iProtect produces covers for all makes and models of iPads.

iProtect sells 1,500,000 units each

year at a price of $30 per unit and a contribution margin of 35%. 
A survey of iProtect’s customers over the past 12 months indicates that customers were
very satisfied with the products but a disturbing number of customers were disappointed because
the products they purchased did not fit their iPads properly. They then had to hassle with returns
and replacements.
iProtect’s managers want to modify their production processes to develop products that more
closely match their specifications because the quality control currently in place to prevent ill-
fitting products from reaching customers is not working very well.
The current COQ are as follows:

Prevention costs $350,000

Appraisal costs $200,000
Internal failure costs
  Rework $475,000
  Scrap $100,000
External failure costs
  Product replacements $450,000
  Lost sales from customer $700,000
returns

The controller and Quality Control manager have determined that the following additional costs
will be required to modify the production process.
CAD Design improvement:  $110,000
Calibration improvement to match specifications:  $220,000

Required:
1. Which cost of quality category are managers focusing on? Why?
2. If the improvements result in a 50% decrease in customer replacement cost and a 50% decrease
in customer returns, what is the impact on the overall COQ and the company’s operating
income? What should iProtect do? Explain.
3. Calculate prevention, appraisal, internal failure, and external failure costs as a percentage of total
quality costs and as a percentage of sales before and after the change in the production process.
Comment briefly on your results.

SOLUTION

(25 min.) Costs of quality, quality improvements.

1. iProtect’s managers plan to increase spending on the design improvement of CAD, which
shall improve machine calibrations to achieve product specifications. These are prevention
activities. iProtect’s managers plan to increase prevention costs to improve quality. This is
consistent with the majority of research on quality. Preventing defects from occurring in the
first place generally gives the best cost-to-benefit gains from quality improvement.
2. Cost of making quality improvements = $110,000 + $220,000 = $330,000
Benefits of quality improvements:
(1)  50% decrease in lost sales from customer returns = 50% × $700,000 = $350,000
       Increase in contribution margin = Contribution margin % × Increase in sales
      = 35% × $350,000 = $122,500
(2)  50% decrease in customer replacement costs = 50% × $450,000 = $225,000
Total benefit = $122,500 + $225,000 = $347,500
The benefits of making the quality improvements exceed the costs by $ 17,500
($347,500 – $330,000), so iProtect should implement the changes to improve quality. 

3. The following table shows the actual COQ at iProtect, as a percentage of total COQ, and
as a percentage of revenues, before the change in the production process. Note that sales
revenues = $30 × 1,500,000 units = $45,000,000.