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The fifth method of presenting performance measures is the cost of poor quality. Money attracts the attention of senier management; quality costs are described in the next section of this chapter. The last method is the.Malcolm Baldrige National Quality Award. Criteria for this award quite effectively measure the performance of the TQM effort on an annual basis. It is described in the last section of this chapter.

The value of quality must be based on its ability to contribute to profits. The goal of most organizations is to make money; therefore, decisions are made based on evaluating alternatives and the effect each alternative will have on the expense and income of the entity. The efficiency of a business is measured in terms of dollars. The cost of poor qualitj can add to the other costs used in decision making, such as maintenance, production, design, inspection, sales, and other activities. This cost is no different than other costs. It can be programmed, budgeted, measured, and analyzed to help in attaining the objectives for better quality and customer satisfaction'at less cost. A reduction in quality costs leads to increased profit. . Quality costs cross department lines by involving all activities of the organizationmarketing, purchasing, design, manufacturing, and service, to name a few. Some costs, such as inspector salaries and rework, are readily identifiable; other costs, such as prevention costs associated with marketilig, design, and purchasing, are more difficult to identify and allocate. There are failure costs associated with lost sales and customer goodwill, which may be impossible to measure and mu.'!tbe estimated. Quality costs are defined as those costs associat~ with the nonachievement of product or service quality as defined by the requirements established by the organization and its contracts with customers and society. Simply stated, quality cost is the cost of poor products or services. Management Technique

Quality costvrrc'used by management in its pursuit of quality improvement, customer satisfaction, market share, and profit enhancement. It is the c:..::oJ1l0rniC cOinmon denominator that forms the basic data for TQM. When qualitY costs are too high, it is a sign of man; agement ineffectiveness, which can affect the organization's competitive position. A quality cost program provides warnings against oncoming, dangerous [mancial situations.

This section is adapted from Guide for Reducing QUlllity Costs, 2 ed., 1987 and Principles of QUlllity Costs, 1986, by the ,~uality Cost Committee, with the penni~sioti of the American Society for Quality.

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A quality cost program quantifies the magnitude of the quality problem in the language that management knows best-dollars. The cost of pOor quality can exceed 2().% of the sales dollar in manufacturing companies and 35% of the sales dollar in service organizations. In addition, the program may show quality problem areas that were previously tinknown. Quality costs identify opportunities for quality improvement and establish funding priorities by means of Pareto analysis. This analysis allows the quality improvement program to concentrate on the vital few quality problem areas. Once corrective action has been completed, the quality costs will measure the effectiveness of that action in terms of dollars. A quality cost program lends credence to management's commitment to quality. Arguments for quality improvement are stronger when the quality costs show a need. The program also provides cost justification for corrective action. All costs associated with poor quality and its correction are integrated into one system to enhance the quality management function. Quality improvement is synonymous with a reduction in the cost of poor quality. Every dollar saved on quality cost has a positive effect on profits. One of the principal advantages of the quality cost program is the identification of hidden and buried costs in all functional areas. Quality costs in marketing, purchasing, and design are brought to the forefront by the system. When senior management has all . the facts on hidden and buried' costs, they will demand a quality cost program .. A cost program is a comprehensive system and should not be perceived as merely a "fire-fightinf technique. For example, one response to a customer's problem could be to increase inspection. Although this action might eliminate the problem, the quality costs would increase. Real quality 'improvement OCCH .. when the root cause of the problem is found and corrected .
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.categories and Elements

For the convenience of future reference and use, detailed quality costs are identified in this section. There are four primary quality cost categories: prevention, appraisal, internal failure, and external failure. The list is not meant to contain every element of quality cost applicable to every organization. It is intended to give a general idea of what types of elements are contail)ed within each category to help in deciding individual classifications. If a significant cost exists that fits any part of the general description of the quality cost element, it should be used. Sub-elements are identified; however, detailed descriptions are not included.

1.0

PREVENTI."E COST CATEGORY

The experience gained from the identification and elimination of specific causesoffail-

:~.;c. uie~d ~eir costs is utilized to prevent the recurrence of the same or similar failures in
~:c-.:QthefpI%l~ctsor services. Prevention is achieved by examining the total of such expe;,c., --),.'q~veloping specific activities for incorporation- into' the basic management """'Lmake it difficult or impossible for the same errors or failureS to occur ~oIt1:osts of poor quality have been defined to include the cost of all .

PERFORMANCE MEASURES
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.,

87

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activities spedfica1ly designed for this purpose. Each activity may involve personnel from one or many departments. No attempt is made to define appropriate depaitments, because each organization is structured differently. 1.1 Marketing/Customer/Uset. Costs are incurred in the accumulation and continued evaluation of customer ai1d user quality needs and perceptions (including feedback on reliability and performance) affecting user satisfaction with the organization's product or service. Sub-elements are marketing research, customer and user-perception surVeys or focus groups, and contract and document review. 1.2 Product/Service/Design Development. Costs are incurred to translate customer and user needs into reliable quality standards and requirements and to manage the quality of new product or service developments prior to the release of authorized documentation for initial production. These costs are normally planned and budgeted and are applied to major design changes as well. Sub-elements are design quality progress reviews, design support activities, product design qualification tests, service design qualification, and field trials. 1.3 Purchasing. Costs are incurred to assure col)formance td requirements of supplier parts, materials, or processes and to minimize the iI11pact of supplier nonconformances on the quality of delivered product or services. This area involves activities prior to and after finalization of purchase order commitments. Sub-elements are supplier reviews, supplier rating, purchase order technical data reviews, and supplier quality planning. 1.4 Operations (Manufacturing or Service): Costs are incurred in assuring the capability and readiness of operations to meet quality standards and requirements, quality control planning for all production activities, and the quality education of operating per- soimel. Sub-elements are operations process validation, operations quality planning, design and development of quality measurement and control equipment, collecting quality costs, operations support quality planning, iUldoperator qualitY education. 1,5 Quality Administration. Costs are incuuw in the overall administration of the quality management function. Sub-elements are administrative salaries, administrative expenses, quality program planning, quality perfoi:mance reporting, quality education, quality improvement, documenting and evaluating quality costs, and quality audits.
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2.0

APPRAISAL

COST CATEGORY

The first responsibility of a quality management system is assurance of the acceptability of product or service as deYvered to customers. this category has the responsibility -for evaluating a produ<;tor service at sequential stages, from design to first delivery and throughout the production process, to determine its acceptability for continuation in the -prqrluction or life cycle.-The frequency and spacing of .theseevaluations are based on a trade-off betw~ the cost benefits of early discov~ry of nonconfonnities and the cost of

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the evaluations (inspections and tests) themselves. Unless perfect control can be: achieved, some appraisal cost will always exist. An organization would never Wantth~ customer to be the only inspector. Thus, the appraisal costs of poor quality have been defined to include all costs incurred in the planned conduct of product or service apprai to determine compliance to requirements. 2.1 Purchasing Appraisal Costs. Purchasing appraisal costs can generally be considered the costs incurred for the inspection and/or test of purchased supplies or service. to determine acceptability for use. These activities can be performed as part of a receiv. ing inspection function or as s'Ourceinspection at the supplier's facility. Sub-elements are receiving or incoming inspections and tests, measurement equipment, qualification of supplier product, and source inspection and control program~. 2.2 Operations (Manufacturing or Service) Appraisal Costs. Operations appraisal _

costs can generally be considered the costs incurred for the inspections, tests, or audits each required discrete to determine step in the and operations assure thc plan acceptability from start of ofproduction product or to service delivery. to continue In e!lch case into' where materialloss'es are an integral part of the appraisal operation, such as machine setup pieces or destructive testing, the cost of the losses is to be included. Sub-elements are planned operations, inspections, tests, audit, setup inspections and tests, special tests (manufacturing), process control measurements, laboratory support, Il)easuremefit (inspection and test) equipment, and outside endorsements and certifications.

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1

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2.3 External Appraisal Costs. External appraisal costs are incurred any time there is 1 need for field setup {)f installation and checkoul priur to official acceptance by the cus1 tomer and also when there is need for field trials of new products or services. Subelements are field performance evaluations, special product evaluations, and evaluations o,tfield stock and spare parts. 2.4 Review of Test and Inspection Data. Costs are incurred for regular reviewing inspection and test data prior to release of the product for shipment, to detennine whether product requirements have been met. 2.5 Miscellaneous Quality Evaluations. This area involves the cost of all support area quality evaluations (audits) to assure continued ability to provide acceptable support to the production process. Examples of areas included are mail rooms, storerooms, and packaging and shipping. 3.0
INTERNAL FAILURE COST CATEGORY

Whenever quality appraisals are performed, the possibility exists for discovery of a fail''''''ure to meet requireIl!ents.When this happens, unscheduled and possibly unbudgeted ex'u,Fpenses are automatically incurred. For example, when a complete lot of metal parts is

PERFORMANCE MEASURES

,.9

.rejected for being oversize, the possibility for rework must be evaluated first. Then the .c,ostof rework may be compared to the cost of scrapping the parts and completely replacing them. Finally, a disposition is made, and the action is carried out. The total cost of this evaluation, disposition, and subsequent action is an integral part of internal fail~rl~'ure costs. ~ ... In attempting to cover all possibilities for failure to meet requirements within the in.ternal product or service life cycle, failure costs have been defined to include basically all costs required to evaluate, dispose of, and either correct or replace nonconforming products or services prior to delivery to the customer, as well as the cost to correct or repla<;eincorrect or incomplete product or service description (documentation). In general, this includes all the material and labor expenses that are lost or wasted due to nonconforming or otherwise unacceptable work affecting the quality of end products or service. CorreCtive action that is directed toward eli,nination of the problem in the future may be classified as prevention. 3.1 Product or Service Design Failure COS(s(Internal). Design failure costs can generally be considered the unplanned costs that are incurred because of inherent design inadequacies in released documentation for production operations. They do not include billable costs associated with customer-directed changes (product improvements) or major redesign efforts (product upgrading) that are part ,!f an organization-sponsored marketing plan. Sub-elements are design corrective action, rework due to design changes,. scrap due to design changes, and production liaison costs. 3.2 Purchasing Failure Costs. Costs are incurred due to purchased item rejects. Subelements are purchased material reject disposition costs, purchased material replacement costs, supplier corrective action, rework of supplier reject" and uncontrolled material losses. <c

3.3 Operlitioils (Product or Service) Failure Costs. Operations failure costs almost always represent a significant portion of overall quality costs and can generally be viewed as the costs associated with nonconforming product or service discovered during the operatioJl$process. They are categorized into three distinct areas: material review and correcti ve action, rework 9r repair'costs, and scrap costs. Sub-elements are material review and corrective action costs, operations rework and repair costs, and internal failure labor losses,

4.0

EXTERNAL FAILURE COST CATEGORY

This category includes all cqs~ incurred due to actual or suspected nonconforming product or service after delivery to the custQmer.These co~ts consist primarily of costs associated with the product or service not meeting customer or user requirements. The responsibility for these losses may lie in marketing or sales, design development, or operations, Determination of responsibility is not part ofllie system. Determination of responsibility can come about only through investigation and' analysis of external failure cost inputs.

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4.1 Complaint Investigations of Customer or User Service. This category incl the total cost of investigating, resolving, and responding to individual customer or ' complaints or inquiries, including necessary field service. 4.2 Returned Goods. This category includes the totiUcost of evaluating and repair" or replacing goods not meetingacceptance by the customer or user due to quality proble It does not include repairs accomplished as part of a maintenance or modification con 4.3 Retrofit am! Recall Costs. Retrofit and recall costs are those costs required modify or update products or field service facilities to a new design change level, b on major redesign due to design deficiencies. They include only the portion of retrofi that are due to quality problems. 4.4 Warranty Claims. Warranty costs include the total cost of claims paid to the cus, tomer or user after acceptance to cover expenses, including repair costs, such as remov~ ing defective hardware from a system, or cleaning costs, due to a food or chemic service accident. In cases where a price reduction is negotiate<! in lieu of a warranty, the, value of this reduction should be counted. 4.5 Liability Costs. Liability costs are organization-paid costs due to liability claims, including the cost of product or service liability insurance. 4.6 Penalties. Penalty costs aJe those costs incurred because less than full product or ' service performance is achieved as required by contracts with customers or by government rules and regulations. 4.7 Customer or User Goodwill. This category involves costs incurred, over and above normal selling costs, to customers or users who are not completely satisfied with tite quality or-delivered product or service because the customers' quality expectations were greater than the quality ihey received. 4.8 Lost Sales. Lost sales comprise the value of the contribution to profit that is lost due to sales reduction because of quality problems. Collection and Reporting
COLLECTION SYSTEM DESIGN

The development of the collection ~ystem requires the close interaction of the quality and accounting departments. Because accounting cost data are established by departr.nentalcost codes, a significant amount of quality cost can be obtained from this source. mJ:;,'~rnfact, the system should be designed using the organizatiol! 's present system and mod ';"'i1lYing it where appropriate. Some existing sources for reporting quality costs are time '~ts,-schedules,minutes of meetings, expense reports, credit and debit memos, and so . Be aw~e .that not all accounting data are accurate.

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MEASURES

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Some quality cost data cross departmental lines, and these types of costs are the most 'llifficult to collect. Specilil fonns may be required to report some quality costs. For ex'-ample, scrap and rework costs may require analysis by quality control personnel to de-termine the cause and the departments responsible. In some cases, estimates are used to allocate the proportion of an activity that must be charged to a particular element. For example, when the marketing department engages in research, it is necessary for the department supervisor to estimate the proportiOI!of the activity that pertains to customer quality needs and should be charged as a ,quality cost. Work-sampling techniques can be a valuable tool for assisting the supervisor:in making the estimate. _ Insignificant costs of poor quality, such as a secretary retyping a letter, may be difficult to determine and may be overlooked. HoweVer, significant ones are frequently hidden or buried because the accounting system is not designed to handle them. Quality cost is 'a tool that can determine opportunities for quality improvement, justify the corrective action, and measure its effectiveness/Including insignificant activities is not essential to use the tool effectively: However, all significant activities or major elements must be ,captured, even if they are only estimated. _ The comptroller's office must be directly involved-in the -design of the quality cost collection system. This office has the ability to create a new system that will integrate quality costs into the existing accounting system. An ideal system would be one where the quality cost is the difference between actual cost and the cost if everyone did a perfect job or the difference between actu,alrevenues' and revenues if there were no unhappy customers. This ideal is most likely impossible to obtain. Allocating the costs to the proper element is difficult. Some example situations are 1. Incoming inspection would be apprais~, whereas supplier certification would be prevention. ,2. An 800 numbenvould be prorated between the cost of doing business and customer complaints. 3. Cost ofa team meeting might be due to failure, but cost of the solution might be appraisal "Or prevention. Quality costs should be collected by product line, projects, departments, operators, IlOIiconfohnity classification; and work centers. This manner of collection is sufficient for subsequent quality,'cost analysis. Procedures are developed to ensure that the system functions correctly. Micro reports are prepared for functional areas and departments, and macro reports are done for the TQM function.
QUALITY COST BASES

Quality costs by themselves present insufficient iMqrmation for analysis. A baseline is required that will relate quaIity costs to some aspect dt the business that is sensitive to change. lypicat bases are labor, production, sales, and unit. When these baselines are compared with q~ity costs, an index is obtained.