financial position. Its
already high market shares are steadily
increasing in most of its global markets,
where its products command some of the
highest prices through a reputation for
the highest quality. T h e company has
successfully demonstrated to its cus­
tomers that high quality reduces to a
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minimum total cost over the life cycle of
the product. Its reward is higher margins
than its competitors.
Paradoxically, this same reputation as
a model of profitable enterprise worked
against the corporate quality department
in selling the idea of improvement pro­
jects within the company. In getting
across the message that to retain its com­
petitive edge the company must intensify
its improvement activities, the quality
manager was therefore eager to demon­
strate the financial potential in quality,
even in a situation of strength.
After training managers in the quality
department in how to create understand­
ing of the methods used for running
assessments, a pilot project was set up
with the backing of senior management
to assess poor quality costs in a unit which
designs and manufactures customized
product models and contains features of
all the company's areas of activity. The
assessment covered the entire process
chain from identifying customer needs to
TO RETAIN A
COMPETITIVE EDGE A
COMPANY MUST
INTENSIFY ITS
IMPROVEMENT
ACTIVITIES.
implementation by the end user. One of
the key objectives of the project was to
obtain quick results that could be used to
stimulate interest in quality activities.
A small project group was formed,
consisting of a representative of the qual­
ity department, an accountant and the
author, whose role was to communicate
VOLUME 2 NUMBER 3 MEASURING BUSINESS EXCELLENCE 13
information and be available for advice.
A reference group, comprising quality
department staff trained in the concepts
of poor quality costs, was also available.
The quality department and com­
pany management defined poor quality
costs as "the total costs which are caused
by deficiencies in our processes, goods
and services". Likely items were identi­
fied in a brainstorming session within the
quality department and interviews with
representatives from the pilot unit.
Starting with an analysis of informa­
tion in the existing system, the assess­
ment followed the flow of processes in
the unit, but later analysis 'against the
flow' - from customer to supplier - also
flagged shortcomings in the earlier
stages. Selected individuals were then
interviewed about their current problems
and deficiencies - essential because much
of the information was not available in
the existing system.
The first stage in the assessment,
which focused on the marketing, devel­
opment, production and after-sales func­
tions (see figure 1), was an analysis of the
information already available in the sys­
tem. Interviews were then arranged with
selected individuals to isolate and mea­
sure problems and deficiencies. The
study was based on business in 1995,
which amounted to about 50 orders.
 CASE STUDY
Costs were estimated based on aver­
age hourly staff costs.
In parallel, the direct costs of each
process were also established to allow for
fair comparison. The poor quality costs
were determined by estimating minimum
and maximum deviations from the regis­
tered estimates. T h e narrow variance -
11% and 13 % of direct process costs -
implies relatively high accuracy'.
However, some poor quality costs, such
as the effects of dissatisfied customers and
loss of market share, remained hidden.
When presented to a pre-arranged
meeting of company management these
results aroused considerable interest - the
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group concluded that the company's total
Company A service enterprise with
annual turnover of more
C than SKr30 billion and
about 20,000 employees.
Once regarded as one of the best in its
industry, in recent years the company
has suffered from poor quality and
profitability. An estimated 35% of ser-
vices are not pa formed on schedule,
14,000 customers are affected every day
by some kind of failure and 36% of the
company's resources arc not utilized.
In response to the company's deteriorat­
ing performance, its quality and financial
control departments proposed to map
poor quality costs to demonstrate poten­
tial for improving the financial position.
T h e objective of the project, which
eventually involved about one man-
month of work, was to develop a docu­
mented model which could be used by
local units to analyse their own opera­
tions for poor quality costs. These were
defined as "those costs which would dis­
appear if the company's products and
14 MEASURING BUSINESS EXCELLENCE VOLUME 2 NUMBER 3
poor quality costs probably amounted to
at least SKr8 billion. An action plan was
drawn up to identify the principal causes
and establish goals for corrective mea­
sures. Priority was given to factors which
could be applied to a new main product
recently introduced and those particularly
visible to customers.
The assessment also helped to
improve knowledge within the company
of its own activities. T h e capacity to gen­
erate valuable results for a small input in
terms of man-hours - a total of about
150 - was particularly appreciated. Since
then, poor quality costs have also been
measured in other business units using
the same techniques.
processes were perfect" and were divided
into internal failure costs, external failure
costs and appraisal costs. Processes, func­
tions and known problem areas that
reflected business character were studied:
■ sales process
■ execution process
■ front office personnel
■ returns
■ lost goods
■ complaints
■ unserved customers.
Responsibility for mapping poor quality
costs in sales, which includes marketing
and customer care, was delegated to the
process owner. From interviews with 160
people about their work and the prob­
lems they experienced the value of poor
quality costs was calculated at SKr63.8
million, or 9% of the cost base. Most
costs were caused by inadequate adminis­
trative procedures and I T systems.
Analysis of the relative importance of
THE HEAVY VOLUME OF
BUREAUCRACY
ASSOCIATED WITH ISO
9001 CERTIFICATION
BRED A NEGATIVE
ATTITUDE TO QUALITY
EXERCISES.
failures in the company showed that
most poor quality costs are caused by
problems which are of great importance
to the business but readily solved (see fig­
ure 2). A follow-up assessment expanded
the analysis and showed the cost of poor
quality to be about 15% of cost base.
Delays and non-conformities in the
execution process - which directly affect
the customer - were estimated to have
cost SKr700-800 million in one year.
Loss of business from failures probably
amounted to SKr1-2 billion annually.
Front office activities gave rise to two
types of poor quality cost: sporadic and
chronic. Sporadic costs - those which are
associated with handling and correcting
irregularities and compensation to cus­
tomers - amounted to SKr188 million in
the previous year. T h e extent of chronic
poor quality costs - deficiencies that
were accepted in the business and were
often due to shortcomings in the way the
service had been designed - is harder to
establish; Company C's focus on under-
 CASE STUDY
Part of a Sweden-based
Company
multinational group,
Β Company Β is a processor
with about 2,000 employ­
ees and annual turnover of about
SKr3.4 billion. Its products are sold
around the world and enjoy a reputation
for high quality. Profitability is good.
As in Company A, the impetus for the
initiative came from the quality manager's
goal of changing attitudes to quality to
pave the way for systematic improvement
projects. Recent quality activities had
focused mainly on ISO 9001 certification
and the heavy volume of bureaucracy
associated with the effort bred a negative
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attitude to quality exercises.
utilized personnel and equipment capac­
ity exposed cost of almost SKr100 mil­
lion. Benchmarking activities, which
involved identifying best practice to
establish a yardstick, showed the busi­
ness' minimum staff requirement to be
1,600 compared with the existing 6,445.
Returning goods to customers due to
non-conformance cost SKr7 million
each year plus loss of income estimated
at SKr50 million. T h e 43,000 customer-
owned packages lost anually cost the
Figure 2 Problems grouped by importance to the business and ease of solution (costs in Swedish krona - SKr)
Very Important
Deal with at once 7,457,549
Can be dealt with 22,402,776
Difficult to deal with 1,306,440
Impossible to deal with
Dont know 2,213,497
TOTAL SKr 33,330,263
Again, a plan was agreed with com­
pany management for an assessment pro­
ject before a group was formed of man­
agers from the various business units and
one representative each from the finan­
cial control and quality departments.
Work started with a one-day training
programme.
Given the poor standing of the term
'quality', poor quality costs were
renamed 'production disturbance costs' -
defined as "costs which are caused by not
doing the right things in the right way
from the very beginning". The potential
candidates for production disturbance
costs which emerged from brainstorming
and interview sessions were classified as:
company SKr170-200 million.
Handling the 35,000 customer com­
plaints received each year occupies 80
employees full-time with a cost of
SKr120 million in administration and
compensation. T h e costs in terms of lost
customers and bad will are incalculable.
In total, the poor quality costs mea­
sured correspond to about 10% of total
turnover. T h e true cost is likely to be far
higher since several areas of the business
were not analysed and many external
Important Not important
3,081,443 173,170
19.267,497 1,524,003
2,309,093 719,312
15,873
1,008,337 620,146
SKr 25,666,371 SKr 3,052,504
VOLUME 2 NUMBER 3 MEASURING BUSINESS EXCELLENCE 15
■ equipment breakdowns - costs or loss of
profit resulting from loss of production;
■
the cost of emergency repairs
planned stoppages - costs or loss of profit
resulting from planned stoppages for
maintenance, excluding necessary
resetting and holidays
■ internal poor quality costs - costs due to
quality non-conformance identified before
delivery to external customers
■ external poor quality costs - costs due to
quality non-conformance discovered after
delivery to external customers.
Systematic analysis identified production
disturbance costs in the various business
processes, from customer to supplier.
losses were not included.
During the mapping process a simple
manual was developed for use in assess­
ing poor quality costs at local level.
Training in how to assess costs was also
incorporated into the company's internal
quality training. Experience from using
the assessment technique was encourag­
ing - indeed, it was considered the only
possible approach for personnel in a ser­
vice organization, who are not in the
habit of reporting such information. ■
Dont know TOTAL
1,712,162
43,194,276
262,609 4,597,455
15,873
1,504,970 5,346,951
SKr 1,767,580 SKr 63,866,717

Mapping these costs took the form of
interviews with personnel responsible for
each process. The extent of non-confor­
mities and disturbances was estimated
from existing data and 'best guesses' by
the interviewees. The result was then
priced according to standard rates and
hourly costs.
Excluding certain costs as controver­
sial, the residual production disturbance
costs amounted to SKr236 million, or
7% of turnover (see figure 3).
When a Pareto study showed that a
small proportion of the problems caused
a high percentage of the production dis­
turbance costs, a cross-function improve­
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ment project was initiated to concentrate
on those areas. Its aim was to improve
operating reliability and to halve poor
quality costs within three years.
Although the methodology is developed
continuously, the original parameters are
A maker of complex elec-
Company
tronic systems for other
D manufacturers. Company
D has annual turnover of
about SKr1 billion and employs 1,000
people. Despite process orientation and
certification to ISO 9001 it had seen lit-
tle benefit front its quality efforts due to
the priority given to day-to-day activi-
ties over systematic improvement.
Poor quality cost analysis was again
adopted as a means of demonstrating the
financial pay-off of quality activities, to
stimulate management interest and to
focus on improvement. T h e assessment
was started by the quality department
and run by a project leader. To support it,
a reference group was selected from the
quality department.
The company defines poor quality
16 MEASURING BUSINESS EXCELLENCE VOLUME 2 NUMBER 3
CASE STUDY
measured separately for fair comparisons activities now occupy a central position
over time. While the costs target was in the company, and continuous
achieved within two years, numerous improvement is firmly established. T h e
new quality costs have been identified so co-operation between the quality and
the project is continuing. financial control functions which began
About three man-weeks were with this project has led, through the dis­
devoted to the assessment, which has covery of shared goals but different
contributed to changing attitudes methods, to the amalgamation of the two
towards quality at every level. Quality departments into a new common unit.
costs as "the additional costs which arise and waiting time were also measured for
on account of poor quality at any stage". a limited period to add depth to this
It divides them into internal failure costs,
external failure costs and appraisal costs.
information.
Three different activities were stud­
Again, interviews and brainstorming ied as representative of the business: an
sessions with key individuals yielded a list administrative unit within the financial
of likely areas for analysis. Appraisal costs
were established from estimates made by
the relevant area managers and discus­
sions with the financial control depart­
ALTERNATIVE CAUSES
ment. External quality failure costs were
restricted to the cost of complaints,
OF FAILURE WERE
repairs, penalties and guarantees which
were also included in the financial
INCLUDED TO COUNTER
accounting system. Internal failure costs
could also be obtained to an extent from
RELUCTANCE TO ADMIT
the financial accounting system and
other internal reports, for example, in
PERSONAL FAULTS.
the cost of scrap, breakdowns and adjust­
ments. The costs of rework, extra work
 CASE STUDY
A small business belong­
Company
ing to a large interna­
Ε tional group, the com­
pany employs 120 people
in making components for high volt­
age applications sold internationally.
Annual turnover is about SKr170
million.
Despite considerable experience of
systematic improvement activities and a
marked degree of process orientation,.
the measurement parameters used by
Company Ε at local level often led to
incorrect prioritization of potential
improvements. It turned to an analysis of
poor quality costs to develop financially
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fairer priorities.
Poor quality costs were defined as
"those costs which would be eliminated if
the company's products and business
processes were perfect", and classified as
appraisal costs, internal failure costs,
control department; a production unit;
and a unit involved in final product
assembly. In each case representatives
were appointed to run the project locally
and provide the necessary support. A
report form was developed as a basis for
making the measurements, concentrat­
ing on the time spent on non-value-
adding activities. Alternative causes of
failure were included to counter the nat­
ural reluctance to acknowledge faults
which could be seen as personal. Once a
day, preferably before they finished work,
the personnel reported the non-value
adding time that had occurred during the
day. Staff meetings before the start of the
study explained the method of reporting
'failure time' and the object of the study.
Measurements were taken over three
weeks and the costs calculated on the
COMPANY Ε ANALYSED
POOR QUALITY COSTS
TO DEVELOP
FINANCIALLY FAIRER
PRIORITIES.
external failure costs and 'grey zone
costs' - those regarded within the com­
pany as controversial.
Interviews were used to build a clear
picture of the business and its more fre­
quent problems. Definitions of relevant
terminology were circulated and agreed
to avoid any misunderstanding later.
basis of hourly rates and overhead mark­
ups. T h e results from the three selected
areas indicated poor quality costs for the
business as a whole of SKr66 million, or
about 7% of turnover. Amended for
internal failure costs - scrap, break­
downs, rework and adjustments - and for
external failure and appraisal costs, the
total rose to about 16% of turnover.
To emphasize the improvement
potential, a time study established the
proportion of non-productive time by
making 250 random observations of 10
employees from different areas of the
company over one week; 153 repre­
sented non-productive time.
Interviews conducted with partici­
pants after the measurements were com­
plete determined their experiences and
views of the methods. In general they
VOLUME 2 NUMBER 3 MEASURING BUSINESS EXCELLENCE 17
Staff from quality and financial control
departments formed a support group.
The first stage of the assessment was
a study of information from existing sys­
tems, mainly financial acccounting.
Interviews were then conducted with
selected representatives of the business.
To maximize the value of the informa­
tion, the interviews were arranged
against the process flow.
Even though costs such as waiting
time and loss of good will were excluded
from the study, the poor quality costs
measured amounted to SKrl5.4 million,
about 9% of turnover. A further SKr10
million of poor quality costs was identi­
fied by comparing the test unit's adminis­
trative procedures for sales, order taking
and design with company best practice in
those areas. Clearly, the potential for
improvement can be immense when
chronic faults are identified. ■
DAILY, PERSONNEL
REPORTED THE NON-
VALUE ADDING TIME
THAT HAD OCCURRED
DURING THE DAY.
were satisfied with the study and consid­
ered the additional work worthwhile.
The results provided useful arguments to
justify improvement activities which, in
many cases, people had been demanding
for a long time. ■