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Quality costmeasurement

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Quality cost measurementunder activity-based costing

Wen-Hsien TsaiNational Central University, Chung-Li, Taiwan, Republic of China

IntroductionMany companies in the world gradually promote quality as the centralcustomer value and regard it as a key concept of company strategy in order toachieve the competitive edge (Ross and Wegman, 1990). Measuring andreporting the cost of quality (COQ) is the first step in a quality managementprogram. Even in s ervice indust ries, COQ systems receive considerableattention (Bohan and Horney, 1991; Carr, 1992; Ravitz, 1991). COQ systems arebound to increase in importance because COQ-related activities consume asmuch as 25 percent or more of the resources used in companies (Ravitz, 1991).

COQ information can be used to indicate major opportunities for correctiveaction and to provide incentives for quality improvement.

Traditional cost accounting, whose main functions are inventory valuationand income determination for external financial reporting, does not yield theCOQ information needed. While most COQ measurement methods areactivity/process oriented, traditional cost accounting establishes cost accountsby the categories of expenses, instead of activities. Under t radit ional costaccounting, many COQ-related costs are lumped into overheads, which areallocated to cost centers (usually departments) and then to products throughpredetermined overhead rates. For example, among various COQ-related costs,the rework and the unrecovered cost of spoiled goods caused by internalfailures are charged to the factory overhead control account which accumulatesthe actual overhead costs incurred (Hammer et al., 1993, pp. 155-64). Thepredetermined overhead rates should be adjusted to incorporate the normallevels of various COQ-related costs, and excess COQ-related costs will be buriedin overhead variances.

The cost accounting treatment described above cannot satisfy the needs of

COQ measurement. Thus, Oakland (1993, p. 210) claims that quality relatedcosts should be collected and reported separately and not absorbed into avariety of overheads. Prevention-appr aisal-failure (PAF) approach andprocess cost approach are two main approaches to measuring COQ. However,

International Journal of Quality& Reliability Management,

Vol. 15 No. 7, 1998, pp . 719-752, MCBUniversity Press, 0265-671X

Received March 1996

Revised March 1998

The author wishes to thank the anonymous referees for many helpful comments and suggestionsabout this paper. The author also wishes to thank the authors of references cited in this paper,especially the authors, Barr ie G. Dale and James J. Plunkett, of the book, Quality Costing, and theauthor, Peter B.B. Turney, of the book, Comm on Cents: The ABC Performance Breakthrough

How to Succeed with Activity-based Costing, from which this paper quotes a lot of COQ and BCconcept.


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these approaches still cannot provide appropriate methods to includeoverhead costs in COQ systems. Accordingly, many quality cost elementsrequire estimates and there is a prevailing belief in COQ literatu re. It is adanger that managers become too concerned with accuracy in COQdetermination a number-crunching exercise that will consume resourcesdisproportionately (Oakland, 1993, p. 197). In addition, most COQmeasurement systems in use do not t race quality costs to their sources(OGuin, 1991, p. 70), which hinders managers from identifying where thequality improvement opportunities lie. Nevertheless, these deficiencies couldbe easily overcome under activity-based costing (ABC) developed by Cooperand Kaplan of Harvard Business School (Cooper, 1988; Cooper and Kaplan,1988). ABC uses the two-stage procedure to achieve the accurate costs ofvarious cost objects (such as departments, products, customers, andchannels), tracing resource costs (including overhead costs) to activities, andthen tracing the costs of activities to cost objects.

The purpose of this paper is to present a conceptual framework formeasuring quality costs under ABC. First, the present approaches to measuring

COQ are reviewed; second, the two-dimensional model of ABC and activity-based management (ABM) is explained; third, COQ approaches and ABC arecompared and an integrated COQ-ABC framework is presented; fourth, COQmeasurement, COQ reporting, and uses of COQ information under ABC arediscussed; finally, a hypothetically simplified example is presented to illustratehow to measure COQ under ABC.

Approaches to measuring COQSince Juran (1951) discussed t he cost of qua lity, many r esearchers have

proposed various approaches to measuring COQ. Reviews of COQ literature canbe found in Plunkett and Dale (1987) and Porter and Rayner (1992). In thissection, we will briefly review the approaches to measuring COQ.

PAF approachAfter Feigenbaum (1956) categorized quality costs into prevention-appraisal-failure (PAF), the PAF scheme has been almost universally accepted for qualitycosting. The failure costs in this scheme can be further classified into twosubcategories: internal failure and external failure costs. Oakland (1993,pp. 186-9) describes these costs as follows:

Prevention costs: These costs are associated with the design,implementation and maintenance of the total qua lity managementsystem. Prevention costs are planned and are incurred before actualoperation.

Appraisal costs: These costs are associated with the suppliers andcustomers evaluation of purchased materials, processes, intermediates,

products and services to assure conformance with the specifiedrequirements.


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Internal failure costs: These costs occur when the results of work fail toreach designed quality standards and are detected before transfer tocustomer takes place.

External failure costs: These costs occur when products or services fail toreach design quality standards but are not detected until after transfer tothe customer.

Quality cost elements. In order to calculate total quality cost, the quality costelements should be identified under the categories of prevention, appraisal,

internal failure and external failure costs. BS 6143: Part 2 (1990) and ASQC(1974) have identified a list of quality cost elements under this categorization.These lists just act as a guideline for quality costing. Most elements in theselists are not relevant to a part icular industry, while many elements identified bypractitioners are peculiar to an industry, or a company (Dale and Plunkett, 1991,p. 28). Some typical COQ elements are shown in Table I. In the initial stages ofthe quality costing exercise, some companies put emphasis on just identifyingthe costs of failure and appraisal activities. The methodology usually used is foreach department, using a team approach, to identify COQ elements which areappropriate to them and for which they have ownership. Several techniques,such as brainstorming, nominal group technique, Pareto analysis, cause andeffect analysis, fishbone diagrams, and forcefield analysis, can be used toeffectively identify COQ elements (Dale and Plunkett, 1991, p. 41; Johnson,1995). The quality cost measurement system developed will improve with useand experience and gradually include all quality cost elements.

Economics of quality-related activities. One of the goals of total qualitymanagement (TQM) is to meet the customers requirements with lower cost.

For this goal, we have to know the interactions between quality -relatedactivities associated with prevention, appraisal, internal failure and externalfailure costs. It will help in finding the best resource allocation among var iousquality-related activities. In the literature, there are many notional modelsdescribing the relationships between the major categories of quality costs.Generally speaking, the basic suppositions of these notional models are thatinvestment in prevention and ap praisa l activities will bring han dsomerewards from reduced failure costs, and that further investment in preventionactivities will show profits from reduced appraisal costs (Plunkett and Dale,

1988). Plunkett and Dale (1988) classify these notional models into fivegroups, which are further aggregated into three by Burgess (1996). After acritical review, Plunkett and Dale (1988) conclude that many of the modelsare inaccurate and misleading, and serious doubts are cast on the concept ofan optimal qua lity level corresp onding to a minimum point on the totalquality-cost curve. Besides, Schneiderman (1986) asser ts tha t, in somecircumstances, if enough effort is put into prevention, no defects at all wouldbe produced, resulting in zero failure costs and no need for appraisal (also

given in Porter and Rayner (1992)). Thus, in these circumstances, the onlyoptimal point is zero-defects.


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However, Burgess (1996) integrated the three types of quality-cost models,derived from reducing Plunkett and Dales categories (1988), into a systemdynamic quality-cost model displaying dynamic behavior consistent withpublished empirical data. According to the simulation results, Burgessconcludes that the simulation provides support for the classic view of quality-cost behavior that an optimal level of quality exists only in certain time-constrained situations. If the time horizon is infinite, or above a particular cut-

off value, then spending on prevention can always be justified, i.e. the modernview prevails.

Categories COQ elements

Prevention Quality cont rol and process control engineeringDesign and develop control equipmentQuality planning by othersProduction equipment for quality maintenance and calibrationTest and inspection equipment maintenance and calibrationSupplier quality assuranceTraining

Administration, audit, improvementAppraisal Laboratory acceptance testing

Inspection and testIn-process inspection (non-inspectors)Set-up for inspection and testInspection and test materialsProduct quality auditsReview of test and inspection dataOn-site performance testingInternal testing and release

Evaluation of materials and sparesData processing, inspection and test reports

Internal failure ScrapRework and repairTroubleshooting, defect analysisReinspect, retestScrap and rework: fault of supplierModification permits and concessionsDowngrading

External failure Complaints

Product service: liabilityProducts returned or recalledReturned material repairWarranty replacementLoss of customer goodwill a

Loss of sales a

Note: a Intangible external failure costs (not included in BS 6143: Part 2)Source: BS 6143: Part 2 (1990) (also given in Dale and Plunkett (1991, p. 71))

Table I.Typical COQ elements


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The first two categories are analogous to Crosbys POC and PNOC respectively.Xerox measures lost opportunities as the profit impact of lost revenues. Itoccurs when a customer chooses a competitive product over a Xerox product,when a customer cancels an order because of inadequate service, or when acustomer b uys Xerox equipment that is inadequate or unnecessary an dswitches to another brand.

Juran claims that both prevention and appraisal costs are inevitable and arenot worth including in quality costs (Juran et al., 1975). Juran advocates a

categorization of quality costs including: tangible factory costs, which are measurable costs such as scrap, rework,

and additional inspection;

tangible sales costs, which are measurable costs such as handlingcustomer complaints and war ranty costs;

intangible costs, which can only be estimated, such as loss of customergoodwill, delays caused by stoppages and rework, and loss of moraleamong staff (also given in Porter and Rayner (1992)).

Jurans categorization scheme focusses on the costs of product failures andemphasizes the importance of intangible quality cost elements, which in thelong term are of greater importance than cost reduction.

Another alternative, proposed by Dale and Plunkett, is to consider theactivities relating to supplier, company (in-house) and customer under the PAFcategorization. This approach has the merit of new categories which closelyrelate to the business activities while retaining the advantages of the PAFcategorization (Dale and Plunkett, 1991, pp. 26-7).

Process cost approachIt seems that the identification of quality cost elements in the PAF approach issomewhat arbitrary. It may focus on some quality-related activities whichaccount for the significant part of total quality cost, not on all the interrelatedactivities in a process. Under the philosophy of process improvement in TQM,analysts should place emphasis on the cost of each process rather than anarbitrarily defined cost of quality (Goulden and Rawlins, 1995). In view of this,

the process cost approach, described in the revised BS 6143: Part 1 (1992), isproposed. It recognizes the importance of process cost measurement andownership. The process cost is the total of the cost of conformance (COC) andthe cost of nonconformance (CONC) for a particular process. The COC is theactual process cost of providing products or services to the required standards,first t ime and every time, by a given specified process. The CONC is the failurecost associated with a process not being operated to the required standard(Porter and Rayner, 1992). According to this definition, we know that thecontent of this categorization (COC and CONC) is different from that of Crosbys(POC and PONC) and Xeroxs (COC and CONC) mentioned previously.


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The process cost model can be developed for any process within anorganization. It will identify all the activities and parameters within the processto be monitored by flowcharting the process. Then, the flowcharted activitiesare allocated as COC or CONC, and the cost of quality at each stage (i.e. COC +CONC) are calculated or estimated. Finally, key areas for process improvementare identified and improved by investing in prevention activities and processredesign to reduce the CONC and the excessive COC respectively (Oakland,1993, pp. 201-7; Porter and Rayner, 1992). The British Standards Institution hasincluded this methodology in the revised BS 6143: Part 1 (1992). Dale andPlunkett (1991, p. 43) state that this will help to extend the concept of qualitycosting to all functions of an enterprise and to non-manufacturingorganizations, and tha t it also gets people to consider in more detail theprocesses being carried out within the organization.

A process modelling method, IDEF (the computer-aided manufacturingintegra ted program definition methodology) (Ross, 1977), can be used toconstruct the process cost models for the processes within an organization(Marsh, 1989). This method utilizes activity boxes with inputs, outputs, controls

and mechanisms to depict the activities of a process. However, the IDEF methodis developed for use by experts for system modeling. It seems to be too complexif departmental manager and staff were to be responsible for identifying theelements of process costs. Thus, Crossfield and Dale (1990) develop a moresimple method called quality management activity planning (Q-MAP) for themapping of quality assu rance procedures, information, flows and quality-related responsibilities. In addition, Goulden and Rawlins (1995) propose ahybrid model to overcome the limitations of the IDEF method for processquality costing. It constructs integrated or functional flowcharts to representthe processes by using informat ion from a three-level hierarchical model(function-depar tment-activity), where the lowest level is an activity defined as atask with a single output. This will reduce the level of complexity of the IDEFtype models.

Other COQ approachesThere are some approaches to measuring COQ in addition to the PAF approachand the process cost approach. For example, Son and Hsu (1991) proposed a

quant itative approach to measu ring quality costs, which considers bothmanufacturing processes and statistical quality control. Statistical terms ofquality are translated to dollar terms in this approach. However, the quality costmodel presented in their paper is restr icted to a s implified manufactu ringsystem which consists of only a machining area (with in-process samplinginspection) and a final inspection area (with 100 percent final inspection).

Besides, Chen and Tang (1992) present a pictorial approach to measuringCOQ, which is pat terned after that used in a computer-based informationsystem design. The COQ variables considered in this approach include directCOQ variables (PAF costs and quality-related equipment costs) and indirect


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COQ variables (customer-incurred costs, customer-dissatisfaction costs andloss of reputation). It includes two major steps:

(1) specifying the COQ variables as well as the significant relationshipsamong the variables, and mapping the variables and relationships intoan influence diagram showing the structure of a COQ system; and

(2) converting the structure into a well-defined entity-relationshipdiagram showing the input-output functions and their associatedproperties.

The influence diagram used in the pictorial approach can provide an easy-to-understand COQ system for quality management practitioners, and the entity-relationship diagram can provide an effective framework for maintaining andmodifying the COQ system.

Quality cost collectionFundamentally, the PAF approach, the process cost approach and even Chenand Tangs pictorial approach need first to identify the quality cost elements.For the PAF approach, COQ elements are identified under the cost categories ofthe selected categorization scheme. Most of COQ elements relate to quality-related activities. For the process cost approach, the cost elements of COC andCONC for a process are derived from the flowcharted activities of the process.Most cost elements of COC do not relate to quality -related activities oftraditional COQ view.

After identifying the quality cost elements, we should quantify the elementsand then put costs (dollar values) on the elements which have been identified(Dale and Plunkett , 1991, pp. 40-1). In COQ litera ture, many authors pay

attention to why COQ information is important and what should be included ina COQ system, and seldom discuss how to measure and collect quality costs.However, Dale and Plunkett give lots of guidance on quality cost collection,including objectives and scope, approaches, sources of data, ease of collection,level of detail, accuracy of data, and people involved (Dale and Plunkett , 1991,Ch. 3, pp. 36-51). Besides, Thorne (1990) recommends some relativelyuncomplicated methods for calculating COQ, i.e. collecting quality costs byaccount, by defect type, by whole person, by labor hours, and by personal log(also given in Johnson (1995)).

Dale and Plunkett state that the collection and synthesis of quality costs isvery much a matter of searching and shifting through data which have beengathered for other purposes (Dale and Plunkett, 1991, p. 38). Some of qualitycosts are readily available from a cost accounting system (e.g. scrap and reworkcosts); some can be derived from the data of activity reports (e.g. repair andinspection costs). Nevertheless, a large portion of quality costs should beestimated by some ways. For example, the opportunity costs of lost customergoodwill and lost sales, which are intangible external failure costs (similar to thethird category of Xeroxs COQ system), can be est imated by Taguchis qualityloss function (Albright and Roth, 1994). Other examples are the costs of


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producing excess inventories and material handling due to suboptimal plantlayouts, which are indirect failure costs and can be estimated by expertise. Inaddition, calculating prevention costs needs the estimates of apportionment oftime by indirect workers and staff who do not usually record how they spendtheir time in various activities.

Deficiencies of most COQ systemsGenerally speaking, there are the following deficiencies in measuring COQamong most COQ systems:

The aspect of overhead allocation in calculating COQ is seldom discussedin the literature. In practice, some companies add overheads to the directcost of labor and material on rework and scrap, while other companies donot. If they do, rework and scrap costs become grossly inflatedcompared with prevention and appraisal costs which are incurred viasalaried and indirect workers (Dale and Plunkett, 1991, p. 45).

Most of COQ measurement systems in use are not (there are someexceptions) intended to trace quality costs to their sources (OGuin, 1991,p. 70) such as parts, products, designs, processes, departments, vendors,dist ribut ion channels, terr itories, and so on. Accordingly, the COQinformation derived from these systems cannot be used to identify wherethe quality improvement opportunities exist.

It is the general lack of information about how people, other than directworkers, spend their time which presents a considerable obstacle to thecollections of quality costs (Dale and Plunkett, 1991, p. 112).

The deficiencies mentioned above will decrease the accuracy of quality costsand limit the usefulness of a COQ system. However, these deficiencies can beeasily solved under ABC (Cooper, 1988; Cooper and Kaplan, 1988), developed byCooper and Kaplan of Harvard Business School, together with other techniques.

Two-dimensional model of A BCEvolution of ABCThe main shortcoming of traditional cost accounting is to distribute overheadcosts over products by using volume-related allocation bases such as direct labor

hours, direct labor costs, direct material costs, machine hours, etc. It will notseriously distort the product cost in the conventional manufacturing environmentwhere overheads are just a small portion of product cost. In the modernmanufacturing environment, however, the overheads will grow rap idly asmanufacturers increasingly promote the level of automation and computerization,and the cost distortion of traditional cost accounting will be significant (Brimson,1991, p. 179). The main reason is that many overhead costs vary with volumediversity, product diversity, and volume-unrelated activities (e.g. set-up andscheduling activities), not with the volume-related measures. For example, high-volume products consume more direct labor hours than low-volume products, but


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high-volume products do not necessarily consume more scheduling cost than low-volume products. Therefore, trad itional cost accounting will overcost high-volume products and undercost low-volume products.

In view of this, Cooper and Kaplan suggested using ABC to improve theaccuracy of product costs. In early ABC systems (Turney, 1991, pp. 77-80),overhead cost is divided into various cost pools, where each cost pool containsthe cost of a group of related activities consumed by products in approximatelythe same way. Each cost pool is distributed to products by using a unique factorthat approximates the consumption of cost. This unique factor, called an

allocation basis in traditional cost accounting, could be volume-related (e.g.direct labor hours and machine hours) or volume-unrelated (e.g. number oforders, set-up hours, and number of parts).

Early ABC systems focus on the accurate assignment of overhead costs toproducts. They do not provide direct information about activities and do notconsider the costs outside the plant. Thus, a two-dimensional model of ABC isproposed as shown in Figure 1. This ABC model is composed of two dimensions:cost assignment view and process view described in the following two subsections.

T he cost assignment view of A BCThe detailed cost assignment view of ABC is shown in Figure 2. ABC assumesthat cost objects (e.g. products, product lines, processes, customers, channels,

Figure 1.Two-dimensional model

of ABC

Resources

Cost Assignment View

Process View

Source: Adapted from Turney, (1991, p. 81)

CostObjects

CostDrivers Activities

PerformanceMeasures

ResourceDrivers

ActivityDrivers


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markets, etc.) create the need for activities, and activities create the need forresources. Accordingly, ABC uses two-stage procedure to assign resource coststo cost objects. In the first s tage, resource cost s are a ssigned t o variousactivities by using resource drivers. Resource drivers are the factors chosen toapproximate the consumpt ion of resources by the activities. Each type of

resource traced to an activity becomes a cost element of an activity cost pool.Thus, an activity cost pool is the total cost associated with an activity. Anactivity center is composed of related activities, usually clustered by functionor process. We can create activity centers by va rious ways according t odifferent information needs. In the second stage, each activity cost pool isdistributed to cost objects by using an adequate activity driver which is usedto measure the consumption of activities by cost objects (Turney, 1992). If thecost objects are products, then total cost of a specific product can be calculatedby adding the costs of various activities assigned to that product. The unit cost

of the product is achieved by dividing the total cost by the quantity of theproduct.

The resources used in manufacturing companies may include people,machines, facilities, and utilities, and the corresponding resource costs could beassigned to activities in the first stage of cost assignment by using the resourcedrivers time, machine hours, square footage, and kilowatt hours respectively(Brimson, 1991, p. 135). For the manufacturing activities, there are the followingcategories of activities (Cooper, 1990):

unit-level activities (performed one time for one unit of product, e.g. 100percent inspection, machining, finishing);

Figure 2.Detailed cost

assignment view ofABC

Resources

Cost Objects

ActivityDrivers

ResourceDrivers

Activity &Activity Cost Pool

Cost Element

ActivityCenter

FirstStage

SecondStage

Source: Adapted from Turney, (1991, p. 97)


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batch-level activities (performed one time for a batch of products, e.g.sampling inspection, set-up, scheduling);

product-level activities (performed to benefit all units of a part icularproduct, e.g. product design, design verification and review);

facility-level activities (performed to sustain the manufacturing facility,e.g. plant guard and management, zero defect program).

The costs of different levels of activities will be traced to products by using thedifferent kinds of activity drivers in the second stage of ABC cost assignmentview. For example, machine hours is used as the activity driver for the activitymachining; set-up hours or the number of set-up for machine set-up; and thenumber of drawings for product design (Tsai, 1996b). Usually, the costs offacility-level activities cannot be t raced to products with the definite cause-effect relationships and should be allocated to products with appropriateallocation bas es (Cooper, 1990). The information achieved from ABC costassignment view is usually used for the decisions of pricing, quoting, productmix (Tsai, 1994), make versus buy, sourcing, product design, profitability

analysis, and so on (Turney, 1992).

T he process view of ABCThe process view of ABC is composed of three building blocks: cost drivers,activities and performance measures. It provides information on why theactivities are performed via cost drivers and on how well the activities areperformed via performance measures. Cost drivers are factors that determinethe workload and effort required to perform an activity (Turney, 1991, p. 87), i.e.

factors that cause a change in the cost of an activity (Raffish and Turney, 1991).For example, the quality of parts received by an activity (e.g. the percent thatare defective) is a determining factor in the work required by that activity,because the quality of parts received affects the resources required to performthe activity. Cost dr ivers identify the cause of activity cost and are usefulbecause they point people to take action at the root cause level, i.e. they revealopportunities for improvement. An activity may have multiple cost driversassociated with it.

Performance measures are used to indicate the work performed and the

results achieved in an activity (Raffish and Tur ney, 1991). They tell us how theactivity is meeting the needs of its internal or external customers. There are fivefundamental elements of activity performance:

(1) the quality of the work done;

(2) the productivity for the activity;

(3) the cycle time required to complete the activity;

(4) the cost traced or allocated to the activity; and

(5) customer satisfaction (Miller, 1996, pp. 94-5; Turney, 1991, pp. 88-9).


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Performance measu res differ from one activity to another and from onecompany to another. Performance measures may be financial or nonfinancial.

The process view of ABC places emphasis on processes. A process is a seriesof activities that are linked to perform a specific objective. A business processoften r uns across art ificial organizational boundaries, departments orfunctions. Because of the interdependency of activities in a process, the work ofeach activity a ffects t he performance of the next activity in the process.Accordingly, performance measures for one activity may become cost driversfor the next activity (Turney, 1991, p. 190). For example, performance measures

for designing new tools may include the number of change in specifications andthe number of new drawings, and these performance measures are just the costdrivers for the succeeding activity, manufacturing new tools. This tells us thatmerely identifying activities without consideration of their relationship to otheractivities in the process will result in overlooking many improvementopportunities (Lawson, 1994, p. 35).

The information achieved from the process view of ABC can be used to aid inprocess/activity improvement. The potential improvement opportunities can belocated by performance measurement and value analysis. First, the areas wherethe improvement is needed can be identified by compar ing th is periodsperformance with performance goals or with best practices of comparableactivities inside or outs ide the company. The lat ter comparison is calledbenchmarking (Turney, 1991, p. 111). Second, the areas where the improvementis needed can be identified through the categorization of activities as value-added or non-value-added. An activity is value-added if it is judged to contributeto customer value or satisfy an organizational need; otherwise, it is non-value-added. For the non-value-added activities, improvement initiat ives should be

directed toward eliminating or minimizing the activities. For the valued-addedactivities, improvement initiatives should be directed toward streamlining,improving what is being done, and optimizing performance (Miller, 1996, pp. 92-3). However, the potential improvement opportunities should be prioritized byPareto analysis. We can rank the activities in descending order of cost achievedfrom the cost assignment view of ABC, and determine the significant activitiesthat will provide the greatest opportunities for improvement. Usually, we willfind that 20 percent of the activities cause 80 percent of the cost. Thus, thesesignificant activities are worth improving in the first place.

After the top-priority areas of improvement are recognized, cost dr iveranalysis can be used to examine, quantify, and explain the effects of cost driversof the significant activities mentioned above. This will help direct improvementefforts to the cause of cost and avoid treating the symptom (Miller, 1996, p. 93).For example, inspecting the incoming material is a non-value-added activity andits cost driver will be the quality of material received from suppliers. If we havesufficient confidence in the quality of material received from suppliers, we mayconduct sampling inspections, even no inspections for incoming material.Otherwise, we may need 100 percent inspections. Therefore, the best way toreduce the efforts of incoming material inspections is to choose the suppliers


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that provide the high-quality material or to help our suppliers establish thequality control/assurance systems.

Activity-based managementUsing ABC to improve a business is called activity-based management (ABM).As defined by the consortium for Advanced Manufacturing International(CAM-I) (Raffish and Turney, 1991), ABM is a discipline that focuses on themanagement of activities as the route to improving the value received by thecustomer and t he profit achieved by providing this value. This discipline

includes cost driver analysis, activity analysis, and performance measurement.ABM uses the cost and nonfinancial/operational informat ion acquired fromABC in various analyses. For example, ABM uses the cost information ofactivities, products, customers, and other cost objects, supplied by the costassignment view of ABC, to perform strategic decision analysis (such aspricing, product mix, sourcing, customer profitability analysis), activity-basedbudgeting, life-cycle costing and target costing. In addition, ABM uses theinformation provided by the process view of ABC to support cost reduction,

downsizing, process/quality improvement, benchmarking, business processreengineering (BPR), and total quality management (TQM). This paper focuseson COQ measurement and continuous quality improvement under ABC.

Comparison between COQ approaches and ABCThe PAF approach of COQ is activity-oriented, the process cost approach ofCOQ is process-oriented, and ABC is activity-oriented for the cost assignmentview and process-oriented for the process view. Accordingly, the PAF approachof COQ regards COQ-related (or PAF-related) activities as improvement objects,

and the process cost approach of COQ and ABC regard processes/activities asimprovement objects. A summary comparison between COQ approaches andABC is given in Table II.

As for activity/cost categories, COQ approaches and ABC have the followingclassifications:

PAF approach prevention, appraisal, internal failure, and externalfailure;

process cost approach conformance and nonconformance;

ABC value-added and non-value-added.

Some authors classify prevention and appraisal costs as the cost ofconformance, and internal and external failure costs as the cost ofnonconformance. However, the content and meaning of conformance andnonconformance costs of the PAF approach are different in nature from that ofthe process cost approach. Under the ABC perspective, only prevention costs inthe PAF approach (Ostrenga, 1991) and only some of conformance costs in theprocess cost approach are value-added, and their relationships are shown inFigure 3. Thus, the cost of nonconformance either in the PAF or in the process


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COQAspects of Processcomparison PAF approach cost approach ABC

Orientation Activity-oriented Process-oriented Activity-oriented (cost assignment view)Process-oriented (process view)

Activity/cost Prevention Conformance Value-addedcategories Appraisal Nonconformance Non-value-added

Internal failure

External failure

Treatment of No consensus method to allocate Assigning overhead to activities byoverhead overhead to COQ elements under using resource drivers in the first stage

current COQ measurement systems of ABC cost assignment viewand traditional cost accounting

Tracing costs No adequate method to trace Tracing activity costs to cost objects byto their sources?quality costs to their sources using activity drivers in the second stage

of ABC cost assignment view

Improvement COQ-related Processes Processes/act ivitiesobjects activities activities

Tools for Quality circle Process/activity value analysisimprovement Brainstorming Performance measurement

Nominal group technique BenchmarkingCause and effect analysis Cost driver analysisFishbone diagramForcefield analysis

Information The cost elements The COC and The costs of activities and processes

outputs of PAF categories CONC elements The costs of value-added and non-value-Total quality cost of the processes added activities and their percentages ofand the costs of investigated various basesPAF categories/ Total process Accurate costs of various cost objectselements and their cost, COC, and (e.g. product, depar tments, customerspercentages of CONC of the and channels)various bases processes Activity-based performance measures

investigated and Cost drivers of activitiestheir percentagesof various bases

Related TQM ABMmanagementtechnique

Table II.

Comparison betweenCOQ approachesand ABC

Figure 3.The relationship

between activity/costcategories of COQ

approaches and ABC

PAF approach

Prevention

Appraisal

Internal Failure

External Failure

ABC

Value-added

Non-value-added

Process cost approach

Conformance

Nonconformance


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cost app roach would be eliminated or minimized through investment inprevention activities. The cost of conformance in the process cost approachwould be reduced by streamlining or redesigning the process.

As for information outputs, the fundamental cost information outputsachieved from the PAF approach are the costs of PAF-related activities; from theprocess cost approach and ABC are the costs of activities and processes. Whileall these three methods will provide the costs of activities, ABC will create avariety of information outputs.

From the discussion above, we can see that there are many similarities in

process perspective between the process cost approach and ABC. In addition,the similarities between these two methods also can be found in the steps ofprocess improvement by the process cost approach and by ABC/ABM, asshown in Table III. In this Table, the corresponding steps are in the same rows,where we will find that these two methods deal with the same thing by usingdifferent terminology.

Integrated COQ-ABC framework

From the explanation in the previous sections, we know that ABC can supplyvarious cost and nonfinancial information to support COQ programs. Moreover,ABC can provide more accurate costs of activities and processes thantraditional cost accounting, which make COQ information more valuable forTQM. Hence, it is better to integrate COQ approaches with ABC. Figure 4shows an integrated COQ-ABC framework. In this framework, we may adoptthe PAF approach or the process cost approach for COQ measurement. Strictlyspeaking, COQ-related activities for the PAF approach or flowcharted activitiesfor the process cost approach should be incorporated into the building block

activities of ABC model. Tha t is , ideally, ABC and COQ blocks in thisframework should be merged as one. Furthermore, there are the followingcharacteristics in the integrated COQ-ABC framework:

ABC and COQ systems should share the common database in order toavoid data redundancy and inconsistency.

The related management techniques of ABC and COQ are ABM andTQM, respectively.

ABC system can provide cost and activity/process-related informationfor ABM, COQ/TQM, and business process reengineering (BPR).

BPR is another management technique for process improvement. Themajor difference between BPR and ABM/TQM is that BPR overthrowsand improves current business processes in a fundamental and radicalway. This can be seen from the definition of BPR: BPR is thefundamental rethinking and radical redesign of business processes toachieve dramatic improvements in critical, contemporary measures ofperformance, such as cost, quality, service, and speed (Hammer andChampy, 1993).


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Process cost approach ABC/ABM

1. Choose a key process to be analyzed 1. Define critical business processes and specify2. Define the process and its boundaries key and significant activities3. Construct the process diagram: 2. Select process owners

(1) Identify the outputs and customers 3. Define the process boundaries(2) Identify the inputs and suppliers 4. Form and train process improvement teams(3) Identify the controls and resources 5. Flowchart the processes

4. Flowchart the process and identify the 6. Analyze activities:process owners. The process owners (1) Define activity outputs/measures

for m the improvement team (2) Identify the customer/user of activity5. Allocate the act ivit ies as COC or CONC outputs6. Calculate or estimate the quality (3) Perform value-added analysis

costs (COC + CONC) at each stage. (4) Identify cost driversEstimates may be required where the (5) Determine activity performance measuresaccounting system is unable to and goalsgenerate the necessary information (6) Define other activity attributes:

7. Construct a process cost report Primary versus secondary activities8. Prioritize the failure costs and select Core, sustaining, and discretionary

the process stages for improvement Cost behavior: fixed or variable, direct

through reduction in costs of or indirect, avoidable or unavoidablenonconformance (CONC). This should (7) Gather activity data required forindicate any requirements for activity/cost object costing and forinvestment in prevention activities. activity/process improvementAn excess cost of conformance (COC) 7. Perform activity/process cost assignmentmay suggest the need for process 8. Summarize processes and costs forredesign. management

9. Review the flowchart to identify the 9. Draw up the process improvement plan:scope for reductions in the cost of (1) Locate the potential improvementconformance. Attempts to reduce COC opportunities by performancerequire a thorough process measurement and value analysisunderstanding, and a second flowchart (2) Prioritize the improvement opportunitiesof what the new process should be by Pareto analysis and select themay help significant activities that will provide the

10. Monitor conformance and greatest opportunities for improvementnonconformance costs on a regular basis, (3) Design and select the improvementusing the model and review for further alternatives by cost driver analysis,improvements (i.e. continuous process redesign, new process designimprovement) (process innovation), and others

10. Implement the process improvement plan11. Monitor the process improvement results by

installing performance measurement andfeedback control systems to ensure that thedesired results are achieved and to providefeedback for continuous improvement

Sources:

1. Steps of process/quality improvement by the process cost approach come from Oakland(1993, pp. 201-3).

2. Steps of process improvement by ABC/ABM are synthesized from Beischel (1990); Harrington

(1993); Miller (1996, pp. 69-98); OGuin (1991, pp. 306-13); Ostrenga and Probst (1992).

Table III.Steps of process

improvement by theprocess cost approach

and ABC/ABM


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The common goal of ABM, TQM, and BPR is continuous improvement

by using various respective tools. In fact, all these tools can be used in

ABM, TQM, and BPR.

The common objectives of ABM, TQM, and BPR are to promote

productivity, to eliminate waste, to reduce throughput time, to reduce

cost, and to improve quality.

Figure 4.Integrated COQ-ABC

framework

Missions

To profitably improve the valuereceived by the customer

To increase the equity ownedby the shareholder

Objectives

To promoteproductivity

To eliminatewaste

To reducethroughput time

To reducecost

To improvequality

Goal

Continuous Process/Activity/Quality Improvement

Tools

Cost Driver Analysis

Process/Activity ValueAnalysis

Performance Measurement

Benchmarking

Business ProcessReengineering

A

B

M

T

Q

M

Forcefield Analysis

Fishbone Diagram

Cause and Effect Analysis

Nominal Group Technique

Brainstorming

Quality Circle

Prevention

Appraisal

Internal Failure

External Failure

COQ-related Activities

PAF Approach

COC

Flowcharted Activitiesof Processes

ORProcess Cost Approach

CONC

COQ Approach

Common Database

Activity-Based Costing

Cost Assignment View

Resources

ResourceDrivers

Activities

Performance

Measures

Cost

Drivers

ProcessView

ActivityDrivers

CostObjects


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The ultimate missions are to profitably improve the value received by thecustomer and to increase the equity owned by the shareholder.

COQ measurement under ABCAs mentioned before, there is no consensus method to allocate overheads toCOQ elements and no adequate method to trace quality costs to their sourcesunder cur rent COQ measurement sys tems and traditional cost accounting.These deficiencies can be overcome easily by using the cost assignment view ofABC (as shown in Figure 1), either in the PAF approach or in the process cost

approach. Overhead costs are traced to activities by using resource drivers inthe first stage of ABC cost assignment view. Then, activity costs are traced totheir sources (i.e. cost objects) by using activity drivers in the second stage ofABC cost assignment view.

COQ measurementFor the PAF approach, the activities of the ABC model would be COQ-relatedactivities (prevention, appraisal, internal failure, and external failure) and COQ-unrelated activities. In the first stage of ABC cost assignment view, resourcecosts (including overhead costs) of the company are traced to various COQ-unrelated and COQ-related activities (as shown in Table I) by using resourcedrivers. The resources used by COQ-related activities may be people,computers, equipment, material (parts), supplies, facilities, energy, and so on. Ifa resource is dedicated to a single COQ-related activity, so the resource cost isdirectly traced to that COQ-related activity. If a resource supports several COQ-related and/or COQ-unrelated activities, the resource cost must be distributedamong these activities by using a appropriate resource driver. The resource

driver of people-related costs (salaries and benefits) will be time. If a COQ-related activity uses a workers pa rt ial time, this COQ-related activity willreceive the workers salary and benefit according to its usage percentage of theworkers time. For another example, the resource driver of energy costs will bekilowatt hours. The cost of any specific COQ-related activity will be achievedby adding all the resource costs (i.e. activity cost elements) traced to that COQ-related activity. Therefore, each of the four components of total COQ can beobtained respectively by accumulating the costs of all the activities related tothat COQ component. Finally, total COQ is the sum of the four components

costs. Accordingly, total COQ, four COQ components, and the costs of detailedCOQ-related activities can be achieved from the first stage of ABC costassignment view.

For the process cost approach, the activities of the ABC model would bethe flowcharted activities of various processes, including COC-related andCONC-related activities. The method of tracing resource costs (includingoverhead costs) to activities is the same as described above. The resultsachieved in the first stage of ABC cost assignment view would be the costs offlowcharted activities, total process costs, COC, and CONC of variousprocesses.


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The treatment of overheads in ABC is different from the practice of includingfull overhead costs in direct labor charges to quality-related costs . It willproduce accurate quality costs and solve the usual problem in current COQsystems: double-counting.

Another deficiency, mentioned before, of a combinat ion of current COQsystems and traditional cost accounting is the lack of information about howindirect workers, whose costs are one part of overhead costs, spend their timeon various activities. This deficiency make prevention the most difficult of thecategories to cost because it depends heavily on the estimates of percentage of

time spent by indirect workers and staff (Dale and Plunkett, 1991, p. 44). Inpractice, these estimates are often derived from information gathered frominterviews or questionnaires (Turney, 1991, p. 277). Nevertheless, theinformation acquired from interviews and quest ionnaires may be undersuspicion because the way that people actually spend their time, after all, canoften be quite different than the way they think that they spend it (Miller, 1992).To overcome this deficiency, Tsai (1996a) suggested using work sampling toestimate the percentage of the indirect worker time spent on each activity. Worksampling (Richardson, 1976), which utilizes the random sampling techniques,allows one to understand the characteristics of a process by collecting data onportions of a process rather than the entire process. This technique isparticularly useful in the analysis of nonrepetitive or irregularly occurringactivities. With the aid of computer software (Lund, 1990), it is feasible to usework sampling to provide more accurate data of first stage resource drivers forindirect workers in the integrated COQ-ABC systems.

Tracing COQ to its sources

We can trace COQ to its sources (such as par ts, products, designs, processes,department, vendors, distribution channel, territories, etc.) through the secondstage of ABC cost assignment view. If we, under the PAF approach, need toknow the COQ information by departments or products, then we could regarddepartments or products as cost objects and trace the various COQ-relatedactivity costs to departments or products by using appropriate activity driversin the second stage of ABC cost assignment view. Most activities related toprevention costs are sustaining activities and their costs are not easy to betraced to departments or products. It is because of no explicit cause-and-effect

relationship between prevention activities and departments (or products). Onthe other hand, cause-and-effect relationships do exist between departments (orproducts) and most activities related to appraisal, internal failure, and externalfailure costs, so these costs could be traced to departments or productsappropriately. Similarly, we could trace external failure costs to distributionchannels or territories (used as the cost objects).

For the process cost approach, the elemental information achieved from thefirst stage of ABC cost assignment view are the COC and CONC elements offlowcharted activities of processes. For the purpose of this paper, we want totrace the cost of CONC-related activities to their sources. This also can be


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achieved by using appropriate activity drivers in the second stage of ABC costassignment view.

COQ reporting unde r ABCFrom the above discussion, we know COQ reports for the PAF approach can beeasily prepared under ABC in the following ways:

COQ reports associated with detailed COQ-related activities for thewhole company.

COQ reports associated with activities related to appraisal, internalfailure, external failure costs by departments, products, or product lines.

COQ reports associated with activities related to external failure costsby distr ibution channels or territories.

These are just some illustr ative COQ report s. These COQ report s usuallyprovide monthly costs, year-to-date costs, variances to budgeted costs, and acomparison with the previous years cost data. These COQ reports may includethe COQ percentage of various bases such as sales revenue, manufacturing cost,

units of product, and so on (Simpson and Muthler, 1987). In addition, trendanalysis can be used to compare present COQ data with historical COQ data inorder to know how COQ changes over t ime.

In order to prepare the above COQ reports, we could use activity centers togroup the related activities under ABC. There may be hundreds of activities ina company. Activity centers allow us to easily locate activities with identicalcharacteristics. If we group the company's activities by processes, then we willhave the COQ activity center and several other activity centers. Within the COQactivity center, four nested activity centers can be established, i.e. prevention,

appraisal, internal failure, and external failure activity centers (as shown inFigure 5). Again, we could, within a sub-activity center, set up a nested activitycenter on demand. This will create hierarchies of COQ information and give usthe different levels and breadths of COQ information. This will form a multi-tierCOQ reporting system. We could use attributes, which are labels describing thetype of activity, to create activity centers on demand in the integrated COQ-ABC information system (Turney, 1991, pp. 271-3). If the COQ activity center isdivided according to the companys organizational structure, then we could, by

adopting the concept of responsible accounting, provide department managers

Figure 5.COQ activity center and

its nested activity

centers

Preventing Appraisal InternalFailure

ExternalFailure

COQ


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with the COQ information and related nonfinancial information which arespecific to them. The COQ responsibility reports will help responsiblemanagers identify the major costs of nonconformance incurred in theirdepar tments and actuate improvement projects to eliminate or reduce thesecosts.

For the process cost approach, the COQ report ing method is the same asdescribed above except that PAF-related activities are replaced with COC-related and CONC-related activities.

Uses of COQ informationUnder the integrated COQ-ABC framework, the quality system and the ABCsys tem must be integra ted to produce COQ information and t he relatedoperational information of activities and processes. The information achievedcan be used in various aspects (Dale and Plunkett , 1991, pp. 59-68; OGuin, 1991,pp. 71-5). Some of the important uses of COQ information are described asfollows.

To identify the magnitude of the quality improvement opportunitiesABC, together with other techniques such as work sampling, can trace resourcecosts (including overhead costs) to various activities in a rational way whichavoids double-counting. Thus, ABC can create the accurate costs of PAF-relatedactivities for the PAF approach and of COC- and CONC-related activities for theprocess cost approach. The prime purpose of the quality improvement is togradua lly eliminate or reduce the cost of poor quality, i.e. to improve theactivities related to the appraisal and failure costs for the PAF approach and tothe CONC for the process cost approach. ABC will tell management the accurate

cost of poor quality and indicate which activities are the most expensivethrough Pareto analysis. Accordingly, management can identify the directionsand magnitude of the quality improvement opportunities. This information isuseful in the investment justification of the quality improvement alternativessuch as investment in prevention activities or equipment.

To identify where the quality improvement opportunities existBy integrating the ABC system and the quality system, the cost of poor qualitycan be traced to its sources. Hence, the integrated system can identify where the

quality improvement opportunities exist and provide the following benefits(OGuin, 1991, p. 72):

By tracing quality losses to product attributes, parts, processes,engineering, and vendors, management can take corrective actionstoward the right direction.

By tracing and costing vendor returns by vendor and parts, purchasingmanagers will understand the true costs of buying from par ticularvendors. This will avoid forcing purchasing managers to buy strictly onprice.


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If scrap costs result from worker errors, the scrap costs are assigned tothe processs overheads. This will provide management wit h clearpictures of who is causing defects and how much they cost.

The integrated system arms the quality department with defect andrework cost information. Some defects are more costly than others andsome mean much more to the customers than others. Thus, the systemcan tell the quality depart ment where to concentrate its qualityimprovement efforts.

By tracing warranty and return costs to their products, it will eliminatethe tendency for product managers to rush a product through testing, orship defective goods to achieve their sales targets.

Before tracing quality costs to their sources, we should dig out their root causesby using t he cost dr iver a nalysis of ABC process view in order to directimprovement efforts to the cause of cost and avoid treating the symptom. TableIV gives a list of some possible cost drivers of four COQ components. Forexample, the root causes of the internal failure rework could be design error,defective purchased material, deficient tooling and maintenance, and worker

error. If we find out the real root cause of excessive rework cost is defectivepurchased material, then we could effectively solve the problem by helpingimprove the suppliers qua lity sys tem or searching another supp lier. Foranother example, if excessive in-process inspections are due to complex design,then we can encourage designers to simplify the design by using the number ofdifferent part numbers as a performance measure or activity driver.

To plan the quality improvement programs

A quality improvement program should depict quality improvement actions,improvement targets, and quality cost budgets. Improvement targets may be set

COQ components Cost drivers

Prevention Investment in reducing overall COQ-related activities

Appraisal Set-up frequencyTight tolerance activitiesComplex design

Internal failure Design errorDefective purchased materialMachine reliabilityTooling age and conditionsWorker error

External failure Order entry errorsIncorrect assembly instructionsProduct failureWorker error

Source: Adapted from Ostrenga (1991, p. 43)

Table IV.Some cost drivers

of COQ components


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after quality improvement actions are evaluated and selected. Under thiscircumstance, improvement targets are set and quality cost budgets areprepared according to the savings of required activity driver quantities for eachquality-activity of the selected quality improvement actions. On the contrary,quality improvement actions may be worked out according to improvementtargets set by management just like the approach of target costing. In thisscenario, management may establish quality improvement targets for everyunit of the organization. Management may request purchasing to reduce vendorquality costs by 20 or 40 percent in a year. The amount of rework, which is the

activity driver of rework activity, may be targeted to be cut by 30 percent.Target quality costs are derived from the quality improvement targets under thepresent operational conditions. Then, various quality improvement actions areevaluated one by one till the ones, whose budgeted quality costs are not greaterthan target quality costs, are found. In either case, quality cost budgets areconstructed incorporating improvement targets by using the budgeted activitydriver quantities based on improved activities and the moving average rates (orthe last periods rate) of activity drivers. This method can be applied in eitherthe PAF approach or the process cost approach (Sharman, 1996).

To control quality costsSince management establishes quality improvement targets for every unit of theorganization, management can then track actual performance to these targetsafter one periods operation. If improvement targets are not met, the variancesbetween actual and budgeted quality costs will emerge. The variances mayrepresent unanticipated quality loss. The variances force management to exploitwhat is causing the variance and encourage management to eliminate the source

of quality loss. This feedback allows management to continuously plan thequality improvement programs and control quality costs (OGuin, 1991, p. 74).The method described above is the budget control of quality costs. It may

report quality costs monthly. However, it is not fit for daily operation control.Turney (1991, pp. 197-9) demonstrated how ABC was used for total qualitycontrol by utilizing daily COQ reporting in a printed circuit board (PCB) plant.The ABC system was used to prepare a report on the cost of poor quality foreach activity immediately after each of the three daily shifts and t o showgraphically the trend in physical defects and cost. The report allows

management to focus immediately on the quality problems with the biggestcost impact. The ABC system also prepared daily a top ten offenders list thatreports the ten products with the highest cost of poor quality on the previousday. It pinpointed the poor quality products and provided the greatest potentialfor redemption. When a product unit on this list was scrapped, a report, whichshowed the cause of the problem as well as the cost, was prepared and sent tothe person most likely to correct the problem. This use of ABC made qualityproblems visible within a matter of hours, or even minutes. Turney suggestedlinking ABC with computer-integrated manufacturing (CIM) to prepare COQreports for real-time and cost-effective control.


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An illustration of COQ measurement under ABCAs an illustration, a hypothetically simplified example is presented in thissection. A department in a manufacturing company produces two products,Product A and Product B. This company adopts the PAF approach to measureCOQ. The workers in this depar tment carry out nine distinct activities. Therelated information of these activities is shown in Table V, including requiredresources, activity levels, PAF categories, value-added or non-value-added, andactivity drivers. Some of these activities are PAF-related activities, and some arenot. There are six workers in this department. The hourly labor cost for each

worker is $10 calculated on the basis of wages and benefits. Four of the workerscarry out five activities, machining, rework, warranty repair, inspection, andpackage. These workers spend most of their time in direct work, and they willrecord how they spend the time by using time cards. The other two workerscarry out four activities, scheduling, maintenance, set-up, and materialhandling, which are indirect works. Work sampling is used to estimate thepercentages of time spent on these four activities for two indirect workers. Forthe machining activity, assume that Product A and Product B can be processedin two general-purpose machines. The hourly machine cost for each machine is

$20 calculated on the basis of the costs of machines and their tools. Theactivities, rework and war rant y repair, are also carried out in these twomachines. For the inspection activity, Product A needs two tests, while ProductB needs only one. In addition, assume that there are 20 work days in a specificmonth with eight work hours per day and that the production quantities ofProduct A and Product B are 225 and 350 respectively in the month. Now, thedepartment manager wants to calculate COQ and unit product costs.

Value-added (VA)Required Activity PAF or non-value- Activity

Activities resources levels categories added (NVA) drivers

Machining People, machines, tools Unit VA Machine hoursRework People, machines, tools Internal failure NVA # of reworksWarrantyrepair People, machines, tools External failure NVA # of warranty

repairsInspection People, test equipment, Unit Appraisal NVA # of teststools, supplies

Package People, tools, supplies Unit VA # of unitsScheduling People Batch Gray a # of batchesMaintenance People, supplies Facility Prevention VA Machine hoursSet-up People, tools Batch NVA # of set-upsMaterial People, moving Batch NVA # of moveshandling equipment

Note: a Gray: Activities of no value to customers, but that may be essential to the functioning of

the department

Table V.Activity-relatedinformation for

the illustration


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Resource cost assignmentIn the first stage of ABC cost assignment view, resources are traced to activities.For the labor resource, the labor hours of the workers spent on various activitiesand their percentages are shown in Table VI. Note that the labor hours of theworker # 1 to # 4 spent on the first five activities are acquired from time cardsand that the percentages of time of the workers # 5 and # 6 spent on the last fouractivities are estimated from a work sampling study (Tsai, 1996a). Total laborcosts traced to activities are shown in the last column of Table VI. For themachine resource, the machine hours of the machines used in the activities,

machining, rework, and warranty repair, are recorded and shown in Table VII.Total machine costs traced to activities are shown in the last column of TableVII. For the other resources consumed by activities, their costs can be directlytraced to activities. Therefore, various resource costs and total activity coststraced to activities are shown in columns (1)-(4) of Table VIII.

From column (4) of Table VIII, the department manager knows that the fourhigh-cost activities are machining ($6,416), inspection ($2,088), set-up ($1,920),and Package ($1,840). Inspection and set-up are non-value-added activities,

Total TotalWorkers labor labor

Activities # 1 # 2 # 3 # 4 # 5 # 6 hours $/hour costs

Machining 99.2 100.8 200.0 10 $2,000(62) (63) (20.8) (20.8)

Rework 24.0 16.0 40.0 10 400(15) (10) (4.2) (4.2)

Warranty repair 16.0 19.2 8.0 8.0 51.2 10 512(10) (12) (5) (5) (5.3) (5.3)

Inspection 8.0 120.0 11.2 139.2 10 1,392(5) (75) (7) (14.5) (14.5)

Package 9.6 16.0 128.0 153.6 10 1,536(6) (10) (80) (16.0) (16.0)

Scheduling 8.0 12.8 20.8 10 208(5) (8) (2.2) (2.2)

Maintenance 12.8 32.0 44.8 10 448

(8) (20) (4.75) (4.7)Set-up 96.0 64.0 160.0 10 1,600

(60) (40) (16.7) (16.7)

Material handling 32.0 35.2 67.2 10 672(20) (22) (7.0) (7.0)

Idle 12.8 14.4 16.0 12.8 11.2 16.0 83.2 10 832(8) (9) (10) (8) (7) (10) (8.7) (8.7)

Total 160.0 160.0 160.0 160.0 160.0 160.0 960.0 10 $9,600

(100) (100) (100) (100) (100) (100) (100) (100)

Note: Figures in parentheses are labor hours indicated as a percentage

Table VI.Assigning laborresource costs

to activities


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which provide the greatest opportunities for improvement. In view of this, thedepartment manager requests quality engineers and industrial engineers to

investiga te the feasibility of changing 100 percent inspection to samplinginspection and to develop the methods of reducing set-up time. In addition, totalcost of the PAF-related activities, inspection ($2,088), warranty repair ($1,120),rework ($1,104), and maintenance ($530), accounts for 27.36 percent($4,842/$17,696) of total manufacturing cost excluding direct material cost; thefirst three PAF-related activities are non-value-added and their cost accounts for24.37 percent ($4,312/$17,696). This indicates that there are great opportunitiesfor reducing quality costs and that there is an emerging need to identify where

the opportunities lie, illustrated in the next subsection.Note that the company in this example separates idle capacity costs from

activity cost calculation. This is not for external financial reporting and just forinternal decision making. It will let managers know how much idle capacitycosts, push managers to deploy the unused resources, and avoid distortingproduct costs.

Activity cost assignment

In the second stage of ABC cost assignment view, activity costs are traced tocost objects. ABC uses activity drivers to measure the consumption of activitiesby cost objects. In this example, products are used as the cost objects. This cantrace COQ-related and COQ-unrelated costs to products. For this example, thefollowing data are shown in columns (5)-(10) of Table VIII:

the activity driver quantities of various activities consumed by ProductA and Product B;

the costs per activity driver of various activities; and

the activity costs of various activities traced to Product A and Product B.

Total TotalMachines machine machine

Activities # 1 # 2 hours $/hour costs

Machining 108.8 112.0 220.8 20 $4,416(68) (70) (69.0) (69.0)

Rework 20.8 14.4 35.2 20 704(13) (9) (11.0) (11.0)

Warranty repair 14.4 16.0 30.4 20 608(9) (10) (9.5) (9.5)

Idle 16.0 17.6 33.6 20 672(10) (11) (10.5) (10.5)

Total 160.0 160.0 320.0 20 $6,400(100) (100) (100) (100)

Note: Figures in parentheses are labor hours indicated as a percentage

Table VII.Assigning machine

resource costs toactivities


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Activity costs ($) Activity driver quantity $/activity Activity cost assignmLabor Machine Others Total Activity Product A Product B Total driver Product A Produ

Activities (1) (2) (3) (4) drivers (5) (6) (7) (8) (9) (10

Machining 2,000 4,416 6,416 Machine 124.2 96.6 220.8 29.06 3,609.00 2,807

hours (32.13) (28.8Rework 400 704 1,104 # of 43 32 75 14.72 632.96 471

reworks (5.63) (4.8

Warranty repair 512 608 1,120 # of warranty 20 12 32 35.00 700.00 420repairs (6.23) (4.3

Inspection 1,392 696 2,088 # of tests 450 350 800 2.61 1,174.50 913(10.45) (9.4

Package 1,536 304 1,840 # of units 225 350 575 3.20 720.00 1,120(6.41) (11.5

Scheduling 208 208 # of batches 18 8 26 8.0 144.00 64.0(1.28) (0.6

Maintenance 448 82 530 Machine 124.2 96.6 220.8 2.40 298.13 231hours (2.65) (2.3

Set-up 1,600 320 1,920 # of set-ups 6 2 8 240.00 1,440.00 480

(12.82) (4.9

Material handling 672 294 966 # of moves 9 14 23 42.00 378.00 588(3.36) (6.0

Idle 832 672 1,504

Total 9,600 6,400 1,696 17,696 Total activity cost 9,096.59 7,095(80.97) (72.9

Direct material cost 2,137.50 2,625

(19.03) (27.0Total product cost 11,234.09 9,270

(100) (10Production quantity 225 35Unit product cost 49.93 27.7

Notes:1. Formulas for calculat ion: (4) = (1) + (2) + (3); (7) = (5) + (6); (8) = (4)/(7); (9) = (5) (8); (10) = (6) (8);2. The percentages within parentheses of columns (9) and (10) are the percentages of total product cost

TableVIII.

Assigningac

tivity

coststoprod

ucts


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This Table includes total activity cost, direct material cost, total product cost,and unit product cost for each product. By using the resulting data shown incolumns (9) and (10), the department can prepare a product cost analysis reportas shown in Table IX. This report portrays product costs by direct material costand activity costs, which is completely different from traditional cost report.This example report gives the department manager the following implications:

For the overall figures, total non-value-added cost accounts for 32.05percent of total manufacturing cost; total COQ accounts for 21.56percent. Thus, there will be great oppor tunit ies for improvement.

Product A incurs more non-value-added cost/quality cost than product B.

For two high-cost activities, inspection and set-up, Product A incursmore cost than Product B, especially for set-up. Thus, reducing set-uptime for Product A has t he first priority in improving the set-upactivity.

ABC CompanyDepartment: XYZ

Product Cost Analysis Report

Product A Product B Total

Unit produced 225 350Direct material cost ($) 2,137.50 (19.03) 2,625.00 (27.01) 4,762.50 (21.21)

Activity costs ($)Machining (VA) a 3,609.00 (32.13) 2,807.00 (28.88) 6,416.00 (28.57)Package (VA) 720.00 (6.41) 1,120.00 (11.52) 1,840.00 (8.19)

Maintenance (VA/COQ) 298.13 (2.65) 231.87 (2.39) 530.00 (2.36)Inspection (NVA/COQ) 1,174.50 (10.45) 913.50 (9.40) 2,088.00 (9.30)Rework (NVA/COQ) 632.96 (5.63) 471.04 (4.85) 1,104.00 (4.92)Warranty repair

(NVA/COQ) 700.00 (6.23) 420.00 (4.32) 1,120.00 (4.99)Set-up (NVA) 1,440.00 (12.82) 480.00 (4.94) 1,920.00 (8.55)Material handling (NVA) 378.00 (3.36) 588.00 (6.05) 966.00 (4.30)Scheduling (Gray) 144.00 (1.28) 64.00 (0.66) 208.00 (0.93)

Total activity cost 9,096.59 (80.97) 7,095.41 (72.99) 16,192.00 (72.10)Total product cost ($) 11,234.09 (100) 9,720.41 (100)

Idle capacity cost 1,504.00 (6.70)Total manufacturing cost 22,458.50 (100)Unit product cost 49.93 27.77Total value-added cost 4,627.13 (41.19) 4,158.87 (42.78) 8.786.00 (39.12)Total non-value-added cost 4,325.46 (38.50) 2,872.54 (29.55) 7,198.00 (32.05)Total COQ 2,805.59 (24.97) 2,036.41 (20.95) 4,842.00 (21.56)Total COQ per unit 12.47 5.82

Notes:a VA = value-added; NVA = non-value-added; COQ = cost of quality

Figures in parentheses indicate a percentage

Table IX.Product cost

analysis report


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For the non-value-added and failure-cost-related activities, rework andwarranty repair, Product A incurs more cost than Product B.

ConclusionsWhile most COQ measurements methods are activity/process oriented,traditional cost accounting establishes cost accounts by the categories ofexpenses, instead of activities. Thus, many COQ elements should be estimatedor collected by other methods. The main deficiencies of most COQ systems inmeasuring COQ are:

no consensus method to allocate overhead costs to COQ elements;

the failure to trace quality costs to their sources; and

the lack of information about how indirect workers spend their time onvarious activities.

These deficiencies can be easily overcome under ABC together with worksampling. Based on the similarities of COQ approaches and ABC, this paperproposes an integrated COQ-ABC framework. Ideally, ABC and COQ systems

should be merged as one and share the common database in order to supplyvarious cost and nonfinancial information for the related managementtechniques, ABM, TQM, and BPR. In add ition, the int egr ated COQ-ABCinformation system should be integrated with the existing company accountingsystem eventually in order to reduce the resources required to manage thesys tem (Goulden and Rawlins, 1995) and t o avoid dat a redundancy a ndinconsistency.

Under ABC, quality cost s ar e achieved in the first st age of ABC costassignment view and then traced to their sources in the second stage of ABC

cost assignment view. ABC uses nested activity centers to create a multi-tierCOQ report ing system to meet various managements information needs andto sup port COQ responsibility accounting. The cost an d nonfinancialinformation achieved from the integrated COQ-ABC system can be used toidentify the magnitude of the quality improvement opportunities, to identifywhere the quality improvement opportunities exist, and to continuously planthe quality improvement programs and control quality costs. The long-termgoal of the integ ra ted COQ-ABC sys tem is to eliminate non-value-addedactivities, which are related to appraisal and failure costs for the PAF approachand CONC and some COC for the process cost approach, and to streamlinevalue-added activities/processes. Moreover, the ultimat e goal will be t ocontinuously improve processes/activities/quality so that no defects at all areproduced and quality cost measurement ultimately becomes unnecessary.

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Appendix: Gloss ary of ABC/ABM terms mentioned in this paper (Raffish andTurney, 19 91 )

Activity. 1.Work performed within an organization. 2.An aggregation of actions performed withinan organization that is useful for purposes of activity-based costing.

Activity analysis. The identification and description of activities in an organization. Activityanalysis involves determining what activities are done within a department, how many peopleperform the activities, how much time they spend performing the activities, what resourcesare required to perform the activities, what operational data best reflect the performance of theactivities, and what value the activity has for the organization. Activity analysis isaccomplished by means of interviews, questionnaires, observation, and review of physicalrecords of work.

Activity attributes. Characteristics of individual activities. Attributes include cost drivers, cycletime, capacity, and performance measures. For example, a measure of the elapsed timerequired to complete an activity is an attribute.

Activity cost pool. A grouping of all cost elements associated with an activity.

Activity driver. A measure of the frequency and intensity of the demands placed on activities bycost objects. An activity driver is used to assign costs to cost objects. It represents a line-itemon the bill of activities for a product or customer. An example is the number of part numbers,which is used to measure the consumption of material-related activities by each product,material type, or component. The number of customer orders measures the consumption of

order-entry activities by each customer. Sometimes an activity driver is used as an indicatorof the output of an activity, such as the number of purchase orders prepared by the purchasingactivity.

Activity-based costing (ABC). A methodology tha t measures th e cost an d p erformance ofactivities, resources, and cost objects. Resources are assigned to activities, then activities areassigned to cost objects based on their use. Activity-based costing recognizes the causalrelationships of cost drivers to activities.

Activity-based management (ABM).A discipline that focuses on the management of activities asthe route to improving the value received by the customer and the profit achieved by providingthis value. This discipline includes cost driver analysis, activity analysis, and performance

measurement. Activity-based management draws on activity-based costing as its majorsource of information.

Best practices. A methodology that identifies an activity as the benchmark by which a similaractivity will be judged. This methodology is u sed to assist in identifying a process ortechnique that can increase the effectiveness or efficiency of an activity. The source may beinter nal (e.g. taken from another p art of the company) or extern al (e.g. taken from acompetitor). Another term used is competitive benchmarking.

Cost driver. Any factor that causes a change in the cost of an activity. For example, the quality ofparts received by

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