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Cost Management: A

Strategic Emphasis, Fourth

Edition

IV. Operational Control 16. The Management and

Control of Quality

The McGrawHill

Companies, 2008

PARTIV

OPERATIONAL

CONTROL

C H A P T E R S I X T E E N

The Managementand Control of QualityAfter studying this chapter, you should be able to . . .

Define accountings role in the management and control of quality

Define quality and the characteristics of total quality management (TQM)Develop a comprehensive framework for the management and control of quality

Understand two approaches for setting quality-related goals (Six Sigma and Goalpost versus

absolute conformance standards)

Prepare and interpret relevant financial information to support TQM initiatives

Discuss the use of nonfinancial performance data to support TQM initiatives

Describe and understand techniques that can be used to detect and correct quality problems

You cant turn quality on like a spigot. Its a culture, a lifestyle within a company.

A Ford Engineer

For decades, management experts in the United States, including W. Edwards Deming andJ. M. Juran, urged manufacturers to design in quality at the beginning of the process, not to

inspect-in quality at the end of the production line. The quality call-to-arms mainly fell on

deaf ears in the United States, but not in Japan. More than 40 years ago, Juran predicted that

a focus on quality would help turn Japan into an economic powerhouse.

Jurans prediction proved true.1 In the late 1970s and the early 1980s, many U.S. firms

had a rude awakening. Many U.S. executives realized, for the first time, that Made in the

U.S.A.no longer stood for the best that was available. Once a term of mockery, Made in

Japanbecame a term synonymous with quality. U.S. executives, especially those working

for firms employing traditional management techniques that had paid off so well a scant 20

years earlier, found themselves searching frantically for answers and desperately seeking to

remain competitive.

U.S. auto manufacturers realized in the late 1970s that Japanese auto manufacturers were

somehow able to sell automobiles that performed better, had far fewer defects, and cost less

than those made in the United States and still earn high returns. Likewise, when Hewlett-Packard tested the quality of more than 300,000 new computer chips, it found those made by

Japanese manufacturers had zero defects per thousand. Those made by U.S. manufacturers

had 11 to 19 defects per thousand. After 1,000 hours of use, the failure rate of U.S. chips was

27 times higher than those of the Japanese chips. Many industry and government leaders in

the United States saw the handwriting on the wall: Get quality or lose the race.

The world had changed. Global competition gave consumers abundant choices and they

became more cost and value conscious, demanding high-quality products and services.

Firms that failed to pay attention to quality often found eroding market shares and operating

profits.

1.

2.3.

4.

5.

6.

7.

648

1N. Gross, M. Stepanek, O. Port, and J. Carey, Will Bugs Eat Up the U.S. Lead in Software? BusinessWeek,December 6, 1999.

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Many U.S. firms have made remarkable changes in the last two decades. Consumers have

witnessed major efforts by U.S. manufacturers to improve quality. Many firms in the United

States have engaged in relentless efforts to improve the quality of their products and services.

Continuous improvement has become a way of life for many firms and organizations, both

in the United States and abroad. For example, AT&T implemented Concept of One, which

means do it once, do it right, and do it everywhere. In four years, AT&T saved about $2 bil-

lion in payroll alone.2

Baldrige Quality AwardIn 1987, Congress established the Malcolm Baldrige National Quality Award to enhance the

competitiveness of U.S. businesses by promoting quality awareness, recognizing quality and

performance achievements, and publicizing successful performance strategies of U.S. organi-

zations in the areas of manufacturing, service, small business, andadded in 1999educationand health-care. Seven broad categories make up the criteria: leadership, strategic planning,

customer and market focus, information and analysis, human resource focus, process manage-

ment, and business results. The fierce competition to win the award is evidence of the impor-

tance these firms place on being recognized for their quality operations.

ISO 9000 and ISO 14000Quality has become a major thrust of businesses worldwide. In response, various groups pro-

mulgated quality-related standards to guide business practice. In 1947, to standardize practices

for quality management, a specialized agency (the International Organization for Standardiza-

tion) was formed. In 1987 this body adopted a set of quality standards, which were revised

in 1994 and again in 2000. Thus, the current set of quality-management standards is referred

to as ISO 9000:2000. Worldwide, ISO 9000 has become a certification sought after by globalcompanies to gain the stamp of approval on the quality of their products and services.

The ISO 9000:2000 standards focus on developing, documenting, and implementing ef-fective procedures for ensuring consistency of operations and performance in production and

service delivery processes, with an overall goal of continual improvement. These standards

actually consist of three documents:ISO 9000Fundamentals and vocabulary;ISO 9001

Requirements (i.e., specifications for a quality management system, to which organizations

must adhere; these requirements are divided into four major sections: Management Respon-

sibility, Resource Management, Product Realization, and Measurement/Analysis/Improve-

ment); and ISO 9004Guidelines for Performance Improvements (i.e., guidelines to assist

organizations in improving their quality-management systems beyond the minimum require-

ments specified inISO 9001). Note that the set of ISO 9000 standards relates toprocessesin

ISO 9000: 2000

is a set of guidelines for quality

management and qualitystandards developed by the

International Organization for

Standardization, located in

Geneva, Switzerland.

ISO 9000: 2000

is a set of guidelines for quality

management and qualitystandards developed by the

International Organization for

Standardization, located in

Geneva, Switzerland.

2S N. Mehta, How to Thrive When Prices Fall, Fortune, May 12, 2003, p. 132.

REAL-WORLD FOCUS Quality Comes to Child-Care Services

For decades, five-star hotels and restaurants have had consumers

lining up to get in. Now comes a new consumer rating: five-star child-

care. Just as if they were restaurants or hotels, child-care concerns

(both childcare centers and family child-care homes) are being

assigned star ratings by state regulators. These ratings are fast be-

coming the linchpin of states drive to raise child-care quality. The

ratings systems evaluate facilities on such criteria as low childadult

ratios, teacher credentials, curriculum, group size, and the safety and

richness of the environment. Some of these criteria have in research

studies been associated with better outcomes in children. There is

some preliminary evidence that the ratings systems are improving

quality. For example, in Oklahoma (the first state to set up a rating

system) close to 60 percent of all child-care slots in the state are in

facilities rated in the top two tiers, up from 30 percent in 2003. In Ten-

nessee, where provider participation in star ratings is mandatory, 50

percent of facilities have earned a top rating, up from 30 percent in

2002. Critics argue, however, that although participation by child-care

providers is growing, the systems are mostly voluntary; provider par-

ticipation ranges from 10 percent to 60 percent in states where the

systems are voluntary.

Source:S. Shellenbarger, Finding Five-Star Child-Care: States Rate Facilitiesin Effort to Boost Quality, The Wall Street Journal(March 23, 2006), p. D1.

The Strategic Importance of Quality

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place that ensure that outputs of the organization satisfy customer quality requirements. Fur-

ther, these standards are intended to apply to all types of businesses, including services such

as transportation, health-care, and banking.

ISO 14000is a set of standards that relate to environmental management, that is, what anorganization does to minimize harmful effects to the environment. As with ISO 9000, ISO

14000 is concerned with quality managementprocesses in place that ensure a product will

have the least harmful impact on the environment, at any stage of its life cycle, either by pol-

lution or by depleting natural resources.

In sum, ISO standards contribute to making the development, manufacturing, and supply

of products and services more efficient, safer, and cleaner. They make trade between countries

easier and fairer. They provide governments with a technical base for health, safety, and en-

vironmental legislation and they aid in transferring technology to developing countries. ISO

standards also serve to safeguard consumers, and users in general, of products and services

as well as to make their lives simpler. As of this writing, more than 700,000 organizations in

154 countries have implemented ISO 9000 and ISO 14000 standards (see www.iso.ch).

Quality and Profitability: Conceptual LinkageWhether a company competes through a strategy of cost leadership or product differentiation,

quality issues permeate every aspect of operations. A company choosing to compete through

low prices is not necessarily choosing to produce low-quality products. Its low-priced pro d-

ucts must still meet customer expectations. Similarly, a differentiation strategy will not be as

successful, or at least will not be as successful as it could be, if the company fails to build

quality into its products. Thus, from top managements perspective, a key question is how best

to manage and control total spending on quality-related costs.

There is evidence that the total cost of quality for an organization can be high; for many

U.S. firms, total quality costs amount to 20 to 25 percent of sales dollars.3 One consultant

estimates that 40 percent of the cost of doing business in the service sector can be attributed

to poor quality.4On the other hand, firms with quality products or services can earn high, and

sustainable, levels of profitability.Exhibit 16.1 shows that a firm with improved quality can achieve competitive advantage

and enjoy higher profitability and a higher return on investment. Improved quality decreases

product returns. Lower returns decrease warranty costs and repair expenses. Improved qual-

ity lowers inventory levels for raw materials, components, and finished products because the

ISO 14000

is a set of quality standards

designed to minimize

environmental effects of an

organizations outputs.

ISO 14000

is a set of quality standards

designed to minimize

environmental effects of an

organizations outputs.

REAL-WORLD FOCUS Environmental Quality Ratings for New-Building Construction

Eco-friendly, or green, buildings are one of the most talked-about

trends in the trillion-dollar U.S. construction industry. Environmental

quality concerns regarding new-building construction are important:

buildings today account for about one-third of U.S. energy consump-

tion, 30 percent of greenhouse gas emissions, and 30 percent of raw

material use. The U.S. Green Building Council (www.usgbc.org), a

private environmental organization, now provides different levels of

green certification for new-building construction, based on six crite-

ria and the use of a 69-point rating scale.

The six evaluation criteria (i.e., green categories) are: sustainable

sites (e.g., public transportation access); water efficiency, energy

and atmosphere; materials and resources (e.g., use of materials with

post-consumer recycled contents); indoor environmental quality (e.g.,

carbon dioxide monitoring); and innovation and design process. In ad-

dition to basic certification, higher-performance designations (silver,gold, and platinum) are awarded.

Green certification is not cheap: costs can run anywhere from

$30,000 to $150,000 for administration and paperwork. Critics argue

that the existing standards are too lenient and that the scoring system

does not give differential weights to what are considered more criti-

cal performance criteria.

BRE, British Research Establishment Limited (www.bre.co.uk) is a

U.K. counterpart organization that, among other things, assesses and

certifies both new and existing buildings using the BRE Environmental

Assessment Method (BREEAM) (see www.breeam.org). This method

is considered in the U.K.s construction and property sectors as the

measure of best practice in environmental design and management.

As worldwide demand for natural resources continues, the man-

agement and control of environmental quality costs will likely take on

increased importance, both in the United States and abroad.

Source:A. Frangos, Is It Too Easy Being Green?, The Wall Street Journal(October 19, 2005), pp. B1, B6.

3M. R. Ostrega, Return on Investment through Cost of Quality, Journal of Cost Management(Summer 1991), pp. 3777;

R. K. Youde, Cost of Quality Reporting, Management Accounting(January 1992), pp. 3338.

4T. Wolf, Becoming a Total Quality Controller, The Small Business Controller(Spring 1992), pp. 2427.

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Chapter 16 The Management and Control of Quality 651

firm has more reliable manufacturing processes and schedules. Improved product quality also

lowers manufacturing costs as the firm reduces or eliminates rework and increases productiv-

ity. Customers are likely to perceive quality products as having higher values, which allows

the firm to command higher prices and enjoy a larger market share. Higher prices and great-

er market shares increase revenues and profits. Improved quality also decreases cycle time.

Faster cycle times speed deliveries, and prompt delivery makes happy customers, creates new

demand, and increases market shares. Higher revenues and lower costs boost net income and

increase the firms return on investment (ROI).

Empirical EvidenceDoes TQM Matter?Empirical studies provide evidence regarding the market reaction to and the financial effects

of quality-related initiatives, such as total quality management (TQM).

Barron and Gjerde (1996) presented early evidence regarding the relationship between

adoption of TQM and firm characteristics, including financial performance.5Their data set in-

cluded approximately 2,300 firms and data from 19831992; during this period, firms that had

adopted TQM experienced a greater growth rate in net sales, employment, and total assets.

Easton and Jarrell (1998) examined the impact of TQM on the performance of 108 firms

that began TQM implementation between 1981 and 1991.6 The authors provide evidence that

performance, measured by both accounting variables and stock returns, is improved for firms

adopting TQM and that this improvement is consistently stronger for firms with more ad-

vanced TQM systems.

PIMS Associates, Inc., a subsidiary of the Strategic Planning Institute, maintains a data-

base of over 1,200 companies to study the relationship between product quality and corporateperformance.7 Their analysis indicates that

Product quality is an important determinant of business profitability.

Businesses that offer premium-quality products and services are more likely to have rela-

tively large market shares.

Quality is positively and significantly related to higher rates of return on investment for

almost all kinds of products and market situations.

EXHIBIT 16.1

Relationship betweenImproved Quality and

Financial Performance

Higher

MarketShare

Lower

Manufacturing

Cost

Improved Quality

Investments in Quality

Financial Performance

Higher

Perceived

Value

Faster

Throughput

Time

Lower

Return

Rate

Lower

Warranty

and

Service

Costs

Faster

Delivery

Higher

Prices

IncreasedRevenues

More

Satisfied

Customers

Lower

Inventory

Higher

Turnover

5J. M. Barron and K. P. Gjerde, Who Adopts Total Quality Management (TQM): Theory and an Empirical Test, Journal of

Economics and Management Strategy5, no. 1 (Spring 1996), pp. 69106.6G. S. Easton and S. L. Jarrell, The Effects of Total Quality Management on Corporate Performance: An Empirical

Investigation,Journal of Business71, no. 2 (1998), pp. 253307.

7As reported in J. R. Evans and W. M. Lindsay, The Management and Control of Quality, 6thed. (Mason, OH: South-Western,

2005), p. 26.

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652 Part Four Operational Control

For most years since 1995, the hypothetical Baldrige Stock Index, consisting of publicly

traded U.S. companies that have received the Malcolm Baldrige National Quality Award, hasoutperformed the Standard & Poors 500 by a margin of almost three to one. In a series of

papers,8Hendricks and Singhal compared the performance of 600 quality award-winning com-

panies, including the Baldrige, state (e.g., the Georgia Oglethorpe Award), and other quality

award programs, with the performance of a control group of companies. These researchers found

that the award-winning companies significantly outperformed the control group in many aspects

of their business, including the value of their common stock, operating income, sales, return on

sales, and asset growth. Saccomano9 reports that companies with effective TQM programs have

higher stock prices, sales, and profits compared to a control sample of firms.

In sum, cost, quality, and time are among the critical factors in successful strategies. Hav-

ing quality products allows firms that compete on differentiation to be effective in sustaining

their strategy. A firm with low costs and quality products provides its customers with products

equal to or better in quality at lower prices. Only with quality products can the firm truly be a

cost leader. Continual improvements in the quality of products and services and in processes

should be a fundamental strategic objective and a major item in the balanced scorecard ofmost firms and organizations.

The preceding discussion should have conveyed to you that quality initiatives, such as TQM,

are management, not accounting, initiatives or prerogatives. Thus, from our perspective the

appropriate question to ask is how accounting can add value to, or support, quality-related

initiatives of management. An inspection of Exhibit 16.1 suggests that accountants can add

value to the process by providing managers with relevant and timely information, of both a

financial and nonfinancial nature.

With their training and expertise in analyzing, measuring, and reporting information, man-

agement accountants can help in the design and operation of a comprehensive system for man-

aging and controlling quality costs. This is where accountants have a competitive advantagewithin the organization.

Chapter PreviewIn the next section of this chapter, we define the term qualityand then present a conceptual

framework for managing and controlling quality costs. This is followed by a discussion of

financial performance measures related to quality (relevant cost analysis and cost of qual-

ity [COQ] reports). We then discuss the role of nonfinancial quality indicators in the overall

framework. We conclude the chapter with a discussion of a number of techniques that can be

used to identify and analyze quality-related problems.

The Meaning of QualityThere are many definitions of quality, and people often view it differently because of differ-

ences in their roles in the production-marketing-consumption chain and in their expectations

for products or services. In simpler times, many CEOs perceived quality as a characteristic

revealed by I know it when I see it. However, such an ad hoc approach to quality provides

no clear guideline for meeting it and as such, makes the management and control of quality

difficult if not impossible.

Accountings Role in the Management and Control of QualityAccountings Role in the Management and Control of Quality

LEARNING OBJECTIVE 1Define accountings role in the

management and control of

quality.

LEARNING OBJECTIVE 1Define accountings role in the

management and control of

quality.

Total Quality Management (TQM)Total Quality Management (TQM)

LEARNING OBJECTIVE 2Define quality and the

characteristics of total quality

management (TQM).

LEARNING OBJECTIVE 2Define quality and the

characteristics of total quality

management (TQM).

8K. B. Hendricks and V. R Singhal, Does Implementing an Effective TQM Program Actually Improve Operating Performance:

Empirical Evidence from Firms That Have Won Quality Awards, Management Science43 (1997), pp. 12581274; K. B.

Hendricks and V. R Singhal, Firm Characteristics, Total Quality Management, and Financial Performance, Journal of Operations

Management19 (2001), pp. 269285; and, K. B. Hendricks and V. R Singhal, The Long-Run Stock Price Performance of Firms

with Effective TQM Programs as Proxied by Quality Award Winners, Management Science47 (2001), pp. 359368.

9A. Saccomano, TQM Works Over Time, Traffic World, 1998, p. 37.

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For purposes of discussion we define the term qualityto mean the total level of customer satis-

faction with the organizations product or service. Defined in this manner, we can decompose thenotion of quality into two broad components:featuresandperformance. The former component

refers to whether the characteristics, attributes, or functionality of the product or service is com-

patible with customer expectationsin short, design quality. Outputs that fail to meet such ex-pectations result in quality-of-design failure costs. Conceptually, you can think of design failure

as the difference between the actual features of the product (or service) and what the customer

wants. Such failures represent one component of total quality cost. One way to manage (i.e., re-

duce) design failure is through the use of target-costing procedures, as discussed in Chapter 10.

In this chapter, we are concerned with the management and control of the other broad com-

ponent of quality, performance quality. Performance quality can be defined as the differencebetween the design specifications of the product and the actual performance of the product.

Thus, a personal computer whose electronic mouse consistently malfunctions or whose oper-

ating system constantly locks up relates to what can be called conformance quality failures.As

such, we define performance quality costs as those related to providing a customers required

level of product or service performance.Not all customers have the same expectations for a product or service. All 3/8-inch drill bits

can drill 3/8-inch holes. Nevertheless, a firm can manufacture a 3/8-inch drill bit that costs $3

for home use and an industrial-strength drill bit that costs $15. The specifications and quality

expectations for the less expensive drill bit are not the same as those for the more expensive

one. The industrial strength drill bit is designed for heavy, continuous use and can be used for,

say, 100 hours before it needs to be replaced. A drill bit for home use, on the other hand, is not

designed for continuous use for long hours and has a shorter expected life of, say, 10 hours.

Expectations for services also differ. A tourist does not expect the same services from a Motel

6 as from a Ritz-Carlton Hotel, although both provide rooms for tourists. A mechanic performs

quality service by changing a cars oil as specified: draining old oil, installing a new oil filter,

lubricating the chassis, and adding clean new oil. The service is a quality service even if the me-

chanic used a regular oil, not a new synthesized oil that improves engine performance, if the cus-

tomer asked for a regular, not a deluxe, oil change. The mechanic has failed to deliver a quality

Quality

is defined as customersatisfaction with the total

experience of a product or

service, that is, the difference

between customer desires and

actual performance of the

product or service.

Quality

is defined as customersatisfaction with the total

experience of a product or

service, that is, the difference

between customer desires and

actual performance of the

product or service.

Design quality

is the difference between

customer desires (for attributes,

services, functionality, etc.) and

product design.

Design quality


customer desires (for attributes,

services, functionality, etc.) and

product design.

Performance quality


actual performance and designspecifications.

Performance quality


actual performance and designspecifications.

REAL-WORLD FOCUS How Costly Is Poor Quality?

As noted earlier, some organizations have a quality orientation and

embrace managerial initiatives such as TQM to support this competi-

tive strategy. For each of the following examples, consider (1) which

nonfinancial performance indicators, or controls, might be instituted

to help control quality and (2) what kinds of quality-related costs might

be involved by failing to control quality:

A recent study published in the November 15, 2005, issue of Can-

cer(a journal of the American Cancer Society) underscores the

difficulty of improving screening rates to detect colon cancer,

the third leading cause of cancer deaths.* Based on a review of

patient charts from individuals associated with a California HMO,

fewer than 30 percent of eligible patients over age 50 received any

of the three types of colon-cancer tests. According to the National

Committee for Quality Assurance, a Washington-based nonprofitorganization that promotes health-care quality, Tufts Health Plan

(Waltham, MA) achieved the highest score in the nation, 72 per-

cent, for colorectal cancer screening.

UnumProvident Corporation, a disability-income insurer, paid an

$8 million civil penalty and $600,000 court costs to settle a suit

brought against the company by the California Department of In-

surance, to resolve allegations that it cheated policyholders by

improperly denying claims. This settlement followed an earlier

fine of $15 million paid by the company to the U.S. Labor Depart-

ment in a multistate settlement.

Boston Scientific Corporation recently reached an agreement

with the U.S. Food and Drug Administration (FDA) in which

the company committed itself to an aggressive timeline for

resolving quality-control problems. Prior to this agreement, the

FDA had announced that it would withhold approval of some

new products from the company until it resolved the issues.

The FDA alleged that the company had failed to report, or

delayed reporting, potential safety problems associated with its

products.

PeopleSoft, Incorporated, reached an agreement to pay Cleveland

State University $4.25 million to settle a lawsuit over computer

problems that delayed financial aid to thousands of students. The

university claimed that students often waited months for financial

aid because of computer problems that also hindered other ser-

vices for more than two years.

Sources:*R. L. Rundle, Colon-Cancer Screening Rates Rise Only Slightly, Study Says,The Wall Street Journal(October 11, 2005), p. B1.D. Gullapalli, UnumProvident Is Set to Pay $8 Million Penalty in California,The Wall Street Journal (October 3, 2005), p. C3.Boston Scientific Sets to Fix Quality Issues, The Wall Street Journal(February 4, 2006), p. A2.Software Firm Will Pay CSU $4.25M Settlement, The Wall Street Journal(February 4, 2006), p. A2.

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service, however, if the new oil filter falls off the next morning due to improper installation or if

the refill is four or six quarts of oil instead of the five quarts specified by the manufacturer.

Characteristics of Total Quality ManagementTotal quality management (TQM) is the unyielding and continuous effort by everyone in thefirm to understand, meet, and exceed the expectations of customers.10Although each organiza-

tion is most likely to develop its own approach to total quality management to suit its particu-

lar culture and management style, certain characteristics are common to most TQM systems.

These characteristics are as follows:

Focusing on satisfying the customer.

Striving for continuous improvement.

Fully involving the entire work force.

Actively supporting and involving top management.

Using unambiguous and objective measures.

Recognizing quality achievements in a timely manner.Continuously providing training on total quality management.

Exhibit 16.2 describes the critical factors for successful TQM.

The Need for a New Accounting SystemAs noted above, a crucial factor for TQM success is having measures that truly reflect the

needs and expectations of customers, both internal and external. A good measurement system

that helps TQM often entails developing a new accounting system because the current system

divides and spreads important quality data among myriad accounts. A good measurement sys-

tem for TQM should also enable all employees to know at all times the progress being made

toward quality-related goods and the additional improvements needed.

A traditional accounting system often fails to associate costs with activities. As a result,

quality teams (i.e., cross-functional teams that oversee the entire quality-management and

continuous improvement process) do not have the information they need to focus on and iden-tify quality problems. The accounting system needs to relate quality costs to activities so that

quality teams can focus their efforts appropriately to ensure the success of the TQM effort.

In short, management accountants need to ensure that the measurement and reporting pro-

cess meets the following criteria:11

Addresses the information needs of internal customers.

Includes all relevant quality-related measures, including both financial and nonfinancial

measures.

Adapts measures as needs change.

Is simple and easy to use, execute, and monitor.

Fosters improvement, rather than just monitoring.

Motivates and challenges team members to strive for the highest quality gains.

Text Exhibits 16.1 and 16.2 provide broad guidance for the development of a comprehensive

framework (or system) for the management and control of quality. One possible framework is

presented in Exhibit 16.3. This exhibit serves as the focal point around which the discussion in

the rest of the chapter is built. By way of introduction, therefore, we now provide an overview

of the primary elements of the framework.

Knowledge of Business ProcessesBecause the model is comprehensive, it presumes knowledge of key business processes.

Thus, the development and implementation of a comprehensive framework for managing and

Total quality management (TQM)

is the unyielding and continuous

effort by everyone in the firm to

understand, meet, and exceed the

expectations of customers.

Total quality management (TQM)

is the unyielding and continuous

effort by everyone in the firm to

understand, meet, and exceed the

expectations of customers.

Comprehensive Framework for Managing and Controlling QualityComprehensive Framework for Managing and Controlling Quality

LEARNING OBJECTIVE 3Develop a comprehensive

framework for the management

and control of quality.

LEARNING OBJECTIVE 3Develop a comprehensive

framework for the management

and control of quality.

10Managing Quality Improvements, Statement on Management Accounting No. 4-R(Montvale, NJ: Institute of Management

Accountants, 1993), p. 17.

11Ibid, p. 31

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controlling quality is best thought of as a cross-functional effort, with input of managers

from across the value chain. Because of their record-keeping and reporting responsibilities,

accountants can be viewed as the key point of contact across various subunits and managers

within the organization. Thus, the development of such a comprehensive system requires the

accountant to have broad business knowledge, including knowledge of fundamental businessprocesses.

Role of the CustomerIn the past, most quality control reporting systems had a decidedly inward focus. That is,

measures and techniques were developed and used based on what the organization felt were

appropriate to the situation. More recently, however, organizations have begun to realize a fun-

damental flaw in system design: failure to embrace an outward (i.e., customer-based) viewpoint.

Focusing on

Customers

Expectations and Requirements

of External Customers

Continuous

Improvement

Involving All

Employees

Support and

Involvement ofTop Management

Clear and

MeasurableObjectives

Timely

Recognition

Continuous

Training

TOTAL QUALITY MANAGEMENT

Specifications for Internal

Suppliers/Customers

Specifications for

External Suppliers

EXHIBIT 16.2

Critical Total QualityManagement (TQM) Factors

EXHIBIT 16.3Comprehensive Framework

for Managing and Controlling

Quality

Customer

Expectations

Work

Processes

Prevention

Costs

Quality-Related Investments/Spending Diagnostic Control

Appraisal

Costs

Internal

Failure Costs

External

Failure Costs

Satisfied

Customers

Dissatisfied

CustomersNonfinancial

Quality Indicators

Statistical

Quality Control

and Run Charts

Set Quality-Related Goals

(i.e., Strategy)

Taguchi Loss

Functions,

Six Sigma

Programs

Perform Work/Monitor Output/

Correct Defects

Deliver

Product/Service andMonitor Customer

Satisfaction

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Thus, in the comprehensive model shown in, Exhibit 16.3, we depict consumer expectations

as the cornerstone of the entire framework. In this sense, then, the model can be viewed ascustomer-based. As well, the model attempts to capture (as external failure costs) various

costs associated with dissatisfied customers.

Financial ComponentYou will notice that the reporting of quality costinformation is a key element of the compre-

hensive framework shown in Exhibit 16.3. In fact, we depict cost information in four separate

categories to give prominence to the different types of quality costs that organizations incur.

This financial approach to the management and control of quality, known as cost of quality, is

dealt with in greater detail later in the chapter.

Nonfinancial Performance IndicatorsAs illustrated in Exhibit 16.3, the financial performance indicators of our comprehensive re-

porting framework are complemented by both internal and external nonfinancial performance

indicators. As we explain later in the chapter, nonfinancial performance indicators can be lead-ing indicators (i.e., predictors) of future financial performance. As such, any comprehensive

framework for managing and controlling quality should have a combination of both financial

and nonfinancial performance indicators.

Feedback LoopsYou will notice that the comprehensive framework illustrated in Exhibit 16.3 contains a number

of feedback loops, designed to inform future decisions and to support an organizations overall

goal of continuous improvement. Thus, for example, the entire model continually helps the

organization better understand customer expectations and, in turn, set appropriate quality

goals for the organization.

Relevant Cost AnalysisAs indicated in Chapter 9, one important role for management accountants is to provide

decision-relevant information to managers. In the present context, based on both financialand nonfinancial performance indicators, managers make decisions regarding quality-related

investments. Thus, management accountants can add value to the overall management and

control of quality by providing decision makers with decision-relevantinformation, using the

approach outlined in Chapter 9.

Link to Operations ManagementThe framework presented in Exhibit 16.3 provides a wonderful example of cross-disciplinary

inputs to a management process. As noted above, accounting has primary reporting responsi-

bility for relevant financial and nonfinancial performance measures. The question arises, then,

as to how managers then identify and analyze quality-related problems. For this, we draw from

the field of operations management techniques such as control charts, Pareto diagrams, and

cause-and-effect diagrams. Management accountants, as members of the overall management

team, should have at least cursory knowledge of these techniques, including the role they play

in the control and management of quality.

Breadth of the SystemIn the past, for many organizations (particularly manufacturers), quality was assumed to be

the responsibility of production (i.e., the manufacturing process). Thus, as indicated earlier in

this text, companies can calculate and report production-related failure costs, such as the cost

of normal spoilage, the cost of abnormal spoilage, and so on. However, as indicated at the

beginning of this chapter, many organizations today are embracing a broader responsibility for

qualityacross all elements of both the internal and external value chain. Any comprehensive

framework developed to support a TQM strategy should therefore have a broad reporting

perspective. You will note that the performance measures reflected in Exhibit 16.3 cut across

the entire value chain.

In the remaining sections of this chapter, we discuss in greater detail the elements of the

framework illustrated in Exhibit 16.3.

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As seen from Exhibit 16.3, the actual quality goals embraced by the organization are affected

principally by customer demandsthat is, the level of quality (including product functional-ity) that the targeted customer group is willing to pay for. In this section we discuss two ap-

proaches to translating customer demands into quality-related goals: Six Sigma and goalpost

versus absolute conformance standards.

Setting Quality Expectations: A Six Sigma ApproachSix Sigma12 has been embraced by many organizations as the guiding principle that drives improve-

ments in products, services, and processes (e.g., product development, logistics, sales, market-

ing, and distribution). Six Sigmacan perhaps best be defined as a business process improvementapproach that seeks to find and eliminate causes of defects and errors, reduce cycle times and

manufacturing costs, improve productivity, better meet customer expectations, and achieve higher

asset utilization and returns on investment in both manufacturing and service operations.13

Rudisill and Clary14 offer the following actual examples of improvements realized by the

move to Six Sigma:

Reduction of scrap in a ball-bearing manufacturing plant and capacity assembly plant.

Identification and reduction of unnecessary spare parts inventory for a paper cup plant.

Reduction of defects and product variation in a textile finishing plant.

Reduction of lead-times for product development and scale-up in a pharmaceutical

company.

Reduction of wait-time for loan approval notification (from the bank).

Six Sigma is based on a simple problem-solving methodology, DMAICDefine, Measure,

Analyze, Improve, and Control. Typically, the application of Six Sigma is done using cross-

Setting Quality-Related ExpectationsSetting Quality-Related Expectations

LEARNING OBJECTIVE 4Understand two approaches

for setting quality-related goals

(Six Sigma and Goalpost versus

absolute conformance standards).

LEARNING OBJECTIVE 4Understand two approaches

for setting quality-related goals

(Six Sigma and Goalpost versus

absolute conformance standards).

Six Sigma

is an overall strategy to

accelerate improvements

and achieve unprecedented

performance levels by focusing

on characteristics that are critical

to customers and identifying andeliminating causes of errors or

defects in processes.

Six Sigma

is an overall strategy to

accelerate improvements

and achieve unprecedented

performance levels by focusing

on characteristics that are critical

to customers and identifying andeliminating causes of errors or

defects in processes.

REAL-WORLD FOCUS Pharmaceutical Companies Use Six Sigma across

the Value Chain to Speed Time to Market, Reduce Costs,and Address Manufacturing Inefficiencies

In recent years, many major pharmaceutical companies have discov-

ered the benefits of using Six Sigma principles to eliminate manu-

facturing process variation, defects, and inefficiencies. A smaller

number of such companies are applying Six Sigma to Research and

Development (R&D), in addition to the manufacturing function. Some

aggressive companies, however, are applying the concept to func-

tions across the entire value chain of activities. Among the benefits

cited by pharmaceutical companies regarding Six Sigma are the

following:

Changing economics of the industry: the Medicare Modernization

Act (January 2006) will likely motivate increased use of genericequivalents. For companies that have a thin pipeline of new drugs

or major drugs going off patent, the only way to enhance profit-

ability (at least in the short run) is to focus on cost controls and

process efficiencies, both of which are supported by the use of

Six Sigma.

Maximizing employee value: the biggest asset for knowledge-

based organizations, such as pharmaceutical companies, is

people. The cultural shift to Six Sigma allows companies to get

their employees more engaged. Tying rewards to accomplish-

ments is particularly important to instituting such a culture change.

Competitive advantage: early adopters of Six Sigma in the pharma-

ceutical industry stand to gain competitive advantage. Tradition-

ally, cost-cutting and eliminating process variation (two targets of

Six Sigma) have not been widely embraced in the industry. Thus,

early adopters of this approach can gain at least temporary com-

petitive advantage in an increasingly competitive environment.

For Six Sigma to work, most consultants believe that top manage-

ment support and commitment are keythat is, that Six Sigma can beused as a leadership tool. In order to change the culture of an organiza-

tion to support Six Sigma, significant personnel training costs are likely.

Still the financial return of such implementations can be significant. For

example, Eli Lilly estimates that its cumulative benefit to date from the

use of Six Sigma, over 160 projects, is approximately $250 million.

Source:N. DAmore, Six Sigma Adds Up for Pharma, MedAdNews25, no. 2(February 1, 2006), p. 18.

12Six Sigma is a federally registered trademark and service mark of Motorola, Inc.13J. R. Evans and W. M. Lindsay, An Introduction to Six Sigma and Process Improvement(Mason, OH: South-Western, 2005), p. 3.14F. Rudisill and D. Clary, The Management Accountants Role in Six Sigma, Strategic Finance(November 2004), pp. 3539.

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functional teams, more or less on a consulting project basis. In the design stage of the project,

the Six Sigma team definesthe problem and the scope of the problem (i.e., specifies the deliv-erables of the project). In the measurestage, the team collects relevant process performance

data. In the analyze stage, the team tries to uncover root causes of an underlying quality

problem. This is followed by the improvestage, in which proposed solutions to the underlying

problem(s) are generated and then implemented. Finally, in the controlstage of the project,

appropriate controls are put in place to ensure that the identified problem does not recur.

Motorola, Inc. pioneered the concept of Six Sigma as a structured approach for assessing

and improving both product and service quality. Today, this approach has gained notoriety and

credibility because of its adoption by firms such as Allied Signal and General Electric. The

term Six Sigma actually comes from statistics: in a normal distribution, the area outside of

+/six standard deviations from the mean is very small. From a control standpoint, we can

express this area in terms of relative number of defects. One interpretation of a Six Sigma

quality expectation is approximately 3.4 defects per million items produced.15

The move from, say, a 3-sigma to a 6-sigma quality level is dramatic. For example, sup-

pose your bank tracks the number of errors associated with checks written on the bank by itscustomers. If the bank finds, say, 12 errors per 1,000 checks processed, this is equivalent to an

error rate of 12,000 per millionsomewhere between 3.5 and 4 sigma levels! As Evans and

Lindsay point out,16a change from 3 to 4 sigma represents a 10-fold improvement in quality; a

change from 4 to 5 sigma, a 30-fold improvement; and a change from 5 to 6 sigma, a 70-fold

improvement. For this reason, Six Sigma is not likely the goal for all processes and operations.

The appropriate quality expectation is a function of the strategic importance of the process and

the anticipated costs of taking the process to a higher level of quality.

Implementation Tips: Six Sigma17

Following are steps management can take to ensure the success of Six Sigma projects.

First and foremost,provide necessary leadership and resources. As with many other stra-

tegic initiatives, the CEO and top-management team must exhibit strong support for the

Six Sigma program. Such support can come in the form of employee training and making

sure that there is appropriate buy-in for the concept on the part of key managers in the

organization.

Implement a reward system.Bonus and incentive schemes for the organization might have

to be amended to accommodate rewards associated with reaching Six Sigma goals.

Provide ongoing training. Since Six Sigma is aprocess(think of the DMAIC approach as

iterative in nature), employee training should be ongoing, reinforcing the strategic impor-

tance of the process and the need for continual improvement.

Judiciously select early projects. As noted above, Six Sigma principles can be applied to

processes throughout the value chain of the organization. It is recommended, however, that

top management starts with easy, nonpolitical, and noncontroversial projects that support

the strategic goals of the organization. Given success with these projects, Six Sigma can

then be rolled out to other more complicated and difficult projects.

Break up difficult projects. Top management should try to parse complicated projects into

smaller, short-term segments, each of which has its own milestone. This allows individu-als to experience success along the way and to be recognized for their efforts to help the

organization succeed.

Avoid employee lay-offs. From a motivational standpoint, it is crucial that improvements

based on Six Sigma should not jeopardize the jobs of those who helped accomplish the

goal. Judicious job reassignment is one strategy for dealing with this situation; layoffs

should probably be viewed as a last resort.

15As Evans and Lindsay (2005, pp. 3638) show, the above interpretation is a loose interpretation of the statistical basis for Six

Sigma. That is, they show that the general specification for a k-sigma quality level is as follows: kProcess standard deviation

= Tolerance/2.16Ibid., p. 39.

17This discussion is adapted from P. C. Brewer and J. E. Eighme, Using Six Sigma to Improve the Finance Function: Here Are

Some Tips for Success, Strategic Finance(May 2005), pp. 2733.

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Setting Quality Expectations: Goalpost versusAbsolute Conformance StandardsAn alternative approach to defining quality expectations, or product tolerances, is to choose

between goalpost and absolute conformance standards. One advantage of the latter is that it

is consistent with the use of Taguchi loss functions for control purposes, a subject dealt with

in Appendix A.

Goalpost ConformanceGoalpost conformance is conformance to a quality specification expressed as a specifiedrange around the target. The target is the ideal or desirable outcome of the operation. The

range around the target is referred to as the quality tolerance.

For example, the target for a production process to manufacture 0.5-inch sheet metal is

0.5-inch thickness for all sheet metal manufactured. Recognizing that meeting the target every

time in manufacturing is difficult, a firm often specifies a tolerance range. A firm that speci-

fies a tolerance of 0.05 inch meets the quality standard when the thickness of its products is

between 0.55 inch and 0.45 inch.

This approach assumes that the customer would accept any value within the tolerance range.

As such, the approach assumes that quality-related costs do not depend on the actual value

of the quality characteristic, as long as this value falls within the specified range. With the

specified range allowed for variations, management expects all outputs to be within this range.

Exhibit 16.4 depicts the goalpost conformance specifications for the sheet metal example.

tolerance

refers to an acceptable range

of a quality characteristic, such

as thickness (measured, for

example, in centimeters).

tolerance

refers to an acceptable range

of a quality characteristic, such

as thickness (measured, for

example, in centimeters).

Goalpost conformance

is conformance to a quality

specification expressed as a

specified range around the target.

Goalpost conformance

is conformance to a quality

specification expressed as a

specified range around the target.

REAL-WORLD FOCUS Can Six Sigma Be Used to Increase Revenues?

Many organizations today are using Six Sigma principles to improve

manufacturing efficiency and to lower costs. Others are using Six

Sigma to improve service processes. Sodhi and Sodhi (2005) provide

a recent example of a global manufacturer of industrial equipment

that applied Six Sigma rigor to increase revenues.

The company in question offers a diverse product line, with many

products manufactured to customer specification. Each sale, there-

fore, has its own individually approved discount and hence its own

invoiced price. With tens of thousands of sales transactions per year,

the task of making sure that each invoice accords with the list and

approved prices is indeed daunting.

The company had already experienced success in applying Six

Sigma principles to its manufacturing operations. In fact, several

individuals within the company had earned Six Sigma certifications

(Green Belt, Black Belt). The company then decided to apply, on apilot basis, a Six Sigma approach to its price-setting process.

The project in question involved a cross-disciplinary team (IT,

sales, pricing, finance, and marketing) and five Six Sigma steps, re-

ferred to as DMAIC: Define (the team decided that a defect should

be defined as a transaction invoiced at a price lower than the one

Pricing had approved); Measure (the team developed a map of the

pricing process, which included six sequential steps; in theory, the

process was straightforward, but in practice shortcuts were often

taken and the quality of information available at various steps was

deemed deficient); Analyze (the team used a cause-and-effect matrix

at each of the six steps to depict possible causes for lack of control);

Improve (the goal here was to decrease the number of unapproved

prices without creating an onerous approval process); and, Control

(in the present case, the company set up a monthly review process to

ensure that the company was experiencing higher transaction prices,

fewer pricing exceptions, and no loss of market share).

The overall result? The original goal was to increase sales rev-

enues by $500,000 for the year. In just six months, however, revenues

had increased by a whopping $5.8 million, most of which went directlyto the bottom line. As such, the company is now rolling out Six Sigma

pricing across the entire organization.

Source:M. S. Sodhi and N. S. Sodhi, Six Sigma Pricing, Harvard BusinessReview(May 2005), pp. 135142.

EXHIBIT 16.4Goalpost Conformance

Loss No Loss

Tolerance

Loss

Lower

Limit

.45

Target

Value

.50

Upper

Limit

.55

Thickness

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Absolute Quality ConformanceAbsolute quality conformanceor the robust quality approachaims for all products or servicesto meet the target value exactlywith no variation. An absolute conformance requires all sheet

metal to have a thickness of 0.5 inch, not 0.5 inch 0.05 inch or even 0.5 inch 0.0005 inch.Exhibit 16.5 depicts the robust quality approach. This approach assumes that the smaller the

departure from the target value, the better the quality.

Variations from the target value are assumed to have negative economic consequences.

Robustness in quality comes with meeting the exact target consistently. Any deviation from

the target is viewed as a quality failure and weakens the overall quality of the product or

service.

Goalpost or Absolute Conformance?Goalpost conformance assumes that a firm incurs no quality or failure cost or loss if all quality

measures fall within the specified limits. That is, the firm suffers quality costs or losses only

when the measure is outside the limits. No such quality tolerance exists in absolute confor-

mance, which views quality costs or losses as a continuously increasing function starting from

the target value. Quality costs, hidden or out-of-pocket, occur whenever the quality measure

deviates from its target value.Which of these two approaches, goalpost or absolute conformance, is better? Perhaps we

can find an answer in the experience Sony had in two of its plants that manufacture color

televisions.18

The two Sony plants manufacture the same television sets and follow the same specifica-

tion for color density. The two plants, however, adopt different types of quality conformance.

The San Diego plant uses goalpost conformance, and the Tokyo plant adopts absolute confor-

mance. On examining the operating data over the same period, Sony found that all the units

produced at the San Diego plant fell within the specifications (zero defect), but some of those

manufactured at the Japanese plant did not. The quality of the Japanese units, however, was

more uniform around the target value, while the quality of the San Diego units was uniformly

distributed between the lower and upper limits of the specification, the goalpost, as depicted

in Exhibit 16.6.

Absolute quality conformance

(robust quality approach)

requires all products or servicesto meet the target value exactly

with no variation.

Absolute quality conformance

(robust quality approach)

requires all products or servicesto meet the target value exactly

with no variation.

18Evans and Lindsay, The Management and Control of Quality, pp. 112113.

EXHIBIT 16.5Absolute Conformance

(Robust Quality Approach)

Loss Loss

.5

Target Value

Cost Management in Action What Is the Most Effective Wayto Implement TQM?

Total quality management (TQM) is a key strategic and operational issue

for most firms, as their customers continue to have higher expectations for

product and service quality. Because it involves most if not all the activities

in the firm, the implementation of TQM is usually a complex and difficult

process. The full implementation of TQM may take several years. The IMA

has identified implementation guidelines that can assist managers in the

process. Some firms such as General Electric (http://ge.com), Honeywell

(http://honeywell.com/), and Weyerhaeuser (http://weyerhaeuser.com/)

take additional steps to ensure the success of their quality initiatives. What

do you think these additional steps might include?

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The average quality cost (loss) per unit of the San Diego plant, however, was $0.89 higherthan that of the Japanese plant. One reason for the higher quality cost for units produced at the

San Diego plant was the need for more frequent field service. Customers are more likely to

complain when the density is farther away from the target value. Although the plant in Tokyo

had a higher rejection rate, it experienced lower warranty and repair costs for its products.

For firms desiring to attain long-term profitability and customer satisfaction, absolute confor-

mance is the better approach.

The extension of absolute performance standards to estimate Taguchi quality loss functions

is covered in Appendix A.

As indicated in Exhibit 16.3, there are two major situations in which accountants can provide

relevant financial information as part of a comprehensive framework for managing and con-trolling quality costs: relevant cost (and revenue) data for decision-making purposes and cost

of quality (COQ) reports.

Relevant Cost AnalysisQuality-related spending (investment) affects the target level of quality and ultimately work

processes and outputsas depicted in Exhibit 16.3. In terms of spending on quality-related

initiatives, we can employ the same decision framework discussed in Chapter 9. That is, finan-

cial information relevant to quality-related decisions consists of future costs (and revenues)

that differ between decision alternatives. In terms of relevant costs, we can also use the term

avoidable costssince, by definition, these are future costs that can be avoided by choosing one

decision alternative over another.

Activity and process decisions are prime examples of quality-related investments. For ex-

ample, some manufacturers are moving from process layouts (batch processing) to cellular

manufacturing. Other firms are embracing a just-in-time (JIT) production philosophy. Obvi-

ously, there can be significant outlay costs associated with a plant-layout change or a change

in manufacturing philosophy.

However, improvements in quality provide an opportunity for increasing revenues and for

significant cost savings. It is here that the managerial accountant can add value to the organi-

zation by providing decision makers with accurate estimates of costs and benefits associated

with quality-related spending, such as a move to JIT. Benefits could include the contribution

margin associated with increased sales (because of decreased cycle times associated with JIT

production or the use of cellular manufacturing). Benefits could also include reduced spend-

ing on rework/scrap costs, lower financing costs associated with inventory reductions, reduced

inventory obsolescence costs, reduced spending on inventory-recording costs, and reduced

inventory-handling and storage-activity costs. Note that, as in Chapter 9, relevant costsinclude

both opportunity costsand out-of-pocket costs.

Financial Measures and Costs of QualityFinancial Measures and Costs of Quality

LEARNING OBJECTIVE 5

Prepare and interpret relevantfinancial information to support

TQM initiatives.

LEARNING OBJECTIVE 5

Prepare and interpret relevantfinancial information to support

TQM initiatives.

EXHIBIT 16.6

Color Density of Sony TV SetsManufactured in the San Diego

Plant and a Japanese Plant

Source:J. R. Evans and W. M. Lindsay, The

Management and Control of Quality, 6thed.

(South-Western, 2005), p. 113.

.50

Target

.45 .55

Japanese

plant

San Diego

plant

Tolerance Limits

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Cost of Quality (COQ) Reporting

Up until the mid-1980s, quality costs were essentially buried in a companys financial state-ments. Some costs appeared in manufacturing (factory) overhead accounts (e.g., product

testing, materials inspection, normal spoilage costs), while other quality costs were included

as part of general and administrative expenses. When warranted, traditional cost accounting

systemsboth job-order and processreport separately the cost of abnormal spoilage.

As indicated in Exhibit 16.3, however, quality costs are associated with activities across

the value chainfrom the design of work processes, to production of outputs (goods and ser-

vices), to delivery of outputs to customers. Thus, quality costs include costs associated with

support functions such as product design, purchasing, public relations, and customer services.

Quality guru Joseph Juran was probably the first to create a more expansive view of quality

costs. According to Juran, the costs of quality(COQ)for an organization are costs of activitiesassociated with prevention, identification, repair, and rectification of poor quality, as well as

opportunity costs from lost production and lost sales as a result of poor quality. Exhibit 16.7

provides examples of the components of the total cost of quality.

Prevention Costs

Prevention costsare incurred to keep quality defects from occurring. Prevention costs includethe following:

Quality training costs.Costs incurred to conduct internal training programs and for em-

ployees to participate in external programs to ensure proper manufacturing, delivering,

and servicing of products and services and to improve quality. These costs include salaries

and wages for time spent in training, instruction costs, clerical staff expenses and miscel-

laneous supplies, and costs expended to prepare handbooks and instructional manuals.

Equipment maintenance costs.Costs incurred to install, calibrate, maintain, repair, and

inspect production equipment.

Supplier assurance costs.Costs incurred to ensure that materials, components, and ser-

vices received meet the firms quality standards. These costs include costs of selection,evaluation, and training of suppliers to conform with the requirements of TQM.

Information systems costs.Costs expended for developing data requirements and measur-

ing, auditing, and reporting of data on quality.

Costs of quality (COQ)

are costs of activities

associated with the prevention,

identification, repair, and

rectification of poor qualityand opportunity costs from lost

production time and sales as a

result of poor quality.

Costs of quality (COQ)

are costs of activities

associated with the prevention,

identification, repair, and

rectification of poor qualityand opportunity costs from lost

production time and sales as a

result of poor quality.

Prevention costs

are costs incurred to keep quality

defects from occurring.

Prevention costs

are costs incurred to keep quality

defects from occurring.

EXHIBIT 16.7Examples of Quality Costs

Prevention Costs Appraisal Costs

Training Raw materials inspection

Instructor fees Work-in-process inspection

Testing equipment Finished goods inspection

Tuition for external training Test equipment

Wages and salaries for time spent Depreciation

on training and education Salaries and wages

Planning and execution of a quality program Maintenance

Salaries SoftwareCost of meetings/Quality circles External Failure Costs

InvestmentsSales returns and allowances

Product redesignWarranty cost / field service

Process improvementContribution margin of cancelled sales orders

Equipment maintenanceContribution margin of lost sales orders*

Internal Failure Costs Product recallsScrap disposal (net cost) Product liability lawsuitsRework (materials, labor, overhead)

Loss due to downgrades*

Reinspection costs

Loss due to work interruptions*

* Opportunity costs

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Product redesign and process improvement.Costs incurred to evaluate and improve

product designs and operating processes to simplify manufacturing processes or to reduceor eliminate quality problems.

Quality circles.Costs incurred to establish and operate quality control circles to identifyquality problems and to offer solutions to improve the quality of products and services.

Appraisal Costs

Appraisal (detection) costs are costs devoted to the measurement and analysis of data todetermine conformity of outputs to specifications. These costs are incurred during produc-

tion and prior to deliveries to customers. Through measurement, analysis, and monitoring of

manufacturing processes and examination of products and services prior to delivery, firms

identify defective items and ensure that all units meet or exceed customer requirements.

Appraisal costs include the following:

Test and inspection cost.Costs incurred to test and inspect incoming materials, work in

process, and finished goods, and the cost incurred to inspect machinery; also, field-testingof products at the site of the consumer.

Test equipment and instruments.Expenditures incurred to acquire, operate, or main-

tain facilities, software, machinery, and instruments for testing or appraising the quality of

products, services, or processes.

Internal Failure Costs

Internal failure costs are incurred to correct defective processes or defective products foundthrough appraisal prior to delivery to customers. These costs are not value-added and include:

Costs of corrective action.Costs for time spent to find the cause of failure and to correct

the problem.

Rework and (net) scrap costs. Materials, labor, and overhead costs for scrap, rework, and

reinspection.

Process costs.Costs expended to redesign the product or processes, unplanned machine down-

time for adjustment, and lost production due to process interruption for repair or rework.

Expediting costs.Costs incurred to expedite manufacturing operations due to time spent

for repair or rework.

Reinspection and retest costs.Salaries, wages, and expenses incurred during reinspection

or retesting of reworked or repaired items.

Lost contributions due to increased demand on constrained resources.Constrained

resources spent on defective units increase cycle time and reduce total output. Contribu-

tions lost from units not produced because of the unavailability of the constrained resources

reduce the operating income potential of the firm.

External Failure Costs

External failure costsare costs related to quality defects detected after unacceptable productsor services reach the customer. External failure costs include the following:

Repair or replacement costs.Repair or replacement of returned failed products.

Costs to handle customer complaints and returns.Salaries and administrative overhead

of the customer service department; allowance or discount granted for poor quality; and,

freight charges for returned products.

Product recall and product liability costs.Administrative costs to handle product recalls,

repairs, or replacements; legal costs; and settlements resulting from legal actions.

Lost sales and customer ill-will due to defective outputs.Lost contribution margins on

canceled orders, lost sales, and decreased market shares.

Costs to restore reputation.Costs of marketing activities to minimize damages from a

tarnished reputation and to restore the firms image and reputation.

Quality circle

is a small group of employees

from the same work area that

meet regularly to identify and

solve work-related problems

and to implement and monitor

solutions to the problems.

Quality circle

is a small group of employees

from the same work area that

meet regularly to identify and

solve work-related problems

and to implement and monitor

solutions to the problems.

Appraisal (detection) costs

are expenditures devoted to the

measurement and analysis of

data to determine conformity of

outputs to specifications.

Appraisal (detection) costs

are expenditures devoted to the

measurement and analysis of

data to determine conformity of

outputs to specifications.

Internal failure costs

are incurred to correct defective

processes or defective products

detected before delivery to

customers.


are incurred to correct defective

processes or defective products

detected before delivery to

customers.

External failure costsare associated with defective/

poor-quality outputs after being

delivered to customers.

External failure costsare associated with defective/

poor-quality outputs after being

delivered to customers.

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Conformance and Nonconformance Costs

Conceptually, the total cost of quality (COQ) can be broken down into conformance costs and

nonconformance costs. Prevention and appraisal costs are costs of conformancebecause theyare incurred to ensure that products or services meet customers expectations. Internal failure

costs and external failure costs are costs of nonconformance. They are costs incurred, includ-ing opportunity costs, because of rejection of products or services. The cost of quality (COQ)

is the sum of conformance and nonconformance costs.

Prevention costs are usually the least expensive and the easiest among the four costs of

quality for management to control. Internal and external failure costs are among the most

expensive costs of quality, especially external failure costs. In a typical scenario, the cost of

prevention may be $0.10 per unit, the cost of testing and replacing poor quality parts or com-

ponents during production may be $5, the cost of reworking or reassembling may be $50, and

the cost of field repair and other external costs may be $5,000 or higher.

External failure costs can be substantial. For instance, Firestone Tire Company was

forced to recall and replace 6.5 million ATX tires in 2000. In the first two months of the

recall, the firm incurred more than $500 million of out-of-pocket cost and suffered sales

decreases of more than 40 percent. The price of its stock fell to less than half of the value

prior to the recall.

Better prevention of poor quality reduces all other costs of quality. With fewer problems

in quality, less appraisal is needed because the products are made right the first time. Fewer

defective units also reduce internal and external failure costs as repairs, rework, and recalls

decrease. By spending more on prevention and appraisal, companies spend less on internal or

external failure costs. The savings alone can be substantial. Meanwhile, the firm enjoys higher

perceived values of its products, increased sales and market share, and improved earnings and

return on investment.

Quality Cost ReportsThe purpose of reporting quality costs is to make management aware of the magnitude

of these costs and to provide a baseline against which the impact of quality-improve-

ment activities can be measured. Tasks for reporting quality costs include data definitions,

identification of data sources, data collection, and preparation and distribution of quality

cost reports.

Data Definition, Sources, and CollectionThe first step in generating a quality cost report is to define quality cost categories and to iden-

tify quality costs within each category. The preceding discussion described common quality

cost categories. However, definitions of cost categories can vary among firms. Considering its

unique operating conditions and experience, each firm identifies appropriate cost categories

and clearly states operational definitions of all quality costs. Every member of the design team

needs to have a clear understanding of the firms quality cost categories.

Costs of conformance

are prevention costs and

appraisal costs.

Costs of conformance

are prevention costs and

appraisal costs.

Costs of nonconformance

are internal failure costs and

external failure costs.

Costs of nonconformance

are internal failure costs and

external failure costs.

REAL-WORLD FOCUS How Much Does External Failure Cost?

Ford Motor Company unveiled the 2001 model of its best-selling sport-

utility vehicle, the Ford Explorer, in late 2000. The 2001 model added a

host of new safety features that enhanced the most popular SUV on

the market since its introduction a few years earlier. Ford expected

the new model to increase the firms market share and to add sub-

stantial amounts to its bottom line. Yet, three months after the rede-

signed Explorer began rolling off the assembly line not a single one of

the 5,000 built was in dealer showrooms. Instead, they were parked

outside factories in St. Louis and Louisville while Ford engineers

pored over them looking for defects. Jacques Nasser, CEO of the Ford

Motor Company, ordered factory managers to hold off on shipping the

new Explorer until engineers had the opportunity to correct quality

problems.

When asked by financial analysts to comment on the cost of delay

and repairing defects, Nasser responded, Pick a number. It is over

$1 billion. The delay was expensive, but Ford executives say the cost

of fixing warranty claims later would be far higher. One defect caught

by engineers was an internal steering-column switch that might have

led motorists to start the engine in the drive position. Left uncor-

rected, this problem had the potential of resulting in big-time safety

recalls. What was the root cause of the problem? It was traced to a

supplier who used too much solder on a $1 circuit board. When you

get to the bottom of it, they are that trivial, says a company official of

such glitches. But when you let them escape, they are just huge.

Source:N. Muller, Putting the Explorer under the Microscope, Business-Week,February 12, 2001, p. 40.

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Cost Management: A


Edition


Control of Quality

The McGrawHill

Companies, 2008


Ideally, each quality cost should have its own account so that quality cost information is

readily apparent, not buried in myriad accounts. These quality cost accounts are the source ofquality cost information.

Report FormatA report on cost of quality is useful only if its recipients understand, accept, and can use the

content of the report. COQ reports can be prepared in different ways. Each firm should se-

lect and design a reporting system that (1) can be integrated into its information system and

(2) promotes TQM. Among considerations in establishing a quality cost report system are

proper stratifications of quality cost reports by product line, department, plant, or division, and

the time periods of the reports so that the firm can easily identify the origins of quality costs.

To facilitate assessment of the magnitude of quality costs and their impact, firms often express

cost of quality in percentages of net sales (or total operating costs) for the period.

A cost of quality matrix, as illustrated in Exhibit 16.8, is a convenient and useful tool in

reporting quality costs. With columns identifying functions or departments and rows delineat-

ing COQ categories, a cost of quality matrix enables each department, function, process, orproduct line to identify and recognize the effects of its actions on the cost of quality and to

pinpoint areas of high-quality costs.

Illustration of a Cost of Quality ReportExhibit 16.9 illustrates a COQ report.19Bally Company is a small midwestern manufacturing

company with annual sales of around $9 million. The company operates in a highly competitive

environment and has been experiencing increasing pressures from new and existing competi-

tors to raise quality and lower cost. The report shows that the external failure costs for such

items as warranty claims, customer dissatisfaction, and loss of market share accounted for 75

percent of the total cost of quality in year 0 ($1,770,000 $2,360,000, or 22.13% 29.5%).

To be more competitive and to increase market share, Bally began a corporatewide three-

year TQM process. The firm started with substantial increases in prevention and appraisal

expenditures. The investment started to pay off in year 2. The internal failure, external failure,

and total quality costs have all decreased.Exhibit 16.9 compares the current years quality costs to those of a base year. Alternative bases

for comparisons can be the budgeted amounts, flexible budget costs, or long-range goals.

EXHIBIT 16.8 Cost of Quality Matrix

Source: J. R. Evans and W. M. Lindsay, The Management and Control of Quality,6thed. (South-Western, 2005), p. 400.

Design

Engineering Purchasing Production Finance Accounting Other Totals % of Sales

Prevention costs

Quality planning

Training

Other

Appraisal costs

Test and InspectInstruments

Other


Scrap

Rework

Other

External failure costs

Returns

Recalls

Other

Totals

19Adapted fromIMA Statement No. 4R.

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Cost Management: A


Edition


Control of Quality

The McGrawHill

Companies, 2008


COQ and Activity-Based Costing (ABC)An activity-based costing system is ideally suited to the preparation of COQ reports. An ABC

system identifies cost with activities and thus increases the visibility of costs of quality. Costs

of activities that are the result of poor quality become clear to the organization. Traditional

costing systems, in contrast, focus the cost reporting on organizational functions such as pro-

duction, sales, and administrations.

An organization with a good ABC system in place needs only to identify costs and activi-

ties relating to costs of quality and quality improvement and classify these costs according

to the cost of quality categories that the firm chooses to use. Firms with traditional costing

systems require additional analyses to identify and measure cost of quality and to prepare cost

of quality reports. Additional tasks and costs of obtaining the necessary cost measures can

discourage management from implementing TQM.

As seen from the preceding discussion, relevant financial data are needed to guide investment

decision-making and in planning and controlling quality-related costs. As indicated in Exhibit

16.3, however, nonfinancialperformance data also play an important role in a comprehensive

framework for managing and controlling quality costs.

Internal Nonfinancial Quality MetricsOrganizations strive to specify internal dimensions of quality that they must focus on in order

to meet customer expectations. Thus, we find the following examples of internal nonfinancial

quality measures:

Process yield (i.e., good output/total output).

Productivity (i.e., ratio of outputsgoods or servicesto resource inputs).

Nonfinancial Quality IndicatorsNonfinancial Quality Indicators

LEARNING OBJECTIVE 6Discuss the use of nonfinancial

performance data to support

TQM initiatives.

LEARNING OBJECTIVE 6Discuss the use of nonfinancial

performance data to support

TQM initiatives.

EXHIBIT 16.9

Cost of Quality (COQ) Reportfor Bally Company

Percent

Year 2 Year 0 Change

Prevention Costs

Training $ 90,000 $ 20,000 350%

Quality planning 86,000 20,000 330

Other quality improvement 60,000 40,000 50

Supplier evaluation 40,000 30,000 33

Total $ 276,000 3.07% $ 110,000 1.38% 151

Appraisal Costs

Testing 120,000 100,000 20

Quality performance measurement 100,000 80,000 25

Supplier monitoring 60,000 10,000 500

Customer surveys 30,000 10,000 200

Total $ 310,000 3.44% $ 200,000 2.5% 55

Internal Failure CostsRework and reject 55,000 150,000 (63)

Reinspection and testing 35,000 30,000 16

Equipment failure 30

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