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The Cost of Quality

The cost of quality encompasses four sub-categories of costs, which are the costs of prevention, appraisal, internal failure, and external failure. These costs are explained below.

The first cost of quality category is prevention costs.  These are the costs that a company incurs to ensure that product failures of various kinds do not occur either during the production process or when in the hands of a customer.  These costs can also be incurred to ensure that there are fewer process-related failures.  These are discretionary costs, for a company’s management may choose not to expend any funds on prevention activities (though there will be an offsetting increase in failure costs).

Examples of prevention costs are:

• New product trial costs.  For those organizations releasing new products, having customers test product designs is a central method for ensuring a high quality of design.  Accordingly, the costs of products given to customers and survey administration can be clustered into this sub-category.
• Procedure and instruction development.  A major prevention activity is the creation of machine operation instructions and other procedures that give employees complete information about how to conduct their jobs.  With this information in hand, there is much less chance that any steps in the production process will be mis-handled, resulting in quality problems.  The cost of this sub-category includes the initial investigation of activities, procedure development, and distribution of the resulting materials.
• Supplier qualification. Products cannot have a high quality level unless the supplier parts comprising them have high quality standards.  The cost of all employee time spent in reviewing and assessing the output of suppliers must fall into this category.
• Warranty reviews.  One form of prevention is to closely review all customer warranty claims in order to discern clues regarding what product problems can be prevented at the company before they can reach customers.  The cost of this review and any subsequent investigation of possible problems should fall into this sub-category.

The second cost of quality category is appraisal costs.  These are the costs incurred to measure products, the material components used in products, and the processes used to manufacture products.  These activities are designed to reduce the number of defective products shipped to customers.  They differ from prevention costs in that they attempt to improve quality strictly through increased inspection activities.  These are also discretionary costs, for a company does not have to use any appraisal activities whatsoever – though eliminating them will increase the number of low-quality products shipped to customers.  Examples of appraisal costs are as follows:

• Incoming component testing.  If there are particularly troublesome problems with materials received from suppliers, then a company may have initiated an extensive effort to review a large proportion of those materials, which will result in costs not only for testing personnel, but also any materials that are destroyed during the testing process.
• Material appraisal.  It is common for the quality control staff to remove items from various stages of the production process for testing purposes.  If the removed materials are destroyed during testing, then the cost of these materials should be recorded as an appraisal cost.
• Outsourced laboratory testing.  Some of the tests conducted on materials are of such a specialized nature that a company finds it to be more cost-effective to send them out to an outside laboratory for review.  The fees of such laboratories should be charged to this cost sub-category.
• Testing equipment.  Depending on the kinds of quality tests performed, the types of testing equipment needed can be very expensive.  If the cost of this equipment falls below a company’s capitalization limit, then the entire cost can be charged straight to this sub-category.  If higher, then the associated deprecation expense should be charged here.

The third cost of quality category is internal failure costs.  These are costs incurred as a result of discovering product defects prior to shipment.  At that time, products can be taken out of the production or warehouse areas, repaired or scrapped, and placed back in the production process if possible.  There are a number of related costs that accompany these activities that make this a very expensive cost category.  Examples of internal failure costs are:

• Redesign.  If a product continues to have high quality error rates over time, the problem may be in the underlying product design.  If so, the engineering staff will require extra time to develop a new design and test it to ensure that all quality problems have been resolved.  The engineering time charged to this work should be summarized into this cost sub-category, as well as the costs of any inventory that will become obsolete as a result of design changes.
• Rework.  Depending on the extent of product rework required, there may be a separate staff devoted to this activity.  If not, then production workers must be drawn from the production line (thereby taking time away from the production of other products) to perform this work.  In either case, the cost of their time is charged to this account.  There may also be a charge for the use of any machinery required to perform rework tasks.
• Scrap.  Some products may be of such a low quality level that they cannot be reworked, and so must be thrown away.  However, some of these costs may be recouped by the income from sale of the scrap (if this is possible).  For high-cost products, this is a very expensive sub-category of internal failure costs.

The final cost of quality category is external failure costs.  These are the costs incurred when low-quality products are shipped to customers.  This tends to be the most difficult quality cost area to measure, because it is difficult to quantify some customer-related costs (as noted in the following bullet points).  There is general agreement among quality experts that these costs are the most expensive of all the various cost of quality categories, for the loss of customers due to low quality can have a catastrophic impact on an organization’s profitability.  Examples of external failure costs are as follows:

• Loss of customers.  This is the potentially largest cost in the external failure cost category.  It can be quantified by tracking those customers who are no longer buying from the company, contacting them to determine if low quality was the reason, and then calculating the lost profit based on sales to those customers in the preceding year.  Though the resulting figure will not tie to any cost recorded through a traditional accounting system, the opportunity cost of sales lost should still be itemized in this account, due to its potential size.
• Loss of reputation.  A potentially very large expense is the reduction in a company’s reputation when it continually sells low-quality products.  This is a very difficult cost to calculate or even estimate, so most companies do not use this cost account, preferring instead to simply itemize the potential for this cost in the narrative sections of their quality cost reports.
• Product recall.  If a company finds that quality problems with a product are sufficiently extensive, it can recall them.  There are many costs when this happens, including payment for the inbound freight costs for returned products, the cost of reworking defective products, the cost of issuing replacement products, and the administrative overhead associated with these tasks.  This can be an inordinately expensive cost sub-category.
• Warranty claim administration.  When there are many product returns from customers, a company will find it necessary to create a full-time warranty claims department.  The cost of the staff for this department, as well as all associated overhead costs, should be charged to this account.