Exercise 19-17: Cost of Quality Analysis

Definitions:
Prevention Costs: Costs incurred to preclude the production of products
that do not conform to quality specifications.
Appraisal Costs: Costs incurred to detect which of the individual units of
products do not conform to quality specifications.
Internal Failure Costs: Costs incurred on a defective product before it is
shipped to customers.
External Failure Costs: Costs incurred on a defective product after it is
shipped to customers.
Dream Rider produces car seats for children from newborn to 2 years old.
The company is worried because one of its competitors has recently
come under public scrutiny because of product failure. Historically,
Dream Rider's only problem with its car seats was stitching in the straps.
The problem can usually be detected and repaired during an internal
inspection. The cost of the inspection is $4, and the repair cost is $.75.
All 250,000 car seats were inspected last year and 9% were found to
have problems with the stitching in the straps during the internal
inspection. Another 3% of the 250,000 car seats had problems with the
stitching, but the internal inspection did not discover them. Defective
units that were sold and shipped to customers needed to be shipped
back to Dream Rider and repaired. Shipping costs are $7, and repair
costs are $.75. However, the out-of-pocket costs (shipping and repair)
are not the only costs of defects not discovered in the internal
inspection. For 20% of the external failures, negative word of mouth
will result in a loss of sales, lowering the following year's sales by $300
for each of the 20% of units with external failures.
Required:
1. Calculate appraisal cost.
Appraisal cost = inspection cost = $4 X 250,000 car seats = $1,000,000
1000000
2. Calculate internal failure cost.
Internal failure costs = rework costs = (9% X 250,000) X $.75 = $16,875
16875
3. Calculate out-of-pocket external failure cost,
Out-of-pocket cost = (shipping cost + repair cost) X defective units
Out-of-pocket cost = ($7 + $.75) X (3% X 250,000) = $7.75 X 7,500 = $58,125
58125
4. Determine the opportunity cost associated with the external failures
External failures = Lost future sales = (3% X 250,000) X 20% X $300
External failures = 7,500 X 20% X $300 = 1,500 X $300 = $450,000

5. What are the total cost of Quality?

Appraisal costs
Internal failure
External failure (out-of-pocket)
External failure (lost sales)
Total

$1,000,000
$16,875
$58,125
$450,000
$1,525,000

6. Dream Rider is concerned with the high up-front cost of inspecting all
250,000 units. It is considering an alternative internal inspection plan that
will cost only $1.00 per car seat inspected . During the internal inspection,
the alternative technique will detect only 5% of the 250,000 car seats as
having stitching problems. The other 7% with stitching problems will be
detected after the car seats are sold and shipped. What are the total costs
of quality for the alternative technique.
Appraisal cost = $1.00 X 250,000 =

$250,000

Internal failure cost = (.05 X 250,000) X $.75 (rework) =

$9,375

External failure (out-of-packet) costs = 7% X 250,000 X ($7 + $.75) =

External failure (0pportuniy cost) = 20% X (.07 X 250,000) X $300 =
Total cost of quality control =
Appraisal costs
Internal failure
External failure (out-of-pocket)
External failure (lost sales)
Total

$135,625
$1,050,000

$250,000
$9,375
$135,625
$1,050,000
$1,445,000

7. What factors other than cost should Dream Rider consider before changing
inspection techniques?
In addition to lower costs under the alternative inspection plan, Dream Rider
should consider a number of other factors.
a. There could easily be serious reputation effects if the % of external failures
increases by 133% from 3% to 7% This rise in external failures may lead to
costs greater than $500 per failure due to lost sales.
b. Higher external failure rates may increase the probability of lawsuits.
c. Government intervention is a concern, with the chances of government
regulation increasing with the number of external failures.
Exercise 19-18: Cost of Quality, Ethical Considerations
Refer to information in Exercise 19-17 in answering this question. Dream Rider has discovered a more
serious problem with the plastic core of its car seats. An accident can cause the plastic in some of the

seats to crack and break, resulting in serious injuries to the occupant. It is estimated that this problem
will affect about 175 car seats in the next year. This problem could be corrected by using a higher
quality of plastic that would increase the cost of every car seat produced by $15. If this problem is not
corrected, Dream Rider estimates that out of the 175 accidents, customers will realize that the problem
is due to a defect in the seats in only three cases. Dream Rider's legal team has estimated that each of
these three accidents would result in a lawsuit that could be settled for about $775,000. All lawsuits
settled would include a confidentiality clause, so Dream Rider's reputation would not be affected.
1. Assuming that Dream Rider expects to sell 250,000 car seats next year, what would be the
cost of increasing the quality of all 250,000 car seats?
$15 X 250,000 =

$3,750,000

2. What will be the total cost of the lawsuits next year if the problem is not corrected?
3 X $775,000 =

$2,325,000

3. Dream Rider has decided not to increase the quality of the plastic because the cost of
increasing the quality exceeds the benefits (saving the cost of lawsuits). What do you
think of this decision? (Note: Because of the confidentiality clause, the decision will have
no effect on Dream Rider's reputation.)
While economically this may seem like a good decision, qualitative factors should be more
important than quantitative factors when it comes to protecting customers from harm and
injury. If a product can cause a customer serious harm and injury, an ethical and moral
company should take steps to prevent that harm and injury. The company's code of ethics
should guide this decision.
4. Are there any other costs or benefits that Safe Rider should consider?
In addition to ethical considerations, the company should consider the societal cost of this decision,
reputation effects if word of these problems leaks out at a later date, and governmental intervention
and regulation.

Exercise 19-20 Quality improvement, relevant costs, relevant revenues

Given:
SpeedPrint manufactures and sells 18,000 high-technology printing presses each year.
The variable and fixed costs of rework and repair are as follows:

Rework costs per hour

Repair costs
Customer-support costs per hour
Transportation costs per load
Warranty repair costs per hour

Variable
Costs
$79

Fixed
Costs
$115

Total
Costs
$194

35
350
89

55
115
150

90
465
239

Quality Problem: Current presses have a quality problem which causes viarations in the
shade of some colors.
Proposal: Change a key component in each press
Extra cost of new component
Component per press
# of presses requiring component
Time horizon (in years)

$70
1
18,000
1

Advantages/Savings with component change

Fixed rework costs saved
$0
Fixed repair costs saved
$0
Rework hours saved
14,000
Customer support hours saved
850
Hours of warranty repairs saved
8,000
Fewer loads moved
225
Additional unit sales of presses
140
Contribution margin generated by
additional sales of presses
$1,680,000
Required:
1. Should SpeedPrint change to the new component?
($1,260,000)

Cost of change: $70 X 1 X 18,000 original sales level

Advantages:
Additional CM generated through sales
COQ Savings
Variable rework cost savings
Variable customer support savings
Variable transportation savings
Variable warranty repair cost savings
Net advantage of changing component

$1,680,000
1,106,000
29,750
78,750
712,000

$3,606,500
$2,346,500

2. Suppose the estimate of 140 additional presses sold is uncertain. What

is the minimum number of additional presses that SpeedPrint needs to
sell to justify adopting the new press?

Net advantage of changing component

Additional CM generated through sales
Additional TCM generated without additional sales
Thus no additional sales are needed.
Note: If additional sales had been needed:
Additional TCM needed through additional sales (assumed)
Since:
TCM generated from 140 units of additional sales =
$1,680,000
Additional CM expected per new unit sold ($1,680,000 / 140)
Additional unit sales needed to justify component change

$2,346,500
$1,680,000
$666,500

$1,000,000

12,000
83.33

Exercise 19-29 Statistical quality control

Given:
Keltrex Cereals produces a wide variety of breakfast products. The company's three best
selling breakfast cereals are Double Bran Bits, Honey Wheat Squares, and Sugar King Pops.
Each box of a particular type of cereal is required to meet pre-determined weight specifications,
so that no single box contains more or less cereal than another. The company measures the
mean weight per production run to determine if there are variances over or under the company's
specified upper and lower level control limits. A production run that falls outside of the specified
control limit does not meet quality standards and is investigated further by management to
determine the cause of the variance. The three Keltrex breakfast cereals had the following
weight standards and production run data for the month of March.
March results:
Double Bran Bits

Lower (1)

Upper (2)

Double Bran Bits

Production

Std. Mean Weight

2-Sigma

2-Sigma

Actual Mean Weight

Run #

Per Production Run

Control Limit

Control Limit

Per Production Run

1
2
3
4
5
6
7
8
9
10

17.97
17.97
17.97
17.97
17.97
17.97
17.97
17.97
17.97
17.97
0.28

17.41
17.41
17.41
17.41
17.41
17.41
17.41
17.41
17.41
17.41

18.53
18.53
18.53
18.53
18.53
18.53
18.53
18.53
18.53
18.53

18.23
18.14
18.22
18.30
18.10
18.05
17.84
17.66
17.60
17.52

Std. Deviation

(1) 17.97 - (2)(.28) = 17.41

(2) 17.97 + (2)(.28) = 18.53
Honey Wheat Squares

Lower (1)

Upper (2)

Honey Wheat Squares

Production

Std. Mean Weight

2-Sigma

2-Sigma

Actual Mean Weight

Run #

Per Production Run

Control Limit

Control Limit

Per Production Run

1
2
3
4
5
6
7
8
9
10

14
14
14
14
14
14
14
14
14
14
0.16

13.68
13.68
13.68
13.68
13.68
13.68
13.68
13.68
13.68
13.68

14.32
14.32
14.32
14.32
14.32
14.32
14.32
14.32
14.32
14.32

14.11
14.13
13.98
13.89
13.91
14.01
13.94
13.99
14.03
13.97

Std. Deviation

(1) 14.00 - (2)(.16) = 13.68

(2) 14.00 + (2)(.16) = 14.32
Sugar King Pops

Lower (1)

Upper (2)

Sugar King Pops

Production

Std. Mean Weight

2-Sigma

2-Sigma

Actual Mean Weight

Run #

Per Production Run

Control Limit

Control Limit

Per Production Run

1
2
3

16.02
16.02
16.02

15.60
15.60
15.60

16.44
16.44
16.44

15.83
16.11
16.24

4
5
6
7
8
9
10
Std. Deviation

16.02
16.02
16.02
16.02
16.02
16.02
16.02
0.21

15.60
15.60
15.60
15.60
15.60
15.60
15.60

16.44
16.44
16.44
16.44
16.44
16.44
16.44

15.69
15.95
15.50
15.86
16.23
16.15
16.60

(1) 16.02 - (2)(.21) = 15.60

(2) 16.02 + (2)(.21) = 16.44
Required:
1. Using the 2-Sigma rule, what variance investigation decision would be made?
The 2-Sigma rule will trigger a decision to investigate whenever the actual mean weight of a
production run is outside of the control limits.
Upper:
Lower:

Mean + (2 X Std. Deviation)

Mean - (2 X Std. Deviation)

The only runs with values outside the specified control limits were associated with the
production of Sugar King Pops. Runs: 6 and 10
2. Present the Statistical Control Charts for each of the three breakfast cereals for
March. What inferences can be drawn from the charts?
See Chart 1, 2, and 3.
Chart 1:

Double Bran Bits had no production run observations outside the control limits.
However, there is an apparent trend observable from the statistical control chart
which shows steady movement toward the lower control limit. This trend should
be investigated by management to learn if there is faulty equipment or an out of
control process that will eventually result in under weighted cereal boxes.

Chart 2:

Honey Wheat Squares has no observations outside of either control limts. In

fact, the process appears to be in control. Variations appear to be random in
nature with no apparent trends that warrant further investigation.

Chart 3:

Sugar King Pops has two observations outside the control limits. One falls below
the lower control limit and one above the upper control limit. These two production
runs are not in conformance with quality standards. Management attention is
needed to determine the cause of the significant variances.

3. What are the costs of quality in this example?

Prevention Costs: Costs incurred to preclude the production of products that do not
conform to quality specifications. Examples include costs of designing the process,
maintaining equipment, and employee training to properly operate the production line.
Appraisal Costs: Costs incurred to detect which of the individual units of products do
not conform to quality specifications. Examples include costs of inspections to check
weight of cereal boxes.
Internal Failure Costs: Costs incurred on a defective product before it is shipped to
customers. Examples include costs of refilling cereal boxes that do not meet specifications;

costs to fix causes of failure such as machine calibration, material variability, or human
error; costs of reconfiguring manufacturing processes to prevent errors in filling cereal boxes.
External Failure Costs: Costs incurred on a defective product after being shipped to
customers. Examples include costs of customer ill-will, costs of returning and replacing
incorrectly filled boxes.
How could Keltrex employ Six Sigma programs to improve quality?
Six Sigma quality is a standard of excellence that requires a strict understanding of both
customer expectations and reasons for manufacturing defects to improve current quality
performance. The statistical term six sigma translates to 3.4 defects per 1 million incidents,
or near perfection in quality variability. Key aspects of Six Sigma are to define, measure,
analyze, improve and control processes.
Keltrex Cereals could employ Six Sigma programs to reduce variability in box weights. The
company would first need to define the quality problem (i.e. variability in weight per cereal
box), measure the incidents of defect using statistical quality control tools, analyze potential
reasons for variability in the weight per cereal box (machine calibration, material variability,
human error, etc). Assuming, as an example, that the variability is due to machines the
compamy may choose to better calibrate the existing machines, purchase new machines
that are more precise, or investigate other engineering alternatives. Finally, as improvements
are made to the existing machines, the company needs to monitor the improvements to
ensure that the variability problem has been resolved.

Statistical Control Chart

Double Bran Bits
for the Month of March
18.8
18.6
18.4
18.2
18
17.8
17.6
17.4
17.2
17
16.8
1

Standard Mean Weight (Ounces)

6
Lower Control Weight

Upper C

ol Chart
Bits
f March

eight

8
Upper Control Limit

10

Statistical
Control Chart for
Honey Wheat Squares for Marc
14.4
14.2
14
13.8
13.6
13.4
13.2
1

Standard Mean Weight (Ounces)

6
Lower Control Limit

Upper C

al
rt for
res for March

Limit

8
Upper Control Limit

10

Statistical Control Chart

Sugar King Pops
March
16.8
16.6
16.4
16.2
16
15.8
15.6
15.4
15.2
15
14.8
1

Standard Mean Weight

6
Lower Control Limit

Upper C

ol Chart
Pops

imit

8
Upper Control Limit

10

Investigate or not investigate

Given:
You are the manager of a manufacturing process. A significant material efficiency
variance of $10,000 has been reported for the week's operations. The magnitude
of the variance falls outside of the upper control limit of a statistical control diagram.
You are trying to decide whether to investigate this variance. You feel that if you do
not investigate and the process is out of control, the present value of the cost savings
foregone over the planning horizon is $3,800. The cost to investigate is $500. The
cost per period of being out of control is $700. If an out-of-control process is
discovered, the cost of correcting it is $300. You assess the probability that the
process is out of control at 30%.
Required:
1. Should the process be investigated? What are the expected costs of
investigating and of not investigating?
State of Nature

Actions

In Control

Probability of the state of nature

Investigate the process (and fix if necessary)
Do not investigate the process

Out of Control

EMV of the
Decision

0.70

0.30

($500)

($1,500)

($800)

$0

($3,800)

($1,140)

Decision: Investigate

2. At what level of probability that the process is out of control would the
expected costs of each action be the same?
State of Nature
In Control
Probability of the state of nature
Investigate the process (and fix if necessary)
Do not investigate the process

EMV of Investigate:
EMV of Do Not Investigate:
Point of Indifference

Investigate the process (and fix if necessary)

Do not investigate the process

EMV of the

1-X

Decision

($500)

($1,500)

#VALUE!

$0

($3,800)

#VALUE!

($500)(X) +(1-X)($1,500) =
($0)(X) + (1-X)($3,800) =
$500(X)+$1,500-$1,500(X) = $3,800-$3,800(X)
$-1,000(X) +$1,500 = $3,800 - $3,800(X)
$2,800(X) = $2,300
X = $2,300/$2,800 =
0.8214285714
(1-X) =
0.1785714286

Proof:
Probability of the state of nature

Out of Control

State of Nature
In Control

Out of Control

EMV of the

0.821428571

0.178571429

Decision

($500)

($1,500)

($679)

$0

($3,800)

($679)

3. If the cost variance is $10,000, why is the cost savings foregone over the
planning horizon $3,800?
The $10,000 is the absolute size of the materials efficiency variance. Perhaps

the plant manager has already taken steps to prevent continued incurrence of the
variance (such as requiring suppliers to check more thoroughly the quality of their
materials). This action would reduce the magnitude of subsequent materials
efficiency variances. Alternatively, a large chunk of the variance may be a random
deviation. If so, it would be impossible to count on saving the full amount even if
the process is out of control.

Exercise 19-25 Theory of Constraints

Given:
The Mayfield Corporation manufactures filing cabinets in two operations: machining
and finishing.
Machining Finishing
Annual capacity (units)
100,000
80,000
Annual production (units)
80,000
80,000
Fixed operating costs (excluding DM)
$640,000 $400,000
Fixed operating costs per unit produced
$8
$5
Each cabinet sells for
Variable costs (all direct materials; added at the beg. of machining)
Demand is unlimited (Can sell all it can produce.)

$72
$32

Required:
1. Mayfield is considering using some modern jigs and tools in the finishing
operation that would increase annual finishing output by 1,000 units. The
annual cost of these jigs and tools is $30,000. Should Mayfield acquire
these tools?
Finishing is a bottleneck.
Modern jigs and tools would relax the bottleneck by 1,000 units.
Benefit of modern jigs and tools:
Additional contribution margin generated
$40,000
Incremental fixed costs associated with tools
(30,000)
Net advantage of buying modern jigs and tools
$10,000
Recommendation: Buy modern jigs and tools
2. The production manager of the Machining Department has submitted a
proposal to do faster setups that would increase the annual capacity of
the Machining Department by 10,000 units and cost $5,000 per year.
Should Mayfield implement the change?
Machining already has excess capacity and is therefore not a bottleneck
operation. Increasing its capacity further will not increase throughput contribution.
Therefore, there is no benefit from spending $5,000 to increase the Machining
Department's capacity by 10,000 units.
Recommendation: Do not implement the change to do faster setups.
3. An outside contractor offers to do the finishing operation for 12,000 units
at $10 per unit, double the $5 per unit that it costs Mayfield to do the finishing
in-house. Should Mayfield accept the subcontractor's offer?
Finishing is a bottleneck operation.
Accepting the outside contractor's offer will increase output by 12,000 units.
Advantage of accepting
Additional Throughput CM from increased sales
$480,000

Cost of outside finishing

Net advantage of accepting the offer

(120,000)
$360,000

Recommendation: Accept the offer.

4. The Hunt Corporation offers to machine 4,000 units at $4 per unit, half the $8
per unit that it costs Mayfield to do the machining in-house. Should Mayfield
accept the subcontractor's offer?
If Mayfield provides the materials to be converted, there is no variable cost savings
by accepting Hunt Corporation's offer. All other costs incurred by Mayfield are fixed.
Therefore, there is no cost savings by accepting the Hunt offer. In addition, since
the machining department is not a bottleneck, no additional throughput contribution
will be generated by accepting the offer from Hunt Corporation. Sales is limited by
the capacity of the finishing department. If the offer is accepted, costs will increase
by 4,000 X $4 = $16,000.
Recommendation: Reject the Hunt offer.
Exercise 19-26
Required:
1. Mayfield produces 2,000 defective units during the machining operation. What is
the cost to Mayfield of the defective items produced?
Machining is not a bottleneck operation.
Producing 2,000 defective units does not reduce throughput contribution; machining
can still produce and transfer 80,000 good units to finishing.
Therefore, the cost of the defective units is $32 X 2,000 = $64,000.
2. Mayfield produces 2,000 defective units at the finishing operation. What is
the cost to Mayfield of the defective items produced?
Finishing is a bottleneck operation.
Producing 2,000 defective units in the bottleneck operation will reduce throughput
contribution.
Therefore, the cost of the defective units is
Lost materials added in the machining department 2,000 X $32 =
Lost throughput contribution in finishing department 2,000 X ($72-$32)=
Total cost of the 2,000 defective units
Another approach:
Revenue from units sold
Cost of units sold (includes spoiled units, if any)
Gross profit
Total cost of the 2,000 defective units

**

$64,000
80,000
$144,000

No Defects

2,000 Defects

$5,760,000
$2,560,000
$3,200,000

$5,616,000
$2,560,000
$3,056,000
$144,000

** Note that the direct material cost is irrelevant; whether the units are defective or good
the direct material costs will be incurred.

Alternative calculation: 2,000 X $72 =

$144,000

$144,000

Exercise 19-31 Waiting times, manufacturing cycle times

Given:
The Seawall Corporation uses an injection molding machine to make a plastic product, Z39.
Seawall manufactures only after an order is received.
Average annual orders expected
50
Expected machine hours required per order
80
Annual machine capacity in machine hours
5,000
Definitions:
AMLT = Average manufacturing lead time
AOWT = Average order wait time
AOMT = Average order manufacturing time
AMLT = AOWT + AOMT
Required:
1. Calculate
a. The average amount of time that an order for Z39 will wait in line before it is
processed
AOWT =

(Average Annual Orders Expected) X (AOMT) X (AOMT)

2 X (Annual Mach. Capacity - (Average Annual Orders Expected X AOMT))

AOWT =

(50) X (80) X (80)

2 X (5,000 - (50 X 80))

AOWT =
AOWT =

320,000 / (2 X (5,000 - 4,000))

320,000
2,000

AOWT =

b.

160

hours per order

The average manufacturing lead time per order for Z39.

AMLT = AOWT + AOMT
AMLT = 160 + 80 = 240 hours

2. Seawall is considering introducing a new product, Y28. Seawall estimates that,

on average, it will receive 25 orders of Y28 in the coming year. Each order of
Y28 will take 20 hours of machine time. The average demand for Z39 will be
unaffected by the introduction of of Y28.
Calculate
a. The average waiting time for an order received and
AOWT =

(Average Annual Orders of Z39) X (AOMT) X (AOMT) + ( Average Annual Orders of Y28) X (AOMT) X (AOMT)
2 X [Annual Mach. Capacity - [(Annual orders expected Z39 X AOMT)] - [(Annual orders expected Y28) X (AOMT)]]

AOWT =

(50 X 80 X 80) + (25 X 20 X 20)

2 X [(5,000 - (50 X 80) - (25 X 20))]

AOWT =

330,000
1,000

AOWT =

330

hours

b. The average manufacturing lead time per order for each product, if Seawall
introduces Y28.
Z39
AMLT = AOWT + AOMT = 330 + 80 = 410 hours

Y28
AMLT = AOWT + AOMT = 330 + 20 = 350 hours

Exercise 19-32 Waiting times, relevant revenues, and relevant costs

Given:
Seawall is still debating whether it should introduce Y28. The following table provides
information on selling prices, variable costs, and inventory carrying costs for Z39 and Y28.
Seawall will incur additional variable costs and inventory carrying costs for Y28 only if it
introduces Y28.
Z39
Y28
Annual average number of orders
50
25
Average Manfucturing Lead Time (AMLT)
Produce only Z39 (from P19-31)
240
N/A
Produce both Z39 and Y28 (from P19-31)
410
350
Average SP per order if AMLT per order is
less than 320 hours
$27,000
$8,400
more than 320 hours
$26,500
$8,000
Variable cost per order
$15,000
$5,000
Inventory carrying cost per order per hour
$0.75
$0.25
Required:
1. Should Seawall manufacture and sell Y28.
Total Revenue /Cost Approach

Expected revenues
50 X $27,000
50 X $26,500
25 X $8,000
Total Revenues
Expected variable costs
50 X $15,000
25 X $5,000
Total VC
Expected carrying costs
50 X $.75 X 240
50 X $.75 X 410

Z39
Z39
Y28

Do Not
Produce
Y28
$1,350,000

$1,350,000
Z39
Y28

$750,000
$750,000

Z39

Produce
Y28

Relevant
Revenues
Costs

$1,325,000
200,000
$1,525,000

$175,000

$750,000
125,000
$875,000

$125,000

$9,000
$15,375.00

25 X $.25 X 350

Y28
$9,000
$591,000

Total Carrying Costs

Expected Revenues less Costs

Net benefit of producing Y28
Recommendation:
2.

$2,187.50
$17,562.50
$632,437.50

$8,562.50
$41,437.50
$41,437.50

Produce and sell Y28.

Should Seawall manufacture and sell Y28. Given changes indicated below.
Z39
Annual average number of orders
Average SP per order if AMLT per order is
less than 320 hours
more than 320 hours
Variable cost per order
Inventory carrying cost per order per hour
Total Revenue /Cost Approach

Expected revenues
50 X $27,000
50 X $26,500
25 X $6,000
Total Revenues
Expected variable costs
50 X $15,000
25 X $5,000
Total VC
Expected carrying costs
50 X $.75 X 240
50 X $.75 X 410
25 X $.25 X 350

Z39
Z39
Y28

Z39
Y28

$6,400
$6,000
$5,000
$0.25
Relevant
Revenues
Costs

$1,325,000
$150,000
$1,475,000

$125,000

$750,000
125,000
$875,000

$125,000

$750,000

$9,000

Y28

Expected Revenues less Costs

Net benefit of producing Y28

$27,000
$26,500
$15,000
$0.75

Produce
Y28

$750,000
Z39

25

$1,350,000

$1,350,000

Total Carrying Costs

Recommendation:

Do Not
Produce
Y28

Y28
50

$9,000
$591,000

$15,375.00
$2,187.50
$17,562.50
$582,437.50

$8,562.50
($8,562.50)
($8,562.50)

Do not produce and sell Y28.

Note: Total revenues decrease by $50,000, therefore difference between Q1

and Q2 is a decrease of $50,000.
($8,562.50)

d Y28) X (AOMT)]]

Exercise 19-17
Definitions:
Prevention Costs: Costs incurred to preclude the production of products
that do not conform to quality specifications.
Appraisal Costs: Costs incurred to detect which of the individual units of
products do not conform to quality specifications.
Internal Failure Costs: Costs incurred on a defective product before it is
shipped to customers.
External Failure Costs: Costs incurred on a defective product after it is
shipped to customers.
Required:
1. Classify the cost items into prevention, appraisal, internal failure, or external
failure categories.
2. Calculate the ratio of each COQ category to revenues in 2007 and 2008. Comment
on the trends in costs of quality between 2007 and 2008.
2007
Annual Revenue
Prevention Costs:
Design Engineering
Preventive equipment maintenance
Supplier evaluation
Total prevention costs
Appraisal Costs:
Inspection of production
Product-testing labor & equipment
Incoming material inspection
Total appraisal costs
Internal Failure Costs:
Scrap & rework
Breakdown maintenance
Total Internal failure costs
External Failure Costs:
Returned goods
Customer support
Warranty repair
Total external failure costs
Total Quality Costs:

Dollars
$210,000
110,000
80,000
$400,000

2007
$20,000,000
Percentages
1.05%
0.55%
0.40%
2.00%

2008

$220,000
530,000
50,000
$800,000

1.10%
2.65%
0.25%
4.00%

$170,000
250,000
80,000
$500,000

0.68%
1.00%
0.32%
2.00%

$720,000
180,000
$900,000

3.60%
0.90%
4.50%

$670,000
80,000
$750,000

2.68%
0.32%
3.00%

$120,000
80,000
1,000,000
$1,200,000
$3,300,000

0.60%
0.40%
5.00%
6.00%
16.50%
16.50%

$300,000
65,000
635,000
$1,000,000
$3,250,000

1.20%
0.26%
2.54%
4.00%
13.00%
13.00%

Dollars
$600,000
200,000
200,000
$1,000,000

2008
$25,000,000
Percentages
2.40%
0.80%
0.80%
4.00%

Between 2007 and 2008, the company's COQ declined from 16.50% to 13.00% of sales.
Analysis of individual COQ categories indicates that the company began allocating more
resources to prevention activities in 2008 relative to 2007. As a result, appraisal costs,
internal failure costs, and external failure costs declined in 2008.
However, management should investigate the reasons why the cost of returned goods
increased and initiate corrrective action where appropriate.

3. Give two examples of nonfinancial quality measures that the company could monitor in its
balanced scorecard as part of a total quality-control effort.
Examples
# of defective units shipped to customers as a % of total units shipped.
Ratio of good output to total output at each production process.
Employee turnover
Customer satisfaction surveys

Exercise 19-19
Given:
Eastern Switching Co. (ESC) produces telecommunications equipment.
The following information is available for the first year (2007) of ESC's
TQM program.
2006
2007
(No TQM) (New TQM)
Total # of units produced and shipped
10,000
11,000
Units delivered before or on scheduled delivery date
8,500
9,900
Number of defective units shipped
400
330
Customer complaints other than for defective units
500
517
Average time from order placement to delivery (in days)
30
25
Number of units reworked during production
600
627
Manufacturing lead time (in days)
20
16
Direct and indirect manufacturing labor-hours
90,000
110,000
Required:
1. For each of the years 2006 and 2007 calculate:
a. % of defective units shipped
b. On-tine delivery rate
c. Customer complaints as a % of units shipped
d. % of units reworked during production

2006
4.00%
85.00%
5.00%
6.00%

2007
3.00%
90.00%
4.70%
5.70%

2. On the basis of your calculations in requirement 1, has ESC's

performance on quality and timeliness improved?
The calculations in requirement #1 indicate:
Quality has improved because
a. % of defective units shipped decreased
b. Customer complaints as a % of units shipped have decreased
c. % of units reworked during production has decreased
Timeliness has improved as on-time delivery has increased. Better quality
and less rework reduces delays in production and enables shorter lead times and
enables on-time delivery to customers.
3. Philip Larken, a member of ESC's board of directors, comments that
regardless of the effect that the TQM program has had on quality, the
output per labor-hour has declined between 2006 and 2007. Larkin
believes that lower output per labor-hour will lead to an increase in costs
and lower operating income.
a. How did Larkin conclude that output per labor-hour declined in 2007
relative to 2006?
2006
2007
Output per labor-hour
0.11
0.10
b. Why might output per labor-hour decline in 2007?
Output per labor-hour may have declined from 2006 to 2007 either because
workers were less productive or more likely because the initial implementation
of the quality program may have resulted in lost production time as employees

were trained and became more adept at solving production quality problems.
As workers implement good quality practices and defects and rework decrease
over time, it is possible that both quality and productivity (output per labor-hour)
will increase.
c. Do you think that a lower output per labor-hour will decrease operating
income in 2007? Explain.
It is not clear that the lower output per labor-hour will decrease operating income
in 2007. The higher labor costs in 2007 could pay off in many ways. Higher quality
and lower defects will likely result in lower material costs because of lower defects
and rework. Internal and external failure costs will also be lower, resulting in lower
customer returns and warranty costs.
Customer satisfaction will likely increase, resulting in higher sales, higher prices,
and higher contribution margins. The 10% increase in the number of units produced
and sold in 2007 may well have been due to quality improvements. Overall, the
benefits of higher quality in 2007 may very well exceed the higher labor costs per unit
of output.

Exercise 19-29
Given:
Jetrans Airlines operates daily round-trip flights on the London-Los Angeles route using a fleet
of three 747s; the Spirit of Atlanta, the Spirit of Boston, and the Spirit of Sacramento.
The budgeted quantity of fuel for each round-trip flight is the 12-month mean (average) roundtrip fuel consumption of 200 gallon-units, with a standard deviation of 20 gallon-units. A gallonunit is 1,000 gallons.
Using a statistical quality control (SQC) approach, Shirly Watson, the Jetrans operations
manager, investigates any round-trip with fuel consumption that is greater than 2 standard
deviations from the mean.
October results:

Spirit of
Spirit of
Spirit of
Mean
Lower (1)
Upper (2)
Atlanta
Boston
Sacramento
Flight Fuel Usage
2-Sigma
2-Sigma
Fuel Usage Fuel Usage Fuel Usage
Number Per Flight Control Limit Control Limit Gallon-Units Gallon-Units Gallon-Units
1
200
160
240
208
206
194
2
200
160
240
187
188
208
3
200
160
240
194
192
221
4
200
160
240
202
214
208
5
200
160
240
211
184
242
6
200
160
240
215
226
234
7
200
160
240
216
198
249
8
200
160
240
218
212
227
9
200
160
240
221
202
232
10
200
160
240
232
186
244
(1) 200 - (2)(20) = 160
(2) 200 + (2)(20) = 240

Required:
1. Using the 2-Sigma rule, what variance investigation decision would be made?
The 2-Sigma rule will trigger a decision to investigate whenever the round-trip fuel usage
is outside of the control limits.
Upper:
Lower:

Mean + (2 X Std. Deviation) = 200 + (2 X 20) = 200 + 40 = 240

Mean - (2 X Std. Deviation) = 200 - (2 X 20) = 200 - 40 = 160

The only plane to be outside the specified control limits is the Spirit of Sacramento.
See red values above -- flights 5, 7, 10.
2. Present the Statistical Control Charts for round-trip fuel usage for each of the
three 747s in October. What inferences can be drawn from the charts?
See Chart 1, 2, and 3.
Chart 1: The Spirit of Atlanta has no observations outside either control limit.
However, there was an increase in fuel use in each of the last 9 round-trip
flights. The probability of 9 consecutive increases from an in-control process
is very low. This is a trend that should be investigated.

Chart 2: The Spirit of Boston appears to be in control regarding fuel usage.

Chart 3: The Spirit of Sacramento has 3 observations outside the upper control limit.
Moreover, the last 6 flights have been hovering close to the upper control
limit. This is unlikely for an in-control operation.
3. Some managers propose that Jetrans Airlines present its quality control chart
in monetary terms rather than in physical-quantity terms (gallon-units). What
are the advantages and disadvantages of using monetary fuel costs rather than
gallon-units in the SQC charts?
Advantage:
Focuses on a variable of overriding concern to top managers -- operating costs ($)
Disadvantages:
Split responsibilities.
Operations managers may not control the purchase of fuel, and therefore may want
to exclude from their performance measures any variation stemming from factors
outside their control.
Offsetting factors may mask important underlying trends when the quantity used
and the price paid are combined in a single observation.
For example, decreasing gallon usage may be offset by increasing fuel costs.
Both of these individual patterns are important in budgeting for an airline.
The distribution of fuel usage in gallons may be different from the distribution
of fuel prices per gallon. More reliable estimates of the mean and standard
deviation parameters might be obtained by focusing separately on the individual
usage and price distributions.
Note: The above disadvantages are most marked if actual fuel prices are used.
The use of standard fuel prices can reduce many of these disadvantages.

Spirit of Atlanta 2-Sigma SCC for Fuel Consumption Expressed in Gallon-Units

300

Gallon-Units

250

200
Column
C
Column
D
Column
E

150

100

50

0
1

5
6
Flight Number

10

Spirit of Boston 2-Sigma SCC for Fuel Consumption Expressed in Gallon Units

300

Gallon-Units

250

200
Column
C
Column
D
Column
E

150

100

50

0
1

5
6
Flight Number

10

Spirit of Sacramento 2-Sigma SCC for Fuel Consumption Expressed in Gallon-Units

300

Gallon-Units

250

200
Column
C
Column
D
Column
E

150

100

50

0
1

5
6
Flight Number

10

Exercise 19-35
Given:
Aardee Industries manufactures pharmaceutical products in two departments:

Measurement units
Capacity per hour (grams; tablets)
Monthly capacity (2,000 hours available per department)
Monthly production of good units
Fixed operating costs
Fixed operating costs per unit (grams; tablets)
DM costs; all incurred in the Mixing Department
% of the DM mixture lost in the tablet-making process
Grams of DMs needed per tablet
Selling price per tablet
All costs other than DM dollars are fixed

Mixing
grams
150
300,000
200,000
$16,000
$0.08
$156,000

Tablet
Making
tablets
200
400,000
390,000
$39,000
$0.10
2.50%
0.50
$1

The Mixing Department makes 200,000 grams of DM mixture (enough to make

400,000 tablets) because the Tablet-Making Department has only enough capacity
to process 400,000 tablets.
Required:
1. If Aardee will supply a contractor with 10,000 grams of mixture, the contractor
will manufacture 19,500 tablets for Aardee (allowing for the normal 2.5% loss
during the tablet-making process) at $.12 per tablet. Should Aardee accept
the contractor's offer?
19,500
Tablet-making is a bottleneck -- supplying the DM mixture and paying for external
tablet processing will generate additional throughput contribution of
Selling price per tablet
$1
DM costs per tablet
0.40
Outside contracting cost per tablet
0.12
Throughput contribution per tablet purchased
$0.48
Benefit if Aardee accepts the outside contractor's offer
$9,360
2. Another company offers to prepare 20,000 grams of mixture a month from
DM that Aardee supplies. The company will charge $.07 per gram of mixture.
Should Aardee accept the company's offer?
The mixing operation is not a bottleneck.
Buying extra mixture will not increase throughput contribution or decrease the
cost of obtaining the mixture since the mixing operations has no avoidable costs.
Recommendation: Reject the offer.
3. Aardee's engineers have devised a method that would improve quality in the
tablet-making operation. They estimate that the 10,000 tablets currently being
lost would be saved. The modifications would cost $7,000 a month.
Should Aardee implement the new method?

Tablet-making is a bottleneck operation.

The quality program will increase sales revenue by (no change in VC)
Monthly incremental cost of the quality program
Advange of the modifications

$10,000
7,000
$3,000

Recommendation: Implement the new methods

4. Suppose that Aardee also loses 10,000 grams of mixture in its mixing operation.
These losses can be reduced to zero if the company is willing to spend $9,000
per month in quality-improvement methods.
Should Aardee adopt the quality-improvement method?
Cost savings from quality programs (cost of previously lost mixture)
Cost of the quality program
Disadvantage of the quality-improvement

$7,800
9,000
($1,200)

Recommendation: Do not Implement the new quality-improvement method.

5. What are the benefits of improving quality at the mixing operation compared with
improving quality at the tablet-making operation?
The benefit of improving quality of the mixing operation is the savings in materials costs
less the cost of the improvement program.
The benefit of improving quality of the tablet-making operation (the bottleneck operation)
is the increased sales revenue less the cost of the improvement program.