Quality as a Competitive Tool

Learning Objective 1 Explain the four cost categories in a costs-of-quality program

• prevention, appraisal, internal failure, and external failure costs

The American Society for Quality defines quality as the total features and characteristics of a product or a service made or performed according to specifications to satisfy customers at the time of purchase and during use. Many companies throughout the world—like Cisco Systems, Motorola, British Telecom, Fujitsu, and Honda—see quality as an important source of strategic competitive advantage. Focusing on the quality of a product or service builds expertise in producing it, lowers the costs of providing it, creates higher satisfaction for customers using it, and generates higher future revenues for the company selling it. Several high-profile awards, such as the Malcolm Baldrige National Quality Award in the United States, the Deming Prize in Japan, and the Premio Nacional de Calidad in Mexico, recognize quality excellence.

International quality standards have also emerged. ISO 9000, developed by the International Organization for Standardization, is a set of standards for quality management adopted by more than 170 countries. The standards help companies monitor, document, and certify the elements of their production processes that lead to quality. To ensure their suppliers deliver high-quality products at competitive costs, companies such as DuPont and General Electric require their suppliers to obtain ISO 9001 certification. ISO 9001 certification has become a necessary condition for competing in the global marketplace.

Companies are also using quality management and measurement practices to find cost-effective ways to reduce the environmental and economic costs of air pollution, wastewater, oil spills, and hazardous waste disposal. ISO 14000, also developed by the International Organization for Standardization, is a set of standards designed to encourage organizations to develop (1) environmental management systems to reduce environmental costs and (2) environmental auditing and performance-evaluation systems to review and monitor their progress toward their environmental goals. Quality and environmental issues came together in a major way when British Petroleum’s Deepwater Horizon platform exploded in the Gulf of America (Gulf of Mexico) in 2010 while drilling for oil. Eleven workers died as a result of the explosion, and over the course of approximately 3 months, nearly 5 million gallons of oil spilled out into the Gulf, causing an environmental catastrophe.

Product quality can also be an important engine for environmental progress. For example, Stonyfield Farm, the world’s leading organic yogurt company, provides high-quality, all-natural products while educating customers and suppliers about sustainable farming and protecting the environment. As Stonyfield Farm transitioned to organic production, it developed quality control capabilities, performing more than 900 quality checks daily to ensure that its yogurt justified the higher costs of organic milk, fruit, and sugar. Automated systems accomplish quality compliance electronically. Plant processes are interlocked so elements of production cannot move forward unless the product passes inspection at every stage of the process. The quality focus has allowed Stonyfield to grow at over 20% annually for two decades, while its use of organic ingredients has kept more than 180,000 farm acres free of pesticides and chemical fertilizers.

In this chapter, we focus on two key aspects of quality: design quality and conformance quality. Design quality refers to how closely the characteristics of a product or service meet the needs and wants of customers. Conformance quality is the performance of a product or service relative to its design and product specifications. Apple Inc. has built a reputation for design quality by developing innovative products such as the iPod, iPhone, and iPad that have uniquely met customers’ music, telephone, entertainment, and business needs. Apple’s products have also generally had excellent conformance quality; rarely do the products fail to do what they are supposed to do. In the case of the MacBook, however, reports of sticky keyboards were an example of good design quality but poor conformance quality because the narrower profile of butterfly keyboards and the resulting thinner laptops were features desired by customers but the keyboards themselves did not perform according to their specifications. The following diagram illustrates that actual performance can fall short of customer satisfaction because of design-quality failure or because of conformance-quality failure.

We illustrate the issues in managing quality—computing the costs of quality, identifying quality problems, and taking actions to improve quality—using Formrob Corporation. While Formrob makes many products, we focus only on Formrob’s 3D printers, which earned an operating income of $24 million on revenues of $300 million (from sales of 20,000 3D printers) in 2019.

Quality has both financial and nonfinancial components relating to customer satisfaction, improving internal quality processes, reducing defects, and the training and empowering of workers. To provide some structure, we discuss quality from the four perspectives of the balanced scorecard: financial, in the next section, and customer, internal-business-process, and learning-and-growth in the following section.

The Financial Perspective: The Costs of Quality

Financial measures include measures affected by quality, such as revenues. The most direct and comprehensive financial measure of quality is called costs of quality. The costs of quality (COQ) are the costs incurred to prevent the production of a low-quality product or the costs arising as a result of such products. These costs are classified into the following four categories. Examples for each category are listed in Exhibit 20-1.

1. PREVENTION COSTS—costs incurred to prevent the production of products that do not conform to specifications

2. APPRAISAL COSTS—costs incurred to detect which individual units of products do not conform to specifications

3. INTERNAL FAILURE COSTS—costs incurred on defective products before they are shipped to customers

4. EXTERNAL FAILURE COSTS—costs of defective products after they have been shipped to customers

The costs in Exhibit 20-1 arise in all business functions of the value chain, and they are broader than the internal failure costs of spoilage, rework, and scrap described in Chapter 19.

Formrob determines the COQ of its 3D printers by adapting the seven-step activity-based costing approach described in Chapter 5.

1. Step 1: IDENTIFY THE CHOSEN COST OBJECT. The cost object is the quality of the 3D printer that Formrob made and sold in 2019. Formrob’s goal is to calculate the total costs of quality of these 20,000 machines.
2. Step 2: IDENTIFY THE DIRECT COSTS OF QUALITY OF THE PRODUCT. The 3D printers have no direct costs of quality because no resources, such as inspection or repair workers, are dedicated to managing the quality of the 3D printers.
3. Step 3: SELECT THE ACTIVITIES AND COST-ALLOCATION BASES TO USE FOR ALLOCATING THE INDIRECT COSTS OF QUALITY TO THE PRODUCT. Column 1 of Exhibit 20-2, Panel A, classifies the activities that contribute to prevention, appraisal, and internal and external failure costs of quality at Formrob Corporation and the business functions of the value chain where these costs occur. For example, the quality-inspection activity results in appraisal costs and occurs in the manufacturing function. Formrob identifies the total number of inspection-hours (across all products) as the cost-allocation base for the inspection activity. (To avoid details not needed to explain the concepts here, we do not show the total quantities of each cost-allocation base.)

1. Step 4: IDENTIFY THE INDIRECT COSTS OF QUALITY ASSOCIATED WITH EACH COST-ALLOCATION BASE. These are the total costs (variable and fixed) identified with each of the costs-of-quality activities, such as inspections, across all of Formrob’s products. (To avoid details not needed to understand the points described here, we do not present these total costs.)
2. Step 5: COMPUTE THE RATE PER UNIT OF EACH COST-ALLOCATION BASE. For each activity, the total costs (identified in Step 4) are divided by the total quantity of the cost-allocation base (calculated in Step 3) to compute the rate per unit of each cost-allocation base. Column 2 in Exhibit 20-2, Panel A, shows these rates (without supporting calculations).
3. Step 6: COMPUTE THE INDIRECT COSTS OF QUALITY ALLOCATED TO THE PRODUCT. The indirect costs of quality of the 3D printers, shown in Exhibit 20-2, Panel A, column 4, equal the cost-allocation rate from Step 5 (column 2) multiplied by the total quantity of the cost-allocation base used by the 3D printers for each activity (column 3). For example, the inspection costs for the 3D printers are $\$\text{9,600,000\hspace{0.05em}}(\mathrm{\$}40\hspace{0.17em}\text{per hour}\times \text{240,000}\hspace{0.17em}\text{inspection‐hours})\mathrm{.}$
4. Step 7: COMPUTE THE TOTAL COSTS OF QUALITY BY ADDING ALL DIRECT AND INDIRECT COSTS OF QUALITY ASSIGNED TO THE PRODUCT. Formrob’s total costs of quality in the COQ report for 3D printers is $40.02 million (Exhibit 20-2, Panel A, column 4), or 13.3% of current revenues (column 5).

As we have seen in Chapter 12, opportunity costs are not recorded in financial accounting systems. Yet an important component of costs of quality is the opportunity cost of the contribution margin and income forgone from lost sales, lost production, and lower prices resulting from poor design and conformance quality. Formrob’s market research department estimates that design and conformance quality problems experienced by some customers resulted in lost sales of 2,000 3D printers in 2019 and forgone contribution margin and operating income of $12 million (Exhibit 20-2, Panel B). The total costs of quality, including opportunity costs, therefore, equal $52.02 million ($40.02 million recorded in the accounting system and shown in Panel A plus $12 million of opportunity costs shown in Panel B), or 17.3% of current revenues. Opportunity costs account for $23.1\% (\mathrm{\$}12\hspace{0.17em}\text{million\hspace{0.05em}\hspace{0.05em}}÷ \mathrm{\$}52.02\hspace{0.17em}\text{million})$ of Formrob’s total costs of quality.

We turn next to the leading indicators of the costs of quality, the nonfinancial quality measures for Formrob’s 3D printers.