By Richard E. Crandall and Oliver Julien
The cost of poor quality in manufacturing companies ranges from 5 percent to 35 percent of your sales dollar. In service organizations, it ranges from 25 percent to 40 percent. Despite that, measuring a company’s quality costs is difficult. The drive to increase quality to the ultimate level of perfection requires managers to support an integrated approach to measuring and improving quality.
Executives may be surprised to learn that researchers estimate that the costs of poor quality in manufacturing companies average around 15 percent, with a range from 5 percent to 35 percent of your sales dollar, depending on product complexity. In service organizations, it averages 30 percent, with a range from 25 percent to 40 percent. For most managers, this is significant enough to get their attention. Unfortunately, many, if not most, companies do not really know what their quality costs are because of the difficulty in measuring them.
Aside from the fact that poor quality may represent a large portion of total costs, there are other reasons to be interested in quality costs.
The American Society of Quality (ASQ) defines quality costs, or “the cost of quality,” as follows:
“The ‘cost of quality’ is a term that’s widely used – and widely misunderstood. It isn’t the price of creating a quality product or service. It’s the cost of not creating a quality product or service. Any cost that would not have been expended if quality were perfect contributes to the cost of quality. Quality costs are the total of the cost incurred by investing in the prevention of nonconformance to requirements, appraising a product or service for conformance to requirements, and failing to meet requirements. The sum of these costs represents the difference between the actual cost of a product or service and what the reduced cost would be if there were no possibility of substandard service, failure of products or defects in their manufacture.”
The Association for Operations Management dictionary defines quality costs as “the overall costs associated with prevention activities and the improvement of quality throughout the firm before, during and after production of a product.”
These definitions suggest quality costs can be associated with products and services, an area of responsibility usually assigned to accounting. However, being able to define cost elements and actually reporting them in a usable format are two different things.
Both ASQ and APICS classify the tangible quality costs as internal failure, external failure, appraisal and prevention costs. This classification is widely accepted as the prevention, appraisal and failure (PAF) model.
Internal failure costs are those costs associated with defects (nonconformance) that are found prior to shipment of the product to the customer, costs that would disappear if there were no defects. Examples include scrap, rework, failure analysis, scrap and rework supplies, sorting inspection, reinspection and retesting, avoidable process losses and downgrading.
In the early 1990s, when a sweeper manufacturer was implementing businessman and author Phil Crosby’s quality improvement process, the engineers hit upon a way to detect and eliminate internal failures. They gave every workstation an air grinder. Every time engineers heard the air grinders’ characteristic screams, they investigated and set up a team to eliminate the cause. Gradually the screams became less frequent; however, it took almost a year before the company could quit using the air grinders. Because engineers had reduced structural variances, the company increased output by half a sweeper a day with no increase in labor costs.
External failure costs are costs associated with defects that are found after the product is shipped to the customer. These costs include warranty charges, complaint adjustment, returned material and allowances.
A major automotive manufacturer implemented a reliability improvement: replacing ignition points with an electronic module that provided the same function. After approximately six months of production (500,000 vehicles), modules were returned under warranty by the dealers, but they were “nondefective” (They tested OK in the lab.). More importantly, the customers’ problems were not fixed. At the same time the vehicles had intermittent fuel filter clogging. Both failures produced the same symptom: The car stops running, but only for an hour or so. Then the car operates again. To solve everyone’s problems (customers, dealers and company), engineers invented a tester that identified the culprit and provided testers to 6,000 dealers. This saved significant emotions, bad press and untold expenses. The moral of the story? Identify quality issues early, and eliminate them, even if it takes an invention.
Appraisal costs are costs incurred in determining the degree of conformance to quality requirements. They include incoming inspection and testing, in-process inspection and testing, final inspection and testing, product quality audits, maintaining accuracy of testing equipment, inspection and testing of materials and services, and evaluation of stock (inventory) for degradation.
In the late 1970s, snowmobiles had a notorious reputation for poor reliability. A major manufacturer decided to improve its product line. In addition to an increase in prototype testing, engineers restructured the assembly process completely. This opportunity existed because the business was seasonal, so the plant remained unused for half of the year. Instead of a serial process, engineers set up subassembly operations with integral inspection operations. Therefore, the engineers knew that all final line components were OK before they were installed on a unit. End-of-line failures and warranty costs were reduced significantly in the following year.
Prevention costs are costs incurred in keeping failure and appraisal costs to a minimum. They include quality planning, new product review, process control, quality audits, supplier quality evaluation and training.
In the late 1980s, a manufacturer of forestry equipment identified an opportunity to reduce warranty costs and assembly time dramatically. Forestry equipment is subjected to one of the worst operating environments in the industrial world. After less than six months in operation, an operator could not even determine the equipment’s original color. Engineers implemented just-in-time practices, reducing the need for inventory storage. Engineers had to redesign many of the structural components, nest the flame-cutting patterns based on model needs instead of by part numbers, and only prep and paint subassemblies needed for the final line. By clustering all the parts needed for a given model, engineers reduced the number of different thicknesses of steel from nine to four, resulting in additional savings through smart buying. Because of the size of the manufacturer’s orders, it could buy from the mill instead of from the distributor. Investment velocity was increased because the company now could produce any of its models in eight work days instead of the previous best time of 28 work days. Customers also could receive their complex tractors in two weeks instead of two months.
These improvements required significant labor flexibility, engineering creativity, organizational revisions and commitment by everyone during the nearly two years of planning and implementation. The result was that customers and holding company accountants loved the engineers. In addition, workers did not need to work as hard because engineers had reduced most of the variances.
These costs are tangible. However, as described later, they are not always easily determined.
In addition to the tangible prevention, appraisal and failure costs, there are hidden, or intangible, costs. Conventional accounting systems have been inadequate to report the costs of poor quality accurately. Some of the hidden costs, originally reported in the third edition of J.M. Juran’s Quality Planning and Analysis, are:
Demands on management time also can be a hidden cost. Problems of any sort require the time of managers at all levels to resolve, and few, if any, systems record how CEOs spend their time.
In addition to the hidden costs that may be difficult to dig out of accounting systems, other intangible costs are even more difficult to determine. They include costs associated with sales lost when a company’s acceptance in the marketplace may be eroded because of product recalls or bad publicity from association with suppliers operating sweatshops or child labor factories.
The pressure to get products to market quickly also may contribute to hidden costs of quality. In the trade-off between speed to market and designed-in quality, the more tangible pressure to get the product to market may overshadow the loss in quality.
In addition to social acceptance considerations, customers also may consider quality failures to be products containing hazardous or nonbiodegradable materials or processes with high carbon or harmful waste emissions.
An area of great interest is the behavior of the prevention, appraisal and failure costs as quality improvement efforts bring about change. The consensus among researchers is that increased spending on prevention costs will bring about decreases in internal failure and external failure costs. This appears logical – as quality improves, there will be fewer failures. The effect on appraisal costs is less certain. Most researchers agree that appraisal costs follow failure costs. If failures increase, appraisal costs (largely inspection) will increase. On the other hand, if failures decrease, appraisal costs also will decrease because less inspection will be required.
The early versions of the cost of quality (COQ) model described companies with less well-developed quality improvement programs where failure costs were high (60 percent to 70 percent), appraisal costs moderate (20 percent to 25 percent) and prevention costs were low (5 percent to 10 percent), as noted by A.V. Feigenbaum in 1991’s Total Quality Control, Third Edition.
There was a need to increase prevention costs to reduce failure costs. However, the feeling at that time was that total quality costs would decrease to a minimum point and then increase as prevention costs began to increase faster than failure costs decreased, as shown in Figure 1.
As quality programs improved toward the end of the 20th century and the goal became zero defects, or perfect quality, this early COQ model presented conflict because it suggested that optimum quality was less than perfect quality. This was resolved by concluding that, as quality programs improved, the total quality cost curve could reflect this improvement, as shown in Figure 2, where the total quality cost curve continues to decrease as quality approaches perfection. Juran and Frank M. Gyrna call this the COQ curve in emerging processes. The authors attribute it to the learning process and discovery of root causes in quality programs.
However, COQ models are not adequate for determining an economically optimal quality level, and increased profit must be considered in addition to reduced cost benefits. We show this conceptual relationship in Figure 3. Initially, total quality costs decrease until prevention costs begin to increase faster than failure costs decrease. As quality continues to improve and increased revenues result, profits from improved quality eventually increase faster than total quality costs increase.
The quality cost curves shown in Figures 1, 2 and 3 represent the behavior reported by most researchers. However, there are few well-documented case histories in this area.
In some cases, the cost of quality failures can be catastrophic, resulting in the need for crisis management. In these cases, the considerations are more than economic; they include permanent damage to the company’s capability to continue in business. Toyota’s recent massive recall of cars and trucks is vivid evidence of this. Most of the attention in a crisis is focused on the reaction of customers or the public. Often overlooked is the effect on the company’s employees and the possible erosion of their confidence in the company and their continued willingness to stay with the company. Companies always should spend some time trying to prevent this type of quality cost by anticipating and avoiding a crisis situation, although this is easier said than done. Keeping a focus on possible disruptions is a test of good top management.
While conventional accounting systems may have the pieces of the total quality cost puzzle, they rarely put them together into a completed picture. Activity-based-costing systems help because they provide more specific classification of costs than can be assembled into composite reports. But they are not the total answer because some costs are difficult to assign to a quality problem versus some other cause. Enterprise resource planning systems also can facilitate identifying and analyzing quality costs. However, some costs, such as lost sales, are not included in any type of accounting system.
While a perfect quality cost reporting system may be elusive, companies should recognize that they could identify the major quality costs – the vital few – and begin to measure them. This partial solution is a step toward a more complete solution.
Usually, it takes a special study or a specific system to isolate and summarize quality costs. While it would be desirable to design a framework to identify and classify costs, it appears that few companies have progressed to the point of having comprehensive quality cost reports produced on a regular basis.
Quality costs, as described earlier, represent a wide variety of cost accounts. Activity-based-costing systems may help, but they are not designed to identify quality costs as described in this article. Although identification of quality costs theoretically is possible, it may prove to be unrealistic with today’s accounting systems.
Companies actively pursue a number of improvement programs. Do these programs help in the assessment of quality costs?
Six Sigma is one of the most active improvement programs these days. However, Six Sigma is associated with the completion of discrete projects, each of which may help to reduce quality costs or improve revenues, and the contribution usually is quantified. However, Six Sigma does not normally have preparation of quality cost reports as a prime objective.
Lean production is another improvement program that requires quality improvement to be successful. Eliminating waste is an objective of lean programs. Waste includes product and service failures, components of quality costs. Therefore, reducing quality costs is an integral element of lean production. However, as with Six Sigma, lean production systems do not necessarily require quality cost reports.
Customer relationship management is a program to keep good customers. Customer retention usually requires good customer service and consistently high-quality products. Consequently, customer relationship management supports quality improvements. But it does not include a total cost report.
Product lifecycle management attempts to preserve the quality of information about products throughout their life cycles. This requires product designs that maintain value throughout their useful lives and a compatibility with sustainability considerations, such as reuse and recycling. Product lifecycle management also strives for information integrity that can be used by multiple parties as the product moves through both its forward and reverse life cycles.
Supply chain management requires reducing variances throughout the supply chain. One of the major variances is often product or service quality. To assure a smooth flow of physical goods, information and funds through all participants, quality must be improved.
These and other programs encourage, even require, the improvement of quality. If companies are to participate confidently in these programs, they must assure themselves that improved quality reduces the cost of poor quality.
In the future, competition will require continued improvement in quality levels, probably even greater than those already achieved. Improved quality will be important to reduce tangible quality costs and prevent the hidden, or intangible, quality costs.
Sustainability issues will become more closely linked with quality because of the need to reduce waste. When sustainability becomes a major driver of change, companies will be forced to pursue reductions in quality costs and will need to design systems that assure them improved quality will have an economic benefit.
Accounting will have to develop better systems. Up to now, financial, or external, accounting requirements have been more important than internal, or management, accounting needs. If companies are to continue progress in their improvement efforts, they will require performance measurement systems that help them identify improvement opportunities, such as in quality costs.
As supply chains grow in complexity and geographic diversity, companies are becoming more aware of the risks associated with this growth. Managers face the possibility, even likelihood, of a crisis in supply chains – automobile gas pedals, contaminated peanut butter, medications with adverse side effects and the like. Inevitably, the public perceives such crises as “quality” problems. While the probability of occurrence may be low, the potential costs are enormous.
Top management will have to support an integrated approach. Localized improvement programs no longer will suffice. While they are beneficial in many cases, they may actually increase costs in areas other than where the improvements are being made. Quality cost thinking used to involve the trade-offs between prevention and failures. Today, the consensus is that there should be continued pressure to improve quality levels to the ultimate level – to perfection. Only top management can require cross-functional participation or endorse decisions that may not have complete tangible justification.
Richard E. Crandall is the Beroth Oil Professor in the Walker College of Business at Appalachian State University in Boone, N.C. He is a certified public accountant. Prior to joining ASU, Crandall worked as an industrial engineer, line supervisor, chief industrial engineer, plant manager, consultant and in general management positions for several companies, both manufacturing and service. He has a bachelor’s degree in industrial engineering from West Virginia University, an M.B.A. in industrial management from Boston University, and a Ph.D. in production and operations management from the University of South Carolina.
Oliver M. Julien is an adjunct professor in the Walker College of Business at Appalachian State University in Boone, N.C. He spent 20 years with Ford Motor Co. as a product design specialist. Following that, he became a principal and co-owner of Design Concepts Inc., an award-winning product design company in Madison, Wis. During his time with Design Concepts, he worked with a variety of companies designing heavy equipment, such as industrial sweepers, and recreational vehicles, such as snowmobiles. He holds an undergraduate degree in engineering from The University of Wisconsin and an M.B.A. (marketing) from Wayne State University.