CHAPTER 14
QUALITY COST MANAGEMENT
QUESTIONS FOR WRITING AND DISCUSSION
1. All quality costs are incurred because poor
quality may or does exist.
2. Prevention costs are incurred to prevent defects in products; appraisal costs are costs
incurred to determine whether products are
conforming to specifications; internal failure
costs are incurred when nonconforming
products are detected prior to shipment; external failure costs are incurred because
nonconforming products are delivered to
customers.
3. External failure costs can be more devastating because of warranty costs, lawsuits, and
damage to the reputation of a company, all
of which may greatly exceed the costs of rework or scrap incurred from internal failure
costs.
4. Agree. It is poor quality, not good quality,
that is costly. All quality costs exist because
poor quality may or does exist.
5.
Interim quality standards are used to measure a firm’s progress toward better quality
within a given period.
6.
Interim quality reports are used to measure
quality improvement with respect to a
current-period standard; multiple-period
reports are used to measure quality improvement with respect to a base period;
long-range reports are used to measure
progress toward achieving the goal of zero
defects.
7.
Both monetary and nonmonetary incentives
can be used to motivate employees. For example, employees can be given a bonus that
is equal to a fixed percentage of the savings
from a suggestion that improved a product’s
quality (referred to as gainsharing). Additionally, awards of excellence can be used to
recognize those employees who make outstanding quality contributions.
8.
Firms should spend about 2.5% of sales on
quality costs. The potential savings from
quality improvement is $31 million [$36 million (0.18  $200 million) – $5 million (0.025
 $200 million)].
9.
A quality cost report shows the amount of
cost for each category as well as the relative
cost of each category. This report requires
managers to identify the costs that should
appear in the report, to identify the current
quality performance level, and to begin thinking about the level of quality performance
that should be achieved.
10.
Two major reasons why the accounting
department should be responsible for producing quality cost reports: (1) they have the
expertise and training, and (2) they have the
objectivity.
11.
ISO 9000 is a series of five international
quality standards. These standards center
on the concept of documentation and control
of nonconformance and change. ISO 9000
certification can be a requirement of doing
business (e.g., in Europe). Also, many
companies have found that the process of
applying for ISO 9000, while lengthy and expensive, yields important benefits in terms of
self-knowledge. U.S. companies are using
ISO 9000 certification as a competitive tool,
as well.
12. An environmental cost is a cost incurred
because poor environmental quality exists or
may exist.
13. The four categories of environmental costs
are prevention, detection, internal failure,
and external failure. Prevention costs are
costs incurred to prevent degradation to the
environment. Detection costs are incurred to
determine if the firm is complying with environmental standards. Internal failure costs
are costs incurred to prevent emission of
contaminants to the environment after they
have been produced. External failure costs
are costs incurred after contaminants have
been emitted to the environment.
14. Realized external failure costs are environmental costs paid for by the firm. Unrealized
or societal costs are costs caused by the
firm but paid for by third parties (e.g., members of society bear these costs).
315
EXERCISES
14–1
1. Internal failure
13. Prevention
2. Prevention
14. Prevention
3. Internal failure
15. External failure
4. External failure
16. Prevention
5. External failure
17. External failure
6. External failure
18. Prevention
7. Prevention
19. Prevention
8. Internal failure
20. Appraisal
9. Appraisal
21. External failure
10. Internal failure
22. Prevention
11. External failure
23. Appraisal
12. Appraisal
316
14–2
1.
Activity rates:
Warranty:
Scrap:
Inspection:
Training:
$204,000/2,550 = $80 per unit
$153,000/4,250 = $36 per unit
$76,500/5,100 = $15 per hour
$42,500/170
= $250 per hour
Product cost:
Warranty:
$80  1,700 ...................
$80  850 ......................
Scrap:
$36  3,400 ...................
$36  850 ......................
Inspection:
$15  3,400 ...................
$15  1,700 ...................
Training:
$250  85 ......................
$250  85 ......................
Total assigned ..................
Divided by units ................
Unit cost .......................
Carburetor A
Carburetor B
$ 136,000
$ 68,000
122,400
30,600
51,000
25,500
21,250
$ 330,650
 170,000
$
1.95*
21,250
$ 145,350
 340,000
$
0.43*
*Rounded.
Carburetor A has more than four times the amount of quality costs assigned
than Carburetor B. Thus, A appears to be the lower-quality product.
2.
The unit quality cost can be used to rank products in order of the lowest quality to that of the highest. This information can then be used to determine
where quality improvement efforts should be focused. It may reveal, for example, that products follow the Pareto Principle: 20% of the products are
causing 80% of the quality problems. (The Pareto Principle claims that 20% of
the people do 80% of the work in any organization.)
317
14–3
1.
Brown Company
Quality Cost Report
For the Year Ended December 31, 2010
Quality Costs
Percentage of
Sales
Prevention costs:
Design review .................
Quality training ...............
$ 405,000
135,000
$ 540,000
Appraisal costs:
Materials inspection.......
Process acceptance.......
Product inspection.........
$ 54,000
67,500
40,500
162,000
2.00
Internal failure costs:
Reinspection...................
Scrap ...............................
$ 67,500
47,250
114,750
1.42
External failure costs:
Recalls ............................
Lost sales .......................
Returned goods ..............
Total quality costs ...............
$ 135,000
270,000
128,250
318
533,250
$1,350,000
6.67%
6.58
16.67%
14–3
Concluded
2.
Relative Distribution of Quality Costs
Percentage of Total
Quality Costs
100
80
60
40
20
0
Quality Costs
Prevention
Appraisal
Internal Failure
External Failure
Relative Distribution of Quality Costs
External Failure
40%
40%
8%
Prevention
12%
Internal Failure
Appraisal
Failure costs are almost 50% of the total costs. This indicates that there is
still ample opportunity for improving quality by investing more in prevention
and appraisal activities.
319
14–4
1.
Quality costs:
Year 1: $2,100,000 (0.21
Year 2: $1,980,000 (0.18
Year 3: $1,540,000 (0.14
Year 4: $1,200,000 (0.10
 $10,000,000)
 $11,000,000)
 $11,000,000)
 $12,000,000)
Net income increase:
Year 1: (0.21 – 0.18)$11,000,000 = $330,000
Year 2: (0.18 – 0.14)$11,000,000 = $440,000
Year 3: (0.14 – 0.10)$12,000,000 = $480,000
2.
Profit potential: (0.10 – 0.025)$12,000,000 = $900,000
The 2.5% goal is the level many quality experts identify as the one that companies should strive to obtain. Pavon Company’s experience shows that it is
an achievable goal. Also, although most Japanese companies do not track
quality costs, some have measured their costs of quality, and they generally
tend to be less than 5% (compared with the U.S. experience that has produced values between 20 and 30%).
3.
Sales ..................................
Variable expenses ............
Contribution margin ....
a$125
Year 3—No Change
$11,000,000
7,236,842a
$ 3,763,158
Year 3—Change
$ 11,000,000
6,345,263b
$ 4,654,737
 $11,000,000/$190.
bQuality
costs per unit:
Year 1: 0.21  $200 = $42.00
Year 3: 0.14  $190 = $26.60
Decrease in per-unit variable quality cost = $42.00 – $26.60 = $15.40
Decrease in per-unit total variable cost = $125.00 – $15.40 = $109.60
Variable costs (total, Year 3) = $109.60  $11,000,000/$190 = $6,345,263
Increase in profitability:
$4,654,737 – $3,763,158 = $891,579
320
14–5
1.
2006: $7,500,000/$30,000,000 = 0.25
2010: $937,500/$37,500,000 = 0.025
The quality cost-to-sales ratio improved from 25% to 2.5%.
2.
Internal failure:
External failure:
Appraisal:
Prevention:
$2,250,000/$7,500,000 = 30%
$3,000,000/$7,500,000 = 40%
$1,350,000/$7,500,000 = 18%
$900,000/$7,500,000 = 12%
The pie chart for 2006 is as follows:
Quality Costs
Prevention
12%
30%
Internal Failure
Appraisal
18%
40%
External Failure
The percentage of quality costs spent on internal and external failures is too
high. If costs are reduced to 2.5%, then the company is approaching the goal
of zero defects. As zero defects is approached, failure costs will approach zero, leaving the bulk of quality costs in the prevention and appraisal categories. Of these two categories, the prevention category would dominate.
321
14–5
3.
Continued
Internal failure:
External failure:
Appraisal:
Prevention:
$112,500/$937,500 = 12%
$75,000/$937,500 = 8%
$281,250/$937,500 = 30%
$468,750/$937,500 = 50%
The pie chart for 2010 is as follows:
Quality Costs
Internal Failure
12%
External Failure
8%
Prevention
50%
30%
Appraisal
Quality costs are better distributed than in 2006. Control costs account for
80% of the total quality costs (versus only 30% in 2006). Failure costs have
shrunk from 70% of the total in 2006 to only 20% in 2010. Moreover, total quality costs have shrunk from 25% of sales to 2.5% of sales. Costs in every category have been reduced. From an activity-based management perspective,
further reductions are possible—at least in the failure categories. These are
non-value-added costs and, in theory, can and should be reduced to zero.
4.
Some external failure costs are not measured and reported in the accounting
records. If the multiplier effect were four (for example), then in 2010, the external failure costs would be $225,000 ([4  $75,000] – $75,000) higher than
reported. Given the reality of hidden costs, there is some validity to his point
of view and it may be wise to invest additional funds for control activities.
322
14–5
5.
Concluded
Gainsharing provides a strong incentive for managers to improve quality and
reduce quality costs. Gainsharing is a good idea, provided the incentive system is carefully designed. The bonus must be truly based on quality improvements. Quality gains, stemming from quality cost reductions, must flow
from true quality improvements. Thus, there should be operational quality
measures that provide evidence of actual quality improvements. One possibility is to base bonuses only on reductions in failure and appraisal categories.
This provides an incentive for managers to invest in preventive activities—
actions that should reduce “poor” quality costs.
14–6
1.
Only four of the activities should be implemented: quality training, process
control, supplier evaluation, and engineering redesign. Each of these four activities reduces failure costs more than it costs to implement the activity
(thus, increasing the bonus pool). The cost reduction for failures is less than
the amount spent for product inspection and prototype testing.
Total quality costs:
Current control .........................
Quality training .........................
Process control ........................
Supplier evaluation ..................
Engineering redesign ..............
Failure costs .............................
$ 160,000
160,000
200,000
120,000
40,000
184,000*
$ 864,000
*$40,000 + ($720,000 – $656,000) + ($200,000 – $120,000) (adds back cost reductions of two activities not implemented).
323
14–6
2.
Concluded
a. Total quality costs were reduced by $736,000 ($1,600,000 – $864,000).
Quality training increased costs by $160,000 but reduced failure costs by
$400,000, for a net gain of $240,000. Process control increased costs by
$200,000 but decreased failure costs by $320,000, for a net gain of
$120,000. Supplier evaluation increased costs by $120,000 but decreased
failure costs by $456,000, for a net gain of $336,000. Engineering redesign
increased costs by $40,000 but decreased failure costs by $80,000, for a
net gain of $40,000.
Total net gain:
$ 240,000
120,000
336,000
40,000
$ 736,000
b. Distribution percentage:
Control costs:* $680,000/$864,000 = 79% (rounded)
Failure costs: $184,000/$864,000 = 21% (rounded)
*Total control costs less costs of activities not implemented:
$1,000,000 – $80,000 – $240,000 = $680,000
Failure costs = $864,000 – $680,000
c. Bonus pool = 0.10  $736,000 = $73,600
3.
All of the same activities would be adopted plus prototype testing. Of the activities adopted, training, supplier evaluation, engineering redesign, and prototype testing are all prevention activities and so would not be counted in the
cost reduction calculation. Failure costs would now be $104,000 (prototype
addition reduces failure costs by an additional $80,000). The initial failure and
appraisal costs are $1,600,000 ($1,440,000 + $160,000). The ending failure and
appraisal costs are the sum of the current appraisal costs, ending failure
costs, and the cost of adding process control: $160,000 + $104,000 +
$200,000 = $464,000. Thus, the cost reductions counted for the bonus pool
would be $1,136,000 ($1,600,000 – $464,000), and the bonus would be
$113,600 (0.10  $1,136,000). This approach has some merit as it encourages
managers to invest in value-added activities and avoid the temptation of reducing prevention costs prematurely. It is possible, however, that some prevention activities are not really worth doing, and this approach may lead to an
overinvestment in this category.
324
14–7
1.
2.
Quality costs, 2009 ................
Less quality costs, 2010 .......
$ 110,000
81,000
$ 29,000
Tru-Delite Frozen Desserts, Inc.
Long-Range Performance Report
For the Year Ended December 31, 2010
Prevention costs:
Training program ................
Supplier evaluation .............
Total prevention .............
Appraisal costs:
Test labor .............................
Inspection labor ..................
Total appraisal ...............
Internal failure costs:
Scrap ....................................
Rework .................................
Total internal failure ......
External failure costs:
Consumer complaints ........
Lost sales, incorrect labeling
Total external failure ......
Total quality costs ....................
Actual Costs*
2010
Long-Range
Target Costs
Variance
$ 6,000
13,000
$ 19,000
$ 3,750
4,688
$ 8,438
$ 2,250 U
8,312 U
$ 10,562 U
$ 10,000
30,000
$ 40,000
$ 4,687
2,813
$ 7,500
$ 5,313 U
27,187 U
$ 32,500 U
$ 18,750
12,500
$ 31,250
$ 2,812
0
$ 2,812
$ 15,938 U
12,500 U
$ 28,438 U
$ 6,250
0
$ 6,250
$ 96,500
$
$ 6,250 U
0
$ 6,250 U
$ 77,750 U
Percent of sales ........................
12.9%
0
0
$
0
$18,750
2.5%
10.4%
*Adjusted for sales of $750,000 [Uses the actual variable cost ratios of 2010 to
compute the “actual” unit-level variable costs for this level of activity;
prevention costs are discretionary fixed and so are assumed to not change
as sales increase; all other costs are assumed to vary with sales volume and
so are adjusted to the $750,000 level; for example, test labor is ($8,000/
$600,000)  $750,000 = $10,000].
325
14–7
Concluded
3.
Prevention and some appraisal costs can be interpreted as value-added
costs. All failure costs are non-value-added. Thus, the distribution of costs
for 2015 cannot all be value-added (there are nonzero internal failure costs). If
they were, then the variances would be the non-value-added costs being incurred in 2010.
4.
There would be a $77,750 increase in profits in 2015 if total quality costs are
2.5% of sales and the targeted distribution is achieved (the $77,750 increase
is the savings reported in the long-range performance report in Requirement
2).
14–8
1. Prevention
2. Prevention
3. Internal failure
4. External failure (societal)
5. Detection
6. Prevention
7. Internal failure
8. External failure (societal)
9. Detection
10. External failure (societal)
11. Prevention
12. External failure (private)
13. Internal failure
14. Detection
15. Internal failure
16. Detection
326
14–9
1.
Hender Chemicals
Environmental Cost Report
For the Year Ended December 31, 2010
Environmental Costs
Prevention costs:
Evaluating suppliers ....................
Recycling products ......................
Detection costs:
Inspecting products/processes ..
Developing perf. measures ..........
Internal failure costs:
Treating toxic waste .....................
Operating equipment ...................
Licensing facilities .......................
External failure costs:
Settling claims ..............................
Cleanup of soil ..............................
Totals .................................................
Percentage*
$ 120,000
75,000
$ 195,000
$ 600,000
60,000
660,000
1.10
$ 4,800,000
840,000
360,000
6,000,000
10.00
$ 1,200,000
1,800,000
3,000,000
$ 9,855,000
0.33%
5.00
16.43%
*Of operating costs: $60,000,000.
2.
Relative Distribution: Environmental Costs
Prevention
2%
Detection
7%
External Failure
30%
Internal Failure
61%
This distribution reveals that the company is paying little attention to preventing
and detecting environmental costs. To improve environmental performance,
much more needs to be invested in the prevention and detection categories.
327
14–10
1.
Both items should be added to the external failure costs category in the report. The first item would add $525,000 and is a private cost. The second
adds $1,200,000 and is a societal cost. Under a full costing regime, the
$1,200,000 should also be included in the report. Often, however, only private
costs will be included.
2.
Hender caused the opportunity cost, and many would argue that it should be
disclosed. Whether it will voluntarily disclose this cost is questionable. Management would likely feel that such disclosure would draw unfavorable attention to the company and damage its image.
Perhaps if the disclosure is coupled with an announcement of the cleanup of
the river and lake, then it could be turned to the advantage of the company:
“We are undertaking a cleanup, and one of the major benefits to the community is the restoration of the fishing and recreational opportunities worth
$1,200,000 to the community.”
328
PROBLEMS
14–11
1.
Lost contribution margin = $8  100,000 = $800,000 or $200,000 per quarter
Sales revenue/Quarter = $92  25,000 = $2,300,000
Percent of sales needed to regain lost contribution margin:
$200,000/$2,300,000 = 8.7%
At 1% gain per quarter, 8.7 quarters, or a little over two years would be needed to regain former profitability.
2.
At the end of three years, quality costs will be 4% of sales, a reduction equal
to 12% of sales.
Savings = 0.12  $92  100,000 = $1,104,000
Increase in unit contribution margin = $1,104,000/100,000
= $11.04
Projected unit CM = $11.04 + ($92 – $90) = $13.04
Projected total CM at $92 price = $13.04  100,000
= $1,304,000
Price decreases:
$1.00: Total CM = $12.04  110,000 = $1,324,400
$2.00: Total CM = $11.04  120,000 = $1,324,800
$3.00: Total CM = $10.04  130,000 = $1,305,200
Recommended decrease is from $92 to $90.
Increase in contribution margin:
$ 1,324,800
(1,304,000)
$
20,800
329
14–11 Concluded
3.
To find the point where the price should first be reduced, we need to find the
point where total contribution margin remains unchanged. Let X = CM/Unit.
Current CM = 100,000X
New CM = 110,000(X – $1)
100,000X = 110,000(X – $1)
10,000X = $110,000
X = $11
When the unit CM is greater than $11, the price should be reduced by $1.00.
To find this point in time:
Current CM = $92 – $90 = $2
Gain needed = $11 – $2 = $9
Annual CM needed = $900,000 ($9  100,000)
Quarterly CM needed = $900,000/4 = $225,000
Quarterly percent of sales needed = $225,000/$2,300,000
= 9.8%
At 1% per quarter, it will take 9.8 quarters to gain $9 per unit. Thus, after 9.8
quarters, the price can decrease by $1.
4.
The difference is long-run versus short-run thinking. The marketing manager
had a strategic orientation. We can see the value of cost information, particularly quality cost information, in strategic decision making. In fact, the emphasis on total quality control and the identification of specific quality costs
drove the decision. Once the decision was made, the need to reduce the
costs as planned is critical, emphasizing the importance of a quality cost control program. Interim and longer-range reports would be quite useful in controlling quality costs.
330
14–12
1.
Quality Costs
Prevention costs:
Quality training .......................
Appraisal costs:
Product acceptance ...............
Internal failure costs:
Scrap .......................................
Rework ....................................
$
External failure costs:
Repair ......................................
Order cancellation..................
Customer complaints ............
Sales allowance .....................
0.2%
$ 240,000
1.6
$ 450,000
270,000
$ 720,000
4.8
$
90,000
150,000
121,500
45,000
$ 406,500
$1,396,500
Total quality costs .......................
2.
30,000
Percentage of Sales
2.7
9.3%
Profits: $1,500,000
Quality costs: $1,396,500
Quality costs/Sales = 9.3%
Quality costs/Profits = 93%
Wayne should be concerned as the quality cost ratio is 9.3%, and the quality
costs are almost as large as income. Although the ratio is lower than the 20
to 30% range that many companies apparently have, there is still ample opportunity for improvement.
3.
Prevention:
Appraisal:
Internal failure:
External failure:
$30,000/$1,396,500 = 2.1%
$240,000/$1,396,500 = 17.2%
$720,000/$1,396,500 = 51.6%
$406,500/$1,396,500 = 29.1%
331
14–12 Concluded
The pie chart is as follows:
Quality Costs
Internal Failure
51.6%
Appraisal 17.2%
2.1%
Prevention
29.1%
External Failure
Too much is spent on failure costs. These costs are non-value-added costs
and should eventually be eliminated. Prevention and appraisal activities
should be given much more emphasis. If anything, experiences of real-world
companies (e.g., Tennant and Westinghouse) indicate that the control costs
should be 80% and the failure costs 20%. The distribution of quality costs
needs to be reversed!
4.
The company should increase prevention and appraisal costs. The additional
amounts spent on these programs will be recouped with additional savings
from a resulting decrease in failure costs.
5.
Quality costs: $15,000,000  2.5% = $375,000
Profits would increase by $1,021,500 ($1,396,500 – $375,000).
332
14–13
1.
Prevention costs:
Quality planning (F).....................
New product review (F)...............
Quality training (F) ......................
Total prevention .....................
Appraisal costs:
Materials inspection (F) ..............
Product acceptance (V) ..............
Field inspection (V) .....................
Total appraisal .......................
Internal failure costs:
Scrap (V) ......................................
Retesting (V) ................................
Rework (V) ...................................
Downtime (V) ...............................
Total internal failure ..............
External failure costs:
Warranty (V) .................................
Allowances (V).............................
Complaint adjustment (F) ...........
Total external failure ..............
Total quality costs ............................
333
January
February
$ 2,000
500
1,000
$ 3,500
$
$ 2,500
13,000
12,000
$ 27,500
2,500
15,000
14,000
$ 31,500
$ 10,000
6,000
9,000
5,000
$ 30,000
$ 12,000
7,200
10,800
6,000
$ 36,000
$ 15,000
7,500
2,500
$ 25,000
$ 86,000
$ 18,000
9,000
2,500
$ 29,500
$100,500
$
2,000
500
1,000
3,500
14–13 Concluded
2.
Actual Costs
Prevention costs:
Quality planning (F)..........
New product review (F)....
Quality training (F) ...........
Total prevention ..........
Appraisal costs:
Materials inspection (F) ...
Product acceptance (V) ...
Field inspection (V) ..........
Total appraisal ............
Internal failure costs:
Scrap (V) ...........................
Retesting (V) .....................
Rework (V) ........................
Downtime (V) ....................
Total internal failure ...
External failure costs:
Warranty (V) ......................
Allowances (V)..................
Complaint adjustment (F)
Total external failure ...
Total quality costs .................
Bud. Costs*
Variance
$ 2,500
700
1,000
$ 4,200
$ 2,000
500
1,000
$ 3,500
$ 500 U
200 U
0
$ 700 U
$ 2,500
14,000
14,000
$ 30,500
$ 2,500
14,300
13,200
$ 30,000
$
$ 12,500
7,000
11,000
5,500
$ 36,000
$ 11,000
6,600
9,900
5,500
$ 33,000
$1,500
400
1,100
0
$3,000
U
U
U
$ 17,500
8,500
2,500
$ 28,500
$ 99,200
$ 16,500
8,250
2,500
$ 27,250
$ 93,750
$1,000
250
0
$1,250
$5,450
U
U
0
300 F
800 U
$ 500 U
U
U
U
*Budgeted costs need to be adjusted to reflect actual sales of $550,000. Fixed
costs don’t change with sales. However, variable costs do, and so the budgeted variable cost ratio can be used to make the adjustment. For example,
the adjusted budget for scrap is ($10,000/$500,000)  $550,000 = $11,000.
For January, quality costs were 18% of sales ($99,200/$550,000). This is higher than the budgeted amount of 17%, but lower than previous periods.
334
14–14
1.
2009
Appraisal costs:
Prevention costs:
Internal failure costs:
External failure costs:
$360,000/$2,048,000 = 17.6%
$8,000/$2,048,000 = 0.4%
$1,000,000/$2,048,000 = 48.8%
$680,000/$2,048,000 = 33.2%
The pie chart for 2009 is as follows:
Quality Costs
Appraisal
17.6%
External
Failure
0.4%Prevention
33.2%
48.8%
Internal Failure
335
14–14 Continued
2010
Appraisal costs:
$328,000/$2,048,000 = 16.0%
Prevention costs:
$160,000/$2,048,000 = 7.8%
Internal failure costs: $820,000/$2,048,000 = 40.0%
External failure costs: $740,000/$2,048,000 = 36.1%
(Total adds to 99.9% due to rounding error.)
The pie chart for 2010 is as follows:
Quality Costs
Appraisal
16.0%
External Failure
36.1%
7.8%
Prevention
40.0%
Internal Failure
Yes. More effort is clearly needed for prevention and appraisal activities. The
movement is in that direction, and total failure costs have declined.
336
14–14 Concluded
2.
Major Company
Performance Report: Quality Costs
One-Year Trend
For the Year Ended December 31, 2010
Actual Costs
2010
Prevention costs:
Quality circles .................
Design reviews ...............
Improvement projects ....
Total prevention ........
Appraisal costs:
Packaging inspection ....
Product acceptance .......
Total appraisal ..........
Internal failure costs:
Scrap ...............................
Rework ............................
Yield losses ....................
Retesting .........................
Total internal failure .
External failure costs:
Returned materials .........
Allowances .....................
Warranty..........................
Total external failure .
Total quality costs ...............
$
Actual Costs*
2009
40,000
20,000
100,000
$ 160,000
$
$ 300,000
28,000
$ 328,000
$ 400,000
50,000
$ 450,000
$ 100,000 F
22,000 F
$ 122,000 F
$ 240,000
320,000
100,000
160,000
$ 820,000
$ 350,000
450,000
200,000
250,000
$ 1,250,000
$ 110,000
130,000
100,000
90,000
$ 430,000
F
F
F
F
F
$ 160,000
140,000
440,000
$ 740,000
$ 2,048,000
$ 200,000
150,000
500,000
$ 850,000
$ 2,558,000
$ 40,000
10,000
60,000
$ 110,000
$ 510,000
F
F
F
F
F
$
4,000
2,000
2,000
8,000
Variance
$ 36,000
18,000
98,000
$ 152,000
U
U
U
U
*To compare 2010 costs with 2009 costs, the costs for 2009 must be adjusted
to a sales level of $10,000,000. Thus, all variable costs will change from the
2009 levels. For example, the adjusted product inspection cost is
($320,000/$8,000,000)  $10,000,000 = $400,000.
Profits increased by $510,000.
3.
$2,048,000 – ($10,000,000  2.5%) = $1,798,000
337
14–15
1.
Prevention
1.00%
4.17
5.00
6.67
10.00
2006 .......
2007 .......
2008 .......
2009 .......
2010 .......
Appraisal
2.00%
2.50
4.29
2.50
1.00
Internal
16.00%
10.00
5.00
4.17
2.40
External
12.00%
8.33
3.57
3.33
1.60
2.
Trend in Quality Costs
35
Percentage of Sales
30
25
20
15
10
5
0
2006
2007
2008
Year
338
2009
2010
Total
31.00%
25.00
17.86
16.67
15.00
14–15 Concluded
Trend by Category
Percentage of Sales
20
15
10
5
0
2006
2007
2008
2009
2010
Year
Prevention
Appraisal
Internal Failure
External Failure
Yes, quality costs overall have dropped from 31% of sales to 15% of sales, a
significant improvement. Real evidence for quality improvement stems from
the fact that internal failure costs have gone from 16% to 2.4%, external failure costs from 12% to 1.6%, and appraisal costs from 2% to 1%. This reduction of failure costs has been achieved by putting more resources into prevention (from 1% to 10%).
3.
Quality costs at the 2006 rates:
2009 ........
2010 ........
Prevention
$6,000
5,000
Appraisal
$12,000
10,000
Internal
$96,000
80,000
Profit increase (2009): $186,000 – $100,000 = $86,000
Profit increase (2010): $155,000 – $75,000 = $80,000
339
External
$72,000
60,000
Total
$186,000
155,000
14–16
1.
Iona Company
Interim Performance Report: Quality Costs
For the Year Ended December 31, 2010
Prevention costs:
Fixed:
Quality planning .....
Quality training.......
Special project .......
Quality reporting ....
Total prevention ................
Appraisal costs:
Variable:
Proofreading ..........
Other inspection ....
Total appraisal ..................
Failure costs:
Variable:
Correction of typos
Rework ....................
Plate revisions .......
Press downtime .....
Waste ......................
Total failure .......................
Total quality costs ............
Actual Costs
Budgeted Costs
Variance
$ 150,000
20,000
100,000
12,000
$ 282,000
$ 150,000
20,000
80,000
10,000
$ 260,000
0
0
20,000 U
2,000 U
$22,000 U
$ 520,000
60,000
$ 580,000
$ 500,000
50,000
$ 550,000
$20,000 U
10,000 U
$30,000 U
$ 165,000
76,000
58,000
102,000
136,000
$ 537,000
$ 1,399,000
$ 150,000
75,000
55,000
100,000
130,000
$ 510,000
$ 1,320,000
$15,000
1,000
3,000
2,000
6,000
$27,000
$79,000
$
U
U
U
U
U
U
U
The firm failed across the board to meet its budgeted goals for the year. All
categories and each item were equal to or greater than the budgeted
amounts.
340
14–16 Continued
2.
Iona Company
Performance Report: Quality Costs
One-Year Trend
For the Year Ended December 31, 2010
Prevention costs:
Fixed:
Quality planning .....
Quality training.......
Special project .......
Quality reporting ....
Total prevention ................
Appraisal costs:
Variable:
Proofreading ..........
Other inspection ....
Total appraisal ..................
Failure costs:
Variable:
Correction of typos
Rework ....................
Plate revisions .......
Press downtime .....
Waste ......................
Total failure .......................
Total quality costs ............
Actual Costs
2010
Actual Costs
2009
$ 150,000
20,000
100,000
12,000
$ 282,000
$ 140,000
20,000
120,000
12,000
$ 292,000
$ 10,000 U
0
20,000 F
0
$ 10,000 F
$ 520,000
60,000
$ 580,000
$ 580,000
80,000
$ 660,000
$ 60,000 F
20,000 F
$ 80,000 F
$ 165,000
76,000
58,000
102,000
136,000
$ 537,000
$1,399,000
$ 200,000
131,000
83,000
123,000
191,000
$ 728,000
$1,680,000
$ 35,000
55,000
25,000
21,000
55,000
$ 191,000
$ 281,000
Variance
F
F
F
F
F
F
F
Profits increased $281,000 because of the reduction in quality costs from
2009 to 2010. Thus, even though the budgeted reductions for the year were
not met, there was still significant improvement. Moreover, most of the improvement came from reduction of failure costs, a positive signal indicating
that quality is indeed increasing.
341
14–16 Continued
3.
Trend in Total Quality Costs
0.25
Percentage of Sales
0.20
0.20
0.18
0.165
0.15
0.14
0.10
0.11
0.05
0.00
2006
2007
2008
2009
Year
Note: Percentages are calculated as follows:
2006: $2,000,000/$10,000,000; 2007: $1,800,000/$10,000,000;
2008: $1,815,000/$11,000,000; 2009: $1,680,000/$12,000,000;
2010: $1,320,000/$12,000,000.
342
2010
14–16 Continued
4.
Multiperiod Trend by Category
10
Percentage of Sales
8
6
4
2
0
2006
2007
2008
2009
2010
Year
Prevention
Appraisal
Internal Failure
External Failure
Increases in prevention and appraisal costs with simultaneous reductions in
failure costs are good signals that overall quality is increasing. (Decreases in
external failure costs are particularly hard to achieve without quality actually
increasing.)
343
14–16 Concluded
5.
Iona Company
Long-Range Performance Report
For the Year Ended December 31, 2010
Actual Costs
2010a
Prevention costs:
Fixed:
Quality planning ........
Quality training..........
Special project ..........
Quality reporting .......
Total prevention ...................
Appraisal costs:
Variable:
Proofreading .............
Other inspection .......
Total appraisal .....................
Failure costs:
Variable:
Correction of typos ...
Rework .......................
Plate revisions ..........
Press downtime ........
Waste .........................
Total failure ..........................
Total quality costs ...............
Long-Range
Target Costsb
Variance
$ 150,000
20,000
100,000
12,000
$ 282,000
$
0
112,500
0
26,250
$ 138,750
$ 150,000
92,500
100,000
14,250
$ 143,250
$ 650,000
75,000
$ 725,000
$ 187,500
48,750
$ 236,250
$ 462,500 U
26,250 U
$ 488,750 U
$ 206,250
95,000
72,500
127,500
170,000
$ 671,250
$ 1,678,250
$
$ 206,250
95,000
72,500
127,500
170,000
$ 671,250
$ 1,303,250
aExcept
0
0
0
0
0
$
0
$ 375,000
U
F
U
F
U
U
U
U
U
U
U
U
for prevention costs, which are fixed, actual costs of 2010 are adjusted to a sales level of $15 million by multiplying the actual costs at $12 million by 15/12. This report is prepared at the end of 2010.
b2.5%
of $15,000,000 = $375,000.
Quality training: 30%  $375,000 = $112,500
Quality reporting: 7%  $375,000 = $26,250
Proofreading:
50%  $375,000 = $187,500
Other inspection: 13%  $375,000 = $48,750
344
14–17
1.
Prevention .................
Appraisal ...................
Internal failure ...........
External failure..........
Total .....................
Diapers
0.9%
0.8
1.8
1.5
5.0%
Napkins
1.00%
1.17
1.08
0.75
4.00%
Paper
Towels
1.63%
1.63
1.63
1.63
6.52%
Total
1.08%
1.08
1.55
1.30
5.01%
The company has achieved its goal as no more than 5% of sales was spent
on quality (in total). Looking at individual products, the best outcome (napkins) seems to be where appraisal and prevention costs exceed failure costs.
If this distribution is better, the total suggests that more should be spent on
prevention and appraisal. Opportunities to do so are present in the diaper and
paper towel lines.
2.
Prevention .................
Appraisal ...................
Internal failure ...........
External failure..........
Total .....................
Diapers
1.8%
1.6
3.6
3.0
10.0%
Napkins
2.00%
2.33
2.17
1.50
8.00%
Paper
Towels
3.25%
3.25
3.25
3.25
13.00%
Total
2.15%
2.15
3.10
2.60
10.00%
For this scenario, the goal of 5% is far from being reached. If the idea of balancing costs by category is true, then further reductions can be achieved by
shifting more resources into prevention and appraisal activities. Of the three
lines, the diaper line is particularly one where more resources should be
spent on prevention and appraisal activities. Shifting more resources into
these two categories has the potential to reduce the percentage for each line
to 5% or below.
Shifting more resources into prevention for paper towels and napkins would
not create balanced categories. It appears difficult to achieve the overall 5%
goal by balancing category costs. The preceding results suggest that the
even distribution suggestion of the divisional manager may not be the optimal combination. Perhaps even more emphasis should be placed on control
costs.
345
14–17 Concluded
3.
Prevention .................
Appraisal ...................
Internal failure ...........
External failure..........
Total .....................
Diapers
1.80%
1.60
3.60
3.00
10.00%
Napkins
3.33%
3.89
3.61
2.50
13.33%
Paper
Towels
2.03%
2.03
2.03
2.03
8.12%
Total
2.15%
2.15
3.10
2.60
10.00%
Again, more should be spent on prevention and appraisal activities. However,
the lines on which to concentrate these resources are now the diaper and
paper towel lines.
4.
If quality costs are reported by segment, a manager will know where to concentrate efforts for cost reduction.
COLLABORATIVE LEARNING EXERCISE
14–18
1.
Len should know that the bonuses are intended for those who legitimately
achieve the budgeted quality goals. The three actions taken by Len were manipulative in nature—their objective was simply to massage the performance
statistic so that he could receive his bonus. Since Len’s bonus is achieved
simultaneously with that of his employees, there is some question whether he
really had their interest in mind or simply his own. The behavior exhibited by
Len is not ethical. The heart of ethical behavior is sacrificing one’s selfinterest for the well-being of others. By engaging in manipulative behavior,
Len is damaging the reputation of the company and providing poor services
and products to customers. Len should have stressed the importance of
achieving the quality goals by continuing to strive for the current year’s goal
by improving quality. If the goal is not achieved this year, then the lack of financial reward should be an additional incentive for better performance for
the coming year.
2.
First and foremost, the company should attempt to hire individuals with integrity. Second, the company should make sure that the performance and reward system is fair and acceptable to managers and employees. Perhaps the
company could provide a percentage of the savings from quality improvements rather than making it an all or nothing bonus, based on achieving
some predetermined target. Finally, the company should have in place a good
monitoring system to discourage the type of behavior Len is exhibiting, e.g., a
good internal audit program.
346
14–18 Concluded
3.
Len has violated the ethical code; he has a responsibility to “refrain from engaging in any conduct that would prejudice carrying out duties ethically” (III2) and to “abstain from engaging in or supporting any activity that might discredit the profession” (III-3).
CYBER RESEARCH CASE
14–19 Answers will vary.
347