1. BU5004 Managerial Accounting
Session 12
Quality Costs

2. BU5004 Managerial Accounting
Quality costs
Cost of quality is the difference between the actual cost of producing, selling and supporting products and services and the equivalent costs if there were no failures during production or usage
(CIMA, 2000)
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3. BU5004 Managerial Accounting
Quality costs
Quality costs are costs incurred to prevent, detect or rectify the production of poor quality products
For most businesses, quality costs are 10 to 20% of sales revenue
Reducing quality costs is an important way to improve a firm’s profitability
Also, improved product quality leads to increased sales demand and profitability
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4. Problems with traditional approach
Most firms have no way of measuring or reporting quality costs
Many quality costs are hidden in traditional accounting reports:
they are subsumed within production costs and
the emphasis is on output and decreasing unit costs
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5. BU5004 Managerial Accounting
What is quality?
The quality of a product is the degree to which it satisfies customer expectations
Customer expectations can be described by quality attributes – performance, features reliability
A quality product is one that meets or exceeds customer expectations
Quality design is the degree to which a product’s design specifications meet customer’s expectations
Production quality is the degree to which the actual product manufactured, meets its design specifications
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6. Aspects of quality Customer expectations Design specifications Actual
results
Design quality
Quality of conformance
(Production quality)
State customer expectations into quantitative functional specifications regarding capabilities of the product
Develop design specifications regarding the physical characteristics of the product
3. Develop the manufacturing specifications that specify how the product is to be produced
4. Manufacture the product using manufacturing specifications
Grade – relates to the differences in ranking between products or services that have the same functional use. For example, a 486 PC and a 386 PC have the same functional use – but the 486 PC is of higher grade due to its increased information processing speed and therefore viewed as being of higher quality.
Quality of design – is the degree to which a company’s design specifications for a product or service meet’s customers expectations for the grade chosen.
There are two determinants of ‘fitness for use’. Quality of design which refers to the degree of conformance between customer expectations for the product and the design specifications for the product. Because the design specifications derve as the satandard by which quality is measured, poor quality of design reduces the usefulness of the resulting performance measures and hinders the operation of the quality control system. Quality of conformance refers to the degree to which a given product conform to its design specifications. Only when we are sure that we have high quality of design, may we expect that increasing quality of conformance will reduce costs an give us satisfied customers. These two sources of poor quality products are illustrated above.
Quality of design is the degree to which a company’s design specifications for a product meet customer’s expectations
Quality of conformance is the degree to which the actual product that is made meets the design specifications
the quality of a product is influenced by design quality and production quality
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7. BU5004 Managerial Accounting
What are quality costs?
A product that meets or exceeds its design specifications and is free from defects is said to have high quality of conformance
Quality related activities are carried out by a firm to prevent, detect and deal with poor quality products
Preventing, detecting, and dealing with defects cause costs that are called quality costs or the cost of quality
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8. Quality cost categories
Quality costs can be broken down into 4 broad groups:
Prevention costs are costs incurred to prevent faulty products being produced
Appraisal costs are costs incurred to detect faulty products – ones not conforming to design specifications
Internal failure costs are costs incurred to correct faulty products before they are delivered to customers
External failure costs are costs incurred to correct faulty products after they are delivered to customers
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9. Examples of quality costs
Prevention costs Appraisal costs
Design reviews Inspection of raw materials
Quality engineering Process acceptance
Supplier reviews Product testing
Quality training programs Package inspection
Preventative maintenance Quality audits
Quality circles Test equipment
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10. Examples of quality costs
Internal failure costs External failure costs
Scrap Product recalls
Rework Complaint investigation
Downtime (defect related) Returns
Re-inspection Warranties
Re-testing Repairs
Design changes Lost sales
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11. BU5004 Managerial Accounting
Hidden quality costs
Hidden quality costs are ‘opportunity costs’ resulting from selling faulty products
These costs are classified as external failure costs and have to be estimated
the ‘multiplier’ method is a popular way of assessing hidden quality costs
Is a method used to estimate hidden quality costs
It assumes that total failure costs are simply some multiple of measured failure costs
Total external failure costs = k (measured external failure costs)
Where k is the multiplier effect
The value of k is based on experience
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12. BU5004 Managerial Accounting
Quality cost report
A quality cost reporting system is essential for an firm that is serious about managing quality costs and improving product quality
Senior managers need to know what quality costs are and how they are changing over time
A quality cost report provides managers with a detailed listing of quality costs by category, for a specific period
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13. Quality cost report - illustration
QC % of sales QC % of sales
Prevention costs:
Design review £40, nil
Quality training 80, ,000
120, ,
Appraisal costs:
Product inspection 20, ,000
Process acceptance 30, ,000
50, ,
Internal failure costs:
Scrap , ,000
Rework 40, ,000
70, ,
External failure costs:
Customer returns 60, ,
Total quality costs £300, ,
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14. Uses of quality cost information
A quality cost report has several uses:
it makes senior managers aware of the magnitude of quality costs and its financial impact
it helps managers identify the relative importance of quality problems faced by the firm
it helps managers to see whether the quality costs are poorly distributed
it helps managers assess the effectiveness of quality improvement programmes
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15. Distribution of quality costs
For 2007
External failure costs
20%
Internal failure costs
23.3%
Prevention costs
40%
Appraisal costs 16.7%
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16. Trend analysis - total quality cost
% of
sales 20 15 10
Total quality cost 5
Year
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17. Managing quality costs
There are two views of how quality costs ought to be managed:
Acceptable quality level view
calls for a trade-off between preventative and appraisal costs, and failure costs
permits a given number of faulty products to be produced
Zero-defects view
calls for the elimination of all failure costs
claims it is cost-beneficial to reduce faulty products to zero
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18. Acceptable quality level view
Total quality cost
Costs
Prevention and appraisal costs
The diagram highlights three important matters:
1. Insufficient investment in quality management results in high costs related to product defects
2. There is a point above which additional investment in quality management proves uneconomical
3. There is a level of product quality at which the total cost of quality is minimised – finding it should be a company’s goal!
Failure costs
100%
Percentage of output without defects
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19. Acceptable quality level view
The diagram highlights three things:
1. Insufficient investment in preventative and appraisal activities results in excessively high costs related to product defects
2. There is a point above which additional investment in preventative/ appraisal activities proves uneconomical
3. There is a level of quality at which the total quality cost is minimised – finding it should be a firm’s goal
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20. BU5004 Managerial Accounting
Zero defects view
Crosby* argues that:
we are conditioned to believe that it is all right to make defective products
it is cheaper to make it right the first time and avoid the costs of scrap and rework
though it is difficult to achieve zero defects in practice, everyone should strive to reach this goal
*Philip B Crosby-”Quality is free” (1979)
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21. BU5004 Managerial Accounting
Quality initiatives
Total quality management advocates:
‘design in’ quality
zero defects
continuous improvement
cost of quality reporting
ISO is a set of standards that provides a framework around which a quality management system can be implemented
Six Sigma (developed originally by Motorola)- is a set of practices developed to systematically improve processes by eliminating defects
Six Sigma is a set of practices originally developed by Motorola to systematically improve processes by eliminating defects.[1] A defect is defined as nonconformity of a product or service to its specifications.
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22. BU5004 Managerial Accounting
Performance measures
The four quality costs may be used as financial performance measures
Non financial measures of customer satisfaction include:
number of customer complaints
number of faulty products delivered to customers
Non financial measures of internal performance include
process yield
number of faulty products for each line
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23. BU5004 Managerial Accounting
ABM and quality costs
ABM classifies activities as value and non value added - the same can be applied to quality related activities
Failure activities are classified as non value added – eliminate these
Prevention activities are classed as value added – perform these efficiently
Appraisal costs can be reduced
Appraisal and failure activities are non value-added and should be eliminated. Prevention activities are value added; need to be performed efficiently.
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24. BU5004 Managerial Accounting
Quality costs
Recommended reading:- No set text-but Phil Crosby has written widely on this subject:- Philip B Crosby-”Quality is free” (1979)
BU5004 Managerial Accounting