Quality Costs:

Financial controls are an important part of business management. These financial controls involve a
comparison of actual and budgeted costs, along with analysis and action on the differences between
actual and budget. It is customary to apply these financial controls on a department or functional
level. For many years, there was no direct effort to measure or account for the costs of the quality
function. However, many organizations now formally evaluate the cost associated with quality. There
are several reasons why the cost of quality should be explicitly considered in an organization. These
include the following:
1. The increase in the cost of quality because of the increase in the complexity of manufactured
products associated with advances in technology.
2. Increasing awareness of life-cycle costs, including maintenance, spare parts, and the cost of field
failures
3. Quality engineers and managers can most effectively communicate quality issues in a way that
management understands.
As a result, quality costs have emerged as a financial control tool for management and as an aid in
identifying opportunities for reducing quality costs.
Generally speaking, quality costs are those categories of costs that are associated with producing,
identifying, avoiding, or repairing products that do not meet requirements. Many manufacturing and
service organizations use four categories of quality costs: prevention costs, appraisal costs, internal
failure costs, and external failure costs. These cost categories are shown in Table below. We will now
discuss these categories in more detail.

Prevention Costs:
Prevention costs are those costs associated with efforts in design and manufacturing that are directed
toward the prevention of nonconformance. Broadly speaking, prevention costs are all costs incurred
in an effort to make it right the first time. The important subcategories of prevention costs follow.
Quality planning and engineering.
Costs associated with the creation of the overall quality plan, the inspection plan, the reliability plan,
the data system, and all specialized plans and activities of the quality-assurance function; the
preparation of manuals and procedures used to communicate the quality plan; and the costs of
auditing the system.
New products review.
Costs of the preparation of bid proposals, the evaluation of new designs from a quality viewpoint, the
preparation of tests and experimental programs to evaluate the performance of new products, and
other quality activities during the development and preproduction stages of new products or designs.

Product/process design. Costs incurred during the design of the product or the selection of the
production processes that are intended to improve the overall quality of the product. For example, an
organization may decide to make a particular circuit component redundant because this will increase
the reliability of the product by increasing the mean time between failures. Alternatively, it may decide
to manufacture a component using process A rather than process B, because process A is capable of
producing the product at tighter tolerances, which will result in fewer assembly and manufacturing
problems. This may include a vendors process, so the cost of dealing with other than the lowest
bidder may also be a prevention cost.
Process control. The cost of process-control techniques, such as control charts, that monitor the
manufacturing process in an effort to reduce variation and build quality into the product.
Burn-in. The cost of pre-shipment operation of the product to prevent early-life failures in the field.
Training. The cost of developing, preparing, implementing, operating, and maintaining formal
training programs for quality.
Quality data acquisition and analysis. The cost of running the quality data system to acquire data
on product and process performance; also the cost of analyzing these data to identify problems. It
includes the work of summarizing and publishing quality information for management.

Appraisal Costs.
Appraisal costs are those costs associated with measuring, evaluating, or auditing products,
components, and purchased materials to ensure conformance to the standards that have been
imposed. These costs are incurred to determine the condition of the product from a quality viewpoint
and ensure that it conforms to specifications. The major subcategories follow. Inspection and test of
incoming material. Costs associated with the inspection and testing of all material. This subcategory
includes receiving inspection and test; inspection, test, and evaluation at the vendors facility; and a
periodic audit of the quality-assurance system. This could also include intra-plant vendors.
Product inspection and test. The cost of checking the conformance of the product throughout its
various stages of manufacturing, including final acceptance testing, packing and shipping checks, and
any test done at the customers facilities prior to turning the product over to the customer. This also
includes life testing, environmental testing, and reliability testing.
Materials and services consumed. The cost of material and products consumed in a
destructive test or devalued by reliability tests.
Maintaining accuracy of test equipment. The cost of operating a system that keeps the measuring
instruments and equipment in calibration.

Internal Failure Costs

Internal failure costs are incurred when products, components, materials, and services fail to meet
quality requirements, and this failure is discovered prior to delivery of the product to the customer.
These costs would disappear if there were no defects in the product. The major subcategories of
internal failure costs follow.
Scrap. The net loss of labor, material, and overhead resulting from defective product that cannot
economically be repaired or used. Rework. The cost of correcting nonconforming units so that they
meet specifications. In some manufacturing operations rework costs include additional operations or
steps in the manufacturing process that are created to solve either chronic defects or sporadic
defects.
Retest. The cost of reinspection and retesting of products that have undergone rework or other
modifications.
Failure analysis. The cost incurred to determine the causes of product failures.
Downtime. The cost of idle production facilities that results from nonconformance to requirements.
The production line may be down because of nonconforming raw materials supplied by a supplier,
which went undiscovered in receiving inspection.
Yield losses. The cost of process yields that are lower than might be attainable by improved controls
(for example, soft-drink containers that are overfilled because of excessive variability in the filling
equipment).
Downgrading/off-specing. The price differential between the normal selling price and any selling
price that might be obtained for a product that does not meet the customers requirements.
Downgrading is a common practice in the textile, apparel goods, and electronics industries. The
problem with downgrading is that products sold do not recover the full contribution margin to profit
and overhead as do products that conform to the usual specifications.

External Failure Costs.

External failure costs occur when the product does not perform satisfactorily after it is delivered to the
customer. These costs would also disappear if every unit of product conformed to requirements.
Subcategories of external failure costs follow.
Complaint adjustment. All costs of investigation and adjustment of justified complaints attributable
to the nonconforming product.
Returned product/material. All costs associated with receipt, handling, and replacement of the
nonconforming product or material that is returned from the field.
Warranty charges. All costs involved in service to customers under warranty contracts.
Liability costs. Costs or awards incurred from product liability litigation.

Indirect costs. In addition

n to direct operating
o
co
osts of exte
ernal failure
es, there are
e a significa
ant numberr
ndirect costss. These arre incurred because off customer dissatisfacction with the level of quality
q
of
of in
the delivered
d
product. Indirect costs may reflectt the custom
mers attitud
de toward the
t compan
ny. They
inclu
ude the cossts of loss of
o business reputation,, loss of futu
ure businesss, and losss of markett share that
inevvitably resullts from delivering prod
ducts and services
s
tha
at do not co
onform to th
he custome
ers
expe
ectations re
egarding fitn
ness for use.

Qua
ality Costts
Quality pla
anning and
engineering
New produ
ucts review
Product/prrocess desig
gn
Process co
ontrol
Burn-in
Training
on and
Quality datta acquisitio
analysis

Scrrap
Rew
work
Rettest
Failure analyssis
Dow
wntime
Yie
eld losses
Dow
wngrading (off-specing
g)

Prevention Costs
C

Intern
nal Failure Costs

Inspection and test off

m
incoming material
Product ins
spection an
nd test
a service
es
Materials and
consumed
g accuracyy of test
Maintaining
equipmentt

A
Appraisal
Co
osts

Exterrnal Failure
e Costs

Complaint adjustment
Retturned prod
duct/materia
al
Wa
arranty charrges
Liability costs
Indirect costs

The Analysis and Use of Quality Costs.

How large are quality costs? The answer, of course, depends on the type of organization and the
success of their quality improvement effort. In some organizations quality costs are 4% or 5% of
sales, whereas in others they can be as high as 35% or 40% of sales. Obviously, the cost of quality
will be very different for a high-technology computer manufacturer than for a typical service industry,
such as a department store or hotel chain. In most organizations, however, quality costs are higher
than necessary, and management should make continuing efforts to appraise, analyze, and reduce
these costs.
The usefulness of quality costs stems from the leverage effect; that is, dollars invested in prevention
and appraisal have a payoff in reducing dollars incurred in internal and external failures that exceeds
the original investment. For example, a dollar invested in prevention may return $10 or $100 (or
more) in savings from reduced internal and external failures.
Quality-cost analyses have as their principal objective cost reduction through identification of
improvement opportunities. This is often done with a Pareto analysis. The Pareto analysis consists
of identifying quality costs by category, or by product, or by type of defect or nonconformity. For

example, inspection of the quality-cost information in Table below concerning defects or

nonconformities in the assembly of electronic components onto printed circuit boards reveals that
insufficient solder is the highest quality cost incurred in this operation.
Monthly Quality-Costs Information for Assembly of Printed Circuit Boards
Type of Defect
Insufficient solder
Misaligned components
Defective components
Missing components
Cold solder joints
All other causes
Totals

Percent of Total Defects

42%
21
15
10
7
5
100%

Scrap and Rework Costs

$37,500.00 (52%)
12,000.00
8,000.00
5,100.00
5,000.00
4,600.00
$72,200.00

Insufficient solder accounts for 42% of the total defects in this particular type of board and for almost
52% of the total scrap and rework costs. If the wave solder process can be improved, then there will
be dramatic reductions in the cost of quality.
How much reduction in quality costs is possible? Although the cost of quality in many organizations
can be significantly reduced, it is unrealistic to expect it can be reduced to zero. Before that level of
performance is reached, the incremental costs of prevention and appraisal will rise more rapidly than
the resulting cost reductions. However, paying attention to quality costs in conjunction with a focused
effort on variability reduction has the capability of reducing quality costs by 50% or 60% provided that
no organized effort has previously existed. This cost reduction also follows the Pareto principle; that
is, most of the cost reductions will come from attacking the few problems that are responsible for the
majority of quality costs.
In analyzing quality costs and in formulating plans for reducing the cost of quality, it is important to
note the role of prevention and appraisal. Many organizations devote far too much effort to appraisal
and not enough to prevention. This is an easy mistake for an organization to make, because
appraisal costs are often budget line items in manufacturing. On the other hand, prevention costs
may not be routinely budgeted items. It is not unusual to find in the early stages of a quality-cost
program that appraisal costs are eight or ten times the magnitude of prevention costs. This is
probably an unreasonable ratio, as dollars spent in prevention have a much greater payback than do
dollars spent in appraisal.
Generating the quality-cost figures is not always easy, because most quality-cost categories are not a
direct component in the accounting records of the organization. Consequently, it may be difficult to
obtain extremely accurate information on the costs incurred with respect to the various categories.
The organizations accounting system can provide information on those quality-cost categories that

coincide with the usual business accounts, such as, for example, product testing and evaluation. In
addition, many companies will have detailed information on various categories of failure cost. The
information for cost categories for which exact accounting information is not available should be
generated by using estimates, or, in some cases, by creating special monitoring and surveillance
procedures to accumulate those costs over the study period.
The reporting of quality costs is usually done on a basis that permits straightforward evaluation by
management. Managers want quality costs expressed in an index that compares quality cost with the
opportunity for quality cost. Consequently, the usual method of reporting quality costs is in the form of
a ratio, where the numerator is quality-cost dollars and the denominator is some measure of activity.

Measureofactivity:

(1)hoursofdirectproductionlabor
(2)dollarsofdirectproductionlabor
(3)dollarsofprocessingcosts
(4)dollarsofmanufacturingcost
(5)dollarsofsales
(6)unitsofproduct

Upper management may want a standard against which to compare the current quality cost figures. It
is difficult to obtain absolute standards and almost as difficult to obtain quality cost levels of other
companies in the same industry. Therefore, the usual approach is to compare current performance
with past performance so that, in effect, quality-cost programs report variances from past
performance. These trend analyses are primarily a device for detecting departures from standard and
for bringing them to the attention of the appropriate managers. They are not necessarily in and of
themselves a device for ensuring quality improvements.
This brings us to an interesting observation: Some quality-cost collection and analysis efforts fail.
That is, a number of companies have started quality-cost analysis activities, used them for some time,
and then abandoned the programs as ineffective. There are several reasons why this occurs. Chief
among these is failure to use quality-cost information as a mechanism for generating improvement
opportunities. If we use quality cost information as a scorekeeping tool only, and do not make

conscious efforts to identify problem areas and develop improved operating procedures and
processes, then the programs will not be totally successful.
Another reason why quality-cost collection and analysis doesnt lead to useful results is that
managers become preoccupied with perfection in the cost figures. Overemphasis in treating quality
costs as part of the accounting systems rather than as a management control tool is a serious
mistake. This approach greatly increases the amount of time required to develop the cost data,
analyze them, and identify opportunities for quality improvements. As the time required generating
and analyzing the data increases, management becomes more impatient and less convinced of the
effectiveness of the activity. Any program that appears to management as going nowhere is likely to
be abandoned.
A final reason for the failure of a quality-cost program is that management often underestimates the
depth and extent of the commitment to prevention that must be made. The author has had numerous
opportunities to examine quality cost data in many companies. In companies without effective quality
improvement programs, the dollars allocated to prevention rarely exceed 1% to 2% of revenue. This
must be increased to a threshold of about 5% to 6% of revenue, and these additional prevention
dollars must be spent largely on the technical methods of quality improvement, and not on
establishing programs such as TQM, Zero Defects, or other similar activities. If management is
persistent in this effort, then the cost of quality will decrease substantially. These cost savings will
typically begin to occur in one to two years, although it could be longer in some companies.

Hidden non-conformance costs (iceberg model)