Applying Cost of Quality to a Service Business

The costs of ensuring good quality and recovering from poor quality have often been found to total 25 percent to 30 percent of sales revenue. No wonder cost of quality (COQ) programs are attractive to senior managers. Kaplan defines such a program in a manufacturing context as “a financial, systemwide measure of the costs associated with preventing, testing for, or correcting defective items.”1 A COQ program may address costs associated with training employees to avoid errors, inspecting products, remaking products, wasted materials, and lost business. There is no commonly accepted definition of accounts or an official program structure.

COQ programs are controversial. Some experts have called them “a useful tool” and others “a waste of time and money.”2 Quality gurus Juran and Crosby have popularized the quality cost concept, but Deming sees no value in financial measures related to quality (nor do the Japanese firms that support his philosophy).3 The key question is: Does COQ aid in the quality process? Both practitioners and academics are trying to answer this question.

At this point, there are few solid examples of firms that have successfully implemented and maintained a COQ program as prescribed by such agencies as the American Society for Quality Control (ASQC).4 In particular, there are few examples of sustained COQ programs that have become an integral part of an organization’s total quality plan or overall management process.5 This paper describes a cost of quality management success story. The story is unusual in two respects. First, the organization made COQ an integral part of its operational management system; it used COQ more as a management tool than as an accounting technique. Second, the program was implemented in a sales and marketing division. COQ was originally developed as a manufacturing tool, and it has not been widely used in services.

The object of my research was the U.S. marketing division of Xerox. I was given access to all relevant documents, and I interviewed the division’s key players — the controller, the cost of quality manager, and functional managers — in addition to corporate senior managers. Xerox executives were fully cooperative, asking only that certain financial information be kept confidential.

In this paper I briefly describe the background and context of the COQ program, the definitions that were developed, and implementation. Three examples show how opportunities for savings were found and exploited. Finally, I list key factors that contributed to the program’s success.

Quality at Xerox

In the 1970s, Cannon, Minolta, IBM, Kodak, and other foreign and domestic competitors entered the global copier market and began making significant gains in market share at the expense of Xerox. In 1984, senior managers launched a dramatic program to change the company’s culture and raise its commitment to quality. They were rewarded in 1989 with the prestigious Malcolm Baldrige Quality Award. Senior managers credit “quality fever” with reversing the negative market trend.

The Xerox approach to COQ differs somewhat from those programs described by ASQC and others. Xerox defines three categories of quality costs: (1) the costs of conformance (prevention and appraisal), (2) the costs of nonconformance (failure to meet customer requirements before and after delivery), and (3) the costs of lost opportunities. The classic COQ model includes the first two categories, but the third category is unique to Xerox (see Table 1). The company’s COQ guide explains that lost opportunities are measured as the profit impact of lost revenues.6 These occur, for instance, when a customer chooses a competitive product over a Xerox product, when a customer cancels an order because of inadequate service, or when a customer buys Xerox equipment that is inadequate or unnecessary and switches to another brand.

Lost opportunity costs are directly influenced by conformance and nonconformance costs. For instance, in the event of a product failure, the company must use resources to correct the problem (nonconformance costs) that could be used for other opportunities. Employee training to build quality awareness is a conformance cost that likewise drains resources that could be used elsewhere. Thus quality directly influences lost opportunities, which translate directly into lost revenues.

The USMG Model

Headquartered in Rochester, New York, the U.S. marketing group (USMG) consists of 35,000 employees, 65 sales districts, and 5 sales regions, and it is responsible for over 5 billion dollars in yearly sales. The division purchases supplies and equipment, mainly document processing products, from Xerox manufacturing divisions worldwide and sells them throughout the United States. Division executives were well aware of the quality crusade going on throughout Xerox, but they delayed joining in until 1987.

The initial COQ estimate for USMG was $1.05 billion per year or 25 percent of sales revenue. This motivated senior managers to consider the program, but they were stymied with the task of translating the traditional definitions used in manufacturing to a service context. They struggled with COQ measures that focus on product cost. How do we define “product”? How do we measure nonconformance cost? What are our measurement standards? Ultimately, they defined their product as 100 percent customer satisfaction. Their job is to deliver the physical product and satisfy customer expectations. They relied heavily on the quality doctrine of “fitness for use.”

The division’s ultimate definitions differ from the traditional model in several ways. Conformance costs at USMG include training, communications, and inspections to ensure that actions are done correctly the first time. Nonconformance costs are those incurred from not meeting customer requirements for services such as training on equipment. A nonconformance cost might be the additional resources expended to go back to a customer and give better instructions, or the resources expended on an overly elaborate presentation. Lost opportunities are determined as in the corporate Xerox model. They occur, for example, when a customer cancels a service contract.

Implementation

It must first be said that USMG’s success in devising its program, which is unique among Xerox divisions, is directly attributable to corporate’s well established quality culture and emphasis on process. Corporate exerted strong pressure on its divisions to embrace quality programs. It trained managers in problem solving and the COQ process. COQ was presented not as the answer to all problems, but rather as a tool for ranking investments in quality programs. The division CFO’s willingness to fund the experiment was critical. Companies without a strong quality culture and the tangible support of senior management will not be able to implement a program like this one.

Several key factors influenced the program’s success. First, the program was established completely outside the operating budget process. COQ was used as a tool to help line managers better serve their customers, not as a financial or accounting measure. It was not just another cost reduction program; the focus was on improving business practices with the ultimate goal of complete customer satisfaction. Second, managers clearly communicated that the measures would not be used to judge individual performance or to eliminate jobs. This greatly facilitated worker involvement. Third, measures were based on rough numbers, not exact calculations. There were no monthly or quarterly progress reports, and COQ measures were not reconciled with accounting. This way the workload was minimized, and COQ figures were not used as targets.

One of the main inhibitors of a sustainable COQ program is the accounting data. Most accounting systems can capture conformance costs (prevention and appraisal) and nonconformance costs that are internal (i.e., fixing problems before they reach the customer). However, these systems have trouble accommodating external nonconformance costs (i.e., making up for failures identified after delivery), which typically constitute about 70 percent of failure costs. In addition, accountants often balk at these deviations from standard accounting practice. By keeping the COQ measures separate from the regular financial reporting system, senior managers kept attention focused on the appropriate issues.

Program implementation began with an extensive education program. All field managers and exempt headquarters employees participated in a one-day training program at which they received abundant, clear, and practical support materials.

A manager from the controller’s office was appointed Manager of Cost of Quality. The CFO made cost of quality the division’s financial quality project. The functional quality manager for finance was given the responsibility of coordinating the cost of quality program. Under Xerox’s Leadership through Quality program, each major functional area is responsible for designing and leading a quality project.

The division CFO chaired the initial meetings with senior staff members and representatives from each function. The task was to identify areas for improvement and assign project management responsibility: Using Pareto analysis, the group listed and ranked the major problems based on their subjective estimates of each problem’s cost, potential for correction, external customer impact, degree of difficulty; and project size.

The 1989 list of top quality problems included the following:

1. Time spent by sales and service personnel on work other than customer calls.
2. Sales personnel turnover.
3. Management of equipment term leases.
4. Parts repair.
5. Spare parts inventory.
6. Spare parts usage.
7. Air freight charges.
8. Product costing.
9. Obsolescence.
10. Third party financing arrangements.
11. Maintenance strategy.

Eleven teams were formed to tackle these projects. Each team included a senior staff member, representatives from appropriate functions, and a controller. The members determined the total cost of quality in their area by comparing the costs in a perfect world with the costs in their real world. For instance, the cost of running the sales department if there were no personnel turnover was subtracted from the cost of running the sales department with current turnover rates. In the spirit of using “roughly right” estimates, the teams did not hesitate to establish total COQ figures. The controllers were heavily involved in helping the teams to estimate costs and pull information from standard cost data. The vice-president of finance, who assigned the controllers, was adamant about their involvement. To him, the controllers were far more than accountants; they provided necessary support to the line managers.

The president empowered the teams to plan and execute changes that would lower quality costs. The teams were expected to determine root causes of problems and define systemic issues. The emphasis was on process over goals and positive change over measurements. Each team would report their accomplishments to the senior staff once a year.

Successes

To give an example of how a quality problem was handled, consider item ten: third party financing arrangements. USMG had an arrangement with a Xerox/Dana Corporation joint venture called Xerox Equipment Leasing, Inc. (XELI). USMG sold equipment to XELI, which leased it to customers with the option to buy. Customers received a lower monthly payment and passed-through tax benefits for purchased capital equipment. Xerox guaranteed residual values to Dana at the end of the term if the customer did not purchase the machine. Between 1985 and 1989, USMG sold over eight thousand machines through the program and generated over $200 million in revenue.

The problem was that 65 percent of the customers either did not buy the equipment at the end of the lease or canceled the lease. Xerox had expected this number to be closer to 20 percent. In 1989, this cancellation rate would have produced a negative accounting charge to income of $10 million. The company did not know what percentage of the customers left Xerox and what percentage purchased new Xerox equipment. The team members who investigated this problem included representatives of finance, pricing, product marketing, and major account marketing. They analyzed the economics to the customer, reviewed the incentives for the sales reps, and interviewed customers. They discovered that customers never intended to take title of the equipment, that they considered the program simply an operating lease that gave them lower monthly costs, and that at the end of the lease they wanted newer Xerox equipment with current technology. Only 14 percent of the customers planned to leave Xerox.

Thus the problem was an accounting one. Most customers did not in fact leave Xerox, so to translate the cancellation rate into a negative accounting charge was inaccurate. The team restructured the accounting system, thereby reducing the negative charge to income by $8 million. In addition, $300,000 in residual overpayment that would have wrongly gone to Dana under the old system was also recaptured.

Another good example is item seven: air freight charges. In 1988, USMG spent $11.2 million on air freight charges for shipping equipment and parts to USMG locations. The team assigned to this problem discovered that shipping decisions were made in many different functions at different levels. There was no reporting system, and the people who made these decisions rarely considered the time and cost tradeoffs of different methods. The team recommended that each USMG operation have one person responsible for making air freight decisions. The team streamlined procedures, enhanced communications between parties, and started a comprehensive reporting system. These changes reduced the air freight charges in 1989 to $4.7 million and in 1990 to an estimated $1.5 million.

Management of equipment obsolescence had also been identified as a problem (item nine). Historically, the annual equipment obsolescence expense had been running at $20 million to $25 million per year. Under the COQ program, finance and equipment personnel formed a team to look at these costs. They met weekly and looked for pricing promotions, major account bids, sales to foreign affiliates, and other possible internal users of the equipment. They considered the costs of refurbishing equipment and salvaging spare parts. One of the team members said, “We manage the off-lease equipment as if it was a gold mine!” The team made an aggressive goal of reducing obsolescence expense to $14 million per year. In 1989, they reduced this expense to $8.6 million, well below their initial goals.

Results

USMG’s total initial COQ estimate was $1.05 billion. The eleven selected projects totaled $250 million. In its first year, the program reduced COQ overall by $53 million (see Figure 1). Xerox senior management considered these results outstanding. And the results had great credibility because they correlated highly with the division’s 1989 profit results. Although dramatic, these changes were relatively painless. No one was laid off and there were no drastic cost-cutting measures, just process change and working smarter. The precision of the estimates was of little concern, but the correlation to the financial results gave real credibility to the achievement.

Implementation was not entirely smooth. Some functional managers were threatened by changes in their areas. There were, and are, doubters and tentative supporters. It became clear that methodologies and definitions needed further refinement and that training for middle managers needed to be increased. However, USMG managers are proud of their accomplishments. As they continue to develop the program, progress will be more visible over time. Senior managers must maintain their attention on the program in order for it to remain viable.

Key Success Factors

Several procedural steps in this extraordinarily successful program are worth noting:

• The parent corporation and the division were very serious about COQ. Xerox had developed an intensely quality-focused culture. USMG senior managers gave strong and visible support for the program. The in-depth training sessions sent a clear message to all employees, and the team’s power to make changes across functional lines further reinforced the message.
• The accuracy of the accounting and of the proper cost categories was not an issue. The emphasis was on producing rough numbers. The financial analysts generated the cost data and served as record keepers for each COQ project team.
• The teams were empowered. They were permitted to change procedures and policies and to incur conformance costs (e.g., hiring an air freight decision maker) to reduce nonconformance costs.
• There were no interim progress reports. Total opportunity costs were compared at the beginning and end of the year. The system was separate from the budgeting process.
• The program focused on setting priorities and selecting the most influential project, not on making mathematical calculations. Project ranking was based on the potential for correction, external customer impact, degree of difficulty, and project size. The division completed the easy projects first, such as equipment obsolescence, to ensure success and quick positive feedback.
• The program was user friendly and oriented toward line managers. It was not oriented toward accountants. Managers could easily see how their activities affected total quality costs.

Conclusion

This study suggests that a COQ program that focuses on operations, one that uses “roughly right” accounting and nonaccounting data, is more useful and provides more valuable information than elusive accounting systems that try to be everything to everyone. The best systems are designed for a purpose. Management accounting should focus on a network of studies rather than a single massive system. This approach is very much in harmony with activity-based accounting.

The program’s success shows that management accounting can provide the impetus for organizational change. At USMG, the COQ program increased cross-functional cooperation and stimulated managers to make significant operational changes. The results are dramatic — $54 million saved in one year — and are corroborated by profit results, but again the important point is not the accuracy of this figure, but the fact that it represents real efficiency gains and that it serves as a motivator for future changes. The success of USMG’s effort demonstrates the robust potential for cost of quality programs.