Ask SCORE: Process Management, A Key Managerial Skill

Ask SCORE
Process Management, A Key Managerial Skill
A Formula to Reduce Costs and Improve Quality Simultaneously
By Richard Walton, Assistant District Director, SCORE, Maryland

Every organization undertakes processes in its daily operations. These may include purchasing, preparing payrolls, collecting payments from customers and many others. Processes may be relatively small or very large consumers of organizational resources. For example, the production process is typically the largest user of financial and human resources as well as capital resources (equipment, building, etc.).
We can develop a sense of the size of the production process by looking at the firm's operating statement. When the cost of production is deducted from revenue generated by the sales process, the firm is left with the gross profit from operations (Revenue-cost of goods sold). The gross profit margin may range from a low of 25 % to a high of 45%, which means that on the basis of $10,000 in sales revenue, gross profit could be as low as $2,500 or as high as $4,500 for the period in which the goods were sold. The significance of the gross profit figure is that it represents the cash available to pay all other costs which are commonly referred to as overhead. Included with overhead costs are salaries, insurance, rent, power, taxes, travel, advertising, healthcare and all other non production related costs.
The key to managing processes within the firm effectively is to pursue continuous improvement both n terms of lower costs and increased quality. Continuous improvement is made by establishing cost reduction and quality management goals simultaneously. It has been said, and we think wrongly, that costs are lowered by taking short cuts and using less costly materials. We feel that costs can best be lowered by benchmarking quality standards and cost percentages simultaneously, which can help direct attention of all employees to the need for quality output and lowered costs of production. For example, we have developed a system for recording the relationships between cost and quality as shown in the figure included.
As can be seen from the data presented, the firm achieved dollar cost savings of $7,000 (on a sales level of $100,000) through lowered materials and labor costs, although the firm did not quite reach its goals. Overhead went up, (a negative variance of $2,000) offsetting part of the production cost gains, and the defect rate reduction initiative (a measure of quality) showed a gain of $2,000. The net gain to the firm was 7% of sales, or $7,000 in the period under review.
Working from percentages gives the manager several benefits. First, it is much easier to work initially in the goal setting mode by percentage relationships, and then later translate these relationships into actual dollars. Second, individual product cost projections can be measured against an overall company target in terms of how each order either contributes or takes away from the goal. Third, using percentages enables the manager to plan for overall company profitability by making certain that gross profit dollars exceed the costs of overhead. In other words, if the gross profit margin is 34%, overhead must be kept below 34% of the sales level for the firm to operate profitably.
The tools for achieving process cost reductions include flow charting (drawing a picture of the production system and its component parts in order to pinpoint potential areas for improvement), close management of employee labor costs per product (using tools such as IT system generated reports including percentage of billable hours to total hours paid), and improved production scheduling to minimize set up costs and maximize machine run time. There are many more tools that can be used depending upon information available and capability of the management team to initiate and maintain continuous improvement program.

Mr. Walton teaches Entrepreneurship and Quality Management at Frostburg State University. He is also Assistant District Director for SCORE, Western Maryland, and the President of ERMACORP, a Hagerstown based Management Consulting Firm. He may be reached at 301-462-9850, or by email to Richard@ermacorp.com.