Costs of Quality: Measurement, Reporting and Control

Costs of Quality: Measurement, Costs of Quality: Measurement, Reporting and ControlReporting and Control

Importance of QualityImportance of Quality

Costs of QualityCosts of Quality

Measuring Quality CostsMeasuring Quality Costs

Methods to identify Quality ProblemsMethods to identify Quality Problems

Reporting Quality CostsReporting Quality Costs

Relevant Costs and Benefits of Quality Relevant Costs and Benefits of Quality ImprovementImprovement


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


Quality improvement can increase Quality improvement can increase firm value because it increases a firm value because it increases a firm’s profitability by:firm’s profitability by:– Increasing customer demandIncreasing customer demand

–Decreasing the cost of providing Decreasing the cost of providing goods and servicesgoods and services

Close association between quality Close association between quality and customer satisfactionand customer satisfaction

Meaning of Quality (cont.)Meaning of Quality (cont.)

Two basic aspects of QualityTwo basic aspects of Quality– Quality of designQuality of design (how closely the (how closely the

characteristics of a product or services characteristics of a product or services meet the needs and wants of meet the needs and wants of customers)customers)

– Conformance qualityConformance quality (performance of (performance of product or service relative to its design product or service relative to its design and product specificationsand product specifications

Conformance is strongly emphasized Conformance is strongly emphasized because it is the key to meet customer because it is the key to meet customer expectationsexpectations

Meaning of QualityMeaning of QualityMeaning of QualityMeaning of Quality

– Quality as the Quality as the degree or grade of degree or grade of excellenceexcellence

– A quality product or service is one that A quality product or service is one that meets meets or exceeds customer or exceeds customer expectationsexpectations on the key attributes of on the key attributes of product performance, reliability, product performance, reliability, durability and fitness for usedurability and fitness for use

Cost of QualityCost of Quality

Costs of quality are the price of Costs of quality are the price of non non conformancesconformances

The optimal level of the cost of quality The optimal level of the cost of quality should be about should be about 2 to 4 percent of sales2 to 4 percent of sales

The difference between The difference between actual and actual and optimal levelsoptimal levels represents a rich represents a rich opportunity of improving quality, thus opportunity of improving quality, thus improving profitabilityimproving profitability

Cost of QualityCost of Quality

Costs of quality are the costs that exist Costs of quality are the costs that exist because because poor quality may or does poor quality may or does existexist..

Refers to costs incurred to prevent or Refers to costs incurred to prevent or the costs arising as a result of the costs arising as a result of producing a low-quality productproducing a low-quality product

Cost of Quality (cont.)Cost of Quality (cont.)

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

–Control activitiesControl activities –Failure activitiesFailure activities

Control activities/costsControl activities/costs

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

Control activitiesControl activities

• Control activities are made Control activities are made up of:up of:

prevention activities prevention activities

appraisal activitiesappraisal activities

Costs of QualityCosts of Quality

Four categories of quality costs:Four categories of quality costs:– Prevention costsPrevention costs (costs incurred to preclude (costs incurred to preclude

the production of products that do not conform the production of products that do not conform to specifications)to specifications)

Examples: Quality engineering, quality training Examples: Quality engineering, quality training training programs, quality planning, quality training programs, quality planning, quality reporting, supplier evaluation and selection, quality reporting, supplier evaluation and selection, quality audits, quality circles, field trials and design reviewsaudits, quality circles, field trials and design reviews

As As prevention cost increaseprevention cost increase , the , the costs of failurecosts of failure are expected to are expected to decreasedecrease

Appraisal CostsAppraisal Costs

Costs incurred to Costs incurred to detect detect which of the individual units of which of the individual units of products do not conform to specifications)products do not conform to specifications)

Main objective of appraisal function is Main objective of appraisal function is to prevent to prevent nonconforming goods from being shipped to customersnonconforming goods from being shipped to customers

Incurred to determine whether products and services Incurred to determine whether products and services are conforming to their requirements or customer needsare conforming to their requirements or customer needs

Examples: inspecting and testing materials, packaging Examples: inspecting and testing materials, packaging inspection, supervising appraisal activities, product inspection, supervising appraisal activities, product acceptance, process acceptance, measurement acceptance, process acceptance, measurement (inspection and test) equipment and outside (inspection and test) equipment and outside endorsementsendorsements

Failure activities (cont.)Failure activities (cont.)

–Failure activities are made of:Failure activities are made of:

internal activitiesinternal activities

external activitiesexternal activities

Failure Activities/CostsFailure Activities/Costs

Failure activitiesFailure activities refer to those activities refer to those activities performed by an organisation or its performed by an organisation or its customers in response to poor qualitycustomers in response to poor quality

Failure costsFailure costs are the cost incurred by an are the cost incurred by an organisation because failure activities are organisation because failure activities are performedperformed

Internal failure costsInternal failure costs

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

Incurred because products and Incurred because products and services do not conform to services do not conform to specifications or customer needsspecifications or customer needs

Detected Detected priorprior to being shipped to to being shipped to outside partiesoutside parties



– Internal failures are those that Internal failures are those that can be can be detected by appraisal activitiesdetected by appraisal activities

– Examples: scrap, rework, downtime Examples: scrap, rework, downtime (due to defects), re-inspection, (due to defects), re-inspection, retesting and design changesretesting and design changes

External failure costsExternal failure costs

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

Incurred because products and services fail to Incurred because products and services fail to conform to requirements or satisfy customer conform to requirements or satisfy customer needs after being delivered to customersneeds after being delivered to customers

The most expensive type of quality costsThe most expensive type of quality costs

Examples: costs of recalls, lost sales because Examples: costs of recalls, lost sales because of poor product performance, returns and of poor product performance, returns and allowances because of poor quality, warranties, allowances because of poor quality, warranties, repair, product liability, customer repair, product liability, customer dissatisfaction, lost market sharedissatisfaction, lost market share

Prevention costsPrevention costs Appraisal costsAppraisal costs

Systems developmentSystems developmentQuality engineeringQuality engineeringQuality trainingQuality trainingQuality circlesQuality circlesSPC activitiesSPC activitiesSupervision of prevention Supervision of prevention activitiesactivitiesQuality improvement Quality improvement projectsprojectsAudit of the effectiveness Audit of the effectiveness of the quality systemof the quality systemQuality data gathering, Quality data gathering, analysis and reportinganalysis and reportingTechnical support provided Technical support provided to suppliers to suppliers

Test and inspection of Test and inspection of incoming materials and in-incoming materials and in-process goods process goods Final product testing and Final product testing and inspectioninspectionSupplies used in testing and Supplies used in testing and inspection activitiesinspection activitiesDepreciation and Depreciation and maintenance of test maintenance of test equipmentequipmentField testing and appraisal Field testing and appraisal at customer site at customer site Plant utilities in the Plant utilities in the inspection areainspection area

Internal failureInternal failure External failureExternal failure Net cost of scrap and Net cost of scrap and spoilagespoilage

Rework labour and Rework labour and overheadoverhead

Reinspection and Reinspection and retesting of reworked retesting of reworked productsproducts

Disposal of defective Disposal of defective goodsgoods

Downtime caused by Downtime caused by quality problemsquality problems

Cost of field servicing and Cost of field servicing and handling complaintshandling complaints

Warranty repairs and Warranty repairs and replacementreplacement

Product RecallsProduct Recalls

Liability arising from Liability arising from defective productsdefective products

Returns and allowance Returns and allowance arising from quality productsarising from quality products

Lost of sales arising from a Lost of sales arising from a reputation for poor qualityreputation for poor quality


Quality costs may be classified as:Quality costs may be classified as:– ObservableObservable

(quality costs available from an (quality costs available from an organisation accounting records)organisation accounting records)

– HiddenHidden

(opportunity costs resulting from poor (opportunity costs resulting from poor quality)quality)

Usually in the Usually in the external failureexternal failure category category

Measuring costs of quality Measuring costs of quality

Multiplier methodMultiplier method– Assumes that total failure cost is some Assumes that total failure cost is some

multiple of measured failure costsmultiple of measured failure costs– Formula: Formula:

Total failure costs= k (Measured external Total failure costs= k (Measured external failure costs)failure costs)

K = multiplier effect whose value depends on K = multiplier effect whose value depends on experienceexperience


Market Research MethodMarket Research Method– Uses formal market research methods to Uses formal market research methods to

assess the effect of poor quality on sales and assess the effect of poor quality on sales and market sharemarket share

– Customer surveys and interviews with members Customer surveys and interviews with members of a firm’s sales force would provide insights into of a firm’s sales force would provide insights into the magnitude of the firm’s hidden quality coststhe magnitude of the firm’s hidden quality costs

– May use to project future profit losses May use to project future profit losses attributable to poor qualityattributable to poor quality


The Taguchi Quality loss FunctionThe Taguchi Quality loss Function– Assumes that any variation from the target value Assumes that any variation from the target value

of a quality characteristic causes hidden quality of a quality characteristic causes hidden quality costscosts

– The hidden quality costs increase quardratically The hidden quality costs increase quardratically as the actual value deviates from the target value as the actual value deviates from the target value as follows:as follows:

The Taguchi Quality loss Function The Taguchi Quality loss Function (cont.)(cont.)

L(y) = k (y –T)L(y) = k (y –T)22

Where y = actual value of quality Where y = actual value of quality characteristiccharacteristicT = Target value of quality characteristicT = Target value of quality characteristicL = Quality lossL = Quality lossK = proportionality constant dependent on K = proportionality constant dependent on the organisation’s external failure cost the organisation’s external failure cost structure that can be estimated as follows:structure that can be estimated as follows:

K = c/d K = c/d 22


Where c = Loss at the lower or upper Where c = Loss at the lower or upper specification limit specification limit

d = distance of the limit from td = distance of the limit from t (the target value) (the target value)

Total hidden quality costsTotal hidden quality costs

= L (y) x Number of units produced= L (y) x Number of units produced

The Taguchi Quality loss Function (cont.)The Taguchi Quality loss Function (cont.)

Example:Example:ABC Sdn Bhd makes components for inclusion in ABC Sdn Bhd makes components for inclusion in electronic testing equipment. Component 5A has electronic testing equipment. Component 5A has a target value of 500 grams. Specifications limits a target value of 500 grams. Specifications limits are minus or plus 10 grams. ABC’s industrial are minus or plus 10 grams. ABC’s industrial engineers have determined that losses at the engineers have determined that losses at the lower specification limit equal RM300. A sample lower specification limit equal RM300. A sample of 5 units yielded the following:of 5 units yielded the following:SampleSample Actual weightActual weight11 495 grams495 grams22 50350333 51151144 48748755 499499


Calculate the loss for each unit and average Calculate the loss for each unit and average loss for the sample of 5.loss for the sample of 5.

k = c/d2 k = c/d2

= 300/102 = 300/102

= RM3 per unit= RM3 per unit

SampleSample Actual wt (y)Actual wt (y) Y -TY -T (y-T)(y-T)22 K(y-T)K(y-T)22

11 495495 -5-5 2525 RM75RM75

22 503503 33 99 RM27RM27

33 511511 1111 121121 RM363RM363

44 487487 -13-13 169169 RM507RM507

55 499499 -1-1 11 RM3RM3

325325 RM975RM975

AverageAverage 6565 195195

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

Methods to identify Quality problemsMethods to identify Quality problems

Control chartsControl charts– Also known as Also known as statistical process controlstatistical process control (SPC) (SPC)

- A - A control chartcontrol chart is a graph of a series of is a graph of a series of successive observations of a particular successive observations of a particular step/procedure/operation taken at a regular step/procedure/operation taken at a regular intervals of timeintervals of time

– FormalFormal means of distinguishing between means of distinguishing between randomrandom and and nonrandomnonrandom variations in an variations in an operating processoperating process


– Random variationsRandom variations : power surges or chance : power surges or chance fluctuation in temperature cause defective fluctuation in temperature cause defective products to be produced in a chemical processproducts to be produced in a chemical process

– Nonrandom variationNonrandom variation occur when defective occur when defective products are produced as a result of a products are produced as a result of a systematic problem such as inaccurate systematic problem such as inaccurate temperature readingstemperature readings

Methods to identify Quality problems Methods to identify Quality problems (cont.)(cont.)

Pareto diagramsPareto diagrams– A chart that indicates how frequently each type A chart that indicates how frequently each type

of defect occurs, ordered from the most of defect occurs, ordered from the most frequent to the least frequentfrequent to the least frequent

– Helps the TQM team visualize and Helps the TQM team visualize and communicate to others what the most serious communicate to others what the most serious types of defects are. Steps can be taken to types of defects are. Steps can be taken to tackle the most serious and most frequent tackle the most serious and most frequent problems firstproblems first


Cause and Effect diagramsCause and Effect diagrams– Identifies potential causes of defectsIdentifies potential causes of defects

– Can be used to analyse the most frequently Can be used to analyse the most frequently recurring and costly problemsrecurring and costly problems

– Also known as fishbone /Ishikawa diagramsAlso known as fishbone /Ishikawa diagrams– Example: refer to Ishikawa diagram used by Example: refer to Ishikawa diagram used by

Xerox Corp. to identify the causes of errors in Xerox Corp. to identify the causes of errors in its billing processits billing process

– Identification of possible causes helps the Identification of possible causes helps the management to take systematic steps to management to take systematic steps to eliminate the root causes of the errors eliminate the root causes of the errors

Bill ing system

Cumbersome

System errors

Input requirement

Pricing actions

Employee driven

External customers

Communication

Reading an invoice

Bill ing meters

Current price information

Timeliness

Out of districtpersonnel

Communication

Training/Education

Awareness

Ownership

District personnel

Communication

Training/Education

Awareness

Ownership

Cause and effect diagram: Billing quality at Xerox Corporation

Reporting Quality CostsReporting Quality Costs

To create a quality cost reporting system, need to To create a quality cost reporting system, need to assess current actual quality costsassess current actual quality costs

A detail listing of actual quality costs by category A detail listing of actual quality costs by category can provide 2 important insights:can provide 2 important insights:– Reveals the magnitude of the quality costs in each Reveals the magnitude of the quality costs in each

category , category , allowing managers to assess their allowing managers to assess their financial impactfinancial impact

– Shows the distribution of quality costs by a category Shows the distribution of quality costs by a category allowing the managers to assess the relative allowing the managers to assess the relative importance of each categoryimportance of each category

Reporting Quality Costs (cont.)Reporting Quality Costs (cont.)

Quality Cost ReportsQuality Cost Reports– Express the quality costs as a Express the quality costs as a

percentage(%) of actual sales in order to percentage(%) of actual sales in order to assess the financial significance of quality assess the financial significance of quality costscosts

– Illustration of a Quality Cost ReportIllustration of a Quality Cost Report

ABC Sdn BhdQuality Cost Report

For the year ended June 30, 2003

CostsCosts Quality CostsQuality Costs Percentage of SalesPercentage of Sales

Prevention costs:Prevention costs:Quality trainingQuality trainingReliability engineeringReliability engineering

10,00010,00065,00065,000 75,00075,000 1.5%1.5%

Appraisal costs:Appraisal costs:Material inspectionMaterial inspectionProduct acceptanceProduct acceptanceProcess acceptanceProcess acceptance

5,0005,00020,00020,00075,00075,000 100,000100,000 2.00%2.00%

Internal failure costs:Internal failure costs:ScrapScrapReworkRework

150,000150,000100,000100,000 250,000250,000 5.00%5.00%

External failure costs:External failure costs:Customer complaintsCustomer complaintsWarrantyWarrantyReturns and allowancesReturns and allowances

150,000150,000250,000250,000175,000175,000 575,000575,000 11.50%11.50%

Total quality costsTotal quality costs 1,000,0001,000,000 20.00%20.00%

Types of Quality Performance ReportTypes of Quality Performance Report

Interim standard reportInterim standard report

Measures and reports the progress Measures and reports the progress achieve by the firm with respect to a achieve by the firm with respect to a current period std or goalcurrent period std or goal

Compares the Compares the actual quality costsactual quality costs for for the period with the the period with the budgeted costsbudgeted costs

Types of Quality Performance Report Types of Quality Performance Report (cont.)(cont.)

Multiple Period Trend reportMultiple Period Trend reportMulti period report which tracks the Multi period report which tracks the progress trend since the inception of progress trend since the inception of the quality improvement program as the quality improvement program as follows:follows:– The change in total quality costs as a The change in total quality costs as a

percentage of sales over timepercentage of sales over time– The change of the relative distribution of The change of the relative distribution of

quality costs as a percentage of sales quality costs as a percentage of sales over timeover time

Types of Quality Performance Types of Quality Performance Report (cont.)Report (cont.)

Long range reportLong range report– The long range report which tracks progress The long range report which tracks progress

with respect to long range with respect to long range standard or goal standard or goal of zero defectsof zero defects

– Compares the current period’s actual costs Compares the current period’s actual costs with the target costs and identifies the with the target costs and identifies the variancesvariances

Target costs are the costs that would be allowed Target costs are the costs that would be allowed if the zero-defects standard were met. The target if the zero-defects standard were met. The target costs are the non value added costscosts are the non value added costs

The variances are The variances are nonvalue added costsnonvalue added costs

Incentives for Quality ImprovementIncentives for Quality Improvement

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

Incentives for Quality Improvement (cont.)Incentives for Quality Improvement (cont.)

Non-monetary incentivesNon-monetary incentives also allows management also allows management to underscore its commitment to quality improvementto underscore its commitment to quality improvement

Participation helps employees internalize quality Participation helps employees internalize quality improvement goals as their own through the following improvement goals as their own through the following program:program:– Error cause identificationError cause identification (a program in which employees (a program in which employees

describe the problems that prevent them from doing their describe the problems that prevent them from doing their jobs right for the first time)jobs right for the first time)

– Error cause removal approachError cause removal approach encourages employees to encourages employees to submit quality improvement suggestions. An employee submit quality improvement suggestions. An employee submitting an entry will receive a note of appreciation from submitting an entry will receive a note of appreciation from management.management.

Incentives for Quality Improvement (cont.)Incentives for Quality Improvement (cont.)

Monetary incentivesMonetary incentives– Gainsharing provides cash incentives for Gainsharing provides cash incentives for

the entire workforce that are keyed to the entire workforce that are keyed to quality or productivity gains quality or productivity gains

– The incentive bonuses might be equal to a The incentive bonuses might be equal to a percentage of the cost savings percentage of the cost savings

– Gainsharing are entirely complementary to Gainsharing are entirely complementary to an integrated measurement system such an integrated measurement system such as Balanced Scorecardas Balanced Scorecard

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Costs of Quality: Measurement, Reporting and Control