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Basic Rules regarding Costs

• satyendra
• May 12, 2013
• 2 Comments
• 1-10-100 rule, Avoidable costs, Basic rules for costs, cost of quality, Failure costs, Inspection costs, Necessary costs, Prevention costs, tip of iceberg,

Basic Rules regarding Costs  

During recession, organizations are forced to cut their costs and while doing it, they sometimes unknowingly break basic rules. There are three basic rules regarding costs which are to be followed while taking important decisions in an organization. These rules are (i) Cost of Quality, (ii) Tip of the Iceberg, and (iii) 1-10-100 rule. These basic rules are applicable both in an individual’s daily life as well as during the functioning of an organization.

The following of above three basic rules regarding costs means giving improved performance with lesser costs. Many examples can be given in all walks of life including the cases in the industry regarding the utilities of these basic rules. Organizations following these rules move forward faster with fewer mistakes and support the efforts of the organization towards continuous improvement.

The three basic rules regarding costs help the organization in cutting the costs without affecting its capabilities in the long run. Normally long term payoffs are forgotten while taking cost cutting measures since they are not crucial for immediate survival. And when such thing happens in an organization, it adversely affects its long term functioning. These basic rules which provide a practical and effective alternative to the normal cost cutting measures are required to be adapted by the organizational management. These three rules are described below.

Cost of Quality

The ‘Cost of Quality’ (Fig 1) is the cost of doing an activity and achieving the targeted results of the activity. It consists of two components namely ‘necessary costs’ and ‘avoidable costs’.

Fig 1 Cost of Quality

Necessary costs are required to achieve and sustain a defined objective or standard of work. These are those costs which are needed to carry out an activity efficiently and to achieve and sustain a defined standard of work. These costs are required to be incurred. Any action to cut or reduce these costs has an adverse affect on the organizational performance. Necessary costs include prevention and inspection costs.  Avoidable costs include some part of inspection costs and failure costs.

Prevention costs of the actions are the costs intended to make sure that things do not go wrong in the organization. Prevention costs to avoid failures are the necessary costs.  Inspection costs are the costs of finding out if things are going on correctly so that in case of a deviation, corrective and preventive actions can be taken.

Avoidable costs are normally incurred whenever wrong things are being done or things are being done in a wrong way in the organization. Organizational management is required to identify where such things are happening in the organization and take the required action to eliminate these things.

Avoidable inspection costs are also those costs which are being incurred in the organization on inspection after the failure.  These costs are normally being incurred whenever inspection is needed because of the organizational management not being able to identify the wrong things which are being done or the things which are being done wrongly in the organization.

Failure costs are the costs incurred when a customer is or going to be dissatisfied. In such case the organization pays the price in the form of damaged reputation, rework, waste, legal penalties, special charges or loss of pride. The cost of failure is always huge and bringing back the things to normal conditions need a herculean task involving substantial cost at each step.

Identifying the necessary and avoidable costs of an activity is the first step towards reducing these costs. Example of the necessary costs are raw material cost, cost of maintenance, and the cost of quality control etc. Any saving in the necessary cost becomes counter-productive and results into expenditure somewhere else.  The organization management is not to take any action towards any savings on the necessary costs. All the savings are to be directed towards incurring of the avoidable costs.

Role of managers – For reducing the cost, line managers are to communicate the priorities and expectations to the employees. They are also to facilitate the improvement process by making sure employees are involved and have the confidence and skills required for the job. Line managers are also responsible to ensure that the employees are not only doing all the things right but also doing the right things.

Role of employees – Every employee of the organization is required to take up the responsibility for doing the right things. Generally the employees have the ability to judge what the right things are, but they cannot make decisions about right things in vacuum. The employees need to have the confidence to discuss with their line managers and their customers to understand the needs of the organization and the need of their customers.

Tip of the Iceberg

The costs of carrying out an activity have two components namely Ii) visible costs, and (ii) invisible or hidden costs. For taking a decision one has to keep in his front both the types of costs. Visible costs are obvious and are visible to everyone in the organization. Invisible costs are the indirect costs which are normally hidden and incurred due to certain action of the management.

When an iceberg floats in a sea then only a small fraction of its volume is visible to the ship captain. The major volume / weight of the floating iceberg remain under the sea water. Any incorrect judgment by the ship captain can result into the ship facing the same fate as the ship ‘Titanic; has faced. The nature of the costs of an activity is similar to that of an iceberg.

Considering only the visible costs can be highly misleading and this can lead to the organization incurring heavy costs somewhere else. Visible costs are normally a small fraction of the total costs and are similar to the small area of the iceberg which is visible while it is floating in the sea. Decision taken, considering only the visible costs, normally ends up in huge escalation in costs afterwards at the time of completion of the activity because of the invisible costs whose effects are normally similar to the hidden part of the iceberg. Organizational management which takes into account the invisible or hidden costs along with the visible costs, while taking a decision for carrying out an activity, avoids cost escalation when the activity is completed.

An example of the tip of the iceberg considering the purchase of refractory for equipment lining is shown in Fig 2. The visible cost is the cost per weight or per unit volume of the refractory. The invisible costs include (i) cost of additional set of refractories needed due to lower lining life, (ii) cost of relining of the equipment, (iii) cost due to the lower availability of equipment for production, (iv) cost of the repair of equipment damaged due to early failure of the refractory lining, (v) cost of handling additionally generated waste materials, and (vi) cost of additional manpower needed for equipment lining etc. Several similar examples can be given from the working of the steel industry.

Fig 2 Tip of the iceberg

1:10:100 rule

This rule states that if a problem is not fixed when it occurs, it only becomes more costly to fix at a later date both in terms of cost and time needed for fixing of the problem.  If the cost involved is 1 while catching and fixing the problem in the initial stage, then the cost of fixing the problem becomes 10 times if it is neglected and allowed to reach the next stage.  The time for reaching the next stage depends on the type of the problem.  If still the action is not taken and the problem is allowed to reach the next stage then the cost of fixing the problem becomes 100 times. The cost of fixing the problem increases by multiple of 10 in each stage. There are several examples which can be given from the steel industry, where the ignoring of the problems in the initial stages has resulted into substantial increased cost for solving of the problem in the later stages.

Fig 3 explains the 1-10-100 rule through an example normally faced in an organization very often. The stage 1 of the 1-10-100 rule is shown as the product being produced in a production shop. The production of the defective product can be detected at an early stage of production and at this stage the corrective actions like the changes in the process parameters, changes in the operating procedures, changes in the inspection and testing practices, or adjustments in the quality of the input materials can be taken. The costs involved in fixing the problem at this stage are not high. The stage 10 is considered when the defective product is not noticed at the place of production and the product is dispatched from the plant. In this case the defect is noticed enroute say in the stock-house. The costs involved in the product rejection / downgrading / rectification are substantially higher than the case 1. The stage 100 is when the defective product reaches the customer / user and they are not satisfied with the product. At this stage, the organization pays the price in damaged reputation, compensation / rework, waste, legal penalties, special charges or loss of pride. The cost of involved is always huge at the stage 100.

Fig 3 1-10-100 rule