Defining Purchasing's Quality Costs
Mark S. Miller, C.P.M., C.I.R.M.
Mark S. Miller, C.P.M., C.I.R.M., Material Control Manager, Case Corporation, Racine, WI 53404, 414/636-6565
81st Annual International Conference Proceedings - 1996 - Chicago, IL
A tool that we have used to reduce costs in our purchasing department is called cost of quality (COQ). The basis for the COQ process is to identify and quantify the key drivers of unnecessary costs that can be affected by purchasing. Unnecessary costs are costs when are incurred when things go wrong, when we lose sales and when we must inspect.
I had the opportunity to serve on a committee whose mission it was to identify our company's COQ drivers. As a member of the committee I first learned the basics of COQ and then met and debated which factors should be included as purchasing COQ. The following is a summary of the basics I learned and the COQ items we identified that related to purchasing. I hope that some of these factors also exist in your departments and they will help you to begin using the "cost of quality" concept to measure your departments effectiveness.
COQ Summary. The COQ basics we learned were based on A.V. Feigenbaum's principles(Total Quality Control). Feigenbaum is recognized as the originator of the COQ concept. We learned that a key to improving our company's profits was to establish a system to identify, track, and control quality costs involved in producing our products. The goal is to reduce operating costs and improve customer service.
We learned that our company's total COQ, as a percentage of sales, was 30 percent in 1991. Good companies are at 10 percent, while world class organizations are at 5 percent or less. Our opportunity for improvement was huge!
Defining COQ should be done by the functional users, not accounting. Accounting can be used as consultants , but each functional group should use a creative approach to establish reasonable, easy-to-track ways to measure quality costs. The idea behind COQ is not the measurable impact to the bottom line; it is to make operational improvements, produce less waste and eliminate redundant effort in the department.
Quality costs can be separated into four categories:
- Prevention - These are costs that prevent failures from occurring and include employee quality training, process control, quality engineering, and quality improvement projects.
- Appraisal - These are expenditures incurred to evaluate the quality of products. Examples of appraisal items are incoming inspection, testing, quality audits, and evaluation of stock.
- Internal Failure - Costs that are the result of defects prior to shipments to the customer are classified as internal failures. Some typical internal failures items are scrap, rework, temporary part outsourcing, redesign by engineering, downtime and overtime.
- External Failure - Defects that are found after shipment is made to the customer is classified as external failure. These costs may include warranty, allowances, returned material, customer complaints, product liability , lawsuits, and customer service.
COQ items Identified For Purchasing. Once the team finished the class on basics, we started the process of identifying potential COQ times for Purchasing. After several meetings our list of items was long. We separated purchasings' COQ into three key areas:
- Customer satisfaction
- Cycle Time, and
- Supplier Performance.
Customer satisfaction - The common goal to unify the organization. Since customer satisfaction is a key mission of our company, the COQ committee concluded that each function within the company should examine how they impact the customer. Defining the cost of not satisfying the customer was our most difficult challenge as a committee.
In Purchasing, there is a tendency to focus on cost measures instead of customer satisfaction. The Purchasing Department is often challenged to find more cost reductions: traffic is driven to find less expensive carriers; and the inventory management department's goals revolve around turn rates and inventory carrying costs. But the lowest price or the lowest inventory level often leads to customer dissatisfaction.
Customer satisfaction is the one common goal that can resolve conflicts between functional groups. The Purchasing Department wants to order large quantities to lower purchase costs, but inventory control wants to order smaller quantities to reduce inventory levels. The sales department wants to maximize sales and will promise a ship date that can't be met. A common customer satisfaction measure that all functions recognize and track will resolve many of the functional conflicts.
Fill rates - The customer service measure we identified was order entry fill rates. We established a fill target and assigned a cost of $100,000 per 1% over the target fill rate.
Cycle time- The key to reducing costs and increasing customer service. Cycle time is the length of time required to move the product through the distribution channel - from the supplier to the customer. A key for purchasing is to reduce the cycle time thus reducing the required investment in inventory, at the same time, increasing customer service. The COQ measurements we identified under cycle time are:
Premium freight - Any time premium freight has to be used , the added cost is considered to be the result of a defect. We track the costs of air freight and premium surface costs and report these actual costs as COQ.
Freight bills: manually processed - All freight bills processed manually, not electronically through EDI(electronic data interchange), cause added costs. We assigned a COQ of $5- per freight invoice processed manually.
Supplier performance - Measuring Purchasings' Main Function. We were able to identify several COQ measurements that related to supplier performance. These measurements were different approaches to identifying how well suppliers were doing regarding on time delivery, competitive pricing and maintaining superior quality. The measurements we selected for supplier performance were:
Inspection costs - If all suppliers were completely reliable regarding quality, no receiving inspection would be needed. Thus all costs associated with receiving inspection is captured as COQ.
Late deliveries - If a supplier delivered on time expediting costs, premium freight and customer service costs would be reduced. We assigned a cost of $50,000 for each 1% under 90%
Supplier quality audits - These are costs associated with auditing a supplier's quality system. We selected a cost of $4,500 per supplier audit. This cost assumed three members were on an audit team, estimated travel expenses for three days, plus documentation costs required once the team returned to the office.
Supplier rejections - These are costs related to poor quality products received from a supplier, which leads to parts being rejected. Rejections are made at receiving inspection or from the production line when the defect is discovered. We assigned a cost of $25 to represent the administration cost to process the rejection.
Number of suppliers over target - By reducing the number of suppliers, many costs were eliminated. These costs include the cost of establishing a contract, the need to negotiate prices, and the number of suppliers to visit and audit. We decided that each supplier over the target affected costs by $10,000.
Invoice discrepancies - Each time a supplier invoice does not match the purchase order or the receiving record, a discrepancy is created that purchasing must resolve. We assigned a cost of $50 as the COQ involved.
Suppliers not on EDI - Suppliers who do not communicate with us electronically for purchase order releases and invoices add costs in the form of added cycle times, duplicate data entry, and unnecessary stationary and postage costs. We calculate that the cost of not having a supplier as an EDI partner is $4,350 per supplier per year.
Expediting - All expediting costs can be eliminated if the forecasts are accurate and the supplier delivers on time. Thus all costs associated with maintaining the expediting function are considered a quality cost.
Suppliers lead-times - The longer the lead-times, the more inventory that is needed as safety stock to compensate for forecast errors, increase in schedules, quality problems or damaged stock. We establish a lead time target each year and for each week lead-times exceed the target a $100,000 COQ is assigned.
Cost of quality matrix All of the COQ items identified for Purchasing can be put in a matrix. Table 1 is a sample of the Purchasing matrix for the COQ items we have discussed.
It is my hope that this review of COQ as it relates to our Purchasing department will be useful to you in defining your quality costs. Major points that I want to emphasize are:
Functional users - not accountants- should define the COQ measures. For instance, we estimate that each supplier we reduced would save $10,000. But accountants keep insisting we show whose budget the effect of $10,000 would impact. Do not let the accountants run the COQ program.
It was very difficult to find customer satisfaction goals for Purchasing. But a customer satisfaction focus will help you remove conflicting goals and help your department work together for a common goal. Force yourself to find a COQ customer satisfaction item.
The COQ concept works well. It took some time and several meetings to identify the COQ items. Then the hard part begins: to attack and reduce these excess costs. But it works. COQ is a tool you can use that will help you reduce costs and improve customer satisfaction.
Feigenbaum, Armand, V. Total Quality Control . New York: McGraw-Hill, 1983.
Table 1. Cost of Quality matrix - Purchasing department Activity Definition
- Department training cost center / actual costs
- SQA training $4,500 per audit
- Inspection costs cost center/ actual costs
- Internal failures
- Scheduled/ change notices $250 per change
- Manual orders $50 per order
- Premium freight cost center/ actual costs
- Suppliers not on EDI $4,350 per supplier
- Late deliveries $50,000 per 1%
- Supplier rejects $25 per reject
- Suppliers over target $10,000 per supplier
- Invoice discrepancies $50 per
- Expediting costs cost center/ actual costs
- External Failures
- Fill rate under target $1000 per 1%
- Warranty cost center/ actual costs