#4 How internal failure costs predict your company’s future

Date: Today
To: Top management
From: Your quality team
Subject: We’re burning through cash

Our company makes products we’re all proud of. But we’re also producing crap—way too much crap.

Crap is what defective, nonconforming output looks like—and feels like—to us, your quality team.

As we all know, there’s a cost to that crap: reworking nonconforming output and scrapping output that can’t be reworked costs money.

But here’s the thing: these internal failure costs aren’t really costs at all. They’re large, avoidable losses.

According to Gartner’s 2022 Cost of Quality Survey^[1], manufacturers who track their total cost of quality spend an average of 25% on internal failure costs (the costs of fixing or disposing of nonconforming products). And as the average spend on quality tends to be around 5% of revenue, it’s reasonable to assume we’re losing at least 1.25% of our revenue on internal failure costs.

What’s more, the real figure is certainly higher.

In fact, it’s so much higher that internal failure costs are known as icebergs: what you see is a fraction of what’s actually there. Which means we stand to gain a whole lot more than just 1.25% of our revenue by getting things right, the first time.

In this memo, we’ll walk you through what our internal failure costs mean for our future—and highlight the significant gains to be made by cracking down on them.

Here are three key insights about internal failure costs, their impact, and how to profit from them.

It’s easy to assume that quality issues are under control if customers aren’t complaining and warranty costs and returns are low.

However, low external failure costs can carry a hefty price tag. They can be low because of the money spent coping with internal failures—all the nonconforming output we deal with onsite.

It would be reasonable to assume that we know exactly what our internal failure costs are. Like many companies (90% according to Gartner’s 2022 Cost of Quality Survey^[1]), we do track them.

But—and this is crucial—we only track some of them.

We tend to monitor the internal failure costs that are easy to track and quantify. (This is mainly because we lack the digital tools—an effective Quality Management System (QMS), for example—to track anything else.) What’s more, we may even be ignoring the ways we compensate for poor quality. (More of this later.)

Returning to the idea that the bulk of our internal failure costs are hidden, we can think of them in terms of the four layers of an iceberg:

• The peak everyone sees
• The area just below the surface that’s easy to forget
• A large midsection that’s often ignored
• An enormous base we’re barely aware of

Here’s what each section means for us.

The peak everyone sees

Like most manufacturers, we track the obvious costs of nonconforming output, such as scrap and rework. 84% of manufacturers surveyed by Gartner track the cost of scrap. 76% track the cost of rework and defect rework.^[1]

The area just below the surface that’s easy to forget

Our awareness of our internal failure costs dips significantly once we turn to less straightforward costs. We’re not alone in this. Only 44% of manufacturers account for what they spend on corrective action processes, while 43% track their disposal costs.^[1]

A large midsection that’s often ignored

Only about a third of manufacturers track what they spend on re-inspection (38%), rework of supplier rejects (38%), re-testing (35%), non-material rework costs (31%) and failure analysis costs (27%).^[1]

Take non-material rework costs for example. These range from the wear and tear of equipment, to what we spend on additional energy, labour, raw materials and cleaning steps.

There’s a reason we tend to ignore these costs. Tracking them efficiently is almost impossible without appropriate digital tools.

An enormous base we’re barely aware of

These can be the most dangerous costs because they are so well disguised.

At this level of the iceberg, internal failure costs are treated as a “normal” part of the manufacturing process. Typical culprits include excess material allowances; planned overruns; standby machines, equipment and personnel; safety stocks; and the use of concessions to maintain production schedules (an unsustainable tactic that removes any incentive to get things right, the first time).

And because these inefficiencies are “built in”, they aren’t even regarded as the costs of poor quality.

As a rule of thumb, manufacturers pay 50% more for nonconforming batches—and pass these costs on to their customers. What this means, of course, is that a quality-conscious producer with significantly lower internal failure costs can easily undercut and outcompete the rest.

Impact: Reduced price competitiveness and market share.

Opportunity: Increased price competitiveness and bigger market share.

Internal failures disrupt the smooth functioning of any factory. For example, reworking nonconforming output causes planning headaches and delays—particularly if additional cleaning or line clearance is involved.

This, in turn, impacts other orders, causing more delays, overtime and, possibly, penalties for late shipments.

Indeed, the very process of dealing with these disruptions creates more disruption. Without the support of tools that automate the necessary communication, employees are caught up in a distracting flurry of emails and phone calls.

The result of all these disruptions is a huge, and potentially damaging, lapse in collective focus.

Unsurprisingly, employees surveyed by Gartner reported a loss of focus after significant quality incidents. According to them, losing focus was the main cause (mentioned by 73%) of work-related errors. (A lack of appropriate training and lapses in judgement trailed far behind in second (62%) and third (58%) place.)^[2]

As Gartner’s findings suggest, quality issues can trigger a spiral of doom in which mistakes that disrupt production workflows lead to a loss of focus, which in turn causes more mistakes and disruptions. While the average employee makes 134 errors a year, those at organizations with “lower focus” commit 71% more errors.^[2]

Manufacturers who remain stuck in this spiral of doom eventually lose the ability to forecast production, sales and revenue. As more time and factory space are dedicated to off-spec output, less output is generated for fewer customers, at increasingly higher costs.

Impact: Inability to compete with manufacturers with a virtuous cycle of quality.

Opportunity: Escaping the spiral of doom. Embracing a virtuous—and profitable—cycle of quality.

The impact of internal failure costs is more than financial. Disrupted production schedules and nonconforming output demoralize and demotivate everyone.

A big part of the problem is the friction they cause among teams with competing priorities. Quality teams become demotivated by their demotivated colleagues in production, and vice versa. Logistics and support personnel grow increasingly frustrated by customer complaints.

To get a feel for what’s at stake, consider this sketch of what goes right—and wrong—in our value chain.

At the top, we have what quality guru Armand Feigenbaum called the “hidden factory”—the shadowy part of our operations where equipment, energy and labor are wasted on producing nonconforming output.

Below it is the factory we’re all proud of: the one producing quality output for our customers.

Both factories have workers and both attract a different kind of worker. The question is who do we want as colleagues?

Do we want those who don’t mind working in the hidden factory, producing crap, reworking crap and scrapping crap?

Or do we want people who are passionate about creating value and figuring out ways to make great products even better?

Impact:
An environment that tolerates poor quality will not be tolerated by the very people we need to attract and retain. There’s a “growing conviction” among today’s employees that “life is too short to waste on demoralizing work”.^[3]

Opportunity:
Creating a high-quality environment for high-quality personnel, thereby securing our future.

As you’ve noticed, the problem of internal failure costs carries huge potential for significant gains—in profitability, customer satisfaction and employee morale.

According to Gartner, companies are already saving millions of dollars by tackling their costs of poor quality.^[4]

Double-digit improvements in first-time-right rates are possible with appropriate investments in prevention. To take just one example, NelfKoopmans, a Dutch paint manufacturer, saw their first-time-right rate rise by 35% with an QMS that, among other things, helped them identify processes that needed adjustment.

We too can turn our internal failure costs into profit. We look forward to discussing the specific, and significant, financial gains with you.

Let’s do this right away. At least 1.25% of our revenue is at stake.

Exact figures are not the point here. (In any case, trends might be more revealing than absolute values.)

Some of your internal failure costs will be easy to pin down. For example, a significant portion of the costs of waste will be documented in invoices from external parties.

Rework, on the other hand, can be harder to quantify. To arrive at a useful guesstimate, think of rework in terms of T-shirt sizes: small/medium/large. This leaves you with only three standard costs to calculate and apply.

The important thing is to get going.