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Understanding Six Sigma

(September 15, 2005)

Dear Subscribers and Readers,

What's New: Again, while not all our subscribers are fans of globalization or Thomas Friedman, I would highly recommend reading his latest work: "The World Is Flat: A Brief History of the Twenty-First Century."  If anything, it is a very easy and entertaining read.  Please see our latest review of the book in our Favorite Books section.  Finally, we would like to hear from our readers what your favorite books are.  Please let us know by posting your personal choices in the "Favorite Books" section of our discussion forum.

While our mission at MarketThoughts.com is to provide unique economic and stock market analyses for our readers, we have - more often than not - also written about other principles and ideas that may also be important to our readers.  Principles such as the 80/20 principle, the necessity to understand one's own psychology, and more recently, our discussion of the field of financial engineering and the "democratization" of finance in the 21st century.  While many of these principles and ideas can be directly applied to business processes, they are also very valuable for individuals and households as well.  For example, while many of your kids may be spending three hours a day studying or doing homework, the logical question to ask is: How efficient are they in doing what they do?  Do they just read the text several times over or do they go through it once and try to synthesize all the somewhat random material into one uniting idea or theme?  How about your approach of the typical job search?  Do you just randomly email your resume to employers or browse endlessly on Monster.com or Yahoo Hot Jobs?  Have you ever thought about utilizing your contacts in the industry you want to work in - such as through your alumni network or through your vendors?  How much more efficient can you be if you adopt the latter approach instead of "mindlessly" emailing your resume to employers who advertise on the web?  As individuals, we also like to take the easy route out of difficult situations.  Folks, this is different from being "efficient."  For example, when you were in college, did you entertain the idea of take the "easy classes" just so you will get higher grades?  Did you sacrifice learning in order to get an "easier professor?"  Did ever try to get stock tips from other investors - simply because you were too lazy or "didn't have time" to do research?

As we progress into the second decade of the 21st century, one of the buzz phrases will continue to be "efficiency, efficiency, and more efficiency" as the costs to do traditional business in the developed world will continue to be squeezed by lower wages in the developing world.  Processes will need to be streamlined, the potential for errors will need to be minimized, and workers will need to be kept happy and motivated, and so forth.  Witness the rise of Nucor within the struggling steel industry, along with the widely-publicized successes of Southwest Airlines within the woeful airline industry (a note to our subscribers: fortunes could have been made by shorting the airlines in the last half century, with the notable exception of shorting shares of Southwest Airlines).  Nucor is a highly decentralized decision-making organization.  Nucor's management does not enjoy "perks" that are enjoyed by upper management in other companies, and each worker within Nucor is rewarded according to his or her productivity.  Obviously, this encourages both efficiency and productivity.  This recipe for success has also been adopted by Herb Kelleher, the founder of Southwest Airlines, ever since the incorporation of the company in 1971.  Through a culture of empowering and rewarding employees, Southwest Airlines has built a reputation (and the numbers show it, with 32 consecutive years of profitability as of the end of 2004) for being the premier low-cost airlines in the United States.  While promoting and maintaining such a culture sounds easy, I can assure you that it is not.  When it comes to being a public company nowadays, it is still "easier" to have a bureaucracy and to take most of your employees out of the picture - until it comes to time to lay them off to ensure "higher efficiency" or "higher productivity."  Again, let me repeat: Such a way to bring about higher efficiency or productivity does not ensure long-term success.

When it comes to running a business, most companies today still act like individuals - in that management and employees alike tend to take the easy route - but most probably the costliest and least efficient route over the long-run.  This culture is especially prevalent among public companies today, as we all strive to try to make or beat the next quarterly earnings estimates put out by Wall Street.  Focusing on the short-term - such as strictly cutting costs without regards to future investment (e.g. Northwest Airlines keeping its fleet of DC-9s in order to cut costs ten years ago, which has come back to haunt them since), taking short-cuts to make deadlines, and so forth, will invariably hurt you in the long-run.

This brings us to the discussion of a business process called "Six Sigma" - a statistical and data-driven process for eliminating defects and to ensure higher (and sustainable) productivity and efficiency in every line of your business over the long-run.  Six Sigma was pioneered by Bill Smith, a senior engineer at Motorola in 1985.  The success of Six Sigma as applied at Motorola led to the company winning the Malcolm Baldrige National Quality Award in 1988.  On a normal bell curve, Six Sigma represents six standard deviations apart, which translates to a probability of two out of one billion, or in quality management terms, two defects in a billion opportunities.  Realistically, however, the universal accepted error rate for Six Sigma is 3.4 defects per million opportunities (or 3.4 DPMO) - which is essentially 4.5 sigmas.  As of this writing, many business writers are still debating where this 1.5 sigma shift originated.

First and foremost, Six Sigma is a quality management program.  As companies move from operating at a three sigma to a four sigma level, the defects per million opportunities decrease from 67,000 to 6,500, to just over 200 when operating at a five sigma level.  More recently (and obviously), companies have focused on cost savings arising from operating at higher sigma levels, as the costs to repair defects or to replace products invariably decreases as quality in their products increase.  According to the book "Six Sigma Demystified" by Paul Keller, "For a two sigma organization, roughly 50% of sales is spent on non-value-added activities.  It's easy to see now why for-profit organizations can't exist at the two sigma level [author's note: with the exception of monopolies].  At three to four sigma, where most organizations operate, an organization spends about 15% to 25% of its sales on "quality-related" activities.  If that sounds high, consider all the non-valued-added costs associated with poor quality: quality departments, customer complaint departments, returns, and warranty repairs . As an organization moves to a five sigma level of performance, its cost of quality drops to around 5% of sales.  The Six Sigma organization can expect to spend between 1% and 2% of sales on quality-related issues."

Without a doubt, however, the application of Six Sigma has resulted in significant cost savings at companies that have made the process a central theme of its core business, such as Motorola, Allied Signal, GE, Honeywell, and Microsoft.  Motorola has claimed that the implementation of Six Sigma has saved the company $16 billion from 1985 to 2001.  Jack Welch, the legendary CEO of GE, had made Six Sigma a primary focus of his managers while he was with the company, stating: "Six Sigma is the most important initiative GE has ever undertaken--it is part of the genetic code of our future leadership."

Okay Henry, I have heard that Six Sigma is just a fad.  The concept is just too convoluted - and how could anyone really quantify the savings that came directly from Six Sigma?  How does Six Sigma make me more efficient as an individual?

Well, no one said this was easy!  Just like the Dow Theory as applied to the stock market, there are many concepts and ideas - with seemingly no overarching theme to the lay reader.  Moreover, the benefits of Six Sigma are more easily quantifiable within an auto manufacturing company like Ford, for example, than within a services company like GE.  There are also just many websites out there trying to "make a buck" selling Six Sigma materials or software.

What the author likes about Six Sigma, ironically, are its definitive steps - steps that are undertaken when trying to improve an existing process or when introducing a new process.  This is different to other quality management theories, where the steps to improvement are not so defined.  Six Sigma is also very data-driven.  This is very important, as our subscribers (and me alike) - as investors in the stock market - have found out to our dismays at various points in time.  Human nature tends to ignore the "ugly facts" (which a program like Six Sigma will reveal if your company is operating at a below-optimal level), but over the long-run, facing the facts can be very beneficial - if we can set aside our egos for the greater good.  Speaking of facing the facts, I am reminded by the following part of the "Iron Curtain Speech" as made by Sir Winston Churchill outlining the growing threats of the post-war communist Soviet Union:

I have a strong admiration and regard for the valiant Russian people and for my wartime comrade, Marshal Stalin. There is deep sympathy and goodwill in Britain -- and I doubt not here also -- toward the peoples of all the Russias and a resolve to persevere through many differences and rebuffs in establishing lasting friendships.

It is my duty, however, to place before you certain facts about the present position in Europe. From Stettin in the Baltic to Trieste in the Adriatic an iron curtain has descended across the Continent. Behind that line lie all the capitals of the ancient states of Central and Eastern Europe. Warsaw, Berlin, Prague, Vienna, Budapest, Belgrade, Bucharest and Sofia; all these famous cities and the populations around them lie in what I must call the Soviet sphere, and all are subject, in one form or another, not only to Soviet influence but to a very high and in some cases increasing measure of control from Moscow.

Prior and throughout the Second World War, Winston Churchill had to face many "ugly facts" - such as Germany reaching air parity with Great Britain many years before the war while the Parliament stood idly by, Germany overrunning Austria, and not to mention the German break of the Maginot Line as Germany overran France in a matter of days.  As we read through Churchill's speeches during the times when Great Britain stood alone against the Axis Powers, one can very well see the inspirational nature and the optimism inherent in his speeches.  What does the typical bearer of bad news do in these kinds of situations?  Given the typical bureaucracy of government, one can very well imagine that many such news items (or "ugly facts" as we come to know them) will get filtered before they reach the top.  Does anyone remember Ken Lay and Enron?  Clearly, Churchill saw this potential problem, and in 1941, he created the Central Statistical Office whose job was to compile statistics on the war, assess the war situation objectively, and to directly report to him their findings.  One can argue that Churchill pioneered this early form of Six Sigma.

Okay, so much for Winston Churchill.  Let's discuss the definitive steps in a typical Six Sigma improvement process.  This standard process or methodology is abbreviated as DMAIC, which stands for define, measure, analyze, improve, and control.  According to the website www.isixsigma.com, DMAIC can be summarized in the following steps:

D: Define the Strategic Direction of the organization
M: Set Measures for the strategic objectives of the organization
A: On a continual basis collect data on the measures set and analyze using Six Sigma tools and techniques
I: Identify the opportunities for improvement and convert them to Six Sigma projects for improvement
C: Set up a management control action of continuous reviews on the improvements made on the Six Sigma Projects

This clear and concise methodology is one key difference between Six Sigma and the typical quality management program, such as TQM.  Another key difference is the fact that a proper implementation of six sigma requires the total support of one's organization, led by the executive staff and actively championed by mid and upper level managers.  Without the support and training of the executive-level decision makers, it will be virtually impossible to implement six sigma improvements and to make sure that these implementations stay within the business principles and objectives of the company.  Finally, as Paul Keller puts it, "The result of a properly implemented Six Sigma deployment is data-driven decision making [emphasis mine] at all levels of organization, geared toward satisfying critical needs of key stakeholders."  Recommendations are then implemented, measured, and subsequently improved based on feedback from both employees and from customers.  Six Sigma is meant to be a continuous improvement process and an integral part of the company.  As Jack Welch so "eloquently" put it in a managers' meeting in January 1997, a year after officially announcing the implementation of Six Sigma at GE (following is account of the speech from "Six Sigma Demystified"):

You've got to be passionate lunatics about the quality issue... This has to be central to everything you do every day.  Your meetings.  Your speeches.  Your reviews.  Your hiring.  Every one of you here is a quality champion or you shouldn't be here... If you're not driving quality you should take your skills elsewhere.  Because quality is what this company is all about.  Six Sigma must become the common language of this company... This is all about better business and better operating results.  In 1997, I want you to promote your best people.  Show the world that people who make the big quality leadership contributions are the leaders we want across the business.

While this is not obvious, readers can also translate the Six Sigma process into one's personal life, such as the investing process (if investing is outside of one's career), losing weight efficiently, or just being a more efficient personal overall.  Or think of the family as a business unit and try to implement Six Sigma within the family unit.  Try to initiate and keep an open line of communications within your family.  Talk to your spouse, talk to your kids, and make sure the family functions as a team and treat each other with respect.  Kids are human beings - so treat them like they deserve to be treated.  You can start by trying to play a more active role in your kid's studies - which doesn't just mean making sure he meets his homework deadline tomorrow, but rather teaching him the necessary tools to learn efficiently over the long-run.  You may be surprised at the results.

As for me, this author is always trying to follow the Six Sigma principle in studying the markets and in most aspects of my life - but once in awhile, I do fall short.  I try to focus on the indicators that I believe are currently important for the markets, and acting to come up with an overarching but concise picture of our current position.  Trust me, writing is the easy part - but using the tools that are available to me in an efficient manner and coming up with a coherent and concise conclusion is not.  But that's just the way Six Sigma works.  It is not meant to be easy, and that is why most people fail at it.

Conclusion: This is just meant to be a basic introduction to Six Sigma and what this author thinks one can do to incorporate this decision-making process to make one's life easier and more efficient in the long-run.  There is a huge library of Six Sigma material out there so I did not want to regurgitate where it is not necessary to do so.  Hopefully, we have added some value for our subscribers with this article.  Please email me at hto@marketthoughts.com if you have "war stories" of your own to share! 

Signing off,

Henry K. To, CFA

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