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Online Student Guide

OpusWorks 2019, All Rights Reserved

Process-Based Costs

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Table of Contents

LEARNING OBJECTIVES ....................................................................................................................................4

INTRODUCTION ..................................................................................................................................................4 COPQ AND DPMO ........................................................................................................................................................................ 4 UNDERSTANDING THE OVERALL COST OF QUALITY ............................................................................................................. 4 HOW THE COST OF QUALITY COMPONENTS IMPACT OVERAL COSTS................................................................................ 4

COST OF QUALITY COMPONENTS .................................................................................................................5 INTERNAL FAILURE COSTS .......................................................................................................................................................... 5 EXTERNAL FAILURE COSTS .......................................................................................................................................................... 5 APPRAISAL COSTS .......................................................................................................................................................................... 6 PREVENTION COSTS ...................................................................................................................................................................... 6 THE OVERALL COST OF QUALITY ............................................................................................................................................... 6 THE COSTS OF QUALITY ............................................................................................................................................................... 7 PROFIT .............................................................................................................................................................................................. 7 FINDING PROFIT ............................................................................................................................................................................. 8 ENTITLEMENT COST ...................................................................................................................................................................... 8

COPQ & DPMO .....................................................................................................................................................9 COPQ ................................................................................................................................................................................................ 9 COPQ & DPMO .......................................................................................................................................................................... 10 DPMO ........................................................................................................................................................................................... 10 DPMO CALCULATION ................................................................................................................................................................ 11 DEFINITION OF A DEFECT ......................................................................................................................................................... 11 HOW TO CALCULATE DPMO .................................................................................................................................................... 12 COMPLETING DPMO CALCULATION ...................................................................................................................................... 12 HOW TO FIND COPQ .................................................................................................................................................................. 12 APPLICATION OF PROCESS IMPROVEMENT METHODOLOGY ............................................................................................. 13 NET PROFIT .................................................................................................................................................................................. 13

SIGMA QUALITY LEVEL ................................................................................................................................. 13 SIGMA QUALITY LEVEL .............................................................................................................................................................. 13 CALCULATING SIGMA QUALITY LEVELS ................................................................................................................................. 14 COPQ CALCULATION ................................................................................................................................................................. 14 REDUCE DPMO ........................................................................................................................................................................... 14 REDUCE COPQ ............................................................................................................................................................................ 14 BENEFITS ...................................................................................................................................................................................... 15 SAVINGS ......................................................................................................................................................................................... 16 LOWER COPQ .............................................................................................................................................................................. 16

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Learning Objectives

Upon completion of this course, student will be able to: • Discuss how the overall cost of quality relates to both the cost of poor quality and the cost of

good quality • Define Cost of Poor Quality (or COPQ), identify its components as they relate to the process • Explain how to calculate the COPQ metric • Identify the benefits derived by a company when they are able to reduce COPQ

Introduction

COPQ and DPMO

COPQ and defects per million opportunities (or DPMO) are the two quality measures most frequently identified in a Process Improvement project. These two key metrics are typically addressed within the Define and Measure phases of the DMAIC process.

Understanding The Overall Cost of Quality

As companies learn more about business improvement methodologies, one factor becomes very evident: quality must be built into products and services, and not added later, after the fact.

Philip B. Crosby explains in his book Quality Is Free that the overall cost of quality has two main components. The first component is the cost of good quality, which is sometimes referred to as the cost of conformance. The second component is the cost of poor quality, referred to as the cost of failure or non-conformance. Let’s take a brief look at these two components.

How the Cost of Quality Components Impact Overal Costs

Good quality affects the cost of an organization’s products and services in a couple ways. First, there are built-in process costs that organizations invest to prevent non-conformance, relative to both internal and external customer requirements. There are also costs for appraising a product or service to proactively assure conformance to requirements; these costs are not reactive to non-conformance.

The cost impact of poor quality is realized through increases in internal and external costs that directly result from failing to meet the requirements of internal and external customers.

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Cost of Quality Components

Internal Failure Costs

Now let’s take a closer look at COPQ. COPQ has two primary components, internal failure costs and external failure costs. Internal failure costs are the direct result of products or services not conforming to the requirements of the next internal customer or process step. Internal costs occur before delivery of products and services to external customers. If these internal failures are not captured, the next user or customer will not be satisfied. Typical internal failures results from deficiencies that are caused by errors in products, or by inefficiencies in processes. Common examples of internal failure costs include the following:

- Cost of failure analysis, which is used to determine the cause of failure - Rework of defective products or services - Unplanned delays of any type - Re-designing to correct errors - Shortages - Re-inspection or re-testing - Downgrading - Downtime - Lack of flexibility and adaptability

Next, we will look at external failure costs.

External Failure Costs

External failure costs are typically the result of product or service deficiencies that are found after delivery to external customers. These failures are the most significant cause of dissatisfied customers; they often lead to lost customers or lost business contracts. The following are common examples of external failure costs:

- Product recalls - Handling of Customer complaints - Rework or Repairing products - Redoing services - Warranties - Customers’ bad will - Losses due to sales reductions - Environmental recovery costs - Safety audits or fines

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Appraisal Costs

The cost of good quality also has two primary components, Appraisal costs and Prevention costs. An organization invests in Appraisal costs to control products and services to ensure the highest quality level for all customers, throughout the entire product or services process and delivery. Ensuring this level of quality requires conformance to both internal and external quality standards and performance requirements. Common examples of Appraisal costs include the following:

- Verifying, checking, and testing of purchased goods and services before use

- In-process and final inspection or 100% testing - Cost of conducting field testing - Product, process, service, and self-conducted safety

audits - Calibration of assembly, measurement, and test equipment

Prevention Costs

Prevention costs are the costs of activities designed to proactively prevent the occurrence of poor quality in products or services. Examples of Prevention costs include the following:

- Quality planning - Supplier evaluation - New product review - Poke Yoke or Error proofing - Process and product capability evaluations - Quality improvement team meetings - Quality improvement projects - Quality education and training - Implementation of Lean and Six Sigma programs

The Overall Cost of Quality

The overall cost of quality is the sum of both good and poor quality costs. Overall costs identify and highlight the difference between the actual cost of a product or service, and what the reduced cost could be if no substandard service or defective product was allowed to escape undetected. This cost difference is often quite significant.

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The Costs of Quality

Often, the costs of quality are not readily identified, or are hidden. This makes them very difficult to capture through traditional measurement methods or systems. To illustrate this issue, we often refer to an iceberg diagram. As you can see in this iceberg diagram, only a fraction of both poor and good quality costs appear above the surface of the water and are visible. When an organization can make the underwater costs visible, it will be able to identify many more opportunities to reduce the overall cost of quality. Reducing and eliminating these costs opens up great opportunities for continuous improvement. Through business improvement methodologies, an organization can use cost of quality reductions to help increase sales and gain a more competitive business edge.

Profit

Now we will demonstrate how organizations can use of cost of quality information to their advantage. This diagram shows two different companies that offer virtually identical services. Company A and Company B both provide the same service, with high levels of customer satisfaction. As you see here, Company A has a credit card with an annual fee of $100. Company B offers the same type of credit card for $90. With the information provided, can you tell which company nets more profit on its service?

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Finding Profit

What information do we need in order to determine which company nets more profit? First, we must define “net profit.” In our example, net profit is the annual fee of the credit card, minus the total service costs. Since we know the annual fees charged by each credit card company, the next step is to determine the costs related to each card. To do this, we begin by calculating the cost associated with doing the right things right the first time. Providing the service right the first time has zero defects. This cost is known as the Entitlement cost.

Entitlement Cost

As you can see from the graph, the Entitlement cost is the same for both products. Neither company has established a competitive advantage at this point. To provide the highest quality product or service, at the lowest possible cost, organizations strive to have the total service cost equal the Entitlement cost. However, there is another component of total service cost, which is COPQ.

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COPQ & DPMO

COPQ

Company A’s COPQ is $30, and Company B’s COPQ is $15. When we add each company’s Entitlement cost and COPQ, we see that Company A’s total service cost is $80, as opposed to $65 for Company B.

Now do we have enough information to determine which company is producing their service more efficiently and making more net profit? As you can see, because of its lower COPQ, Company B nets more profit than Company A. The result is that Company B has gained a distinct competitive advantage. Company B has both a lower COPQ and a lower product price. Because Company B also appears to have fewer defects, it is likely that their customers are more satisfied as well.

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COPQ & DPMO

Now that you have a basic understanding of COPQ, let’s examine how improving the quality level in the process can drive down this metric. In this diagram, we see a typical process step, with a decision point where an inspection occurs regarding the quality level. If the work is accepted it moves on to the next process step. But if a defect is discovered and the work is sent back, it enters a rework loop. The defect level at this point in the process can have a profound effect on the COPQ. Let’s see why.

DPMO

To calculate the COPQ for this rework loop, we need to gather some basic information regarding the defect rate; the volume of work, in units, that flows through the process; and the process costs. First, we will calculate the defect rate for the unit of work. This rate is expressed as Defects per Million Opportunities (or DPMO). As the name implies, it represents the number of defects that would occur for

every one million opportunities. In this example our volume of work is 2.5 million units per year, and our defect rate is .11, or 11%. In other words, 11% of the units produced go through the 2 day rework cycle, which is non value-added work.

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DPMO Calculation

Let’s look at an example of a DPMO calculation. Because the definitions of a “defect” and an “opportunity” are critical to the calculation of DPMO, we

begin by defining the opportunity. Here you see a customer application form for a credit card. The form contains five sections. We could define the opportunity in many ways, including the form, each section, customer information, every word, or even every letter or number. For this example, we have decided to count each form as an opportunity and to measure the defect rate at the form level.

Definition of a Defect

Next, we must determine our definition of a defect. We must be very specific and clear in the definition. It is also important to make sure everyone on the team agrees to the definition and commits to following the rules when tracking defects. Again, we could define a defect in many ways. For example, we may consider a defect to be at least one error on a form; any error on transactions made; any piece of incorrect customer information; any incorrect word; or any incorrect letter or number. In this example, we have decided to define the application as containing a defect if at least one error occurs on the application.

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How to Calculate DPMO

Now that we have defined the opportunity and the defect, we can calculate DPMO. To calculate the defect rate as a DPMO value, we divide the number of defects by the number of opportunities, and multiply by one million. In our example, 2000 forms were inspected, and 220 defects were found. Now let’s plug our numbers into the DPMO formula. 220 divided by 2000 equals 0.11 (or 11%). Next, we multiply 0.11 times one million for a DPMO value of 110,000.

This means that for every one million application forms processed, 110,000 will have a defect.

Completing DPMO Calculation

To complete the calculation of COPQ, we need to know the volume or flow rate for the process, and the process costs associated with reworking each unit. In our example, there are 2.5

million application forms processed per year. Each application form that is sent back for reprocessing, due to the erroneous information on the application, has a rework cost of $2.50.

How to find COPQ

The COPQ for this process is found by multiplying the defect rate times the volume, times the cost of rework. Recall that our defect rate is .11, 0r 11%, our volume is 2.5 million application forms per year, and each defect costs $2.50 to correct. Now that we have the data we need, we simply plug it into the COPQ formula as follows: 0.11

times 2.5 million, times $2.50 = $687,500. This means that the COPQ for this rework loop is $687,500 per year.

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Application of Process Improvement Methodology

Now, let’s go back to our earlier example of the two credit card companies. As you recall, company A’s COPQ was $30, which resulted in a net profit of $20; and Company B’s COPQ was $15, for a net profit of

$25. Armed with this data, let’s see what Company A was able to accomplish by a simple application of process improvement methodology. Keep in mind that although it is helpful for an organization to know how to calculate COPQ, if it fails to use the data to its advantage, then it really hasn’t accomplished anything.

Net Profit

Based upon the COPQ information Company A gathered in its process, it completed several process improvement projects that reduced its COPQ by over 60%, from $30 to approximately $10. With this reduction in COPQ, Company A lowered its costs; increased its net profit from $20 to $40; and improved customer satisfaction. In short, Company A used the COPQ to gain a competitive edge over Company B.

Sigma Quality Level

Sigma Quality Level

Another Six Sigma metric, used to show the quality level of a process, is the Sigma Quality Level. This horizontal axis of this chart shows the Sigma Quality Level, represented as a number from zero to

six, with zero being the lowest quality level, and six being the highest. The vertical axis shows defect rate, expressed as DPMO. This chart (allowing for a slight shift in the process mean) is used to show the long-term quality level of a process when it runs at a stated level, such as 2 Sigma, 3 Sigma, or 6 Sigma. Next, we will show you how this chart is used to translate DPMO into a Sigma Quality Level.

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Calculating Sigma Quality Levels

Recall that in our earlier example, we calculated a DPMO value of 110,000. Using this chart to translate the DPMO to a Sigma Quality Level, we locate 110,000 on the vertical axis, and draw a horizontal line until it intersects the curve. From this point of intersection, we then draw a vertical line down to the horizontal axis. This point on the horizontal axis shows us the Sigma Quality Level that corresponds to a DPMO value of 110,000. As you can see, the Sigma Quality Level for this process is approximately 2.73.

COPQ Calculation

Before we continue with our current example, let’s take a moment to review the process details. At this point, we know the process is operating at a 2.73 Sigma Quality Level, with a COPQ of $687,500 per year, based on a flow of 2.5 million units annually. For every defect sent back for rework, the cost is $2.50. Keep in mind that this rework loop does not provide any Value Add to the customer.

Reduce DPMO

As this chart shows, when the process improves from 2.73 Sigma Quality Level to a higher Sigma Quality Level, in this case 6, the defect rate drops from approximately 110,000 to approximately 3.4. That’s quite an improvement! A key benefit of improving the Sigma Quality Level is a reduced defect rate. Next, we will explain how improving the Sigma Quality Level decreases COPQ and improves customer satisfaction.

Reduce COPQ

With our process running at a 2.73 Sigma Quality Level, COPQ was equal to $687,500. Now let’s calculate the COPQ at a 6 Sigma Quality Level. As you learned earlier, the COPQ calculation is the defect rate times the volume, times the cost of rework. Remember, the defect rate is our DPMO of 3.4, divided by one million, which equals 0.0000034. Our volume is still 2.5 million, and our cost of rework is still $2.50. Now that we have our data, we simply plug it into the COPQ formula as follows: 0.0000034 times 2.5 million, times 2.50, equals 21.25.

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This means that by increasing the Sigma Quality Level from 2.73 to 6, the COPQ dropped from $687,500 to just $21.25! For a company producing at this volume, this low COPQ level is essentially zero. Reduced COPQ is another key benefit of an improved Sigma Quality Level.

Benefits

In addition to reduced DPMO and COPQ, there are many intangible, or hidden, benefits of improving the Sigma Quality Level. These types of benefits are commonly known as soft savings, as opposed to hard savings, because they don’t directly affect the bottom line. An organization cannot precisely calculate the direct effect or dollar value of soft savings, as it can with DPMO or COPQ. However, it can make some strong observations. The following are some observations we could make from our process example: - As the process improves from a 2.73 Sigma Quality Level to a 6 Sigma, customer satisfaction will improve. - With a drop in the DPMO value to 3.4, fewer defects are created. This makes it less likely a defect will reach the customer. - With a lower COPQ, the company becomes more competitive. A more competitive company is better positioned to act quickly, and profitably, during market changes. - With less rework in the process, Cycle Time improves, and more customers receive faster and better service.

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Savings

There are three types of savings that can be generated by reducing COPQ. As you just learned, two of these are hard savings and soft savings. The third is called cost avoidance savings.

Hard Savings – are quantifiable savings that allow an organization to do the same amount of work (or more work) with fewer resources or lower operating costs Soft Savings – intangible benefits that are not easily quantifiable such as increased job satisfaction or more time available. Cost Avoidance – allows an organization to handle more business without adding resources, people or equipment, or a planned expense is not longer necessary

Lower COPQ

In this module, you have learned that lowering COPQ provides business benefits for several reasons, including the following: - Reducing variation and defects in a process can improve quality, while lowering the overall cost of the service or product delivered to the customer. - Reducing COPQ increases net profit and return on investment (ROI). For this reason, finding ways to reduce COPQ enables companies to reallocate their human and financial assets more effectively. - COPQ measures can help strengthen consensus for improvement. In addition, these measures can help teams select improvement projects with clear bottom line benefits.