Supplier Charge-backs

Most manufacturers have implemented a Supplier charge-back program, where a supplier is charged for the
additional cost incurred by a manufacturer due to non-conforming components, materials and late deliveries
from suppliers. A charge-back system is an effective way to introduce business discipline and accountability
into the supply chain.

However, most manufacturers only end up recovering the material costs of non-conforming components
from their supplier. This is primarily attributed to lack of ability of their information systems to capture non-
material costs associated with the non-conforming component. These non-material costs normally exceed
the costs of non-conforming material and can end up costing manufacturers millions of dollars a year on
accumulated basis due to supplier poor quality.

Supplier manual of a major consumer electronics manufacturer suggests that as a result of non-
conformance, the following activities will charge back to the supplier on per-hour wage-costs:

• Operator/Foreman handling
• Eventual disassembly of the part
• Administration to take the part out of stock
• Quality department handling
• Handling by the planner to get a new part
• Transportation back to the receiving area
• Communications with the supplier - what shall be done with the part?
• New instructions
• Attention from engineers
• Packing and arranging transport back to the supplier
• Invoice handling

Our research shows that current ERP systems or departmental quality management systems do not support
this process well. Hence, most companies end up using manual systems such as spreadsheets to calculate
charge-backs. As a result, the actual COPQ (Cost of Poor Quality) costs are always higher than what charged
back is. Before investing in "add-on" software applications, we recommend that you design a quality
management process that spans the entire organization and includes relevant suppliers. This step should
incorporate key quality processes including audit, non-conformance tracking, corrective action, change
control and charge backs. Once a sound non-conformance process workflow is outlined, you should then
evaluate and select software applications that provide a standardized platform for automating dispute
discovery and capture. The system should enable charge-backs to be more easily itemized, categorized,
routed and escalated. In contrast to manually tracking data on spreadsheets, which allows only a periodic,
after-the-fact review of charge-backs, a new system should provide an integrated, real-time solution that
enables deductions to be managed and addressed at any level of detail and resolved in a timely manner.
Such a system also exposes the actual cost of poor quality and provides a backdrop for the manufacturer to
work closely with the supplier in identifying the root cause of the problem and implementing Corrective
Actions.

What is Your Company's Cost of Poor Quality (CoPQ) - Tools for calculating
and reducing it
"Quality is never an accident, it is always the result of an intelligent effort"

A manufacturing company had annual sales of $250 million. Its quality department calculated the total cost
of repair, rework, scrap, service calls, warranty claims and write-offs from obsolete finished goods. This
aggregated cost, called Cost of Poor Quality (COPQ), amounted to 20% of their annual sales. A 20% COPQ
implied that during one day of each five-day workweek, the entire company spent its time and effort making
scrap, which represented a loss of approximately $ 100,000 per day.

Experts have estimated that Cost of Poor Quality typically amounts to 5-30% of gross sales for
manufacturing and service companies. Independent studies reveal that COPQ is costing companies millions
of dollars each year and its reduction can transform marginally successful companies into profitable ones.
Yet most executives believe that their company's COPQ is less than 5%, or just do not know what it is. All
levels of executives recognize that quality is an absolute necessity to survive and succeed in today's
business environment. The diagram below provides a framework for calculating COPQ as a percentage of
sales.

In a recently published book "Success through Quality", the author estimates that COPQ for an average
company is about 20% of sales, with a range as wide as under 1% for companies who have achieved "six
sigma", about 15%-25% for companies who are at "four sigma" level and about 25% to 40% of revenue for
companies who are at "three sigma" levels. A large fortune 500 communications company calculated its
COPQ at 8.6% of sales in 2002 and has set a goal of 5.4% for 2005, which will result in a savings of a little
less than $1 Billion per year!

COPQ in a Supply Chain

The Cost of Poor Quality of individual suppliers participating within a supply chain has a cumulative effect on
the COPQ of the OEM shipping the end product - see figure below. As a result, companies are working very
proactively with their suppliers to reduce their COPQ. Many OEMs are also implementing supplier charge-
backs (also called cost recovery), where a supplier is charged for the additional cost incurred by the OEM
due to non-conforming components and materials and late deliveries from suppliers. A charge-back system
is an effective way to introduce business discipline and accountability into the supply chain. OEMs use it as a
"stick" for their suppliers to drive them to collaboratively identify the root cause of quality problems and to
implement corrective actions.

Reducing Cost of Poor Quality

Systematic reductions in the Cost of Poor quality can be attained by implementing a Quality Management
System (QMS) that provides an integrated and closed loop corrective action process. In a manufacturing
organization, when deviations, nonconformance, out of specifications, quality incidents or customer
complaints occur, corrective and preventive actions need to be initiated to remedy the problems.

Once a quality problem has been identified, the first step is to initiate an investigation and to properly
identify the root cause of the problem. After the root cause has been identified, Corrective Action (CAPA)
items are created and routed for approval. When approved, appropriate changes are implemented in the
environment and then the CAPA is closed out. These changes may include amendments to a documented
procedure, upgrading the skill set of an employee through a training and certification process, or
recalibrating the manufacturing equipment. In addition, the system may capture COPQ associated with that
non-conformance and use that information to initiate and complete a cost recovery process with a supplier.

It is critical to deploy a closed-loop, integrated quality management system, rather than a set of loosely
connected modules from one or more vendors. Integration ensures that the information flows out the
corrective action process with a high degree of accuracy and velocity without falling through the cracks. It
also ensures that the entire change control process is auditable from end-to-end - a critical requirement to
support FDA 21CFR part 11 and the Sarbanes-Oxley Section 404 audit criteria.
The QMS system should also be web-based, so that the suppliers can easily participate in the quality
management process. The suppliers often use the same plant to manufacture products for multiple OEMs. As
a result, they cannot be forced to install different systems for different OEMs at the same plant to support
their respective quality needs. Hence the OEM has to rely on process and product quality information from
the supplier's quality system. That information usually does not integrate well with the OEM's own systems
and is frequently not available in a timely manner. A Web-based QMS allows the OEM to make the
application available to the supplier without requiring the supplier to implement the system at their site. As
a result, the supplier can provide relevant quality information about the shipment to the OEM even before it
ships from the supplier's dock. If there are quality issues with any supplier component, manufacturers can
take appropriate preventive action even before it arrives or take it out of the supply chain to reduce their
own COPQ. QMS systems that do not support web architecture make it difficult for an OEM, participating in a
supply chain, to reduce its effective COPQ.