UNIT-IV

THE COST OF QUALITY

COST OF QUALITY:

Cost of Quality is a methodology used to define and measure where and what amount of an organization’s
resources are being used for prevention activities and maintaining product quality as opposed to the costs
resulting from internal and external failures. The Cost of Quality can be represented by the sum of two
factors. The Cost of Good Quality and the Cost of Poor Quality equals the Cost of Quality, as represented
in the basic equation below:

CoQ = CoGQ + CoPQ

Cost of quality = Cost of conformance + Cost of nonconformance

 Cost of conformance is the cost of providing products or services as per the required standards.
This can be termed as good amount spent. (Prevention & Appraisal costs)
 Cost of non-conformance is the failure cost associated with a process not being operated to the
requirements. This can be termed as unnecessary amount spent.( Internal & External failure costs)

The Cost of Quality equation looks simple but in reality it is more complex. The Cost of Quality includes
all costs associated with the quality of a product from preventive costs intended to reduce or eliminate
failures, cost of process controls to maintain quality levels and the costs related to failures both internal
and external.

QUALITY COSTS

Quality costs are the costs associated with preventing, detecting, and remediating product issues related to
quality. Quality costs do not involve simply upgrading the perceived value of a product to a higher
standard. Instead, quality involves creating and delivering a product that meets the expectations of a
customer. Thus, if a customer spends very little for an automobile, he will not expect leather seats and air
conditioning - but he will expect the vehicle to run properly. In this case, quality is considered to be a
vehicle that functions, rather than a luxury experience.

The Cost of Quality can be divided into four categories. They include Prevention, Appraisal, Internal
Failure and External Failure. Within each of the four categories there are numerous possible sources of
cost related to good or poor quality. Some examples of typical sources of Cost of Quality are listed
below.

1
The Cost of Good Quality (CoGQ)
1. Prevention Costs – costs incurred from activities intended to keep failures to a minimum. It is much
better to prevent defects rather than finding and removing them from products. The costs incurred to
avoid or minimize the number of defects at first place are known as prevention costs. Some
examples of prevention costs are improvement of manufacturing processes, workers training, quality
engineering, statistical process control etc. These can include, but are not limited to, the following:
 Establishing Product Specifications
 Quality Planning
 New Product Development and Testing
 Development of a Quality Management System (QMS)
 Proper Employee Training
2. Appraisal Costs – Appraisal costs (also known as inspection costs) are those cost that are incurred
to identify defective products before they are shipped to customers. All costs associated with the
activities that are performed during manufacturing processes to ensure required quality standards are
also included in this category. Identification of defective products involve the maintaining a team of
inspectors. It may be very costly for some organizations. Costs incurred to maintain acceptable
product quality levels.
Appraisal costs can include, but are not limited to, the following:
 Incoming Material Inspections
 Process Controls
 Check Fixtures
 Quality Audits
 Supplier Assessments
The Cost of Poor Quality (CoPQ)
 Internal Failures – costs associated with defects found before the product or service reaches the
customer.
Internal Failures may include, but are not limited to, the following examples:
 Excessive Scrap
 Product Re-work
 Waste due to poorly designed processes
 Machine breakdown due to improper maintenance
 Costs associated with failure analysis

2
  External Failures – costs associated with defects found after the customer receives the product or
service. If defective products have been shipped to customers, external failure costs arise. External
failure costs include warranties, replacements, lost sales because of bad reputation, payment for
damages arising from the use of defective products etc. The shipment of defective products can
dissatisfy customers, damage goodwill and reduce sales and profits. External Failures may include,
but are not limited to, the following examples:
 Service and Repair Costs
 Warranty Claims
 Customer Complaints
 Product or Material Returns
 Incorrect Sales Orders
 Incomplete BOMs
 Shipping Damage due to Inadequate Packaging
These four categories can now be applied to the original Cost of Quality equation. Our original equation
stated that the Cost of Quality is the sum of Cost of Good Quality and Cost of Poor Quality. This is still
true however the basic equation can be expanded by applying the categories within both the Cost of
Good Quality and the Cost of Poor Quality.
 The Cost of Good Quality is the sum of Prevention Cost and Appraisal Cost (CoGQ = PC + AC)
 The Cost of Poor Quality is the sum of Internal and External Failure Costs (CoPQ = IFC + EFC)
By combining the equations, Cost of Quality can be more accurately defined, as shown in the equation
below:
COQ = (PC + AC) + (IFC + EFC)
One important factor to note is that the Cost of Quality equation is nonlinear. Investing in the Cost of
Good Quality does not necessarily mean that the overall Cost of Quality will increase. In fact, when the
resources are invested in the right areas, the Cost of Quality should decrease. When failures are
prevented / detected prior to leaving the facility and reaching the customer, Cost of Poor Quality will be
reduced.

MEASURING QUALITY COSTS

Quality costs may be classified as:

 Observable
- Quality costs available from an organization accounting records
 Hidden
- Opportunity costs resulting from poor quality
- Usually in the external failure category

METHODS OF MEASURING QUALITY COSTS

1. MULTIPLIER METHOD

 Assumes that total failure cost is some multiple of measured failure costs

3
Formula:

Total failure costs= k (Measured external failure costs)

K = multiplier effect whose value depends on experience

2. MARKET RESEARCH METHOD

 Uses formal market research methods to assess the effect of poor quality on sales and market
share
 Customer surveys and interviews with members of a firm’s sales force would provide insights
into the magnitude of the firm’s hidden quality costs
 May use to project future profit losses attributable to poor quality

3. THE TAGUCHI QUALITY LOSS FUNCTION

 Assumes that any variation from the target value of a quality characteristic causes hidden quality
costs
 The hidden quality costs increase quardratically as the actual value deviates from the target value
as follows:

L(y) = k (y –T)2

Where y = actual value of quality characteristic

T = Target value of quality characteristic

L = Quality loss

K = proportionality constant dependent on the organization’s external failure cost structure that can
be estimated as follows:

K = c/d 2

Where c = Loss at the lower or upper specification limit

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

Total hidden quality costs= L (y) x Number of units produced

THE USE OF QUALITY COST INFORMATION

A quality cost report has several uses.

 Quality cost information can be used in a number of ways:21

4
  To make capital budgeting and other investment decisions (quality, as opposed to payback, is the
driver of decisions to purchase new equipment or dispose of unneeded equipment; equipment for
rework is not needed if the rework is eliminated or reduced)
 To improve purchasing and supplier-related costs
 To identify waste in overhead caused by activities not required by the customer
 To identify redundant systems
 To determine whether quality costs are properly distributed
 To establish goals for budgets and profit planning
 To identify quality problems
 As a management tool for comparative measures of input–output relationships (e.g., the cost of a
reliability effort vs. warranty costs)
 As a tool of Pareto analysis to distinguish between the “vital few” and the “trivial many”
 As a strategic management tool to allocate resources for strategy formulation and implementation
 As an objective performance appraisal measure

ACCOUNTING SYSTEMS AND QUALITY MANAGEMENT

Accounting information by itself provides little help for reducing costs and improving quality and
productivity. The tendency is to allocate rather than manage costs. Moreover, the allocation is normally a
function of direct labor, an item that has shrunk to 15% or less of manufacturing costs. Overhead, at about
55%, is spread across all products using the same formula. Accounting also cannot identify or account for
the many non-dollar hidden costs of quality and productivity.

Critics claim that management accounting systems should be designed to support the operations and
strategy of the company, two dimensions in which quality plays a dominant role. This is increasingly
evident in the “new” manufacturing environment, sometimes known as advanced manufacturing
technology, which is characterized by a number of emerging trends. Some of the decision-making needs
and how traditional accounting practices may fall short in meeting them are listed here:

Decision needs Traditional accounting

Activity management Financial accounting

Investment management Payback or ROI

Non-dollar measures Dollar accounting

Process control Cost allocation

Just-in-time Inventory turns

Feed forward control Historical control