Six Sigma: Turning COPQ into Expansion Capital (Cost of Poor Quality)

Have you ever wondered how you can increase growth in your business to increase profits and business valuation? Today we go over turning COPQ into expansion capitalĀ and how you can manage it to accelerate your companies growth using QuikSigma.




I’m Denton Bramwell, President of Promontory Management Group, PMG. We’re providers of QuikSigma, the new Six Sigma. What I’d like to discuss today is a perspective on quality that is different from what you may have heard before. The relentless pursuit of real quality provides probably the easiest path available to expanding your business and not just because it generates customer satisfaction. In fact, it is probably the easiest path to expansion capital. If you’re an employee, it’s also the best path to having stable employment with advancement opportunities. First, a definition. COPQ stands for cost of poor quality. It’s the cost of everything an organization does less than perfectly. If you’re a fan of lean, think of the seven mudas. If you’re a fan of Six Sigma, think of unoptimize processes. It includes everything that flows from not doing things perfectly. Inspection product returns, rejected incoming materials, idle time, inefficient processes, and all the costs of rework and redos. If a manager reads and marks up a report prepared by a subordinate and suggest changes, that’s inspection and rework and it’s part of COPQ.

In my experience, most companies think of quality is something you need to avoid problems. A final check on incoming material. A check on outgoing materials to make sure that they are ok to ship. Some companies put quality people in charge of document control and audits. A few enlightened companies see the quality function as a resource for line managers, a repository of quality knowledge that helps everyone do their jobs better. I think all of those views fall well short of the real vision of equality or a process improvement program. In my view, quality is the engine of growth and prosperity for a company. It’s a vast strategic importance. While it’s true that a good process improvement program will produce greater customer satisfaction, and that’s extremely important, it is not the most important reason to have a process improvement program.

Here’s a reality of the business world. The amount of profit a company makes will set its maximum growth rate. If your company is making ten percent profit, that’s about all you have to put back into the business. That’s what you have available to create revenue producing assets. So in a very simple model, without leverage a company’s growth rate is about the same as its profit. So if you want to grow faster what are your options? One thing you can do is sell equity in the company. Sell some of the stock and that’s a common strategy. The bad part of that is your new part owners will now share in the worth of the company and in any cash it throws off in the form of dividends. The amount you get for your stock? Well, that depends on profitability again. Investors are purchasing an annuity and the more the annuity pays in dividends, or accumulated worth, the more they’re willing to pay for the stock. Another strategy is to borrow money. If you can borrow at five percent and earn ten percent in your business, then you’re making money on the lenders money. Of course, you’re committed to pay interest rain or shine, good times or bad. That increases your financial risk and in the end, the lenders will want their money back. A lender will look closely at the worth of a company and will only lend a percentage of that worth.

So the amount of expansion capital you can get this way also depends greatly on profitability and that brings us to a third way to generate expansion capital, be more cost-efficient. That drives profitability. If you can convert the cash stream that’s going into COPQ to expansion capital, wonderful things can happen. You can accumulate the money and turn it into new capital equipment and labor or you can use it to greatly increase what you can get through debt or equity financing. You don’t have to pay any interest on it. You don’t have to pay it back and you don’t have to share the wealth with anyone you don’t want to. COPQ is a lot larger than most people expect. In the late nineteen eighties Wayne Stewart, one of our company’s co-founders, was a Vice President of Hewlett-Packard. He was also chairman of the supply chain steering committee and that committee made regular estimates of HP’s COPQ. Now, HP is a very well-run company, yet time after time this committee came up with COPQ estimates in the range of thirty-five to forty percent of total revenue. Think of it, thirty-five to forty cents of every one of the billions of dollars they took in went to finance waste of some sort. If you can convert your COPQ to cash, it’s not only a source of expansion capital, it’s a large source. That leads me to this astonishing statement. COPQ is often the best source of growth capital that you can access and that’s the connection to the quality function.

What should your quality or process improvement program be doing all day everyday? Attacking COPQ. In other words, converting COPQ to cash you can use to create a better business. Here’s an example of a business that did exactly that. Now these aren’t my slides. They are slides presented by the owner of the company at a public presentation. He’s given us permission to use them. The company is Intermountain Electronics in Price, Utah. Their business is supplying electronic and power control equipment to the mining industry. They’re a small company, but quite remarkable. They’re also the only client we’ve ever had who asked us to start our project preparation workshops at 6:00 am so the project leaders could get part of a day’s work in after class. We chartered 10 projects for them and here are four. The first required the basic tools and consisted in making sure that invoices exactly matched purchase orders. The non matches went from about ten percent to essentially nothing and that avoided delayed payments. They sped up the receivables and got a nice dividend. The second project required the advanced tools. Their laser cutter was a bottleneck for the whole shop floor and they were losing production time with excessive setup difficulty. This project essentially gave them back additional production hours that let the shop produce more. The other projects attacked excess inventory, shipping costs, supplier terms, and other issues. The company owner was delighted with what we helped his people do. But here’s the most important outcome. The company’s annual revenue was about 5 million dollars per year and investors valued his company at about 4.8 million dollars. It’s not too hard to figure out that the company was generating about half a million dollars per year in profit, but with process improvements, they were able to change that to a million and a quarter per year in profit. Then investors valued his company at ten million dollars still doing the same amount of business with the same people in the same workplace. Now, John the owner had much more equity, and investors were willing to loan a lot more money against that equity. So he borrowed money and expanded his company through acquisition. The important point is that he literally turned COPQ into expansion capital.

Here’s a second example. This is a client in the basic chemical feed stock business. Now I want to make it clear that we haven’t seen any of their financials and wouldn’t tell you about them if we had, but we surmise that this plant is generating roughly 300 million dollars in annual sales. In very round numbers, operations in this industry tend to make about seven percent profit. So that would put them somewhere in the broad neighborhood of 21 million dollars in profit. This client just started a QuikSigma process improvement program with 10 projects. We’re two months into the program and the first two projects are just finishing up for about a million dollars per year in savings. We think the whole program will net about four million dollars per year. That increases the site’s profit from 21 to about 25 million dollars per year, nineteen percent increase, and that has a profound effect on the value of the enterprise and is a source of expansion capital.

Here’s one more example. PMG took a division turnaround job in Juarez, Mexico. When we went in, the division occupied 200,000 square feet of space and was bursting at the seams. They’d already picked out an additional 200,000 square feet to expand into, doubling their floor space. The problem was that they had a huge hidden factory. The rework they had to do. Their first pass quality was only forty-six percent. They were spending more money and consuming more space doing rework then they were on doing just the job the first time. In a matter of weeks first pass quality was at ninety-nine percent and with that the unproductive half of the work went away. In the end, we were able to help the client get forty percent more throughput in the space that they already occupied. That’s a huge increase in business and was done by converting COPQ to expansion capital.

So far we’ve talked about what this means to an owner or an investor. It’s true that turning COPQ into growth capital is a wonderful growth strategy. But what about the view from an employee’s standpoint? From that standpoint, converting COPQ is tremendously important. First it creates a more vital competitive company and that’s a good place to work. All other factors equal, companies that work hard at killing COPQ will be able to provide more stable jobs and more personal advancement opportunities. Here’s a personal example. When my partner Wayne Stewart joined HP, I joined Tektronix. In those days, Tektronix was a powerhouse of a company. HP was a little bigger, about forty percent, and they out managed Tektronix and were more successful in generating and employing growth capital. Long after I left, Tektronix was acquired. HP became one of the largest and most successful companies in the world. How you get an employee capital makes a huge difference in the future of the company and in the lives of the people that are part of it.

Just a couple of final thoughts. Here’s one of my favorite quotes from W Edwards Deming, “No one has to change, survival is optional.” I think that’s important. Similarly, I often say that if you are planning to do about as well this year as you did last, you are depending on lazy competition for your survival. This message comes to you courtesy Promontory Management Group system of process improvement, QuikSigma. It’s the new Six Sigma. It’s faster, more powerful, and much easier to apply. Find us on the web at Thanks for watching.

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