Quantification of Quality Initiatives

© M Hariharan
Organisations embark on myriad quality initiatives. Many of these initiatives emerged from Japan –
5S, Kaizen, Quality Circles, TQM, TPM, etc., and a few from the West, six sigma being the most
popular. Quite often we find that ideas of improvement are rejected by the financial controllers as
no perceptible improvement is visible to the bottom line; worse, at times the bottom line dips post
an initiative. In the earlier articles we have seen the concept of Theory of Constraints, where
improvements every where need not lead to overall improvement; we have seen how to make the
initiative sustainable by linking the people performance to the bottom line. In this piece we shall
discuss the basic tenets of quantification of improvement. I have used a modified version of DuPont
Chart developed by K Ramakrishna (adjunct Professor of SP Jain Institute Management and
Research) a renowned expert in Project Financing. I have used his model as a base, applied the
principles of Activity Based Costing to that and developed a model for quantifying the benefits of
Operations initiatives (be it quality initiatives or supply chain initiatives).

DuPont’s Chart:/
DuPont’s chart of ratios is a very popular and useful model for measuring the profitability
performance. (See figure 1). This was developed by Frank Donaldson Brown (1885-1965) who was a
financial executive and corporate director with both DuPont and General Motors.

Goal of a business enterprise: Maximising Investor’s Wealth

PAT

Net Worth
Total
PAT Assets
PAT CE
PBIT Net
NW
Sales Worth

Sales
PBIT
Total
CE
Assets

Sales Fixed Asset

(-) Cost of Sales (Variable cost, Fixed cost incl. Depreciation) + Working Capital
= Profit before Interest and Tax = Capital Employed
(-) Long Term Interest
= Profit before Tax Net Worth
(-) Taxation (i.e. Capital plus reserves)
= Profit After Tax + Long Term Debt
= Capital Employed

Figure 1: DuPont Chart

This model is very useful for analysing the performance on three parameters viz. Operating
Efficiency (PAT/Sales), Efficiency of Asset Usage (Sales /Total Assets) and Efficiency of Financial
Leverage (Total Assets/Net Worth). This is till date a popular model, widely used and appropriate for
understanding the overall performance of an enterprise. However, to get into further analysis of
operations performance one needs to go further into a micro level.

K Ramakrishna’s Model:
The model developed by K Ramakrishna is a variant of DuPont chart. (See Figure 2).

Goal of a business enterprise: Maximising Investor’s Wealth

PAT
Figure 2: K Ramakrishna’ Model
NW

PAT CE
PBIT NW

X X
PBIT
PBIT
PBT (1-T) Capital (NW + D)
CE (1 + D/E)
PBIT Employed NW
X PBIT Sales X
PBIT Sales
Contribut Capital
Contri. CE
ion Employed
Sales X X
(-) Variable Cost Contribut
Contri.
= Contribution ion
(-) Fixed cost incl. Depreciation)
Sales
Sales Finance
= Profit before Interest and Tax
(-) Long Term Interest
= Profit before Tax
(-) Taxation
= Profit After Tax Operations

This model differentiates between the areas under the control of Finance and Operations. I have
extended this model to develop a methodology to address the key impact areas of operations

Factors that impact the three Operations ratio:

Contribution / Sales Ratio: This ratio is the popular Profit Volume Ratio. This ratio signifies the direct
profitability of the product. There are three factors that impact this ratio – Viz – Change in Variable
Cost per unit, Change in Selling Price per unit and Change in Product Mix. Any action taken by
operation that impact these three factors will impact this ratio.

Profit Before Interest and Tax /Contribution: This ratio is the popular Margin of Safety. This ratio
signifies two issues – a) How safe is my business? And b) How well I’m utilising the Fixed Cost
Resource. In addition to the three factors listed for the Profit Volume Ratio, two more factors
impact this ratio – Viz., –Change in Fixed Cost and Change in Sales Volume. Any action taken by
operation that impact these five factors will impact this ratio.

Sales/ Capital Employed: This ratio is the popular Asset Turn over ratio. This ratio signifies how well
my assets (Fixed Assets and Working capital) are utilised. Of the five factors that impact the Margin
of safety three factors impact this ratio. Viz., Sales Volume, Sales Mix and Sales Price. In addition to
these three, our decision on Fixed asset and change in working capital will also impact this ratio. Any
action taken by operation that impact these five factors will impact this ratio.
Seven Operations Triggers of the Bottom line:
The triggers of the three ratios are essentially seven triggers. I’ve grouped them under Sales,
Expenses and Investment.

Sales Triggers: Sales Price, Sales Volume and Sales Mix are the three sales factors that trigger the
bottom line

Cost Triggers: Change in Variable cost and Change in Fixed cost will impact the bottom line. In other
words, any process improvement that releases Fixed Cost Capacity will not result in short term cost
reduction.

Investment Triggers: Change in Working Capital and Decision on Fixed Asset are the two triggers.
Any action that releases capacity of Fixed assets will help us to postpone the investment to a later
date.

Savoir faire Model for quantification of Operations and Quality Measures:

Not all results of operations and quality will lead to cost reduction and asset reduction. It may result
in reducing tomorrow’s cost and investment today. Savoir faire model for quantification traces the
actions of operations to these seven triggers of bottom line. This model uses an activity based
approach to understand the financial reaction of the actions. The model follows a four stage
approach:

Stage 1: Identifying the activities Pre and Post Implementation of the Initiative

Stage 2; Identifying the resources required Pre and Post Implementation of the initiative

Stage 3: Compare the resources requirement Pre and Post Implementation of the initativie

Stage 4: Trace the impact of the changes to the seven triggers of the bottom line

Stage 5: Quantification of the benefits/costs of the initiative

In this series I shall be discussing various initiatives like Six Sigma, 5S, SMED, Autonomous
Maintenance, Cycle time reduction, Single Piece Flow, Milk run, cross docking, and similar initiatives.

Conclusion:
Initiatives cannot be justified based on intellectual satisfaction levels attained. Initiatives should help
the organisations to improve their profitability for a sustainable period of time. At the same time,
one cannot expect the initiatives to derive the benefit within a few months. So a model to quantify
today’s costs and tomorrow’s benefit is critical for sustainable initiative. After all for every action
there is a financial reaction.