Measuring the "Cost of Quality": A Strategic Cost Managetnent Perspective John K. Shank and Vijay Govindarajan

Quality bas become such an imponant strategic variable that management accounting can no longer ignore it. This artic:le surveys the authoritative literature on total quality management (TQM) to contrast two paradigms for quality-the traditional view and TQM. Conventional managemeDt accounting panders to the traditional views ou qnality and tends to discourage companies from implementing TQM, which can be characterized as "phase 1" thinking about quality costs. A cost analysis framework that snppons TQM ("'phase 2" thinking) is explained. This cost analysis framework can be modified for strategic decision making and control to produce a "phase 3" perspective.

Cost is caused, or driven, by many factors that are interrelated in complex ways. Understanding COSt behavior means understand~ ing the complex interplay of the

set of cost drivers at work in any given situa­tion. Each driver involves choices a company makes (e.g., whether to have a large- or a small-scale operation) that drive unit cose

To facilitate making the right choices. the relationship of each driver to total cost should be specified. For example. activity-based management (ABM) is a way to emphasize the :mpact of eliminating non-value-added work In total cost. This article discusses several ~ost analYSis frameworks for one of the "sort" :05t drivers: management commitment to (Hal quality. Many firms call this commit­nent tOlal quality management. or TQM; oth. "rs be/icv\," that quality is best applied without reatlllg yet anotlln flJrtllal prograrll witll it.,

'wit three It:ll..:r ~lcr(ll1yrll

A survey of TQM literature

Quality is now widely acknowledged as a key competitive weapon. Some say it is the key differential advantage in a global mar­ketplace. Such firms as American Express, Ford. General Electric. IBM. and Xerox emphasize quality in their overall strategy. This section presents an overview of the four main "schools- of quality manage­ment: Juran. Deming. Crosby_ and the -Japanese- approach. While these approaches all have Similarities, they differ in subtle, but important, ways. The follow­ing short descriptions of the four approaches should help managers focus on the important cost analysis issues.

}oseph}uran. Juran was (with Armand Feigenbaum) a pioneer of quality cost analysis during the 19505. Juran divided quality costs into four categories:

• Prevention costs; • Appraisal costs; • Internal failure costs: and • External failure costs. I·

This method of classifying quality costs is stil! widely used today.

According to Juran, control costs (i.e .. preven­tion and appraisal costs) increase as quality increases. but failure costs (internal and exter­n;]1 costs) decrease. Adding these two compo­nents together. the result is;]n overall qLlalit~· cost curve that is U-shaped, as shown in Exhibit I. This suggests that the Objl:Llivl: llr;1

4u~dity man~lgelllent program ShOlllu he ttl

find tht.' level pf qllalit~, (or IllI111hcr ,,( ddeCi'.) [Iu[ minlllll:e'i !ill: tPLd C(!';[ (lr quality-i.e, 1" lind [Il..: h()(((lill "f tite U-..;it.lpnl CUf\l'

COST MANAGEMENT

Conceptually and practically, there is no reason why the minimum total cost posi­tion in this model could not be 100 percent quality. That is, there is nothing in the con­cept that requires optimum quality to be less than 100 percent perfection. Where the optimum point falls is a function of the shape of the various curves. Indeed, it is surprising how many managers in the 1990s still firmly believe in the U-shaped quality cost curve - who believe, in other words, that "those last few defects are very expensive to eliminate."

w.. Edwards Deming. Deming is perhaps the best-known scholar of quality manage­ment. Although Deming is an American, acceptance of his ideas occurred first in japan. Since 1951, the japanese have awarded an annual Deming Prize for advancements in the precision and dependability of products. In the United States, recognition of the importance of Deming's ideas did nOt come until many years later. Not until 1987 was the Deming Prize awarded to a U.S. firm (Texas Instru­ments). In the same year, the Malcolm Baldrige National Quality Award was established in the United States.

Deming believes that the loss of competitive­ness of U.S. industries in the international marketplace has occurred because of a lack of attention to quality. 2 The fundamental tenet of Deming's view of quality is that the coStS of nonconformance (and the resulting loss of customer goodwill) are so high that evaluating the costs of quality is unneces­sary. For Deming, measuring quality costs and seeking optimum defect levels is evi­dence of a failure to understand the problem. The proper objective, in his view, is zero defects. Deming's philosophy is summarized in the 14 points shown in Exhibit 2.

Philip Crosby. Uke Deming, Crosby believes that the cOSt of quality is minimized by "making it right the first time. "3 The objec­tive for any operation should therefore be zero defects. Like juran, however, Crosby does see a need for measuring quality costs.

Crosby divides quality costs into two components:

6 Summer 1994

Q; a..

'" o o

Exhibit I. Contrasting Vil"ws on (hI" Optimum Numbl"r of Defects

Optimum Defect Level Undor The Traditional v_

raM Vifsw

• Optimum Defect LavuI Under TOM

1 00% Defective Quality Level 100% Good

• The price of conformance; and • The price of nonconformance.

The price of conformance includes the explicitly quality-related costs incurred in ensuring that things are done right the first time. The price of nonconformance includes all the costs incurred because quality is not right the first time. According to Crosby, the price of conformance for a well-run company is typically 2 percent to 3 percent of sales, while the price of noncon­formance of most firms is closer to 20 to 25 percen t of sales. ~

Crosby argues that there is no such thing as a quality problem; there are only engineer­ing, manufacturing, labor, or other prob­lems that cause poor quality. Crosby does not accept juran's idea of quality cost analy­sis as a management control tool. As a tool for improving quality, Crosby proposes instead a "quality management maturity grid" (see Exhibit 3) that traces the devel­opment of quality thinking from uncer-

Mtasurtng tht ·Cost o/Quality"

Exhibit 2. Dtndng's FOllrtt(lt Martagtmt'nt Ptinciplts

Requirements for a business whose management plans to remain competitive In providing goods and services that will have a market.

1. Create constancy of purpose toward improving products and services, allocating resources 10 provide for long-range needs rather than short­term profitability.

2. Adopt the new philosophy for economic stability by refusing to allow commonly accepted levels of delays, mistakes, defective materials and defective wonunanship.

3. Cease dependence on mass inspection by requiring statistical evidence of built-in quality in both manufacturing and purchasing functions.

4. Reduce the number of suppliers for the same item by eliminating those Ihat do not qualify with statistical evidence of quality: end the practice of awarding business solely on the basis of price.

5. Search continually for problems in the system to constartUy improve processes.

6. Institute modem meU'lods ot training to make better use of all employees.

7. Focus supervision on helping people do a better job: Ensure that immediate action is taken on reports of defects, maintenance requirements. poor tools, inadequate operating definitions, or other conditions detrimental to quality.

tainty through awakening, enlightenment, and wisdom, to certainty. Senior managers achieve certainty when they deem quality management essential to operations.

While Crosby and Juran do not agree on =luality costing as a management tool, . "':ir views on the elements of quality

.... st can be reconciled. Crosby'S price of :onformance includes juran's preven tion md inspection costs; his price of noncon­'ormance includes Juran's internal and :xternal failure costs. Also. although :rosby rejects the notion of ongoing cost If quality measurement systems. he does lelieve it is useful for a company to do a luality cost analysiS once when it begins formal quality management program to

etermine where the company stands on he maturity grid.

'he "Japanese" approach. Although no sin­Ie quality system is followed by :.111 Japan­.:;e rirms, there arc several Lummon themes I the best-known Japanesl' quali!y rro~

8. Encourage effective, two-way communication and other means to drive out lear throughout the organization and help people work more productively.

9. Break down barriers between departments by encouraging problem SOlving through teamwork. combining the efforts of people from different areas such as research, design. sales. and production.

10. Eliminate use of numerical goals. posters. and slogans lor the work force that ask for new levels of productivity without providing methods.

11. Use statistical methods for continuing improvement of quality and productivity. and eliminate work standards that prescribe numerical quotas.

12. Remove all barriers thaI inhibit the worker's. right to pride of workmanship.

13. Institute a vigorous program of education and re­training to keep up with changes in materials, methods. product design. and machinery.

14. Clearly define top management's permanent commitment to Quality and productivity and its obligation to implement all of these principles.

grams. Charles Fine describes the Japanese approach as follows:

Briefly described. the ultimate objective of Japanese quality management is [0 improve the quality of life for producers. consumers and investors. The Japanese define quality as uniformity around the target. and their goal is continual improvement toward perfection . The Japanese USt cOSt of quality similarly [0

Crosby-for directing action. not as a goal in itself.

The Japanese allocate responsibility for qual­ity management among all employees. The workers are primarily responsible for main­taining the system. although they have some responsibility for improving it. Higher up the ladder. managers do less maintaining and more improving. At th~ highest levels, the emphasis is on breakthrough.

Then~ 3re a number of now·r;lmiliar concept.;; associatetl with Japanese qUillll)' Il1an;lgement. These indutle CO!l1lnilll1ent til Improvenlent anti pcrrc~tiol1 (kai::cnJ. inSistence Oil ulIllpll" ,IIlCC c,.rn·l·ting "lIl'·., OWl1 crr"r-; .. lllt! lOll pncclll qllillil~' dll·ck-;. VClflOll'i pr;Il'lln'~ I.Killliltc lllialilY 1ll.lIwgcllll"nl 11\ j,lp.IIl'·'l·

l.. \.)~ I .\-Il\."""\' ,. I~IL .... J

Exhihit 1. Tllr Qlwli,.,· Manu)::!'",rn, Mel/uri,.\' Grid

Quality Management Maturity Grid Rater Unit

Measurement Stege 1: Stlg. II: Stag. III; Stage IV: Stag. V: Cite gory Uncertainty Awaklnlng En"ghtenm.nt~ Wisdom Certainty

Managemenl under- No comprehension Recognizing that While going Participaling. Consider quality standing and 01 qualily as a quality manage- through quality Understand absoh .• - management an attitude management tool. ment may be of improvement pro- tion of quality essential part 01

Tend to blame value but not will- gram learn more management. company quality department ing to provide about quality man· Recognize their system. for "quality money or time to agement becoming personal role in problems.- make it all happen. supportive and continuing

helplul. emphasis.

Quality organiza- Quality is hidden in A strong quality Quality department Quality manager to Quality manager lion status manufacturing or leader is appointed reports to top man- an officer of com- an board of direc-

engineering depart- but main emphasis agement. All pany. EHective sta· tors. Prevention is ments. Inspection is stilt on appraisal appraisal is incorpo- tus reporting and main concern. prObably not part 01 and moving the rated and manager preventive action_ Quality is a thoug'" organization. product. Still part 01 has role in manage-- Involved with can- leader. Emphasis on manufacturing or ment of company. sumer affairs and appraisal and other. special assign-sorting. ments.

Problem Problems are Teams are set up Corrective action Problems are iden- Except in the most

handling lought as they to attack major communication tilied early in their unusual cases.

occur. No resolu- problems Long- established.Prob- development. All problems are

tion. Inadequate range solutions are lems are lac!)d functionS are open prevented.

definition, lots of not SOlicited. openly and to suggestion and

yelling and resolved in an improvement.

accusations. ordenyway.

Cost 01 quality as Reported Reported 3%. Reported 8"1.. Reported 6.S"lo. Reported 2.5%, percent of sales unknown. Actual ActuaIIS-;". Actual 12%. ActuaIS'%.. Actual 2.S%.

20%.

Quality improve- No organized activ- Trying obvious Implementation of Continuing the 14- Quality improve-ment actions ities. No under- "motivational- the 14-step step program and ment is a nonnal

standing of such short-range effOrts. program with starting to make and continued

activities. understanding and cenain. activity. establishment ot each step.

Summation at "We don', know Is it absolutely "Through manage- "Defect prevention "We know Why we company quality why we have prob- necessary to ment commitment is a routine part of do not have prob-posture lems with quality. always have and quality our operation lems with quality.-

problems with improvement we

quality? are identifying and resolving our problems.

SOURCE: Charles Fine. "Managing Quality: A Comparative Assessment: Booz Allen Manufacturing Issues (1985).

cororations-smalllot sizes, minimal watk­in-process inventory, housekeeping. daily machine checking. and quality circles. ~

The basic notions of the Japanese approach are that quality is a journey rather than a destination and that quality

8 Summer 1994

enhancement is a fundamental way of life. not a business target. Exhibit 4 summarizes the important features of the approaches to quality described so far. While differ­ences exist, the programs suggested by Juran, Deming. Crosby, and others have common themes that can be collectively

.---~ .. --... -."'"."".~""."""""-----

Exhibit .oJ. Summary oJ ApprOQchts to Quality

Definition 01 quality

Deming

Conformance to specs

Juran

COnformance to specs

Croaby Japaneae

Conformance 10 !lpecs Uniformity around target

Why worry llbout quality Competitive position Prollls/quality 01 lile Prolits Oualily of lile

Goal 01 program Improve compelitlve position

Decrease coo Decrease costs Continual improvement

Quality goal Zero defects Minimile COO Zero delects Zero defects

How to select projects Pareto anatysis defects Cost analysis Cost analysis Cost analysis

How to measure improvement

Role 01 QC department

Direct measurement

Low

COO data

Extensive

COO data and direct Direct measurement measurement maturity grid

Moderate Low

Role of top management Leadership. Leadership Must stress Breakthroughs and zero defects participation participation

Role 01 workers

coo emphasis

Maintenance and improvement

None

Moderate

Hig"

improvments

Moderate

Moderate

Maintenance and improvements

Low

Statistical analysis High use For lower management Mixed High use

IItural Changes required Great change required Little change required New quality attitude Greal cnange required PartiCipative managment Fits traditional culture Fits traditional culture Participative management Needed Need Grave threat Grave threat

Managing the transition state

No guidance much needed

NO guidance little needed

Excellent treatmentc No guidance Classic example much needed

Decision Optimize DMOa zero defects

Minimize COO COO for management Optimize OMOQ

described using the familiar catch phrase total quality management.

Traditional views-phase 1 thinking about quality and cost. The characteristics of TQM r'\n best be understood by contrasting TQM

.:h traditional views on quality as exemplified by GM cars during the 19705. the airline industry during the 1980s. or the forest products industry during the 19905. Exhibit 5 contrasts the key elements of TQM with elements common to traditional approaches to quality.

Traditional responsibility for quality. In the traditional paradigm. quality problems Hart in "operations"-poor quality is attributable mainly to workers. The best way to control quality. therefore. is £0

'inspect it in." This requires a large quality :ontrol department whose job is to inspect lutpul and certify that it meets <:LtStorner 'pecificalions,

Attention OMOQ for zero defects implementation zero defects

In the traditional paradigm. an adversarial relationship typically develops between the operations personnel (whose objective is to

maximize output) and the quality control staff (whose objective is to monitor output quality). Historically. many U.S. companies have placed more emphasis on output than on quality. because customers did not demand defect~free products. But the envi­ronment has changed-drastically in the last decade. Customers now demand high quality. particularly now that many companies can provide top quality at competitive prices.

Responsibility for quality under TQM. According to TQM, everyone in the organiza­tion shares responsibility for quality; in fact, mOSt of the quality problems stan long before the operations s[:lge even begins_

Deming ;lrgues that ~\ process can be sepa­rated into two pans:

• The systcm. which is under Ihe cllnlwl or management; and

• The workers. who arc under their own control.

Deming's experience indicates that 85 per­cent of quality problems are attributable to faulty systems and only 15 percent to work­ers. A system can be faulty for such reasons as the following:

• Difficult-to-execute operation; • Inferior inpuls; • Inadequate equipment maintenance; • Poor working conditions; and • Excessive pressure to maximize output.

Since management designs the system, qual­ity is primarily a management responsibility.

Under TQM, the overriding consideration is to -build quality into the output ft rather than ~inspect quality into the output. ft Errors should be detected and corrected at the source. Quality at the source implies that the workers should be held responsible for their work and should not pass defective work downstream. Instead of appointing quality inspectors to locate defects, the workers in a TQM operation are their own inspectors. This philosophy also implies a fundamental change in the role of the qual­ity control department, moving away from inspection and toward facilitation. Instead of inspecting in quality at the output stage, the quality control staff should monitor the process and facilitate the workers' ability to do things right the first time.

Linkages with suppliers. The traditional view argues thal obtaining inputs from sev­eral suppliers gives a firm bargaining lever­age: Competition among the suppliers who are pitted against each other leads (at least theoretically) to lower input prices. The problem with the traditional view is that quality control becomes extremely dif­ficult if there are numerous suppliers. If the firm starts with inputs of inferior qual­ity, it can prove to be very costly even if the process is in control. For example. in 1984, the Ford Motor Company stopped production of the Tempo and Topaz mod­els in four plants because of a faulty engine part purchased from an outside supplier. Each day production was

10 Summer 1994

Exhihit 5. C"nlrasllns Quality PamdiRms: Tradilional Vkws on Quality Vasus To/al

Quality Managemenl

Traditional Paradigm TOM Paradigm Responsibility for QUilI/ty

Worker is responsible lor poor quality

Quality problems start in operations

Inspect quality in

Alter·tha-fact inspection

Quality inspeclors are the gatekeepers of quality

Quality control department has large staff

The focus of the quality control department is to reject quality output

Managers and engineers have the expertise workers serve their needs

Everyone is responsible lor poor quality

Majority of the quality problems start long belore the operations stage

Build quality in

Quality at the source

Operators are responSI' ble for quality reliability

Quality control depart­ment has small staff

The focus Of quality control department is to-monitor and lacilitate the process

Workers have the exper tise-managers and engineers serve their needs

Linkage5 With suppliers

Procure from multiple suppliers

Acceptance sampling of inputs at point of receipt

procure"trom a single supplier

Certify suppliers who candeliver right quan tity.right quality. and on time No incoming inspection

New Product/Service Development

Separate designers from operations

Design for performance (with more parts, more features), not to faCilitate operations

Use teams with opera tions. marketing, and designers

Design tor performance and ease of processing

Overall OUlfllty GOlfl

Zero defects is nOI practical

Mistakes are inevitable and have to be inspected out

It costs too much money to make defect-free products

A "reasonable· tradeoff is the key

Zero detects is the goal

Mistakes are opportuni ties to learn and become perfect

Quality is free

Perfection is Ihe key: perfection is a journey. 1'101 a destinalion

stopped. Ford lost the opportunity to produce about 2,000 cars.

Quality and dependability, nor just price. Under TQM. suppliers are selected based on quality and delivery dependability. rather than price alone. The firm certifies a few suppliers who can deliver defect-free inputs

M~asuti"g th~ ·Cost of Quality·

.{ "'f ",'-." .. ;:'

on time in a reasonable price. Typtcairy: ;~le firm will procure most of its requiremems for each input item from a single supplier out of a list of certified suppliers. Develop­ing long-term relationships with a single supplier pays off both in terms of higher quality and lower price over the long term. Between 1980 and 1985, for example. Cater­pillar reduced its suppliers of drill bits from 24 to 3 and cut drill bits cost by 40 percent.

Sourcing from a single supplier results in higher quality for several reasons:

• The company views the supplier as an integral part of its operations. Thus, the company has the time and the motivation to work with the supplier to improve supplier process quality.

• The supplier, for whom the company's business is Significant. is motivated to produce and ship small lots with exact specifications, and to work with the buyer to improve process quality.

Single-sourcing can lead to lower costs as well as higher quality, for such reasons as the follOWing:

• If the firm is confident of the supplier's process quality, the inputs can bypass incoming inspection and thus save inspection costs.

• The firm can save the costs of poor qual­ity downstream that are the direct result of processing inferior quality inputs.

• Given the Significant purchasing volume from the company. [he supplier can enjoy longer runs and the resulting benefits of scale and experience.

Single~sourcing brings with it the risk of a breakdown in supply for such reasons as :;trikes. machine breakdowns. or natural Jisas(ers. However. these concerns are (ypi~ :ally overstated for at least two reasons. :irst. though the company may procures nost inputs from a single supplier, typically Jne or two backup suppliers are qualified lO

.upply and may get an occasional order lO

~eep the channel open. Second, the com­tany faces similar risks every day in its own 'pcn.Jtions, because downstream stages arc 00 percent depcndent on upstream stages.

The de"\lelopment stage. Companies that operate under the traditional point of view separate designers from operations person­nel. DeSigners. who are given a charter to

conceive new products or services that have high customer appeal, are told not to feel constrained by current operational capabili­ties. Unfortunately, this approach often leads [0 elegant deSigns that are difficult to implement. Indeed, many quality experts insist that 50 percent of quality problems arise at the design stage. It is difficult to

produce a product reliably if it has been deSigned for performance (thus having. e.g .. more parts or more features) without due consideration of ease of manufacturing.

Quality is now widely acknowledged as a key

competitive weapon.

According to TQM, the best way to assure quality is to get operations managers and deSigners closely involved in developing new products and services. If the deSigners thor~ oughly understand the operations process, they are more likely to create designs that not only have high customer acceptance but also fit the firm's operations capability.

Overall quality goal. The traditional para­digm argues that mistakes are inevitable and tha tit is too expensive to rectify all the defects. In contrast, TQM takes the position that zero defects should be the goal. A firm should analyze the causes of all errors and take actions to remedy them.

Exhibit 5 compares the conflicting view­points on the optimal number of defects. According to the traditional view. the low­est cost is attained at some nonzero level of defects. Proponents of this view argue that the cost of removing errors increases as more and more errors are deteCted antl fewer errors remain. The last errors are the most expensive w detl'cI ancicorrl'Ct.

In sharp contrast, TQM maintains that till' lowest cost is attained ~\l :::ero defects. Sup-

porttrs of Ihis view reason that even though error!' arc numerous. the (05t of rectifying the last error is no higher than the cost of rectifying lht first. Hence. the total cost keeps declining until the last error is removed. In Ihis sense, TQM advocates argue that "quality is free."

Contrasting cost management paradigms. More and more companies are convinced that shifting from the traditional quality-philoso. phy to TQM is essential for success. Such a shift requires fundamental changes in the atti· tudes that managers and workers have about quality. Far from facilitating this change, tra­ditional cost accounting systems can be a great hindrance to implementing TQM.

The serious shortcomings of traditional cost accounting can be best understood by contrasting it with strategic cost manage­ment. Such a comparison is presented in Exhibit 6. Several points are noteworthy:

• Standard cost systems usually institution­alize waste (e.g., scrap and rework) by having -normal allowances" for them. In fact, the cost of the defective units are allocated to "good" units based on elabo­rate cost procedures. This practice of pro­viding a "normal allowance" for waste panders to the traditional views on quality that it is too expensive to rectify all the defects. In TQM, on the other hand, there is no such thing as "allowable waste."

• In a traditional system, overhead vari­ances are used to evaluate performance. Overhead variance analysis encourages managers to maximize production vol­ume-at the expense of quality-as a way to absorb overhead costs and avoid unfa­vorable variances.

• Traditional systems highlight raw mater­ial price variances and penalize managers for unfavorable price variances. This again reflects the traditional view on quality-obtain raw materials from a large number of suppliers and encourage competition among suppliers to obtain lower input prices. This view, as explained earlier, is detrimental to a company's profitability.

• Traditional systems do not directly

12 Summer 1994

Exhihil h. Cmllra.~li"g Cns! Manog('nH'nl Paradigms: Tra(/i!i(lllal Cns! Management Venus

SIr-alcgic Cost Management

Trl!ldltlonl!ll Coat Management

Siandard cost system wilh "normal' allowanCe lor scrap. waste. rework; zero delect is not practical

Overhead variance analysis; maximize production volume (not quality) to absorb overhead

Variance analysis on raw malerial price; procure from multiple suppliers to avoid unfavorable price variance; low pricel10w quality raw malerials

No emphasis on nonfinancial periormance measures

No tracking of customer acceptance

No cost of quality analysis

Centrol Ph,7os0phy:

StrategIc Coat Management

No allowance for scrap. waste. rework; zero defect il> the concept

Overhead absorption is nOI the key; standard costs and varience analysis are de­emphasized. in general

No control on raw material price; certify vendors who can deliver right quantity. right quality. and on time

Heavy use of nonfinancial measures (parts-per-million defects. percentage yields. scrap. unSCheduled machine downtimes. first· pass yields. number of employee suggestions)

Systematic tracking of customer acceptance (customer complaints. order lead time. on-time delivery incidence of fail ures in customers' locations)

Quality costing as a diagnostic and manage ment control tool

The goal is to be in the "top tier'" The goal is kaizen of the "reference group"

The annual target is to meet the Industry norms set the standards floor

Standards are to be met. not The annual target is to exceeded beat last year's pertor

mance

Standards are "'tough" but attainable

A regularty exceeded standard setsis not tough enough

Strive to beat this year's tar get ("continual improve ments·)

Each achiellement level a new floor for future achievement

reward nonfinancial measures of quality, such as parts-per-million defect rates, first-pass yields, on· time delivery, and shorter cycle time.

• Traditional systems emphaSize meeting standard costs. (In fact, a regularly exceeded standard is viewed as not tough enough.) Under TQM, the emphaSis is on "continual improvement."

Mtasuring tnt ·Cost of Quality·

Exhibit 7. An lllustrcUivt Example of Cost of Quality Analysis for ABC Corporation

Quality cost 1982 category

Units produced 10,000

Preventlo $ 200 Appraisal 400 Intema! failure 200 External failure ~ Total $ 4,800

Total manufacturing cost s 20.000

Total quality cost as percent of total cost 25%

The next section describes in more detail a cost analysis framework that should help companies as they shift from traditional views on quality to TQM.

Quality costing methodology­phase 2 thinking

Cost of quality (COQ) analysis aggregates all the costs to the company of doing things wrong by failing to confornl to specifica­tions. COQ is a comprehensive financial measure of conformance quality and can be calculated for individual locations, indiVid­ual business units, or the entire firm.

This framework attempts to put dollar fig­ures on all the costs that are attributable to a nonconforming operation. As noted earlier, coSts that a company incurs for quality can be grouped into the following categories:

• Prevention costs. The sum of all the costs associated with actions taken to plan the process to ensure that defects do not occur. Examples: -Designing a defect-free manufactUring

process; -Stable product deSign; -Employee training and development; -Quality circles; -Preventive maintenance; -Cost of managing supplier relations to

increase the quality of raw inputs reccivcl.t

• Appraisal custs, Those costs assotl:Jtcu with measuring the kvd of quality

1984 1986 1988 (Thousands of Dollars)

10.000 20,000

$ 400 $ 600 $ 800 800 800 400

2,400 1,600 600 BOO 400 200

$ 4,400 S 3.400 S 2,000

525,000

8"10

attained by the system (in other words, costs associated with inspecting t6 ensure that customer requirements are met). Examples: -Prototype inspection and testing; -Receiving inspection and testing: -In-process inspection; and -Quality audits of finished Outputs.

• Incernal failure costs. Those COStS incurred to rectify defective OUtput before it reaches the customer. Examples: -Scrap; -Rework; -Repair; -Redesign: -Reinspection of rework: -Downtime due to defects; and -Opportunity cost of lost sales caused by

having fewer units of product to selL

• External failure COSlS. Those costs associ­ated with delivering defective output to the customer. Examples: -Warranty adjustments; -Investigation of defects: -Returns: -Recalls:' -Liability suits: and -Loss of customer goodwill.

It should be noted that not all quality costs fit neatly into one or anolher of lhcse call> gories. For example, the cost of inspecting ~aw material might bc viewed as cithcr an appraisal COSt (Iookin,; for tldects) or a prc­vention coSt (prevC'l1tin,; defcctive raw matcrials from foulill'; the prnduc(ioll

COST MANAGEMENT

process). In such cases, placing costs in one calegory or another is somewhat arbitrary. As long as the company classIries the costs consistently. trends over time in the cate­gories can provide powerful insights.

It is surprising how many managers in the 1990s still finnly

believe in the V~shaped quality cost curve-who believe, in other words, that "those last few defects are very

expensive to eliminate."

Exhibit 7 presents the quality costs for a disguised manufaCturing company, ABC Corporation. over an eight-year period. 6

Based on the experience of ABC Corpora­tion and the quality cOSt studies completed by other companies, the following two gen­eral conclusions emerge.

• Cost of quality is a big opportunity. When bad quality represents such a sig­nificant cost item (25 percent of the total cost for ABC Corporation), quality man­agement represents the most Significant opportunity for improved profitability.

• Firms spend quality dollars in the wrong place. Companies spend far more on internal and external failure cOSts than on prevention and appraisal costS, and more on appraisal than on prevention. This was true for ABC Corporation in 1982. In companies in which total quality cost is in the range of 25 percent of sales. cate­gory 4 is usually the largest. When total quality cost is in the 5 percent range, cat­egory 1 is usually the largest.

Interaction among the fOUT categories. Spending money on prevention can result in more than offsetting cost savings on the other categories. Thus, it is possible to maintain or improve quality while, at the same time, dramatically lowering quality costs. For ABC Corporation in Exhibit 7, as product quality increased over the eight years. total quality costS declined by 60 per-

14 Summer 1994

cenl. The firm achieved this by consciously changing the mix of prevention, appraisal, and failure costs. Prevention and appraisal costs doubled, while internal and external failure costs declined by over 80 percent.

The implication is that improving quality by spending more on upstream activities (prevention costs) is a good investment for any organization. One rule of thumb is that -for every dollar a firm spends on preven-

, tion, it can eventually save $10 in appraisal and failure costs.

The impact of investing upstream can yield benefits over several years. but there is a time lag between expenditures on preven­tion and the resulting decrease in failure costs. When ABC Corporation doubled pre­vention costS in 1984. there was no imme­diate reduction in downstream costs. This suggests that when changing the mix, man­agement must be prepared to see quality cOSts increase before they decrease.

Companies that adopt TQM should antici­pate interactions among the four categories of .quality costs. As ABC Corporation dou­bled appraisal costs in 1984, the internal fail­ure costs increased dramatically, but the external failure costs decreased even more' dramatically. This makes sense: The improved inspection system caused more defects to be detected before they reached the customer. Management should not be sur­prised to see repair and rework departments exceeding their budg"ets as a result of increased appraisal spending. Similarly, war­ranty and customer return costs should show a favorable trend. These trends could be antiCipated in setting budgets during a period in which the quality cost mix changes.

Conventional reporting a barrier to TQM. Conventional reporting formats can be a barrier to TQM initiatives, whereas cost of quality reporting can help TQM. Conven­tional reports often discourage TQM efforts, because any additional costs incurred in prevention appear immediately on a manager's performance report but the resulting benefits (e.g., a reduction in external failure costs) are not fully quanti­fied and are therefore not recognized.

Mtasuring tht ~Cost oj QUdlity"

For ABC Corporation, a manager's perfor­mance report in the conventional frame­work would report the total prevention. appraisal, and internal failure COSts. These amounted to $800,000 in 1982 and increased dramatically to $3.6 million in 1984. This might imply an adverse perfor­mance, whereas COQ reporting tells a very different story. The big gain is in external failure cost, most of which is an oppOrtu­nity cost that does not show up at all in conventional reports.

One cautionary note should be offered about quality cost reduction. Quality costs, like many other costs, have the frustrating

. characteristic of being variable on the way up, but fixed on the way down. That is, it is not as easy as one might think to reduce quality costs. We may be able to reduce the level of defective output by 25 percent, but that may not necessarily enable us to reduce the rework department's work force by 25 percent. Reducing that department requires a conscious management decision to scale back or even eliminate the function.

Just as quality costs will not disappear right away. neither will "'quality revenues" appear immediately. It is not always the case that customers are anxious to get better quality. Many successful firms have built up, over time, an infrastructure for dealing with the bad quality they receive from suppliers, such as raw material inspection systems or more sophisticated handling equipment. Since much of this infrastructure is a fixed cost, such a customer may find little immediate advantage in a supplier's higher conformance input. In addition, a customer who uses mul­tiple sources of supply may find no advan­tage-indeed, there may be a disadvantage in the short term-in receiving a higher-quality product from one supplier. It may well be that the industry leaders are those firms that have best learned how to neutralize the bad quality they are receiving, A supplier who begins offering better quality may thus, strangely, be betrer able to sell it to the less successful firms that have nOl figured out how to offset bad incoming quality.

COQ reporting. Since investments "upstream"" ~'icld benefits over scvl:r;.tl years, it is oftl:n suf­!"ident if quality reponing is done once a year.

By preparing a COQ report once a year, a firm can maintain pressure on managers and work­ers to "continually" improve performance toward the ideal goal of "zero defects."

COQ measurement cannot be the sole basis for facilitating TQM efforts, It should be supplemented with specific and timely feedback on nonfinancial measures of qual­ity as welU Some examples are as follows:

• Suppliers: -Number and frequency of defective

units delivered. by each supplier: and -Number and frequency of deliveries

not on time, by each supplier.

• Product design: -Number of parts in a product: arid -Percentage of commC'n versus unique

parts in a product.

• Production process: -Percentage yields (good units to total

units) (this is a measure of quality at the output stage and does not necessarily measure the firm's efforts on prevention);

-First-pass yields (percentage of units finished without any rework) (this measure reflects the results of the firm's efforts on prevention):

-Scrap; -Rework; -Unscheduled machine breakdowns: -Number and duration of limes the pro-

duction and delivery schedules were not met; and

-Number of employee suggestions. (General Motors averages four sugges­tions per employee per year, while Toyota averages 61).8

• Marketing: -Number of customer complaints: -Level of customer satisfaction (which

is measured by administering ques~ tionnaires to customers);

-Warranty claims: -Field service expenses; and -Number and frequency of product

returns.

There are two major advantages with these nllnfinand~ll measures:

• Most of dll'lll call hc rrpllrtnloll ;lIn1(l'>t ;\ rl'~" limc basis: and

COST MANAC(MENT

Exhihit H. ThrC'f Possiblr ManagC'm(rtl AccOllnling Rcsp{I"s i bi IiI in

Proponent

1. Deming

2. CrOSby

3. Juran

Role for Management

Approach Accountants

Don't do quality High costing analysis. Just spend the money ·upstream" to do things ·right" the first time.

Do a coa analysis as a ·special" study (to assess the stage 01 quality management). Do not use this as a management tool on an ongoing basis. Do not prepare periodic coa reports.

Prepare quality costing reports on a periodic basis (say. once a year) as a management control tool,

Low

• Corrective actions on these measures can be initiated almost immediately.

Thus, reporting performance on nonfinancial measures is essential to providing continuous feedback to managers and workers in their pursuit of better quality. We view COQ reporting and the related nonfinancial mea­sures as both providing useful information. COQ reponing provides the big picture. whereas the nonfinancial measures give ongoing, actionable feedback about a TQM implementation.

Cost of quality analysis-phase 3 thinking

This concluding section of the article syn­thesizes the several schools of thought on measuring quality costs. They range from belief in regular quantification and monitor­ing of cost of quality to strict attention to zero defects but no attention to cost mea­surement. There are. nonetheless. several common themes:

• Poor quality costs far more than manage­ment usually realizes.

• Most firms' expenditures on quality occur in the wrong places (I.e., they fix things rather than doing them right the first time).

16 Summer 1994

• Spending on prevention recluces the need for inspection and can potentially elimi­nate internal and external failure costs.

• Large cost savings or revenue opportuni­ties exist in creating customer goodwill by conSistently providing conforming products and services.

• For qualitypragrams to succeed, top man~ agement must be committed to quality and must accept full responsibility far it.

• Conventional management accounting (i.e., standard costs, overhead variance analysis. analysis of raw material price variances) is a great barrier in implementing TQM.

Supporting TQM. There are three possible approaches to developing and using manage­ment accounting systems in suppart of TQM (see Exhibit 8). These approaches roughly correspond to the approaches of Deming. Crosby, and Juran. A company that adopts TQM for the first time might benefit by start· ing with Juran's approach. which calls for an explicit quantification of quality costs (as in the third approach in Exhibit 8). The ultimate goal should be to make quality part of a com­pany's culture and way of life so that quality cost measurements ultimately become unnec'­essary (which is the Deming approach).

Some firms that have experimented with COQ reporting (including Texas Instru­ments and Florida Power and Light) have decided that formalized reporting require­ments are not an aid to enhanced quality. For firms just starting TQM programs, how­ever, the benefits of formal cost reporting are sufficiently important to warrant the risk that the reporting may engender game· playing that would hinder quality enhance­ment effort: this risk can be managed.

This article has summarized the strategic cost management perspective on quality. As a firm's quality management program devel­ops. the approach to COQ reporting can take several different forms. Exhibit 9 sum­marizes four different approaches in use at various companies today.9

Whichever approach a firm chooses, quality is such an important strategic variable that management accounting can no longer ignore it. One way or another, a strategically

MtcUuring Lht "Cost of Quality"

Exhibit 9. Tltt ContTolltrship Rolt In Total Quality Managtmtnt: Four Possiblt Approachts

1. Cost of quality analysis as a regular man~ 3. Focus on nonfinancial. "hard science~ agement reporting and control tool. production information to monitor TOM Examples of this approach Include: progress with an emphasis on input mea-• The companies referenced by Joseph sures and statistical process control (SPC).

Juran (tradeoff between price of confor~ Examples of this approach include: mance and price of nonconformance) • Texas Instruments-Materials and in his books; Controls Group; and

• Formosa Plastics; and • Paper Industry-Daishowa Paper • Ford Motor Company in the 1980s. Company (Japan).

Formal coa reporting as a regular control tool applied to Ford throughout most of the 1980s and Texas Instruments until about 1990. According to Management Accounting in a 1991 article this approach was still being followed then by Formosa Plastics, one of the largest Taiwanese manufacturing firms.

2. Focus on reducing the price of nonconfor­mance. including opportunity losses. Exam~ pies of this approach include: • Tennant Company; • Westinghouse; and • Xerox.

'-his second approach assumes that "confor~ mance" (i.e .• the price of conformance, in Crosby's terminology) will continue at a high level and will be managed by means of budgets and continuous improvement programs for critical nonfinancial performance indicators.

If spending on conformance remains consis~ tently high. the reporting focus can switch to "nonconformance" costs (I.e .• the price noncon~ formance. in Crosby's terminology), with specific inclusion of the opportunity cost of bad quality. The goal becomes a steady reduction in the price of nonconformance toward zero. In 1992, many companies with a strong TOM commitment (e.g .. Xerox. Westinghouse, and the Tennant Company) were following this approach.

effective management reporting system must deal explicitly with the issue of quality. ..t..

John K.. Shank is Nobl~ Foundation Professor of Manag~rial Accounting and Vijay Govin~ darajan is Earl C. Daum Prof~ssor of Manag~­m~nt at th~ Amos Tuck School of Busin~ss. Dartmouth Coll~g~. Hanover, New Hampshir~.

Notes 1. J .M. Jur:.n and Frank M. G ryna. Jr.. QUlllily P/Ilnninx and

Anu/.vsis (:-lew York: McGraw·Hill. «HOL 2. W. Edwards Deming. Qua/il,Y. Prouu(liYil.v (HIU C"m,.I'"II'

lille PIISilio" (Cambridge. Ma!>saehU';"lls: M IT C~ntrr hJr Aunnel'd Engineering Stuuy. 1<JH2).

I. rhilip O. Cwshr. Quulitv h I'ra (New Yurk: t-.kt;raw· Hill. 1'17'1)

This approach deemphasizes formal COO cost reporting systems in favor of formal nonfinan­cial reporting. with a heavy emphasis on contin~ uously improving quality in operations. One name for this is SPC. Notable examples of the success of thiS approach are Oaishowa Paper Company and the Materials and Controls Group in Texas Instruments.

4. Focus on nonfinancial, Mhard science~ production information to monitor TOM progress with an emphasis on output mea­sures of conformance. Examples include:

• Motorola-ACIS Division; • IBM (the MOO Program); and • Analog Devices. Inc.

This approach also deemphasizes cost report­ing in favor of nonfinancial measures, but the tocus here is on output measures rather than input measures. Motorola's well~known Six SiQma Program for customer~reported defects in Its integrated circuits division is a good example. IBM has announced a similar pro~ gram for eradicating customer~reported defects, which it calls MOO for Irarket-deter­mined quality. Analog Devices 1 is another example of a firm whose quality reporting emphasis is on defect~free deliveries rather than on cost reports.

4. Philip B. Crosby. Qualit.\" Witho,,1 Uars ("t:"W York: McGraw-HilI. 1984): 86.

5. Charles Fine. ~Man3ging Qualil~': .-\ Comparali"l": Ass~ss· menlo ~ in 800:: Allen .\fanujl.lctllrin): IHllt'S (St:w York: Boo;: Alll'n. 19!:!5).

6. See James B. Simpson and D",·.u l. ~luthl"r. -QU31i(\' Cos IS: F3eililating th~ Quality l!lillall\"l:.- J.,lJrllal,,{ ClISI

.\Ianage-m("nl (Spring I <l!:!,): 25-H. ,. See Joseph Fisher. -Csc: of ,",,,nhnano.;i:!1 Performance .... 1,,3·

sures.- Journu/ .. { CII~I .\/tll1l'Xl'''',,"1 (Spnn).: I 'N.! 1. 31-31:\ 8. Thomas P. Eumnnus.l.\nr·yj Tsal". JnJ W"n·\\"". Lin.

-Analy;:ing Quality C,"IS." .\I,II"I.\:(·",.-n( rkWlllllln.~ (:-luycmhc:r 14!:!<l): 25· 2<l.

<.l. L3Wt"nee CoIrr. -Applying ellstS of QU.lhl\' hI J Sl"t\"l(~ I.\U>I·

ne5S.~ SI,Iu" M"nugrmt'IlI Rt"V .. · ... ISuI/"na 1'/lJ21 ;-.! --;7 It). Rnhen .-\. Huw':!l "I al.. -Cnst lvt.w;I/:<:menl Itlt rUII",r'

rnw S"ckillg thl" CUrI1l'l·tltl\·l· EJ/:\· ... f, .. ,,,,, "II "'n ,,11\"'<

Rt"\eun"h Fuu'hl,u.ou ''11('' 'f" jI" I .. ,.o'"ill,\ t' .\ldilt'.t.:i"mnU

I I'll,.! I 127-1 ~<J