Shifting the Paradigm: Reporting Improvement Projects' Financial Benefits: COPQ or CODND
The following is an excerpt from the book,Integrated Enterprise Excellence Volume III - Improvement Project Execution: A Management and Black Belt Guide for Going Beyond Lean Six Sigma and the Balanced Scorecard Citius Publishing, 2008. Previous blogs have described a business system that integrates the selection of improvement projects so that the enterprise as a whole benefits. In my next series of blogs, I will be elaborating on various aspects of executing improvement projects using the enhanced project execution roadmap contained in the Integrated Enterprise Excellence (IEE) business management system.
A mission of Six Sigma has been the reduction of cost of poor quality (COPQ). In Six Sigma, the interpretation for COPQ has a less rigid interpretation than traditional quality cost categories and perhaps a broader scope; however, its calculation centers around costs associated with defects or perhaps targets that have been established since no specification exist.
I prefer to base project financial benefits from the cost of doing nothing differently (CODND), which has broader costing implications than COPQ. In a traditional Six Sigma implementation, a defect needs to be defined, which impacts COPQ calculations. In transactional and other environments when there are no natural specifications, this can be difficult to accomplish.
Defect definition is not a requirement within an IEE implementation, which has been described in previous blogs, or a CODND calculation. Not requiring a defect definition for financial calculations has advantages since the non-conformance criteria placed on many transactional processes and metrics such as inventory, and cycle times are often arbitrary in that criteria can differ between people who are creating the metric.
In an IEE implementation, if a defect definition is clear and most appropriate than CODND could equal a COPQ calculation. However, when there is no obvious defect definition, we can determine a CODND from which the project would give focus to reduce; e.g., reducing work in progress (WIP) and its current CODND carrying cost.
Quality cost issues can dramatically affect a business, but very important issues are often hidden from view. Organizations can be missing the largest issues when they focus only on the tip of the iceberg. It is important for organizations to direct their efforts so that these hidden issues, which are often more important than the readily visible issues, are uncovered. IEE techniques can help flatten many of the issues that affect overall cost. However, management needs to ask the right questions so that these issues are effectively addressed. Success is a function of a need, vision, and plan.
Project benefits are usually classified as hard or soft savings. Hard savings are either above or below the operating profit line. Above the operating profit line examples are cost reduction and revenue enhancement. Below the operating profit line examples are working capital reductions and cost avoidance. The quantification of these benefits is typically expressed as cost of doing nothing differently (CODND). Soft savings have indirect benefits.
Let’s use a days sales outstanding (DSO) IEE project example to illustrate two options for conducting a project benefit analysis. DSO is typically the average number of days it takes to collect revenue after a sale has been made. For purposes of this study we defined DSO as the number of days before or after the due date that a payment is to be received. A +1 would indicate that an invoice receipt was one day after the due date, while a −1 would indicate that receipt was one day before the due date.
For an individual invoice, its DSO would be from the time the invoice was created until payment was received. CODND considerations could include the monetary implications of not getting paid immediately; e.g., costs associated with interest charges on the money due and additional paperwork charges. COPQ calculations typically involve the monetary implications beyond a criterion; e.g., costs associated with interest charges on the money due after the due date for the invoice and additional paperwork/activity charges beyond the due date.
One might take the position that incurred costs should not be considered until the due date of an invoice since this is the cost of doing business. This could be done. However, consider that some computer companies actually get paid before products are built for their internet on-line purchases and that their suppliers are paid much later for the parts that are part of the product assembly process. If we look at the total CODND opportunity costs, this could lead to out-of-the-box thinking. For example, we might be able to change our sales and production process so that we too could receive payment at the time of an order.
Finally, it needs to be highlighted that if all product produced from a process can be sold and if the project improved the overall capacity of the process (i.e., improved the capacity of the process bottleneck), the project financial credit should be total additional revenue for the additional product sold less cost of goods sold. That is, all current fixed costs are already covered and should not be spread across the new production capacity resulting from the project.