Quality Costs and Productivity: Measurement, Reporting, and Control CHAPTER Quality Costs and Productivity: Measurement, Reporting, and Control

After studying this chapter, you should be able to: Objectives 1. Identify and describe the four types of quality costs. 2. Prepare a quality cost report and explain the difference between the conventional view of acceptable quality level and the view espoused by total quality control. 3. Tell why quality cost information is needed and how it is used. 4. Explain what productivity is, and calculate the impact of productive changes on profits. After studying this chapter, you should be able to:

Quality Defined A quality product or service is one that meets or exceeds customer expectations...

Quality Defined … on the following eight dimensions: Performance Aesthetics Serviceability Features Reliability Durability Quality of conformance Fitness for use

Quality Defined … on the following eight dimensions: Performance How consistently and well a product functions Performance Aesthetics Serviceability Features Reliability Durability Quality of conformance Fitness for use The appearance of tangible products (style, beauty) Measures the ease of maintaining and/or repairing the product Characteristics of a product that differentiate functionally similar products The probability that the product or service will perform its intended function for a specified length of time

Quality Defined … on the following eight dimensions: Performance The length of time a product functions Performance Aesthetics Serviceability Features Reliability Durability Quality of conformance Fitness for use A measure of how a product meets its specifications The suitability of the product for carrying out its advertised functions

A defective product is one that does not conform to specifications. Quality Defined A defective product is one that does not conform to specifications.

Zero defects means that all products conform to specifications. Quality Defined Zero defects means that all products conform to specifications.

Quality Defined The definition of quality-related activities imply four categories of quality costs: Incurred to prevent poor quality or services being produced Incurred to determine whether products and services conform to requirements Preventive costs Appraisal costs Internal failure costs External failure costs Incurred when products and services do not conform to specifications Incurred when products and services fail to conform to requirements after being delivered

Examples of Quality Costs Prevention costs Quality engineering Quality training programs Quality planning Quality reporting Supplier evaluation and selection Quality audits Quality circles Field trials Design reviews

Examples of Quality Costs Appraisal Costs Inspection of raw materials Testing of raw materials Packaging inspection Supervising appraisal Product acceptance Process acceptance Inspection of equipment Testing equipment Outside endorsements

Examples of Quality Costs Internal failure costs Scrap Rework Downtime (defect related) Reinspection Retesting Design changes

Examples of Quality Costs External failure costs Cost of recalls Lost sales Returns/allowances Warranties Repairs Product liability Customer dissatisfaction Lost market share Complaint adjustment

Measuring Quality Costs Hidden Quality Costs are opportunity costs resulting from poor quality. The Multiplier Method The Market Research Method Taguchi Quality Loss Function

The Multiplier Method The multiplier method assumes that the total failure cost is simply some multiple of measured failure costs: Total external failure cost = k(Measured external failure costs) where k is the multiplier effect If k = 4, and the measured external failure costs are $2 million, then the actual external failure costs are estimated to be $8 million.

The Market Research Method The 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 company’s sales force can provide significant insight into the magnitude of a company’s hidden costs. Market research results can be used to project future profit losses attributable to poor quality.

The Taguchi Quality Loss Function The Taguchi loss function assumes any variation from the target value of a quality characteristic causes hidden quality costs. Furthermore, the hidden quality costs increase quadratically as the actual value deviates from the target value.

The Taguchi Quality Loss Function $ Cost Lower Specification Limit Upper Specification Limit Target Value

The Taguchi Quality Loss Function L(y) = k(y – T)² k = A proportionately constant dependent upon the organization’s external failure cost structure y = Actual value of quality characteristic T = Target value of quality characteristic L = Quality loss

Quality Cost Report Unit Actual Diameter (y) y-T (y –T)² k(y-T)² 1 9.9 -0.10 0.010 $ 4.00 2 10.1 0.10 0.010 4.00 3 10.2 0.20 0.040 16.00 4 9.8 -0.20 0.040 16.00 Total 0.100 $40.00 Average 0.025 $10.00

For the Year Ended March 31, 2004 Image Products Quality Cost Report For the Year Ended March 31, 2004 11-22 Quality Costs % of Sales Prevention costs: Quality training $35,000 Reliability engineering 80,000 $115,000 4.11 % Appraisal costs: Materials inspection $20,000 Product acceptance 10,000 Process acceptance 38,000 68,000 2.43 Internal failure costs: Scrap $50,000 Rework 35,000 85,000 3.04 External failure costs: Customer complaints $25,000 Warranty 25,000 Repair 15,000 65,000 2.32 Total quality costs $333,000 11.90 %

Relative Distribution of Quality Costs External Failure (19.5%) Prevention (34.5%) Internal Failure (25.6%) Appraisal (20.4%)

Quality Cost Graph Total Quality Costs Cost Failure Costs AOL Control Costs 100% Percent Defects

Contemporary Quality Cost Graph Total Quality Costs Failure Costs Control Costs 100% Percent Defects

Trend Analysis Assume the following data: Quality Costs Actual Sales % of Sales 2000 $440,000 $2,200,000 20.0% 2001 423,000 2,350,000 18.0 2002 412,500 2,750,000 15.0 2003 392,000 2,800,000 14.0 2004 280,000 2,800,000 10.0

Multiple-Period Trend Graph: Total Quality Costs % of Sales 20 15 10 5 0 1 2 3 4 5 Year

Multiple-Trend Analysis for Individual Quality Costs Assume the following quality cost data: Internal External Prevention Appraisal Failure Failure 2000 2.0%1 2.0% 6.0% 10.0 % 2001 3.0 2.4 4.0 8.6 2002 3.0 3.0 3.0 6.0 2003 4.0 3.0 2,5 4.5 2004 4.1 2.4 2.0 1.5 1Expressed as a % of sales

Multiple-Period Trend Graphic: Individual Quality Cost Categories Percentage of Sales 10 9 8 7 6 5 4 3 2 1 Prevention Appraisal Internal failure External failure 0 1 2 3 4 Year

Productivity: Measurement and Control Productivity is concerned with producing output efficiently, and is it specifically addresses the relationship of output and the inputs used to produce the outputs.

Productivity: Measurement and Control Total productive efficiency is the point at which two conditions are satisfied: 1. for any mix of inputs that will produce a given output, no more of any one input is used than necessary to produce the output 2. given the mixes that satisfy the first condition, the least costly mix is chosen.

Technical Efficiency Technical Efficiency is the condition where no more of any one input is used than necessary to produce a given output. Technical efficiency improvement is when less inputs are used to produce the same output or more output are produced using the same input. Current productivity Inputs: Labor Capital 4 Outputs: 6

3 6 4 8 Technical Efficiency Same Output, Fewer Inputs Inputs: Labor Capital 3 Outputs: 6 More Output, Same Inputs Inputs: Labor Capital 4 Outputs: 8

3 8 3 8 Technical Efficiency More Output, Fewer Inputs Inputs: Labor Capital 3 Outputs: 8 Technically Efficient Combination I: Inputs: Labor Capital $20,000,000 3 Outputs: 8

2 8 Technical Efficiency Technically Efficient Combination II: Inputs: Labor Capital $25,000,000 2 Outputs: 8 Of the two combinations that produce the same output, the least costly combination would be chosen.

Partial Productivity Measurement Partial Productivity Measurement: Measuring productivity for one input at a time. Partial Measure = Output/Input Operational Productivity Measure: Partial measure where both input and output are expressed in physical terms. Financial Productivity Measure: Partial measure where both input and output are expressed in dollars.

Profile measurement provides a series or a vector of separate and distinct partial operational measures.

Profile Productivity Measures Example 1: The productivity of both labor labor and materials moves in the same direction: 2003 2004 Number of motors produced 120,000 150,000 Labor hours used 40,000 37,500 Materials used (lbs.) 1,200,000 1,428,571 150,000/37,500 150,000/1,428,571 Partial Productivity Ratios 2003 Profile 2004 Profile Labor productivity ratio 3.000 4.000 Material productivity ratio 0.100 0.105

Profile Productivity Measures Example 2: Assume the same data as Example 1 except the material used is 1,700,000 pounds. 2003 2004 Number of motors produced 120,000 150,000 Labor hours used 40,000 37,500 Materials used (lbs.) 1,200,000 1,700,000 150,000/37,500 150,000/1,700,000 Partial Productivity Ratios 2003 Profile 2004 Profile Labor productivity ratio 3.000 4.000 Material productivity ratio 0.100 0.088

Profit-Linked Productivity Measurement Profit-Linkage Rule: For the current period, calculate the cost of the inputs that would have been used in the absence of any productivity change, and compare this cost with the cost of the inputs actually used. The difference in costs is the amount by which profits changed because of productivity changes. To compute the inputs that would have been used (PQ), use the following formula: PQ = Current Output/Base-Period Productivity Ratio

Profit-Linked Productivity Measurement Example: Kunkul provided the following data: 2003 2004 Number of motors produced 120,000 150,000 Labor hours used 40,000 37,500 Materials used (lbs.) 1,200,000 1,700,000 Unit selling price (motors) $50 $48 Wages per labor hour $11 $12 Cost per pound of material $2 $3

Profit-Linked Productivity Measurement PQ (labor) = 150,000/3 = 50,000 hrs. PQ (materials) = 150,000/0.100 = 1,500,000 lbs. Cost of labor: (50,000 x $12) $ 600,000 Cost of materials: (1,500,000 x $3) 4,500,000 Total PQ cost $5,100,000 Cost of labor: (37,500 x $12) $ 450,000 Cost of materials: (1,700,000 x $3) 5,100,000 Total current cost $5,550,000 The actual cost of inputs:

Profit-Linked Productivity Measurement Profit-linked effect = Total PQ cost - Total current cost = $5,100,000 – $5,550,000 = $450,000 decrease in profits The net effect of the process change was unfavorable. Profits declined $450,000 because of productivity changes.

Price-Recovery Component The difference between the total profit change and the profit-linked productivity change is called the price-recovery component. 2004 2003 Difference Revenues $7,200,000 $6,000,000 $ 1,200,000 Cost of inputs 5,550,000 2,840,000 2,710,000 Profit $1,650,000 $3,160,000 $-1,510,000 Price recovery = Profit change – Profit-linked productivity change = $1,510,000 – $450,000 = $1,060,000

Chapter Eleven The End