Using Finance for Improvement to Demonstrate the Economic Value of Improvement

Using Finance for Improvement to Demonstrate the Economic Value of Improvement, Excellence and Quality
Douglas Wood

Using the principles of finance for improvement you can show the specific economic benefits of a six sigma, ISO, Baldrige based, or other process improvement program. This article provides some guidance on applying what was formerly called Cost-of-Quality principles.

Why would an organization apply this approach?

Finance for improvement measures the costs connected with either attaining the desired level of quality in a service or product, or missing the desired level of quality. These are the costs of preventing quality issues, appraising quality level, controlling quality level, or failing to make the desired quality level. Quality of product, quality of service, and quality of process are all included. This is called finance for improvement since financial information is used to identify improvement areas and show the level of improvement in a dollars and cents manner.

Setting up a formal measure of these costs allows many benefits, largely unobtainable with other approaches.

  1. To move an organization along quickly without using trial and error methods while integrating improvement approaches into functional areas, finance for improvement must be a significant part of managing the enterprise. Trial and error methods require extensive 'safety nets' in the form of inspection or auditing to prevent errors from passing into customer's hands. Only finance for improvement provides a means to reduce inspection while retaining clear control of process risks.
  2. Some forms of organizational improvement will shift costs from one area to another. When finance for improvement is applied correctly, every dollar of these cost reductions are directly added to profits, and trade-offs are avoided. Reducing cost in this way can increase quality levels, control risks while savings are created.
  3. Looking at the range of business measures from the top to the bottom of an organization, top managers usually use money in the key measures, and lower level areas use pieces, transactions, things to measure their work. This is true with improvement measures; few focus on money. Finance for improvement creates a measure from senior management's perspective, so that quality and/or improvement programs will be strategically planned by leaders.
  4. Improvement has an economic case to be considered. The salient points of this economic case are:
    • Businesses are in highly competitive arenas.
    • Improvement needs to be used as a strategic tool.
    • Quality is the 'right thing to do' and quality is understood by senior managers as imperative. Product and service quality are mere 'entry to the marketplace.'
    • To effectively move improvement methods into varying functional areas, there needs to be a translation of process improvement measures into the common language of business: money. Finance for improvement provides that translation.

Key definitions of terms

The terms describing this approach were coined decades ago, and our use of language has changed immensely. Today, the older terms of 'quality cost' or ‘cost of quality' are confusing; is this approach just about cost control? No, not really. How does 'quality cost' relate to quality of process, quality of product, and ways of handing poor quality risk?

To resolve this confusion, some have coined the terms "cost of poor quality" or "cost of poor execution," but these names do not connect to current thinking (2008) on business improvement. What used to be called 'quality' is now ‘improvement’, and it is carried on across the organization. One way to view this change is to think of newly hatched birds. The tools of quality have grown up and left the nest, and have begun their life anew as improvement tools.

There is a highly useful structure embedded in the old 'quality cost' model. We do not need to start over from scratch. Over the last several decades, quality costs have been divided into several categories. This tried and true definition categorizes quality costs as 1) prevention, 2) appraisal, and 3) failure costs. Failure costs are usually split into internal failure costs and external failure costs. This is often called the "PAF" model.

Here are the definitions of these terms:

Prevention costs: costs of all activities specifically designed to prevent poor quality in products or services. Examples are the costs of new-product review, quality planning, supplier capability surveys, process capability evaluations, quality-improvement team meetings, quality-improvement projects, quality education and training. All improvement approaches (six sigma, ISO, Baldrige, for example) will invest in some prevention activity. The costs of these prevention activities are investments tied to specific failure costs.

Appraisal costs: costs associated with measuring, evaluating or auditing products or services to assure conformance to quality standards and performance requirements. These include the costs of incoming and source inspection/test of purchased material, in process and final inspection/test, product, process, or service audits, calibration of measuring and test equipment, and the costs of associated supplies and materials. Most improvement programs enable reduction of these classic "quality" area expenses as work processes are better controlled and prevention investments bear fruit.

Failure costs: costs resulting from products or services not conforming to requirements or customer/user needs. Failure costs are divided into internal and external failure cost categories. Reducing failure cost is the main objective of an improvement program.

Internal failure costs: failure costs occurring prior to delivery or shipment of the product, or the furnishing of a service, to the customer. Examples are the costs of scrap, rework, re-inspection, re-testing, material review, and down grading. In the service environment, effort that does not support service delivery may be considered internal failure. Part of implementation of finance for improvement requires identifying costs that are part of the PAF model and costs that are part of regular business activities.

External failure costs: failure costs occurring after delivery or shipment of the product, and during or after furnishing of a service, to the customer. Examples are the costs of processing customer complaints, customer returns, warranty claims, and product recalls. Service businesses often count second and third customer contacts as external failures, if the contacts are a follow up to the initial contact.

The total of these costs defines finance for improvement measurement in the broadest sense. The choice of including or excluding some of these costs should be made according to your needs and capabilities.

What are the core values of finance for improvement?

Flexibility

Finance for improvement can be applied at any organization that tracks cost. Service organizations can apply finance for improvement as well as manufacturing concerns: there are clear costs of poor processes in service industries as well as costs of measuring quality levels (appraisal) and investments in prevention of poor process outcomes. Most importantly, the defined elements of finance for improvement are meant to be considered and applied in the context of an individual organization. Because of this, these techniques can be applied to many types of organizations, and for almost all improvement approaches.

Cost reduction via prevention

Managing your improvement program is done best by using a careful balance of prevention activity cost, measurement activity cost, and connected costs. Increased and refocused prevention activities are used to first attack failure costs, then reduce appraisal costs.

Reducing the overall costs is the goal

A properly managed improvement program will show bottom-line cost savings while avoiding the serious pitfalls that can accompany simplistic cost cutting. These pitfalls may include decreases of product or service quality, increased customer dissatisfaction, added rework costs, or simple shifts of costs from one area to another.

The later a problem is found, the more it costs to fix

The central theme behind finance for improvement is that the largest costs occur after product has shipped or a service has been performed: that is, in the category of external failure costs. By showing costs in the order of flow, managers can alter activities and focus improvement efforts on finding issues at the earliest possible point in the flow. Solving problems at the point of internal failure (before shipment), during appraisal, or particularly in a prevention timeframe will provide the greatest improvement.

Showing the quality payoff

A finance for improvement system shows the payoff of improvement activities. Quality may be free, as Philip Crosby said, but not showing cost of conformances compared to the cost of non-conformances will hamper the decisions guiding your improvement program. For example, after an organization has completed many improvement projects, senior managers may ask if there is a point of diminishing returns. In other words, has the organization reached the point where added improvement activity consumes more resources than it returns in benefits? An ongoing finance for improvement program will answer that by showing the pace of improvement. Many improvement programs are discontinued too soon, before their benefits are fully realized.

A global look

Finance for improvement measurement allows a monetary measure of overall organizational progress. No longer will departments waste time arguing that their 'parts per million' improvement trumps the contribution of another department's 'cycle time reduction.' All improvement will be measured in terms of their contribution to the bottom line. Only then can improvement approaches be judged and compared strategically.

Implementation steps

There are seven key parts to implementing a finance for improvement program:

  1. Learn all you can: This is the process of obtaining as much information about finance for improvement as you can. There are courses and books available that outline the process, and using other's experience is almost always less expensive than learning it on your own. Be sure to look at materials that reference the older subject of cost of quality.
  2. Who is involved: Find out whom in your organization will need to support a finance for improvement program. These key people will need to understand the program in the context of your organization and your chosen improvement approach.
  3. Planning ahead for sound measurement: In assembling the nuts and bolts of your finance for improvement measure, understanding your existing measures is essential. Finance for improvement needs to use existing sources and be integrated in your planning and measurement processes.
  4. Keeping credibility: Operating your improvement program may take one, five, possibly ten years. Maintaining the integrity of a finance for improvement system over this span needs to be considered. The speed of improvement depends on your organizational culture, people's motivation for change, and the resources devoted to the effort.
  5. Goal setting: All measures need to have a dynamic goal setting process, one that will react to changing conditions and keep various areas moving in the same direction. Goals need to be created from specific initiatives, so that arbitrary 'stretch' goals do not set conditions for the wrong behavior.
  6. Institutionalizing the process: Leaders at all levels of your organization will need to become familiar with finance for improvement. If you can build the process into your everyday work processes, then the finance for improvement measure and the improvement approach itself will not be cast aside easily.
  7. Re-casting: Whether one year, five years or ten years along, your organization will reach a point where the cost improvement dollars will shrink. This does not mean your improvements are over. As your measured costs have declined, there will be new costs and issues to face. The program will need to be reset, and a fresh look will be needed to solve deeper issues.

A successful finance for improvement program will be comprehensive, and not just cover those portions of the business (or cost areas) that are simple or obvious. Leaving out portions that are significant but difficult to measure will skew the decisions and approaches taken to drive improvement. Be sure you have included all the key aspects in your measure, even if you need to add to your data collection or cost breakdown systems.

The Whole Organization

Improvements may be easily identified on one area, but spreading those improvements to other areas can be a struggle. The common link between dissimilar areas is money. By using costs as the measure of improvement, upstream and downstream areas can pursue improvements in common. The measurement is understandable for all.

With a comprehensive finance for improvement program, the costs from each organizational area can be totaled to provide an overall organizational measure. By comparing the pace of change of each area to its own track record, senior managers can allocate resources according to measured need and strategic plans.

Improvement methodologies such as lean, six sigma, ISO, and Baldrige-type programs all reference the need to measure an organization's performance. Finance for improvement provides the way to measure improvement so that measure can be integrated into an organization's strategic plan.

The core values of the Baldrige approach drive a holistic approach to improvement. 'Management by Fact,' 'Focus on Results and Creating Value,' and 'Systems Perspective' in particular support the use of finance for improvement.

Linkage is the key: from improvement approaches to dollars and cents, from failure costs to prevention activities, from early flow to middle and late flow of product, from supply chain beginnings to final customer and the end of the waste stream: linkage of key costs along these routes allows strategic improvement, and avoids disruptive improvement.

The Final Analysis

The name of the game is dollars and cents. Finance for improvement will demonstrate the value of improvement approaches in enhancing the profitability of an organization. Finance for improvement makes an ongoing "economic case" for the value of improvement, excellence, and quality, no matter what improvement approach is used.