Making Money by Working Smart
Hidden costs are really hidden profits.

A. Blanton Godfrey
agodfrey@qualitydigest.com

Years ago, Joseph M. Juran stunned senior management audiences by introducing the idea of the hidden factory. Having discovered that the waste caused by the cost of poor quality averaged more than 30 percent in most companies, he described them as having "hidden factories." It's as if the companies had two manufacturing plants that made products and one that produced scrap. Juran asked the executives to consider how much they could improve profits by finding their hidden factories and closing them.

He offered a simple example. A company has $1 billion in sales and 30-percent waste. Senior management wants the company to grow and double its profits; it's currently making 10-percent margins, or a profit of $100 million per year. They could double sales to $2 billion per year with the same margins and double profits. Or they could reduce their waste by one-third, from 30 percent to 20 percent and achieve the same profit increase of $100 million per year. Every dollar saved by reducing this waste goes straight to the bottom line.

This example was often met with skepticism by executives. But it is, in essence, exactly what many companies are doing today with Six Sigma quality initiatives. And it's what many companies did with total quality management, reengineering, kaizen or whatever their quality improvement efforts were named. Many companies have reduced waste by one-third or even more in a few plants or selected administrative functions or service operations, but very few have achieved these savings throughout the entire organization.

If these costs are eliminated, savings will flow immediately to the bottom line. Hidden costs are really hidden profits.

There are many reasons why these potential profits remain hidden. Perhaps the main one is that our accounting systems aren't designed to maximize profits. Most have evolved historically and were designed to ensure that proper taxes were paid, that shareholders received fair value for their investments, that laws were followed, and that various parts of the business were managed. Because accounting practices in large corporations are quite complex, many simplifications and approximations were devised. These included allocations based on labor costs, average costs for space, depreciation costs set by government formulae, standard charges for inventories and so on. Not only are most of these measures out of date or no longer applicable, but they're just plain wrong. They lead companies to make wrong decisions.

Examples abound. One company found that its standard practice of negotiating the lowest transportation costs meant that it "owned" its finished goods an average of 30 days instead of the seven it could achieve with direct shipments. Because the company's finished goods were specialty chemicals, the costs of carrying this high-value inventory an extra 23 days equaled 30 percent of the company's annual profit.

Other companies have discovered the hidden costs in labor turnover. One company that makes high-tech devices for consumer electronics and computers found that, on average, experienced employees produced five times as many items per day as employees with fewer than three months' experience. Yet this company had a 20-percent employee turnover. In its effort to keep salaries as low as possible, it was losing trained employees to competitors. But just as important, it was losing huge amounts of production.

Lost capacity is common in many companies. By minimizing raw materials costs, companies create downtime on expensive machinery. Many companies have discovered that by reducing downtime through proper preventive maintenance, correct raw materials and trained employees, they can gain 30- or even 40-percent capacity. For many companies this is like adding a new factory for free.

The good news is that solutions abound. Most were created for very specific problems. Some are so successful at reducing one particular type of cost that they become management fads. Examples include reengineering and business process quality improvement. There is so much waste in the white-collar side of business operations--the administrative rather than the manufacturing side--that reengineering had a huge impact on waking companies up and achieving spectacular savings.

Many years before, the same thing happened with reducing variation in manufacturing processes. The advent of control charts, and the ensuing near-religious fervor by companies to use them, was a direct result of the enormous savings those companies achieved by simply controlling variation in their production processes.

It's not hard to trace the advent of each of the many (perhaps hundreds) of tools in well-managed companies' quality toolboxes to the problems they were designed to solve. When first used, many of these tools had spectacular results. When applied to other problems, they either had little impact or failed completely. Sometimes they even did more harm than good.

During the past few years, analysts have begun to systematically identify waste in organizations. A science is emerging. We're now not only able to identify hidden costs far better than ever before, but also to begin matching the right tools for eliminating the costs with the actual problems.

About the author

A. Blanton Godfrey is dean and Joseph D. Moore Distinguished University Professor at North Carolina State University's College of Textiles. Letters to the editor regarding this column can be sent to letters@qualitydigest.com.