Management And Accounting Web

Rust, K. G. 1995. Measuring the costs of quality. Management Accounting (August): 33-37.

Summary by Carolina Saavedra
Master of Accountancy Program
University of South Florida, Summer 2002

Deming Main Page | Quality Related Main Page

"The Costs of quality are the costs that would be eliminated if all workers were perfect at their jobs" (p. 36). They can be separated into two areas;

1. the price of nonconformance, which measures expenses that are incurred when things are done incorrectly (includes internal and external failure costs), and

2. the price of conformance, which includes all expenses needed to implement and maintain a system that strives to eliminate deficiencies and achieve quality products.

BAC Engineering Plastics, a small Midwestern firm that converts virgin plastic into reinforced thermoplastic, applied these cost of quality concepts to one of the products they purchased. Using cost-benefit analysis, they studied one of their raw materials referred to as RM #033 and found that the costs were so high they could justify terminating its use.

Quality Cost of RM#033

RM#033 is a byproduct of XYZ Corporation that they regrind and sell to BAC which later uses it in four of its different nylon products A,B,C, and D. When the RM #033 is received by BAC, it’s processed by a machine designed to melt everything down and separate out the metal pieces found in the raw material. The large metal pieces get caught on die plates about 3/16 of an inch wide and sometimes clogs these plates. They get clogged because the machines are not designed to accommodate metal impurities and each time they are used, additional wear is created and also a gassy oil byproduct is released that may be dangerous to the workers. The machines must be shut down and cleaned when they get clogged and this requires downtime of about an hour. This happens about twice in every 6 hour material run and has caused a need for overtime or late shipments to customers, so now they are realizing that the money and time spent correcting this problem could be better spent on revenue-generating activities instead.

Benefits from RM#033

First, when using this raw material, the final products always meet customer’s specifications. It costs only $.50 per pound and its closest substitute costs $.99 per pound. It’s also safe to assume that the costs spent on preparing and shipping RM#033 to the production plant could be spent on other activities that generate higher profits. For XYZ, they have quality costs that include inspecting the outgoing RM#033 and costs of retransforming or scrapping rejected RM#033, as well as possibly incurring external failure costs due to rejection by BAC.

Alternative Solutions to Quality Problem

The management of BAC has several alternatives to solve this problem:

1. make no changes at all since there have been no customer complaints about the product.

2. have the purchasing agent discuss with XYZ about the possibility of having them remove the metal particles before it gets shipped.

3. investigating other substitute materials that may be cheaper.

4. invest in new machinery that’s designed to remove all the metal particles.

5. discontinue the line of products that use RM#033 completely since its only responsible for 4% of total sales of the nylon division.

In order to decide, management must identify and measure all of the relevant quality costs and compare the base cost to the cost of each alternative.

Product Contribution to Expense and Income

Product Sales Revenue/lb Standard Cost/lb Contribution Contribution/hour**
A $1.74 $0.89 $0.86 $431.50
B 2.84 0.95 1.89 946.00
C 1.71 0.96 0.75 375.00
D 2.10 0.91 1.19 596.00
  $8.39     $2,348.50
Packing cost at a
constant rate of $0.03/lb 
Average $2.10     $572.13
*Standard cost includes material cost, cost of scrap (at a 10% rate), fixed costs of the machine.
**Throughput rate of 500 lbs/hr is typical.

Extra costs arise when downtime is due to problems with RM#033. A production supervisor estimates that he spends four hours per month in additional inspection and analysis when the machines shut down. The costs are 2.5% of monthly wages and $695 total cost per hour of downtime.

RM#033 Costs Compared to Regular Nylon

If regular nylon was used, the downtime could be reduced to almost zero. With the necessary setup and cleanup hours included, the total production time per batch would be 12 hours and generate 18% more revenue per hour. The differential costs include material costs, downtime costs, and the extra machine wear. No additional costs would be incurred by using the regular nylon. The cost savings using a higher quality material would be $760 per run.

Steps to a Quality Cost System and BAC

The nonconformance price is estimated to be $760 per each 6 hour production run plus the quality costs incurred by the supplier. To arrive at zero nonconformance cost, BAC needs to decide how to deal with the extra costs. In order to reduce the downtime, inspection costs, and overtime charges, and reduce the overall costs of producing the four products, BAC should design and communicate appropriate specifications to their suppliers so the suppliers know the quality expectations. Second, BAC must consider quality costs as part of the direct costs of products A, B, C, and D. The contribution margins are acceptable because they only measure the difference between the selling price and the standard costs and leave other indirect costs (overtime, downtime, and maintenance) to be allocated and hidden. The BAC buyer, manager, and controller should be aware and accountable for these quality costs that should be considered part of the direct costs of the four products. The purchasing agent is the one who should talk to the current supplier and decide how to resolve the situation in a way that best favors BAC.

Future Consideration

BAC should expand the improvements it made with respect to RM#033 throughout the rest of its product lines. They need to change how they identify the true costs of producing items. Cost accounting should also facilitate quality cost identification and control. In order to eliminate the costs of poor quality, (rework and scrap, or excess time spent on customer problems) the costs first need to be traced to the source. To improve quality cost accounting, interdepartmental cooperation is needed, and support of top management is crucial in defining the goals of the new improved accounting system. Continuous efforts to identify and measure quality costs lead to reduced direct and indirect costs due to poor quality and satisfy customers while at the same time increasing profits.

Making a Quality Change

The sales manager of the nylon division stated, “Therefore, I request that we change the [Bills of Material] that call for [RM #033] to our current prime nylon [raw material].” Although the raw material price will increase and affect standard costs and profit margins negatively, the hidden costs associated with the poor quality raw material may not have a negative affect overall and the change may be beneficial to BAC in the long run.


Related Summaries:

Albright, T. L. and H. Roth. 1992. The measurement of quality costs: An alternative paradigm. Accounting Horizons (June): 15-27. (Summary).

Albright, T. L. and H. Roth. 1993. Controlling quality on a multidimensional level. Journal of Cost Management (Spring): 29-37. (Summary).

Albright, T. L. and H. P. Roth. 1994. Managing quality through the quality loss function. Journal of Cost Management (Winter): 20-37. (Summary).

Anderson, S. W. and K. Sedatole. 1998. Designing quality into products: The use of accounting data in new product development. Accounting Horizons (September): 213-233. (Summary).

Carr, L. P. and L. A. Ponemon. 1994. The behavior of quality costs: Clarifying the confusion. Journal of Cost Management (Summer): 26-34. (Summary).

Fargher, N. and D. Morse 1998. Quality costs: Planning the trade-off between prevention and appraisal activities. Journal of Cost Management (January/February): 14-22. (Summary).

Gabel, N. 1991. Is 99.9% good enough? Training Magazine (March). (Summary).

Kettering, R. C. 2001. Accounting for quality with nonfinancial measures: A simple no-cost program for the small company. Management Accounting Quarterly (Spring): 14-19. (Summary).

Kim, M. W. and W. M. Liao. 1994. Estimating hidden quality costs with quality loss functions. Accounting Horizons (March): 8-18. (Summary).

Martin, J. R. Not dated. Constrained optimization techniques. Management And Accounting Web.

Martin, J. R. Not dated. Summary of the 1992 PBS Program Quality or Else. Management And Accounting Web.

Morse, W. J. 1983. Measuring quality costs. Cost and Management(July-August): 16-20. (Summary).

Pasewark, W.R. 1991. The evolution of quality control costs in U.S. manufacturing. Journal of Cost Management (Spring): 46-52. (Summary).

Roth, H. P. and T. L. Albright. 1994. What are the costs of variability? Management Accounting (June): 51- 55. (Summary).