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Blog posts tagged in Cost Management

Posted by on in Management

The old saying “When the going gets tough the tough get going” is probably most apt to describe the current situation that most organizations are facing!  There is pressure all around – strong evidence of slowing down of the economy, inflation -prices  of key raw materials are going up, interest rates are going up all of which are clear pointers that margins are going to be under enormous pressure.  It would not be possible to increase prices under these circumstances or even maybe suicidal!

In an extremely challenging and competitive environment, like this, it is impossible to pass on all increases in costs to customers. The fact is that the customers have become very discerning with greater choices and more importantly availability of information. In such a situation if a company is desirous of increasing or retaining customers, it may even have to do it by reducing its prices without compromising on its profitability. It then becomes imperative for them to target all costs that do not add value to its products. 

It is here that companies should focus on a great opportunity to focus on “Cost of Quality”.  Like the term quality itself, the term “Cost of Quality” is used loosely and not entirely in the right context.  The term “Cost of Quality” refers to the summation of all costs associated with not delivering product or service in accordance with the requirements. These requirements can be regulatory, customer specifications or even internal.

Many organizations while monitoring performance do not measure this in its entirety effectively losing a great opportunity to manage costs.  It is estimated that in a typical organization the cost of quality would in be region of 30% of its sales, if not higher, while ideally the number should be less than half of it. The problem is that there is really no validated data but past experience does tend to point towards these numbers.

There is management quote that says that “What is measured gets managed”. A focused assessment of cost of quality will have an impact not only on the profitability of the company but on the quantum of resources that a company would require.  It could reduce the inventory requirements, make the collections more efficient and probably even impact the fixed assets acquisition.  Interest rates being high the lower the capital employed the better it would be.

There are four broad parameters under which “Cost of Quality” has to be measured under two categories.  The categories are “Cost of Non-conformance” and “Cost of Conformance”. Costs of Non-conformance include costs associated with internal failures & external failures. Conformance costs include costs of appraisal and costs of prevention.  To elaborate, internal failures would include costs associated with wastages & scrap, rework, breakdowns etc and external failures would include warranty claims, costs associated with addressing customer complaints, litigation costs etc.  Appraisal costs would include all costs associated with inspecting goods and services to ensure that they meet the specifications.  Preventive costs are costs associated with establishing good systems, training costs etc. In the ultimate analysis the first three costs namely internal failures, external failures and appraisal costs have to be brought down.  Preventive costs are proactive measures and it is the only cost that is permitted to go up though its incremental growth has to be continuously brought down.

It is strongly recommend that all costs are monitored using the four M approach – Men, Machines, Materials and Methods.  This captures all the elements of costs barring financial costs though even that is done indirectly.  The various parameters of costs of quality can be monitored under the above four heads and it would be possible to get a fairly reasonable picture of what the targets should be.  Every organization tends to have some low hanging fruits and that can easily be initial target. 

For prioritizing the target the ABC analysis of costs would be best approach where “A” items could account for about 65% of total costs, “B” 25% and “C” 10%. Invariably material and labour costs account for a significant part of the costs and that would be best starting point. It has been observed that revisiting the bill of material and checking out the ideal material consumption norms is very effective. It is critical to get back to basics and use the zero base approach where you have to justify expenditure from the first rupee. Better material specifications, choosing the right vendor are all integral part of the exercise.  We must remember that when are sourcing goods and services we not buying just products but capabilities.  Coming to manpower costs, much higher in the context of service industries, good job definitions, recruitment policies go a long way in reducing costs.

The cost of quality can also be used judiciously by companies to compensate employees as a part of their variable pay component.  This will make the employees also part of the process of cost management.

In addition to constantly monitoring cost of quality it is critical to monitor capacity utilizations. Capacity utilization monitoring helps to take dynamic pricing decisions to ensure that organizational activity is maintained at a healthy level. Again the primary metric would have to change depending on the industry, why a typical manufacturing company would monitor the capacity determining equipment a service company should be monitoring the utilization levels of the manpower. For example in a situation when the capacity utilization low it may be good idea to price a product or service below full cost recovery. That would ensure atleast partial recovery of fixed costs. From a metric perspective, it would be good idea to monitor “Overall Equipment Effectiveness” as it considers all the aspects namely availability, efficiency and quality. Best in class measures of OEE would be anything in excess of 85%.

Management of cost of quality is definitely the right route to cost optimization and strongly recommended even in good times!

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