Lesson 3

COSTS OF QUALITY

Instructor: Assoc. Prof. Dr. Do Thi Dong

 OVERVIEW

- Definitions and categoriration of quality costs

- The traditional cost of quality model
- The emerging cost of quality model
- Uses of quality costs
Readings
- S.Thomas Foster (2013), Managing quality: Intergrating the supply
chain, Prentice Hall, Chapter 4- Strategic Quality Planning
- Barrie G. Dale, Managing quality, 2003, Chapter 9- Quality costing

Questions
- What are costs of quality?
- Why does a company need to measure costs of quality?
- How to classify costs of quality?
- Describe the difference between external and internal failure costs. Is
one cost more important than the other? Explain your answer.
- Describe the difference between traditional and emerging cost of
quality models?
Definitions and categorization of quality costs
DEFINITIONS AND CATEGORIRATION OF
QUALITY COSTS

Quality-Related Costs are large.

- They can exceed 20% of the sales in manufacturing

companies and 35% of the sales in service organizations.
- 95 percent of this cost is expended on appraisal and failure.
- These expenditures add little to the value of product or
service and substantial portion of them is avoidable.
- Unnecessary and avoidable costs make goods and services
more expensive. This in turn affects customer satisfaction,
market share and profit.
DEFINITIONS AND CATEGORIRATION OF
QUALITY COSTS

Why do we need to measure cost of quality (COQ)?

- Organizations communicate results in monetary terms-
the language senior managers know best.
- They want to judge the overall impact of quality on
their area of responsibility and to determine whether this
has an effect on the total financial performance of the
organization.
- One of the strongest attributes of COQ is its ability to
stimulate awareness and generate interest in a quality
program.
DEFINITIONS AND CATEGORIRATION OF
QUALITY COSTS

Why do we need to measure cost of quality (COQ)?

- COQ offers managers a financial method to evaluate
the level of their quality and costs associated with
different levels of quality.
- Obsession with quality does not guarantee success.
Managers can not just spend for the sake of quality. It
requires managers to realize the quality cost savings
from the market.
 DEFINITIONS AND CATEGORIRATION OF
QUALITY COSTS
Definition of quality costs
Traditional view
Quality costs are costs
incurred to ensure that the
manufactured products or
delivered services conform to
specifications and those
associated with failures due
to products or services’ non-
conformance to
specifications.
Definition of quality costs
Modern view
Quality costs are costs
incurred to ensure that the
manufactured products or
delivered services conform to
customer’s requirements
and those associated with
failures due to products or
services’ non- conformance
to customer’s requirements.
 DEFINITIONS AND CATEGORIRATION OF
QUALITY COSTS

Categorirations of quality costs

Prevention costs

Conformance costs

Appraisal costs
Quality costs
Internal failure
costs
Non- conformance costs
(Failure costs)
External failure
costs
 DEFINITIONS AND CATEGORIRATION OF
QUALITY COSTS

Definitions of quality costs

Conformance costs incurred to ensure that the manufactured
products or delivered services conform to specifications/
customer’s requirements.
Non conformance costs (failure costs) associated with
products or services those do not conform to specifications/
customer’s requirements.
 DEFINITIONS AND CATEGORIRATION OF
QUALITY COSTS

Definitions of quality costs

Conformance costs are of two types:

Prevention cost associated with activities designed to

prevent defects from being made.

Appraisal cost associated with the evaluation of already

completed output and auditing to measure all functions’
conformance to established criteria and procedures.
DEFINITIONS AND CATEGORIRATION OF
QUALITY COSTS

Definitions of quality costs

Prevention costs include the direct and indirect costs
related to:
- Quality training and education,
- Pilot studies, new product reviews.
- Quality circles, quality engineering, quality audits,
- Supplier capability surveys, vendor technical support,
process capability analysis.
 DEFINITIONS AND CATEGORIRATION OF
QUALITY COSTS

Definitions of quality costs

Appraisal costs include the cost of inspection, test or audit
of
- purchases,
- manufacturing or process operations, and
- finished goods or services.
 DEFINITIONS AND CATEGORIRATION OF
QUALITY COSTS

Definitions of quality costs

Non conformance costs consists of two types:
- Internal failures: costs incurred prior to the delivery of
products or services. These costs are associated with defects
found prior to customer delivery.
- External failures: costs of discovered defects occurring
after product shipment or service delivery.
 DEFINITIONS AND CATEGORIRATION OF
QUALITY COSTS

Definitions of quality costs

Internal failures costs include costs of
- scrap, spoilage, rework and overhead,
- failure analysis,
- supplier rework and scrap, re-inspection and re-test,
- down time due to quality problem,
- product downgrades.
 DEFINITIONS AND CATEGORIRATION OF
QUALITY COSTS

Definitions of quality costs

External failure costs include:
- warranty charges,
- customer complaint adjustments,
- returned merchandise,
- product recalls, allowances and product liability.
External failures also include direct and indirect costs such as
labor and travel associated with the investigation of customer
complaints, warranty field inspection, tests and repairs.
The traditional cost of quality model
THE TRADITIONAL QUALITY COST MODEL

Total
quality costs
Cost per production unit

Non conformity costs

Prevention +
Appraisal costs

100% 100%
Conformity quality
Defective Good

The traditional quality costs model

 THE TRADITIONAL QUALITY COST MODEL

- The model suggests that a relationship exists between

conformance and nonconformance quality costs with a
minimal total quality cost at the optimal balance.
- Implicitly indicating the tradeoff of conformance costs
for nonconformance costs to achieve the lowest total
quality cost.
 THE TRADITIONAL QUALITY COST MODEL

- Using this model a company can monitor the amount of

quality costs tradeoff over time.

The company with poor quality can reduce total cost of

quality by spending on relatively inexpensive preventive
and appraisal measures. At a certain point, however, the
additional costs will only increase total quality costs.
The emerging cost of quality model
THE EMERGING COST OF QUALITY MODEL

Total quality cost

cost per production unit

non-conformance cost

cost of appraisal
plus prevention

100% 100%
quality of conformance, %
defective good
 THE EMERGING COST OF QUALITY MODEL

The emerging COQ model recognizes that:

- Total quality costs include indirect and intangible
costs.
- These costs are not minimized at less than 100 percent
conformance. Because of the multiplier effect of
perceived quality deficiencies intangible failure cost
may linger even though the actual conformance
deficiencies has been put to an end.
- Optimization is a moving target owing to technology
breakthroughs, learning factors and competitive
pressures.
 THE EMERGING COST OF QUALITY MODEL

The emerging COQ model recognizes that:

- Minimizing quality loss acknowledges the multiplier effect
of intangible failure costs and recognizes the need to sustain
the quality improvement effort beyond the minimization of
out-of-pocket costs.

- The emerging model thus ignores the traditional trade-off

concept. Rather this approach is to plot the behaviour of the
various COQ categories
Uses of quality costs
 USES OF QUALITY COSTS

Setting up a Quality Costing System

- Involve accountants right from the outset to establish

the level of detail and the association of activities to cost
categories
- Clarify the purpose of quality costing at the start to
determine the strategy of the exercise and avoid
difficulties later
 USES OF QUALITY COSTS
Setting up a Quality Costing System
- Examine the potential for change of a cost element in
both absolute and relative terms.
The inclusion of fixed or immutable costs carries little
or no value while reducing the sensitivity of costs to
performance changes

- The key to producing the COQ report is the effort

made to ensure that the Costs of quality are properly
captures. Often, these issues must be resolved:
 USES OF QUALITY COSTS

Setting up a Quality Costing System

- Appraisal and internal failure costs are often quite
straightforward, problem often arises with the cost related to
external failure and prevention.
- These issues need to be discussed among quality, purchasing,
engineering, production and accountancy personnel to reach
agreement before the COQ data are collected.
- With the assistance of the accounting department, the relationship
between the regular cost structure categories and the cost of quality
categories can be mapped through the accounting general ledger.
 USES OF QUALITY COSTS

COQ cost elements

Company Prevention Appraisal Failure (I &E)
function
Development Design review Prototype Re-design
Inspection Scrap
Design test
Purchasing Supplier assessment Product inspection Corrective action on
Supplier inspection supplier failures
Parts rejection
Production Quality team training Work in process Rework
Quality process audit inspection Scrap
Sales Sales team quality Order entry inspection Re-shipment due to
Training shipping error
Orders Reprocessing
 USES OF QUALITY COSTS
Analysis and use of COQ information
- Attribute costs to department, defect type, product, cause,
supplier, etc. Identify responsibility for costs with function
and people.
- Rank problems and cost reduction projects by size and
importance.
- Quality cost bases such as labour, production, sales and
units.
+ Labour: quality costs per hour of direct labour or quality
cost per dollar of direct labour
+ Production: Quality costs per dollar of production cost
+ Sales: Quality cost per dollar of net sales
+ Unit: Quality cost per unit
 USES OF QUALITY COSTS
Analysis and use of COQ information
- Various ratios can be used.
- Typical ratios:
+ Operations failure costs as percent of production costs
+ Purchasing quality costs as a percent of materials costs
+ Designing quality costs as a percent of design costs
- The most common techniques for quality costs analysis are
Trend and Pareto.
 USES OF QUALITY COSTS
Analysis and use of COQ information

Trend analysis
- involves comparing present cost levels to past cost level
- provides information for long-range planning, for the instigation
and assessment of quality management programs
- can be accomplished by cost category, sub-category, by product,
measurement base, by plants, etc.

Pareto analysis
- by operator, machine, department, product line, category, etc..
- once the vital few are known, projects can be developed to reduce
their quality costs
 USES OF QUALITY COSTS

Use Quality costs:

- as catalyst, driving people into action for quality seriously
- to set priority, highlight for managers the areas in which
investment will have the greatest effect.
- as an indication of how a company spends its quality
dollars.

Useful information can be gained by comparing the

subtotal of the various cost-of quality categories.
 USES OF QUALITY COSTS
Limitations to costs of quality:
- Knowing the cost does not provide any hint to specific
action.
- COQ calculations may not capture all the cost.
- Garvin emphasizes involuntary costs arising whenever
customers choose alternative suppliers due to actual or
perceived quality deficiencies.
- Quality costs are subject to judgment and estimation.
- Many investments in quality are long-term whereas COQ
has a tendency to be short-term.
 Key terms
- Conformance cost
- Non- conformance cost
- Appraisal cost
- Failure cost
- External failure cost
- Internal failure cost
- Prevention cost
- Emerging quality cost model
- Traditional quality cost model
- Optimal point