Quality programs in banking: A critical view

Hindi, Nitham M

A well-known banker believes that successful companies in the 21 st century will operate against three fundamental components of success: an unshakable commitment to quality control, strategic investment in human resources, and productive and creative application of technology. He further emphasized that of these three components, quality control may be the most visible, and carry the potential for the greatest returns.1

These remarks are supported by real experience of banks and financial institutions which come to realize that although quality initiatives require significant investment, the benefits reaped from them by far outweigh the investment.2 Demanding higher quality for lower costs, customers in recent years have been pressuring companies to shape their processes to meet the higher standards of excellence. The themes for the 1980s and 1990s include total quality management (TQM), customer satisfaction, cost, quality, and time, technology, market globalization, reengineering, outsourcing, availability of capital and markets, and finally costs of quality. Although costs of quality concept is usually applied to the manufacturing industry, the thesis of this paper is that the banking industry would also benefit from such application. The purpose of this study is to discuss the feasibility of applying costs of quality concepts to the banking industry. This study is divided into seven sections: the meaning of quality, reasons to implement quality programs, materiality of quality costs, calculating costs of quality, methods to identify quality problems, key success factors for successful quality programs, and summary and conclusions.

THE MEANING OF QUALITY

There are many ways to define quality. M.L. White, for example, defines quality as "performance leadership in meeting customer requirements by doing the right things right the first time. Doing the right things means focusing work processes on essential tasks which add value to customers, both internal and external. Doing them right the first time means working as efficiently and accurately as possible avoiding the wasted efforts required to correct mistakes."3 Therefore, quality should be defined to include customer perception, eliminating non-value added activities, continuous improvement (Kaizen in Japanese), greater market penetration, sales performance, customer retention, meeting or exceeding customers' expectations, and future market prospects. With the wide spread of TQM in the 1980s and continuing in the 1990s, more businesses have added quality programs to enhance their competitive positions. TQM plays a very important role in achieving quality. Some TQM concepts include customer orientation, do it right the first time, train and retrain, empower employees, continuous improvement, use of statistical analysis to understand and continually improve the process, and concentrate on long term and team concepts. Many companies (such as Hewlett-Packard, Ford Motor Company, and Toyota) list TQM as one of their key success factors. There are many awards (such as the Malcolm Baldrige Quality Award, the Deming Prize, and the Premio Nacional de Calidad) to recognize exceptional quality.

To implement quality programs, it is essential that companies be made aware of the cost of quality. Cost of quality includes costs of compliance and costs of non-compliance (failure). Compliance costs include prevention costs and appraisal costs. Prevention costs are the costs of quality assurance efforts. They are incurred to prevent errors from occurring, and include such items as do it right the first time, and that services meet customer expectations. It sounds easy, but what investments have to be made to prevent defective products or services from occurring in the first place? Necessary are quality hiring and training of workers, quality circles, better designs and engineering, better production systems and equipment, technical support to suppliers or vendors, inspection, statistical process control, shelf-life programs to prevent spoilage, design review, vendor certification programs, quality orientation training, and preventive maintenance.

Appraisal costs are incurred to identify non-conforming units, which include inspecting units at various points in the production cycle (inputs, work-in-process, and finished goods). Activities include inspection of incoming materials, testing during production, testing and inspection of final products, supplier surveillance, prototype evaluation, and performing quality audits.

The cost of non-compliance (failure) includes the cost of making a bad product that does not perform according to standards. Non-compliance costs include internal failure costs and external failure costs. Internal failure costs include costs of non-conforming units before they are shipped to customers. It includes reworking defects, inspecting rework, and disposing of waste or scrap. External failure costs are the most expensive type of quality cost (while Gray estimates the majority of quality costs is caused by failure costs, Harrington estimates failure costs to be 75% of total quality costs), and include the cost of nonconforming units after delivery to customers. The failure has all the costs found internally plus the cost of distribution to the customer, replacement, in-field repair, warranty, product liability, and recalls.

In addition to the four categories discussed above, there are intangible (hidden) costs. Intangible costs of quality include customers lost, employee turnover, lost productivity, customer dissatisfaction, and ultimately lost sales. While measuring intangible costs is a more difficult task than measuring the tangible costs, Gray estimates these costs as high as four times the visible costs of prevention, detection, and correction. KPMG Peat Marwick reports that companies estimate hidden costs as high as 20% of the costs of sales or three times all measurable quality costs (Margavio, Margavio, and Fisk).

REASONS TO IMPLEMENT QUALITY PROGRAMS

There are many reasons for companies to implement quality programs. Some of the most important reasons include higher profitability (cost reduction), compliance with environmental quality laws, customer satisfaction, and increased productivity.

Profitability: Improvements in quality results in higher profitability. Burrows (1991) reports that Grant Thornton International surveyed two hundred and fifty mid-sized manufacturing companies and found that two-thirds of respondents did not know the relationship between quality and profitability. This survey did show that the seventy-seven firms which accumulated costs of quality and then investigated the relationship between quality and profitability reported an increase in the bottom line of from 9% to 25%. As a result of implementing a quality program, Motorola reported $2 billion savings in 1994 (9% of revenues) [Horngren, Foster, and Datar, 1997]. In the last eight years, Motorola has reported a 380% increase in revenue, an 800% increase in profit, and a 600% increase in stock price. By applying cost of quality concepts, Xerox saved over $200 million in four years in its U.S. Sales and Marketing Group (Carr,1995).

AT&T's management is referenced as requiring that any new quality initiative must have an expected yield of a 30% drop in defects and a 10% return on investment (Greising, 1994). The new view that high product quality can mean low cost was proven by Jaguar in 1983. The company had major losses in the 1980s, then Jaguar realized that quality improvements were at the heart of their success. They decided that product quality does not have to be a trade-off for cost (Wettach,1985).

Compliance with environmental quality laws, such as the Clean Air Act: Environmental quality and the problem of air pollution, waste water, oil and chemical spills, hazardous waste, and waste management. The cost of environmental damage (failure cost) can be quite high under the 1990 amendments to the Clean Air Act. For example, Exxon paid $125 million for the Alaskan coast oil spill. Compliance costs, such as permit fees, cost of filling compliance forms, and training costs, are usually assigned to overhead and subsequently allocated to products, processes, or services.

Customer satisfaction: When TQM swept the nation in the 1980s, Varian Associates Inc. put a thousand of its managers through a four-day course on quality. A unit that made vacuum systems for computer clean rooms boosted on-time delivery from 42% to 92%. Obsessed with meeting production schedules, the staff in that vacuum-equipment unit did not promptly return customers' phone calls and the operation ended up losing market share. Such scenarios have led to a refinement of the measures used for quality management, with an emphasis on return on quality (Greising, 1994). At UPS, instead of stressing prompt delivery at any cost, the company allows drivers time to talk to customers. This helps improve customer relations and develops sales leads (Greising,1994).

Productivity: Productivity and quality were once viewed as unrelated; however, General Electric proved that by establishing planning and station controls, their amount of defects decreased. This led to the belief that taking time to make it right the first time pays off in the end (Wettach, 1985). Another change in quality emphasis is that defects not only can, but should be, reduced to zero. The mission of a manufacturing division is to strive for perfection. This change really came into effect after David Garvin conducted a quality study of Japanese air conditioners versus American air conditioners. The results indicated that the defect rate of Japanese air conditioners was seventy times lower than American air conditioners.

Automation was once used to reduce labor costs, and there were many examples that proved this assertion to be true. However, the new belief is that automation will not only reduce labor costs but also improve quality. Such was the case with General Electric's flexible machining system project, which showed a 240% improvement in employee productivity and a reduction in manufacturing loss (Wettach, 1985).

MATERIALITY OF QUALITY COSTS

Although there are no empirical studies to calculate the aggregate costs of quality, many studies have tried to estimate it. While Carr (1992) reports that the cost of quality in the service industry is 25 to 30% of sales revenue, Pitman estimates that 20% to 50% of a service firm's annual expenses are due to poor quality costs, with the majority of those expenses caused by failure costs. Rust (1995) reports poor quality causes 20% to 30% losses in gross sales. While Gray reports that 30% to 50% of operating expenses are quality costs in service industry, with approximately 70% of which is failure costs, Kush (1988) estimates cost of quality about 30% of total U.S. manufacturing costs. In addition to identifying the obvious costs in an organization, the hidden costs are even more critical. For example, lost sales, customer dissatisfaction, and employee turnover should be factored into the quality cost equation. Hidden costs have a direct influence on profitability.

CALCULATING COSTS OF QUALITY

Tyson randomly chose one hundred twenty-five of the Fortune 500 companies and contacted their controllers. Of these, ninety-four responded. Tyson found that 31% of the respondents specifically measured quality costs on a regular basis. He found evidence that quality cost measurement consistently was highest among manufacturing industries who were forced to confront strong foreign competition. He reported that among those companies who specifically used quality cost measures, a clear correlation between quality and profitability existed. It is worth mentioning that precise numbers may not be necessary. The figures that managers derive should be used as a benchmark for improvement. This policy encourages honest calculations.

Recently, accounting professionals realized the need to expand the accounting system to include measures and costs of quality. The ISO guidelines for quality management identify quality cost reporting as a means for evaluating the adequacy and effectiveness of quality systems. Suver, Neumann, and Boles, in their book entitled Management Accounting for Healthcare Organizations, argue that "TQM will require new methods of accounting that will enable the effects of declining quality to be recognized and evaluated . . . , and management accounting reports will identify opportunities for quality improvements and monitor the effectiveness of quality management endeavors." Kaplan wrote in 1983, "The challenge is to devise new internal accounting systems that will be supportive of the firm's new manufacturing strategy. Improved measures of quality, inventory performance, productivity, flexibility, and innovation will be required." Such systems must identify the different activities associated with different categories of quality costs and then assign costs to these activities. Such systems should be able to "systematically accumulate (or estimate) all quality costs" [Diallo, Khan, and Vail].

The need to measure the costs of quality and the need to understand the costs/benefits of quality programs is essential to the successful implementation of quality programs (Karnes and Kanet). The traditional cost system must be modified to separately state the costs of items scrapped and the costs of rework. This can be done by creating a cost account within each job in which we can accumulate the costs of scrapped items. The same treatment can be done for the costs of rework.

Sales returns and allowances authorized because of quality problems should be separated from others. Costs of customer "hotlines" and other customer service departments who take an active role in correcting failures should be accounted for separately. The accounting system must identify the different activities associated with different categories of quality costs and then assign costs to these activities. Costs include, but are not limited to, materials, labor, and supplies. The challenge is the ability to identify and measure the activities.

Although measuring tangible costs is somewhat easy, measuring hidden costs is challenging. However, there are many models to measure the hidden costs of quality in the literature. It is worth mentioning that these models are estimating the costs. Atkinson, Hohner, Mundt, Troxel, and Winchell (1991) wrote:

Cost of quality reporting has evolved from being primarily a cost reduction tool to being a manufacturing and service philosophy that supports the pursuit of continuous improvement to reach sustained profitability and competitiveness.

Measuring the hidden costs is the most challenging step in calculating the costs of quality. Montgomery (1991) writes "Although measuring these hidden quality costs may be difficult, accountants need methods for estimating the magnitude of the costs even if the costs can not be estimated with pinpoint accuracy. Striving for too much accuracy is a pitfall because it will cause managers to become impatient and abandon quality cost programs." The use of multiplier (similar to the concept used in calculating Goodwill -- multiplier of excess earnings) has been suggested in the literature. As a fact, Quality Costs Committee (1990) writes:

The effect of intangible quality costs, often called "hidden quality costs," is difficult, if not impossible, to place a dollar value on.... Some companies, however, have found a "multiplier effect" between measured failure costs and "true failure costs." Westinghouse Electric Corporation, for example, reported that its "experience indicates that a multiplier effect of at least three or four is directly related to such hidden effects of quality failure."

There are many models available in the literature to estimate the costs of quality. The conventional loss function (Figure 1, next page) predicts no loss if units fall within the specification limits. When units fall below the lower limit or above the upper limit, companies lose as a result of scrap or rework costs. The objective of the company under this model is to produce within the specification limits.

Taguchi loss function (Figure 2, next page), on the other hand, predicts losses if units deviate from the target value (not specification limits). The loss is quadruple when the deviation from the target value is doubled. Therefore, the company's objective is to produce units equal to the target value. Mathematically, Taguchi's Loss Function is expressed in the following equation:

L(y) = k(y-T)^sup 2^

Where:

y = actual value of specification

T = target value of specification

k = proportionality constant = c / d^sup 2^

c = loss associated with the limit

d = deviation from target value

The disadvantage of Taguchi's model is that it assumes that losses for the company are the same whether the unit is deviating above or below the target value. Many examples are contrary to that assumption. An example is airline on-time arrival. If a flight arrives one hour early, the cost to customers is waiting for their next flight. If the flight is one hour late, the customer may miss the connecting flight and thus the cost is more to both customers and airline due to unsatisfied customers. According to Taguchi, the cost is the same whether the flight is one hour early or one hour late.

Trying to eliminate the disadvantage of Taguchi's model, Kim and Liao developed their own model, asymmetric quality loss function. Their model uses two values for the loss from poor quality; one is associated with the upper specification limit, and one with the lower specification limit. The model is expressed mathematically in the following manner:

L(y) = k^sub 1^ [ (y-T)]^sub 2^ + k^sub 2^ [(T-y)]^sup 2^

Where:

y = actual value

T = target value

k^sub 1^ is greater than or less than k^sup 2^

k^sub 1^ = c^sub 1^ / (U-T)^sup 2^

k^sub 2^ = c^sub 2^ / (T-L)^sup 2^

U = upper specification limit

L = lower specification limit

c^sub 1^ loss associated with U

c^sub 2^ = loss associated with L

The advantage of the asymmetric model is that it allows the users to associate two different costs with deviation above or below the target, thus eliminating the disadvantage of Taguchi's loss function.

Juran's Model of quality costs (Figure 3, next page) shows that as companies invest in prevention and appraisal costs, they will be able to reduce their failure costs. Companies have to decide the level of conformance of goods (services), and then decide how much to invest in prevention and appraisal costs.

Measuring the cost of quality is a team effort that requires technical and accounting knowledge. This joint effort includes quality control, accounting, engineering, production, marketing, and service. Each party has something different to offer to ensure the credibility of the data. Accountants offer comparability and consistency. Technical personnel help ensure that all quality costs are captured and identified. Together, this team identifies and understands the critical factors leading to customer satisfaction. Calculating the costs of quality in the banking industry requires (1) identification of specific activities associated with each type of quality costs (prevention, appraisal, internal failure, and external failure), (2)calculating the time required to perform the activity, (3) frequency, and (4) the individual(s) who will be performing the activities. Identification of activities associated with each category of quality costs is very challenging and require employees' involvement.

Figure 4 (next page) lists some of the suggested activities to include in the different categories of quality costs. Every bank might have a different list. Employees should be encouraged to calculate the amount of time it takes them to complete each activity. Honest calculation is crucial to fully understand and account for the costs of quality. Frequency of occurrence is also important. Banks should concentrate on activities that are costly and/or frequent in occurrence. Once the individuals who perform these activities are identified, calculating the costs of quality is a matter of addition and multiplication.

Figure 5 (following next page) demonstrates a method of calculating the costs of quality. Each activity is identified. The time it requires to complete and the person responsible for completing it are identified. Labor cost is calculated by multiplying the amount of time required for completion by the rate per hour. Any other expenses associated with the activity should also be identified and included in the costs of quality. Monthly and annual costs of quality are then calculated.

METHODS TO IDENTIFY QUALITY PROBLEMS

There are many methods to identify quality problems in any industry. Some of these methods are discussed in the following section.

1. Control Charts (Statistical Quality Control or Statistical Process Control): A run chart with upper and lower limits drawn on either side of the process average.

2. Pareto Diagrams: Pareto diagrams are used mainly to determine priorities.

3. Cause-and-Effect Diagrams (Fishbone Diagrams): Mainly used in brainstorming sessions to identify all the causes of a given scenario.

4. Flowcharts: Process improvements start with a flow chart of the current process. Flow charts are a very useful method to understand the process.

5. Scattergraph: Chart the relationship between two variables.

6. Histograms: Measures how frequently something occurs.

7. Run charts: This is used mainly to identify trends by plotting data over a period of time.

KEY SUCCESS FACTORS FOR SUCCESSFUL QUALITY PROGRAMS

For quality programs to be achieved successfully, the following is a list of activities that companies should participate in.

1. All levels of management and personnel must be committed (participate and communicate). Quality concepts must be leaderdriven. Leaders should be able to provide vision, provide necessary resources, remove road blocks, and recognize innovators. Total involvement of employees and acting as a team to achieve common corporate goals, and eliminating the "THEY" mentality will be very beneficial to companies.

2. Keep communication channels open. Communication should flow from top to bottom and from bottom to top. Open and honest communication channels are needed. Communications are needed for both internal and external customers and potential customers. Open communication channels will assist in removing fear and thus increasing productivity.

3. Institute training and retraining. Employees and management must be trained and retrained to fully understand the concepts involved in quality management. Training should encourage teamwork. The training should provide a vehicle to empower employees.

4. Institute leadership. Failure to lead is a typical example of causes of failure. Leaders must have the vision of the organization and counsel for organizational improvements.

5. Eliminate numerical quotas. Companies should develop multiple methods of measuring improvements rather than meeting quotas.

6. Be patient. Face each problem and take one step at a time while making small goals that are achievable.

7. Continually monitor training effectiveness and make changes as needed. Managing change is without a doubt a key for any successful management. The change efforts should be linked to customers' needs.

8. Continually motivate the employees to strive to achieve their goals, recognize their accomplishments, and reward them accordingly. In order to have a successful quality program, companies should change their performance evaluation systems to reward success.

9. Report quality progress. A successful quality program requires data collection, analysis, and reporting. Definition and measurement of quality and quality costs are crucial elements for the successful implementation of quality programs.

10. Focus on customers. Companies need to meet or exceed customer expectations. Customers are both internal and external. The common mistake is believing customers are external, and thus emphasizing external customers and ignoring the needs of internal customers.

11. Avoid the mistakes identified in Figure 6.

Generally, the important thing, as Douglas Adamson stated, is to strive for continuous quality improvement. Banks need an Olympic gold medalist mind-set: zero defect and zero deflections. Many people may consider uptime of 98% on ATMs as good, but if you have one thousand ATMs, that means you have twenty ATMs not working at any time, which is not good.4

It is important to keep in mind that traditional cost of quality reporting has the limitation of not associating costs with specific activities. Activitybased costing overcomes this limitation by relating costs to activities and thus enhances the usefulness of the cost of quality reports.5

PRACTICAL CHALLENGES IN IMPLEMENTATION

The industry as a whole is headed in the direction of identifying better quality measurements for the purpose of developing a better overall performance measurement system. The challenge is defining what needs to be measured and how to incorporate the necessary feedback to adequately measure performance and effect behavior. Discussions with bank executives indicated that there is a host of other problems which they face in the course of implementing quality programs. The following are examples of such problems. Because of space limitations, these problems are not addressed in this paper, but provided for the readers' benefit.

Conflict between managing consistency and customization: While quality emphasizes consistent output and meeting the target value, modern business concepts highlight the importance of customizing the products/services. Competition in banking is driving up the customization concept. Thus, managers have to find the balance between finding ways to customize the services and maintaining consistency.

Managing the transition of customer delivery preference: While traditional business policies emphasize the face-to-face concept, the new business requires more on-line, real-time technology. Smaller banks in specific will have to decide how to handle the transition from faceto-face to on-line banking. Customers are demanding more on-line, although traditional customers are happy with the old-fashioned faceto-face banking.

Effectively using technology to de-standardize and decentralize: Responsiveness to customers' needs requires banks to utilize technology to decentralize the decision making and to de-standardize the products/services.

Market requirement to change more quickly that requires decision making skills regarding change, along with alignment of resource capabilities to effectively implement change: One of the challenges banks have to meet is to find ways to empower their employees. Decision-making capabilities need to be emphasized, and training and retraining of employees will be crucial to the successful implementation of cost of quality concepts.

The difficulty in discarding much of the old while adding the new: Change is difficult and many people resist it. Banks have to find the balance between adding new services and processes in place and dropping some of the old policies/procedures.

The market requirement for NEW often requires total process change rather than incremental improvement: In many scenarios, banks will have to change the total process. Continuous improvement concepts will be very important once the process in place is acceptable. If the process in place is not consistent with the mission of the bank, major (total) change will be required.

Challenge of efficiently providing expertise at multiple locations and different market segments: With segmentation and multiple locations (on-line as well as traditional locations), banks will find it very hard to provide the expertise needed to meet customer demands and the technology involved.

Defining, establishing and maintaining the individual and collective capabilities to execute the corporate strategies: Empowering employees will require defining the capabilities needed to accomplish the different tasks.

Using previous skill at specific routines may be doing something well that the customer no longer wants: Identifying the value added vs. non-value added activities will be an important step. Rules, policies and procedures must be established at every level of the organization, having internalized the mission with the ability and authority to respond to the customers requirements.

SUMMARY AND CONCLUSIONS

This study discusses the application of costs of quality concepts to the banking industry. The authors firmly believe that cost of quality concepts are beneficial to the banking industry and have the potential to improve and create a competitive advantage for banks. Although measuring some of these costs is challenging, the benefits of such measurement and reporting justifies the challenge. Quality measurements determine when, where, and how quality dollars are spent, identify improvement needs, and also help communicate quality costs throughout the organization. We believe that the application of the costs of quality concepts to the banking industry is justified for the following reasons:

1. Materiality: The size of the costs of quality without a doubt is material. It is estimated that the costs of quality are 25 to 30% of sales revenue or approximately 30% to 50% of service firm's operating expenses.

2. Usefulness of information: The preparation of costs of quality reports is believed to produce more useful information to managers and users to help them make informed decisions. Usefulness is usually measured in terms of the information being relevant and reliable. Reporting the costs of quality will provide the managers and investors with information to help them make their decisions. Companies that invest in quality programs are more likely to eliminate some of the failure costs, which in turn improves profitability.

3. Reporting costs of quality provides incentive to U.S. companies to view cost of quality as a long-term project with benefits covering multiple periods. Such a treatment encourages more companies to invest in quality programs, thus improving the competitive advantage of U.S. firms.

Many manufacturing and service firms, according to a 1990 survey, viewed quality programs as not having significant contributions. This view can be attributed not to the programs themselves, but rather to the lack of understanding of these programs. While many companies do not calculate quality costs, many well-known companies like Xerox, Westinghouse, and Motorola have experienced measurable success and have reduced quality costs from 30% of sales to a mere 2% to 3%.

1 Richard M. Rosenberg, "Success Components for the 21 st Century," Bank Management, January/February, 1994. P. 36.

2 Anat Bird, e Bank's Approach to Total Quality Management.," The Bankers Magazine, May-June, 1993, p. 68.

3 M. L. White, "Doing the Right Things Right the First Time," Trusts and Estates, September 1993, p. 30.

4 Penny Lunt, "Just What Exactly Is Quality Services?" ABA Banking Joumal, June 1992, pp. 78-81. Richard K. Youde, "Cost of Quality Reporting: How We See it," Management Accounting, January 1992, pp. 34-38.

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by Nitham M. Hindi, DBA, CMA * and Medhat A. Helmi, PhD., CMA*

* Associate Professor and Chair, Division of Accounting and Computer Information Systems, Emporia State University, 1200 Commercial Street, Campus Box 4057, Emporia, Kansas 66801

**Professor of Accounting, Department of Accounting, The University of Alabama at Birmingham, 307-D Business-Engineering Complex, 1150 Tenth Avenue South, Birmingham, AL 35294-4460

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