Professional Documents
Culture Documents
by Peter J. Sherman
and James G. Vono
In 50 Words
Or Less
Imagine you are presenting the analysis and findings of a critical operational issue or proposed improvement
project to senior management. You feel confident because
youve thoroughly measured and analyzed the data.
Your presentation includes several statistical and quality
metrics, such as the mean, standard deviation, sigma level,
percentage nonconforming, defect rates, defects per million
opportunities (DPMO) and process capability. You may even
produce the results of a Pareto analysis that shows the frequency of defects.
To your disappointment, you notice eyes starting to glaze
over and heads bobbing. Some of the senior managers are text
messaging, while others are talking. What happened? What
went wrong?
July 2009 QP 17
What is profit?
creasing costs.
$5,000 a month.
ance of $500,000.
be relatively flat.
gins by 4%.
Warranty costs have risen 150% and now represent 5% of total costs.
Total cost
Fixed cost
18 QP www.qualityprogress.com
Output in units
for the total cost curve to be sloped down or up, depending on the variable costs per unit.
Understanding fixed costs and variable costs is important from the standpoint of a companys operating
leverage. Operating leverage is the trade-off between
fixed costs and variable costs, and it measures how
revenue growth translates into growth in operating
income (revenue less total costs). Operating leverage
can also be thought of as a measure of leverage and of
how risky (variable) a companys operating income is.
The degree of operating leverage (DOL) is defined
as the percentage change in operating income that results from a given percentage change in sales. This can
be expressed as:
DOL =
Revenue
Sales of goods
$1,200,000
($375,000)
($10,000)
($25,000)
($100,000)
($25,000)
($30,000)
($15,000)
___________
Total COGS
($580,000)
$620,000
52%
Operating costs
Sales, general and administrative
Quality design
Inspection and audit
Research
Office and facility rent
Equipment leases
Utilities
Travel
($250,000)
($15,000)
($10,000)
($35,000)
($30,000)
($30,000)
($20,000)
($5,000)
___________
Fixed
costs
($395,000)
$225,000
Taxes
($105,000)
$120,000
Cost
Variable
costs
Volume
(10,000 units)
Cost
Volume
19%
10%
firms costs that are fixed, the greater the firms busi-
company.
Income statement
period.
$1.2 million.
July 2009 QP 19
Savings
600
500
ries:
capital savings.
Cost avoidance: cost prevention.
300
200
100
Labor
Material
Inventory
Working
capital
New
machine
Training
Lost
Net cost
production of quality
total
A simple and effective way to show projected savings to management is through a project savings waterfall (see Figure 3).
The waterfall breaks down all costs in color-coded
graphical form.
cost of quality).
The green bars represent direct savings associated with the project, including labor, material and
inventory.
In another example, a company that invests significant resources in maintaining equipment and training
generally go down.
20 QP www.qualityprogress.com
Key metric
Unit produced
PMO
Break-even revenue
Difference
10,000
10,000
NA
$120
$120
NA
$395,000
$430,000
$35,000
$58
$52
($6)
FMO
6,371
6,324
(47)
$764,520
$758,880
($5,640)
Payback period
+ VC = TR.
This equation can be further broken down as follows: FC + (variable cost per unit x BEV) = (retail price
per unit x BEV).
We can derive the BEV algebraically from the fact
that at the BEV, total cost and total revenue are equal.
Hence,
years).
Shorter payback-period projects may not necessar-
BEV = $395,000
$120 $58
BEV = 6,371 units
The associated break-even revenue is 6,371 units x
Break-even analysis
$120 = $764,520.
July 2009 QP 21
You are a project manager and have identified an improvement to the manufacturing process discussed earlier. The improvement reduces variable costs by 10%, or
approximately $52 per unit (a $6 reduction per unit).
The first step might be to compare the gross profit and operating profit levels of the current situation
and the proposed new improvement. An effective
First-year ROI:
$6 x 10,000 units
$100,000
$6 x 10,000
/ Figure 4
months x 1.67)
Based on these four key financial metrics, you
$1,500,000
$1,250,000
Profit
$1,000,000
$764,520
$750,000
Break-even revenue
each company. Before making your final recommendation, lets perform a break-even analysis to determine
how many units the firm would have to produce with
the new improvement so revenue is equal to total costs.
BEVYear one = $430,000(fixed costs)
$500,000
$120 $52
Loss
$250,000
$0
2,000
4,000
6,371
6,000
Units
8,000
10,000
Total cost
Total revenue
22 QP www.qualityprogress.com
PMO
Unit produced
FMO
Difference
10,000
10,000
NA
$120
$120
NA
$395,000
$430,000
$35,000
$58
$52
($6)
Total revenue
$1,200,000
$1,200,000
NA
Variable costs
$580,000
$520,000
($60,000)
sales VC
sales VC fixed cost
Key metric
expressed as follows:
DOL =
$1,200,000 $580,000
DOL(PMO) = 2.76
DOL(FMO) =
$1,200,000 $520,000
$1,200,000 $520,000 $430,000
Gross profit
$620,000
$680,000
$60,000
Fixed costs
$395,000
$430,000
$35,000
Operating income
$225,000
$250,000
$25,000
DOL(FMO) = 2.72
In the PMO, a 10% increase in sales generates a 27.6%
increase in operating income (2.76 x 10). In the FMO,
leverage is negligible.
margins.
pressed as:
cisions. QP
Reference
1. Lean Six Sigma Enters the Finishing Arena, an interview with Joseph De
Feo of the Juran Institute, Products Finishing Magazine, June 2005.
HELP YOURSELF
Learn how to speak the language of management when asking for a raise. Read Russ
Westcotts Career Corner column, Do You Deserve a Raise? in the May 2008 QP, which
can be found at www.qualityprogress.com under Past Issues.
July 2009 QP 23