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Articles | September 26, 2013

The Hidden Cost of Poor Quality in Manufacturing

It is not uncommon for studies to indicate that cost of quality for manufacturers is typically 35% or higher as a percent of total sales. This number can be...

By WorkWiseSoftware

It is not uncommon for studies to indicate that cost of quality for manufacturers is typically 35% or higher as a percent of total sales. This number can be astounding to some, and we will attempt to expand the details behind these numbers.

By the end of this article, we hope you will have a better handle on your costs of poor quality, to help you make informed decisions on the directions you need to take in regard to this area. Many companies have found quality as an area that they can research and resolve with big benefits and, not so big an investment.

What are the Costs of Quality?

First, before we start, I would like to clear up a point of confusion. There are really two sources of costs in regard to quality. The first source of quality costs are the losses experienced because of poor quality. These can include lost revenues, lost production time, rework, warranty, and the like. For the purposes of this article, we will call them ‘Failure Costs.’

The second source of quality costs are the investments you make to improve quality. These include tools, gages, inspectors, and other tools you implement to have good quality. For this article we will call these costs ‘Prevention Costs.’ Your final cost of quality is the combination of the two. Your objective is to lower the final total cost, although you may have to increase prevention costs in order to lower failure costs.

You will also notice that several of the costs below are marked with the tag of ‘hidden.’ These are the costs that are often missed because they are either not measured for the purposes of quality, or are reported as expenses of other areas outside of quality.

Failure Costs

Internal Failure Costs

Many companies have the ability to track the non-hidden costs in their ERP manufacturing systems (some ERP systems lack this capability, particularly in overhead costs). However, even for those who have the ERP capability, these costs can become buried in the overhead accounts and stay invisible for all intents and purposes. These overhead costs, and the hidden costs create what has been popularly called the ‘second factory’, a place where there are lots of activities related to poor quality that managers do not have a dollarized perspective on. These costs can be, and often are, considerable.

One category of hidden costs that is worth special mention is lost shop time costs. If the poor quality product happens to run through one of your bottleneck operations, your cost for the time involved with the product that is scrapped can sum to the total cost of all time for your entire shop. In other words, your bottlenecks dictate the maximum of throughput that can run through your shop. For every hour lost on a bottleneck, there is one less hour for any other production, thereby costing one unit of time across the entire shop.

External Failure Costs

Example of a PPAP provided from RB-ERP® supplied by WorkWise, Inc.

As mentioned in the previous item, many of the non-hidden costs become hidden when they are recorded in accounts that are not included in the cost of quality, and are assumed to be the normal costs of other operations.

These external failure costs typically represent some of the largest and most hidden costs of poor quality. Tops on this list are the lost customers and corresponding lost revenues from poor quality. It is easy to calculate the value of the customer who confronts you and tells you they are leaving due to your poor quality. You simply tally the lifelong sales that this customer would represent. However, it is near impossible to determine the other 22 similar customers that leave silently because something in your organization just doesn’t meet their standards, and the competition does.
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Another area on this list that merits mentioning is in the cost of the warranty area. Most people understand that any failure of product recorded with a warranty claim is definitely a cost of poor quality. However, what about the failures in product after the warranty? For example, if you purchase a car, and there have been no failures in the first 100,000 miles (and the warranty was 36,000 miles), wouldn’t you be more prone to buy the next car from that same manufacturer? Absolutely! So building quality at a level that reaches beyond warranty periods may be as important as reducing warranty period problems. Now, what is the cost of poor quality for those who do not meet the expectations of the customer? It may be the full value of all future lost sales. Some would argue that you would measure this as the gross margin lost, or maybe the net profit lost, but what if the lost sales causes the plant to run at half capacity, or causes the closing of the plant altogether? It is not hard to see that lost customers can be a silent killer of your business.

Prevention Costs

Example of Gage and Tool Preventative Maintenance provided from RB-ERP supplied by WorkWise:

Prevention costs are the investments a company makes to deliver higher quality. As with any investment, good investments yield good results, and poor investments yield poor results. After investing in good people and process improvements, the next high yielding investment is typically a good quality management system (QMS) that works together as a high speed problem identification system, a fast problem resolution system, and a complete process documentation system. Investments in prevention costs are usually minor when compared to the magnitude of the failure costs.

As part of attacking the prevention cost area, one of the key areas of quality improvement that a good QMS can address are Appraisal Costs:

Appraisal Costs

Appraisal costs are the subject of much discussion, and are probably also one of the most misunderstood. When you mention quality to most people, they conjure up images of multiple inspectors running around the plant, measuring every little thing. In fact, good quality operations have few inspectors, and use them to help identify problem areas, and to help build dependable processes that don’t need to rely on minute by minute inspections. The secret is not to build more inspections, it is to quickly identify and eliminate problems. A good quality management system helps the organization to identify the problems, and to quickly manage the process of eliminating the problems. The quality management system can gives a voice to everyone to id problems, and then a problem resolution system to coordinate all the necessary parties (marketing research, engineering, production, shipping, or whoever else may be required). Imagine coordinating this multi-part effort with just email or spreadsheets. A quality management system keeps all parties on track, all documentation immediately available, and a history of all that has been done.

How Quality Makes Money

The answer to this is quite simple. Products that meet customer expectations at a cost that is equal to or lower than the competition attract more business. Higher quality products have a higher perceived value, and corresponding price. Higher quality products have lower failure costs, and lower manufacturing costs. The end result is higher revenues with lower costs. What could be better?

Summary

Many people are surprised to learn of the full extent of the costs of poor quality. In part, this is caused by the inability of normal business reporting systems to either consolidate the costs, or to capture them at all. This hidden nature causes a de-emphasis of a problem that deserves much more attention because of its magnitude, and the damage it causes to the business.

As an example, let’s assume for a minute, that your cost of quality runs between 35 and 50% of revenues. (Even the best of companies admit their COQ is at least as high as 21-25%). What portion of your attention and effort would you typically focus on a cost this high? These costs can often run higher than the total costs of marketing, accounting, and research/ development combined.

Now is the time for you to evaluate your programs, tally your true costs of quality and begin to make the type of investments that can potentially yield high results. From people, to systems, on to processes, you need to begin now to avoid losing to your competition.

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