Cost of quality has four components: (a) prevention costs, (b) appraisal costs, (c) internal failure costs and (d) external failure costs. In general, an increase in prevention and appraisal costs results in a multiple-fold reduction in (internal and external) failure costs.
Writing Tools, Inc. is a company that produces high-end writing instruments. The company has communicated a steep target in its latest earnings call and the company’s CEO is under a lot of pressure from the Wall Street.
A meeting is held to review the situation and make changes to better position the company to meet the target. The CEO suggests the following measures: (a) the finished goods inspection target per head shall be increased and some inspection people shall be laid off, (b) quality training for engineers shall be postponed to the next year, (c) third-party inspection of some raw material shall not be required, (d) work-in-process batches shall be tested on sample basis only and (e) shipment time target for the last quarter shall be reduced by 20%.
The company’s chief production manager has some reservations regarding the proposed decisions. The company’s cost controller agrees with him. He suggests that the company should (a) carry out a complete quality audit of its production process to identify improvement areas, (b) replace the existing inspection equipment, (c) appoint a supply chain expert to liaison with suppliers and (d) install SAP Quality Management. He assures the CEO that undertaking such quality control measure will not only increase sales in the long-run it will reduce (a) spoilage and scrap items, (b) repairs and warranty expense, (c) inspection time of finished goods and (d) work force needed to handle complaints and returns.
He goes on to explain that cost of quality has four components: (a) prevention costs, (b) appraisal costs, (c) internal failure costs and (d) external failure costs. He estimates that currently an increase in prevention and appraisal costs results in a twofold reduction in (internal and external) failure costs.
Prevention costs are costs incurred to ensure that defects are minimized and prevented at the earliest stage. Prevention activities are most effective because preventing a unit from becoming defective at the earliest stage saves the labor and manufacturing overheads that would have been consumed had the unit moved on in production and the defect was identified at a later stage. Examples of prevention costs in case of Writing Tools, Inc. include:
- Quality training for engineers
- Hiring a supply chain expert to coordinate with suppliers
- Carrying out a complete quality audit
- Installing software to gather more accurate data on quality management
Appraisal costs are costs incurred to identify defective products before they are shipped off. These include costs incurred on inspecting raw materials, work-in-progress and finished goods.
In the above example, appraisal costs include:
- Salaries of inspection staff
- Maintenance and utilities of inspection equipment
- Replacement of inspection equipment
Internal Failure Costs
Internal failure costs refer to costs incurred on the defective units before they are identified before shipment. These costs represent the direct material, direct labor and manufacturing overheads consumed by the defective unit.
In case of Writing Instruments, Inc., these include:
- Spoilage of material
- Cost of scrapped units
- Cost of disposing off the scrapped items and spoiled material
- Production disruptions due to defective units
External Failure Costs
External failure costs are cost associated with defective units which are shipped to customers. External failure costs are the most expensive in that they result in lost repute, extensive warranty and repair costs and in worst case may result in legal action.
In the above-mentioned example, external failure costs are:
- Lost sales due to bad customer experience
- Recalls, warranty expense and repairs
- Cost of customer services department in handling the complaints, warranty claims and recalls
Correct classification of quality costs into prevention costs, appraisal costs and internal and external failure costs will help businesses arrive at the optimal budget for quality costs and efficient allocation among different quality control activities.
Written by Obaidullah Jan, ACA, CFA and last revised on