2

Shank & Govindarajan:

Measuring the "Cost of Quality": A Strategic Cost Management
Perspective
Shank, 1.K. & Govindarajan, V. 1994. Measuring the "Cost of
Quality": A Strategic Cost Management Perspective. Journal of
Cost Management, Vol. 8, Swnmer, pp. 5-17.
Measuring the "Cost of Quality":
A Strategic Cost Managetnent
Perspective
John K. Shank and Vijay Govindarajan
Quality bas become such an imponant
strategic variable that management accounting
can no longer ignore it. This artic:le surveys the
authoritative literature on total quality
management (TQM) to contrast two paradigms
for quality-the traditional view and TQM.
Conventional managemeDt accounting panders
to the traditional views ou qnality and tends to
discourage companies from implementing
TQM, which can be characterized as "phase 1"
thinking about quality costs. A cost analysis
framework that snppons TQM ("'phase 2"
thinking) is explained. This cost analysis
framework can be modified for strategic
decision making and control to produce a
"phase 3" perspective.
C
ost is caused, or driven, by many
factors that are interrelated in
complex ways. Understanding
COSt behavior means
ing the complex interplay of the
set of cost drivers at work in any given situa-
tion. Each driver involves choices a company
makes (e.g., whether to have a large- or a
small-scale operation) that drive unit cose
To facilitate making the right choices. the
relationship of each driver to total cost should
be specified. For example. activity-based
management (ABM) is a way to emphasize the
:mpact of eliminating non-value-added work
In total cost. This article discusses several
analYSis frameworks for one of the "sort"
:05t drivers: management commitment to
(Hal quality. Many firms call this commit-
nent tOlal quality management. or TQM; oth.
"rs be/icv\," that quality is best applied without
reatlllg yet anotlln flJrtllal prograrll witll it.,
'wit three It:ll..:r
A survey of TQM literature
Quality is now widely acknowledged as a
key competitive weapon. Some say it is the
key differential advantage in a global mar-
ketplace. Such firms as American Express,
Ford. General Electric. IBM. and Xerox
emphasize quality in their overall strategy.
This section presents an overview of the
four main "schools- of quality manage-
ment: Juran. Deming. Crosby_ and the
-Japanese- approach. While these
approaches all have Similarities, they differ
in subtle, but important, ways. The follow-
ing short descriptions of the four
approaches should help managers focus on
the important cost analysis issues.
}oseph}uran. Juran was (with Armand
Feigenbaum) a pioneer of quality cost
analysis during the 19505. Juran divided
quality costs into four categories:
Prevention costs;
Appraisal costs;
Internal failure costs: and
External failure costs. I
This method of classifying quality costs is
stil! widely used today.
According to Juran, control costs (i.e .. preven-
tion and appraisal costs) increase as quality
increases. but failure costs (internal and exter-
n;]1 costs) decrease. Adding these two compo-
nents together. the result is;]n overall
cost curve that is U-shaped, as shown in
Exhibit I. This suggests that the Objl:Llivl: llr;1
program ShOlllu he ttl
find tht.' level pf (or IllI111hcr ,,( ddeCi'.)
[Iu[ minlllll:e'i !ill: tPLd C(!';[ (lr quality-i.e,
1" lind [Il..: h()(((lill "f tite U-..;it.lpnl CUf\l'
COST MANAGEMENT
Conceptually and practically, there is no
reason why the minimum total cost posi-
tion in this model could not be 100 percent
quality. That is, there is nothing in the con-
cept that requires optimum quality to be
less than 100 percent perfection. Where the
optimum point falls is a function of the
shape of the various curves. Indeed, it is
surprising how many managers in the
1990s still firmly believe in the U-shaped
quality cost curve - who believe, in other
words, that "those last few defects are very
expensive to eliminate."
w.. Edwards Deming. Deming is perhaps
the best-known scholar of quality manage-
ment. Although Deming is an American,
acceptance of his ideas occurred first in
japan. Since 1951, the japanese have
awarded an annual Deming Prize for
advancements in the precision and
dependability of products. In the United
States, recognition of the importance of
Deming's ideas did nOt come until many
years later. Not until 1987 was the Deming
Prize awarded to a U.S. firm (Texas Instru-
ments). In the same year, the Malcolm
Baldrige National Quality Award was
established in the United States.
Deming believes that the loss of competitive-
ness of U.S. industries in the international
marketplace has occurred because of a lack
of attention to quality.
2
The fundamental
tenet of Deming's view of quality is that the
coStS of nonconformance (and the resulting
loss of customer goodwill) are so high that
evaluating the costs of quality is unneces-
sary. For Deming, measuring quality costs
and seeking optimum defect levels is evi-
dence of a failure to understand the problem.
The proper objective, in his view, is zero
defects. Deming's philosophy is summarized
in the 14 points shown in Exhibit 2.
Philip Crosby. Uke Deming, Crosby believes
that the cOSt of quality is minimized by
"making it right the first time. "3 The objec-
tive for any operation should therefore be
zero defects. Like juran, however, Crosby
does see a need for measuring quality costs.
Crosby divides quality costs into two
components:
6 Summer 1994
Q;
a..
'" o
o
Exhibit I. Contrasting Vil"ws on (hI" Optimum
Numbl"r of Defects
Optimum Defect
Level Undor The
Traditional v_
raM Vifsw

Optimum Defect
LavuI Under TOM
1 00% Defective Quality Level 100% Good
The price of conformance; and
The price of nonconformance.
The price of conformance includes the
explicitly quality-related costs incurred in
ensuring that things are done right the first
time. The price of nonconformance
includes all the costs incurred because
quality is not right the first time. According
to Crosby, the price of conformance for a
well-run company is typically 2 percent to 3
percent of sales, while the price of noncon-
formance of most firms is closer to 20 to 25
percen t of sales. ~
Crosby argues that there is no such thing as
a quality problem; there are only engineer-
ing, manufacturing, labor, or other prob-
lems that cause poor quality. Crosby does
not accept juran's idea of quality cost analy-
sis as a management control tool. As a tool
for improving quality, Crosby proposes
instead a "quality management maturity
grid" (see Exhibit 3) that traces the devel-
opment of quality thinking from uncer-
Mtasurtng tht Cost o/Quality"
Exhibit 2. Dtndng's FOllrtt(lt Martagtmt'nt Ptinciplts
Requirements for a business whose management plans to remain competitive
In providing goods and services that will have a market.
1. Create constancy of purpose toward improving
products and services, allocating resources 10
provide for long-range needs rather than short-
term profitability.
2. Adopt the new philosophy for economic stability
by refusing to allow commonly accepted levels
of delays, mistakes, defective materials and
defective wonunanship.
3. Cease dependence on mass inspection by
requiring statistical evidence of built-in quality in
both manufacturing and purchasing functions.
4. Reduce the number of suppliers for the same
item by eliminating those Ihat do not qualify with
statistical evidence of quality: end the practice of
awarding business solely on the basis of price.
5. Search continually for problems in the system to
constartUy improve processes.
6. Institute modem meU'lods ot training to make
better use of all employees.
7. Focus supervision on helping people do a better
job: Ensure that immediate action is taken on
reports of defects, maintenance requirements.
poor tools, inadequate operating definitions, or
other conditions detrimental to quality.
tainty through awakening, enlightenment,
and wisdom, to certainty. Senior managers
achieve certainty when they deem quality
management essential to operations.
While Crosby and Juran do not agree on
=luality costing as a management tool,
. "':ir views on the elements of quality
.... st can be reconciled. Crosby'S price of
:onformance includes juran's preven tion
md inspection costs; his price of noncon-
'ormance includes Juran's internal and
:xternal failure costs. Also. although
:rosby rejects the notion of ongoing cost
If quality measurement systems. he does
lelieve it is useful for a company to do a
luality cost analysiS once when it begins
formal quality management program to
etermine where the company stands on
he maturity grid.
'he "Japanese" approach. Although no sin-
Ie quality system is followed by :.111 Japan-
.:;e rirms, there arc several Lummon themes
I the best-known Japanesl' quali!y
8. Encourage effective, two-way communication
and other means to drive out lear throughout the
organization and help people work more
productively.
9. Break down barriers between departments by
encouraging problem SOlving through teamwork.
combining the efforts of people from different
areas such as research, design. sales. and
production.
10. Eliminate use of numerical goals. posters. and
slogans lor the work force that ask for new
levels of productivity without providing methods.
11. Use statistical methods for continuing
improvement of quality and productivity. and
eliminate work standards that prescribe
numerical quotas.
12. Remove all barriers thaI inhibit the worker's. right to
pride of workmanship.
13. Institute a vigorous program of education and re-
training to keep up with changes in materials,
methods. product design. and machinery.
14. Clearly define top management's permanent
commitment to Quality and productivity and its
obligation to implement all of these principles.
grams. Charles Fine describes the Japanese
approach as follows:
Briefly described. the ultimate objective of
Japanese quality management is [0 improve
the quality of life for producers. consumers
and investors. The Japanese define quality as
uniformity around the target. and their goal is
continual improvement toward perfection .
The Japanese USt cOSt of quality similarly [0
Crosby-for directing action. not as a goal
in itself.
The Japanese allocate responsibility for qual-
ity management among all employees. The
workers are primarily responsible for main-
taining the system. although they have some
responsibility for improving it. Higher up the
ladder. managers do less maintaining and
more improving. At highest levels, the
emphasis is on breakthrough.
3re a number of nowr;lmiliar concept.;;
associatetl with Japanese qUillll)' Il1an;lgement.
These indutle CO!l1lnilll1ent til Improvenlent
anti (kai::cnJ. inSistence Oil ulIllpll"
,IIlCC c,.rnlting "lIl'., OWl1 crr"r-; .. lllt! lOll
pncclll dllck-;. VClflOll'i
I.Killliltc lllialilY 1ll.lIwgcllll"nl 11\ j,lp.IIl''l
l.. I .\-Il\."""\' ,. .... J
Exhihit 1. Tllr Qlwli,., Manu)::!'",rn, Mel/uri,.\' Grid
Quality Management Maturity Grid
Rater Unit
Measurement Stege 1: Stlg. II: Stag. III; Stage IV: Stag. V:
Cite gory Uncertainty Awaklnlng Wisdom Certainty
Managemenl under- No comprehension Recognizing that While going
Participaling.
Consider quality
standing and 01 qualily as a quality manage- through quality
Understand absoh . -
management an
attitude management tool. ment may be of improvement pro-
tion of quality
essential part 01
Tend to blame value but not will- gram learn more
management.
company
quality department ing to provide about quality man
Recognize their
system.
for "quality money or time to agement becoming
personal role in
problems.- make it all happen. supportive and
continuing
helplul.
emphasis.
Quality organiza- Quality is hidden in A strong quality Quality department Quality manager to Quality manager
lion status manufacturing or leader is appointed reports to top man- an officer of com- an board of direc-
engineering depart- but main emphasis agement. All pany. EHective sta tors. Prevention is
ments. Inspection is stilt on appraisal appraisal is incorpo- tus reporting and main concern.
prObably not part 01 and moving the rated and manager preventive action_ Quality is a thoug'"
organization. product. Still part 01 has role in manage-- Involved with can- leader.
Emphasis on manufacturing or ment of company. sumer affairs and
appraisal and other. special assign-
sorting. ments.
Problem Problems are Teams are set up Corrective action Problems are iden- Except in the most
handling lought as they to attack major communication tilied early in their unusual cases.
occur. No resolu- problems Long- established.Prob- development. All problems are
tion. Inadequate range solutions are lems are lac!)d functionS are open prevented.
definition, lots of not SOlicited. openly and to suggestion and
yelling and resolved in an improvement.
accusations. ordenyway.
Cost 01 quality as Reported Reported 3%. Reported 8"1.. Reported 6.S"lo. Reported 2.5%,
percent of sales unknown. Actual ActuaIIS-;". Actual 12%. ActuaIS'%.. Actual 2.S%.
20%.
Quality improve-
No organized activ- Trying obvious
Implementation of Continuing the 14- Quality improve-
ment actions
ities. No under- "motivational- the 14-step step program and ment is a nonnal
standing of such short-range effOrts.
program with starting to make and continued
activities.
understanding and cenain. activity.
establishment ot
each step.
Summation at "We don', know Is it absolutely "Through manage- "Defect prevention "We know Why we
company quality why we have prob- necessary to
ment commitment
is a routine part of do not have prob-
posture lems with quality. always have and quality our operation lems with quality.-
problems with improvement we
quality?
are identifying and
resolving our
problems.
SOURCE: Charles Fine. "Managing Quality: A Comparative Assessment: Booz Allen Manufacturing Issues (1985).
cororations-smalllot sizes, minimal watk-
in-process inventory, housekeeping. daily
machine checking. and quality circles.
The basic notions of the Japanese
approach are that quality is a journey
rather than a destination and that quality
8 Summer 1994
enhancement is a fundamental way of life.
not a business target. Exhibit 4 summarizes
the important features of the approaches
to quality described so far. While differ-
ences exist, the programs suggested by
Juran, Deming. Crosby, and others have
common themes that can be collectively
..--...
Exhibit .oJ. Summary oJ ApprOQchts to Quality
Definition 01 quality
Deming
Conformance to specs
Juran
COnformance to specs
Croaby Japaneae
Conformance 10 !lpecs Uniformity around target
Why worry llbout quality Competitive position Prollls/quality 01 lile Prolits Oualily of lile
Goal 01 program Improve compelitlve
position
Decrease coo Decrease costs Continual improvement
Quality goal Zero defects Minimile COO Zero delects Zero defects
How to select projects Pareto anatysis defects Cost analysis Cost analysis Cost analysis
How to measure
improvement
Role 01 QC department
Direct measurement
Low
COO data
Extensive
COO data and direct Direct measurement
measurement maturity
grid
Moderate Low
Role of top management Leadership. Leadership Must stress Breakthroughs and
zero defects participation participation
Role 01 workers
coo emphasis
Maintenance and
improvement
None
Moderate
Hig"
improvments
Moderate
Moderate
Maintenance and
improvements
Low
Statistical analysis High use For lower management Mixed High use
IItural Changes required Great change required Little change required New quality attitude Greal cnange required
PartiCipative managment Fits traditional culture Fits traditional culture Participative management
Needed Need
Grave threat Grave threat
Managing the
transition state
No guidance
much needed
NO guidance
little needed
Excellent treatmentc No guidance
Classic example much needed
Decision Optimize DMOa
zero defects
Minimize COO COO for management Optimize OMOQ
described using the familiar catch phrase
total quality management.
Traditional views-phase 1 thinking about
quality and cost. The characteristics of TQM
r'\n best be understood by contrasting TQM
.:h traditional views on quality as
exemplified by GM cars during the 19705. the
airline industry during the 1980s. or the
forest products industry during the 19905.
Exhibit 5 contrasts the key elements of TQM
with elements common to traditional
approaches to quality.
Traditional responsibility for quality. In
the traditional paradigm. quality problems
Hart in "operations"-poor quality is
attributable mainly to workers. The best
way to control quality. therefore. is 0
'inspect it in." This requires a large quality
:ontrol department whose job is to inspect
lutpul and certify that it meets <:LtStorner
'pecificalions,
Attention OMOQ for zero defects
implementation zero
defects
In the traditional paradigm. an adversarial
relationship typically develops between the
operations personnel (whose objective is to
maximize output) and the quality control
staff (whose objective is to monitor output
quality). Historically. many U.S. companies
have placed more emphasis on output than
on quality. because customers did not
demand products. But the envi-
ronment has changed-drastically in the last
decade. Customers now demand high quality.
particularly now that many companies can
provide top quality at competitive prices.
Responsibility for quality under TQM.
According to TQM, everyone in the organiza-
tion shares responsibility for quality; in fact,
mOSt of the quality problems stan long before
the operations s[:lge even begins_
Deming ;lrgues that process can be sepa-
rated into two pans:
The systcm. which is under Ihe cllnlwl or
management; and
The workers. who arc under their own
control.
Deming's experience indicates that 85 per-
cent of quality problems are attributable to
faulty systems and only 15 percent to work-
ers. A system can be faulty for such reasons
as the following:
Difficult-to-execute operation;
Inferior inpuls;
Inadequate equipment maintenance;
Poor working conditions; and
Excessive pressure to maximize output.
Since management designs the system, qual-
ity is primarily a management responsibility.
Under TQM, the overriding consideration is
to -build quality into the output
ft
rather
than quality into the output. ft
Errors should be detected and corrected at
the source. Quality at the source implies
that the workers should be held responsible
for their work and should not pass defective
work downstream. Instead of appointing
quality inspectors to locate defects, the
workers in a TQM operation are their own
inspectors. This philosophy also implies a
fundamental change in the role of the qual-
ity control department, moving away from
inspection and toward facilitation. Instead
of inspecting in quality at the output stage,
the quality control staff should monitor the
process and facilitate the workers' ability to
do things right the first time.
Linkages with suppliers. The traditional
view argues thal obtaining inputs from sev-
eral suppliers gives a firm bargaining lever-
age: Competition among the suppliers who
are pitted against each other leads (at least
theoretically) to lower input prices.
The problem with the traditional view is
that quality control becomes extremely dif-
ficult if there are numerous suppliers. If
the firm starts with inputs of inferior qual-
ity, it can prove to be very costly even if the
process is in control. For example. in
1984, the Ford Motor Company stopped
production of the Tempo and Topaz mod-
els in four plants because of a faulty
engine part purchased from an outside
supplier. Each day production was
10 Summer 1994
Exhihit 5. C"nlrasllns Quality PamdiRms:
Tradilional Vkws on Quality Vasus To/al
Quality Managemenl
Traditional Paradigm TOM Paradigm
Responsibility for QUilI/ty
Worker is responsible
lor poor quality
Quality problems start in
operations
Inspect quality in
Altertha-fact inspection
Quality inspeclors are the
gatekeepers of quality
Quality control department has
large staff
The focus of the quality
control department is to reject
quality output
Managers and engineers have
the expertise workers serve
their needs
Everyone is responsible
lor poor quality
Majority of the quality
problems start long
belore the operations
stage
Build quality in
Quality at the source
Operators are responSI'
ble for quality
reliability
Quality control depart-
ment has small staff
The focus Of quality
control department is
to-monitor and
lacilitate the process
Workers have the exper
tise-managers and
engineers serve their
needs
Linkage5 With suppliers
Procure from multiple
suppliers
Acceptance sampling of inputs
at point of receipt
procure"trom a single
supplier
Certify suppliers who
candeliver right quan
tity.right quality. and on
time No incoming
inspection
New Product/Service Development
Separate designers from
operations
Design for performance
(with more parts, more
features), not to
faCilitate operations
Use teams with opera
tions. marketing, and
designers
Design tor performance
and ease of processing
Overall OUlfllty GOlfl
Zero defects is nOI practical
Mistakes are inevitable and
have to be inspected out
It costs too much money to
make defect-free products
A "reasonable tradeoff is
the key
Zero detects is the goal
Mistakes are opportuni
ties to learn and
become perfect
Quality is free
Perfection is Ihe key:
perfection is a journey.
1'101 a destinalion
stopped. Ford lost the opportunity to
produce about 2,000 cars.
Quality and dependability, nor just price.
Under TQM. suppliers are selected based on
quality and delivery dependability. rather
than price alone. The firm certifies a few
suppliers who can deliver defect-free inputs
Cost of Quality
.{ "'f ",'-." .. ;:'
on time in a reasonable price. Typtcairy:
firm will procure most of its requiremems
for each input item from a single supplier
out of a list of certified suppliers. Develop-
ing long-term relationships with a single
supplier pays off both in terms of higher
quality and lower price over the long term.
Between 1980 and 1985, for example. Cater-
pillar reduced its suppliers of drill bits from
24 to 3 and cut drill bits cost by 40 percent.
Sourcing from a single supplier results in
higher quality for several reasons:
The company views the supplier as an
integral part of its operations. Thus, the
company has the time and the motivation
to work with the supplier to improve
supplier process quality.
The supplier, for whom the company's
business is Significant. is motivated to
produce and ship small lots with exact
specifications, and to work with the
buyer to improve process quality.
Single-sourcing can lead to lower costs as
well as higher quality, for such reasons as
the follOWing:
If the firm is confident of the supplier's
process quality, the inputs can bypass
incoming inspection and thus save
inspection costs.
The firm can save the costs of poor qual-
ity downstream that are the direct result
of processing inferior quality inputs.
Given the Significant purchasing volume
from the company. [he supplier can enjoy
longer runs and the resulting benefits of
scale and experience.
brings with it the risk of a
breakdown in supply for such reasons as
:;trikes. machine breakdowns. or natural
Jisas(ers. However. these concerns are
:ally overstated for at least two reasons.
:irst. though the company may procures
nost inputs from a single supplier, typically
Jne or two backup suppliers are qualified lO
.upply and may get an occasional order lO
the channel open. Second, the com-
tany faces similar risks every day in its own
'pcn.Jtions, because downstream stages arc
00 percent depcndent on upstream stages.
The de"\lelopment stage. Companies that
operate under the traditional point of view
separate designers from operations person-
nel. DeSigners. who are given a charter to
conceive new products or services that have
high customer appeal, are told not to feel
constrained by current operational capabili-
ties. Unfortunately, this approach often
leads [0 elegant deSigns that are difficult to
implement. Indeed, many quality experts
insist that 50 percent of quality problems
arise at the design stage. It is difficult to
produce a product reliably if it has been
deSigned for performance (thus having.
e.g .. more parts or more features) without
due consideration of ease of manufacturing.
Quality is now widely
acknowledged as a key
competitive weapon.
According to TQM, the best way to assure
quality is to get operations managers and
deSigners closely involved in developing new
products and services. If the deSigners
oughly understand the operations process,
they are more likely to create designs that
not only have high customer acceptance but
also fit the firm's operations capability.
Overall quality goal. The traditional para-
digm argues that mistakes are inevitable
and tha tit is too expensive to rectify all the
defects. In contrast, TQM takes the position
that zero defects should be the goal. A firm
should analyze the causes of all errors and
take actions to remedy them.
Exhibit 5 compares the conflicting view-
points on the optimal number of defects.
According to the traditional view. the low-
est cost is attained at some nonzero level of
defects. Proponents of this view argue that
the cost of removing errors increases as
more and more errors are deteCted antl
fewer errors remain. The last errors are the
most expensive w detl'cI ancicorrl'Ct.
In sharp contrast, TQM maintains that till'
lowest cost is attained :::ero defects. Sup-
porttrs of Ihis view reason that even though
error!' arc numerous. the (05t of rectifying
the last error is no higher than the cost of
rectifying lht first. Hence. the total cost
keeps declining until the last error is
removed. In Ihis sense, TQM advocates
argue that "quality is free."
Contrasting cost management paradigms.
More and more companies are convinced that
shifting from the traditional quality-philoso.
phy to TQM is essential for success. Such a
shift requires fundamental changes in the atti
tudes that managers and workers have about
quality. Far from facilitating this change, tra-
ditional cost accounting systems can be a
great hindrance to implementing TQM.
The serious shortcomings of traditional
cost accounting can be best understood by
contrasting it with strategic cost manage-
ment. Such a comparison is presented in
Exhibit 6. Several points are noteworthy:
Standard cost systems usually institution-
alize waste (e.g., scrap and rework) by
having -normal allowances" for them. In
fact, the cost of the defective units are
allocated to "good" units based on elabo-
rate cost procedures. This practice of pro-
viding a "normal allowance" for waste
panders to the traditional views on quality
that it is too expensive to rectify all the
defects. In TQM, on the other hand, there
is no such thing as "allowable waste."
In a traditional system, overhead vari-
ances are used to evaluate performance.
Overhead variance analysis encourages
managers to maximize production vol-
ume-at the expense of quality-as a way
to absorb overhead costs and avoid unfa-
vorable variances.
Traditional systems highlight raw mater-
ial price variances and penalize managers
for unfavorable price variances. This
again reflects the traditional view on
quality-obtain raw materials from a
large number of suppliers and encourage
competition among suppliers to obtain
lower input prices. This view, as
explained earlier, is detrimental to a
company's profitability.
Traditional systems do not directly
12 Summer 1994
Exhihil h. Cns! Manog('nH'nl Paradigms:
Tra(/i!i(lllal Cns! Management Venus
SIr-alcgic Cost Management
Trl!ldltlonl!ll Coat
Management
Siandard cost system
wilh "normal'
allowanCe lor scrap. waste.
rework; zero delect is
not practical
Overhead variance analysis;
maximize production volume
(not quality) to absorb overhead
Variance analysis on raw malerial
price; procure from multiple
suppliers to avoid unfavorable
price variance; low pricel10w
quality raw malerials
No emphasis on nonfinancial
periormance measures
No tracking of customer
acceptance
No cost of quality analysis
Centrol Ph,7os0phy:
StrategIc Coat
Management
No allowance for
scrap. waste. rework; zero
defect il> the concept
Overhead absorption is nOI
the key; standard costs and
varience analysis are de-
emphasized. in general
No control on raw material
price; certify vendors who
can deliver right quantity.
right quality. and on time
Heavy use of nonfinancial
measures (parts-per-million
defects. percentage yields.
scrap. unSCheduled
machine downtimes. first
pass yields. number of
employee suggestions)
Systematic tracking of
customer acceptance
(customer complaints.
order lead time. on-time
delivery incidence of fail
ures in customers'
locations)
Quality costing as a
diagnostic and manage
ment control tool
The goal is to be in the "top tier'" The goal is kaizen
of the "reference group"
The annual target is to meet the Industry norms set the
standards floor
Standards are to be met. not The annual target is to
exceeded beat last year's pertor
mance
Standards are "'tough" but
attainable
A regularty exceeded standard
setsis not tough enough
Strive to beat this year's tar
get ("continual improve
ments)
Each achiellement level
a new floor for future
achievement
reward nonfinancial measures of quality,
such as parts-per-million defect rates,
first-pass yields, on time delivery, and
shorter cycle time.
Traditional systems emphaSize meeting
standard costs. (In fact, a regularly
exceeded standard is viewed as not tough
enough.) Under TQM, the emphaSis is on
"continual improvement."
Mtasuring tnt Cost of Quality
Exhibit 7. An lllustrcUivt Example of Cost of Quality Analysis for ABC Corporation
Quality cost 1982
category
Units produced 10,000
Preventlo $ 200
Appraisal 400
Intema! failure 200
External failure
~
Total $ 4,800
Total manufacturing
cost s 20.000
Total quality cost
as percent of total cost 25%
The next section describes in more detail a
cost analysis framework that should help
companies as they shift from traditional
views on quality to TQM.
Quality costing methodology-
phase 2 thinking
Cost of quality (COQ) analysis aggregates
all the costs to the company of doing things
wrong by failing to confornl to specifica-
tions. COQ is a comprehensive financial
measure of conformance quality and can be
calculated for individual locations, indiVid-
ual business units, or the entire firm.
This framework attempts to put dollar fig-
ures on all the costs that are attributable to a
nonconforming operation. As noted earlier,
coSts that a company incurs for quality can
be grouped into the following categories:
Prevention costs. The sum of all the costs
associated with actions taken to plan the
process to ensure that defects do not
occur. Examples:
-Designing a defect-free manufactUring
process;
-Stable product deSign;
-Employee training and development;
-Quality circles;
-Preventive maintenance;
-Cost of managing supplier relations to
increase the quality of raw inputs
reccivcl.t
Appraisal custs, Those costs assotl:Jtcu
with measuring the kvd of quality
1984 1986 1988
(Thousands of Dollars)
10.000 20,000
$ 400 $
600 $ 800
800 800 400
2,400 1,600 600
BOO 400 200
$ 4,400 S 3.400 S 2,000
525,000
8"10
attained by the system (in other words,
costs associated with inspecting t6
ensure that customer requirements are
met). Examples:
-Prototype inspection and testing;
-Receiving inspection and testing:
-In-process inspection; and
-Quality audits of finished Outputs.
Incernal failure costs. Those COStS incurred
to rectify defective OUtput before it
reaches the customer. Examples:
-Scrap;
-Rework;
-Repair;
-Redesign:
-Reinspection of rework:
-Downtime due to defects; and
-Opportunity cost of lost sales caused by
having fewer units of product to selL
External failure COSlS. Those costs associ-
ated with delivering defective output to
the customer. Examples:
-Warranty adjustments;
-Investigation of defects:
-Returns:
-Recalls:'
-Liability suits: and
-Loss of customer goodwill.
It should be noted that not all quality costs
fit neatly into one or anolher of lhcse call>
gories. For example, the cost of inspecting
~ a w material might bc viewed as cithcr an
appraisal COSt (Iookin,; for tldects) or a prc-
vention coSt (prevC'l1tin,; defcctive raw
matcrials from foulill'; the prnduc(ioll
COST MANAGEMENT
process). In such cases, placing costs in one
calegory or another is somewhat arbitrary.
As long as the company classIries the costs
consistently. trends over time in the cate-
gories can provide powerful insights.
It is surprising how many
managers in the 1990s still finnly
believe in the quality cost
curve-who believe, in other words,
that "those last few defects are very
expensive to eliminate."
Exhibit 7 presents the quality costs for a
disguised manufaCturing company, ABC
Corporation. over an eight-year period.
6
Based on the experience of ABC Corpora-
tion and the quality cOSt studies completed
by other companies, the following two gen-
eral conclusions emerge.
Cost of quality is a big opportunity.
When bad quality represents such a sig-
nificant cost item (25 percent of the total
cost for ABC Corporation), quality man-
agement represents the most Significant
opportunity for improved profitability.
Firms spend quality dollars in the wrong
place. Companies spend far more on
internal and external failure cOSts than on
prevention and appraisal costS, and more
on appraisal than on prevention. This was
true for ABC Corporation in 1982. In
companies in which total quality cost is
in the range of 25 percent of sales. cate-
gory 4 is usually the largest. When total
quality cost is in the 5 percent range, cat-
egory 1 is usually the largest.
Interaction among the fOUT categories.
Spending money on prevention can result
in more than offsetting cost savings on the
other categories. Thus, it is possible to
maintain or improve quality while, at the
same time, dramatically lowering quality
costs. For ABC Corporation in Exhibit 7, as
product quality increased over the eight
years. total quality costS declined by 60 per-
14 Summer 1994
cenl. The firm achieved this by consciously
changing the mix of prevention, appraisal,
and failure costs. Prevention and appraisal
costs doubled, while internal and external
failure costs declined by over 80 percent.
The implication is that improving quality
by spending more on upstream activities
(prevention costs) is a good investment for
any organization. One rule of thumb is that -
for every dollar a firm spends on preven-
, tion, it can eventually save $10 in appraisal
and failure costs.
The impact of investing upstream can yield
benefits over several years. but there is a
time lag between expenditures on preven-
tion and the resulting decrease in failure
costs. When ABC Corporation doubled pre-
vention costS in 1984. there was no imme-
diate reduction in downstream costs. This
suggests that when changing the mix, man-
agement must be prepared to see quality
cOSts increase before they decrease.
Companies that adopt TQM should antici-
pate interactions among the four categories
of .quality costs. As ABC Corporation dou-
bled appraisal costs in 1984, the internal fail-
ure costs increased dramatically, but the
external failure costs decreased even more'
dramatically. This makes sense: The
improved inspection system caused more
defects to be detected before they reached the
customer. Management should not be sur-
prised to see repair and rework departments
exceeding their budg"ets as a result of
increased appraisal spending. Similarly, war-
ranty and customer return costs should show
a favorable trend. These trends could be
antiCipated in setting budgets during a period
in which the quality cost mix changes.
Conventional reporting a barrier to TQM.
Conventional reporting formats can be a
barrier to TQM initiatives, whereas cost of
quality reporting can help TQM. Conven-
tional reports often discourage TQM
efforts, because any additional costs
incurred in prevention appear immediately
on a manager's performance report but the
resulting benefits (e.g., a reduction in
external failure costs) are not fully quanti-
fied and are therefore not recognized.
Mtasuring tht oj QUdlity"
For ABC Corporation, a manager's perfor-
mance report in the conventional frame-
work would report the total prevention.
appraisal, and internal failure COSts. These
amounted to $800,000 in 1982 and
increased dramatically to $3.6 million in
1984. This might imply an adverse perfor-
mance, whereas COQ reporting tells a very
different story. The big gain is in external
failure cost, most of which is an oppOrtu-
nity cost that does not show up at all in
conventional reports.
One cautionary note should be offered
about quality cost reduction. Quality costs,
like many other costs, have the frustrating
. characteristic of being variable on the way
up, but fixed on the way down. That is, it is
not as easy as one might think to reduce
quality costs. We may be able to reduce the
level of defective output by 25 percent, but
that may not necessarily enable us to reduce
the rework department's work force by 25
percent. Reducing that department requires
a conscious management decision to scale
back or even eliminate the function.
Just as quality costs will not disappear right
away. neither will "'quality revenues" appear
immediately. It is not always the case that
customers are anxious to get better quality.
Many successful firms have built up, over
time, an infrastructure for dealing with the
bad quality they receive from suppliers, such
as raw material inspection systems or more
sophisticated handling equipment. Since
much of this infrastructure is a fixed cost,
such a customer may find little immediate
advantage in a supplier's higher conformance
input. In addition, a customer who uses mul-
tiple sources of supply may find no advan-
tage-indeed, there may be a disadvantage in
the short term-in receiving a higher-quality
product from one supplier. It may well be
that the industry leaders are those firms that
have best learned how to neutralize the bad
quality they are receiving, A supplier who
begins offering better quality may thus,
strangely, be betrer able to sell it to the less
successful firms that have nOl figured out
how to offset bad incoming quality.
COQ reporting. Since investments "upstream""
benefits over scvl:r;.tl years, it is oftl:n suf-
!"ident if quality reponing is done once a year.
By preparing a COQ report once a year, a firm
can maintain pressure on managers and work-
ers to "continually" improve performance
toward the ideal goal of "zero defects."
COQ measurement cannot be the sole basis
for facilitating TQM efforts, It should be
supplemented with specific and timely
feedback on nonfinancial measures of qual-
ity as welU Some examples are as follows:
Suppliers:
-Number and frequency of defective
units delivered. by each supplier: and
-Number and frequency of deliveries
not on time, by each supplier.
Product design:
-Number of parts in a product: arid
-Percentage of commC'n versus unique
parts in a product.
Production process:
-Percentage yields (good units to total
units) (this is a measure of quality at the
output stage and does not necessarily
measure the firm's efforts on prevention);
-First-pass yields (percentage of units
finished without any rework) (this
measure reflects the results of the
firm's efforts on prevention):
-Scrap;
-Rework;
-Unscheduled machine breakdowns:
-Number and duration of limes the pro-
duction and delivery schedules were
not met; and
-Number of employee suggestions.
(General Motors averages four sugges-
tions per employee per year, while
Toyota averages 61).8
Marketing:
-Number of customer complaints:
-Level of customer satisfaction (which
is measured by administering
tionnaires to customers);
-Warranty claims:
-Field service expenses; and
-Number and frequency of product
returns.
There are two major advantages with these
measures:
Most of dll'lll call hc rrpllrtnloll ;lIn1(l'>t ;\
limc basis: and
COST MANAC(MENT
Exhihit H. ThrC'f Possiblr ManagC'm(rtl AccOllnling
Rcsp{I"s i bi IiI in
Proponent
1. Deming
2. CrOSby
3. Juran
Role for
Management
Approach Accountants
Don't do quality High
costing analysis.
Just spend the
money upstream"
to do things right"
the first time.
Do a coa analysis
as a special" study
(to assess the stage 01
quality management).
Do not use this as a
management tool on an
ongoing basis. Do not
prepare periodic coa
reports.
Prepare quality costing
reports on a periodic basis
(say. once a year) as a
management control tool,
Low
Corrective actions on these measures can
be initiated almost immediately.
Thus, reporting performance on nonfinancial
measures is essential to providing continuous
feedback to managers and workers in their
pursuit of better quality. We view COQ
reporting and the related nonfinancial mea-
sures as both providing useful information.
COQ reponing provides the big picture.
whereas the nonfinancial measures give
ongoing, actionable feedback about a TQM
implementation.
Cost of quality analysis-phase 3 thinking
This concluding section of the article syn-
thesizes the several schools of thought on
measuring quality costs. They range from
belief in regular quantification and monitor-
ing of cost of quality to strict attention to
zero defects but no attention to cost mea-
surement. There are. nonetheless. several
common themes:
Poor quality costs far more than manage-
ment usually realizes.
Most firms' expenditures on quality occur
in the wrong places (I.e., they fix things
rather than doing them right the first
time).
16 Summer 1994
Spending on prevention recluces the need
for inspection and can potentially elimi-
nate internal and external failure costs.
Large cost savings or revenue opportuni-
ties exist in creating customer goodwill
by conSistently providing conforming
products and services.
For qualitypragrams to succeed, top m a n ~
agement must be committed to quality
and must accept full responsibility far it.
Conventional management accounting (i.e.,
standard costs, overhead variance analysis.
analysis of raw material price variances) is a
great barrier in implementing TQM.
Supporting TQM. There are three possible
approaches to developing and using manage-
ment accounting systems in suppart of TQM
(see Exhibit 8). These approaches roughly
correspond to the approaches of Deming.
Crosby, and Juran. A company that adopts
TQM for the first time might benefit by start
ing with Juran's approach. which calls for an
explicit quantification of quality costs (as in
the third approach in Exhibit 8). The ultimate
goal should be to make quality part of a com-
pany's culture and way of life so that quality
cost measurements ultimately become unnec'-
essary (which is the Deming approach).
Some firms that have experimented with
COQ reporting (including Texas Instru-
ments and Florida Power and Light) have
decided that formalized reporting require-
ments are not an aid to enhanced quality.
For firms just starting TQM programs, how-
ever, the benefits of formal cost reporting
are sufficiently important to warrant the
risk that the reporting may engender game
playing that would hinder quality enhance-
ment effort: this risk can be managed.
This article has summarized the strategic
cost management perspective on quality. As
a firm's quality management program devel-
ops. the approach to COQ reporting can
take several different forms. Exhibit 9 sum-
marizes four different approaches in use at
various companies today.9
Whichever approach a firm chooses, quality
is such an important strategic variable that
management accounting can no longer
ignore it. One way or another, a strategically
MtcUuring Lht "Cost of Quality"
Exhibit 9. Tltt ContTolltrship Rolt In Total Quality Managtmtnt: Four Possiblt Approachts
1. Cost of quality analysis as a regular 3. Focus on nonfinancial. "hard
agement reporting and control tool. production information to monitor TOM
Examples of this approach Include: progress with an emphasis on input mea-
The companies referenced by Joseph sures and statistical process control (SPC).
Juran (tradeoff between price of Examples of this approach include:
mance and price of nonconformance) Texas Instruments-Materials and
in his books; Controls Group; and
Formosa Plastics; and Paper Industry-Daishowa Paper
Ford Motor Company in the 1980s. Company (Japan).
Formal coa reporting as a regular control tool
applied to Ford throughout most of the 1980s
and Texas Instruments until about 1990.
According to Management Accounting in a 1991
article this approach was still being followed
then by Formosa Plastics, one of the largest
Taiwanese manufacturing firms.
2. Focus on reducing the price of nonconfor-
mance. including opportunity losses.
pies of this approach include:
Tennant Company;
Westinghouse; and
Xerox.
'-his second approach assumes that
mance" (i.e . the price of conformance, in
Crosby's terminology) will continue at a high
level and will be managed by means of budgets
and continuous improvement programs for
critical nonfinancial performance indicators.
If spending on conformance remains
tently high. the reporting focus can switch to
"nonconformance" costs (I.e . the price
formance. in Crosby's terminology), with specific
inclusion of the opportunity cost of bad quality.
The goal becomes a steady reduction in the
price of nonconformance toward zero. In 1992,
many companies with a strong TOM commitment
(e.g .. Xerox. Westinghouse, and the Tennant
Company) were following this approach.
effective management reporting system must
deal explicitly with the issue of quality. ..t..
John K.. Shank is Foundation Professor
of Accounting and Vijay
darajan is Earl C. Daum of
at Amos Tuck School of
Dartmouth Hanover, New
Notes
1. J .M. Jur:.n and Frank M. G ryna. Jr.. QUlllily P/Ilnninx and
Anu/.vsis (:-lew York: McGrawHill. HOL
2. W. Edwards Deming. Qua/il,Y. Prouu(liYil.v (HIU C"m,.I'"II'
lille PIISilio" (Cambridge. Ma!>saehU';"lls: M IT hJr
Aunnel'd Engineering Stuuy. 1<JH2).
I. rhilip O. Cwshr. Quulitv h I'ra (New Yurk: t-.kt;raw
Hill. 1'17'1)
This approach deemphasizes formal COO cost
reporting systems in favor of formal nonfinan-
cial reporting. with a heavy emphasis on
uously improving quality in operations. One
name for this is SPC. Notable examples of the
success of thiS approach are Oaishowa Paper
Company and the Materials and Controls Group
in Texas Instruments.
4. Focus on nonfinancial, Mhard
production information to monitor TOM
progress with an emphasis on output mea-
sures of conformance. Examples include:
Motorola-ACIS Division;
IBM (the MOO Program); and
Analog Devices. Inc.
This approach also deemphasizes cost report-
ing in favor of nonfinancial measures, but the
tocus here is on output measures rather than
input measures. Motorola's Six
SiQma Program for defects
in Its integrated circuits division is a good
example. IBM has announced a similar
gram for eradicating
defects, which it calls MOO for Irarket-deter-
mined quality. Analog Devices 1 is another
example of a firm whose quality reporting
emphasis is on deliveries rather
than on cost reports.
4. Philip B. Crosby. Qualit.\" Witho,,1 Uars ("t:"W York:
McGraw-HilI. 1984): 86.
5. Charles Fine. .-\ Comparali"l":
menlo in 800:: Allen .\fanujl.lctllrin): IHllt'S (St:w York:
Boo;: Alll'n. 19!:!5).
6. See James B. Simpson and D",.u l. -QU31i(\'
Cos IS: F3eililating Quality l!lillall\"l:.- J.,lJrllal,,{ ClISI
.\Ianage-m("nl (Spring I <l!:!,): 25-H.
,. See Joseph Fisher. -Csc: of ,",,,nhnano.;i:!1 Performance ....1,,3
sures.- Journu/ .. { .\/tll1l'Xl'''',,"1 (Spnn).: I 'N.! 1. 31-31:\
8. Thomas P. Eumnnus.l.\nryj Tsal". JnJ W"n\\"". Lin.
-Analy;:ing Quality C,"IS." .\I,II"I.\:(",.-n(
(:-luycmhc:r 14!:!<l): 25 2<l.
<.l. L3Wt"nee CoIrr. -Applying ellstS of QU.lhl\' hI J I.\U>I
SI,Iu" M"nugrmt'IlI Rt"V .. ... ISuI/"na 1'/lJ21 ;-.! --;7
It). Rnhen .-\. Huw':!l "I al.. -Cnst lvt.w;I/:<:menl Itlt rUII",r'
rnw S"ckillg thl" CUrI1l'ltltl\l EJ/:\ ... f, .. ,,,,, "II "'n ,,11\"'<
Rt"\eun"h Fuu'hl,u.ou ''11('' 'f" jI" I .. ,.o'"ill,\ t' .\ldilt'.t.:i"mnU
I I'll,.! I 127-1