Exploratory Evidence on the Behavior of Quality Costs

Author(s): Christopher D. Ittner

Source: Operations Research, Vol. 44, No. 1, Special Issue on New Directions in Operations
Management (Jan. - Feb., 1996), pp. 114-130
Published by: INFORMS
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 EXPLORATORYEVIDENCEON THE BEHAVIOROF QUALITYCOSTS
CHRISTOPHERD. ITTNER
University of Pennsylvania, Philadelphia, Pennsylvania
(Received October 1992; revisions received July 1993, July 1994; accepted September 1994)

This study examines the time series behavior of quality costs reported by 49 manufacturing units of 21 companies. Analyses using
both pooled annual data and plant-specific quarterly data indicate that the majority of units in the sample achieved ongoing
reductions in nonconformance costs while maintaining or reducing reported prevention and appraisal costs. These findings are
consistent with recent quality-based learning and continuous improvement models which suggest that, once an effective quality
program is established, companies can reduce nonconformance costs over time with little or no subsequent increase in conform-
ance expenditures.

Since the introduction of the traditional quality cost
model in the 1950s (Juran 1951, Feigenbaum 1957,
Masser 1957), managers have been urged to base quality-
related decisions on the hypothesized tradeoff between
the costs of prevention and appraisal (or conformance
costs) and the costs of internal and external failure (or
nonconformance costs). According to the traditional
model shown in Figure 1, a company producing subopti-
mally poor quality (i.e., defective) products can greatly
reduce nonconformance costs by adding relatively inex-
pensive prevention and appraisal measures. As preven-
tion and appraisalexpenditurescontinue to rise, the rate of
improvementis assumed to diminish until additionalcon-
formance expenditures produce little decrease in non-
conformance costs. The model resolves the hypothesized
tradeoff by specifying a nonzero optimal level of defects
at the point where the marginalcost of increased preven-
tion and appraisal activities equals the marginal benefit
from nonconformance cost reductions.
Many proponents of traditional quality cost theory
have interpreted the tradeoffs portrayed in this model to
mean that nonconformance costs can only be reduced by
increasing expenditures on conformance activities. Con-
tinuous improvement advocates, however, have criti-
cized this interpretation, claiming that ongoing quality
improvements can be achieved with little or no incre-
mental investment (e.g., Schneidermann 1986, 1988,
Harrington 1987, Cole 1992). These claims have been
supported by recent theoretical work on quality-based
learning(Fine 1986, Marcellus and Dada 1991)which sug-
gests that the traditionaltradeoffmodel may be an accurate
static representationof quality cost economics, but that in
dynamic, multiperiodsettings, nonconformancecosts can
continue to decline over time with no corresponding in-
crease in conformancecosts.
This paper examines the hypothesis that conformance
expenditures must continue to be increased to achieve
ongoing reductions in nonconformance costs. Reported
annual quality cost data from 49 manufacturingunits of
21 companies indicate that increases in conformance ex-
penditures generally led to failure cost reductions in the
current or following year. However, in the years follow-
ing the start of the quality program, many plants contin-
ued reducing nonconformance costs while maintainingor
even reducing existing expenditures on conformance ac-
tivities, supporting claims that prevention and appraisal
expenditures can be cut back as the quality program
progresses (Fine 1986, Harrington1987). Over the life of
the quality program, 29 of the 39 plants that reduced
reported nonconformance costs also reduced expendi-
tures on conformance activities. These findings are rein-
forced by time series analyses of quarterly quality cost
data reportedby 24 manufacturingunits belongingto seven
of the participatingcompanies, which indicate that reduc-
tions in nonconformanceexpenditureswere, on average,
associated with simultaneous reductions in conformance
costs. Overall, the empirical evidence is consistent with
continuous improvementand quality-basedlearningmod-
els which indicatethat, once an effective qualityprogramis
established, ongoing nonconformance cost reductions
can be achieved with little or no subsequent increase in
conformance expenditures.
The remainder of the paper is organized as follows.
Section 1 provides an overview of the quality cost con-
cept and reviews the various models of quality cost be-
havior. Section 2 discusses the sample, followed by
descriptive statistics in Section 3. Empirical results are
presented in Section 4. A summary and implications for
future research conclude the paper.
1. MODELS OF QUALITY COST BEHAVIOR
1.1. Defining Quality Costs
Quality costs have traditionally been defined as all ex-
penditures associated with ensuring that products con-
form to specifications or with producing products that do

Subject classifications: Cost analysis: quality-cost tradeoffs. Reliability, quality control: quality control economics.
Area of review: MANUFACTURING, OPERATIONS AND SCHEDULING (SPECIAL ISSUE ON NEW DIRECTIONS IN OPERATIONS MANAGEMENT).

Operations Research 0030-364X/96/4401-0114 $01.25

Vol. 44, No. 1, January-February 1996 114 ? 1996 INFORMS

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 IVITNER / 115
qualitycost model
(a) Thetraditional Intemal Failure: The costs incurred when products
which fail to meet quality specifications are identified
before reaching the customer, including the costs of
scrap, rework, spoilage, rescheduling, expediting, and
downtime.
External Failure: The costs incurred when non-
TOTAL COSTS
QUALITY conforming products reach the customer, including
0
warranty charges, liability claims, penalties, error in-
vestigation charges, and the opportunity costs of lost
customer goodwill.
CONFORMANCE
Recent views on quality cost measurement suggest
that this "conformance to specifications" definition of
NON-CONFORMANCE quality costs underestimates failure costs. The conven-
tional conformance to specifications definition assumes
101% 100%
DEFECTIVE GOOD that no loss occurs as long as output lies within upper
and lower specification limits. Taguchi, however, argues
that "losses to society" occur whenever output deviates
(b) The continuous improvement model
from its target value (Taguchi, Elsayed and Hsiang 1989,
Taguchi and Clausing 1990). Taguchi offers a quadratic
"quality loss function" to estimate these costs. The qual-
ity loss function is defined as:
L(y) = k(y - T)2, (1)

o TOTAL
QUALITY
PREVENTION
APPRAISAL
100%
DEFECTIVE
Figure 1. The competing models of
behavior.
not conform.1 These cost can be classified into the fol-
lowing categories:
Conformance Costs: The costs of achieving conform-
ance to specifications. Conformance costs are comprised
of two elements:
Prevention: The costs incurred to keep nonconforming
products from being produced. Examples include the
costs associated with implementing and maintaining a
quality system, quality-related training, new product
reviews, quality planning, and the development of pro-
cess controls.
Appraisal: The costs incurred to ensure that materials
and products meet conformance standards, including
the costs of receiving, in-process, and final inspection,
lab tests, quality audits, and field tests.
Nonconformance Costs: The costs of failure to con-
form to specifications. These include:
COSTS where y is the actual value for a product characteristic, T
is the target value for the characteristic, and k is a con-
stant representing the cost of the countermeasure (i.e.,
nonconformance cost) that must be employed by the
company. Although the specific functional form of
the quality loss function has not been validated empiri-
NON-CONFORMANCE cally (Taguchi and Clausing),2 the view that any devia-
tion from target results in losses suggests that the
100%
GOOD conventional definition of failures in terms of nonconfor-
mance to specifications understates the costs of poor
quality cost quality, leading to suboptimal quality improvement de-
cisions (Taguchi and Clausing 1990, DeVor, Chang and
Sutherland 1992).
It is important to note, however, that the Taguchi loss
function is not necessarily inconsistent with the four tra-
ditionalqualitycost categories or the notion of quality-cost
tradeoffs. Taguchi, for example, argues that management
must choose the precision level that minimizes total cost,
not just quality loss (Taguchiand Clausing).This implies a
tradeoffbetween investments in improving,checking, and
adjustingprocesses, i.e., prevention and appraisalcosts,
and the resulting reduction in quality losses, i.e., failure
costs (Taguchi and Clausing, 1990, DeVor, Chang, and
Sutherland,1992). See Albrightand Roth (1992)and Wong
(1992) for frameworkslinkingthe Taguchi loss function to
the four traditionalquality cost categories.
1.2. Competing Models of Quality Cost Behavior
The two competing models of quality cost behavior are
illustrated in Figure 1.3 As noted earlier, the traditional
quality cost model specifies a nonzero optimal defect
level at the point where the marginal cost of prevention
and appraisal expenditures equals the marginalreduction

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116 / ITTNER
in internal and external failure costs. The continuous im-
provement model, in turn, suggests that nonconformance
costs can be reduced with little or no incremental invest-
ment in prevention and appraisal. Although illustrations
of these models typically plot quality costs against qual-
ity or defect levels, Bowbrick (1992) notes that most of
the quality literature either implicitly or explicitly as-
sumes that the models reflect the optimal movement of
costs over time.
Many proponents of traditionalquality cost theory, for
example, have interpreted the tradeoffs portrayed in the
traditionalmodel to mean that nonconformance costs can
only be reduced by increasing expenditures on conform-
ance activities. Lockyer (1983), Noz, Redding and Ware
(1989), and others have extended this logic to develop
multiperiod theories of quality cost behavior that are
based on an organization's stage in the quality improve-
ment process. These frameworks indicate that managers
must continue to increase conformance expenditures
over time to achieve continuous quality improvements
and move to higher stages of the quality process. When
these increases stop, quality improvement ceases. This
interpretation of the traditional tradeoff model suggests
the following hypothesis.
Hi. Conformance expenditures must be increasing over
time to achieve ongoing reductions in nonconformance
costs.
Continuous improvement advocates, on the other
hand, question the claim that managers must continue to
increase conformance costs to achieve ongoing quality
improvements. Quality experts such as Deming (1982),
Schneiderman (1986, 1988), and Harrington (1987), for
example, argue that in firms committed to continuous
incremental improvement, a relatively fixed level of
conformance expenditures can lead to reductions in
nonconformance costs over time as quality improve-
ment teams continuously identify and eliminate quality
problems.4
The continuous improvement philosophy of quality
cost behavior has received theoretical support from work
on quality-based learning. These models suggest that the
traditional tradeoff model may be an accurate static rep-
resentation of quality cost economics, but that in dy-
namic learning environments, conformance expenditures
need not be increased to achieve ongoing reductions in
failure costs. Fine (1986), for example, develops a dy-
namic model in which the identification and correction of
quality problems allow a manufacturer to increase its
rate of learning and thereby lower its quality assurance
costs below their previous level. As the efficiency and
effectiveness of quality control activities increase due to
organizational learning, the conformance cost curve
shifts down and to the right, thereby allowing reductions
in nonconformancecosts over time to be accompaniedby
reductionsin conformance expenditures (see Figure 2).5
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Interestingly,this result runs counterto the beliefs of some
continuous improvement advocates who maintain that
companies that reduce preventionexpenditureswill be un-
able to hold theirprevious gains (e.g., Schneiderman1988).
In Marcellus and Dada's model, each investment in
prevention provides a learning opportunity that de-
creases the future costs of defectives.6 Consequently, at
least part of the investment in prevention is analogous to
a capital investment that provides benefits over multiple
periods. Given the capital investment-like nature of qual-
ity improvement activities, the cost of prevention be-
comes concave over time as opposed to strictly convex
in the traditionalquality cost model. Unlike the simulta-
neous conformance and nonconformance cost reductions
found in Fine's model, however, the resulting dynamic
model of quality cost behavior implies that a relatively
fixed level of prevention expenditures can produce de-
creasing marginal reductions in failure costs over
multiple periods, a result similar in spirit to the continu-
ous improvement model shown in Figure 1 (Marcellus
and Dada, p. 1371).
In summary, the continuous improvement and quality-
based learning models suggest the following null hypoth-
esis regardingquality cost behavior.
H1lnul.Ongoing reductions in nonconformance costs can
be achieved over time while maintaining(e.g., Marcellus
and Dada) or even reducing (e.g., Fine) existing con-
formance expenditures.
TOTAL
QUALITY
COSTSt+z
TOTAL
QUALITY
COSTSt
NON-CONFORMANCE
/ X ,' ~~~CONFORMANCE
t+z
100% 100%
DEFECTIVE qt q t+z GOOD
Figure 2. Fine's (1986) model of quality-based learning.
The subscript t indicates the quality cost
tradeoffs in period t. The subscript t + z indi-
cates the quality cost tradeoffs after z periods
of quality-based learning.

Although the traditional and continuous improvement
models of quality cost behavior provide conflicting impli-
cations for the allocation of resources to quality improve-
ment activities, only limited empirical evidence on the
behavior of quality costs exists. Cross-sectional studies
by Chauvel and Andre (1985) and Krishnamoorthi(1989)
generally support the traditional tradeoff model, find-
ing inverse relationships between conformance and
nonconformance costs. However, the nature of their
tests (cross-sectional in levels) makes it impossible to
conclude that managers must continue increasing
conformance expenditures to achieve ongoing quality
improvements. Plunkett and Dale's (1988) examination
of time series quality cost trends from five companies,
in contrast, suggests that lower failure costs were
achieved over time with little change in conformance
costs, though the authors provide no statistical tests to
support their conclusions.
The conflicting results from these studies leave the ap-
propriate quality cost model an open empirical question.
But empirical tests of the competing models face a num-
ber of hurdles. Using historicaldata, a researchercan only
observe expost the choices made by a firm. These choices
reflect management'sperceptionof the appropriatequality
cost model as well as the company's own efforts to assess
the quality-cost tradeoffs it faces. Since few, if any, firms
use experimentationto identify the shapes of their quality
cost curves, historical data may not reveal the true eco-
nomics underlying the operation's quality initiatives.
Moreover, since the traditionalmodel represents the hy-
pothesized shape of a production frontier, it can only be
tested if firms are using their quality-relatedresources effi-
ciently (i.e., are operatingon the frontier).
Even when the choices made by a firm are optimal for
a given period, subsequent organizational and environ-
mental changes (other than quality-based learning) may
cause the cost curves, and therefore the equilibrium
point, to shift over time. For example, falling factor
prices for conformance inputs may shift the conformance
curve down, allowing increased conformance activities
with no increase in cost. Time series data would show
reductions in nonconformance costs with no correspond-
ing increase in conformance expenditures, even though
the traditional model may accurately portray the trade-
offs confronting the organization in a given period. If
quality cost curves are shifting from period to period due
to factors other than quality-based learning, a time series
regression of nonconformance costs on conformance ex-
penditures suffers from the classic econometric problem
of underspecification. As a result, the correlation be-
tween conformance and nonconformance costs may be
any sign depending upon how the omitted variables
cause the two cost curves to shift.
Given the difficulties in empirically distinguishing be-
tween the competing quality cost models, this paper ex-
amines the less restrictive proposition that companies,
for whatever reason, have been able to reduce
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ITTNER / 117
nonconformance costs while maintainingor even reduc-
ing existing conformance expenditures. In line with re-
cent dynamic models on the subject, the study focuses
on changes in quality cost expenditures over time. This
specification offers two advantages over the earlier cross-
sectional studies by Chauvel and Andre, and Krishna-
moorthi. First, it allows an examination of the potential
lag between increased conformance expenditures and re-
duced failure costs, an issue that has not been addressed
in previous studies. More importantly, it provides pre-
liminary evidence on the hypothesis that conformance
costs must continue to be increased over time to achieve
ongoing failure cost reductions, the principal debate be-
tween proponents of the traditional tradeoff model and
advocates of continuous improvement.
2. SAMPLE
To examine the behavior of quality costs, a search of
accounting and quality publications was made to identify
companies that measure quality costs on an ongoing
basis. The corporate quality director or controller at each
of the 50 firms identified in the search was then contacted
to discuss the company's possible participation in the
study. Of the initial 50 firms, 10 were eliminated because
quality costs were not tracked on a regular basis and
three were eliminated because the systems were too new
to provide useful data. Twenty-one of the remaining 37
companies (58.6%) agreed to participate in the study.7
The 21 participatingcompanies provided annual qual-
ity cost data for 49 manufacturingunits in five two-digit
SIC codes:
SIC Code and Industry Description Participant
28 Chemicalsand Allied Products 7
35 IndustrialEquipmentand Computers 12
36 ElectronicEquipmentexcept Computers 16
37 TransportationEquipment 6
38 Measurementand PhotographicEquipment 8
Each of the 49 manufacturingplants reports conformance
and nonconformance costs on a regularbasis; in 33 of the
facilities, reported quality costs are furtherbroken down
into prevention, appraisal, internal failure, and external
failure subcategories.
Table I summarizes the quality cost elements tracked
by the 49 plants. Consistent with survey results in
Sullivan and Owens (1983), the table indicates that
reported quality costs are generally limited to
manufacturing-related expenditures for quality plan-
ning and administration, training, inspection and test,
scrap, rework, and warranty expenditures.8 These cat-
egories are not only the most frequently measured
quality cost elements, but also the largest proportion
of reported quality costs in most systems. In the 31
manufacturing units that provided detailed information
on the components of reported quality costs, the costs
of quality planning and administration, training, and
118 / ITTNER
Table I
Elements Included in Reported Quality Costs; 49
Manufacturing Units From 21 Companies
Percentageof ManufacturingUnits
TrackingEach Category % extending through 1989 or 1990. The total sample con-
Qualityplanningand analysisa 100
Inspection and testb 100
Scrap 100
Rework and repair 100
Warrantiesand returns 100
Quality-relatedtraining 94
Preventivemaintenance 55
Quality-relatedwait/downtime 33
Liabilityclaims/insurance 33
Excess/obsolete inventory 20
Quality-relatedovertime 12
aIncludes quality and engineeringdepartmentcosts for imple-
mentingand maintainingthe qualitysystem, quality-relateddesign
reviews, qualityplanning,etc.
bIncludes inspectionby productionworkers.
inspection accounted for over 92% of conformance expen-
ditures on average, with scrap, rework, and warranty
claims representing 87% of reported nonconformance
costs.9
The figures in Table I point out several limitations in
reported quality costs. The most notable is the omission
of the opportunity costs of lost sales due to poor quality.
Although the quality cost literature lists "lost customer
goodwill" as a major source of nonconformance costs,
none of the firms in the sample attempts to estimate the
impact of defective products on sales. The quality costs
reported by the participating firms also omit the addi-
tional costs incurred when higher quality inputs are sub-
stituted for lower quality materials, components, and
production equipment. Consequently, if input costs were
increased to achieve higher quality, the increase would
not be reflected in reported conformance costs. Finally, a
number of observers have asserted that reported quality
costs significantly underestimate the indirect losses from
defective products (e.g., Deming 1982, Mefford 1989,
Taguchi and Clausing 1990, Ittner 1994). Deming, for ex-
ample, argues that quality cost systems typically focus
on the direct effects of poor quality such as scrap, re-
work, and warranty claims and ignore significant indirect
effects, such as disruptions in operations due to out-of-
conformance purchases and products, excessive inven-
tory levels held to accommodate poor quality, and
quality-related schedule changes and downtime. While
these limitations are potentially troublesome, studies by
the consulting firm KPMG Peat Marwick indicate that
substantially all of the unreported quality costs in prac-
tice are related to the internal and external failure cost
categories (Atldnson et al. 1991, p. 66). These findings
suggest that the reported gains from quality improvement
will be biased downward. Reported prevention and ap-
praisal costs, however, should closely reflect the actual
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conformance expenditure patterns of the participating
companies.
The 49 manufacturingunits in the sample provided 2 to
13 annual observations each (median = 5), with the data
tains 250 plant-years of data for the conformance and
nonconformance categories and 206 for the prevention,
appraisal, internal failure, and external failure subcatego-
ries. To control for variations in quality cost levels that
were due solely to volume differences, observations are
standardized by dividing each quality cost category by
sales during the period.10Annual percentage changes for
each quality cost category are then calculated using the
general formula:
%A Quality Costsi,t
(Quality Costs/Sales)j,, - (Quality CostslSales)j,-1
(Quality CostslSales)j, 1
(2)
The resultingvariables are defined as follows: %APREV=
the percentagechange in preventioncosts, %AAPPR= the
percentagechange in appraisalcosts, %ACONF= the per-
centage change in total conformancecosts, %AINT= the
percentage change in internal failure costs, %AEXT =
the percentage change in external failure costs, and
%ANCONF = the percentage change in total noncon-
formance costs.1" Differencing eliminates one observa-
tion per unit, yielding 201 usable plant-yearsof data for the
conformance and nonconformancecategories and 157 for
the prevention, appraisal, internal failure, and external
failure subcategories.
3. DESCRIPTIVESTATISTICS
3.1. Reported Quality Cost Levels
Summary data on reported quality cost levels during the
first and most current years of the participatingplants'
quality programs are provided in Table II. Between these
periods, the units reduced mean (median) quality costs
from 11.2% (10.4%) of sales to 8.9% (8.6%). These re-
ductions were primarilyin nonconformance costs, which
fell from 6.4% (5.4%) of sales to 4.7% (4.1%). Preven-
tion, appraisal, and total conformance expenditures as a
percent of sales were not significantlydifferentduringthe
two periods.
Figures on the distributionof quality cost expenditures
among the various categories show that internal failure
costs comprised the largest component of reported qual-
ity costs during each period, followed by appraisal and
prevention costs. Reported external failure costs repre-
sented the smallest category, reflecting the difficulty in
measuring these costs. Mean (median) nonconformance
expenditures declined from 56.7% (58.7%) of quality
costs during the first year of the quality program to
51.5% (53.1%) in the latest year. While the ratio of ap-
praisal to total quality costs did not change significantly,
 ITTNER / 119

Table II
Reported Quality Costs for 49 Manufacturing Units Belonging to 21 Companies; n = 49 for Conformance and
Nonconformance and 33 for Prevention, Appraisal, Internal Failure, and External Failure.
First Year of QualityProgram Latest Year of QualityProgram
Mean Median Standard Mean Median Standard
n (%) (%) Deviation (%) (%) Deviation
PanelA: Reportedqualitycosts as a percentof sales
Prevention 33 2.1 1.8 1.5 2.0 2.3 1.1
Appraisal 33 3.1 2.4 2.5 2.5 1.8 2.3
Internalfailure 33 4.6 3.6 3.9 3.4 2.5a 3.1
Externalfailure 33 1.5 1.4 1.1 1.0 0.7a 1.1
Total conformance 49 4.8 4.4 3.0 4.2 3.8 2.6
Total nonconformance 49 6.4 5.4 4.0 4.7b 4.1c 3.2
Total qualitycosts 49 11.2 10.4 5.6 8.9b 8.6" 4.7
PanelB: Percentagedistributionof total reportedqualitycosts amongqualitycost categories
Prevention 33 18.4 17.9 10.6 23.9b 23.8" 10.9
Appraisal 33 27.3 25.1 12.8 28.7 25.9 14.4
Internal failure 33 38.9 38.0 14.6 34.8 33.1 14.5
External failure 33 16.2 9.7 14.3 13.3 8.0 13.2
Total conformance 49 43.3 41.3 15.4 48.4C 46.9a 15.9
Total nonconformance 49 56.7 58.7 15.4 51.6c 53.la 15.9
aSignificantlydifferentthan the correspondingfigurefor the firstyear of the qualityprogramat the 10%level, two-tailedt-test (means)or
Mann-Whitneytest (medians).
bSignificantlydifferentthan the correspondingfigurefor the firstyear of the qualityprogramat the 5% level, two-tailedt-test (means)or
Mann-Whitneytest (medians).
cSignificantlydifferentthan the correspondingfigurefor the firstyear of the qualityprogramat the 1%level, two-tailedt-test (means)or
Mann-Whitneytest (medians).

Table III
Summary Statistics on Annual Changes in Reported Quality Costs as a Percent
of Sales,a Pooled Observations From 49 Manufacturing
Units Belonging to 21 Companies
Standard
n Mean Median Deviation
PanelA: Changesin reportedqualitycosts/sales
APREV 157 -0.00 0.02 0.41
AAPPR 157 -0.06c -0.05d 0.36
AINT 157 -0.20d _0 11d 0.90
AEXT 157 -0.10 -0.04 1.23
ACONF 201 -0.08 -0.06b 0.37
ANCONF 201 0.33 0.26 1.54
PanelB: Percentagechangesin reportedqualitycosts/sales
%APREV 157 4.2%c 1.9% 25.8
%AAPPR 157 3.4% -5.0%c 66.8
%AINT 157 0.4% -6.3%d 86.0
%AEXT 157 11% -11.1%C 53.6
%ACONF 201 -1.4% -2.2%c 16.6
%ANCONF 201 -4.5%c -7.9%d 31.2
aAnnualchangesin qualitycost categoriesare calculatedusing the generalformulas:
AQualityCosti,t =(Quality Costs/Sales)i,t - (Quality Costs/Sales)i,tl

%AQuality (Quality Costs/Sales)i,t - (Quality Costs/Sales)i,t1

%AQuality CoStSi-=
Costsi,t
(Quality Costs)i,t-1
with PREV = preventioncosts, APPR = appraisalcosts, INT = internalfailurecosts, EXT =
externalfailurecosts, CONF = total conformancecosts, andNCONF = total nonconformancecosts.
bSignificantat the 10%level, two-tailedt-test (means)or Wilcoxonsigned ranktest (medians).
cSignificantat the 5%level, two-tailedt-test (means)or Wilcoxonsigned ranktest (medians).
dsignificantat the 1%level, two-tailedt-test (means)or Wilcoxonsignedranktest (medians).

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120 / IT-rNER

the mean (median) proportion of expenditures on preven-
tion rose from 18.4% (17.9%) to 23.9% (23.8%), leading
to an overall increase in the percentage of reported qual-
ity costs dedicated to conformance activities.
3.2. Annual Changes in Quality Costs
Table III presents data on standardized annual changes
in conformance and nonconformance costs for the entire
sample, as well as changes in the prevention, appraisal,
internal failure, and external failure categories for the
subsample of manufacturing plants that utilize these
breakdowns. As shown in the table, both mean (-0.33)
and median (-0.26) annual changes in nonconformance
costs are negative and significant at the 1% level. In per-
centage terms, these reductions represent 4.5% and 7.9%
of reported quality costs, respectively, both of which are
statistically significant at the 5% level or better. Mean
(-0.20) and median (-0.11) changes in internal failure
and median (-0.04) changes in external failure costs are
also significant, as are median percentage changes in
both of the failure categories.
The summary data in Table III indicate that the reduc-
tions in nonconformance costs were not accompanied by
significant increases in prevention and appraisal activi-
ties. In fact, median changes in appraisal and total con-
formance costs as a percent of sales are negative and
statistically significant. Although the mean percentage
change in prevention expenditures is positive, mean and
median changes in prevention levels and median percent-
age changes in prevention are not significantly different
from zero at conventional levels. Thus, for the sample as
a whole, the evidence suggests that the plants achieved
annual nonconformance cost reductions while maintain-
ing a relatively fixed level of prevention expenditures.
Moreover, as quality improved, the plants appear to
have reduced appraisal expenditures, leading to lower
overall conformance expenditures. This finding is incon-
sistent with traditionalquality cost model, which implies
that lower nonconformance costs can only be achieved
through increased conformance expenditures.
One possible explanation for the reduction in appraisal
costs is that companies pushed inspection responsibilities
onto their suppliers during the period under study. Data
on receiving inspection costs in 19 of the 49 plants are
available to examine this hypothesis. Over the years cov-
ered by the study, the 19 units achieved mean (median)
annual percentage reductions in the ratio of total ap-
praisal costs to sales of 3.2% (4.2%), significant at the
10% level. Of these improvements, reductions in receiv-
ing inspection costs accounted for only 7.9% on average
(median = 13.0%). Mean and median annual percentage
reductions in the ratio of receiving inspection costs to
sales were 2.5% and 4.4%, respectively, neither of which
is statistically significant at conventional levels. In con-
trast, the mean (median) percentage change in appraisal
costs other than receiving inspection is a statistically sig-
nificant -3.2% (-5.6%). This evidence indicates that in
the 19 plants for which data are available, reductions
in receiving inspection costs explain only a small fraction
of the observed decrease in appraisal expenditures.
To investigate whether the results in Table III are sen-
sitive to the maturity of the quality improvement pro-
cess, the sample is partitioned by the number of years
since the start of the quality program, with the first year
of the programdefined as year k. 12 Table IV summarizes
the results from this partition for the six subsequent
years with fifteen or more observations. Over these peri-
ods, nonconformance costs declined significantly in
years k + 1 through k + 4, with the improvement be-
coming progressively smaller each period (median
change in reported nonconformance costs from the pre-
vious year = -12.0% in year k + 1, -8.9 % in year k +

Table IV
Median Annual Percentage Changes in Reported Quality Costs/Sales Partitioned
by the Year of the Quality Program;a Pooled Observations From 49
Manufacturing Units Belonging to 21 Companies
Year
k+ 1 k+ 2 k+ 3 k+ 4 k +5 k+ 6
%APREV -5.0%c 0.9% 0.0% 5.9% 5.5% 2.4%
%AAPPR -11.5%c -6.7%c 2.8% 1.9% -1.3% -6.3%
%AINT -15.4%d _14.1%e -4.5% -1.6% -4.7% 0.0%
%AEXT - 15.0%e 0.0% _19.0%d -9.7% 8.4% -22.6%
%ACONF -9.4%e -2.2% -1.0% -1.0% 2.3% -5.0%
%ANCONF -12.0%e _8 9%e _8.7%d _7.0%c -0.4% -1.7%
nb 49 (33) 38 (26) 29 (25) 23 (20) 19 (18) 18 (17)
aTheyear in the tablesrefersto the numberof years since the startof the qualityprogram,with the
firstyear of the programdefinedas Year k.
bThelargersample size relates to the numberof observationsfor total conformanceand noncon-
formancecosts. The samplesize in parenthesesrefersto the numberof observationsfor the preven-
tion, appraisal,internalfailure,and externalfailurecategories.
cSignificantlydifferentfromzero at the 10%level, Wilcoxonsigned ranktest.
dSignificantlydifferentfrom zero at the 5%level, Wilcoxonsigned ranktest.
eSignificantlydifferentfromzero at the 1%level, Wilcoxonsigned ranktest.

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2, - 8.7% in year k + 3, and -7.0% in year k + 4). By
year k + 5, the median percentage change in nonconfor-
mance costs, though negative (-0.4%), is not statistically
significant. The percentage change in nonconformance
costs remains insignificant in year k + 6.
Although the rate of improvement tends to decline
over time, the data do not suggest that the diminish-
ing improvement rate was due to reductions in conform-
ance expenditures. Over the six periods, total con-
formance costs declined significantly in year k + 1, with
reductions in both prevention and appraisal expendi-
tures, but remained relatively stable over the remaining
five years. Similar trends are found when prevention ex-
penditures are examined separately. Taken together, the
evidence in Table IV is consistent with the null hypoth-
esis that nonconformance costs can be reduced over
time with little or no increase in prevention or total
conformance expenditures. More specifically, the data
suggest that a relatively fixed or declining level of pre-
vention expenditures can continue to produce signifi-
cant ongoing reductions in nonconformance costs once
an effective quality program is established, but that the
returns to prevention activities diminish as the most
serious quality problems are identified and eliminated.
Discussions at the participating companies indicated
that the reductions in conformance costs in year k + 1
were due to a number of factors. Many plants in the
sample made substantial investments in the development
of quality systems and procedures during the first year of
the quality program (year k). Because these investments
did not need to be repeated in following years, preven-
tion expenditures were reduced. Trainingcosts were also
frequently cut back in subsequent periods. Companies
typically focused their initial training efforts on develop-
ing a new quality-oriented "culture" by educating all
employees in the need for quality improvement and the
basic tools of quality control. Once the initial awareness
phase was completed, plants often began targeting
smaller numbers of employees for education in more ad-
vanced techniques, leading to lower annual training
expenses.
The significant appraisal cost reductions in the two
years following after the start of the quality program
were achieved in large part through changes in inspection
techniques that were undertaken as the plants' level of
process knowledge increased. Prior to the introduction
of the quality program, many companies had relatively
poor control over their processes and limited knowledge
of key process parameters. Instead, many units relied on
100% inspection to sort good product from bad. As the
quality philosophy changed from containment of defects
to prevention, efforts were undertaken to uncover and
eliminate the sources of variation, thereby bringing pro-
cesses under statistical control and allowing lower cost
statistical sampling to be employed.
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I1TNER / 121
4. EMPIRICALRESULTS
Three sets of empirical tests are used to explore the as-
sociation between conformance and nonconformance
costs, with the multiple methods providing evidence on
the robustness of the findings to empirical specification.
The first set of tests takes a relatively short-term per-
spective by looking at the relationship between changes
in annual conformance expenditures and corresponding
changes in nonconformance costs in the current and fol-
lowing year. The second set takes a longer view by ex-
amining changes in reported quality costs over the lives
of the 49 plants' quality programs, thereby minimizing
the impact of short-run variations in quality costs that
may be due to new product introductions, settlement of
liability claims, etc. Finally, the third set estimates sepa-
rate plant-specific regressions rather than the cross-
sectional models used in the other tests. The plant-
specific regressions alleviate differences in production
functions, product attributes, and quality cost systems
that may impact the associations among the quality cost
categories but are not controlled for in the cross-
sectional tests.
4.1. The Association Between Annual Changes in
Conformance and Nonconformance Costs
This section investigates the short-run association be-
tween changes in conformance and nonconformance
costs using pooled annual cross-sectional and time series
data from the 49 manufacturing units in the sample,
yielding 201 annual plant-year observations for the con-
formance and nonconformance categories, and 157 ob-
servations for the prevention and appraisalsubcategories
of conformance costs.
The relationship between changes in conformance and
nonconformance costs is examined by subdividing the
sample into quintiles formed on the basis of the magni-
tude of percentage changes in prevention, appraisal, and
total conformance costs. This method allows an investi-
gation of the impact of both the sign and magnitude of
conformance changes on nonconformance costs. Not
surprisingly, the results in Table V indicate that large
increases in conformance expenditures are associated
with statistically significant reductions in nonconfor-
mance costs. The evidence on more modest increases,
however, is somewhat mixed. Plants in quintile 2
increased prevention expenditures by 10.3% but
experienced no statistically significant decrease in
nonconformance costs during the current year. Quin-
tile 3's smaller 2.4% increase in prevention costs, on
the other hand, was accompanied by a 9.0% reduction
in nonconformance costs, significant at the 1% level.
Similar mixed results emerge for increases in appraisal
and total conformance expenditures.
Contrary to the predictions of the traditional quality
cost model, the evidence in Table V indicates that lower
122 / ITTNER

Table V
The Association Between Median Changes in Conformance and Nonconformance Costs; Pooled Annual
Observations From 49 Manufacturing Units Belonging to 21 Companiesa; Percentage Changes in
Nonconformance Costs/Sales Partitioned by the Magnitude of Percentage Changes in
Conformance Costs/Salesb
Sorted on %APREV Sorted on %AAPPR Sorted on %ACONF
Quintile %APREV %ANCONF %AAPPR %ANCONF %ACONF %ANCONF
1 27.5 -6.2c2 19.6 -12.0d2 19.2 -6.5e2
2 10.3 -1.8 3.3 1.1 4.5 -0.8
3 2.4 90 e2 _4.9 _9.od2 -2.2 -8.1d2
4 -6.4 _-11.1e2 -8.9 -9.8e2 -9.2 -10.6e2
5 -19.5 -14 gel,2 -22.9 -11.6e2 -18.6 -12.9e2,3
'N = 201 for %ACONF and 157 for %APREV and %AAPPR.
bThe table reports median percentage changes in nonconformance costs for quintiles formed on the basis of the magnitude of
percentage changes in conformance costs.
c= Significantly different from zero at the 10% level, Wilcoxon signed rank test.
d= Significantly different from zero at the 5% level, Wilcoxon signed rank test.
e= Significantly different from zero at the 1% level, Wilcoxon signed rank test.
1 = Significantly greater reduction than quintile 1 (10% level, Mann-Whitney test); 2 = Significantly greater reduction than quintile 2;
3 = Significantly greater reduction than quintile 3.

nonconformance costs were also associated with reduc-
tions in conformance expenditures. Quintiles 4 and 5 re-
duced prevention costs by 6.4% and 19.5%, respectively,
while, at the same time, lowering nonconformance costs
by 11.1% and 14.9%. Patterns are similar when changes
in appraisaland total conformance costs are used to form
the portfolios. The majority of observations in quintiles 4
and 5 represent plants that reduced conformance expen-
ditures after making large investments in quality training
and systems development during the early years of their
quality programs, supporting Harrington's claim that
many of the prevention and appraisal costs that are in-
curred at the beginning of a q-ualityprogramto systemat-
ically track down and prevent defects can be cut back as
the improvement process drives the defect rate lower.13
The tests in Table V examined the association be-
tween contemporaneous changes in conformance and
nonconformance costs. Yet a significant lag may exist
between increases in conformance activities and reduc-
tions in nonconformance costs. As Morse (1989, p.
131) notes, "Effort and accomplishment are probably
not matched in a single reporting period. It may take
months, or even years, for investments in prevention
to pay off." To investigate this possibility, Table VI
presents median annual changes in nonconformance
costs for quintiles formed on the basis of the magni-
tude of percentage changes in conformance costs dur-
ing the previous year.
The evidence shows that although plants with the larg-
est increases (quintile 1) and decreases (quintiles 4 and 5)

Table VI
The Association Between Median Changes in Conformance Costs and Lagged Median Changes in
Nonconformance Costs; Pooled Annual Observations From 49 Manufacturing Units Belonging to 21
Companiesa; Lagged Percentage Changes in Nonconformance Costs/Sales Partitioned by the
Magnitude of Percentage Changes in Conformance Costs/Salesb
Sorted on %APREVt Sorted on %AAPPRt Sorted on %ACONFt
Quintile %APREVt %ANCONFt+1 %AAPPRt %ANCONFt+1 %ACONFt %ANCONFt+?
1 27.5 -4.0 19.6 -3.9 19.3 -1.7
2 10.3 _10.2C3 5.9 -8.2c3 5.7 -90od1,3
3 3.0 0.0 -4.5 -1.8 -1.9 -5.9
4 -5.3 -12.8el,3 -8.9 -12.81,3 -8.4 -7.fel
5 -18.1 -7.7 -24.7 -8.7 -18.6 _8.7el,3
'N = 152 for %ACONF and 108 for %APREV and %AAPPR.
bTables report median changes in nonconformance costs in year t + 1 for quintiles formed on the basis of the magnitude of percentage
changes in conformance costs in year t.
c= Significantly different from zero at the 10% level, Wilcoxon signed rank test.
d= Significantly different from zero at the 5% level, Wilcoxon signed rank test.
e= Significantly different from zero at the 1% level, Wilcoxon signed rank test.

1 = Significantly greater reduction than quintile 1 (10% level, Mann-Whitney test); 3 = Significantly greater reduction than quintile 3.

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 ITrNER / 123
in conformance costs both experienced statistically sig- subsample of plants that provided data on prevention and
nificant reductions in nonconformance costs in the year appraisal expenditures, 28 of 33 units (84.8%) achieved
of the change, only the units in quintiles 4 and 5 contin- reductions in nonconformance costs as a percent of
ued to improve the following year. These patterns high- sales. Of these, 15 (53.6%) decreased prevention costs
light two distinct approaches to quality improvement. and 23 (82.1%) decreased appraisalcosts.
Many of the observations in quintile 1 are associated The association between changes in conformance and
with plants that increased conformance expenditures in nonconformance costs over the life of the quality pro-
response to earlier quality problems, a tactic commonly gram is examined by regressing each unit's average an-
referred to as "firefighting.",14 While the additional con- nual change in nonconformance costs to sales on the
formance activities helped to eliminate the sporadic unit's average change in conformance costs to sales, with
problems that appeared in earlier periods, they did little averages used to compensate for differences in the ages
to foster sustained improvement in subsequent years. of the units' quality initiatives.15 Because surveys indi-
Plants with observations in quintiles 4 and 5, in contrast, cate that quality costs can vary substantially among in-
typically made significant upfront investments in quality dustries (Gilmore 1983, Harrington 1987), dummy
programimplementation that supported ongoing noncon- variables are introduced into the regression models to
formance cost reductions in later years. Unlike the "fire- partially control for industry differences. As shown in
fighting" mentality that permeated many of the plants Table VII, the estimated coefficient on the mean percent-
with observations in quintile 1, the emphasis in the ma- age change in conformance is positive and statistically
jority of units in quintiles 4 and 5 was on continuous significant at the 1% level (t = 3.81), a result consistent
improvement and the elimination of chronic problems. with the simultaneous reductions in conformance and
The capital investment-like nature of the initial quality nonconformance costs exhibited by quintiles 4 and 5.16
investments made by many of the units in quintiles 4 and When conformance expenditures are subdivided into pre-
5 is consistent with the theoretical work of Marcellus vention and appraisal components, the coefficients on
and Dada which argues that investments in prevention
can provide benefits over multiple periods.
Finally, the data in Table VI indicate that increases in Table VII
conformance expenditures that did not yield significant Cross-Sectional Regressions of Mean Annual
reductions in nonconformance costs in the year of the Percentage Changes in Nonconformance Costs/Sales
increase often yielded results the following year. Al- on Mean Annual Percentage Changes in
though quintile 2's 10.3% annual increase in prevention Conformance Costs/Sales Over the Life of the
costs produced no significant decrease in nonconfor- Quality Program;' 49 Manufacturing Units From 21
mance costs during the period of the increase, the plants Companies (t-statistics in parentheses)
in the portfolio were able to achieve a statistically signif-
icant reduction of 10.2% in the following year. Similar Mean Mean
%ANCONF %ANCONF
delayed gains are also found when quintile 2 is formed on
the basis of changes in appraisal or total conformance Constant -0.16e 0.17e
costs. (-3.28) (-2.79)
Mean %ACONF 0.93e
Overall, the results in Tables V and VI once again (3.81)
contradict the hypothesis that conformance expenditures Mean %APREV 0.09
must be increasing over time to achieve ongoing reduc- (1.06)
tions in nonconformance costs. Reductions in both pre- Mean %AAPPR 0.79d
vention and appraisal costs are associated with (2.09)
SIC 28 0.14c __b
significant reductions in nonconformance costs during (1.89)
the same year. Moreover, there is no evidence that the SIC 35 0.16d 0.16c
reductions in conformance expenditures led to higher (2.41) (2.02)
nonconformance costs in the following period. SIC 36 0.13d 0.15d
(2.15) (2.17)
4.2. Changes Over the Life of the Quality Program SIC 37 0.07 0.11
(0.97) (1.16)
This section takes a longer-term look at the association Adj. R2 0.26 0.17
between conformance and nonconformance costs by ex- n .49 .33
amining changes in quality costs from the beginning of aSIC 38 (Measurement and Photographic Equipment) serves as
the quality program to the most recent period with avail- the base case in the regressions.
able data. Of the 49 plants in the sample, 39 (79.6%) bManufacturing units in SIC 28 (Chemicals and Allied Products)
reduced nonconformance costs as a percent of sales from did not provide separate breakdowns of prevention and appraisal
costs.
the beginning of the quality initiative to the most recent cSignificant at the 10% level, two-tailed test.
year. Of the 39 units, 29 (74.4%) did so while also reduc- dSignificant at the 5% level, two-tailed test.
ing the ratio of conformance costs to sales. In the esignificant at the 1%olevel, two-tailed test.

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124 / ITrNER

mean annual percentage changes in prevention and ap-
praisal are both positive, though the change in preven-
tion is not statistically different from zero. In conjunction
with the lower nonconformance costs observed in nearly
80% of the plants in the sample, the significant positive
coefficient on appraisaland statisticallyinsignificantcoeffi-
cient on prevention suggest that, on average, the plants'
reductions in nonconformancecosts since the start of the
quality program were accompanied by reductions in ap-
praisal costs and a relatively fixed level of prevention ex-
penditures, not the increasing conformance expenditures
predicted by the traditionalquality cost model.
5.3. Plant-Specific Time Series Analysis
Subject to the econometric and data limitations noted
earlier, the preceding analyses support the quality-based
learning models' implication that nonconformance costs
can be reduced over time without increasing conform-
ance costs. But the pooling of observations from manu-
facturing units with different production functions,
product attributes, and quality cost systems may obscure
the underlying relationships among quality cost catego-
ries. This section controls for these differences by exam-
ining the time series behavior of reported quality costs
from 24 manufacturing units belonging to seven of the
participatingcompanies.
The 24 plants provided quality cost data for periods
ranging from 14 to 28 quarters each (median = 19). Over
these periods, the units reduced nonconformance costs
as a percent of sales by 17.8%on average, with a median
reduction of 27.8%. Plant-specific regressions are
estimated to examine the association between these im-
provements and changes in conformance expenditures.
To control for volume fluctuations, each category of
quality costs is first regressed on sales to estimate the
category's fixed and variable components. The residuals
from this regression (denoted PREV.R, CONF.R, and
NCONF.R) represent the difference between actual costs
during the period and expected costs given the period's
sales, thereby providing a measure of the variation in
quality-relatedexpenditures that is not predictable based
on knowledge of the variation in sales volumes.17
Table VIII presents summary statistics from the 24
individual plant-level regressions. A test of the null hy-
pothesis that the average coefficient from the individual
regressions is equal to zero can be constructed as follows
(Anderson 1971):
Z = =1NE tJ
t /1/ (+lr (3)
wNji kj /(kj -2)
where
tj = the t-statistic for plant j;
kj = the degrees of freedom in the regression for plant
r = the mean correlation between plant's t-statistics;
and

Table VIII
Summary Statistics From Plant-Specific Regressions Examining the Longitudinal Relationship Between
Conformance and Nonconformance Costsa, 24 Manufacturing Units From 7 Companiesb
(t-statistics in parentheses)
PanelA: Total ConformanceCosts
NCONF.Rt= a + I1 CONF.Rt+ 02 CONF.Rt1 + I0 CONF.Rt2 + 4 CONF.Rt-3+ I0 CONF.Rt4 + e

Ad'.
CONF.Rt CONF R 1 CONF.Rt2 CONFRt3 CONF R R
R
Mean 0.78 -0.45 -0.02 0.12 0.02 0.34
(1.57) (-0.46) (-0. 10) (0.09) (0.07)
Median 0.40 -0.09 -0.07 -0.00 0.03 0.26
(1.99) (-0.37) (-0.26) (-0.04) (0.15)
Z-statisticc 6.87e 2.08 -0.45 0.42 0.29
PanelB: PreventionCosts
NPREV.Rt = a + y1 PREV.Rt + -y PREV.Rt1 + 03 PREV.Rt2 + -y PREV.Rt3 + -y PREV.Rt4 + e

Ad'.
PREV.Rt PREV.Rt1 PREV.Rt2 PREV.Rt3 PREV.Rt4 R
Mean 0.71 -1.21 0.04 -0.25 -0.17 0.38
(1.30) (-0.74) (0.02) (-0.33) (-0.10)
Median 0.72 -0.46 -0.22 -0.03 -0.05 0.28
(1.46) (-0.88) (-0.33) (-0.10) (-0.12)
Z-statisticc 5.56e _3.23e 0.04 -0.41 -0.46
aVariablesrepresentthe residualsfromthe regressionof qualitycost expendituresin each categoryon sales duringthe period.Regressions
reportedin the table are run in generalizeddifferencesusing the Cochrane-Orcutt
procedureto correctfor serialcorrelation.
b14 to 28 quarterlyobservationsper plant.
cThe reportedZ-statisticsare calculatedunderthe assumptionthat the individualt-statisticsbeing aggregatedare independent.
d= Significantat the 5% level, two-tailedtest.
e= Significantat the 1%level, two-tailedtest.

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 I1FNER / 125
N = the number of plants in the sample. Table IX
The Z-statistics reported in the paper are computed un- Summary Statistics From Plant-Specific Regressions
der the assumption of independence (i.e., r = 0). The Examining the Longitudinal Relationship Between
validity of this assumption can be assessed by examining the Direction of Conformance Cost Changes
the cross-sectional dependence among the regression re- and Changes in Nonconformance Costs'
siduals from the plant-specific regressions. The pairwise (t-statistics in parentheses)
correlations between the residuals from the plant-specific Panel A: Total Conformance Costs
regressions range from 0.04 to 0.15 (mean = 0.08), sug- NCONF.Rt = a + .1 (POS*CONF.R)t +
gesting that cross-sectional dependence is not a serious 02 (NEG*CONF.R)t + e
problem in the data. 16, 32
Panel A of Table VIII examines the association be- Mean 0.78 0.81
tween conformance and nonconformance costs by re- (1.00) (1.45)
gressing NCONF.R on sales-adjusted conformance Median 0.53 0.58
expenditures in the current and four preceding quar- (0.82) (1.04)
Z-statistic 4.42c 6.47c
ters.18 During the current quarter, the mean and median
coefficients on conformance are positive and highly sig- Panel B: Prevention Costs
nificant (Z = 6.87, p < 0.01), a finding consistent with the NCONF.Rt = a + y (POS*PREV.R)t +
y2 (NEG*PREV.R)t + e
regression results using pooled annual data (see Note
13). The coefficient on CONF.R in the previous period, Yi Y2

in contrast, is negative (Z = -2.08, p = 0.05), indicat- Mean 0.52 1.27

ing that increased investments in conformance activities
began to pay off roughly one quarter following their im-
plementation. The relationships between nonconfor-
mance costs and lagged conformance expenditures in
quarters t - 2 through t - 4 are not statistically differ-
ent from zero.19
Since investments in prevention may have a greater
influence on quality improvement than other conform-
ance expenditures, Panel B of Table VIII investigates the
relationship between prevention and nonconformance
costs. The results are similar to those using total con-
formance costs. As before, the coefficient on PREV.Rt is
positive and statistically significant (Z = 5.65, p <
0.01), while prevention expenditures in quarter t - 1
are again negatively correlated with the current period's
nonconformance costs (Z = -3.23, p < 0.01).20
The positive coefficients on conformance and preven-
tion costs in quarter t are consistent with two explana-
tions. As previously seen in quintiles 4 and 5, plants may
have reduced both conformance and nonconformance
costs as the quality program progressed. Alternatively,
the units may have responded to sporadic quality defi-
ciencies by "firefighting," leading to a positive relation-
ship as conformance expenditures were increased to
identify and eliminate the problems. The following mod-
els are estimated to examine the extent to which these
explanations account for the positive relationship be-
tween conformance and nonconformance costs:
NCONF.Rt
= a + 131(NEG*CONF.R)t
+ 132(POS*CONF.R)t + Et (4)
NCONF.Rt
= a + y 1(NEG*PREV.R)t
+ zy2(POS*PREV.R)t + Et, (5)
(0.75) (1.35)
Median 0.20 1.02
(0.27) (1.13)
Z-statistic 3.35C 6.02c
aVariablesrepresentthe residualsfrom the regressionof quality
cost expendituresin each category on sales during the period.
POS = 1 if the independentvariableis positive duringthe quarter
and zero otherwise;NEG = 1 if the independentvariableis nega-
tive duringthe quarterandzero otherwise.14 to 28 quarterlyobser-
vations per plant.
bRegressionsreportedin the table are run in generalizeddiffer-
ences using the Cochrane-Orcuttprocedureto correct for serial
correlation.The reportedZ-statisticsare calculatedunder the as-
sumption that the individual t-statistics being aggregated are
independent.
c= Significantat the 1%level, two-tailedtest.
where NEG (POS) = 1 if the independent variable is
negative (positive) duringthe quarterand zero otherwise.
If plants reduced conformance costs as quality improved,
nonconformance costs should be positively correlated
with negative values of CONF.R and PREV.R (i.e.,
lower than expected conformance and prevention expen-
ditures). Conversely, if conformance costs were in-
creased in response to quality problems, 132and 72 should
emerge positive and statistically significant. As shown in
Table IX, each of the four variables is positively corre-
lated with nonconformance costs at the 1% level. These
results suggest that the plants condition their conform-
ance expenditure levels on the magnitude of quality
problems facing the unit during the period. When
quality is high during a quarter, conformance costs are
cut back; when quality problems are encountered, the
units respond by increasing conformance expenditures.2'
Although conformancecosts tended to rise and fall with
increases and decreases in failures, the overall results from
the plant-specific tests indicate that, on average, the 24
units reduced both conformance and nonconformance

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126 / VITNER
costs over the periods studied. These findings are rein-
forced by plant-specific regressions (not reported in the
tables) of conformance and nonconformance costs on
the period's sales and linear time trend variables (ranging
from 1 to n, where n represents the number of quarterly
observations for the plant). After controllingfor sales vol-
umes, the Z-statistics for the coefficients on the time trend
variables are -2.07 (p = 0.05) in the conformanceregres-
sion and -4.82 (p < 0.01) in the nonconformance
regression, corroboratingearlierevidence that many of the
plants in the sample reduced conformanceexpendituresas
quality improved. As with the other two sets of tests, the
findingsfrom the plant-specificregressions run contraryto
the hypothesis that conformance expendituresmust be in-
creasing over time to achieve ongoing reductions in con-
formance costs.
5. SUMMARY
This paper examined the hypothesis that conformance
expenditures must continue to be increased over time to
achieve ongoing reductions in nonconformance costs, the
principal debate between proponents of the traditional
quality cost model and continuous improvement theories
of quality cost behavior. Contrary to the prediction of
the traditional model, three sets of empirical analyses
found that many of the plants in the sample achieved
significant reductions in reported nonconformance costs
while maintaining or reducing existing conformance
expenditures.
The first set of tests took a short-term perspective by
examining the association between annual changes in
conformance expenditures and changes in nonconfor-
mance costs in the current and following year. The evi-
dence indicated that additional investments in prevention
and appraisal activities were associated with significant
reductions in nonconformance costs in the current or
following year. However, reductions in prevention and
appraisal costs were also associated with lower noncon-
formance costs, a finding that is inconsistent with the
traditional quality cost model. Moreover, the data pro-
vided no evidence that reductions in conformance expen-
ditures led to higher nonconformance costs in the
following period.
The second set of tests took a longer view of the asso-
ciation between conformance and nonconformance costs
by examining quality cost behavior since the beginning of
the quality program. Nearly 80% of the plants in the
sample reduced nonconformance costs as a percent of
sales over the lives of their quality programs. Regression
analyses indicated that these reductions were positively
associated with changes in conformance costs, implying
that the reductions in nonconformance costs were gener-
ally accompanied by reductions in conformance expendi-
tures, not the increasing conformance expenditures
predicted by the traditional quality cost model.
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The final set of tests controlled for differences in pro-
duction functions, product attributes, and quality cost
systems by estimating plant-specific regressions. Both
preventionand total conformanceexpenditureswere again
positively associated with nonconformance costs. Addi-
tional analysis indicatedthat the plants tended to condition
conformance expenditures on the quality problems facing
the unit, with conformance costs increasing when prob-
lems were encountered, and decreasing when quality im-
proved. When conformance activities were increased, the
increase typically produced lower nonconformancecosts
roughly one month following their implementation. By
conditioning conformance expenditures on the level of
quality problems being encountered, the plants reduced
both conformance and nonconformancecosts as the qual-
ity programprogressed, contradictingthe hypothesis that
conformanceexpendituresmust be increasingover time to
achieve ongoing reductionsin conformancecosts.
This study makes two contributions to the quality cost
economics literature. First, it provides the first empirical
support for the continuous improvement models of qual-
ity cost behavior. In doing so, the study reinforces the
need for greater use of dynamic models of quality man-
agement rather than the static models that predominate
today (see also Jaikumar and Bohn 1992). Second, the
study points out the need to abandon the use of an aggre-
gate "conformance cost" category that includes both
prevention and appraisal. Neither the traditional quality
cost model nor Fine's quality-based learning model dis-
tinguish between prevention and appraisal costs.22 Yet
both the descriptive statistics and the second set of em-
pirical analyses show that plants typically reduced ap-
praisal and nonconformance costs since the start of the
quality programwhile maintaininga relatively fixed level
of prevention expenditures. This finding suggests that ef-
fective prevention activities can reduce both appraisal
and nonconformance costs, and that the economics un-
derlying the prevention and appraisal categories are dis-
tinctly different. A potentially useful avenue for future
theoretical work is understanding the interactions be-
tween prevention and appraisal activities in a dynamic
learning environment.
Although the evidence is generally consistent with re-
cent continuous improvement and quality-based learning
models, the results from this study in no way invalidate
the traditionalquality cost model. As noted earlier, data
and econometric limitations make it difficult to
definitively test the competing theories of quality cost
behavior. Moreover, even if quality-based learning mod-
els correctly depict quality cost behavior over time, the
traditionalmodel may still be an accuratestatic represen-
tation of quality cost economics. The evidence does,
however, suggest that in dynamic, multiperiod environ-
ments, many companies that have committed the neces-
sary resources to quality improvement and embraced the
continuous improvement philosophy have, for what-
ever reason, been able to achieve ongoing reductions

in nonconformance costs while maintaining, or even
reducing, the existing level of reported conformance
expenditures.
Future empirical studies can attempt to overcome
some of the limitations of this study by moving beyond
reported quality costs to estimate the total costs of poor
quality. Indirect or "hidden" internal failure costs, for
example, can be estimated by evaluating the impact of
poor quality on total factor productivity (Ittner). Simi-
larly, the effect of process variability on productivity and
customer satisfaction can be investigated to provide evi-
dence on the Taguchi quality loss function and its func-
tional form in various industries. Particularly important
to any future study of quality cost economics will be
assessing the opportunity costs of lost sales due to poor
quality. Studies by the Technical Assistance Research
Programs (TARP) indicate that the opportunity costs of
field defects may greatly exceed the external failure costs
reported by most systems (TARP 1976). The expected
repurchase rate for a product costing $100 or more
ranged from 54% if the complaint was resolved satisfac-
torily to only 19%if the problem was not resolved to the
customer's satisfaction. Moreover, while satisfied cus-
tomers tell an average of five others about their experi-
ence with the product, dissatisfied customers tell 19.
Estimating the opportunity costs of field defects will
probably require joint research with marketing research-
ers who are experienced at estimating purchase elastici-
ties with respect to factors such as quality. An additional
challenge to empirical studies in this area will be control-
ling for factors other than quality-based learning (e.g.,
factor prices and technological changes) that may affect
the quality-cost tradeoffs facing an organization. The de-
tailed information and organizational knowledge needed
to conduct such a study suggests that an in-depth exam-
ination of a few organizations may be the most fruitful
avenue for future empirical research on quality cost
economics.
Finally, the empirical analyses in this study (as well as
existing quality cost theories) utilize aggregate changes in
prevention, appraisal, and nonconformance costs. A use-
ful extension would be an examination of the impact of
specific activities within the prevention and appraisalcat-
egories. For example, do certain elements within the pre-
vention category (e.g., training, preventive maintenance,
quality engineering) have a greater impact on nonconfor-
mance costs than others? Does the distribution of pre-
vention costs among the subcategories change as the
quality level improves? Do companies that achieve
higher quality with no increase in conformance expendi-
tures allocate their prevention and appraisalresources to
different activities than their competitors? A more mic-
rolevel examination of quality cost behavior may provide
a better understanding of the underlying economics of
quality improvement, thereby allowing more informed
decisions on the allocation of resources to quality-related
activities.
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ITNER / 127
NOTES
1. The "conformance to specifications" definition of
quality refers to whether or not a product meets the
design specifications set by engineering, i.e., the num-
ber of manufacturingdefects. This definition stands in
contrast to broader definitions of quality which en-
compass quality characteristics such as performance,
reliability, features, serviceability, and aesthetics as
well as conformance to specifications. For an exten-
sive discussion of the many definitions of quality, see
Garvin (1988).
2. Kim and Liao argue that the specific functional form
of the loss function may vary by product and indus-
try, and may actually have "insensitive" regions in
which small deviations from the target value do not
lead to quality losses. However, the authors present
no evidence to support this conjecture.
3. These illustrations are based on those in Schmenner
(1984).
4. The continuous improvement philosophy promotes
the need for never-ending improvement. Although the
philosophy rejects the notion that quality improve-
ment efforts can be relaxed short of perfection, most
continuous improvement advocates maintainthat zero
defects is a long-run goal rather than an attainable
short-runoptimum (e.g., Schneiderman 1987).
5. In much the same vein, Milgrom and Roberts (1990)
argue that the introduction of new manufacturing
technologies such as Computer-Aided Design and
Manufacturing(CAD/CAM) systems lower the overall
costs of achieving higher quality by increasing the ef-
ficiency and effectiveness of prevention activities.
6. The model by Marcellus and Dada does not address
appraisal costs. Fine's model, in contrast, only ad-
dresses total conformance costs and does not distin-
guish between prevention and appraisal expenditures.
Consequently, the model provides no insight into
whether quality-based learning primarilyimpacts pre-
vention activities, appraisal activities, or both.
7. A comparison of the participatingand nonparticipat-
ing groups revealed no systematic differences in terms
of size or industry. However, the use of companies
that formally track quality cost expenditures intro-
duces a potential self-selection bias into the sample
because firms with more sophisticated quality pro-
grams may be more likely to measure quality costs.
8. The quality cost elements tracked by the units in the
sample remained consistent from year to year. Where
possible, actual warranty claims were aligned with the
period in which the goods were manufactured. In the
remainingcases, plant-specific estimates of the lag be-
tween factory shipment and the recording of warranty
claims were used to estimate the warranty costs asso-
ciated with a given manufacturingperiod.
128 / ITTNER
9. To ensure that the results in this paper were not
driven by reporting differences, the tests were re-
peated using data from the 31 plants that provided
detailed information on the components of reported
quality costs. After eliminating reported costs for ac-
tivities other than quality planning and administra-
tion, training, inspection and test, scrap, rework, and
warranties, the results remained unchanged, suggest-
ing that the findings are not an artifact of differences
in reported quality cost elements.
10. For the entire sample of annual quality cost expendi-
tures, the Pearson correlations between percentage
changes in quality costs and percentage changes in
sales exceed 0.40 (p < 0.01) for each of the quality
cost categories. In the 24 plants that provided quar-
terly quality cost data, the mean time series correla-
tions between quarterly quality cost expenditures
and quarterly sales in each plant are:
Prevention 0.48
Appraisal 0.61
Conformance 0.69
Internal Failure 0.48
External Failure 0.60
Nonconformance 0.60
11. The correlations in Note 10 indicate that each of the
quality cost categories contains both fixed and vari-
able components. Consequently, sales increases will
lead to fixed costs being spread over a greater num-
ber of units, reducing the ratio of fixed costs to sales
even though actual fixed expenditures have not
changed. To examine whether the empirical results
are robust to variable specification, tests using both
pooled annual data and plant-specific quarterly time
series data were also performed using alternative,
methods to control for volume fluctuations (see
Notes 13 and 16 and subsection 4.3). The results are
similar to those using the specification in Equation 2,
suggesting that the findings reported in Tables II-VII
are not merely due to fixed costs being spread over
larger sales volumes.
12. Since the participating companies did not measure
quality costs before implementing quality programs,
data on increases in conformance costs from year
k - 1 (the year prior to the start of the quality
program) to year k are not available. As a result,
upfront investments in the development of quality
systems and company-wide training in quality im-
provement philosophies and techniques are not cap-
tured in the analyses.
13. Regression results support the findings from the
quintile tests. When %ANCONF was regressed on
%ACONF, the coefficient on the conformance vari-
able emerged positive and highly significant (t =
2.95, p < .01). After subdividing the sample by the
sign of the change in conformance expenditures, the
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coefficient on %ACONFin the subsample of periods
with increased conformance costs was not statisti-
cally different from zero (t = -0.07). In contrast,
the coefficient for the subsample with reduced con-
formance expenditures was positive and significant
at the 2% level (t = 2.36). To examine whether
these results were simply due to fixed costs being
spread over larger sales volumes, percentage
changes in nonconformance costs (unadjusted for
volume) were regressed on percentage changes in
both conformance expenditures and annual sales. As
expected, changes in nonconformance costs were
highly correlated with changes in sales (t = 5.92,
p < 0.01). More importantly, the coefficient on the
change in conformance costs remained positive and
statistically significant (t = 1.81, p = 0.07).
14. In year t - 1, median changes in nonconformance
costs for quintile 1 are positive and significant at the
10% level. Median nonconformance cost changes in
year t - 1 for the other quintiles are all negative.
15. The White (1980) test for heteroscedasticity was con-
ducted for each of the cross-sectional regressions re-
ported in the paper. In no case did the test reject the
null hypothesis that the error terms were homosce-
dastic. Because the relationshipbetween conformance
and nonconformance costs may not be linear, rank
transformregressions,which provide good approxima-
tions to unknown nonlinear relations (Iman and
Conover 1979), were also run. The results did not
change appreciablyfrom those reportedin the tables.
16. Average annual percentage changes in nonconfor-
mance costs (unadjusted for volume) were also re-
gressed on average percentage changes in both
conformance expenditures and sales to ensure that
the results were not driven by fixed costs being
spread over additional units. The coefficient on con-
formance remained positive and significant (t =
2.57, p = 0.01) when the alternative specification
was employed.
17. Regressingnonconformancecosts (unadjustedfor vol-
ume) on conformanceexpendituresand sales produced
results similarto those using the residualsapproach.
18. Durbin-Watson statistics indicate that the residuals
from the time series regressions exhibit strong first-
order serial correlation. The regressions are there-
fore estimated in first differenced form using the
Cochrane-Orcutt procedure.
19. As noted earlier, the reported Z-statistics are com-
puted under the assumption that the quality cost
expenditures in the 24 plants are independent. The
minimum number of independent observations
needed to obtain a particular significance level for
the Z-statistic can be obtained based on an approach
used in Lambert and Larcker (1987). Given the mean
t-statistic of 1.57 for the coefficient on CONF.Rt, the
minimum number of independent observations
needed to obtain a Z-statistic of 2.0 is (2.0/1.57)2 =

1.62, or as few as two plants. The required number
of independent observations for CONF.R,-1, on the
other hand, is 19, implying that the finding of a sta-
tistically significant lagged relationship is subject to
quality cost expenditures being independent among
most of the plants.
20. Using the Lambert and Larcker approach, the mini-
mum number of independent observations required
to obtain a Z-statistic of 2.0 are three for PREV.R,
and eight for PREV.R_1.
21. Regression models similar to those in Equations 4
and 5 were also estimated to explain the negative
coefficients on CONF.Rt_1 and PREV.R,-1. Only
higher than expected conformance and prevention
expenditures had a significant negative correlation
with nonconformance costs in the following period,
suggesting that the increases in conformance costs
that accompanied quality problems generally re-
duced the problems by the following quarter. Lower
conformance costs were not significantly associated
with later changes in nonconformance costs, indicat-
ing that reductions in conformance expenditures did
not prevent plants from maintaining or continuing
the previously achieved gains. Finally, CONF.R, and
PREV.Rt were also regressed on NCONF.R,_1 to
examine the association between the current quar-
ters conformance expenditures and earlier quality
problems. The Z-statistics for the coefficients on
NCONF.R,_1 were not statistically significant.
22. Marcellus and Dada's model does not address ap-
praisal costs.
ACKNOWLEDGMENT
This study has benefitted from the insightful comments
of Bruce Chew, Robin Cooper, Morris Cohen, George
Foster, Robert Kaplan, David Larcker, Fred Lindahl,
Leif Sjoblom, two anonymous referees, and the associate
editor. I also wish to thank seminar participants at
Harvard, Purdue, and Stanford. The financial support of
KPMG Peat Marwick and the Division of Research,
Harvard University is greatly appreciated.
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