When Al Roach and I formed Callahan/Roach & Associates in 1989, we based our management training and consulting upon the process of continuous improvement in hvacr companies. We adhered to the principles set out by Phillip Crosby in his groundbreaking book, Quality is Free. In this book, Crosby pointed out that in order to make a significant improvement in bottomline profitability, a business must first calculate — as closely as possible — how much it is spending to correct mistakes and carelessness. This calculation, called the cost of quality, is divided into three distinct elements: cost of conformance, cost of nonconformance, and cost of lost opportunity. Al and I restated the definitions of these
elements to reflect the perspective of hvacr contractors. For the past 20 years, our contractor’s cost of quality has been useful in helping people just like you determine how much you really are spending on fixing mistakes. Let’s take a closer look at each of these three elements.
Cost of Conformance
We define cost of conformance as “the hard dollars that a contractor invests in DIRTFT (do it right the first time). This is real money taken from the revenue stream and invested in such things as training, planning, supervision, communication tools, and anything else that improves customer service. It is important to understand that all of these things are measurable in dollars, and, that they are conscious investments.
Cost of Nonconformance
The cost of nonconformance is defined as the hard dollars that a contractor spends on DIRE (do it right eventually). This is also real money. However, it is taken out of the revenue stream to correct mistakes that could have been prevented by a better (or larger) investment in the customer-service tools listed above. Cost of nonconformance include such things as wasted time and materials, call-backs, vehicle costs, and anything else that can be calculated as a direct cost that could have been prevented. These things also are measurable in dollars that, unfortunately, are spent in correcting mistakes.
Cost of Lost Opportunity
Finally, the cost of lost opportunity is defined as the loss of revenue because employees could have been doing billable work instead of going back to correct mistakes. This includes loss of billable hours and markup on equipment and materials that could have been installed. Again, these costs are measurable in dollars. However, there are two other, more painful, ingredients in the cost of lost opportunity. They are loss of the customer and loss of referral due to mistakes and poor customer service. While these two costs are usually impossible to measure, they are, by far, the most expensive of all the costs of quality.
Service providers are told that providing exceptional customer service is critical to the success of their business, that their reputation can be either their greatest asset or their greatest liability. You have probably heard, “If you do a good job for a customer, they will tell five people. Do a bad job, and they will tell 15.” I don’t know the true ratio. I don’t think that anyone does.
However, I do know this! We in hvacr are not in a very glamorous industry. We are not typically the topic of cocktail party conversations (unless the party is at my house). If I am your customer, and you do a good job for me, I am not going to go to tonight’s cocktail party and announce to the world that you blew me away with your excellent service. What I will do, however, is give you a glowing recommendation if someone should ask for a referral. On the other hand, if you do a bad job for me, I will stop perfect strangers and tell them how you stuck it to me. This phenomenon is known as “vigilante consumerism,” and it is rampant.
Calculating Cost of Quality
Let’s look at an example of calculation of cost of quality. Say you are a residential replacement and service contractor who did $1 million in volume last year and made a profit of $40,000. Assuming that you track your call-back costs, you see that you spent $10,000 in directlabor dollars running call-backs (cost of nonconformance). That’s 1% of revenue, which is at or below industry standard. So, you did pretty well — right? Wrong!
If your cost per man-hour for direct labor is $25 per hour plus payroll taxes and benefits, then last year you spent 400 man-hours running call-backs. Assuming a street rate of $100 per hour, you lost $40,000 in labor revenue (cost of lost opportunity) because of the unnecessary labor costs. In addition, you would have been selling parts and materials. If you have a labor-to-material ratio of 2/1, and an average parts gross margin of 50%, you lost an additional $10,000 in parts mark-up. Your total cost of lost opportunity is $50,000. This does not include the fuel, insurance, benefits, and other indirect and overhead costs incurred because of the call-backs — let alone the cost of the lost customer and future referrals.
Remember, in this example, you made a profit of $40,000 last year. Therefore, every dime of this money would have dropped to the bottom line, and you would have more than doubled your profit as a result of eliminating these mistakes. You could have used some of this additional profit to take a bigger bonus, some to improve your employees’ compensation, and the biggest portion could have been used to invest in even greater cost of conformance. Everybody wins!
Crosby summed it up nicely in his book by saying that for every dollar invested in cost of conformance, we save $10 in cost of nonconformance and $100 in cost of lost opportunity. I’m a Clint Eastwood fan, so I look at it a different way. Cost of conformance is good cost. Cost of nonconformance is bad cost. Cost of lost opportunity is ugly cost. The Good, the Bad, and the Ugly, add them all up and you have a Fistful of Dollars.