MANAGEMENT ACCOUNTING

Don R. Hansen
Maryanne M. Mowen
Nabil S. Elias
David W. Senkow

Copyright 2001 Nelson Thomson Learning

Chapter 16-1

Chapter Sixteen

Quality Costs and Productivity:

Measurement, Reporting, and Control

Chapter 16-2

Learning Objectives

Identify and describe the four types of quality

costs.
Prepare a quality cost report and explain the
difference between the conventional view of
acceptable quality level and the view
espoused by total quality control.
Explain why quality cost information is
needed and how it is used.
Explain what productivity is and calculate the
impact of productivity changes on profits.

Chapter 16-3

Quality Defined

Features (Quality of Design) refer to characteristics

of a product that differentiate functionally
similar products.

Example: Compare a Cadillac Seville with a Honda Civic. The

Seville is a luxury car with specially designed features and the
Civic is an economy car with standard features. Both are
designed to provide transportation but the design qualities are
obviously different.

Quality of Conformance is a measure of how well

the product meets its requirements or
specifications.

Example: If a Honda Civic does what it is designed to do

and does it well, quality exists. For example, if economy cars
are designed to provide reliable, low-cost, low-maintenance
transportation, the desired quality exists.

Chapter 16-4

Measuring Quality Costs

Prevention costs
Appraisal costs
Internal failure costs
External failure costs

Chapter 16-5

Examples of Quality Costs

Prevention costs

Appraisal Costs

Quality engineering
Quality training programs
Quality planning
Quality reporting
Supplier evaluation and selection
Quality audits
Quality circles
Field trials

Inspection of raw materials

Testing of raw materials
Packaging inspection
Supervising appraisal activities
Product acceptance
Process acceptance
Inspection of equipment
Test equipment

Design reviews

Outside endorsements

Chapter 16-6

Examples of Quality Costs

Internal failure costs

External failure costs

Scrap
Rework
Downtime (defect related)
Reinspection
Retesting
Design changes

Cost of recalls
Lost sales
Returns/allowances
Warranties
Repairs
Product liability
Customer dissatisfaction
Lost market share
Complaint adjustment

Chapter 16-7

Estimating Hidden Quality Costs

Hidden Quality Costs are
opportunity costs resulting from
poor quality.

The Multiplier Method

The Market Research Method
Taguchi Quality Loss Function

Chapter 16-8

The Multiplier Method

The multiplier method assumes that the total
failure cost is simply some multiple of
measured failure costs:
Total external failure cost = k(Measured external failure costs)
where k is the multiplier effect
If k =4, and the measured external failure costs are $2 million,
then the actual external failure costs are estimated to be $8
million.

Chapter 16-9

The Market Research Method

The market research method uses formal market
research methods to assess the effect of
poor quality on sales and market share.
Customer surveys and interviews with members of a
companys sales force can provide significant
insights into the magnitude of a companys hidden
costs.
Market research results can be used to project future
profit losses attributable to poor quality

Chapter 16-10

The Taguchi Quality Loss

Function
The Taguchi loss function
assumes any variation
from the target value of a
quality characteristic
causes hidden quality
costs.
Furthermore, the hidden quality
costs increase quadratically
as the actual value deviates
from the target value.

Chapter 16-11

Reporting Quality Costs

Quality Costs
Prevention costs:
Quality training
Reliability engineering
Appraisal costs:
Materials inspection
Product acceptance
Process acceptance
Internal failure costs:
Scrap
Rework
External failure costs:
Customer complaints
Warranty
Repair
Total quality costs

% of Sales

$35,000
80,000

$115,000

4.11%

$20,000
10,000
38,000

68,000

2.43%

$50,000
35,000

85,000

3.04 %

65,000
$333,000
=======

2.32%
11.90%
=====

$25,000
25,000
15,000
Chapter 16-12

Reporting Quality Costs

(continued)
Prevention costs
Internal failure costs

Appraisal costs
External failure costs

19.5%

25.5%
34.5%
20.5%

Chapter 16-13

AQL Quality Cost Graph

Cost of Failures

Cost

Cost of Control
0

100%
Optional (AQL)
Percent Defects
Chapter 16-14

Zero-Defect Graph
Total
Quality
Cost

Cost

Percent Defects
Chapter 16-15

100%

Multiple-Period Quality Costs

Assume the following data:
Quality Costs
Sales
1997
1998
1999
2000
2001

$440,000
423,000
412,500
392,000
280,000

Actual Sales
$2,200,000
2,350,000
2,750,000
2,800,000
2,800,000

Chapter 16-16

% of
20.0
18.0
15.0
14.0
10.0

% of
Sales

Multiple-Period Trend Graph:

Total Quality Costs

20
15
10
5

Year

3
5
Chapter 16-17

Multiple-Period Total Quality

Costs
Total Quality Costs as a % of Sales
25
Column 2
%of Sales

20
15
10
5
0
1997

1998

1999
Chapter 16-18

2000

2001

Multiple-Trend Analysis for

Individual Quality Costs
Assume the following quality cost data:
Prevention Appraisal
1997
1998
1999
2000
2001
1

6.0%1
6.0
5.4
5.6
4.4

4.5%
4.0
3.6
3.2
2.4

Expressed as a % of sales

Chapter 16-19

Internal
Failure
4.5%
3.5
3.0
3.1
3.0

External
Failure
6.0%
4.5
3.0
2.6
2.3

Multiple-Trend Analysis for

Individual Quality Costs
External Costs
Internal Costs
Appraisal
Prevention

25

% of
Sales

20
15
10
5
0
1997

1998

1999
Chapter 16-20

2000

2001

Productivity: Measurement and

Control
Productivity is the relationship between output and the
inputs used to produce the output.

Total productive efficiency is the point at

which two conditions are satisfied:
1. for any mix of inputs that will produce a
given output, no more of any one input is
used than necessary to produce the
output
2. given the mixes that satisfy the first
condition, the least costly mix is chosen.
Chapter 16-21

Illustration of Productivity
Improvement
Technical Efficiency is the condition where no more of
any one input is used than necessary to produce
a given output.
Technical efficiency improvement is when less inputs are
used to produce the same output or more output are
produced using the same input.
Current productivity
INPUTS / OUTPUT

Chapter 16-22

Illustration of Productivity
Improvement
Same output, fewer inputs:
INPUTS

OUTPUT

Chapter 16-23

Illustration of Productivity
Improvement
More outputs, same inputs:
INPUTS

OUTPUT

Chapter 16-24

Illustration of Productivity
Improvement
Input trade-off efficiency is when a less costly input mix is
used to produce the same output.
Combination I: Total cost of inputs = $20,000,000
INPUTS

OUTPUT

Chapter 16-25

Illustration of Productivity
Improvement
Combination II: Total cost of inputs = $27,000,000
INPUTS

OUTPUT

Of the two combinations that produce the same output,

the least costly combination would be chosen.

Chapter 16-26

Partial Productivity Measures

Partial Productivity Measurement:

Measuring productivity for one input at a time.
Partial Measure = Output/Input

Operational Productivity Measure:

Partial measure where both input and output
are expressed in physical terms.
Financial Productivity Measure:
Partial measure where both input and output
are expressed in dollars.

Chapter 16-27

Partial Productivity Measures

Example 1:
In 2000, Tick-Tock Company produced 100 clocks and used
200 direct labour hours and 50 kilograms of raw materials.
Compute the labour and materials productivity ratios.
Answer:
Labour productivity ratio
Materials productivity ratio

Chapter 16-28

= 100 clocks/200 hours

= 0.5 clocks per hr
= 100 clocks/50 kilogram
= 2 clocks per kilogram

Partial Productivity Measures

Example 2:
In 2001, Tick-Tock Company produced 100 clocks and used 175
direct labour hours and 40 kilograms of raw materials. Compute the
partial productivity ratios. Compared to 2000, has productivity
improved?
Answer:
A. Ratios computed:
labour productivity ratio

Materials productivity ratio

= 100 clocks/175 hrs

= 0.57 clocks per hr
= 100 clocks/40 kilograms
= 2.5 clocks per kilogram

B. Ratios compared:
2000
2001
labour
0.50
0.57
Materials
2.00
2.50
Both ratios have improved, so productivity has improved.
Chapter 16-29

Profile Measurement
Profile Measurement provides a series or a vector of
separate and distinct partial operational measures.
Example:
Kankul implements a new production and assembly process in
2001. Only now lets assume that the new process affects both
labour and materials. The following data for 2000 and 2001 are
available
2000
120,000
40,000
1,200,000

Number of motors produced

labour hours used
Materials used (kg)

Chapter 16-30

2001
150,000
37,500
1,428,571

Profile Analysis with No Trade-offs

Partial Productivity Ratios

2000 Profilea 2001 Profileb
labour productivity ratio
Materials productivity ratio

3.000
0.100

labour: 120,000 / 40,000; Materials: 120,000 / 1,200,000

blabour: 150,000 / 37,500; Materials: 150,000 / 1,428,571
a

Chapter 16-31

4.000
0.105

Profile Analysis with Trade-offs

Partial Productivity Ratios
2000 Profilea 2001 Profileb
labour productivity ratio
Materials productivity ratio

3.000
0.100

labour: 120,000 / 40,000; Materials: 120,000 / 1,200,000

blabour: 150,000 / 37,500; Materials: 150,000 / 1,700,000
a

Chapter 16-32

4.000
0.088

Profit-Linked Productivity Measurement

Profit-Linkage Rule: For the current period,
calculate the cost of the inputs that would have
been used in the absence of any productivity
change and compare this cost with the cost of
the inputs actually used. The difference in
costs is the amount by which profits changed
because of productivity changes.
To compute the inputs that would have been used
(PQ), use the following formula:
PQ = Current Output/Base-Period Productivity Ratio
Chapter 16-33

Profit-Linked Productivity
Measurement
Example:
Tick-Tock Company provided the following data for 2000 and 2001:
2000
2001
Production (no. of clocks)
100
120
Selling price
$500
$500
Materials used (kg.)
50
72
labour hours used
200
228
Cost per kg. of material
$5
$5
Cost per hr. of labour
$10
$10

Chapter 16-34

Profit-Linked Productivity Measurement

Compute the profit change attributable to productivity changes.
PQ (materials)
PQ (labour)
Profit change:

Input

= 120/2
= 120/0.5

PQ

PQ x P

= 60 kgs.
= 240 hrs.

AQ

AQ x P

(PQ x P) - (AQ x P)

Matls

60

$ 300

72

$ 360

$ (60)

labour

240

2,400

228

2,280

120

$2,700

$2,640

Profits have improved by $60 because of productivity changes.

Chapter 16-35

$ 60

Price-Recovery Component and

Gainsharing

The difference between the total profit change and

the profit-linked productivity change is called
the price-recovery component.
Gainsharing is providing to a companys entire
workforce cash incentives that are keyed to
quality and productivity gains.

Chapter 16-36

End of Chapter 16

Chapter 16-37