CHAPTER 14

QUALITY COST MANAGEMENT

QUESTIONS FOR WRITING AND DISCUSSION
1. All quality costs are incurred because poor
quality may or does exist.

million (0.18 $200 million) $5 million

(0.025 $200 million)].

2. Prevention costs are incurred to prevent

defects in products; appraisal costs are
costs incurred to determine whether
products are conforming to specifications;
internal failure costs are incurred when
nonconforming products are detected prior
to shipment; external failure costs are
incurred because nonconforming products
are delivered to customers.

9.

A quality cost report shows the amount of

cost for each category as well as the
relative cost of each category. This report
requires managers to identify the costs that
should appear in the report, to identify the
current quality performance level, and to
begin thinking about the level of quality
performance that should be achieved.

3. External failure costs can be more

devastating because of warranty costs,
lawsuits, and damage to the reputation of a
company, all of which may greatly exceed
the costs of rework or scrap incurred from
internal failure costs.

10.

Two major reasons why the accounting

department should be responsible for
producing quality cost reports: (1) they have
the expertise and training, and (2) they have
the objectivity.

11.

ISO 9000 is a series of five international

quality standards. These standards center
on the concept of documentation and
control of nonconformance and change. ISO
9000 certification can be a requirement of
doing business (e.g., in Europe). Also, many

4. Agree. It is poor quality, not good quality,

that is costly. All quality costs exist because
poor quality may or does exist.
5. Interim quality standards are used to measure a firms progress toward better quality
within a given period.

companies have found that the process of

applying for ISO 9000, while lengthy and
expensive, yields important benefits in
terms of self-knowledge. U.S. companies
are using ISO 9000 certification as a
competitive tool, as well.

6. Interim quality reports are used to measure

quality improvement with respect to a
current-period standard; multiple-period
reports are used to measure quality
improvement with respect to a base period;
long-range reports are used to measure
progress toward achieving the goal of zero
defects.
7.

Both monetary and nonmonetary incentives

can be used to motivate employees. For
example, employees can be given a bonus
that is equal to a fixed percentage of the
savings from a suggestion that improved a
products
quality
(referred
to
as
gainsharing).
Additionally,
awards
of
excellence can be used to recognize those
employees who make outstanding quality
contributions.

8.

Firms should spend about 2.5% of sales on

quality costs. The potential savings from
quality improvement is $31 million [$36

12. An environmental cost is a cost incurred

because poor environmental quality exists
or may exist.
13. The four categories of environmental costs
are prevention, detection, internal failure,
and external failure. Prevention costs are
costs incurred to prevent degradation to the
environment. Detection costs are incurred to
determine if the firm is complying with
environmental standards. Internal failure
costs are costs incurred to prevent emission
of contaminants to the environment after
they have been produced. External failure
costs are costs incurred after contaminants
have been emitted to the environment.
14. Realized external failure costs are
environmental costs paid for by the firm.
Unrealized or societal costs are costs

59

caused by the firm but paid for by third

parties (e.g., members of society bear these

costs).

EXERCISES

141
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.

Internal failure
Prevention
Internal failure
External failure
External failure
External failure
Prevention
Internal failure
Appraisal
Internal failure
External failure
Appraisal

13.
14.
15.
16.
17.
18.
19.
20.
21.
22.
23.

60

Prevention
Prevention
External failure
Prevention
External failure
Prevention
Prevention
Appraisal
External failure
Prevention
Appraisal

142
1.

Activity rates:
Warranty:
Scrap:
Inspection:
Training:

$204,000/2,550 = $80 per unit

$153,000/4,250 = $36 per unit
$76,500/5,100 = $15 per hour
$42,500/170
= $250 per hour

Product cost:
Warranty:
$80 1,700....................
$80 850.......................
Scrap:
$36 3,400....................
$36 850.......................
Inspection:
$15 3,400....................
$15 1,700....................
Training:
$250 85.......................
$250 85.......................
Total assigned...................
Divided by units.................
Unit cost........................

Carburetor A

Carburetor B

$136,000
$ 68,000
122,400
30,600
51,000
25,500
21,250
$330,650
170,000
$
1.95*

21,250
$145,350
340,000
$
0.43*

*Rounded.
Carburetor A has more than four times the amount of quality costs assigned
than Carburetor B. Thus, A appears to be the lower-quality product.
2.

The unit quality cost can be used to rank products in order of the lowest
quality to that of the highest. This information can then be used to determine
where quality improvement efforts should be focused. It may reveal, for
example, that products follow the Pareto Principle: 20% of the products are
causing 80% of the quality problems. (The Pareto Principle claims that 20% of
the people do 80% of the work in any organization.)

60

143
1.

Brown Company
Quality Cost Report
For the Year Ended December 31, 2010
Quality Costs

Percentage of
Sales

Prevention costs:
Design review.................
Quality training...............

$405,000
135,000

$ 540,000

Appraisal costs:
Materials inspection.......
Process acceptance.......
Product inspection.........

$ 54,000
67,500
40,500

162,000

2.00

Internal failure costs:

Reinspection...................
Scrap................................

$ 67,500
47,250

114,750

1.42

External failure costs:

Recalls.............................
Lost sales........................
Returned goods..............
Total quality costs...............

$135,000
270,000
128,250

61

533,250
$1,350,000

6.67%

6.58
16.67%

143

Concluded

2.
Relative Distribution of Quality Costs

Percentage of Total
Quality Costs

100
80
60
40
20
0

Quality Costs
Prevention

Appraisal

Internal Failure

External Failure

Relative Distribution of Quality Costs

External Failure

40%

40%

8%
Internal Failure

Prevention

12%
Appraisal

Failure costs are almost 50% of the total costs. This indicates that there is
still ample opportunity for improving quality by investing more in prevention
and appraisal activities.

62

144
1.

Quality costs:
Year 1: $2,100,000 (0.21
Year 2: $1,980,000 (0.18
Year 3: $1,540,000 (0.14
Year 4: $1,200,000 (0.10

$10,000,000)
$11,000,000)
$11,000,000)
$12,000,000)

Net income increase:

Year 1: (0.21 0.18)$11,000,000 = $330,000
Year 2: (0.18 0.14)$11,000,000 = $440,000
Year 3: (0.14 0.10)$12,000,000 = $480,000
2.

Profit potential: (0.10 0.025)$12,000,000 = $900,000

The 2.5% goal is the level many quality experts identify as the one that
companies should strive to obtain. Pavon Companys experience shows that
it is an achievable goal. Also, although most Japanese companies do not
track quality costs, some have measured their costs of quality, and they
generally tend to be less than 5% (compared with the U.S. experience that has
produced values between 20 and 30%).

3.
Sales...................................
Variable expenses.............
Contribution margin....
a

Year 3 No Change
$ 11,000,000
7,236,842a
$ 3,763,158

Year 3 Change
$ 11,000,000
6,345,263b
$ 4,654,737

$125 $11,000,000/$190.

Quality costs per unit:

Year 1: 0.21 $200 = $42.00
Year 3: 0.14 $190 = $26.60
Decrease in per-unit variable quality cost = $42.00 $26.60 = $15.40
Decrease in per-unit total variable cost = $125.00 $15.40 = $109.60
Variable costs (total, Year 3) = $109.60 $11,000,000/$190 = $6,345,263

Increase in profitability:
$4,654,737 $3,763,158 = $891,579

63

145
1.

2006: $7,500,000/$30,000,000 = 0.25

2010: $937,500/$37,500,000 = 0.025
The quality cost-to-sales ratio improved from 25% to 2.5%.

2.

Internal failure:
External failure:
Appraisal:
Prevention:

$2,250,000/$7,500,000 = 30%
$3,000,000/$7,500,000 = 40%
$1,350,000/$7,500,000 = 18%
$900,000/$7,500,000 = 12%

The pie chart for 2006 is as follows:

Quality Costs
Prevention
12%
30%
Appraisal

I nternal Failure

18%

40%
External Failure

The percentage of quality costs spent on internal and external failures is too
high. If costs are reduced to 2.5%, then the company is approaching the goal
of zero defects. As zero defects is approached, failure costs will approach
zero, leaving the bulk of quality costs in the prevention and appraisal
categories. Of these two categories, the prevention category would dominate.

64

145
3.

Continued

Internal failure:
External failure:
Appraisal:
Prevention:

$112,500/$937,500 = 12%
$75,000/$937,500 = 8%
$281,250/$937,500 = 30%
$468,750/$937,500 = 50%

The pie chart for 2010 is as follows:

Quality Costs
Internal Failure

12%
External Failure

8%

Prevention

50%

30%
Appraisal

Quality costs are better distributed than in 2006. Control costs account for
80% of the total quality costs (versus only 30% in 2006). Failure costs have
shrunk from 70% of the total in 2006 to only 20% in 2010. Moreover, total
quality costs have shrunk from 25% of sales to 2.5% of sales. Costs in every
category have been reduced. From an activity-based management
perspective, further reductions are possibleat least in the failure
categories. These are non-value-added costs and, in theory, can and should
be reduced to zero.
4.

Some external failure costs are not measured and reported in the accounting
records. If the multiplier effect were four (for example), then in 2010, the
external failure costs would be $225,000 ([4 $75,000] $75,000) higher than
reported. Given the reality of hidden costs, there is some validity to his point
of view and it may be wise to invest additional funds for control activities.

65

145
5.

Concluded

Gainsharing provides a strong incentive for managers to improve quality and

reduce quality costs. Gainsharing is a good idea, provided the incentive
system is carefully designed. The bonus must be truly based on quality
improvements. Quality gains, stemming from quality cost reductions, must
flow from true quality improvements. Thus, there should be operational
quality measures that provide evidence of actual quality improvements. One
possibility is to base bonuses only on reductions in failure and appraisal
categories. This provides an incentive for managers to invest in preventive
activitiesactions that should reduce poor quality costs.

146
1.

Only four of the activities should be implemented: quality training, process

control, supplier evaluation, and engineering redesign. Each of these four
activities reduces failure costs more than it costs to implement the activity
(thus, increasing the bonus pool). The cost reduction for failures is less than
the amount spent for product inspection and prototype testing.
Total quality costs:
Current control..........................
Quality training..........................
Process control.........................
Supplier evaluation...................
Engineering redesign................
Failure costs..............................

$160,000
160,000
200,000
120,000
40,000
184,000*
$ 864,000

*$40,000 + ($720,000 $656,000) + ($200,000 $120,000) (adds back cost

reductions of two activities not implemented).

66

146
2.

Concluded

a. Total quality costs were reduced by $736,000 ($1,600,000 $864,000).

Quality training increased costs by $160,000 but reduced failure costs by
$400,000, for a net gain of $240,000. Process control increased costs by
$200,000 but decreased failure costs by $320,000, for a net gain of
$120,000. Supplier evaluation increased costs by $120,000 but decreased
failure costs by $456,000, for a net gain of $336,000. Engineering redesign
increased costs by $40,000 but decreased failure costs by $80,000, for a
net gain of $40,000.
Total net gain:
$240,000
120,000
336,000
40,000
$ 736,000
b. Distribution percentage:
Control costs:* $680,000/$864,000 = 79% (rounded)
Failure costs: $184,000/$864,000 = 21% (rounded)
*Total control costs less costs of activities not implemented:
$1,000,000 $80,000 $240,000 = $680,000
Failure costs = $864,000 $680,000
c. Bonus pool = 0.10 $736,000 = $73,600

3.

All of the same activities would be adopted plus prototype testing. Of the
activities adopted, training, supplier evaluation, engineering redesign, and
prototype testing are all prevention activities and so would not be counted in
the cost reduction calculation. Failure costs would now be $104,000
(prototype addition reduces failure costs by an additional $80,000). The initial
failure and appraisal costs are $1,600,000 ($1,440,000 + $160,000). The ending
failure and appraisal costs are the sum of the current appraisal costs, ending
failure costs, and the cost of adding process control: $160,000 + $104,000 +
$200,000 = $464,000. Thus, the cost reductions counted for the bonus pool
would be $1,136,000 ($1,600,000 $464,000), and the bonus would be
$113,600 (0.10 $1,136,000). This approach has some merit as it encourages
managers to invest in value-added activities and avoid the temptation of
reducing prevention costs prematurely. It is possible, however, that some
prevention activities are not really worth doing, and this approach may lead
to an overinvestment in this category.

67

147
1.

2.

Quality costs, 2009................. $ 110,000

Less quality costs, 2010........
81,000
$ 29,000
Tru-Delite Frozen Desserts, Inc.
Long-Range Performance Report
For the Year Ended December 31, 2010

Prevention costs:
Training program.................
Supplier evaluation..............
Total prevention..............
Appraisal costs:
Test labor..............................
Inspection labor...................
Total appraisal................
Internal failure costs:
Scrap.....................................
Rework..................................
Total internal failure.......
External failure costs:
Consumer complaints.........
Lost sales, incorrect labeling
Total external failure......
Total quality costs.....................

Actual Costs*
2010

Long-Range
Target Costs

Variance

$ 6,000
13,000
$ 19,000

$ 3,750
4,688
$ 8,438

$ 2,250 U
8,312 U
$ 10,562 U

$ 10,000
30,000
$ 40,000

$ 4,687
2,813
$ 7,500

$ 5,313 U
27,187 U
$ 32,500 U

$ 18,750
12,500
$ 31,250

$ 2,812
0
$ 2,812

$ 15,938 U
12,500 U
$ 28,438 U

$ 6,250
0
$ 6,250
$ 96,500

$ 6,250 U
0
$ 6,250 U
$ 77,750 U

Percent of sales.........................

12.9%

0
0
$
0
$18,750
2.5%

10.4%

*Adjusted for sales of $750,000 [Uses the actual variable cost ratios of 2010
to compute the actual unit-level variable costs for this level of activity;
prevention costs are discretionary fixed and so are assumed to not change
as sales increase; all other costs are assumed to vary with sales volume and
so are adjusted to the $750,000 level; for example, test labor is ($8,000/
$600,000) $750,000 = $10,000].

68

147

Concluded

3.

Prevention and some appraisal costs can be interpreted as value-added

costs. All failure costs are non-value-added. Thus, the distribution of costs
for 2015 cannot all be value-added (there are nonzero internal failure costs). If
they were, then the variances would be the non-value-added costs being
incurred in 2010.

4.

There would be a $77,750 increase in profits in 2015 if total quality costs are
2.5% of sales and the targeted distribution is achieved (the $77,750 increase
is the savings reported in the long-range performance report in Requirement
2).

148
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
11.
12.
13.
14.
15.
16.

Prevention
Prevention
Internal failure
External failure (societal)
Detection
Prevention
Internal failure
External failure (societal)
Detection
External failure (societal)
Prevention
External failure (private)
Internal failure
Detection
Internal failure
Detection

149

69

1.

Hender Chemicals
Environmental Cost Report
For the Year Ended December 31, 2010
Environmental Costs
Prevention costs:
Evaluating suppliers.....................
Recycling products.......................
Detection costs:
Inspecting products/processes...
Developing perf. measures..........
Internal failure costs:
Treating toxic waste......................
Operating equipment....................
Licensing facilities........................
External failure costs:
Settling claims...............................
Cleanup of soil...............................
Totals..................................................

Percentage*

$ 120,000
75,000

$ 195,000

$ 600,000
60,000

660,000

1.10

$4,800,000
840,000
360,000

6,000,000

10.00

$1,200,000
1,800,000

3,000,000
$ 9,855,000

0.33%

5.00
16.43%

*Of operating costs: $60,000,000.

2.
Relative Distribution: Environmental Costs

Prevention
2%

Detection
7%

External Failure
30%

Internal Failure
61%

This distribution reveals that the company is paying little attention to preventing
and detecting environmental costs. To improve environmental performance,
much more needs to be invested in the prevention and detection categories.

1410

70

1.

Both items should be added to the external failure costs category in the
report. The first item would add $525,000 and is a private cost. The second
adds $1,200,000 and is a societal cost. Under a full costing regime, the
$1,200,000 should also be included in the report. Often, however, only private
costs will be included.

2.

Hender caused the opportunity cost, and many would argue that it should be
disclosed. Whether it will voluntarily disclose this cost is questionable.
Management would likely feel that such disclosure would draw unfavorable
attention to the company and damage its image.
Perhaps if the disclosure is coupled with an announcement of the cleanup of
the river and lake, then it could be turned to the advantage of the company:
We are undertaking a cleanup, and one of the major benefits to the
community is the restoration of the fishing and recreational opportunities
worth $1,200,000 to the community.

71

PROBLEMS
1411
1.

Lost contribution margin = $8 100,000 = $800,000 or $200,000 per quarter

Sales revenue/Quarter = $92 25,000 = $2,300,000
Percent of sales needed to regain lost contribution margin:
$200,000/$2,300,000 = 8.7%
At 1% gain per quarter, 8.7 quarters, or a little over two years would be
needed to regain former profitability.

2.

At the end of three years, quality costs will be 4% of sales, a reduction equal
to 12% of sales.
Savings = 0.12 $92 100,000 = $1,104,000
Increase in unit contribution margin = $1,104,000/100,000
= $11.04
Projected unit CM = $11.04 + ($92 $90) = $13.04
Projected total CM at $92 price = $13.04 100,000
= $1,304,000
Price decreases:
$1.00: Total CM = $12.04 110,000 = $1,324,400
$2.00: Total CM = $11.04 120,000 = $1,324,800
$3.00: Total CM = $10.04 130,000 = $1,305,200
Recommended decrease is from $92 to $90.
Increase in contribution margin:
$ 1,324,800
( 1,304,000)
$
20,800

72

1411 Concluded
3.

To find the point where the price should first be reduced, we need to find the
point where total contribution margin remains unchanged. Let X = CM/Unit.
Current CM = 100,000X
New CM = 110,000(X $1)
100,000X = 110,000(X $1)
10,000X = $110,000
X = $11
When the unit CM is greater than $11, the price should be reduced by $1.00.
To find this point in time:
Current CM = $92 $90 = $2
Gain needed = $11 $2 = $9
Annual CM needed = $900,000 ($9 100,000)
Quarterly CM needed = $900,000/4 = $225,000
Quarterly percent of sales needed = $225,000/$2,300,000
= 9.8%
At 1% per quarter, it will take 9.8 quarters to gain $9 per unit. Thus, after 9.8
quarters, the price can decrease by $1.

4.

The difference is long-run versus short-run thinking. The marketing manager

had a strategic orientation. We can see the value of cost information,
particularly quality cost information, in strategic decision making. In fact, the
emphasis on total quality control and the identification of specific quality
costs drove the decision. Once the decision was made, the need to reduce
the costs as planned is critical, emphasizing the importance of a quality cost
control program. Interim and longer-range reports would be quite useful in
controlling quality costs.

73

1412
1.

Quality Costs
Prevention costs:
Quality training.......................
Appraisal costs:
Product acceptance...............
Internal failure costs:
Scrap........................................
Rework.....................................

External failure costs:

Repair.......................................
Order cancellation..................
Customer complaints.............
Sales allowance......................

0.2%

$ 240,000

1.6

$ 450,000
270,000
$ 720,000

4.8

90,000
150,000
121,500
45,000
$ 406,500
$1,396,500

Total quality costs........................

2.

30,000

Percentage of Sales

2.7
9.3%

Profits: $1,500,000
Quality costs: $1,396,500
Quality costs/Sales = 9.3%
Quality costs/Profits = 93%
Wayne should be concerned as the quality cost ratio is 9.3%, and the quality
costs are almost as large as income. Although the ratio is lower than the 20 to
30% range that many companies apparently have, there is still ample
opportunity for improvement.

3.

Prevention:
Appraisal:
Internal failure:
External failure:

$30,000/$1,396,500 = 2.1%
$240,000/$1,396,500 = 17.2%
$720,000/$1,396,500 = 51.6%
$406,500/$1,396,500 = 29.1%

74

1412 Concluded
The pie chart is as follows:

Quality Costs

Internal Failure
51.6%

Appraisal 17.2%

2.1%
Prevention

29.1%
External Failure

Too much is spent on failure costs. These costs are non-value-added costs
and should eventually be eliminated. Prevention and appraisal activities
should be given much more emphasis. If anything, experiences of real-world
companies (e.g., Tennant and Westinghouse) indicate that the control costs
should be 80% and the failure costs 20%. The distribution of quality costs
needs to be reversed!
4.

The company should increase prevention and appraisal costs. The additional
amounts spent on these programs will be recouped with additional savings
from a resulting decrease in failure costs.

5.

Quality costs: $15,000,000 2.5% = $375,000

Profits would increase by $1,021,500 ($1,396,500 $375,000).

75

1413
1.
Prevention costs:
Quality planning (F).....................
New product review (F)...............
Quality training (F).......................
Total prevention......................
Appraisal costs:
Materials inspection (F)...............
Product acceptance (V)...............
Field inspection (V)......................
Total appraisal........................
Internal failure costs:
Scrap (V)........................................
Retesting (V).................................
Rework (V)....................................
Downtime (V)................................
Total internal failure...............
External failure costs:
Warranty (V)..................................
Allowances (V)..............................
Complaint adjustment (F)............
Total external failure...............
Total quality costs.............................

76

January

February

$ 2,000
500
1,000
$ 3,500

$ 2,500
13,000
12,000
$ 27,500

2,500
15,000
14,000
$ 31,500

$ 10,000
6,000
9,000
5,000
$ 30,000

$ 12,000
7,200
10,800
6,000
$ 36,000

$ 15,000
7,500
2,500
$ 25,000
$ 86,000

$ 18,000
9,000
2,500
$ 29,500
$100,500

2,000
500
1,000
3,500

1413 Concluded
2.

Actual Costs
Prevention costs:
Quality planning (F)..........
New product review (F)....
Quality training (F)............
Total prevention...........
Appraisal costs:
Materials inspection (F)....
Product acceptance (V)....
Field inspection (V)...........
Total appraisal.............
Internal failure costs:
Scrap (V).............................
Retesting (V)......................
Rework (V)..........................
Downtime (V).....................
Total internal failure.....
External failure costs:
Warranty (V).......................
Allowances (V)...................
Complaint adjustment (F).
Total external failure....
Total quality costs..................

Bud. Costs*

Variance

$ 2,500
700
1,000
$ 4,200

$ 2,000
500
1,000
$ 3,500

$ 500 U
200 U
0
$ 700 U

$2,500
14,000
14,000
$ 30,500

$ 2,500
14,300
13,200
$ 30,000

$ 12,500
7,000
11,000
5,500
$ 36,000

$ 11,000
6,600
9,900
5,500
$ 33,000

$1,500U
400 U
1,100 U
0
$3,000 U

$ 17,500
8,500
2,500
$ 28,500
$ 99,200

$ 16,500
8,250
2,500
$ 27,250
$ 93,750

$1,000
250
0
$1,250
$5,450

0
300 F
800 U
$ 500 U

U
U
U
U

*Budgeted costs need to be adjusted to reflect actual sales of $550,000. Fixed

costs dont change with sales. However, variable costs do, and so the budgeted variable cost ratio can be used to make the adjustment. For example,
the adjusted budget for scrap is ($10,000/$500,000) $550,000 = $11,000.
For January, quality costs were 18% of sales ($99,200/$550,000). This is
higher than the budgeted amount of 17%, but lower than previous periods.

77

1414
1.

2009
Appraisal costs:
Prevention costs:
Internal failure costs:
External failure costs:

$360,000/$2,048,000 = 17.6%
$8,000/$2,048,000 = 0.4%
$1,000,000/$2,048,000 = 48.8%
$680,000/$2,048,000 = 33.2%

The pie chart for 2009 is as follows:

Quality Costs

Appraisal
17.6%
External
Failure

Prevention
0.4%

33.2%

48.8%
Internal Failure

78

1414 Continued
2010
Appraisal costs:
$328,000/$2,048,000 = 16.0%
Prevention costs:
$160,000/$2,048,000 = 7.8%
Internal failure costs: $820,000/$2,048,000 = 40.0%
External failure costs: $740,000/$2,048,000 = 36.1%
(Total adds to 99.9% due to rounding error.)
The pie chart for 2010 is as follows:
Quality Costs
Appraisal
16.0%

External Failure

36.1%

7.8%

Prevention

40.0%
Internal Failure

Yes. More effort is clearly needed for prevention and appraisal activities. The
movement is in that direction, and total failure costs have declined.

79

1414 Concluded
2.

Major Company
Performance Report: Quality Costs
One-Year Trend
For the Year Ended December 31, 2010
Actual Costs
2010
Prevention costs:
Quality circles.................
Design reviews...............
Improvement projects....
Total prevention........
Appraisal costs:
Packaging inspection....
Product acceptance.......
Total appraisal...........
Internal failure costs:
Scrap................................
Rework.............................
Yield losses.....................
Retesting.........................
Total internal failure..
External failure costs:
Returned materials.........
Allowances......................
Warranty..........................
Total external failure.
Total quality costs...............

Actual Costs*
2009

40,000
20,000
100,000
$ 160,000

$ 300,000
28,000
$ 328,000

$ 400,000
50,000
$ 450,000

$ 100,000 F
22,000 F
$ 122,000 F

$ 240,000
320,000
100,000
160,000
$ 820,000

$ 350,000
450,000
200,000
250,000
$ 1,250,000

$ 110,000
130,000
100,000
90,000
$ 430,000

F
F
F
F
F

$ 160,000
140,000
440,000
$ 740,000
$ 2,048,000

$ 200,000
150,000
500,000
$ 850,000
$ 2,558,000

$ 40,000
10,000
60,000
$ 110,000
$ 510,000

F
F
F
F
F

4,000
2,000
2,000
8,000

Variance
$ 36,000
18,000
98,000
$ 152,000

U
U
U
U

*To compare 2010 costs with 2009 costs, the costs for 2009 must be adjusted
to a sales level of $10,000,000. Thus, all variable costs will change from the
2009 levels. For example, the adjusted product inspection cost is
($320,000/$8,000,000) $10,000,000 = $400,000.
Profits increased by $510,000.
3.

$2,048,000 ($10,000,000 2.5%) = $1,798,000

80

1415
1.

Prevention
1.00%
4.17
5.00
6.67
10.00

2006........
2007........
2008........
2009........
2010........

Appraisal
2.00%
2.50
4.29
2.50
1.00

Internal
16.00%
10.00
5.00
4.17
2.40

External
12.00%
8.33
3.57
3.33
1.60

2.
Trend in Quality Costs
35

Percentage of Sales

30
25
20
15
10
5
0
2006

2007

2008
Year

81

2009

2010

Total
31.00%
25.00
17.86
16.67
15.00

1415 Concluded
Trend by Category

Percentage of Sales

20

15

10

0
2006

2007

2008

2009

2010

Year
Prevention

Appraisal

Internal Failure

External Failure

Yes, quality costs overall have dropped from 31% of sales to 15% of sales, a
significant improvement. Real evidence for quality improvement stems from
the fact that internal failure costs have gone from 16% to 2.4%, external
failure costs from 12% to 1.6%, and appraisal costs from 2% to 1%. This
reduction of failure costs has been achieved by putting more resources into
prevention (from 1% to 10%).
3.

Quality costs at the 2006 rates:

2009.........
2010.........

Prevention
$6,000
5,000

Appraisal
$12,000
10,000

Internal
$96,000
80,000

Profit increase (2009): $186,000 $100,000 = $86,000

Profit increase (2010): $155,000 $75,000 = $80,000

82

External
$72,000
60,000

Total
$186,000
155,000

1416
1.

Iona Company
Interim Performance Report: Quality Costs
For the Year Ended December 31, 2010
Prevention costs:
Fixed:
Quality planning.....
Quality training.......
Special project........
Quality reporting....
Total prevention................
Appraisal costs:
Variable:
Proofreading...........
Other inspection.....
Total appraisal...................
Failure costs:
Variable:
Correction of typos
Rework.....................
Plate revisions........
Press downtime......
Waste.......................
Total failure........................
Total quality costs.............

Actual Costs

Budgeted Costs

Variance

$ 150,000
20,000
100,000
12,000
$ 282,000

$ 150,000
20,000
80,000
10,000
$ 260,000

0
0
20,000 U
2,000 U
$22,000 U

$ 520,000
60,000
$ 580,000

$ 500,000
50,000
$ 550,000

$20,000 U
10,000 U
$30,000 U

$ 165,000
76,000
58,000
102,000
136,000
$ 537,000
$ 1,399,000

$ 150,000
75,000
55,000
100,000
130,000
$ 510,000
$ 1,320,000

$15,000
1,000
3,000
2,000
6,000
$27,000
$79,000

U
U
U
U
U
U
U

The firm failed across the board to meet its budgeted goals for the year. All
categories and each item were equal to or greater than the budgeted
amounts.

83

1416 Continued
2.

Iona Company
Performance Report: Quality Costs
One-Year Trend
For the Year Ended December 31, 2010

Prevention costs:
Fixed:
Quality planning.....
Quality training.......
Special project........
Quality reporting....
Total prevention................
Appraisal costs:
Variable:
Proofreading...........
Other inspection.....
Total appraisal...................
Failure costs:
Variable:
Correction of typos
Rework.....................
Plate revisions........
Press downtime......
Waste.......................
Total failure........................
Total quality costs.............

Actual Costs
2010

Actual Costs
2009

Variance

$ 150,000
20,000
100,000
12,000
$ 282,000

$ 140,000
20,000
120,000
12,000
$ 292,000

$ 10,000 U
0
20,000 F
0
$ 10,000 F

$ 520,000
60,000
$ 580,000

$ 580,000
80,000
$ 660,000

$ 60,000 F
20,000 F
$ 80,000 F

$ 165,000
76,000
58,000
102,000
136,000
$ 537,000
$1,399,000

$ 200,000
131,000
83,000
123,000
191,000
$ 728,000
$1,680,000

$ 35,000
55,000
25,000
21,000
55,000
$ 191,000
$ 281,000

F
F
F
F
F
F
F

Profits increased $281,000 because of the reduction in quality costs from

2009 to 2010. Thus, even though the budgeted reductions for the year were
not met, there was still significant improvement. Moreover, most of the
improvement came from reduction of failure costs, a positive signal
indicating that quality is indeed increasing.

84

1416 Continued
3.
Trend in Total Quality Costs
0.25

Percentage of Sales

0.20

0.20
0.18
0.165

0.15

0.14
0.10

0.11

0.05

0.00
2006

2007

2008

2009

Year

Note: Percentages are calculated as follows:

2006: $2,000,000/$10,000,000; 2007: $1,800,000/$10,000,000;
2008: $1,815,000/$11,000,000; 2009: $1,680,000/$12,000,000;
2010: $1,320,000/$12,000,000.

85

2010

1416 Continued
4.
Multiperiod Trend by Category
10

Percentage of Sales

0
2006

2007

2008

2009

2010

Year
Prevention

Appraisal

Internal Failure

External Failure

Increases in prevention and appraisal costs with simultaneous reductions in

failure costs are good signals that overall quality is increasing. (Decreases in
external failure costs are particularly hard to achieve without quality actually
increasing.)

86

1416 Concluded
5.

Iona Company
Long-Range Performance Report
For the Year Ended December 31, 2010
Actual Costs
2010a
Prevention costs:
Fixed:
Quality planning........
Quality training..........
Special project..........
Quality reporting.......
Total prevention...................
Appraisal costs:
Variable:
Proofreading..............
Other inspection.......
Total appraisal......................
Failure costs:
Variable:
Correction of typos...
Rework.......................
Plate revisions...........
Press downtime........
Waste..........................
Total failure...........................
Total quality costs...............
a

Long-Range
Target Costsb

Variance

$ 150,000
20,000
100,000
12,000
$ 282,000

0
112,500
0
26,250
$ 138,750

$ 150,000
92,500
100,000
14,250
$ 143,250

$ 650,000
75,000
$ 725,000

$ 187,500
48,750
$ 236,250

$ 462,500 U
26,250 U
$ 488,750 U

$ 206,250
95,000
72,500
127,500
170,000
$ 671,250
$ 1,678,250

$ 206,250
95,000
72,500
127,500
170,000
$ 671,250
$ 1,303,250

0
0
0
0
0
$
0
$ 375,000

U
F
U
F
U

U
U
U
U
U
U
U

Except for prevention costs, which are fixed, actual costs of 2010 are
adjusted to a sales level of $15 million by multiplying the actual costs at $12
million by 15/12. This report is prepared at the end of 2010.

2.5% of $15,000,000 = $375,000.

Quality training: 30% $375,000 = $112,500

Quality reporting: 7% $375,000 = $26,250
Proofreading:
50% $375,000 = $187,500
Other inspection: 13% $375,000 = $48,750

87

1417
1.
Prevention..................
Appraisal....................
Internal failure...........
External failure..........
Total......................

Diapers
0.9%
0.8
1.8
1.5
5.0%

Napkins
1.00%
1.17
1.08
0.75
4.00%

Paper
Towels
1.63%
1.63
1.63
1.63
6.52%

Total
1.08%
1.08
1.55
1.30
5.01%

The company has achieved its goal as no more than 5% of sales was spent
on quality (in total). Looking at individual products, the best outcome
(napkins) seems to be where appraisal and prevention costs exceed failure
costs. If this distribution is better, the total suggests that more should be
spent on prevention and appraisal. Opportunities to do so are present in the
diaper and paper towel lines.
2.
Prevention..................
Appraisal....................
Internal failure...........
External failure..........
Total......................

Diapers
1.8%
1.6
3.6
3.0
10.0%

Napkins
2.00%
2.33
2.17
1.50
8.00%

Paper
Towels
3.25%
3.25
3.25
3.25
13.00%

Total
2.15%
2.15
3.10
2.60
10.00%

For this scenario, the goal of 5% is far from being reached. If the idea of
balancing costs by category is true, then further reductions can be achieved
by shifting more resources into prevention and appraisal activities. Of the
three lines, the diaper line is particularly one where more resources should
be spent on prevention and appraisal activities. Shifting more resources into
these two categories has the potential to reduce the percentage for each line
to 5% or below.
Shifting more resources into prevention for paper towels and napkins would
not create balanced categories. It appears difficult to achieve the overall 5%
goal by balancing category costs. The preceding results suggest that the
even distribution suggestion of the divisional manager may not be the
optimal combination. Perhaps even more emphasis should be placed on
control costs.

88

1417 Concluded
3.
Prevention..................
Appraisal....................
Internal failure...........
External failure..........
Total......................

Diapers
1.80%
1.60
3.60
3.00
10.00%

Napkins
3.33%
3.89
3.61
2.50
13.33%

Paper
Towels
2.03%
2.03
2.03
2.03
8.12%

Total
2.15%
2.15
3.10
2.60
10.00%

Again, more should be spent on prevention and appraisal activities. However,

the lines on which to concentrate these resources are now the diaper and
paper towel lines.
4.

If quality costs are reported by segment, a manager will know where to

concentrate efforts for cost reduction.

COLLABORATIVE LEARNING EXERCISE

1418
1.

Len should know that the bonuses are intended for those who legitimately
achieve the budgeted quality goals. The three actions taken by Len were
manipulative in naturetheir objective was simply to massage the performance statistic so that he could receive his bonus. Since Lens bonus is
achieved
simultaneously with that of his employees, there is some question whether he
really had their interest in mind or simply his own. The behavior exhibited by
Len is not ethical. The heart of ethical behavior is sacrificing ones selfinterest for the well-being of others. By engaging in manipulative behavior,
Len is damaging the reputation of the company and providing poor services
and products to customers. Len should have stressed the importance of
achieving the quality goals by continuing to strive for the current years goal
by improving quality. If the goal is not achieved this year, then the lack of
financial reward should be an additional incentive for better performance for
the coming year.

2.

First and foremost, the company should attempt to hire individuals with
integrity. Second, the company should make sure that the performance and
reward system is fair and acceptable to managers and employees. Perhaps
the company could provide a percentage of the savings from quality
improvements rather than making it an all or nothing bonus, based on
achieving some predetermined target. Finally, the company should have in
place a good monitoring system to discourage the type of behavior Len is
exhibiting, e.g., a good internal audit program.

89

1418 Concluded
3.

Len has violated the ethical code; he has a responsibility to refrain from
engaging in any conduct that would prejudice carrying out duties ethically
(III-2) and to abstain from engaging in or supporting any activity that might
discredit the profession (III-3).

CYBER RESEARCH CASE

1419 Answers will vary.

90