Avoiding the High Hidden Costs of Noncompliance
EU RoHS, China RoHS, Korea RoHS, California RoHS, ELV, REACH – the list of environmental regulations for reducing hazardous substances in products keeps growing. What, exactly, are the costs if your products fail to comply? Missed customer requirements, blocked shipments, costly redesigns, and scrapped parts are just the tip of the iceberg. No doubt, the stakes are high, with potentially millions of dollars in lost revenue and related costs.
To avoid these costs, manufacturers must identify, track, and control a constantly evolving list of high-risk substances, both in their products and in their supply chain. Spreadsheets, homegrown databases, and manual processes simply can’t meet this enormous data management challenge.
When a manufacturer is compelled to preemptively remove a product from the market, potential revenue is lost. In the time it takes to introduce a new compliant product, the company may also lose market share. Even after a new replacement product is introduced, ongoing operating costs may increase, especially if the company must manage two versions of the same product – one that is compliant and one that is not. In each of these cases, no fines are levied, but the cost of noncompliance is significant.
Manufacturers, particularly those attempting to address compliance for the first time, tend to underestimate the true costs of noncompliance. As a result, compliance programs may not receive sufficient commitment from senior management. Compliance initiatives may be neglected, delayed, or if undertaken, result in inadequate solutions, which can expose the company to a significant risk.
The first step in mitigating these risks is to fully understand all the costs of failure in each of nine broad categories – costs that will be unique to your company and products.
Modeling the Failure Scenario
The total cost associated with a compliance failure can be modeled by looking at the cash flows generated by a product over its lifetime (see Figure 1). The upper curve represents the typical product cash flow. At first, cash flows are negative as the company invests in design and development. Cash flows turn positive as the product goes into production. Cash flows decline slightly as the product matures, and decline sharply when it is retired. The lower curve shows what happens when there is a compliance failure. The area between the two curves represents the total cost to the company due to this compliance failure.
The total cost of compliance failure will depend on many factors including where in the product’s lifecycle the fail ure occurs and what corrective action the company takes. The company may decide to simply retire the product. It may decide to halt shipment and later introduce a compliant version of the product. In some cases, the company may be forced to rework or replace units that have already been shipped. One high-tech company took this approach in 2001 after Dutch authorities determined that its product contained cadmium levels that exceeded the limits set by Dutch regulations. This particular company took action on several fronts, including reworking units in inventory and replacing units that had already shipped. At the time, the estimated total cost of the failure, including rework, was 110 million Euros in sales and 52 million Euros in profits.
Quantifying the Nine Components of Cost
There are typically nine cost components associated with an environmental compliance failure. These costs fall into three main categories: lost revenue, short-term crisis mode costs, and longterm capability building costs.
Cost #1: Lost Revenue - Short-Term. A compliance failure will likely lead to a period of time in which the product is taken off the market – perhaps several months. This means immediate, shortterm lost revenue. In addition, if the product is early in its lifecycle, the window of opportunity in which the product may have 100% market share – and therefore greater pricing power and higher margins – is reduced. Cost #2: Lost Revenue – Long-Term. A late or interrupted product launch due to a compliance failure will have a longterm revenue impact as well. The total sales life of the product will be shorter. In addition, a late introduction may mean a missed opportunity to lock in buyers if there is a transition cost associated with the product. Long-term lost market share is generally never regained. Finally, a late introduction may have a lasting effect on profit margins since the delay opens the door for competitors to reduce the manufacturing learning curve ahead of the company.
Short-Term Crisis-Mode Costs
Cost #3: Fines and Fees. Fines and fees are one-time costs. These are perhaps the most obvious costs associated with compliance failure, but actually may represent the smallest contributor to overall costs. Additional costs may include regulatory fines, customer penalties and other fees, including those arising from lawsuits and public relations services.
Cost #4: Design, Requalification, and Test. Fixing a noncompliant product is seldom a trivial task and may involve a significant redesign effort. For example, transitioning from a noncompliant to a compliant electrical component may require a new printed circuit board layout. All the costs associated with a new design should be considered, such as retooling, requalification, and reliability testing of all new components and assemblies.
Cost #5: Address Units in the Field. Fixing or replacing units that are already in the field presents numerous challenges and costs. The company must decide whether to rework or scrap these units. The company may decide to replace units at the customer site with reworked units. All shipping costs must be included here. Finally, original equipment manufacturers (OEMs) typically cannot sell refurbished units as fullpriced units, which represents one more cost to be considered.
Cost #6: Address Units in Inventory. Another set of decisions and costs is associated with the units in inventory. The company may decide to scrap or redirect noncompliant components or sub-assemblies for use in other products or markets. The company will also have to transition existing suppliers, or identify and ramp up new ones. If both compliant and noncompliant parts will be held in inventory for a period of time, there will be an increase in overall inventory holding costs. On the product side, the company may decide to temporarily deliver two versions of the product to market – one that is compliant and one that is not. This will increase inventory and other operational costs.
Cost #7: Data Collection, Doc - umentation, and Reporting. A key component of regulations such as REACH and RoHS is that the company must track and ensure product compliance internally, and ultimately provide evidence that the product is compliant. This verification involves collecting the relevant material content data from all suppliers and performing the required analysis and documentation at the product level. The cost of this effort will increase if internal and external supply chain members need to be educated about what data needs to be collected and how it is to be reported. If the product involves many components and suppliers — for example, some large OEMs must account for hundreds of thousands or even millions of supplier parts and their specifications — the effort and cost here is considerable.
Cost #8: Process and Organization – Short-Term. While dealing with the crisis, the company will likely need to change its way of doing business. The amount of change required will vary, but some corrective action must be taken. For example, teams and processes may need to be established to fill gaps in the current supplier declaration, collection, validation, and documentation process. These costs may be increased because the company will generally be operating in crisis mode, which generates expediting costs, higher labor costs, redundancies, and errors, as employees and the supply chain learn the new processes.
Long-Term Capability-Building Cost
Cost #9: Process and Organization – Long-Term. Lastly, it should be noted that Cost #8 concerns only building the minimal capability required to fix the immediate crisis. These processes will generally be manual and focused on a single design team and one operational group. They may be focused on just one regulation or just a single set of restricted substances. The company may eventually decide to incur additional costs such as building long-term, enterprise-wide capabilities to prevent additional compliance failures in the future. These costs will include building new business processes and systems around product design, manufacturing, supplier data collection, and supply chain assurance.
Avoiding These Costs
The scenario shown in Figure 1 depicts a single-failure event; for example, a product blocked from shipment because it has been found to contain a restricted substance. An event like this is usually an indicator of bigger problems with an organization’s processes and systems for managing compliance and risk. These problems will likely lead to more failures over time, although they may involve different products and different restricted substances, regulations, or customer requirements.
In an effort to avoid the costs of failure, many companies have made the mistake of taking an event-driven approach focused on a single failure point; for example, one restricted substance, one customer requirement, or one regulation such as RoHS. This reactive approach is apparently low cost, but actually leads to much greater costs down the road as new, more restrictive regulations like REACH emerge.
Consider two companies: Company A builds capabilities to address long-term risks arising from current and horizon regulations and customer requirements. Company B, in contrast, focuses exclusively on addressing the current failure event. The relative costs of each approach – proactive and reactive – are illustrated in Figure 2. As shown in the figure, Company A, by taking a proactive approach, incurs an initial cost. Company B, meanwhile, takes a reactive approach and incurs a series of recurring costs, the sum of which is much greater than that incurred by Company A. In this way, the “low-cost” approach actually becomes the higher-cost approach.
Adopting a Long-Term Strategy
As companies establish priorities, weigh alternatives, and plan an approach to addressing REACH, RoHS, and similar environmental regulations, they must take into account all of their potential costs, including those related to lost revenue. Similarly, they must account for all potential sources of risk, including those related to horizon regulations and customer requirements.
Failure to understand all the costs and risks associated with the challenge may lead to shortsighted and risky solutions. For example, companies that have invested considerable time and effort building processes, systems, and databases tailored to the six RoHS-restricted substances may now be unprepared to track and manage the new and growing list of REACH SVHC (substances of very high concern).
The key to succeeding and avoiding costs in this new, constantly evolving regulatory environment is a scalable and proactive approach tailored to the unique needs and risks of your business. It’s vital to invest in building processes and systems that support this long-term approach before an actual crisis occurs. The long-term costs of being unprepared are simply too high.
This article was written by Andrew Wertkin, Vice President, InSight Products and Technology, at PTC, Needham, MA. For more information, visit http://info.hotims.com/22928-121.