COST MANAGEMENT

Guan ▪ Hansen ▪ Mowen

Quality and Environmental

Cost Management

COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. 1

Cengage Learning and South-Western are trademarks used herein under license.
 Study Objectives
1. Define quality, describe the four types of quality
costs, discuss the approaches used for quality
cost measurement, and prepare a quality cost
report.
2. Explain why quality cost information is needed
and how it is used.
3. Describe and prepare three different types of
quality performance reports.
4. Explain how environmental costs can be
measured and reduced.

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 Costs of Quality
• Quality-linked activities
– Activities performed because poor quality may
or does exist
– Control activities
• performed by an organization
• to prevent or detect poor quality
– Failure activities
• Performed by an organization or its customers
• In response to poor quality

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 Costs of Quality
• Categories of quality costs
– Prevention costs: incurred to prevent poor quality in
product or services from being produced
– Appraisal costs: Incurred to determine whether
products and services are conforming
• Product acceptance: sample finished goods
• Process acceptance: sample goods while in process
– Internal failure costs: incurred because products or
services do not conform; discovered prior to delivery
– External failure costs: incurred because products or
services do not conform; discovered after delivery
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Costs of Quality

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Costs of Quality

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 Costs of Quality
• Quality cost
– Observable
• Available from the accounting records
– Hidden
• Opportunity costs resulting from poor quality
• Estimating hidden quality costs
– The multiplier method
– The market research method

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 Costs of Quality
Multiplier Method
Assumes that the total failure cost is simply some multiple of
measured failure costs:


Total external = k Measured external
failure cost failure cost 
where k is the multiplier effect

If k = 4, and the measured external failure costs are $3

million, then the actual external failure costs are
estimated to be $12 million.

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 Costs of Quality
Market Research Method
Uses formal market research methods to assess the effect of
poor quality on sales and market share.

Market research results can be used to project

future profit losses attributable to poor quality.

Customer surveys and interviews with members of a

company’s sales force can provide significant insights into the
magnitude of a company’s hidden costs.

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Costs of Quality

a
Actual sales of
$5,000,000.

b
$1,000,000 ÷ $5,000,000
= 20%.
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Costs of Quality

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 Quality Cost Information and
Decision Making
Strategic Pricing
Product-line Income Low-Level Instrument Group
Revenues (1,000,000 @ $20) $ 20,000,000 Quality costs (estimated):
Cost of goods sold (15,000,000) Inspection - materials $ 200,000
Operating expenses (3,000,000) Scrap 800,000
Product-line income $ 2,000,000 Rejects 500,000
Rework 400,000
Product inspection 300,000
Warranty work 1,000,000
Total Estimate $ 3,200,000

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 Quality Cost Information and
Decision Making
Cost-Volume-Profit Analysis and Strategic Decisions
New Product Analysis, Project #675
Projected sales potential:44,000 units
Production capacity: 45,000 units
Unit selling price: $60
Unit variable costs: $40
Fixed costs: Includes $5 quality
Product development $ 500,000 costs
Manufacturing 200,000
Selling 300,000 Includes $100,000
Total $1,000,000 quality costs

Break-even: 50,000 units

Decision: Reject (breakeven
exceeds capacity and potential) 13
 Quality Cost Information and
Decision Making
Cost-Volume-Profit Analysis and Strategic Decisions
New Product Analysis, Project #675, Revised
Projected sales potential:44,000 units
Production capacity: 45,000 units
Unit selling price: $60
Unit variable costs: $40 $35
Fixed costs:
Product development $ 500,000 $500,000
Manufacturing 200,000 100,000
Selling 300,000 300,000
Total $1,000,000 $900,000

Break-even: 50,000 units Break-even: 36,000 units

Decision: Reject (breakeven Decision: Accept
exceeds capacity and potential) 14
Quality Cost Information and
Decision Making

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 Controlling Quality Costs
Traditional Approach
• Acceptable quality level (AQL) is the standard
– Includes a certain number of defective products
– Ship products if defective units do not exceed AQL
• Creates a “commitment to deliver” defective
products

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 Controlling Quality Costs
Total Quality Approach
Zero-defect standards
• Reflects a philosophy of total quality control
• Calls for products and services to be produced
and delivered that meet the targeted value
• Implies the elimination of failure costs

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 Controlling Quality Costs
Total Quality Approach
• Quantify the standard
– As the costs of quality decrease, higher
quality results
– 2.5% standard is accepted by many QC
experts
• Interim standards
– Mid-range goals while pursuing the zero-
defects level
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 Controlling Quality Costs
Quality Performance Reports
1. Interim Standard Report: Progress with
respect to a current-period standard or goal
2. Multiple-Period Trend Report: The progress
trend since the inception of the quality-
improvement program
3. Long-Range Report: Progress with respect to
the long-range standard or goal

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Controlling Quality Costs

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Controlling Quality Costs

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Controlling Quality Costs

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Controlling Quality Costs

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Controlling Quality Costs

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Controlling Quality Costs

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Controlling Quality Costs

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Controlling Quality Costs

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Controlling Quality Costs

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Controlling Quality Costs

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Controlling Quality Costs

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 Defining, Measuring, and
Controlling Environmental Costs
• Environmental costs: costs that are incurred
because poor environmental quality exists or
may exist
• Damage
– Direct degradation of the environment
– Indirect degradation (unnecessary usage)
• Categories
– prevention costs
– detection costs
– internal failure costs
– external failure costs

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 Defining, Measuring, and
Controlling Environmental Costs

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 Defining, Measuring, and
Controlling Environmental Costs

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 Defining, Measuring, and
Controlling Environmental Costs

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 Defining, Measuring, and
Controlling Environmental Costs

continued

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 Defining, Measuring, and
Controlling Environmental Costs

Note: “S” = societal costs

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 Defining, Measuring, and
Controlling Environmental Costs

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 Defining, Measuring, and
Controlling Environmental Costs

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 Defining, Measuring, and
Controlling Environmental Costs

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COST MANAGEMENT

Guan ▪ Hansen ▪ Mowen

End Chapter 14

COPYRIGHT © 2009 South-Western Publishing, a division of Cengage Learning. 40

Cengage Learning and South-Western are trademarks used herein under license.