Quality Digest Daily, August 2, 2010

Manuscript No. 215

The Effective Cost of Production and Use

How to turn capability indexes in dollars Donald J. Wheeler
Capability indexes allow us to characterize the relationship between the process potential and the specifications. Performance indexes characterize the past performance relative to the specifications. Yet in practice we seek to make sense of these index numbers by converting them into other quantities such as the fraction nonconforming or the ppm defect rates. This article will outline a better way to make sense of capability and performance indexes by converting them into the Effective Cost of Production and Use. THE EFFECTIVE COST OF PRODUCTION AND USE Let use define the Effective Cost of Production and Use as: Effective Cost of Production and Use = Actual Cost of Production & Use Nominal Cost of Production

The actual cost of producing and using an item (the numerator) will consist of the nominal cost of production plus the average excess costs per unit associated with producing and using such items. Actual Cost of Production & Use = Nominal Cost of Production + Average Excess Cost of Production + Average Excess Cost of Use

Thus, in order to determine the Effective Cost of Production and Use we will need to characterize these Average Excess Costs. These excess costs can be broken down into three components: the costs of scrap; the costs of rework; and the excess costs associated with the use of conforming product. To create our Excess Cost Function we shall need to look at each of these three excess costs. DEFINING AN EXCESS COST FUNCTION Since scrapping an item is a cut-your-losses action, ideally taken only when it is cheaper to scrap the item than to use it, we can think of the cost of scrap as a fixed cost. That is, let CS denote the cost of scrapping an item. This cost will have to equal the cost of the raw materials plus the cost of all processing done to the item, the cost of inspection, and perhaps the cost of disposal as well. In Figure 1 this fixed cost of scrapping an item is denoted by a horizontal line beyond the lower specification limit, LSL.

2010 SPC Press

August 2010

The Effective Cost of Production and Use

Donald J. Wheeler

C SCRAP Excess Costs

f(x)

C REWORK scrap LSL target rework USL Product Values

Figure 1: Scrap and Rework Costs Let CR denote the average cost of reworking an item. This cost will usually be less than or equal to the cost of scrapping the item. In Figure 1 this average cost of reworking an item is denoted by a horizontal line beyond the upper specification limit, USL. Thus, we know the Excess Cost Function in two regionsscrap and rework. To fill in the rest of the curve we need to think about the nature of excess costs. Excess costs are the result of variation. They are costs incurred because everything is not right at the target value. If we could make everything right at the target value, there would, by definition, be no excess costs of production. Therefore, we define the excess costs to be zero at the target value, and this gives us a third point for the Excess Cost Function as shown in Figure 2.

Excess Costs

Cost of scrap over here LSL

Excess Costs are zero here

Cost of rework over here USL

target

Product Values

Figure 2: The Three Known Portions of the Excess Cost Function But how do we fill in the gaps? Since we know that small deviations from the target can be tolerated, we prefer to use quadratic curves to connect the three known portions of the Excess Cost Function. These quadratic curves will have their minimum at the target value, and will connect with the fixed portions of the Excess Cost Function to give the piecewise continuous curve shown as L(x) in Figure 3.

www.spcpress.com/pdf/DJW215.pdf

August 2010

The Effective Cost of Production and Use

Donald J. Wheeler

C SCRAP Excess Costs

f(x)

L(x) scrap LSL target rework USL

C REWORK

Product Values

Figure 3: A Realistic Excess Cost Function This Excess Cost Function suggests that when an item falls near the target there will be few excess costs associated with its use. However, as an item falls further and further away from the target the costs of using the item will increase. Moreover, these costs will increase up to that point where it will be cheaper to scrap or rework the item than it will be to try to use it. Since this is consistent with reality, the curve in Figure 3 is a realistic Excess Cost Function. It is important to note that the Excess Cost Function in Figure 3 is completely determined by the three points shown as black dots. (Since each quadratic curve has a vertex at the target value, each quadratic curve is fully defined by the target value and one of the other two points.) It is this property of our realistic Excess Cost Function that will allow us to use the capability and performance indexes to obtain the excess costs. THE AVERAGE EXCESS COSTS In Figure 3 the probability model f(x) represents the product distribution. Whether it is a description of the past or a prediction for the future does not matter at this point. When we multiply the Excess Cost Function L(x) by the probability model f(x) and then integrate over all values of x, we end up with the weighted average excess cost of production and use.

Average Excess Cost of Production and Use =

L(x) f(x) dx

The portion of this integral where x is between the specifications will define the Average Excess Costs of Use. The two portions of this integral where x is outside the specifications will define the Average Excess Costs of Production. Thus, we have in this one integral the last two parts of the numerator defined earlier: Actual Cost of Production & Use = Nominal Cost of Production + Average Excess Cost of Production + Average Excess Cost of Use

Returning to the definition of the Effective Cost of Production and Use we have: Effective Cost of Production and Use = Actual Cost of Production & Use Nominal Cost of Production

www.spcpress.com/pdf/DJW215.pdf

August 2010

The Effective Cost of Production and Use

Donald J. Wheeler

Nominal Cost Average Excess Cost of Production Average Excess Cost of Use = Nominal Cost + + Nominal Cost of Production Nominal Cost of Production = 1.0 + Excess Cost of Production + Excess Cost of Use where the last two quantities are expressed as a percentage of the nominal cost. Thus, the Effective Cost of Production and Use is a multiplicative value which expresses the amount by which the actual costs of production and use exceed the nominal cost of production. It can be used in this form, or it can be converted into dollars by multiplying by the nominal cost of production. WHERE DO THE CAPABILITIES COME IN? The three points that define the Excess Cost Function in Figure 3 occur at the target and the specifications. The relationship between the process outcomes and the specifications is characterized by the capability indexes. Thus, for a given situation, it is possible to express the excess cost of production and the excess cost of use as a function of the capability indexes. Tables based on this relationship will allow you to convert the capability indexes directly into excess costs of production and excess costs of use without having to actually evaluate the integral defined above. To illustrate this we shall use as an example the baseline computation for the Tokai Rika Cigar Lighter Detent Dimension. In what follows I will compare the direct computation of the Effective Cost of Production and Use with the table look up approach.
Day 10 am 11 am 2 pm 4 pm Average Range Day 10 am 11 am 2 pm 4 pm Average Range -190 88 91 89 89.50 3 -1389 89 91 89 89.50 2 -291 87 89 89 89.00 4 -1491 88 88 92 89.75 4 -388 91 90 89 89.50 3 -1591 89 89 87 89.00 4 -488 89 90 90 89.25 2 -1690 92 92 89 90.75 3 -587 91 91 90 89.75 4 -1791 92 89 92 91.00 3 -690 91 92 89 90.50 3 -1892 89 89 90 90.00 3 -788 92 91 90 90.25 4 -1990 91 90 89 90.00 2 -890 90 88 89 89.25 2 -2089 92 92 88 90.25 4 -991 89 89 87 89.00 4 -2188 89 90 90 89.25 2 -1090 91 88 90 89.75 3 -2291 92 90 89 90.50 3 -1192 89 90 90 90.25 3 -2391 91 90 90 90.50 1 -1291 88 89 88 89.00 3 -2492 91 88 88 89.75 4

Figure 4: Tokai Rika Lighter Detent Data for Days 1 to 24 Figure 4 gives the data for the Tokai Rika Lighter Detent Dimension. Four pieces are measured each day and arranged into daily subgroups. The first 24 days of production are used as the baseline period for computing the limits for the Average and Range Chart shown in Figure 5. The values recorded are in hundredths of a millimeter in excess of 15.00 mm. Thus, the target value of 15.90 mm is shown as 90. The specifications are 80 to 100. The grand average is 89.80 and the average range is 3.04. When the average range is divided by the bias correction factor for subgroups of size four we end up with a value for Sigma(X) of 1.48. Assuming that nonconforming items are scrapped we end up with a symmetric excess cost function like that in Figure 6.

www.spcpress.com/pdf/DJW215.pdf

August 2010

The Effective Cost of Production and Use

Donald J. Wheeler

Day

10

15

20

24 92.02

Averages

90 87 5

89.80 87.58 6.94

Ranges

3.04 0

Figure 5: Average and Range Chart for Tokai Rika Lighter Detent

CS

f(x)

L(x)

CS

80

90

100

Figure 6: The Excess Cost Function for the Tokai Rika Lighter Detent Data The Capability Indexes for these data are: 100 80 C p = 6 (1.48) 89.8 80 C pk = 3 (1.48) = 2.25 = 2.21

Using a table for the situation where all nonconforming product is scrapped, and rounding these capability indexes off to 2.30 and 2.20, we can convert these capability indexes into the following excess costs: Excess Costs of Production = 0.000 Excess Costs of Use = 0.023 Effective Cost of Production and Use = 1.023 For this process Tokai Rika has excess costs that amount to about 2% of the nominal costs. All of these excess costs are Excess Costs of Use, which is consistent with Figure 6. To see how these excess costs were obtained consider the following direct evaluation approach. The natural process limits for this process are 85.4 to 94.2. These values fall well within the specifications of 80 to 100, as shown in Figure 6. Since we will only need to evaluate the integral over this reduced range of values our generalized Excess Cost Function of Figure 3 effectively becomes a simple quadratic equation of the form:

www.spcpress.com/pdf/DJW215.pdf

August 2010

The Effective Cost of Production and Use CS 2 ( 100 90 )2 ( x 90 )

Donald J. Wheeler

L(x) =

K ( x target )2

Whenever the Excess Cost Function is a quadratic equation, the Average Excess Cost will always reduce down to the following expression regardless of which probability model f(x) is used: Average Excess Cost of Production and Use = = K [ 2 + ( )2 ]

K ( x target) 2 f(x) dx

where is the mean of f(x), is the standard deviation of f(x), and K is a constant that defines the quadratic curve and converts everything into monetary units. Inspection of this perfectly general result will show that the Average Excess Cost will always be minimized by operating On Target with Minimum Variance. We may evaluate the expression for the Average Excess Cost using: Average Excess Cost = CS = 2 2 (USL target)2 [ Sigma(X) + ( X target) ]

If we assume that the cost of scrapping a lighter shell is the same as the nominal cost of production, and that this cost is C S = 20 then we have: Average Excess Cost = = K [ Sigma(X) 2 + ( X ) 2 ] 20 = 102 [ 1.482 + ( 89.80 90.0 )2 ] = 0.446 per piece Thus, the Effective Cost of Production and Use for this process is estimated to be: Effective Cost of Production and Use = 20 + 0.446 = 1.0223 20

Thus, whether by direct computation, or by simply converting the capability indexes, we arrive at the Effective Cost of Production and Use for this process. Tables for converting capability indexes into (1) the Excess Cost of Production, (2) the Excess Cost of Use, and (3) the Effective Cost of Production and Use may be found in my new book Reducing Production Costs. How you can use the Effective Cost of Production and Use to define entitlements and potential returns for improvement projects will be the topic of my September Column.

www.spcpress.com/pdf/DJW215.pdf

August 2010