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CHAPTER 16: THE MANAGEMENT AND CONTROL OF QUALITY

QUESTIONS

16-1 The American Heritage Dictionary defines quality as: 1. a characteristic or attribute
of something; property; a feature. 2. the natural or essential character of something.
3. excellence; superiority.

From a managerial perspective, quality can be defined as the degree of conformity


between what a customer receives and what a customer is promised. Alternatively,
we can conceptualize quality as the total level of satisfaction received by the
customer.

For purposes of management accounting and control, quality can be broken down
into two components: design quality and performance quality. The former refers to
the extent to which the features (attributes or characteristics) of the product or
service are those desired by the customer. The latter refers to the difference
between the design specifications of the product and the actual performance of the
product. Chapter 16 deals primarily with the management and control of
performance quality failures.

16-2 Among factors that might have caused lapses in quality in some firms in the United
States were: (1) years of success, (2) lack of competition from foreign companies
and (3) absence of information regarding total spending on quality. These and other
factors contributed to a lack of awareness that the cost of quality could be
substantial and, more often than not, more than the cost of manufacturing.
Alternatively, minimizing the total quality-related costs could be the source of
competitive advantage for an organization.

16-3 Procter & Gamble defines TQM as the unyielding and continually improving effort
by everyone in an organization to understand, meet, and exceed the expectations of
customers. Typical characteristics of TQM include focusing on satisfying
customers, striving for continuous improvement, and involving the entire workforce.

TQM is a continual effort and therefore never complete. Global competition, new
technologies, and ever-changing customer expectations make TQM a continual
effort for a successful firm.

16-4 The Malcolm Baldridge National Quality Award (www.quality.nist.gov) is an annual


award created by the U.S. government to recognize U.S. companies in
manufacturing, small business, service, education, and healthcare that excel in
quality achievement and quality management. ISO 9000 is a set of certification
guidelines for quality management and quality standards developed by the
International Organization for Standardization in Geneva, Switzerland
(www.iso.ch/welcome.html). To be ISO-9000 certified, a firm must document a
process to ensure quality related to the design, development, production, final

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inspection and testing, installation, and servicing of products, services, and
processes. To be certified, an organization has to document its process for
controlling quality and must pass a rigorous third-party audit of its manufacturing
and customer-service processes.

As quality became a major focus of many businesses throughout the world, being
recognized as having high quality, or at least processes in place to ensure quality,
opens the door to potential customers, increases the confidence of current
customers, raises the morale of employees, and improves operating results. Many
European companies and governments purchase products or services only from
ISO-9000 certified firms.

16-5 Traditional accounting systems do not attempt to track the total cost of quality. That
is, quality-related costs are spread throughout various accounts, including overhead,
selling, general, and administrative expenses. As a result, organizations cannot
know how much of each sales dollar is consumed by quality costs and, further, for
any quality-related investments what the financial return might be. That is, traditional
systems are not helpful for managing and controlling quality and quality-related
costs.

16-6 Continuous improvement (Kaizen) in total quality management is the belief that
quality is not a destination; rather, it is a way of life and firms need to continuously
strive for better products with lower costs.

In today's globally competitive environment, where firms are forever trying to


outperform the competition and customers present ever-changing expectations, a
firm may never reach an ideal quality standard and, as such, needs to continuously
improve quality and reduce costs to remain competitive.

16-7 As illustrated in Exhibit 16.3, a comprehensive framework for managing quality


consists of a number of elements and characteristics. For example, the driving force
behind the framework is the goal of understanding and then satisfying customer
expectations. Second, consistent with the principle of TQM, the framework depicts a
cyclical (or continuous) process. Third, the framework includes the reporting and
analysis of both financial and nonfinancial quality indicators. Fourth, techniques
from outside of accounting (e.g., Taguchi loss functions, Six Sigma goals, Pareto
charts, cause-and-effect diagrams, etc.) are needed to help identify and then correct
quality problems. Finally, the framework depicts a process that involves the entire
value-chain of activities (i.e., upstream activities, production activities, and
downstream activities).

16-8 The purposes of conducting a periodic quality audit are to identify strengths and
weaknesses in quality practices and levels of a firms quality and to help the firm
identify the target areas for quality improvements.

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16-9 Six Sigma is an analytical method designed to achieve near-perfect results in terms
of quality. In statistics, the Greek letter sigma stands for standard deviation (i.e., a
measure of dispersion around a mean value). On a standard normal bell curve, one
sigma above and below the mean covers approximately 68% of the area. The
complement of this, 32%, represents the area outside of the mean +/- 1 standard
deviation. In absolute terms, a one-sigma quality level represents approximately
320,000 defects per million. A two-sigma quality level represents approximately
4,000 errors per million. By contrast, a Six-Sigma quality level represents
approximately 3.4 defects per million!

In terms of implementing Six Sigma, organizations typically use a DMAIC process.


In the Define stage, managers identify the underlying quality problem, establish
baseline measures and benchmarks (goals for improvement), and agree upon
measures of success.

In the Measurement stage, the Six Sigma team studies and evaluates relevant
measurement systems to determine whether they are capable of measuring key
inputs and quality attributes (e.g., product dimensions) with the desired level of
accuracy.

In the Analysis stage, the team performs graphical and statistical analyses in order
to develop preliminary hypotheses for improvement. This involves the identification
of root causes and the enablers of poor performance that need to be corrected.

In the Improve stage, the Six Sigma team designs and conducts experiments to find
the optimal conditions needed to operate the process.

In the final stage, Control, the team implements an on-going auditing and control
mechanism to help ensure the sustainability of the new process.

16-10 One can think of Six Sigma as a management process. Thus, the basic literature
from change management may provide useful tips for successfully implementing
such programs. Brewer and Eighme, Using Six Sigma to Improve the Finance
Function, Strategic Finance (May 2005), pp. 27-33, provide the following
implementation guidance regarding Six Sigma:

Provide necessary leadership and resourcesfor Six Sigma to succeed, the


CEO and other senior managers must commit to the program. Furthermore, they
must provide the necessary resources, such as funding, training, and time.
Finally, top management should get key people to buy into the need for Six
Sigma; once buy-in is secured by key people, others are likely to follow.
Use top talentusing top talent within the organization provides a strong signal
that top management is committed to Six Sigma.

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Make training ongoingavoid one-time-event training by providing refresher
courses for all Six-Sigma participants. Such courses not only reinforce prior
training, they also introduce new ideas.
Select initial projects carefully (i.e., simple ones with high probability of
success)successful projects build momentum and credibility.
Design projects for short-term winsshort-term wins provide confirmation
that efforts are paying off. Recognitions for a job well done along the way can
help sustain long-term commitment to Six Sigma projects.
Keep people informedto overcome the fear of change, people must
understand the reasons for change. Special efforts should be made to explain to
employees why current Six Sigma projects are needed and to keep them
informed as to the progress of such projects.
Set up a Websitea dedicated Six-Sigma Web site can help project teams
avoid reinventing the wheel by providing access to a project library and
message board.

16-11 Goalpost conformance is conformance to a quality specification expressed as a


specified range (quality tolerance) around the target, where the target is the ideal
value for the process.

16-12 A goalpost conformance specifies quality as a range around the target (or ideal)
value while absolute conformance requires exact meeting of the target value with no
variation allowed.

16-13 Taguchi argues that any variation from the exact specifications entails a cost or loss
to the firm and that this loss is a quadratic functionthat is, the loss grows larger as
the variation from target, in either direction, increases.

Deviation from the exact specification increases costs such as rework, loss on
disposal, warranty repair or replacement, and hidden quality losses such as
customer dissatisfaction and loss of future business and market share. In todays
global competitive environment, these quality costs increase rapidly as customers
become ever more demanding for complete satisfaction.

16-14 In general, financial data (such as COQ reports) will be more relevant to managers.
These individuals have overall decision-making authority and responsibility for the
financial results of operations. Note that such information is prepared only
periodically.

On the other hand, nonfinancial quality data are likely to be of greater value to
operating personnel. For one thing, such measures are readily understandable by
these individuals. For another thing, such information can be used by operating
personnel to make process changes/interventions. That is, they direct attention to
underlying quality problems in the process. Finally, such measures can be produced
on a timely basisin the extreme, in a real-time basis.

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16-15 Some examples of costs associated with cost of quality (COQ) categories are:

Prevention Costs: Training costs such as instructors fees, purchase of training


equipment, tuition for external training, training wages and salaries; salaries for
quality planning, cost of preventive equipment, printing and promotion costs for
quality programs, application expenses in conjunction with awards for quality; costs
incurred to certify suppliers; research on customer needs; quality audits.

Appraisal Costs: Cost of inspecting raw materials, work-in-process, and finished


goods inventories; maintenance of test equipment; process control monitoring;
inspecting machines; field testing; using statistical process control.

Internal Failure Costs: Net cost of scrap, rework cost, loss due to downgrade of
product (opportunity cost), re-inspection costs, and loss due to work interruptions.

External Failure Costs: handling of sales returns; customer complaint resolution;


sales allowances due to quality deficiency; warranty claims; product liability lawsuits;
service calls; product liability recalls; repair costs in the field; cancelled sales orders
due to quality deficiency; loss of sales and market share due to customer ill-will and
dissatisfaction.

16-16 Prevention costs rise during the early years of implementing TQM as the firm
engages in education to prepare its employees and in the planning and promotion
of the quality program. Appraisal costs will also likely rise during the early years of
TQM, because the firm needs to ensure that quality is actually being achieved. The
increase in appraisal cost, however, is most likely to occur at a slower pace than
those of the prevention costs because at the beginning of a TQM program there will
be substantial increases in quality training and in promotion to raise awareness on
the importance of quality.

The firm may see some decreases in internal and external failure costs in the early
years of implementing TQM. However, these two costs most likely will remain at
about the same level as before during the first several years of TQM. Many firms
may actually see internal failure cost rise, because of the higher standard
demanded by the TQM or the higher level of employees awareness on the critical
importance of perfection in every step of the process. As the firm makes progress in
TQM, both internal failure and external failure costs should decrease.

16-17 Costs of conformance are costs incurred to ensure that products or services meet
quality standards and include prevention costs and appraisal costs.

Internal and external failure costs are costs of nonconformance. They are costs
incurred or opportunity costs because of poor-quality outputs (goods or services).

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-5 The McGraw-Hill Companies 2008
16-18 Better prevention of poor quality often reduces all other costs of quality. With fewer
problems in quality, less appraisal is needed because the products are made right
the first time. Fewer defective units also reduce internal and external failure costs as
the occasion for repairs, rework, and recall decreases.

Thus, it is generally considered easier to design and build quality in than try to
inspect or repair quality in. Theoretically, if prevention efforts are completely
successful, there will be no need to incur appraisal costs and there will be no
internal failure or external failure costs. In practice, appraisal costs usually do not
decrease, partly because management needs to ensure that quality is there as
expected. Nonconformance costs, however, decrease at a much faster pace than
prevention costs increase.

16-19 A cost of quality (COQ) report describes quality cost items a firm incurred during the
reporting period. A COQ report can help users identify and recognize the effects of
their actions on quality costs and to pinpoint areas that need attention.

16-20 Tools for identifying and/or correcting quality problems include:

Control chartA graph that depicts successive observations taken at a constant


interval with the horizontal line representing time intervals, batch number, or
production run and the vertical line representing a measure of conformance to the
quality specification.

HistogramA graphical representation of the frequency of events or causes of an


indicated (i.e., identified) quality problem.

Pareto diagram (chart)A histogram of factors contributing to a quality problem,


ordered from the most to the least frequent.

Cause-and-effect (fishbone or Ishikawa) diagramA graph that consists of


spine, ribs, and bones. At the end of the horizontal spine is an indicated (specified)
quality problem. The spine itself connects causes to the effectthe quality problem.
Each branch or rib pointing into the spine describes a main cause of the problem.
Bones pointing to each rib are contributing factors to the cause.

16-21 A cause-and-effect diagram is a graphical method to represent a chain of causes


and effects used to sort out root causes and identify relationships between causes
or between variables. Because of its shape, the diagram also is called a fishbone
diagram. Cause-and-effect diagrams can be used diagnostically, in conjunction
with control charts, to identify the principal causes of an identified quality problem.

16-22 Typical main causes of quality problems in manufacturing operations are: 1)


machines, 2) materials, 3) methods, and 4) manpower.

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16-23 A Pareto chart (diagram) is a vertical bar chart (graph) displaying the frequency or
the number of occurrences of each quality problem, ordered from the most to the
least frequent. As such, a Pareto chart can be used diagnostically to identify the
primary sources of quality problems and to help managers prioritize quality
improvement efforts.

16-24 Customer-response time (CRT) is defined as the amount of time between the time a
customer places an order and the time the order is received by the customer. CRT
can be broken down into three components: receipt time (lapse of time between
when a customer places an order and when that order is received by
manufacturing); manufacturing lead time (the amount of time between when an
order is received by manufacturing and when that order is completedsee below);
and, delivery time (lapse of time between when an order is finished and when the
customer receives that order).
Manufacturing lead (manufacturing cycle) time is defined as the lapse of time
between when an order is received by manufacturing and when that order is
completed. Thus, manufacturing lead time is equal to the sum of waiting time +
processing (manufacturing) time.
Cycle time efficiency (also known as throughput time ratio or process cycle
efficiency) is the ratio of time spent on value-added activities to the sum of time
spent on value-added and non-value-added activities; for example, cycle time
efficiency = processing time/(processing time + moving time + storage time +
inspection time).

16-25 As indicated by Exhibit 16.3 and the accompanying discussion in the chapter,
management accountants are involved extensively in the design and operation of a
comprehensive model (framework) for managing and controlling quality. However,
the key role played by management accountants, because of their expertise in this
regard, is the generation of relevant financial and nonfinancial measures of quality.
In terms of the former, accounting provides relevant cost (and revenue) data that
decision-makers can use to evaluate the desirability of spending and investments in
quality. (This role is compatible with the discussion in Chapter 9 of the text.) As well,
management accountants play a key role in helping a cross-disciplinary team
develop a COQ reporting systemthat is, a comprehensive model, with
subcategories, for capturing quality costs across the value chain.
Also noted in Exhibit 16.3 is the use of nonfinancial quality indicators, both internal
and external (customer satisfaction measures). The management accountant would
typically be involved in the design of systems or processes that would capture and
report this information.
Finally, the management accountant can help in the design of two internal audit
functions associated with the comprehensive framework: one, the development of
quality audits (designed to ensure quality); two, the Control stage of Six Sigma
(where processes are put in place to monitor progress and to sustain the gains
associated with process improvements).

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16-26 To be relevant for decision-making, financial information (i.e., costs and revenues)
must meet the dual test of being: (a) a future item, that (b) differs between decision
alternatives. Relevant costs can also be defined as avoidable costs, or as the sum
of opportunity costs plus out-of-pocket costs.

In terms of quality-related spending and investments, firms can anticipate the


following financial benefits: reduction in scrap/waste costs; reductions in rework and
re-inspection costs; reduction in inventory-holding costs; reduction in inventory
recordkeeping costs; reduction in inventory financing costs; and, increases in sales
due to improvements in quality (e.g., reduction in production cycle times).

16-27 From a design standpoint, the following are likely desirable qualities (attributes) of a
COQ reporting system:

The system collects costs across the entire value chain, both internal and
external (so, for example, costs related to gathering consumer-preference data
and costs associated with certifying external suppliers would be captured as part
of the total cost of quality).
The system focuses on costing of activities (i.e., uses data obtained from an
ABC system).
The system includes both out-of-pocket and opportunity costs (the latter occur
within the performance failure category, i.e., either as an internal failure or an
external failure cost).
The system provides a breakdown of total quality-related costs according to
logical categories (such as prevention, appraisal, internal failure, and external
failure).
The system reports data in a time-series fashion (this would allow managers to
assess the financial effects of spending and investments in quality; it would also
allow managers to assess trade-offs between COQ categories over time).
The system includes some baseline or appropriate benchmark (e.g., quality
costs could be reported as a percentage of sales or as a percentage of total
operating costs; benchmarks could include best-in-class performance, either
on an internal or an external basis).

16-28 In most cases, external failure costs (of the four categories) would be most
damaging to the organization. Some costs within this category (e.g., product-liability
lawsuits) can be huge in terms of out-of-pocket terms. Other costs in this category
relate to loss of reputation or market share associated with customer dissatisfaction
or ill-will. These costs are referred to as opportunity costs and can also be huge in
dollar terms.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-8 The McGraw-Hill Companies 2008
16-29 As shown in Exhibit 16.1, investments in quality can lead to improved business
processes, which in turn result in improved quality of outputs (goods and services).
Improvement in quality of outputs reduces external failure costs (e.g., warranty
expenses), reduces the amount of inventory, can lower total manufacturing costs
(e.g., inspection, rework, and inventory control costs). On the revenue side,
improvements in quality can result in an improved product image of the company in
the mind of consumers and faster throughput times. These, in turn, can lead in the
mind of the consumer to higher perceived value of the organizations output, the
financial consequence of which is higher selling prices and increased market share.
The combination of reduced costs and increased revenues provides an increase in
financial performance (e.g., ROI, earnings per share, etc.).

16-30 High degree of process variation from target usually leads to variation in product
attributes, which are important contributors to the quality of a product. Significant
variation in process activities usually implies that there is an increased chance that
product attributes are below customer expectations. For this reason, the Taguchi
Loss Function is represented by a quadratic functionthe more the departure from
the target, the greater the assumed quality loss.

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BRIEF EXERCISES

16-31 Total customer response time (CRT) = order receipt time + order wait time +
production processing (manufacturing) time + order delivery time = 10 days + 15
days + 20 days + 10 days = 55 days.

16-32 Manufacturing cycle efficiency is defined as the ratio of value-added time to the
sum of value-added time + non-value-added time. In this case, PCE = 4/(4 + 4 +
3 + 2) = 4/13 = 31% (approximately). That is, actual processing time is
approximately 31% of total cycle time for a typical order. Note that manufacturing
cycle efficiency is also referred to as process cycle efficiency (PCE).

16-33 Manufacturing cycle efficiency = ratio of actual processing (manufacturing) time


to total cycle time (processing time + moving time + storage time + inspection
time) = 8/(8 + 2 + 5 + 1) = 8/16 = 50%. That is, for a typical order, actual
manufacturing (processing) time is 50% of total cycle time.

16-34 The estimated cost coefficient, k, in the Taguchi loss function is calculated as
follows:
2
L(x) = k (x T)
$500 = k (5)2
k = $20
16-35 The estimated total quality loss (cost) using the Taguchi loss function is calculated
as follows:
2
L(78) = $20 (78 75)

L(78) = $20 x 9 = $180


16-36 Average cost per unit, based on the Taguchi loss function, is:
2 2 2 2
EL(x) = k ( + D ) = $20 (2 + 0 ) = $80

16-37 Total prevention cost = equipment maintenance = $1,154; total appraisal cost =
product testing = $786. Total prevention + appraisal costs = $1,940.

16-38 Customer Response Time (CRT) = elapsed time between when a customer
places an order (September 1, 2008) and when the customer receives the order
(December 1, 2008). Thus, for this example, the CRT = 3 months.

Receipt time can be defined as the elapsed time between the date an order is
placed (September 1, 2008) and the date Manufacturing receives the order
(September 15, 2008). In this case, receipt time = 2 weeks.

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Manufacturing lead time (cycle time) is the elapsed time between when
Manufacturing Department receives an order (September 15, 2008) and when
actual manufacturing is completed (November 15, 2008). In this case,
manufacturing lead time is 2 months (8 weeks).

Manufacturing lead time (8 weeks) can be broken down into waiting time and
processing (manufacturing) time, as follows:

Manufacturing wait time = time between when manufacturing receives an order


(September 15, 2008) and when manufacturing on the order actually begins
(October 15, 2008). In this case, wait time = 4 weeks

Manufacturing (processing) time = time between when manufacturing


commences (October 15, 2008) and when the job is completed (November 15,
2008). In this case, processing time = 4 weeks.

Delivery time = time lapse between when an order is finished (November 15,
2008) and when the order is received by the customer (December 1, 2008). Here,
delivery time = 2 weeks.

16-39 Correct answer is a (an increase in conformance costs resulted in a higher-


quality product, and therefore a decrease in nonconformance costs).
Conformance costs include prevention and appraisal costs; nonconformance
costs include failure costs (internal and external). In the present case,
conformance costs in total increased by 50% in total while total failure costs
decreased by $655 (i.e., $1,390 $735).

16-40 Each TV set contains 100 components; thus, if each component is produced
according to a 3-sigma quality level, then the probability that a given unit will be
100
defect-free is: 0.997 = 0.740484. Therefore, the probability that a unit has one
or more defective modules is: 1 0.740484 = 0.259516. In practical terms, this
means that, on average, for each 100 sets produced only 74 will be defect-free.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-11 The McGraw-Hill Companies 2008
EXERCISES

16-41 Cost of Quality (COQ) ReportingMultiple-Choice (15 minutes)

1. d 5. b
2. c 6. d
3. b 7. b
4. e 8. c

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16-42 Interpretation of Six-Sigma quality expectations (ppm) (30 minutes)

Sigma One-Tailed Two-Tailed Errors (Defects)


1
Level Area Area Per Million
1 0.158655254 0.317310508 317,310.51
2 0.022750132 0.045500264 45,500.26
3 0.001349898 0.002699796 2,699.80
4 3.16712E-05 6.33425E-05 63.34
5 2.86652E-07 5.73303E-07 0.57
6 9.86588E-10 1.97318E-09 0.00
1
Excel formula: = 1 - NORMSDIST(n), where n = sigma level (1, 2,...)

The preceding data indicate suggest a common misconception regarding the quality
level assumed under Six Sigma. Only when a defect is defined as any deviation from
the targeted level of the attribute (i.e., only when the tolerance is zero) will the above
approach represent the maximum number of defects per million opportunities for error.
Note, for example, that the expected number of errors (defects) under Six Sigma is
approximately 2 per billion (when any deviation from target is considered a defect).

In actual practice, based on initial experience by Motorola, the application of Six Sigma
allows some variation (drift) around the target value. That is, there is an assumption
that no process can be maintained in perfect control (i.e., no drift at all). Thus, in
practice, a drift of 1.5 standard deviations around the target value is allowed. Any
deviation beyond this allowable drift would be considered a defect or out-of-control
process.

What this means is that a revised formula is needed to calculate the defects per million
as the Six Sigma methodology is applied in practice. According to Pyxdek
(http://www.qualitydigest.com/may01/html/ sixsigma.html) the Excel formula (under the
assumption of an allowable drift of 1.5 sigma) is: 1000000*(1-NORMSDIST(Z-1.5)),
where 1.5 = allowable drift (in standard deviations) and Z = Sigma level. For Z = 6.0,
the Excel formula returns: 3.398, the defect-per-million figure commonly, but perhaps
mistakenly, reported in the literature. (Also see, J. R. Evans and W. M. Lindsay, The
th
Management and Control of Quality, 6 ed. (South-Western, 2005), Chapter 10.

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16-43 Quality RatingsGraduate Business Programs (30 Minutes)

As indicated in the exercise, the various ranking sources to some extent use different
quality-related criteria. We provide an example response below, that is, an overview of
the ranking criteria used by U.S. News & World Report in their annual ranking of
graduate schools of business. U.S. News & World Report bases 40% of its judgment on
opinions of business school deans, program directors, and corporate recruiters.
Placement success accounts for 35% of the ranking, while the remaining 25% is based
on student selectivity. The intent of this question is not to develop a definitive listing of
quality criteria. Rather, the intent is to provide a nonmanufacturing example of quality
rankings that would likely be of interest to many students.
In the 2005 survey, all 399 master's programs in business accredited by AACSB
International were surveyed by U.S. News & World Report (347 responded, of which
240 provided the data needed to calculate rankings based on a weighted average of
the quality indicators described below).

Quality Assessment (weight = 40%):

Peer Assessment Score (25%)In the fall of 2005, business school deans and
directors of accredited master's programs in business were asked to rate programs
on a scale from "marginal" (1) to "outstanding" (5). Those individuals who did not
know enough about a school to evaluate it fairly were asked to mark "don't know." A
school's score is the average of all the respondents who rated it. Responses of
"don't know" counted neither for nor against a school. About 50 percent of those
surveyed responded.

Recruiter Assessment Score (15%)In the fall of 2005, corporate recruiters and
company contacts who hire from previously ranked programs were asked to rate
programs on a scale from "marginal" (1) to "outstanding" (5). Those individuals who
did not know enough about a school to evaluate it fairly were asked to mark "don't
know." A school's score is the average of all the respondents who rated it.
Responses of "don't know" counted neither for nor against a school. About 31
percent of those surveyed responded.

Placement Success (weight = 35%):

Mean Starting Salary and Bonus (14%)The average starting salary and bonus
of 2005 graduates of a full-time master's program in business. Salary figures are
based on the number of graduates that reported data. The mean signing bonus is
weighted by the proportion of those graduates that reported a bonus, since not
everyone who reported a base salary figure reported a signing bonus.

Employment Rates for Full-time Master's Program in Business Graduates


(11%)The employment rate for 2005 graduates of a full-time master's program in
business. Those not seeking jobs or for whom no job-seeking information is

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16-43 (Continued)

available are excluded. If the proportions of graduates for whom no job-seeking


information is available and who are not seeking jobs are high, then the information
is not used in calculating the rankings. Employment rates at graduation (0.07) and
three months after graduation (0.14) are used in the ranking model.

Student Selectivity (weight = 25%):

Mean GMAT Scores (16.25%)The average Graduate Management Admission


Test score of students entering the full-time program in fall 2005. Scores on the test
range from 200 to 800.
Mean Undergraduate GPA (7.5%)The average undergraduate grade-point
average of those students entering the full-time program in Fall 2005.
Acceptance Rate (1.25%)The percent of applicants to the full-time program in fall
2005 who were accepted.

Overall Program Rank: Data were standardized about their means, and standardized
scores were weighted, totaled, and rescaled so that the top school received a score of
100; others received their percentage of the top score.

Source: U.S. News & World Report, April 10, 2006 (or, http://www.usnews.com/usnews/
edu/grad/rankings/about/07biz_meth_brief.php, accessed on April 4, 2006).

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-16 The McGraw-Hill Companies 2008
16-44 Spotting Quality in Business Programs (30 Minutes)

The purpose of this exercise is to provide an example of nonfinancial quality measures


in a context likely to be of interest to most students, not to provide a definitive list. The
instructor might point out that, depending on the mission of the institution and its
competitive strategy, items listed below could be of greater or lesser importance (i.e.,
could be assigned different weights in evaluating the overall quality of a business
school).

Bulletin Boards: take a look at what is posted on the bulletin boards of the business
school. Will you find a cluttering of cheap magazine offers and offers for temporary
employment, or do you observe notices of distinguished visiting speakers, upcoming
chamber music series, meeting news from discipline-based student clubs, and fliers for
study-abroad opportunities and graduate education? (This is an example of what is
considered an unobtrusive indicator of educational quality.)

Intellectual capital represented in the Faculty: Are the faculty active in the
profession? Do they conduct research and publish in areas that support the educational
mission of the school?

Educational Content of the Curricula: Are the curricula offered in the business school
up to date? Are there specified educational objectives associated with each degree
program? Is there a comprehensive, program-level assessment plan to provide
assurances of learning?

Resources Devoted to Education: Does the program have adequate resources


(human and financial) to accomplish its specified mission? Is the institution financially
stable? Is there adequate spending on technology?

Student-Faculty Interactions: Are the faculty involved in significant out-of-classroom


activities related to the educational process? Is there ample opportunity for independent
studies and joint faculty-student research? Are there sufficient study-abroad
opportunities in which business school faculty participate?

Mission Statement/Vision Statement: What is the societal role fulfilled by the


business school? That is, how is the world different because this business school
exists? Is the mission of the school adequately communicated to stakeholders, both
internal and external?

Assurances of Learning: Does the institution have in place a process for determining
value added? That is, is there a formal process for determining learning outcomes vis-
-vis stated learning goals?

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-17 The McGraw-Hill Companies 2008
16-44 (Continued)

Diversity: Is there diversity of faculty background? To what extent does a diverse


student body exist?

Placement: What firms and organizations regularly recruit graduates of the business
school?

Alumni: How active are alumni in terms of providing financial support and placement
opportunities (i.e., internships and full-time jobs) for graduates? Does the school have
an active business advisory board/council? In what other ways are alumni involved in
the business school?

Characteristics of Entering Students: What are the average SAT scores and high
school ranks of the most recent entering class of freshmen?

Faculty Qualifications: From what institutions did faculty earn their terminal degrees?
What proportion of faculty is considered full-time? What percentage of faculty have
recent relevant professional experience? To what extent are faculty actively engaged in
the profession?

Source: The preceding listing of quality criteria is drawn from M. R. Blood, Spotting
Quality, Decision Line, Vol. 36, No. 4 (July 2005), pp. 1420.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-18 The McGraw-Hill Companies 2008
16-45 Management Accountings Role in Six Sigma (20-30 Minutes)

At the most general level, the management accountant (because of expertise in the
measurement process) should be included as a member of the cross-functional Six-
Sigma project team whose responsibility it is to focus on a particular business process,
improve that process, and then move on to another project. The role of the
management accountant on the project team can perhaps best be described within the
context of the five phases of the DMAIC approach to process improvement: Define,
Measure, Analyze, Improve, and Control.

In the define phase, management accountants, because they are in the best position
to observe and document waste and excessive costs, can help identify opportunities
that warrant Six-Sigma-type projects. As a follow-up, management accountants can
help in the project selection process by providing reliable data regarding estimated
costs (e.g., required resources degree of difficulty, chance of success) and benefits
(e.g., cost savings, customer impact, expected time for project completion) associated
with alternative projects under review. In other words, they can play a key role in
making sure that the organization does not assume projects where the expected
savings wont justify the investment of Six-Sigma resources.

In the measurement phase, the management accountant would work with other
members of the project team to determine whether the current measurement system is
able to collect accurate and timely data for both process inputs (e.g., temperatures,
speeds, pressures) and process outputs (e.g., product dimensions or product
performance). Furthermore, the management accountant in this phase of the project
helps define and measure the factors that have the most influence on process
performance.

In the analysis phase, the management accountant participates in the development of


process maps, development of hypotheses regarding potential root causes of quality-
related problems, and collection of data that either confirm or refute the hypothesized
root causes. Finally, the management accountant would help in the determination of the
most important root causes.

In the improvement phase, the project team chooses the most useful and feasible
solutions to the root causes identified in the preceding step. Here, the management
accountant can help verify and document that planned or anticipated improvement
actually occur.

Finally, in the control phase, the management accountant can help in the development
of control tools such as audits and check sheets that can be used to ensure
sustainability of the process improvements implemented in the preceding stage.

Source: F. Rudisill and D. Clary, The Management Accountants Role in Six Sigma,
Strategic Finance (November 2004), pp. 35-39.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-19 The McGraw-Hill Companies 2008
16-46 Applying Six-Sigma Principles to the Accounting Function (30 Minutes)

Perhaps the most fundamental step in the project is selection of an appropriate cross-
functional team, including a project champion (in this case, it was the CFO of the
organization) and a project leader (usually either a Green Belt or Black Belt). One
framework for the project management process is DMAIC (Design, Measure, Analyze,
Improve, and Control). In the present example, the DMAIC phases consisted of the
following stages:
The Define Stagethe project team developed a statement of the problem (Too many
hours are being spent preparing quarter-end financial statements.) and a goals
statement (Reduce direct hours worked for 18 schedules from over 100 hours to 26
hours.). The latter was determined in consultation with the primary customer of these
quarterly financial statements: the controller of the parent company. This stage also
included the development of a graphical representation of the quarterly closing process,
from the recording of journal entries to the electronic transmission (E-trans submission)
of 18 end-of-quarter schedules to the parent company.
The Measure Stagethe project team assessed the current cycle time of the quarterly
closing process and then developed a cycle-time goal for the process (in hours). The
current process consumed approximately 109 hours, as follows: preparation of eight
balance sheet schedules, 65 hours; preparation of eight income statement schedules,
16 hours; and, preparation of two inter/intracompany schedules, 28 hours. Thus, the
overall cycle-time reduction goal was approximately 84 hours!
The Analyze Stagein this stage, the team created a fish-bone (i.e., cause-and-
effect) diagram to identify possible root causes of the excessive cycle time for quarterly
closings. Four primary causes were identified: (1) a high number of hours were spent
on the balance sheet schedules, (2) the E-Trans submissions were started late in the
day; (3) one-time items were a surprise; and (4) there was a lack of valid references.
After completing the fish-bone diagram, the project team hypothesized that three critical
root causes were responsible for a large portion of the excess cycle time: (1) lack of
ongoing review of balance sheet and inter/intracompany schedules; (2) insufficient
automation in generating data; and (3) lack of communication in financial reporting. For
each of these three primary root causes, the team identified one or more failure
modes, that is, ways in which a process could fail and what could be done to prevent
or minimize such failures.
The Improve Stagefor each failure mode identified in the preceding stage, the
team calculated a risk priority number (RPN), which was defined as the product of
three characteristics of the failure mode: severity of the potential failure mode,
frequency of occurrence, and detectability. After all RPNs were calculated, the team
compiled a list of actions that addressed the causes of the potential failure modes.
Implementing these actions resulted in substantial process improvements: in the first
quarter alone, the total cycle time of the process was reduced to 32 hours, slightly
above the 26-hour goal.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-20 The McGraw-Hill Companies 2008
16-46 (Continued)

The Control Stagein a sense, the most important control-related decision occurred
at the beginning of the project: selection of the CFO as the project champion (process
owner). After the project had been completed, the team kept its measurement system
in place so schedule-preparation times could be monitored on an on-going basis. The
team also documented for future staff members new process procedures.

Source: P. C. Brewer and J. E. Eighme, Using Six Sigma to Improve the Finance
Function, Strategic Finance (May 2005), pp. 2733.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-21 The McGraw-Hill Companies 2008
16-47 Cost of Quality Reporting for Environmental Performance (2030 Minutes)

The purpose of this exercise is to get students to think strategically as to how COQ
reporting might be used as part of a comprehensive approach to the management and
control of environmental costs.

1. As global natural resources become more scarce, and therefore subject to


increasing demand, society may demand greater accountability as to the
environmental performance of businesses. One recognition of this is the ISO 14000
family of standards that relate to the processes organizations have in place to
ensure environmental quality. Other firms simply feel that, as with the case of
business ethics, good environmental performance can lead to sustainable
competitive advantage.

2. There is no set answer to this part of the assignment, but student samples might
include some of the following elements:

Prevention Costs:
Process design/redesign (to produce environmentally friendly outputs)
Product design/redesign (to consume fewer natural resources, emit fewer
by-products and pollutants, etc.)
Supplier evaluation/certification costs (for example, do preferred suppliers
have ISO 14000 certification?)
Product recycling costs
ISO 14000 application costs

Appraisal/Detection Costs:
Product or process inspection
Contamination testing
Verifying supplier environmental performance
Development of environmental performance standards

Internal Failure Costs:


Treating/Disposing of Toxic Materials
Maintaining Pollution-Control Equipment
Licensing of facilities for producing contaminants
Using materials and energy inefficiently

External Failure Costs:


Government-imposed fines
Restoring land to natural state
Cleaning up contaminated soil
Cleaning up a polluted lake
Loss of reputation

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-22 The McGraw-Hill Companies 2008
16-47 (Continued)

3. There are likely opposing points of view. Companies that are included in portfolios
of high performance in the environmental (or social) area are certainly likely to favor
such disclosures. Stockholders (and potential investors) may favor such disclosures,
particularly since the external failure costs that some companies face can have
devastating effects on the ability of an organization to be a going concern. That is,
investors may value the disclosure of environmental performance data as part of
their risk-management objectives. As well, companies that are performing well in
terms of environmental performance are likely to favor such disclosures to the
investing public.

On the negative side, there is a likely bias: unless all companies would be required
to disclose such information, it might be difficult to benchmark environmental
performance. Also, it may be difficult (or even impossible) to achieve
standardization, which may reduce the informativeness of such disclosures.
Finally, some companies may oppose the disclosure of this information for
competitive reasons (that is, the disclosure of such information might be used
strategically by the companys competitors).

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-23 The McGraw-Hill Companies 2008
16-48 Cost of Environmental Quality Report (30 Minutes)

1. Sample Cost of Environmental Quality Report:


% of Total
Operating
Amounts Subtotals Cost
Prevention Costs:
Employee training $100,000
Product design $140,000
Supplier certification $40,000 $280,000 2.8%
Detection Costs:
Process inspection $320,000 3.2%
Internal Failure Costs:
Depreciationpollution-
control equipment $400,000
Maintaining pollution-
control equipment $200,000 $600,000 6.0%
External Failure Costs:
Lake clean-up $500,000
Land restoration $700,000
Property-damage claim $600,000 $1,800,000 18.0%
Totals $3,000,000 30.0%

2. With only a single year of data, it is difficult to draw any meaningful conclusions.
However, a tentative conclusion is that the company may be spending far too little in
the conformance quality area (i.e., Prevention and Detection Costs) and, as a
consequence, is incurring significant failure costs in the environmental area.

3. Some qualities (attributes) of an effective (good) environmental quality cost


system:

Collect environmental quality-cost data from across the value chain (i.e., the
scope of data collection should be broad).
If possible, utilize activity-based cost (ABC) data, which could be used to
motivate (a) the elimination of non-value-added activities, and (b) improved
efficiency in the conduct of value-added activities.
Baseline data: environmental cost data should be compared to one or more
relevant benchmarks (sales, best-in-class performance, etc.).
Time-series results (data from a single time period are not likely to be very
informative and, in fact, can be misleading; the provision of time-series data will
inform management as to the success in reducing total spending in the
environmental cost area and trade-offs between categories).

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-24 The McGraw-Hill Companies 2008
16-49 Nonfinancial (operational) Control Measures: Environmental Performance
(1520 Minutes)

The purpose of this exercise is to get students to think about the process of developing
nonfinancial quality indicators, based on specified Environmental Objectives (five in the
present case). The purpose of these indicators is to gauge progress in accomplishing
the specified Environmental Objectives and, as such, to motivate improved quality in
environmental performance. The following answers are suggestive only:

Minimize Hazardous Materials:


Types and quantities of hazardous materials produced (in total,
and per unit of output)
Hazardous materials as a percentage of total materials cost
Productivity measures (ratio of hazardous outputs to inputs)

Minimize Raw Materials Usage:


Types and quantities of virgin (i.e., non-recycled) materials used (in total,
and per unit of output)
Productivity measures (e.g., ratio of outputs to virgin/raw materials
consumed)

Minimize Energy Requirements:


Types and quantities of energy consumed
Productivity measures (energy consumption per unit produced, etc.)

Minimize Release of Residues into the Environment:


Pounds of toxic waste produced
Cubic metric tons of effluents
Tons of greenhouse gases produced
Percent reduction in materials used for packing product

Maximize Opportunities to Recycle:


Pounds (or tons) of material recycled
Percentage of units of output that had to be remanufactured
Power (energy) produced from incineration

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-25 The McGraw-Hill Companies 2008
16-49 (Continued-1)

The instructor might want to use some of the following example disclosures from First
Energy Corporation (www.firstenergycorp.com/environment) for illustrative purposes:

Environmental Characteristics Associated with Various


Sources of Power Generation

Biomass Power Air Emissions & Solid Waste


Coal Power Air Emissions & Solid Waste
Hydro Power Wildlife Impacts
Natural Gas Power Air Emissions & Solid Waste
Nuclear Power Radioactive Wastes
Oil Power Air Emissions & Solid Waste
Other Sources Unknown Impacts
Solar Power No Significant Impacts
Unknown Purchased Resources Unknown Impacts
Wind Power Wildlife Impacts

Air Emission Disclosure: First Quarter 2005

First Energy Corp: Air Emissions--Projected vs. Actual,


Compared to Regional Average (2005)

30
25
20
Projected
Tons

15
Actual
10
5
0
Carbon Sulfur Dioxide Nitrogen Regional
Dioxide Oxides Average
Emissions

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-26 The McGraw-Hill Companies 2008
16-49 (Continued-2)

Radioactive Waste Produced:


Projected vs. Actual, 2004 & 2005

2004 2005
Projected Actual Projected Actual
Quantity Quantity Quantity Quantity Measure

High-Level
Radioactive 0.0036 0.0018 0.0040 0.0018 Lbs./1,000 kWh
Waste

Low-Level
Radioactive 0.0001 <0.0001 0.0001 <0.0001 Ft3/1,000 kWh
Waste

Source: www.firstengergycorp.com/environment

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-27 The McGraw-Hill Companies 2008
16-50 Graphical Depiction: Is there an Optimal Level of Spending on Quality, or,
Is Quality Free? (30-40 Minutes)

Quality is Free Representation

Revenues/
Costs

Revenues

Maximum
Profit
Level

Costs

Maximum quality level


(e.g., zero defects)

Quality

Interpretation: Under this conceptualization, profit maximization occurs under only


when total (i.e., maximum) quality-levels are achieved for the organizations outputs.
This view is based on a premise that customers seek the highest-quality products and
services and are willing to pay for this level of quality, even if at a premium price. Thus,
there is an underlying assumption that increases in spending on quality are more than
offset by increases in revenues; in short, quality is free. Individuals who subscribe to
this point of view maintain that increases in product and service quality lead to
increased customer satisfaction which, in turn, is a leading indicator of improved
financial performance.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-28 The McGraw-Hill Companies 2008
16-50 (Continued-1)

Diminishing-Returns Conceptualization

Cost of Total
Quality Cost of
Quality

Failure
Costs

Prevention &
Appraisal Costs

Quality
Zero Optimum Quality Maximum Level
Quality Level Quality

Interpretation: This conceptualization for spending on quality assumes a trade-off


between the costs and financial benefits of improving quality. As compared to the
previous graph, the one above suggests that optimum profits are obtained at a
quality level below maximum quality. In other words, at some point, there are
decreasing financial returns on additional spending on quality. Beyond a point, the
financial returns (benefits) from additional spending on quality are less than the
costs incurred to improve quality. This point is illustrated in the graph below.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-29 The McGraw-Hill Companies 2008
16-50 (Continued-2)

Diminishing Returns Conceptualization: Trading Off Costs and


Benefits for Spending on Quality
Page: 1
Same as above
Revenues
& Costs

Total
Costs

Total Maximum
Revenue Profit
s

Quality
Optimum Level
Quality Level

Basically, the above representation assumes that after a point, increases in quality
spending do not generate commensurate financial benefits (marginal revenues).
The quality is free argument would hold that marginal revenues always exceed
marginal costs. The diminishing-returns representation, however, assumes that,
as is the case with other economic activities, at some point the marginal cost of
increasing quality will exceed the marginal revenues from doing so.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-30 The McGraw-Hill Companies 2008
16-51 Pareto Diagram (15 min)

Page: 1
Fonts different from the rest of text.
Can not edit graphic. Let me know if
you want me to recreate it.

RESPONSE: I do not think it


necessary to recreate this. I would
leave it as is.

(1) (2) (3) (4) (5) (6)

(1) Personal emergency (32) (4) Unexpected visitor (11)


(2) A childs illness (26) (5) Overslept (9)
(3) Personal illness (12) (6) Car broke down (8)

Pareto Charts (Diagrams) can be used for diagnostic control purposes, that is, to
identify the primary causes of an identified quality problem (such as absenteeism)
and, as such, to identify possible solutions to the problem. These charts are named
after the Italian economist Wilfredo Pareto; they provide a prioritization of causes of
an indicated quality problem, based on frequency of occurrence. Thus, they focus
attention on causes that could offer the greatest potential for improving quality. A
loose interpretation of the information contained in Pareto charts is that a relatively
small number (e.g., 20%) of causes represent a majority (e.g., 80%) of reasons for
the quality failure (here, absenteeism).

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-31 The McGraw-Hill Companies 2008
16-52 COQ Histogram (30 min)

1. COQ Histogram

Genova Company: Cost of Quality as % of Cost of


Goods Sold, 2007 - 2009

70.00%

60.00%

50.00%

40.00%

30.00%

20.00%

10.00%

0.00%
Prevention Appraisal costs Internal failure External failure Total cost of
costs costs costs quality

2009 2008 2007

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-32 The McGraw-Hill Companies 2008
16-52 (continued)

2. Cost of Quality (COQ) as Percentage of Costs of Goods Sold (CGS):

2009 2008 2007


Prevention Costs 2.0% 4.0% 1.0%
Appraisal Costs 1.5% 2.5% 3.0%
Internal Failure Costs 14.0% 23.0% 27.0%
External Failure Costs 12.0% 18.0% 31.0%
Total Cost of Quality 29.5% 47.5% 62.0%

Prevention costs increased, then decreased, over the past three years.
Appraisal costs decreased steadily over the years.
Total failure costs, as well as internal and external components, decreased over
the years.
Total COQ as a percentage of CGS decreased from 62.0 percent to 29.5 percent.

3. The company can probably expect its total cost of quality to continue declining
provided it maintains adequate level of quality training and other efforts to prevent poor
quality from occurring and to continue emphasis on the importance of quality.

The company was able to see the results within one year of increased efforts in
prevention. The company increased its spending on prevention costs fourfold from
2007 to 2008 and both internal and external failure costs decreased in the same year
and continued into 2009. However, the company reduced its spending on prevention
costs in 2009 to only half of the level the year before; therefore, it may need to monitor
closely the internal failure and external failure costs in 2010. It will be a good
investment to increase prevention costs if the failure costs start to climb in 2010.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-33 The McGraw-Hill Companies 2008
16-53 Quality Cost Classification (5-10 min)

1. Internal failure cost

2. Internal failure cost

3. Appraisal cost

4. Prevention cost

5. Prevention cost

6. Prevention cost

7. External failure cost

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-34 The McGraw-Hill Companies 2008
16-54 Quality Cost Classification (10 min)

1. External failure cost

2. Internal failure cost

3. Appraisal cost

4. Internal failure cost

5. Appraisal cost

6. Prevention cost

7. Prevention cost

8. Prevention cost

9. External failure cost

10. External failure cost

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-35 The McGraw-Hill Companies 2008
16-55 Cost of Quality ImprovementRelevant Cost Analysis (20-30 Minutes)

1. Relevant cost analysis (short-term impact on annual operating profit):


Annual Cost of Lighting:
Cost of a new lighting system: $100,000 5 years = $20,000
Additional operating cost per year 5,000
Incremental cost per year $25,000
Annual Cost Savings:
Current cost of scrapped components:
50,000 units x 5% x $30/unit = $75,000
Cost of scrapped units with adequate lighting:
50,000 units x 3% x $30/unit = 45,000
Net annual cost savings 30,000
Net Annual Cost ($5,000)

2. Some additional factors that might bear on this decision:


Time-value-of money (this type of problem is an example of a capital budgeting
decision; as such, the time-value-of-money should be taken into consideration).
The reduction in waste/scrapped products produced effectively increases the
capacity of the manufacturing facilityare there any viable uses for this freed-up
capacity?
What effect might the improvement in quality have on the reputation of the company
and hence sales and market share?
The financial return from reducing scrap is limited (above) to the manufacturing cost
of units that must be discarded. Are there any additional cost savings that might be
realized because of the reduction in scrap costs?

3. As indicated in Exhibit 16.3 and the accompanying text discussion, the management
accountant plays a pervasive role in a comprehensive quality management and control
system. Fundamentally, the management accountant is involved in generating relevant
financial and nonfinancial quality-related data. Such data are used by managers for
decision-making purposes (as in this exercise) and for controlling quality-related costs.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-36 The McGraw-Hill Companies 2008
16-56 Cost of Quality Improvements (510 Minutes)

Cost of auditors $80,000 x 3 = $240,000

Office space and equipment 100,000

Total cost $340,000

Savings from reduced errors = $600,000 x 90% = 540,000

Net savings per year $200,000

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-37 The McGraw-Hill Companies 2008
16-57 Taguchi Loss Function Analysis (Appendix) (3040 Minutes)

1. Value of k, the cost coefficient, in the Taguchi Loss Function:


2
k = $20/0.0002
= $20/0.00000004 = $500,000,000

2. Expected Loss Using Taguchi Function:

Quality Loss Probability Expected


X L(x) f(x) Loss
0.1996 80 0.02 1.60
0.1997 45 0.05 2.25
0.1998 20 0.12 2.40
0.1999 5 0.11 0.55
0.2000 0 0.45 0.00
0.2001 5 0.10 0.50
0.2002 20 0.08 1.60
0.2003 45 0.05 2.25
0.2004 80 0.02 1.60
$12.75

3. Expected Loss Using Variance Data (see table below), per Albrecht and Roth, The
Measurement of Quality Costs: An Alternative Paradigm, Accounting Horizons (June
1992), pp. 1527:
2 2
a. D = (0.199991 0.2) , where 0.20 = target value and 0.199991 = x (bar)

= mean value of the quality characteristic

= 0.000000000081
2 2
b. Expected loss = k ( + D )
= $500,000,000 x (0.000000025419 + 0.000000000081)

= $12.75

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-38 The McGraw-Hill Companies 2008
16-57 (Continued)

2
X Probability, f(x) x*f(x) (x 0.199991) f(x)
0.1996 0.02 0.003992 0.00000000305762
0.1997 0.05 0.009985 0.00000000423405
0.1998 0.12 0.023976 0.00000000437772
0.1999 0.11 0.021989 0.00000000091091
0.2000 0.45 0.090000 0.00000000003645
0.2001 0.10 0.020010 0.00000000118810
0.2002 0.08 0.016016 0.00000000349448
0.2003 0.05 0.010015 0.00000000477405
0.2004 0.02 0.004008 0.00000000334562
x (bar) = 0.199991 0.00000002541900

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-39 The McGraw-Hill Companies 2008
16-58 Using Taguchi Function to Determine Tolerance (10 Minutes)

2
Total quality cost = k * (Tolerance), where k = cost coefficient and Tolerance =
quality tolerance allowed
2
$40.00 = k * (0.0001)

k = $4,000,000,000

The loss function, L(x), is therefore


2
$1.60 = $4,000,000,000 (x 0.2)

So that tolerance = 0.00002, which provides the following specification:


0.2 0.00002

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-40 The McGraw-Hill Companies 2008
16-59 Relevant Cost AnalysisConversion to JIT (20 Minutes)

Current After
Income Statement Items Situation JIT

Sales $1,350,000 $1,650,000 $300,000


Less: Costs
Direct materials 405,000 330,000 (75,000)
Direct labor 297,000 247,500 (49,500)
Variable overhead 378,000 165,000 (213,000)
Product-level support costs 162,000 82,500 (79,500)
Inventory carrying costs 18,000 3,000 (15,000)
Operating profit $90,000 $822,000 $732,000

Note to Instructor: An Excel spreadsheet solution file for this exercise is embedded in
this document. You can open the spreadsheet object that follows by doing the
following:

1. Right click anywhere in the worksheet area below.


2. Select worksheet object and then select Open.
3. To return to the Word document, select File and then Close and return to...
while you are in the spreadsheet mode. The screen should then return you to
the Word document.

16-59: Relevant Cost Analysis--Conversion to JIT Manufacturing

Data Input
Current After
Item Situation JIT
Manufacturing Costs as a Percentage of Sales:
Product-level support costs 12.00% 5.00%

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-41 The McGraw-Hill Companies 2008
16-60 Relevant Cost AnalysisQuality Improvements (20 Minutes)

Estimated cost savings resulting from the recently enacted quality program come from
two sources:

1. Manufacturing cost savings associated with the reduction in rework costs:

(reduction in reject rate) x (annual volume of output) x (total rework cost per unit)
x annual volume
= (0.05 0.035) x 15,000 units x [($480 70 200) + ($362 80) + ($80
40)]/unit
= (0.015) x 15,000 units/year x $532/unit = $119,700

2. Financing cost savings associated with the reduction in inventory holdings:

Reduction in Inventory Holdings = $400,000 $250,000 = $150,000


Estimated inventory carry cost rate, per annum x 0.12
Estimated annual savings due to reduction in inventories = $18,000

3. Total estimated savings due to quality improvement program

= rework cost savings + inventory financing cost savings

= $119,700 + $18,000 = $137,700

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-42 The McGraw-Hill Companies 2008
16-61 Control Chart (3040 Minutes)

1. Control ChartManufacturing Cycle Times (Weekly Data)

Control Chart: Destin Company


Manufacturing Cycle Time

26
(Weekly Average)

24
22
20
18 Average
16
14
12
10

10
11
12
#
1
2
3
4
5
6
7
8
9
k
ee
W

Week #

2. The target cycle time is 14.0 minutes; the lower control limit is 12.0 minutes and the
upper control limit is 16.0 minutes. As indicated in the accompanying Excel file, the
mean of the 12 weekly observations is 15.2, while the sample standard deviation is
3.6 minutes (which seems high).

Note: An Excel spreadsheet solution file for this exercise is embedded in this
document. You can open the spreadsheet object that follows by doing the following:

1. Right click anywhere in the worksheet area below.


2. Select worksheet object and then select Open.
3. To return to the Word document, select File and then Close and return to...
while you are in the spreadsheet mode. The screen should then return you to the
Word document.

16-61: Control Chart

Data Input
Average
Week # Cycle Time
1 12.5 Target Value = 14.0
2 18.0 Upper Limit Value - 16.0

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-43 The McGraw-Hill Companies 2008
16-61 (Continued)

3. As indicated in part (2), the mean of the sample observations (15.2) is not that far
from the target value (14.0). However, inspection of the control chart suggests wide
variability in the process, which is confirmed by the sample standard deviation of the
12 observations around the mean value of the dataset. As well, we note that six of the
12 observations lie outside of the control limits (4 exceed the upper control limit, while
2 are below the lower control limit). The control of process variability is one of the key
goals of quality improvement. It may be the case that the underlying process in this
case needs to be investigated in order to determine why there seems to be so much
variability in weekly cycle times. Perhaps some type of intervention/correction is
warranted.

4. Management can determine the upper and lower control limits on their control charts
through experience (e.g., trial and error) or through the use of statistical procedures.
When these control limits are determined statistically (based on process variability,
measured either by standard deviations or on the range of observations over time),
the control chart is referred to as a statistical control chart. Thus, the principal
difference between the two types of charts is the method used to construct the control
limits.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-44 The McGraw-Hill Companies 2008
16-62 Quality Cost Classification (10 Minutes)

1.
Internal External
Prevention Appraisal Failure Failure
a. Materials for repair of goods under
warranty x
b. Inspection of goods repaired under x
warranty
c. Processing customer returns x
d. Canceled sales orders due to
unsatisfactory products previously
delivered to its customers x
e. Maintenance costs for testing x
equipment
f. Inspecting finished goods x
g. Time spent to determine courses
needed for quality training x
h. Debugging production software x
before production begins
i. Technical help to resolve a
customers production problems that
may have been caused by bugs in the
software shipped with the companys x
product
j. Supervision of testing personnel x

2. Conformance costs include prevention and appraisal costs. Nonconformance costs


are internal and external failure costs.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-45 The McGraw-Hill Companies 2008
16-63 Quality Cost Classification (10 Minutes)

Internal External
Prevention Appraisal Failure Failure
a. Warranty repairs x

b. Scrap (net) x

c. Sales allowance granted due x


to blemish

d. Contribution margin of lost x


sales

e. Tuition for quality x


management courses
f. Raw materials inspections x
g. Work-in-process inspection x
h. Shipping cost for product x
replacements
i. Recallsprocessing costs
x

j. Attorneys fee for handling


environmental litigation x

k. Inspection of reworked x
products

l. Overtime premium caused by x


rework
m. Machine maintenance x
n. Tuning of testing equipment x

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-46 The McGraw-Hill Companies 2008
16-64 Cost of Quality Category (3040 Minutes)

1. Cost of Quality (COQ) Report


Internal External
Quality-Related Costs Prevention Appraisal Failure Failure
Rework (labor + materials) $6,000
Recalls (processing costs) $15,000
Reengineering efforts $9,000
Repairs to Equipment 12,000
Product Replacements 12,000
Retesting 5,000
Supervision (Inspection) $18,000
Scrap (net cost) 9,000
TrainingTQM 15,000
Testing of incoming 7,000
materials
Inspection of Work- 18,000
in-Process Inventories
Downtime (estimated lost
production) 10,000
Product liability insurance 9,000
Quality audits 5,000
Process evaluation (to
remove causes of defects) 1,000
Warranty repairs 15,000

2. Category Totals $25,000 $48,000 $42,000 $51,000

3. The company is currently spending the least on preventive costs. They should
concentrate their efforts on preventive costs because they prevent poor quality products
from being manufactured. Such failure costs (internal + external) are generally far
more costly to the organization. Therefore, by increasing the amount spent on
prevention, management should be able to reduce spending on the other cost of quality
categories.

4. There are a number of possible improvements to the COQ reporting framework


illustrated above:

It is not clear from the sample report above whether the company takes a value-
chain approach to collecting COQ data; that is, in theory COQ data should be
collected from across the entire value chain of activities, both internal and external
(another way to put this is that it is not clear from the report whether a
comprehensive framework is being used to collect COQ data for the organization)

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-47 The McGraw-Hill Companies 2008
16-64 (Continued)

Does Brooks Company have an activity-based costing (ABC) system? If so, it


should identify the drivers of good quality (and poor quality!) and the activity costs
across the value chain; armed with this information the company should work to
eliminate non-value-added costs of quality (such as internal and external failure
costs).

Relative cost informationbecause the sample report includes only absolute dollar
amounts, it is impossible to determine the relative importance of both total cost of
quality and the mix of spending across the four cost categories; thus, Brooks can
relate spending to total sales revenue for the period or perhaps total operating
expenses.

Benchmarkingas noted above, in the absolute it is difficult to draw conclusions


regarding spending on quality (in total, and across categories); thus, some type of
standard or benchmark information is needed against which the companys results
can be compared. One possibility is to compare this periods results to those from
last period. A comparison to budgeted results or best-in-class performance (either
internal or external) would likely be even more informative.

Time-series datain order to properly evaluate spending on quality (i.e., assess the
results of investments in quality), it is necessary to collect time-series data. That is,
there is generally a lag between time of investment outlay and realized financial
returnsas is the case with other capital budgeting investments. Ideally, for
example, a company would want to show a decrease in total COQ over time, with
perhaps a greater proportion of conformance, rather than failure, costs.

Relevant costsconsistent with the definition of relevant costs in Chapter 9, COQ


should include both out-of-pocket and opportunity costs.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-48 The McGraw-Hill Companies 2008
16-65 Cost of Quality (COQ) Analysis (4550 Minutes)

1 and 2. Cost of Quality (COQ) Report

Duncan Materials Company


Cost of Quality (COQ) Report
2008 and 2007
2008 2007
% of % of
Amount Sales Amount Sales
Sales $18,750 $15,000
Cost of Quality
Prevention Cost
Preventive equipment maintenance $60 $20
Vendor certification 60 10
Training of factory workers 140 40
Product design engineering 270 150
Total prevention costs $530 2.83% $220 1.47%
Appraisal Cost
Materials inspection 60 300
Production inspection 125 160
Finished product inspection 70 225
Product testingequipment maintenance 60 60
Product testing labor 90 210
Total appraisal costs $405 2.16% $955 6.37%
Internal Failure Cost
Scrap (net) 300 500
Rework (before shipment) 180 240
Emergency repair and maintenance 60 190
Total internal failure costs $540 2.88% $930 6.20%
External Failure Cost
Warranty repairs 400 700
Direct costs of returned goods 80 250
Field repairs 30 70
Product-liability settlement 60 360
Total external failure costs $570 3.04% $1,380 9.20%

Total cost of quality (COQ) $2,045 10.91% $3,485 23.23%

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-49 The McGraw-Hill Companies 2008
16-65 (Continued)
3. From 2007 to 2008, Duncans total cost of quality (COQ) has decreased from 23%
of sales to 11% of sales. Part of the decrease in COQ as a percentage of sales is
the higher sales in 2008 compared to 2007. However, even without the sales
increase, the total COQ has decreased, both in absolute and relative amount
($2,045/2007 sales of $15,000 = 13.6%).
Duncan increased spending in 2008 on prevention (241% of 2007 amount). As a
result, each of the other three categories of COQ (viz., appraisal, internal failure,
and external failure) decreased in 2008, in both absolute dollars and as a
percentage of sales dollars.

4. To complement the COQ data, the company may want to collect both internal and
external nonfinancial measures of quality, such as the following:
Internal Measures of Quality
The number of defects per period
Process yield (ratio of good output to total output)
Percentage first-pass yield
The percentage of defective units shipped to customers to total units of
products shipped
Throughput (or, throughput efficiency)
External Measures of Quality
The number of customer complaints
Difference between delivery date and date requested by the customer
On-time delivery percentage (total units shipped on or before the scheduled
date to the total units shipped)
Surveys of customer satisfaction

5. As should be obvious from an examination of Exhibit 16.3, there is a role for both
financial and nonfinancial quality data (metrics) in a comprehensive framework for
managing and controlling quality. COQ (i.e., financial) data are reported only
periodically. As such, they are likely of greater interest/value to managers. After all,
these are the individuals who ultimately have responsibility over financial
performance and who make spending and investment decisions regarding quality
costs.
Operating personnel, on the other hand, are likely to find nonfinancial quality
data to be more useful. For one thing, such data are expressed in terms that are
understandable/comprehensible to operating personnel. For another thing, these
measures focus attention on processes, techniques, and procedures that are at
the root cause of quality problems. Finally, to maximize the value of quality-related
data, the information should be presented to users as quickly as possiblein the
extreme, in real-time basis. Current accounting systems are less capable of
reporting financial data in such a timely basis. Thus, for all of the above reasons,
one can argue that nonfinancial quality indicators are likely of greater value to
operating personnel.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-50 The McGraw-Hill Companies 2008
16-66 Cost of Quality (COQ) AnalysisExcel Application (50 Minutes)

1-4: Cost of Quality (COQ)Excel-Generated Report

Duncan Materials Company


Cost of Quality Report
2008 and 2007
2008 2007
Cost as a Cost as a
Amount % of Sales Amount % of Sales
Sales $18,750 $15,000
Cost of Quality
Prevention Cost
Preventive equipment maintenance $60 $20
Vendor certification 60 10
Training of factory workers 140 40
Product design engineering 270 150
Total prevention costs $530 2.83% $220 1.47%
Appraisal Cost
Materials inspection 60 300
Production inspection 125 160
Finished product inspection 70 225
Product testing equipment
maintenance 60 60
Product testing labor 90 210
Total appraisal costs $405 2.16% $955 6.37%
Internal Failure Cost
Scrap 300 500
Rework before shipment 180 240
Emergency repair and maintenance 60 190
Total internal failure costs $540 2.88% $930 6.20%
External Failure Cost
Warranty repair 400 700
Direct costs of returned goods 80 250
Field Repairs 30 70
Product liability settlement 60 360
Total external failure costs $570 3.04% $1,380 9.20%

Total cost of quality $2,045 10.91% $3,485 23.23%

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-51 The McGraw-Hill Companies 2008
16-66 (Continued-1)

5. Data for Trend Analysis (2008 and 2007 Category Results)

Duncan Materials Company


Cost of Quality (COQ)Trend Analysis
2008 and 2007
2008 2007
Prevention costs 2.83% 1.47%
Appraisal costs 2.16% 6.37%
Internal failure costs 2.88% 6.20%
External failure costs 3.04% 9.20%
Total cost of quality 10.91% 23.23%

6. Bar Chart: COQ Report, 2008 and 2007

Cost of Quality as % of Sales

25.00%
20.00%
15.00%
10.00%
5.00%
0.00%
Prevention Appraisal Internal External Total cost
costs costs failure failure of quality
costs costs

2008 2007

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-52 The McGraw-Hill Companies 2008
16-66 (Continued-2)

7. Sensitivity Analysis

Duncan Materials Company


Cost of Quality (COQ) Report
Sensitivity Analysis

2008 2008Revised
Cost as a Cost as a
Amount % of Sales Amount % of Sales
1
Sales $18,750 $19,688
2
Prevention costs $530 2.83% $562 2.85%
Appraisal costs 405 2.16% 405 2.06%
3
Internal Failure Cost 540 2.88% 216 1.10%
4
External Failure Cost 570 3.04% 285 1.45%
Total COQ $2,045 10.91% $1,468 7.46%

Notes:
1 3
1.05 x $18,750 0.40 x $540
2 4
1.06 x $530 0.50 x $570

Note: An Excel spreadsheet solution file for this Problem is embedded in this
document. You can open the spreadsheet object that follows by doing the following:

1. Right click anywhere in the worksheet area below.


2. Select worksheet object and then select Open.
3. To return to the Word document, select File and then Close and return to...
while you are in the spreadsheet mode. The screen should then return you to the
Word document.

16-66: Duncan Materials Company

2008 2007
Sales $18,750 $15,000

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-53 The McGraw-Hill Companies 2008
16-67 Cost of Quality (COQ) Report (40 Minutes)
1&2
BUSTER COMPANY
Cost of Quality (COQ) Report
For 2008 and 2007

Cost of Quality 2008 2007


(COQ) Category Dollar % Dollar %
Prevention costs:
Quality training $ 40,000 $ 50,000
Product design 300,000 $340,000 5.67 270,000 $320,000 5.33

Appraisal costs:
Testing $80,000 80,000 1.33 $60,000 60,000 1.00

Internal failure costs:


Rework $200,000 $250,000
Retesting (defective
products) 50,000 90,000
Disposal of
defective units 90,000 340,000 5.67 85,000 425,000 7.08

External failure costs:


Product recalls $360,000 $500,000
Field service 230,000 590,000 9.83 350,000 850,000 14.17

Total Cost of Quality (COQ) $1,350,000 22.50 $1,655,000 27.58

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-54 The McGraw-Hill Companies 2008
16-67 (Continued)

There were slight increases in both prevention and appraisal costs from 2007 to
2008. The share of sales dollars consumed by each of these two categories also
increased slightly (0.33 percentage points). These two costs increased by
$40,000 over the two years.

Both internal failure costs and external failure costs decreased substantially in
2008 as compared to those in 2007. The company experienced a 1.41 percent
decrease in internal failure and a 4.34 percent decrease in external failure costs,
which together provided a total savings of $345,000. The savings was 863
(345,000/40,000) percent of the increase in the sum of conformance costs
(prevention plus appraisal cost).

3. Among nonfinancial measures the firm may want to monitor are:

The number of defects (e.g., per thousand or million opportunities)


Process yield (i.e., ratio of good output to total output)
Percentage first-pass yield (i.e., percentage of output meeting quality standards
upon initial production)
Throughput, in dollar of physical terms (or throughput efficiency, which is a
measure of outputs to resources used)
Average cycle time (i.e., total processing/manufacturing time for all units
produced divided by good units produced)
The percentage of defective units shipped to customers to total units of products
shipped
The number of customer complaints
Difference between delivery date and date requested by the customer
On-time delivery percentage (total units shipped on or before the scheduled date
to the total units shipped)
Surveys of customer satisfaction
Manufacturing lead time (i.e., the sum of order-wait time plus manufacturing/
processing time)

It should be noted that nonfinancial measures by themselves often have limited


meaning. Nonfinancial measures are more informative when trends of the same
measure over time are examined or when they are benchmarked against a relevant
standard, such as best-in-class performance (either internal or external).

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-55 The McGraw-Hill Companies 2008
16-68 Ethics (4045 Minutes)

1. COQ provides a general, comprehensive framework for reporting quality-related


costs using a four-category approach: prevention costs, detection/appraisal costs,
internal failure costs, and external failure costs. Thus, the COQ framework can
theoretically be applied to the management and control of environmental-related
quality costs. That is, it is theoretically possible for an organization to prepare a Cost
of Environmental Quality Report. Such a report would likely be of use to managers
for many of the same reasons that managers see value in a COQ report:

A Cost of Environmental Quality Report brings together environmental quality


costs into a single number, which can be an effective attention-getter for top
management (e.g., top management could see how much of each sales dollar is
consumed by environmental quality costs).
Such a report, if constructed using activity-cost data, can provide some direction
for controlling environmental costs: eliminate non-value-added environmental
activities and perform value-added activities more efficiently.
Using a category analysis allows decision-makers to assess the value of
spending trade-offs across categories (e.g., do investments in the prevention
area result in decreased environmental failure costs?).

2. Several Standards from the IMAs Statement of Ethical Professional Practice


(www.imaorg.net) relate to the ethical situation faced by Williams. The crux of the
matter, however, is that Williams has an ethical responsibility to take some action in
the matter of GroChem, Inc. and the dumping of toxic wastes. Specific Standards
that relate to the present context are as follows:

Competencemanagement accountants have a responsibility to perform their


professional duties in accordance with relevant laws and regulations.

Confidentialityin general, management accountants are required to keep


information confidential except when disclosure is authorized or legally required; in
this case, Williams may have a legal responsibility to take some type of action
regarding the dumping behavior.

Integritymanagement accountants have a responsibility to abstain from engaging


in or supporting any activity that might discredit the profession.

Credibilitymanagement accountants have a responsibility to disclose all relevant


information that could reasonably be expected to influence an intended users
understanding of reports or recommendations; furthermore, such accountants have
a responsibility to disclose deficiencies in information or internal controls, in
conformance with organization policy and/or applicable laws.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-56 The McGraw-Hill Companies 2008
16-68 (Continued)

3. In accordance with the IMA Standards, the first alternative (seeking the advice of
her boss) is appropriate. To resolve an ethical conflict, the IMA Standards specify
that the first step is to discuss the problem with the individuals immediate
supervisor, unless it appears that the supervisor is involved in the conflict. In this
case, it does not appear that Williams boss is involved.

Communication of confidential information to anyone outside the company is


inappropriate, unless there is a legal obligation to do so, in which case Williams
should contact the appropriate authorities.

Contacting a member of the Board of Directors would be inappropriate at this stage.


Basically, the IMA Standards specify that Williams should report the conflict to
successively higher levels within the organization and turn only to the Board of
Directors if the problem is not resolved at lower levels.

4. Jan Williams should follow the established policy of the organization bearing on the
resolution of such conflict. If these policies do not resolve the ethical conflict,
Williams should report the problem to successively higher levels of management, up
to the Board of Directors, until it is satisfactorily resolved. There is no requirement
for Williams to inform her superior of this action because there is credible evidence
that the supervisor is involved in the conflict. If the conflict is not resolved after
exhausting all courses of internal review, Williams may have no other recourse but
to resign from the organization and to submit an informative memo to an
appropriate member of the organization.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-57 The McGraw-Hill Companies 2008
16-69 Cost of Quality (COQ) Reporting (4550 Minutes)

1. Quality Cost Report: 2008 vs. 2007


2008 2007 % Change
PREVENTION COSTS
Systems development $ 680 $ 120 + 467
Quality engineering 1,650 1,080 + 53
Total $2,330 $1,200 + 94
APPRAISAL COSTS
Inspection $2,770 $1,700 + 63
Statistical process control (SPC) 270 - N/A
Supplies used in testing 40 30 + 33
Cost of testing equipment 390 270 + 44
Total $3,470 $2,000 + 74
INTERNAL FAILURE COSTS
Downtime due to quality problems $1,100 $ 600 + 83
Net cost of scrap 1,300 800 + 63
Rework labor 1,600 1,400 + 14
Total $4,000 $2,800 + 43
EXTERNAL FAILURE COSTS
Product recalls $ 600 $ 3,500 83
Warranty repairs 2,800 3,300 15
Customer returns 200 3,200 94
Total $ 3,600 $10,000 64
TOTAL QUALITY COSTS $13,400 $16,000 16

2.

12000
10000
8000
6000
4000
2000
0
Prevention Appraisal Internal External
Failure Failure

2008 2007

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-58 The McGraw-Hill Companies 2008
16-69 (Continued)

3. The firm increased spending on prevention and appraisal and saw its external
failure cost decrease by 64%. Although the internal failure costs increased from
2007 to 2008, the efforts to improve quality had begun to pay off as indicated by a
decrease of $2,600 (16%) in total quality cost from 2007 to 2008.

The most significant decreases in external failure costs were in costs for product
recalls and customer returns of defective goods. These two costs accounted for 42
percent of the total COQ in 2007. Decreases in these two cost categories in 2008
led to the decrease in the overall COQ. Customers were apparently more satisfied
with the product in 2008 than the year before.

4. No. The company has just started to improve its quality and increase customer
satisfaction. A cut in quality cost will likely jeopardize the improvements in quality
the company has achieved so far. Furthermore, the cut may cast doubt on the
dedication of the company to quality improvements. Continuing the efforts to
improve quality will eventually reduce the total cost of manufacturing and selling the
product, as the company witnessed in 2008. The company most likely will enjoy
increases in sales in the long run as its customers realize the high product quality of
the companys products.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-59 The McGraw-Hill Companies 2008
16-70 Cost of Quality (COQ) ReportingExcel-Generated Solution (4550 Minutes)

1. LEE ENTERPRISES
COST OF QUALITY REPORT
FOR YEARS 2008 AND 2007
2008 2007 % Change
PREVENTION COSTS
Systems development $106 $64 + 66
Quality engineering 80 56 + 43
Total $186 $120 + 55
APPRAISAL COSTS
Inspection $120 $ 76 + 58
Product testing 160 98 + 63
Statistical process control (SPC) 74 - N/A
Supplies used in testing 6 4 + 50
Depreciation of testing equipment 34 22 + 55
Total $394 $200 + 97
INTERNAL FAILURE COSTS
Disposal of defective products $ 76 $ 54 + 41
Net cost of scrap 124 86 + 44
Rework labor 200 140 + 43
Total $400 $280 + 43
EXTERNAL FAILURE COSTS
Product recalls $ 82 $ 340 76
Warranty repairs 140 420 67
Warranty replacements 18 60 70
Field servicing 120 180 33
Total $ 360 $1,000 64
TOTAL QUALITY COSTS $1,340 $1,600 16

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-60 The McGraw-Hill Companies 2008
16-70 (Continued-1)

2.
Cost of Quality (COQ) Summary: 2007 vs. 2008

$1,800
$1,600
$1,400
$1,200
$1,000
$800
$600
$400
$200
$0
Prevention Appraisal Internal External Total quality
failure failure cost

2008 2007

3. The report indicates that prevention, appraisal, and internal failure costs have increased
from 2007 to 2008. The external failure cost category decreased by 64%. It is likely that
the intensive efforts to improve quality has begun to pay off as, indicated by a decrease
of 16% in total COQ, from 2007 to 2008.

Lee Enterprises benefits from decreases in its external failure costs. Three external
failure costs (product recalls, warranty repairs, and warranty replacements) have
decreased by approximately 70 percent from what these costs were the year before.

The cost of field services decreased 33%. Some of the field services in 2008 were likely
for sales prior to the launching of the intensive quality-improvement effort. As the
company continues with its quality improvement program, field service costs should
continue to decrease.

4. One of the most effective ways for production workers to be conscientious in their work
is to hold them responsible for mistakes. Holding employees responsible for their work
can include a policy for workers to do rework on their own time and to pay for costs
incurred for rework. Lincoln Electric Company (Harvard Business School case) has
successfully implemented such a policy for years. However, Carrie Lee is more likely to
be successful in adopting this proposal if she can implement the new procedure
gradually over a period of two to three years. The firm also would need to revise its
compensation scheme to reflect the change.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-61 The McGraw-Hill Companies 2008
16-70 (Continued-2)

Note: An Excel spreadsheet solution file for this Problem is embedded in this
document. You can open the spreadsheet object that follows by doing the following:

1. Right click anywhere in the worksheet area below.


2. Select worksheet object and then select Open.
3. To return to the Word document, select File and then Close and return to...
while you are in the spreadsheet mode. The screen should then return you to the
Word document.

LEE ENTERPRISES
COST OF QUALITY REPORT
FOR YEARS 2007 AND 2008

2008 2007 % Change

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-62 The McGraw-Hill Companies 2008
16-71 Ethics (45 Minutes)

1. An examination of the IMAs Statement of Ethical Professional Practice


(www.imanet.org) suggests that Maria Sanchez likely violated the following standards
of ethical conduct when she asked Mary Stein to suppress pertinent information.

CompetenceMaria Sanchez, controller, has a responsibility to:

Provide decision support information and recommendations that are accurate,


clear, concise, and timely.
Perform professional duties in accordance with relevant laws, regulations, and
technical standards.

In this instance, Sanchezs request to Mary Stein, assistant controller, to suppress


information about the component failures is unethical. This action keeps both
Sanchez and Stein from performing their duties in accordance with technical
standards and has a favorable impact on earnings, as requested by Jim March, vice
president of manufacturing. Thus, the reported financial information with the omission
lacks relevance and reliability for decision-making. Management does not have a
clear solution to overcome the component failure.

IntegritySanchez has a responsibility to:

Mitigate actual conflicts of interest. Regularly communicate with business


associates to avoid apparent conflicts of interest. Advise all parties of any potential
conflicts.
Abstain from engaging in or supporting any activity that might discredit the
profession.

Sanchezs request is unethical because she has responsibilities to report all


information of use to decision-makers in the company. Thus, she has a responsibility
to protect the overall interests and goal attainment of the company by encouraging
further study of the problem, informing her superiors of this matter, and working with
others to find solutions.

CredibilitySanchez has a responsibility to:

Disclose all relevant information that could reasonably be expected to influence an


intended users understanding of the reports, analyses, or recommendations.
Disclose deficiencies in information, in accordance with organization policy and/or
applicable law.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-63 The McGraw-Hill Companies 2008
16-71 (Continued)

The request by Sanchez is unethical because it would suppress information that could
influence an understanding of the results of operations by the company. Also, by
withholding information about the contingent liability, Sanchez is not communicating
information objectively.

2. Resolution of Ethical Conflictthe IMA Standards specify that when an individual is


faced with ethical issues, the individual should follow the policies established by the
organization to deal with (resolve) such conflicts. If these policies do not resolve the
ethical conflict, then the following courses of action are recommended:
The individual should discuss the issue with his/her immediate supervisor (except
when it appears that the supervisor is involved). In this regard, Stein might want to
write a report that provides details regarding the issue, including the probable
economic effects of the situation at hand. As well, she might want to mention in the
memo the request by Sanchez to suppress information regarding the component
failures.
If Stein is not able to achieve a satisfactory resolution of the matter, she should
submit the issue to the next management level. (Note: contact with levels above the
immediate supervisor should be initiated only with the knowledge of the supervisor,
assuming he or she is not involved. Normally, communication of such problems to
authorities or individuals not employed by the organization is not considered
appropriate, unless the employee believes there is a clear violation of law.
Stein may then proceed to initiating a confidential discussion with an IMA Ethics
Counselor or other impartial advisor, in order to obtain a better understanding of
possible courses of action.
If, after exhausting all other options, the ethical conflict still exists, then Stein may
have no choice but to resign and to write an informative memorandum to the
appropriate organizational representative.
Finally, Stein may want to contact a qualified attorney to more fully determine her
legal obligations and rights concerning this ethical conflict.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-64 The McGraw-Hill Companies 2008
16-72 Relevant Costs and Quality Improvement (2030 min)

1.
Lightening Bulk Company
Cost and Benefit Analysis of the Proposed
Scheduling and Tracking System

Cost of the new system (per year) $ 150,000


Expected benefits each year from the new system:
Contribution margin from sales increase:
5,000 x 10% x $200 x 40% = $ 40,000
Savings from decrease in misplaced items:
5,500 x (12% 1.0%) x $60 = 36,300
Savings from decrease in lost items:
5,500 x (3.0% 0.50%) x $300 = 41,250 117,550
Pre-tax cash flow per year ($32,450)

The new scheduling and tracking system will most likely decrease the firms pre-tax
cash flow per year. Thus, from a purely financial point of view the company cannot
justify the purchase of the new system.

2. Among other factors the manager needs to consider are: reliability and accuracy of the
estimates, including contribution margins, cost of tracking misplaced and lost items (and
their behavior patterns), and the estimated decreases in misplaced and lost items; sales
growth; useful life of the new system; changes in technologies (how soon will a newer
system replace the new system); and, training cost, including possible downtime, for the
new system.

3. Cost to handle lost or misplaced items in the country in question:

Misplaced items: 5,000 x 12.0% x 0.8 x $60 = $28,800


Lost items: 5,000 x 3.0% x 0.8 x $300 = + 36,000
Total cost of lost/misplaced items $64,800
Expected decrease x 90%
Maximum amount to pay for improvements $58,320

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-65 The McGraw-Hill Companies 2008
16-73 Relevant Costs and Quality Improvement (50 Minutes)

1. Cost of new equipment and installation $12,000,000


Training 3,000,000
Net investment cost of the new process $15,000,000

2. Quality cost if no change is made:

Rework (3,000 x 40%) x $2,000/unit = $ 2,400,000


Repair (3,000 x 15%) x $2,500/unit = 1,125,000
Appraisal 600,000
Inspection 3,000 x $50 = 150,000
Foregone contribution from lost sales:
Contribution margin per unit:
($12,000 x 85%) $2,500 = $7,700
Lost sales units = (3,000 0.8) 3,000 = 750 5,775,000
Total current cost of quality per year = $10,050,000

Quality cost of the new process:


Warranty repairs (3,000 0.8) x 5.0% x $1,000/unit = 187,500
Savings from the new process each year $ 9,862,500
Years effective x 3
Savings over Three-Year Period $29,587,500
Appraisal and inspection cost, Year 1($600,000 +
$50/unit x 3,000 units) = 750,000
Total savings over 3 years $28,837,500

3. Yes. The cost of the new process is $15,000,000 and the expected benefits total
$28,837,500 over three years. The pattern of pre-tax cash flows for this investment
opportunity is as follows:

Year 0 = ($15,000,000)
Year 1 = $9,112,500 (i.e., $9,862,500 $750,000)
Year 2 = $9,862,500
Year 3 = $9,862,500

Thus, the payback period for this proposed investment is less than two years. Its
internal rate of return (IRR) is approximately 41%, as shown in the following screen
shot from Excel:

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-66 The McGraw-Hill Companies 2008
16-73 (Continued)

4. The following factors should be considered before making the final decision:

a. Accuracy of cost estimates, including:


contribution margin per unit
costs of current repair and rework
cost of repair with the new process
cost of the new process

b. Reliability of estimations of
rates of rework and repair
lost sales
amount of time before the current product become obsolete

c. Reaction of competitors

d. Time-value-of-money factor (discount rate) for capital budgeting decision-making

5. The member of the board would be right if we ignore the financial payoff of the new
process and if the company is going to be in business for only three years. Having
high-quality products, especially for a high-end product such as the one the company
is selling, is crucial for a long-term success.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-67 The McGraw-Hill Companies 2008
16-74 Taguchi Loss Function Analysis (Appendix) (1520 Minutes)

2
1. a. $150 = k x (0.0025)
k = $24,000,000
2
b. L(x = 0.1893) = $24,000,000 x (0.1893 0.1875) = $77.76

2
2. a. Total quality cost = k x (Tolerance)
2
$6 = $24,000,000 x (Tolerance)
Tolerance = 0.0005 inches
b. The specification should be set at 0.1875 0.0005

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-69 The McGraw-Hill Companies 2008
16-75 Taguchi Loss Function Analysis (Appendix) (1520 Minutes)

2
1. a. $200 = k x (5.0)
k = $8.00
2
b. L(x = 122) = $8.00 x (122 125)
= $72.00
2
2. a. Total quality cost = k x (Tolerance)
2
$12.00 = $8.00 x (Tolerance)
Tolerance = 1.2247
b. The specification should be set at 125 1.2247

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-70 The McGraw-Hill Companies 2008
16-76 Taguchi Loss Function Analysis (60 Minutes)
2
1. k = ($50 + $70)/(0.025) = $192,000

Measured Prob. Loss Function Weighted Loss Mean Diameter


2 2
Diameter (x) Freq. f(x) L(x) L(x) * f(x) x * f(x) (x xbar) f(x) *(x xbar)
1.232 4.4376 0.015400 0.001904275 0.000023803
1.240 0.0250 235.200 5.8800 0.031000 0.001270067 0.000031752
1.250 3 0.0375 120.000 4.5000 0.046875 0.000657307 0.000024649
1.258 2 0.0250 55.488 1.3872 0.031450 0.000311099 0.000007777
1.262 2 0.0250 32.448 0.8112 0.031550 0.000185995 0.000004650
1.270 3 0.0375 4.800 0.1800 0.047625 0.000031787 0.000001192
1.272 6 0.0750 1.728 0.1296 0.095400 0.000013235 0.000000993
1.273 6 0.0750 0.768 0.0576 0.095475 0.000006959 0.000000522
1.274 7 0.0875 0.192 0.0168 0.111475 0.000002683 0.000000235
1.275 18 0.2250 0 0 0.286875 0.000000407 0.000000092
1.276 8 0.1000 0.192 0.0192 0.127600 0.000000131 0.000000013
1.277 5 0.0625 0.768 0.0480 0.079813 0.000001855 0.000000116
1.280 2 0.0250 4.800 0.1200 0.032000 0.000019027 0.000000476
1.288 2 0.0250 32.448 0.8112 0.032200 0.000152819 0.000003820
1.292 2 0.0250 55.488 1.3872 0.032300 0.000267715 0.000006693
1.292 1 0.0125 55.488 0.6936 0.016150 0.000267715 0.000003346
1.294 4 0.0500 69.312 3.4656 0.064700 0.000337163 0.000016858
1.298 2 0.0250 101.568 2.5392 0.032450 0.000500059 0.000012501
1.300 2 0.0250 120.000 3.0000 0.032500 0.000593507 0.000014838
1.304 1 0.0125 161.472 2.0184 0.016300 0.000804403 0.000010055
1.320 1 0.0125 388.800 4.8600 0.016500 0.001967987 0.000024600
Totals 1.0000 36.3624 1.2756375 0.000188981

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-71 The McGraw-Hill Companies 2008
16-76 (Continued)

Mean actual diameter, X-bar = 1.275638


2 2
D = (1.275638 1.275000) = 0.00000040640625
2
= 0.000188981
EL(x) = $192,000 x (0.000188981 + 0.00000040640625) = $36.36
2. Allowed tolerance:
2
Repair Cost = k x (Tolerance)
2
$50 = $192,000 x (Tolerance)
Tolerance = 0.016 cm (i.e., specification = 1.291 to 1.259)
Alternative calculation for Tolerance, given Customer Tolerance, T0:
1/2
Tolerance = T0 x (C1/C2)
1/2
= 0.025 cm x ($50/$120)
= 0.025 cm x 0.645497 = 0.016 cm
Note: An Excel spreadsheet solution file for this Problem is embedded in this document.
You can open the spreadsheet object that follows by doing the following:

1. Right click anywhere in the worksheet area below.


2. Select worksheet object and then select Open.
3. To return to the Word document, select File and then Close and return to... while
you are in the spreadsheet mode. The screen should then return you to the Word
document.

16-76: Taguchi Loss Function Analysis

Inputs

Manufacturing Cost per Unit = $50.00


Handling/Shipping Costs for Repl. = $70.00
Total quality cost = $120.00

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-72 The McGraw-Hill Companies 2008
16-77 Analyzing Cost of Quality (COQ) Reports (50 Minutes)

1. There is an extensive literature in the area of change management from which


students can draw in order to respond to this question. Based on this literature, the
following factors might be mentioned as being critical for an organization's successful
quality program:

Evidence of top-management support, including motivational leadership and


resource commitments.
Training (including ongoing training and re-education) of those affected, including
employees and suppliers.
A cultural change leading to a corporate culture committed to the customer and to
continuous, dynamic improvement; related to this is the need to develop an effective
reward system (i.e., link performance and compensation).

2.
BERGEN, INC
Quality Cost Report
Most Recent and Most-Distant Quarter

6/30/2007 9/30/2008
% of % of % of % of
Quality Amount Quality Prod. Amount Quality Prod
Cost Category (In 000) Cost Cost (In 000) Cost Cost

Prevention $240 25 5.83 $270 46 5.99

Appraisal 205 21 4.98 116 20 2.57

Internal failure 188 20 4.56 102 17 2.26

External failure 331 34 8.03 103 17 2.28

Total COQ $964 100 23.4 $591 100 13.1

From an analysis of the COQ Report (oldest vs. most recent quarterly results) it would
appear that Bergen Inc.'s program has been successful because:
Total COQ as a percentage of total production cost has declined from 23.4% to
13.1%.
External failure costs, those costs signaling customer dissatisfaction, have declined
from 8.03% of total production cost to 2.28%. These declines in warranty repairs
and customer returns should translate into increased sales and lower costs (and
therefore increased profitability) in the future.
The total internal failure cost was 4.56% of the total production cost in 2007, and is
now only 2.26% of the total production cost.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-73 The McGraw-Hill Companies 2008
16-77 (Continued)
Appraisal costs have decreased 48%from 4.98% to 2.57% of production cost.
Higher initial quality (via Prevention expenditures) is likely reducing the demand for
testing.
Quality costs have shifted to the area of prevention where problems are solved
before the customer becomes involved. Prevention costs, such as maintenance,
training, and design reviews, have increased from 5.83% of total production to
5.99% and from 25% of total quality costs to 46%. This $30,000 increase was more
than offset by decreases in other quality costs.
3. Tony Reese's current reaction to the quality-improvement program is more favorable as
he is seeing the benefits of having the quality problems investigated and solved before
they reach the production floor. Because of improved designs, quality training, and
additional preproduction inspections, scrap, and rework costs have declined.
Production does not have to spend an inordinate amount of time with customer service
since those individuals are now making the product right the first time. It is plausible
that throughput has increased and that throughput time has decreased: work is now
moving much faster through the department. (Of course, this last assertion can be
tested through the collection of relevant nonfinancial quality indicators.)

4. To measure the opportunity cost of not implementing the quality program, Bergen Inc.
could assume that:
a. Sales and market share would continue to decline and then estimate the revenue
and income lost.
b. The company would have to compete on price rather than quality and calculate the
impact of having to lower product prices to do so.
5. This question is designed to make students think about a proper role of a COQ
reporting system as part of a comprehensive framework for managing and controlling
quality, such as the framework presented in Exhibit 16.3. The main point is that COQ
data can be a valuable attention-director. For example, many organizations (confirmed
by our own in-class discussions with MBA students) are surprised to see how much
spending (i.e., portion of each sales dollar) is consumed by spending on quality. For
many organizations, a reduction in overall quality costs can be a key to significantly
increasing financial performance (a point substantiated by the empirical evidence
referenced early in the chapter). Therefore, if COQ reports are accessible,
comprehensible, and viewed as reliable, they can inform managers and operating
personnel alike that quality failures can be exceedingly expensive to the organization.
However, COQ measures are not diagnostic in nature. That is, these financial
measures do not point to ways to eliminate quality problems; however, it does quantify
in financial terms the impact of these failures on profitability. In short, diagnostic
control of quality is probably better achieved through the application of techniques
borrowed from operations management (cause-and-effect diagrams, Pareto charts,
etc.) applied to nonfinancial measures of quality. This suggests, therefore, that one
characteristic of a comprehensive framework for managing and controlling quality is the
use of both financial and nonfinancial quality indicators.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-74 The McGraw-Hill Companies 2008
16-78 Expected Quality Cost, Confidence Intervals, and Sample Size
(30-40 Minutes, requires some material from Chapter 6: Cost Estimation)

1. Paragon Manufacturing would be willing to spend $509,000 annually to implement


quality control inspection of the housings before assembly begins. This amount is
equal to the expected cost of rejections and repairs without quality control
inspection, calculated as follows.

Expected Value of Housings


Rejected During Assembly
(1) (2) (1) x (2)
Quantity Probability Outcome
90 0.40 36
70 0.30 21
50 0.20 10
30 0.10 3
70
Expected Value of Housings
Rejected During Performance Testing
(1) (2) (1) x (2)
Quantity Probability Outcome
50 0.50 25
40 0.15 6
20 0.15 3
10 0.20 2
36

Cost/direct labor hour = $12.00 + 18.00 = $30.00 per hour

Cost of repair material = $7.00 x 0.5 = $3.50 per housing

Rejection/repair cost per production lot

= Cost of assembly rejections + Cost of performance test rejections


= (70 x $3.50) + (70 x 0.15 x $30) + (36 x $3.50) + (36 x 1.25 x $30)
= $245 + $315 + $126 + $1,350
= $2,036 per lot

Number of lots = Demand Lot size


= 200,000 800
= 250 lots
Annual cost = Cost per lot x Number of lots
= $2,036 x 250
= $509,000

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-75 The McGraw-Hill Companies 2008
16-78 (Continued)

2. The sample size that Ross Webster should select from a lot of 800 housings is 265
units, calculated as follows:
2
nc = (2.00) (0.01) (0.99)
2
(0.01)
= 0.0396 0.0001
= 396

nf = 396 (1 + (396 800))


= 396 1.495
= 264.88 or 265 units in sample

3. a. Two defective housings in a sample of 240 is a 0.0083 rejection or error rate


(2/240). Thus, this lot should be accepted as the error rate is less than one
percent, the acceptable rate.

b. Three defective housings in a sample of 240 is a 0.0125 rejection or error


rate (3/240). Thus, this lot should be rejected as the error rate exceeds one
percent, the acceptable rate.

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-76 The McGraw-Hill Companies 2008
16-79 Benefits of Switching to JIT (50-60 Minutes)

1. A JIT manufacturing approach is considerably different from a conventional


manufacturing system. Under JIT, an output is produced only when demanded
by the customer (internal or external). At the core of JIT is a strong
commitment to quality (i.e., eliminating or reducing processing delays,
eliminating or reducing inventory holdings, reductions in operator errors and
production waste). The conceptual goal is a manufacturing cycle efficiency
ratio equal to 1.0 (i.e., elimination of all non-value-added activities).
Under conventional manufacturing, outputs are produced according to a
production schedule that may or may not be tied directly to customer delivery
demands. Inventories of materials, WIP, and finished goods are kept on-hand
as a cushion to compensate for error, waste, and inefficiencies, or for
unforeseen circumstances. Normal inefficiencies, in fact, are built into
overhead application rates.

2. The response to this question can be crafted around an examination of Exhibit


16.3. As indicated in this exhibit, the management accountant, because of
expertise in the area of measurement, can supply to management relevant
cost information and relevant nonfinancial performance indicators associated
with a change in manufacturing process, such as a move to JIT.
Specifically, the management accountant can help estimate the financial
savings associated with inventory reductions and with manufacturing
efficiencies associated with JIT (e.g., reduction of scrap and rework costs), as
illustrated in this problem. However, the management accountant can also
assist in the development of nonfinancial quality indicators associated with the
move to JIT. Thus, manufacturing cycle time information, process yields, and
percentage first-pass yield data can all be collected to help assess the overall
benefits associated with the move to JIT. These characteristics of the
manufacturing process are important to monitor because they can be leading
indicators of future financial performance.
3. Annual benefits associated with the proposed move to JITin general,
improvements in quality, such as those associated with the adoption of JIT,
result in two separate benefits: increases in revenues (or, contribution margin),
and decreases in costs.

Estimated annual increase in contribution margin


= [($65 $35) x 52,000 units] + [($65 $50) x 40,000 units]
= $1,560,000 + $600,000 = $2,160,000

Estimated decrease in inventory carrying costs:


Pre-JIT Inventory Holdings:
Raw materials = 40,000 x $15 x 4/12 = $200,000
WIP Inventory = 40,000 x $25 x 3/12 = $250,000
Finished Goods = 40,000 x $40 x 2/12 = $266,667
Average Inventory Holdings = $716,667

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-77 The McGraw-Hill Companies 2008
16-79 (Continued)

Post-JIT Inventory Holdings:


Raw Materials = 52,000 x $12 x 2/12 = $104,000
WIP Inventory = 52,000 x $20 x 1.5/12 = $130,000
Finished Goods = 52,000 x $30 x 1/12 = $130,000
Average Inventory Holdings = $364,000

Difference in Average Inventory Holdings = $352,667


x Inventory Holding Cost Rate = x 15%
Estimated Decrease in Inventory Holding Costs = $52,900

Increase in annual lease cost


= $2,000,000 $500,000 = $1,500,000

Annual Cost/Benefit of Switch to JIT


= $2,160,000 + $52,900 $1,500,000 = $712,900

4. Based solely on the short-term financial effect, ABC should replace the
equipment and move to JIT. The annual pre-tax net benefit ($712,900)
greatly exceeds the one-time penalty the company would have to pay to
break its existing lease.

5. Additional considerations:

This decision is technically a capital budgeting decision; as such, the future


cash flows should be stated on an after-tax basis and discounted (at the
weighted-average cost of capital) back to present value.
Is the assumption regarding a constant sales price between the two
alternatives realistic? That is, could the company increase its selling price,
post-JIT, if it realizes a significant increase in the quality of its product?
JIT places significant pressures on employees and managers alike, to
constantly improve: is there an appropriate change agent in the
organization to lead this effort? Does the change have the full, and visible,
support of top management? Will appropriate incentives and rewards be
instituted to compensate employees for their efforts? Does the company
plan to include appropriate training programs to support the move to JIT?
Since JIT involves smooth and efficient flows throughout the entire value
chain, have suppliers and customers been consulted and included in any
planning efforts regarding the implementation of JIT?
Has the cost of collecting, reporting, and interpreting key nonfinancial
quality indicators been factored into the analysis?

Blocher, Stout, Cokins, Chen, Cost Management, 4/e 16-78 The McGraw-Hill Companies 2008