The Bottom Line
How an effective QMS and EMS can boost financials
by Sandford Liebesman
Today’s multiple business management systems usually do not talk to one another. They behave like independent silos, which results in less-than-optimal operations, excessive costs, dissatisfied customers and unhappy investors.1 Linking these systems provides an opportunity for quality and environmental professionals to communicate with financial counterparts, top management and the board of directors.
Quality and environmental managers need to understand the language of finance and the effect of operations on the bottom line, while financial managers need to know how quality and environmental managers can help improve results. In the long run, that includes cost savings, continual improvement of processes and products, and a greater understanding of each other’s work and responsibilities.
But how can organizations link their quality, environmental and financial management systems? What are the benefits of having these systems work together? Let’s start with a short overview of each system.
All about quality
The strategic framework of management systems consists of core values and services, guiding principles and a mission statement. The organization’s mission statement should define the role the organization plays in its industry, the products and services it provides, and how it benefits its customers and stakeholders.
The implementation of a quality management system (QMS) enhances customer and employee satisfaction, and improves awareness of customer requirements. ISO 9001:2008—Quality management systems—Requirements promotes a process approach to developing, implementing and improving the effectiveness of an organization. This consists of identifying the organization’s processes, determining their interactions, and managing and improving processes over time.
A quality manual should be constructed to cover the eight basic clauses of ISO 9001. The first three clauses cover the scope of the standard, references, terms and definitions. Clauses four through eight contain the basic structure of a good management system:
Clause four (QMS) defines the process approach and documentation requirements, which include a quality manual and procedures for control of documents and records.
Clause five (management responsibility) requires management commitment, customer focus, a quality policy, measurable objectives, planning, definition of responsibilities and authorities, establishment of internal communication and management review of the management system.
Clause six (resource management) requires provision of resources to implement the management system, continually improve its effectiveness and enhance customer satisfaction. It also requires procedures to ensure competence of personnel and maintenance of the organization’s infrastructure and work environment.
Clause seven (product and service realization) requires planning of the realization process; determination and review of customer requirements; and procedures for customer communication, design and development, purchasing, production and service, and for the control of monitoring and measuring devices.
Clause eight (measurement, analysis and improvement) requires monitoring and measuring customer satisfaction, processes, and products and services. It also requires documented procedures covering internal audits, control of nonconforming products and services, and corrective and preventive actions. The organization must analyze the data gathered and use it to continually improve the effectiveness of the management system.
Lean and Six Sigma are two tools that are generally linked to improve the QMS. Both focus on customer satisfaction and improved business performance. Lean analyzes ways of reducing cycle time and waste, while Six Sigma reduces costs and increases profits by eliminating variability, defects and waste.
Know your environment
The model for an environmental management system (EMS) is ISO 14001:2004—Environmental management systems—Requirements, which defines a structure similar to ISO 9001:2008.
The initial sections of ISO 14001 include the scope, references, terms and definitions. These are followed by section four, which includes the definition of a compliant system with requirements for an environmental policy, the definition of environmental aspects, and legal and other requirements. It also requires the organization to define measurable objectives and targets, as well as programs to achieve them.
The implementation and operation clauses define required resources, roles, responsibilities and authorities, as well as requirements for competence, training and awareness. These clauses also include requirements for internal communication, control of documentation, operational control, and emergency preparedness and response.
The analysis clauses require environmental monitoring and measuring of operations, evaluation of compliance and procedures required to identify nonconformities, corrective actions, preventive actions, control of records and internal audits.
Finally, there is a clause that requires management review at planned intervals. The review is aimed at ensuring the effectiveness of all aspects of the EMS and is similar to the quality management review. The QMS and EMS requirements are similar and should be developed in a way that ensures compatibility between the two.
A typical financial management system consists of six elements:
- Investment management.
- Statement of cash flow.
- Profit and loss (P&L) statement.
- Balance sheet.
- General ledger.
- System of internal control.
Let’s look at each of these elements and how the other management systems can provide inputs and supports for financial management.
1. Investment management
The foundation of the investment management process is the tools used to make good decisions concerning the costs and benefits of projects. Some decision tools commonly used are:
- Payback—the time it takes to recoup the original investment.
- Net present value—the cash flow of the investment in a project discounted to reflect the time value of money.
- Economic value added = (return on capital – cost of capital) x (capital invested).
- Review of the variances associated with current budgets.
- Statistical forecasting—estimating the future results of investments.
- The breakeven point—when total revenue received equals total costs associated with the sale of the product. Breakeven analysis provides an understanding of an individual product’s profitability and is used to analyze the product mix.
QMS and EMS support of investment management focuses on strategic planning and management. Some examples of this support are supply chain management, new product introduction, review of environmental concerns, inventory management, marketing strategy, R&D management, customer communication and intelligent management controls.
2. Statement of cash flow
The statement of cash flow describes day-to-day business operations, reflecting the flow of activity in the P&L statement and balance sheet (excluding investing and financing). There are three types of cash flow: from operations, from investments and from financing. A QMS and EMS can provide support for the sources of funds (Table 1) and the uses of funds (Table 2).
3. P&L statement
The P&L statement measures the performance of the business at a point in time. It consists of income (revenues, earnings and investments) and expenses (cost of goods sold, or COGS, operating expenses, provision expense, capital expense and income tax). Provision expense is money set aside for future liabilities, and capital expense is the depreciation expense of assets.
COGS is a major input from quality and environmental management. It consists of the costs associated with raw materials, purchased components, direct labor, operating and repairing manufacture equipment, and other manufacturing expenses, such as utilities and maintaining the facilities.
A QMS and EMS both provide information on operating expenses, including selling, general and administration expenses, sales and marketing, finance, HR, administration, supply chain, R&D, engineering and expenses associated with running a specific business unit.
Improvements stemming from the QMS and EMS contribute to financials and affect the P&L by reducing the cost of operations, production and transactions. Other positive impacts are reduced head count and cycle time, increased sales and revenue, reduced cost of supply, more effective control of logistics and cost-effective management of inventories. Lean Six Sigma is often used as a method for creating these improvements.
4. Balance sheet
The balance sheet measures the financial health and liquidity of the business over time. Comparing the balance sheet at various times shows whether the business is improving or declining. The balance sheet covers current assets, long-term assets and liabilities, such as accounts payable, taxes and short-term debt. Equity is total assets minus total liabilities and is reflected in the price of common and preferred stock, as well as retained earnings.
The following financial measures are associated with the balance sheet:
- Price-to-earnings ratio = (market value per share) / (annual earnings per share).
- Market capitalization = number of shares outstanding x price of shares.
- Asset turnover = revenue divided by total assets.
- Return on investments = profit / average investment.
- Return on equity = profit / average shareholder equity.
QMS and EMS improvements contribute to financials by creating shorter lead times and faster time to market, managing risk, avoiding single-source suppliers, increasing financial reliability, reducing cash tied up in inventory and decreasing capital spending.
5. General ledger
The general ledger is where all accounting transactions are recorded. It is the data source for most of the basic financial statements. The general ledger must always be in balance, which means total assets must equal total liabilities.
Assets consist of the funds from the sale of goods and services, as well as fixed assets, including land, buildings, machinery, equipment, vehicles, patents, trademarks, copyrights and goodwill contributions. Also included are depreciation, investments and inventory. Liabilities include debt, stockholder equity, accounts payable, payroll and benefits, operating expenses, COGS and other obligations.
Much of the data in the general ledger is provided by the QMS and EMS, including improvements from lean Six Sigma projects.
6. System of internal control
Section 404 of the Sarbanes-Oxley Act (SOX) mandates an effective system of internal control.2 The purposes of internal control are to aid in achieving an organization’s goals and objectives, assist in reliable financial reporting and compliance, lead the organization through its day-to-day operations and provide rules or guidelines for activities that identify and mitigate risks.
Section 404 defines the requirements for an effective system of internal control. The compliance system most often used is the one defined by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission.3 The U.S. Securities and Exchange Commission recommends using COSO guidance for SOX 404 compliance.
According to COSO guidance, quality plays a key role in the development of an internal control system:
The quest for quality is directly linked to how businesses are run, and how they are controlled. … Quality initiatives become part of the operating fabric of an enterprise as evidenced by establishing quality objectives linked to the entity’s information collection, analysis and other processes. These quality factors parallel those in effective internal control systems. In fact, internal control not only is integrated with quality programs, it usually is critical to their success.4
A compliant system of internal control ensures achievement of the three COSO objectives:
- Effectiveness and efficiency of operations.
- Reliability of financial reporting.
- Compliance with laws and regulations.
COSO also consists of five interrelated components:
- The control environment.
- Information and communication.
- Risk assessment.
- Control activities.
ISO 9001 and ISO 14001 provide support for a compliant system of internal control.5
The central theme of quality and environmental management is continual improvement, which results in improved financial results. The contributions to financials include hard and soft savings.
Hard savings affect the bottom line of the P&L by helping to increase revenues while decreasing expenses. Soft savings are more difficult to quantify and affect the balance sheet in a number of ways. For example, better control of inventories results in less cash tied up in the inventories or a decreased spending of capital. Or, quality analysis and improvement can help avoid planned capacity enhancements, which may eliminate a budgeted staff increase.
Soft examples of intangible improvements are increases in customer satisfaction, employee satisfaction and workplace safety. An effective EMS can result in a better understanding of significant aspects of the workplace and the satisfaction of legal requirements.
QMS and EMS support provides financial management with a better understanding of current operations. The result is a much more accurate measure of the status and effectiveness of the organization, as well as greater transparency of operations.
An effective QMS and EMS help top management and the board of directors identify business risks, control those risks and prevent major surprises. These management systems provide added resources, especially for internal auditing, reducing the cost of compliance and improving corporate governance by connecting management systems.
References and notes
- Sandford Liebesman, "Down with Silos," Quality Progress, September 2008, pp. 64-67.
- U.S. Securities and Exchange Commission, "SEC Implements Internal Control Provisions of Sarbanes-Oxley Act," www.sec.gov/news/press/2003-66.htm, May 27, 2003.
- The Committee of Sponsoring Organizations (COSO) of the Treadway Group is a group of professional auditing organizations that developed Internal Control—Integrated Framework (1992) and Evaluation Tools (1994) for the Treadway Commission. The COSO organizations are the American Institute of Certified Public Accountants, the Institute of Internal Auditors, Financial Executives International, the Institute of Management Accountants and the American Accounting Association.
- COSO, Internal Control—Integrated Framework, September 1992.
- For ISO 9001 and ISO 14001 support of COSO guidance, see Sandford Liebesman, "Mitigate SOX Risk with ISO 9001 and 14001," Quality Progress, September 2005, pp. 91-93.