Weighing the Costs and Benefits of Improving Quality

Learning Objective 3 Use costs-of-quality measures to make decisions

Recall from the analysis of the cause-and-effect diagram that mishandling of the aluminum frame during transportation from a supplier’s warehouse to Formrob’s warehouse and then to the production line results in printed objects that have small holes in them. The frame must meet very precise specifications or else the 3D printer components (such as the printing bed, extruders, and motor) will not align exactly on the frame.

A team of engineers offers two solutions: (1) electronically inspect and test the frames before production starts or (2) redesign and strengthen the frames and their shipping containers to withstand mishandling during transportation. The cost structure of the costs of quality for 2020 is expected to be the same as the cost structure for 2019 presented in Exhibit 20-2.

To evaluate each alternative versus the status quo, managers focus on the relevant costs and benefits for each solution in 2020. How will total costs and total revenues change under each alternative? The relevant-cost and relevant-revenue analysis ignores all allocated costs (see Chapter 12).

Formrob uses a 1-year time horizon (2020) for the analysis because it plans to introduce a completely new line of 3D printers at the end of 2020. The new line is so different that the choice of either the inspection or the redesign alternative will have no effect on the sales of 3D printers in future years.

Exhibit 20-6 shows the relevant costs and benefits for each alternative.

Exhibit 20-6

Estimated Effects of Quality-Improvement Actions on Costs of Quality for 3D Printers at Formrob Corporation

Spreadsheet screenshot shows relevant costs and benefits of further inspecting incoming frames and redesigning frames.

Details are as follows:

Further Inspecting Incoming Frames

1. Relevant Items

Additional inspecting and testing costs

Total Benefits: $(400,000) in parentheses

Savings in rework costs:

2. Relevant Benefit per Unit: $40 per hour

3. Quantity: 24,000 hours

4.Total Benefits (product of above 2 and 3): 960,000

Savings in customer support costs:

2. Relevant Benefit per Unit: $20 per hour 

3. Quantity: 2,000 hours

4.Total Benefits (product of above 2 and 3): 40,000

Savings in transportation costs for repair parts

2. Relevant Benefit per Unit: $180 per load

3. Quantity: 500 loads

4.Total Benefits (product of above 2 and 3): 90,000

Savings in warranty repair costs:

2. Relevant Benefit per Unit: $45 per hour

3. Quantity: 20,000 hours

4.Total Benefits (product of above 2 and 3): 900,000

Total contribution margin from additional sales:

2. Relevant Benefit per Unit: $6000 per copier

3. Quantity: 250 copiers

4.Total Benefits (product of above 2 and 3): 1,500,000

Redesigning Frames

Additional process engineering costs

Total Benefits: $(300,000) in parentheses

Additional design engineering costs: $(160,000) in parentheses

Additional cost of frames ($10 per frame times 20,000 frames): $(200,000) in parentheses

Savings in rework costs:

2. Relevant Benefit per Unit: $40 per hour 

5. Quantity: 32,000 hours

6.Total Benefits (product of above 2 and 5): 1,280,000

Savings in customer support costs:

2. Relevant Benefit per Unit: $20 per hour

5. Quantity: 2,800 hours

6.Total Benefits (product of above 2 and 5): 56,000

Savings in transportation costs for repair parts

2. Relevant Benefit per Unit: $180 per load

5. Quantity: 700 loads

6.Total Benefits (product of above 2 and 5): 126,000

Savings in warranty repair costs:

2. Relevant Benefit per Unit: $45 per hour

5. Quantity: 28,000 hours

6.Total Benefits (product of above 2 and 5): 1,260,000

Total contribution margin from additional sales:

2. Relevant Benefit per Unit: $6000 per copier

5. Quantity: 300 copiers

6.Total Benefits (product of above 2 and 5): 1,800,000

Net cost savings and additional contribution margin

7. Sum of Total Benefits from Further Inspecting Incoming Frames: $3,090,000

8. Sum of Total Benefits from Redesigning Frames: $3,862,000 

Difference in favor of redesigning frames (difference between above 8 and 7): $772,000

  1. ESTIMATED INCREMENTAL COSTS: $400,000 for the inspection alternative; $660,000 for the redesign alternative ($300,000 for process engineering, $160,000 for design engineering, and $200,000 for the frames).
  2. COST SAVINGS FROM LOWER REWORK, CUSTOMER SUPPORT, AND REPAIRS: Exhibit 20-6, line 10, shows that reducing rework saves $40 per hour of rework. However, Exhibit 20-2, Panel A, column 2, line 13, shows that the total rework cost per hour is $100, not $40. Why the difference? Because as it improves quality, Formrob will save only the $40 variable cost per rework-hour, not the $60 in fixed cost per rework-hour. Exhibit 20-6, line 10, shows Formrob will save a total of $960,000 ($40 per hour×24,000 rework‐hours saved) if it inspects the frames versus $1,280,000 ($40 per rework‐hour×32,000 rework‐hours saved) if it redesigns the frames. Exhibit 20-6 also shows Formrob’s expected variable-cost savings for customer support (line 11), transportation (line 12), and warranty repair (line 13) for the two alternatives.
  3. INCREASED CONTRIBUTION MARGIN FROM HIGHER SALES AS A RESULT OF BUILDING A REPUTATION FOR QUALITY AND PERFORMANCE: Exhibit 20-6, line 14, shows $1,500,000 in higher contribution margins from selling 250 more 3D printers under the inspection alternative and $1,800,000 in higher contribution margins from selling 300 more 3D printers under the redesign alternative. Management should always look for opportunities to generate higher revenues, not just cost reductions, from quality improvements.

Exhibit 20-6 shows that both the inspection and the redesign alternatives yield net benefits relative to the status quo. However, consistent with value engineering, design for manufacturing, and Kaizen or continuous improvement that emphasize eliminating the root causes of defects, Formrob expects the net benefits from the redesign alternative to be $772,000 greater than the inspection alternative. Toyota has a similar philosophy emphasizing defect prevention (“front of the pipe solutions”) over defect inspection (“back of the pipe solutions”).

Note how quality improvements affect the costs of quality. Redesigning the frame increases Formrob’s prevention costs (the costs of process engineering, design engineering, and the cost of the frames themselves), but decreases the firm’s internal failure costs (rework) and external failure costs (customer-support costs, transportation costs, and warranty repairs). Improving quality also results in greater sales and higher contribution margins. COQ reports provide insight into quality improvements, allowing managers to compare trends over time. In successful quality programs, costs of quality and, in particular, internal and external failure costs as a percentage of revenues decrease over time. Many companies, such as Hewlett-Packard, go further and believe they should eliminate all failure costs and have zero defects.

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