A few weeks ago I blogged about the hidden costs (or hidden factory, as Lean Six Sigma refers to it) associated with quality problems, which in my case was inspired by redundant software systems at my current employer. This week I want to continue with the topic by focusing on measuring the size of the hidden factory, or the cost of poor quality.
When we think of what a company does to add value to a product or service for its customer base, we should look at it as if there are two factories at work. The first factory is the primary factory, or the visible factory, that executes the normal, value-added processes to produce a value-added output. The second factory is the hidden factory. This is the factory that kicks into action when things go wrong and it costs a lot more that what people might think. My posting on Hidden Costs / Hidden Factory from a couple of weeks ago will give some perspective on this.
Essentially, the hidden costs become much more destructive, simply because they are hidden or unknown. I think business executives would likely agree that when it comes to running a business, it’s the unknowns that should cause the most worry. As Plato put it “Better be unborn than untaught, for ignorance is the root of misfortune.” So, to avoid misfortune, let’s explore how we can measure the cost of poor quality.
The following excerpt is from a Quality Digest article (Lee, G., n.d.) that examines how a large, global energy company, ABB, attempts to measure the cost of poor quality.
When we think of what a company does to add value to a product or service for its customer base, we should look at it as if there are two factories at work. The first factory is the primary factory, or the visible factory, that executes the normal, value-added processes to produce a value-added output. The second factory is the hidden factory. This is the factory that kicks into action when things go wrong and it costs a lot more that what people might think. My posting on Hidden Costs / Hidden Factory from a couple of weeks ago will give some perspective on this.
Essentially, the hidden costs become much more destructive, simply because they are hidden or unknown. I think business executives would likely agree that when it comes to running a business, it’s the unknowns that should cause the most worry. As Plato put it “Better be unborn than untaught, for ignorance is the root of misfortune.” So, to avoid misfortune, let’s explore how we can measure the cost of poor quality.
The following excerpt is from a Quality Digest article (Lee, G., n.d.) that examines how a large, global energy company, ABB, attempts to measure the cost of poor quality.
At ABB we use a metric known as cost of poor quality (COPQ). COPQ is measured by estimating the cost of all efforts undertaken in an organization, including materials and processes used in assembling our products, that don’t provide value to customers. In the lexicon of lean manufacturing, these are nonvalue-added activities. At ABB, COPQ is the sum of all nonvalue-added costs divided by the total revenue that’s generated. The resulting measurement is the percentage of revenue that’s lost due to waste.
COPQ is measured, reported, and tracked in each of the business units. COPQ is used to measure progress within the organization and to identify best practices that can be shared throughout the company. COPQ is a metric and a learning tool, helping an organization to understand what’s nonvalue-added and to establish opportunities for improvement.
COPQ is measured, reported, and tracked in each of the business units. COPQ is used to measure progress within the organization and to identify best practices that can be shared throughout the company. COPQ is a metric and a learning tool, helping an organization to understand what’s nonvalue-added and to establish opportunities for improvement.
My first thought, upon reading the article, is how impressive ABB’s measurement capabilities are, given that they can track and report nonvalue-added costs across all their business units. The article doesn’t say how ABB did that, but the excerpt does provide us the simple math behind their COPQ metric. We’ll have to devise our own approach for determining nonvalue-added costs.
I think all approaches, as ABB did, should start with total revenue. That’s easy. It’s the cost part that will likely be tough, requiring some creative approaches. Using my current company, a default management law firm, I’m going to explore what I hope will be a reasonably simple approach. We have no ability to precisely track value-added costs and nonvalue-added costs, so I need an alternative. Since our legal processors (they’re the hourly Operations staff that does the work to generate the revenue) spend a lot of time on rework and quality issues, I can’t simply take their total compensation costs and treat it as value-added cost. Plus there is also staff from Operations management, IT, Accounting, and HR that get sucked into our quality problems. Their labor needs to be reflected in our nonvalue-added costs.
What I will propose is that my company establish a benchmark cost per legal case type. For example, through a bit of analysis, we may determine that a typical bankruptcy costs us $1,000 to execute, an eviction may cost $1,500, and a foreclosure may cost $500. Since we know the volume of cases for each type, we then know what our value-added costs should be.
If we take the total costs of the Operations department, plus the total costs of the departments that directly support Operations (IT, HR, Accounting) in the execution of our customer value stream(s), we can then come up with our own COPQ formula that resembles the ABB approach.
I think all approaches, as ABB did, should start with total revenue. That’s easy. It’s the cost part that will likely be tough, requiring some creative approaches. Using my current company, a default management law firm, I’m going to explore what I hope will be a reasonably simple approach. We have no ability to precisely track value-added costs and nonvalue-added costs, so I need an alternative. Since our legal processors (they’re the hourly Operations staff that does the work to generate the revenue) spend a lot of time on rework and quality issues, I can’t simply take their total compensation costs and treat it as value-added cost. Plus there is also staff from Operations management, IT, Accounting, and HR that get sucked into our quality problems. Their labor needs to be reflected in our nonvalue-added costs.
What I will propose is that my company establish a benchmark cost per legal case type. For example, through a bit of analysis, we may determine that a typical bankruptcy costs us $1,000 to execute, an eviction may cost $1,500, and a foreclosure may cost $500. Since we know the volume of cases for each type, we then know what our value-added costs should be.
If we take the total costs of the Operations department, plus the total costs of the departments that directly support Operations (IT, HR, Accounting) in the execution of our customer value stream(s), we can then come up with our own COPQ formula that resembles the ABB approach.
W = Total costs of Operations plus supporting departments (IT, HR, Accounting)
X = Total value-added cost of all processed cases (based on benchmarking)
Y = Total revenue
Z (nonvalue-added costs) = W (total costs) - X (value-added costs)
Z (nonvalue-added costs) = W (total costs) - X (value-added costs)
With our nonvalue-added costs established, we can then rejoin the ABB approach and compute our COPQ to equal Z divided by Y, which gives us a metric that we can track over time. We can further refine the total operating costs by doing things such as taking a portion of HR based on the number of new hires brought into Operations versus the number of new hires across the enterprise. Basically, we want our total operating costs to, ideally, be associated with our customer value stream(s), and not include overhead for such things as Marketing and new business development.
Measuring the hidden costs of poor quality is not going to be the easiest metric to obtain, but it isn’t unreasonable. If a company really cares about quality and knowing how big their hidden factory is, then finding the motivation to calculate a COPQ shouldn’t be that hard. Hopefully, the effort will make the hidden costs a little less hidden and decision-making a little more sound, and maybe, just maybe, knowledge of their hidden costs will allow businesses to avoid a little misfortune.
Measuring the hidden costs of poor quality is not going to be the easiest metric to obtain, but it isn’t unreasonable. If a company really cares about quality and knowing how big their hidden factory is, then finding the motivation to calculate a COPQ shouldn’t be that hard. Hopefully, the effort will make the hidden costs a little less hidden and decision-making a little more sound, and maybe, just maybe, knowledge of their hidden costs will allow businesses to avoid a little misfortune.
References
Lee, Gerald. (n.d.). The Hidden Costs of Poor Quality. Retrieved from http://www.qualitydigest.com/dec07/articles/06_article.shtml
Scott,
ReplyDeleteGreat point on bringing out things in the open. Indeed things hidden from the organization's consciousness -- ignorance as Plato said, can be its undoing. And without awareness, they cannot measure. Fast forward to our modern day business Plato, Peter Drucker continues the warning that if they cannot measure, they cannot improve.
Kaizen strategy and TQM are both significant value drivers in many aspects of management. Integrating these two practices into the EA discipline could be an interesting set of explorations, and can make dramatic improvements in the quality of the EA process and its delivery. At the end of the day we ask ourselves, did EA bring value? Or is the EA practice more of a non-value adding cost? i.e. Did the time and/or money spent on EA activities and service enhance the stakeholder/customer perception of the business outcomes?
Linking your discussion of costs of poor quality to the EA practice, the challenges you mention, becomes very resonant. Given the supposedly high-impact effect of a well executed EA practice (whether the practice is called EA or labeled otherwise), the opposite scenario of a poorly executed EA, can result in wasted cycles i.e. spinning wheels without traction. We'll need more discussions on how to better measure EA performance and value.
Thanks for sharing the insights from the ABB process, and for all your discussions on EA.
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