TOTAL VALUE GENERATED BY THE ENTERPRISE, AND QUALITY METRICS

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1 TOTAL VALUE GENERATED BY THE ENTERPRISE, AND QUALITY METRICS Silvio Rubbia Mgt Consultant, Italy, Via dell Orso Milan, Tel , Summary The conceptual relationship between quality and the value generated by an enterprise is currently recognised by academics and practitioners. Nevertheless, there is a huge absence of clear and quantitative links between value metrics and quality metrics. The author presents a general framework integrating these two fields, based on an economic point of view. Keywords Quality Metrics, Total Quality, Shareholder Value, Economic Value 1. INTRODUCTION: DIFFERENT SCHOOLS OF QUALITY SCIENCE The aim of this paper is to introduce a general model that correlates, in a causal and quantitative way, quality with the value produced by the enterprise, all within a management view. I shall start by saying that the theory and the practices of Quality (what we will call Quality Science), as a part of management, have had, over the years, a paradoxical destiny. On one hand, Quality has obtained, mainly in the 80s and 90s, considerable recognition and success both in applications and in theoretical contributions, well represented in tools and specific technologies, that are still today spreading in use in business practices. On the other hand, attempts to make Quality Science a general effective and excellent theory of management, (see TQM) have not had an easy life, and I would say that, since as early as the '90s, Quality Science has been progressively excluded from the standard theory of management. We can find dramatic confirmation of this "marginalisation" by examining the lists of The 50 Top Mgt Gurus (Accenture 2003; Thinkers 50, 2007) to find that, in the two lists, no expert appears as a Quality scientist. If we want a confirmation of this paradox, we can verify that in none of the last 200 articles of the prestigious HBR, neither the term Quality Science nor anything pertinent appears in the titles in a comparison of 40 quotations for leadership and 20 for innovation. Of course we could say the quoted references are strongly "US-biased", and are therefore not necessarily a correct representation of the business world, or the quoted sources are too oriented to the new, rather than to persisting fundamentals. However, these quotations are certainly indicative of a phenomenon that must be explained, and Tito Conti (Conti 2009) also gives ample testimony to this problem in his intervention. This paradox may have three different explanations, which three different lines of development of quality offered by various experts and practitioners correspond to: they form three different schools of Quality Science, and therefore different positioning regarding management.

2 The first line of development: Quality Science as Tool Set The first approach assumes that the useful essence of Quality is its techniques for improving business activities and specific problem solving. Therefore Quality Science as Tool Set builds a culture distinct from management, where the community of Quality experts, mainly self-referential, is separated from management experts (students and practitioners). Quality and Management are, here, two parallel lines that meet each other at infinity. Therefore, according to these authors, there s nothing strange in not finding Q experts among the top management gurus! The second line of development: Quality Science as System Model of Effective Enterprise According to the second school, the development of quality has been, and must be in future, a progressive enlargement of the "subject" to which quality, as "fitness to purpose", should be applied. According to this view, we can say that, in the '60s - '70s, quality of product was central to analysis, to pass then to that of processes and above all, in the '80s, to quality of total organization (CWQC). Today we enlarge the view to quality of inner and external system (CSR), including the interests of all the stakeholders, deepening the associate-cultural dimensions of the organisational system. The third line of development: Quality Science as Diffusion of Quality Concepts and Techniques into Management Thought Under this approach, quality becomes management when it transfers to the management key concepts that change and enrich the models of the management. This thesis can be supported by a lot of concepts that, not discovered by quality, but emphasised from it and applied by it, have become inseparable parts of managerial thought. This third approach would explain well the paradox I started my intervention with: the absence of a quality approach in standard management thought is only apparent as, in contrast, it permeates management deeply under different names and forms. As an example to all, the so-called school of excellence (see T. Peters) is deeply determined by the Quality approach. Figure 1 shows these three schools of Quality Science according to two classificatory dimensions (technical vs. management and width of quality object). From this figure we can verify the relevance that concepts "rediscovered" and "relaunched" by quality have had in management thought. All three schools are present and coexisting in the community of Quality Science professionals, and this Congress is a proof of this variety of approaches. 2. THE VALUE REVOLUTION My presentation belongs to the third type of Quality Science approach. To introduce it better, I want to emphasise that horizontal contributions to management by Quality have always proved important when the prevalent management approach had come in crisis before economic reality. A classic case was, as all of you remember, the crisis of American management in the competitive situation with Japan during the 80s, with the consequent development of the above-mentioned School of Excellence, certainly inspired by Quality Science. Now (in the first decade of the new century) a deep challenge to traditional

3 management thought is posed by the concept of economic value for shareholders as dominant objective for the enterprise. This innovation has quickly spread in recent years, supported by the penetration of finance in business decision-making, but has a much deeper origin. In fact, shareholder value depends both on current (short period) and on future (long term) profitability, and emphasises drivers of future value at the centre of managerial interest, besides current profit. Object width Social System (stakeholders) Today Inner System (organization) Processes SWQC CWQC Awards MARKET IN 3 CSR, etc. Leadership Excellence, etc. Process re-engineering, etc. Customer driver School 1 School 2 School 3 Product/ service/client 70 Q Techniques QUALITY FITNESS FOR USE Q Concepts and policies Value for the customer MANAGEMENT Approaches Figure 1 - The three schools of Quality Science Then a model is necessary that explains both current and future economic value: this model should be based on use value of business output. Attention: I said use value (a paradoxically innovative concept) as opposed to exchange value or price. Why has the concept of use value become an unexpected innovation in management thinking? Because the whole classical theory of enterprise (micro-economy) is based on price, i.e. exchange value, as the variable of evaluation by the market of the output, and therefore it neither recognises nor measures the use value. The problems deriving from the absence of the concept of use value are several in classical theory: in particular, the classical theory does not adequately explain market share or the existence of oligopolies, or give information on the dynamics of building value: it is a theory of general equilibria (Marshall). At last the classical equilibria theory has proved inadequate to the current systemic crisis of the world economy, having been able neither to foresee nor to diagnose it. There is a second deep reason for use value becoming central in management: today the economic scarce factor is not resources, now totally overflowing, although expensive, but the solvent demand that has become the universal scarce factor in developed economies. If so, it is clear that, today, competition is held over the scarcity of solvent demand (effectiveness) and not on the scarcity of resources (efficiency). But competition over demand scarcity becomes the maximization of use value as assessed by the demand, with exchange value (price) becoming a simple constraint to participate in competition. Once again, the last statement puts in crisis the same foundations of traditional theory of enterprise, and requires new theoretical contributions that can explain how companies behave in a very different way from that which is required by traditional economic theory. In fact, companies that

4 successfully survive the competition need to practice effective solutions to the external environment, otherwise in their Darwinian condition disappear and this, paradoxically, without it being necessary that the management has a clear understanding and modelling of reasons for their success ( The Blind Watchmaker for remembering the words of the evolutionary biologist Dawkins). Therefore the economist must become an experimental scientist, and must humbly examine competitive reality in the new global context of the shortage of solvent demand, and draw the correct theoretical consequences. In the logic of an experimental economy, we can easily argue that competitive enterprise shows strategic centrality and the necessity of a company-wide management of use value for the customer of product-services. This orientation must permeate all the business functions, on one hand giving priority to the functions of marketing and planning ( customer-driver enterprise ), and on the other giving an industrial base to shareholder-value-based finance. 3. THE ECONOMIC MEASURE OF ENTERPRISE OUTPUT QUALITY At this point, we once more cross the road of quality, simply recognising that the use value of a unit of business output (VUU) can be taken as a measure of economic quality itself (E [Q]). To support this assumption, it is sufficient to note that (i) the measure of product unit quality is its level of fitness to the expectations of the customer, and (ii) the economic measure of this level is the indifference price for the customer to acquire that output in comparison of alternatives (scarce solvent demand and overflowing offer). E (Q) VUU (1) The relationship allows us, in principle, to measure the economic value of the quality of a product unit for a customer making explicit the indifference price of that product for him. We now apply this definition to the case of an enterprise that sells a quantity VOL of product to a customer segment, when customers have preferences and different utility. Figure 2 shows it graphically as follows: if n is the number of customers willing to buy the product at price p (curve A-B-C-D, i. e. the indifferent price curve of the product for segment customer), then n customers buy at price P, where marginal customers have a use value equal to P, and the others have greater value. The total use value generated by the enterprise and purchased by customers is given by the ACEO area, while the use value, if all the market has bought, is the ADO area underlying the curve p = p (v).

5 P (indifferent price) A B Countervalue Actual price (P) C Use value of product/service p* 0 Buying clients E n D Clients buying from others Purchased volume (v) Countervalue = Quality - Price Figure 2 - The indifferent price curve [p = p (v)] Using definition (1) of quality economic measure, we can introduce, as follows: Economic Quality measure of a product Q (2) for the total segment customer who could potentially buy We can derive the following conclusions, which are proved in Appendix 1: Q is a characteristic of the product in relationship to a segment (perceived quality), and it doesn't depend on price of sale; we set to assume it as the economic measure of product quality for the segment; quality, Q, is measured by an economic value for a product unit. It is therefore a dimensionless measure, as must be correct for an indicator of state, as the level of quality should be; the share of the market VOL, being equal to relative distribution of the utility for the various customers within the segment, depends on the price-quality ratio, or: P MARKET SHARE = Function ; RELATIVE UTILITY (3) Q DISTRIBUTION Expression (3) is a fundamental result that is, entirely, empirically confirmed by the large experience of the PIMS database (Profit Impact of Marketing Strategy) that has verified that quality is the variable with the highest, almost complete, correlation with market share (volume). Since only a part of the segment buys our product and, particularly, this part includes the customers that mostly appreciate the product itself, the economic value of product unit quality that indeed comes purchased ( Q = purchased quality ) is different, and more than Q, as shown in Appendix 2.

6 Then (Appendix 2) we can say, in the accounting model of enterprise and in perpetuity conditions: SHAREHOLDER VALUE = Function (Q; P...) (4) Expression (4) confirms the causal relationship between the economic measure of the output quality and shareholder value, in the accounting model of the enterprise. 4. TOTAL QUALITY METRICS AND SHAREHOLDER VALUE CREATION As I said at the beginning of this paper, the hedge to Quality Science is its ability to connect Quality Science with shareholder value, as the ultimate reason for the existence of the enterprise. Shareholder value is given, as we know, by the actual value of the future flows of income. Therefore it depends on current profit value and on its future dynamics. This assumption exceeds the previous accounting model and requires a corresponding generalisation in the concept of quality: it is necessary to pass from Product (process) Quality to Total Quality. This generalization leads us to define the economic measure of the quality of the whole enterprise (which of course we will identify with Total Quality) as the total economic value created for all the stakeholders by the activity unit: We have: E(TQ) = TOTAL ECONOMIC VALUE = VTU (5) GENERATED BY ACTIVITY UNIT Total economic value generated by enterprise = Total output use value Total input use value That is, referring to stakeholders and adding and subtracting revenues and costs: Total economic volume generatedby enterprise = Customer Revenues use value Revenues- Costs Suppliers use extra value that is: TOTAL ECONOMICVALUE GENERATEDBY ENTERPRISE COUNTERVALUE FOR CUSTOMERS SHAREHOLDER PROFIT SUPPLIERS EXTRA USE VALUE = (6) Expression (6) shows that the total economic value generated by the enterprise is the sum of three quantities: (i) shareholder profit (ii) customer countervalue (iii) suppliers extra use value (staff and external suppliers).

7 If we recall the definition (6) of TQ we obtain, and referring to the activity unit (volume) we had: PURCHASED UNIT SUPPLIERS E(TQ) = PRICE (7) QUALITY PROFIT EXTRA UNIT VALUE Expression (7) shows that the level of Total Quality of an enterprise is a multidimensional variable and, as intuition suggests, is the result of composition of the level of quality components at which it works for different stakeholders. Expression (7) is the synthetic answer to the theme that we have addressed, that is to say how Total Quality determines shareholder value. In fact, if we remember that, according to Shareholder Value Theory (one for everybody, Reichheld, 1996), future flows are primarily determined by three drivers, there is a biunivocal correspondence with the components of Total Quality, as reported in (8). Shareholder Value Drivers Profit Customer loyalty Staff loyalty Total Quality Quantitative Components Profit Customer countervalue Suppliers extra value (8) Therefore, (8) shows how it is possible to correlate, in a quantitative way, Total Quality and shareholder value. 5. APPLICATIONS IN THE REAL WORLD In my experience as a consultant to large organisations, I have experienced the usefulness of this approach in terms of instruments for the cultural evolution of management: this also in public organisations, where the use value concept (here called Public Value generated) has no alternatives since, obviously, there is no market for them (no exchange value). As an example, I will outline an application based on a real use of total quality metrics. The managerial theme of this application is an extremely common one, i.e. how to improve the components of the marketing mix of a product-service line to maximize shareholder value. To solve this question I have introduced a new metric tool, the Integrated Scoreboard shown in Figure 3.

8 1 2 PURCHASED QUALITY STANDARD UNIT PROFIT E(TQ)= 3 4 EFFICIENCY PRICE Figure 3 - Quality Integrated Scoreboard The Integrated Scoreboard (IS): graphically shows the multi-dimensionality of TQ, as "addenda" to the TQ measure which we have seen in Section 4. Its principal property is the additionality of different components which are measured by appropriate indicators and relative weights. is not the classic Balanced Scorecard because you can now add sections ( Horizontal Scoreboard ) whereas, in the classic one, you have "vertical" sections, i.e. linked by a cause-effect relationship. Obviously, this difference is fundamental in terms of metrics (Meyer 2002). The management operability of three of the components (,, ) is clearly direct. The Purchased Quality also becomes operable if you relate it to delivered quality through a classic Quality Function Deployment approach. In practice, this QFD is adequately achievable if a few Customer Satisfaction Surveys are available. At this point we can assess the impact of marketing mix variables on the Total Quality components and, by them, as shown in Section 4, estimate the effects of value drivers. This procedure has shown, in many cases, a good way to organize, rationally and clearly, investment decision-making process of improvement. I hope this contribution might be useful, and I thank you for your attention. REFERENCES [1]. Accenture (2003), Top 50 Management Gurus (Business Expert) List [2]. Conti T. (2009), Systems Thinking: the new frontier in Quality Management, EOQ Congress, Dubrovnik [3]. Dawkins R. (1986), The Blind Watchmaker, Penguin Books [4]. Meyer M. (2002), Rethinking Performance Management, Cambridge U. Press [5]. Peters T. & Waterman R. (1982), In search of Excellence, Harper & Row [6]. PIMS (2008), Profit Impact of Marketing Strategy,

9 [7]. Reichheld F. (1996), The Loyalty Effect, HBS Press [8]. Thinkers 50 (2007), APPENDIX 1: THE INTRINSIC QUALITY OF ENTERPRISE OUTPUT With the symbols of the text, we can hold: Q P 1 = p( v) dv 0 where ( VOL) = Q f ( VOL) p(vol) f = 1 p dv 0 and having set segment volume = 1 APPENDIX 2: THE PURCHASED QUALITY OF ENTERPRISE OUTPUT With the symbols of the text, we can hold: Q = 0 VOL p(v) dv = Q h (VOL) VOL It is possible now to correlate the metric economic of product quality with the accounting metric profit and shareholder value, as follows: Pr ofit = Re venues Costs = P Unit cost VOL Pr ofit Perpetuity Value for shareholders = r hypothesis where P VOL = f Q Unit Cost = function ( Q/...) r = Capital cos t that is to say, in the event of perpetuity: Shareholde r value = Function ( Q; P;...)