Costs of Quality: Measurement,

Reporting and Control

Importance of Quality
Costs of Quality
Measuring Quality Costs
Methods to identify Quality Problems
Reporting Quality Costs
Relevant Costs and Benefits of Quality
Improvement

Importance of Quality
Quality as a competitive tool
(improving quality can improve their
financial and competitive position)
Research has shown that there is a
positive correlation between quality
and firm value

Importance of Quality
Quality improvement can increase
firm value because it increases a
firms profitability by:
Increasing customer demand
Decreasing the cost of providing
goods and services
Close association between quality
and customer satisfaction

Meaning of Quality (cont.)

Two basic aspects of Quality
Quality of design (how closely the
characteristics of a product or services
meet the needs and wants of
customers)
Conformance quality (performance of
product or service relative to its design
and product specifications
Conformance is strongly emphasized
because it is the key to meet customer
expectations

Meaning of Quality
Meaning of Quality
Quality as the degree or grade of
excellence
A quality product or service is one that
meets or exceeds customer
expectations on the key attributes of
product performance, reliability,
durability and fitness for use

Cost of Quality
Costs of quality are the price of non
conformances
The optimal level of the cost of quality
should be about 2 to 4 percent of sales
The difference between actual and
optimal levels represents a rich
opportunity of improving quality, thus
improving profitability

Cost of Quality
Costs of quality are the costs that exist
because poor quality may or does
exist.
Refers to costs incurred to prevent or
the costs arising as a result of
producing a low-quality product

Cost of Quality (cont.)

Quality costs are associated with 2
sub categories of quality related
activities:
Control activities
Failure activities

Control activities/costs
Control costs are the costs of
performing control activities.

Control activities
Control activities are made
up of:
prevention activities
appraisal activities

Costs of Quality
Four categories of quality costs:
Prevention costs (costs incurred to preclude
the production of products that do not conform
to specifications)
Examples: Quality engineering, quality training
training programs, quality planning, quality
reporting, supplier evaluation and selection, quality
audits, quality circles, field trials and design reviews
As prevention cost increase , the costs of failure
are expected to decrease

Appraisal Costs
Costs incurred to detect which of the individual units of
products do not conform to specifications)
Main objective of appraisal function is to prevent
nonconforming goods from being shipped to customers
Incurred to determine whether products and services
are conforming to their requirements or customer needs
Examples: inspecting and testing materials, packaging
inspection, supervising appraisal activities, product
acceptance, process acceptance, measurement
(inspection and test) equipment and outside
endorsements

Failure activities (cont.)

Failure activities are made of:
internal activities
external activities

Failure Activities/Costs
Failure activities refer to those activities
performed by an organisation or its
customers in response to poor quality
Failure costs are the cost incurred by an
organisation because failure activities are
performed

Internal failure costs

Costs incurred on a defective product
before it is shipped to customers)

Incurred because products and

services do not conform to
specifications or customer needs
Detected prior to being shipped to
outside parties

Internal failure costs

Internal failure costs
Internal failures are those that can be
detected by appraisal activities
Examples: scrap, rework, downtime
(due to defects), re-inspection,
retesting and design changes

External failure costs

Costs incurred on a defective product after it is shipped
to customers)

Incurred because products and services fail to

conform to requirements or satisfy customer
needs after being delivered to customers
The most expensive type of quality costs
Examples: costs of recalls, lost sales because
of poor product performance, returns and
allowances because of poor quality, warranties,
repair, product liability, customer
dissatisfaction, lost market share

Prevention costs

Appraisal costs

Systems development
Quality engineering
Quality training
Quality circles
SPC activities
Supervision of prevention
activities
Quality improvement
projects
Audit of the effectiveness
of the quality system
Quality data gathering,
analysis and reporting
Technical support provided
to suppliers

Test and inspection of

incoming materials and inprocess goods
Final product testing and
inspection
Supplies used in testing and
inspection activities
Depreciation and
maintenance of test
equipment
Field testing and appraisal
at customer site
Plant utilities in the
inspection area

Internal failure
Net cost of scrap and
spoilage
Rework labour and
overhead
Reinspection and
retesting of reworked
products
Disposal of defective
goods
Downtime caused by
quality problems

External failure
Cost of field servicing and
handling complaints
Warranty repairs and
replacement
Product Recalls
Liability arising from
defective products
Returns and allowance
arising from quality products
Lost of sales arising from a
reputation for poor quality

Measuring Quality Costs

Quality costs may be classified as:
Observable
(quality costs available from an
organisation accounting records)
Hidden
(opportunity costs resulting from poor
quality)
Usually in the external failure category

Measuring costs of quality

Multiplier method
Assumes that total failure cost is some
multiple of measured failure costs
Formula:
Total failure costs= k (Measured external
failure costs)
K = multiplier effect whose value depends on
experience

Measuring Quality Costs

Market Research Method
Uses formal market research methods to
assess the effect of poor quality on sales and
market share
Customer surveys and interviews with members
of a firms sales force would provide insights into
the magnitude of the firms hidden quality costs
May use to project future profit losses
attributable to poor quality

Measuring Quality Costs

The Taguchi Quality loss Function
Assumes that any variation from the target value
of a quality characteristic causes hidden quality
costs
The hidden quality costs increase quardratically
as the actual value deviates from the target value
as follows:

The Taguchi Quality loss Function

(cont.)
L(y) = k (y T)2
Where y = actual value of quality
characteristic
T = Target value of quality characteristic
L = Quality loss
K = proportionality constant dependent on
the organisations external failure cost
structure that can be estimated as follows:
K = c/d 2

The Taguchi Quality loss Function

(cont.)
Where c = Loss at the lower or upper
specification limit
d = distance of the limit from t
(the target value)
Total hidden quality costs
= L (y) x Number of units produced

The Taguchi Quality loss Function (cont.)

Example:
ABC Sdn Bhd makes components for inclusion in
electronic testing equipment. Component 5A has
a target value of 500 grams. Specifications limits
are minus or plus 10 grams. ABCs industrial
engineers have determined that losses at the
lower specification limit equal RM300. A sample
of 5 units yielded the following:
Sample
Actual weight
1
495 grams
2
503
3
511
4
487
5
499

The Taguchi Quality loss Function

(cont.)
Calculate the loss for each unit and average
loss for the sample of 5.
k = c/d2
= 300/102
= RM3 per unit

Sample

Actual wt (y)

Y -T

(y-T)2

K(y-T)2

495

-5

25

RM75

503

RM27

511

11

121

RM363

487

-13

169

RM507

499

-1

RM3

325

RM975

65

195

Average

Total hidden quality cost = 195 x 2,500 = RM487,500

Methods to identify Quality problems

Control charts
Also known as statistical process control (SPC)
- A control chart is a graph of a series of
successive observations of a particular
step/procedure/operation taken at a regular
intervals of time
Formal means of distinguishing between
random and nonrandom variations in an
operating process

Methods to identify Quality problems

Random variations : power surges or chance
fluctuation in temperature cause defective
products to be produced in a chemical process
Nonrandom variation occur when defective
products are produced as a result of a
systematic problem such as inaccurate
temperature readings

Methods to identify Quality problems

(cont.)
Pareto diagrams
A chart that indicates how frequently each type
of defect occurs, ordered from the most
frequent to the least frequent
Helps the TQM team visualize and
communicate to others what the most serious
types of defects are. Steps can be taken to
tackle the most serious and most frequent
problems first

Methods to identify Quality problems

Cause and Effect diagrams
Identifies potential causes of defects
Can be used to analyse the most frequently
recurring and costly problems
Also known as fishbone /Ishikawa diagrams
Example: refer to Ishikawa diagram used by
Xerox Corp. to identify the causes of errors in
its billing process
Identification of possible causes helps the
management to take systematic steps to
eliminate the root causes of the errors

External
customers

Billing system

Communication

Cumbersome
System errors

Reading an
invoice
Billing meters

Input requirement

Current price
information

Pricing
actions
Employee
driven

Timeliness

Ownership

Ownership

Awareness
Awareness
Training/Education
Training/Education
Communication
Communication
Out of district
personnel

District
personnel

Cause and effect diagram: Billing quality at Xerox Corporation

Reporting Quality Costs

To create a quality cost reporting system, need to
assess current actual quality costs
A detail listing of actual quality costs by category
can provide 2 important insights:
Reveals the magnitude of the quality costs in each
category , allowing managers to assess their
financial impact
Shows the distribution of quality costs by a category
allowing the managers to assess the relative
importance of each category

Reporting Quality Costs (cont.)

Quality Cost Reports
Express the quality costs as a
percentage(%) of actual sales in order to
assess the financial significance of quality
costs
Illustration of a Quality Cost Report

ABC Sdn Bhd

Quality Cost Report
For the year ended June 30, 2003

Costs

Quality Costs

Percentage of Sales

Prevention costs:
Quality training
Reliability engineering

10,000
65,000

75,000

1.5%

Appraisal costs:
Material inspection
Product acceptance
Process acceptance

5,000
20,000
75,000

100,000

2.00%

Internal failure costs:

Scrap
Rework

150,000
100,000

250,000

5.00%

150,000
250,000
175,000

575,000

11.50%

1,000,000

20.00%

External failure costs:

Customer complaints
Warranty
Returns and allowances
Total quality costs

Types of Quality Performance Report

Interim standard report
Measures and reports the progress
achieve by the firm with respect to a
current period std or goal
Compares the actual quality costs for
the period with the budgeted costs

Types of Quality Performance Report

(cont.)
Multiple Period Trend report
Multi period report which tracks the
progress trend since the inception of
the quality improvement program as
follows:
The change in total quality costs as a
percentage of sales over time
The change of the relative distribution of
quality costs as a percentage of sales
over time

Types of Quality Performance

Report (cont.)
Long range report
The long range report which tracks progress
with respect to long range standard or goal
of zero defects
Compares the current periods actual costs
with the target costs and identifies the
variances
Target costs are the costs that would be allowed
if the zero-defects standard were met. The target
costs are the non value added costs
The variances are nonvalue added costs

Incentives for Quality Improvement

Should provide both monetary and nonmonetary recognition for significant
contributions to quality improvement as
follows:
Non monetary incentives such as nonfinancial awards and public recognition for
outstanding performance are useful because
they create greater employee job satisfaction
and further commitment to quality

Incentives for Quality Improvement (cont.)

Non-monetary incentives also allows management
to underscore its commitment to quality improvement
Participation helps employees internalize quality
improvement goals as their own through the following
program:
Error cause identification (a program in which employees
describe the problems that prevent them from doing their
jobs right for the first time)
Error cause removal approach encourages employees to
submit quality improvement suggestions. An employee
submitting an entry will receive a note of appreciation from
management.

Incentives for Quality Improvement (cont.)

Monetary incentives
Gainsharing provides cash incentives for
the entire workforce that are keyed to
quality or productivity gains
The incentive bonuses might be equal to a
percentage of the cost savings
Gainsharing are entirely complementary to
an integrated measurement system such
as Balanced Scorecard