COSTS OF QUALITY - Chapter Highlights Unit 3 - Chapter 2, Appendix 2A, pp 54-6 Quality Costs (Reinforcing Exercises: E2-5 and

E2-9.) The term quality has many meanings. Quality can mean that a product has many features not found in other products; it can mean that it is well-designed; or it can mean that it is defect-free. In this appendix, the focus is on the presence or absence of defects. The quality of conformance is defined to be the degree to which the actual product or service meets its design specifications. Anything that does not meet design specifications is a defect and is indicative of low quality of conformance. 1. Costs of Internal and External Failure. The costs of not meeting design specifications are classified as internal failure costs and external failure costs. Defects that are detected internally result in costs such as scrap or rework. Defective units that are released to customers create external failure costs. Examples of external failure costs include customer returns and exchanges, repairs under warranties, product recalls, and lost sales due to a reputation for selling defective products. 2. Costs of Reducing Defects. There are basically only two ways to reduce defects and the resulting costs of internal and external failures. Either the defects can be prevented or they can be detected and corrected. a. Defects can be prevented by designing products that are robust; that is, that are not sensitive to variations and errors in the production process. Defects can also be prevented by improving production processes. Statistical process control has been especially useful in driving variation out of production processes and thereby reducing defect rates. Most experts believe that until the late 1980s too little attention was paid in North America to prevention. Instead, reliance was placed on detecting defects once they had occurred. b. Defective units can be detected before they are delivered to customers by inspecting and testing units throughout the production process. This approach to reducing defects is expensive since it involves inspection labour and testing equipment. Moreover, when there is no idle capacity every defective unit that must be reworked or that is scrapped uses precious capacity. The resulting opportunity costs can be quite large.

I. The Trade-Off Between Prevention and Appraisal Costs and Internal and External Failure Costs. Generally speaking, companies should focus more effort on prevention and appraisal. And prevention is usually better than appraisal. Most authorities agree that the costs of internal and external failures have been largely hidden and as a consequence managers are unaware of the magnitude of the problem. Very simple steps can often be taken to prevent defects. These simple steps pay enormous dividends in terms of reducing the need for appraisal and in reducing the incidence of internal and external failures. C. Quality Cost Report Quality consultants claim that top managers often do not pay enough attention to quality since the costs of low quality (i.e., high defect rates) are hidden by the typical cost accounting system. While accounting systems often report statistics concerning scrap and there may be a quality assurance department with its own budget, many of the other costs associated with defects are buried in general overhead or in other accounts. A quality cost report makes these costs visible and organizes the data so as to help managers make trade-offs. Since the reports are really just attentiondirecting devices, the numbers in the reports do not have to be precise. 1. Data for the Quality Cost Report. The costs of nonconformance (i.e., defects) often cut across departmental lines and are therefore somewhat difficult to collect. Moreover, some of the costs of nonconformance are entirely external to the firm and are not captured by the accounting system at all. The most prominent example of this is the cost of lost sales. Nevertheless, as we indicated above, precision is not terribly important so these measurement and identification problems should not be overemphasized. All of the examples and problems in the text assume that the data collection work has already been done. Format and use of the Quality Cost Report. It is very helpful to sort the various quality costs into the four categories of prevention, appraisal, internal failure, and external failure costs. By comparing the amounts in the various categories, managers can get some feel for what should be done. For example, if the prevention and appraisal costs are very small relative to the internal and external failure costs, it is likely that not enough is being spent to prevent and detect defects. If prevention costs are low relative to appraisal costs, it is likely that not enough is being spent on prevention relative to inspection. Moreover, by comparing results across years, managers can track the effects of their decisions and gauge the success of quality improvement programs.

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The future of the Quality Cost Report. A companys first quality cost report probably has the greatest effect. Managers are often surprised by the magnitude of the costs associated with defects. This is often enough by itself to propel the company into ambitious quality improvement programs. However, unless the firms chart of accounts is modified, compiling periodic quality cost reports is a time-consuming task. Moreover, some of the most important datathe data external to the firmwill almost always be missing. And, while the quality cost report can help steer managers in the appropriate direction (e.g., increase prevention costs), it cannot tell managers how to go about preventing defects. For these reasons, many companies stop producing quality cost reports once their quality improvement program is well established.