Quality – Productivity Ratio

Introduction

In an effort to evaluate two divisions of a company that makes and sells jewelry this ratio was developed to measure sales and profits. It incorporates the Total Sales, Customer Returns, the Cost of Goods Sold and the Cost of Rework. The intent is to compare the Total Sales minus the Customer Returns against the Cost of Goods Sold and Cost of Rework. It goes back to the basic output versus input ratio (defined as efficiency in a Manufacturing Management Newsletter).

Definition

This ratio can be used by various divisions and departments to look for improvement opportunities. Sales might emphasize the Total Sales variable. Marketing might look strongly at the customer return dollars. The Cost of Goods Sold would be a point of interest for manufacturing. The Cost of Rework could be important for quality concerns. Each variable means something and effects the overall ratio. Which is:

Quality Total Sales – Customer ReturnsProductivity = ------------------------------------------ = EfficiencyRatio Cost of Goods Sold + Cost of Rework

An example of the QP ratio is:

Quality $5,000,000 - $200,000Productivity = ---------------------------- = 2.00Ratio $2,000,000 + $400,000

Evaluation

When evaluating your performance using this ratio you can also determine what improvements in each variable can effect the overall performance. For example, when trying to determine what the effect of increasing sales would be on the overall ratio you find that if the other variables increase linearly, there is no real change. Increasing Total Sales 25% would probably increase Customer Returns, Cost of Goods Sold and the Cost of Rework 25% as well. There may be some efficiency because of scale, but in general you are still the same ratio.

But if you decrease the Customer Returns, the Cost of Goods Sold, or the Cost of Rework, you get real improvements in the QP ratio. It is evident that these changes would be good for the company and make real improvements in quality and profitability. The question of which improvement has the most effect is handled by “What if” spreadsheet comparisons. You may even be able to put a cost estimate on the improvement and make decisions on which type of improvement is the most effective and profitable. For example:

This information is a paraphrase of an article in the Nov. 2002 issue of “Quality Progress” magazine from ASQ written by Richard A. Reid.

Lennie Briese, Consultant 11/16/2002

Example 1 Example 2 Example 3 Example 4 Example 5

Total Sales 5,000,000 6,250,000 5,000,000 5,000,000 5,000,000

Customer Returns

200,000 250,000 150,000 200,000 200,000

Cost of Goods Sold

2,000,000 2,500,000 2,000,000 1,500,000 2,000,000

Cost of Rework

400,000 500,000 400,000 400,000 300,000

QP Ratio 2.00 2.00 2.02 2.53 2.09

% Change - - 1 % 26.5% 4.5 %

This chart assumes a 25% improvement in each of the variables. When Total Sales goes up, the rest also go up because they are directly related by the process of production and rework. Changing the Customer Returns variable gives little (1%) change in the ratio. The most effective change is the Cost of Goods Sold, but changing this by 25% can be an expensive proposition. If you decrease the Cost of Rework 25% there is a slight improvement. But what is the best place to start?

Improvement Cost

Now lets introduce the cost of change into the analysis. If the change to increase Total Sales was $100,000 for advertising, the improvement was in Sales volume only not in quality or productivity. This could be good in itself, but not in an effort to increase efficiency.

A change in Customer Returns might be much less expensive. A change in returns policy may be accomplished by just an announcement. This could be under $10,000, but still with little return. And such a change could have a disastrous negative impact in the Total Sales dollars.

Changing the Cost of Goods Sold is by far the best improvement, but at what cost. Cutting the cost of goods 25% could require such a massive project that it might not be a reasonable choice. The costs to redesign and rebuild the entire production process (including purchasing) could be several times the yearly sales. So payback on a $10,000,000 process improvement could be years. But we do see that changes in this variable have the most direct effect.

Changing the Cost of Rework by 25% is more manageable than Cost of Goods Sold. It is a subset of the production process and has a more limited scope. It can be addressed by a change in the rework process, or even better yet, a change in production quality to reduce the quantity on rework. Ultimately, production quality changes help lower the Cost of Goods Sold too.

Conclusion

No matter what type of business you run, looking at this type of metric will help you evaluate or compare your business(es). Documenting the inputs in this ratio will also help you see what issues you have. If the Customer Returns or Cost of Rework numbers are so large that they have a big effect on the ratio this may point to specific problem. If you aren’t tracking the Cost of Rework, maybe there is a hidden cost that also effects profitability. Remember knowledge is power.

Lennie Briese, Consultant 11/16/2002