Quality Costs2

Quality Costs A product that meets or exceeds ex ceeds its design specifications and is free of defects that mar its appearance or degrade its performance is said to have high quality of conformance . Note that if an economy car is free of defects, it can have a quality of conformance that is just as high as defect-free luxury car. The purchasers of economy cars cannot expect their cars to be as opulently as luxury cars, but they can and do expect to be free of defects. Preventing, detecting and dealing with defects cause costs that are called quality costs or costs c onfusing to some people. It does not refer to of quality. The use of the term "quality cost" is confusing costs such as using a higher grade leather to make a wallet or using 14K gold instead of gold  plating in jewelry. Instead the term quality cost refers to all of the costs that are incurred to  prevent defects or that result from defects in products. Qual it y costs  costs   can be broken down  can do wn into four broad groups. These four fou r groups are also termed as

four (4) types of quality costs. Two of these groups are known as prevention as prevention costs and andappraisal appraisal costs.. These are incurred in an effort to keep defective products from falling into the hands of costs customers. The other two groups of costs are known kno wn as internal failure costs an and dexternal failure costs.. Internal and external failure costs are incurred because defects are produced despite efforts costs to prevent them therefore these costs are also known kn own as costs of poor quality. The quality costs do not just relate to just manufacturing; rather, they relate to all the activities in a company from initial research and development developmen t (R & D) through customer service. Total quality cost can be quite high unless management gives this area special attention.

Control Activities Control activities are the policies, procedures, techniques, and mechanisms that help ensure that management's response to reduce risks identified during the risk assessment process is carried out. In other words, control activities are actions taken  to minimize risk. The need for a control activity is established in the risk assessment process. When the assessment identifies a significant risk to the achievement of an agency's a gency's objective, a corresponding control activity ac tivity or activities is determined and implemented. Control activities can be preventive or detective: Preventive activities  are designed to deter the occurrence of an undesirable event. The development of these controls involves predicting potential problems before they occur and implementing procedures to avoid them. Detective activities  are designed to identify undesirable events that do occur and alert management about what has happened. This enables management to take corrective action  promptly.

Internal control activities can be incorporated into the following:      

Policies Procedures Sequences or combinations of procedures Assignments of duties, responsibilities, and authorities Physical arrangements or processes Combinations of the above.

Failure Activities Environmental internal failure cost  are cost of activities performed because contaminants and waste have been produced but not discharge into the environment. Thus, internal failure costs are incurred to illuminate and manage contaminants or wastes once produced.

Internal failure activities have one of the two goals:  

To ensure that the contaminants and waste produced are not released to the environment To ensure that the level of the contaminants released to an amount that complies with environmental standards

Examples of internal failure activities include operating equipment to minimize or eliminate  pollution, treating and disposing of toxic materials, maintaining pollution equipment, licensing facilities for producing contaminants, and recycling scrap. Environmental External failure cost are the cost of activities performed after discharging contaminants and waste into the environment. Realized external failure cost  are those incurred and paid for by the firm. Examples of realized external failure activities are cleaning up a  polluted lake, cleaning up oil spills, cleaning up contaminated soil, using materials and energy inefficiently, settling personal injury claims from environmentally unsound practices, settling  property damage claims, restoring land to its natural state, and losing sales from a bad environmental reputation. Unrealized external failure cost, or societal costs, are caused by the firm but are incurred and paid for by parties outside the firm. Examples of societal cost include receiving medical care because of polluted air (individual welfare), losing lake for recreational use because of contamination (degradation), losing employment because of contamination (individual welfare), and damaging ecosystems from solid waste disposal (degradation).

Compliace Cost A Compliance cost  is expenditure of time or money in conforming with government requirements such as legislation or regulation. For example, people or organizations registered for value added taxhave the extra burden of having to keep detailed records of all input tax and output tax to facilitate the completion of VAT returns. This may necessitate them having to employ someone skilled in this field, which would be regarded a compliance cost.

Compliance costs arise from most government interventions. However, businesses, other organizations and private individuals should not incur more compliance costs than necessary. This requires an increased awareness of the balance between the costs of compliance and the objectives of government policy. In practical terms, this means compliance costs will be given due weight with other costs and benefits when new laws, regulation, and administrative  processes are being designed. The new requirement for a BCCS will help ensure that business compliance costs are given adequate upfront consideration in developing policy. Meeting Obligations Imposed by Regulation There are three broad categories of regulation: regulations that facilitate the collection of taxation or other monies b y the government (such as PAYE, ACC levies, student loan repayments); regulations that require businesses to record information or submit information to the government (such as statistics, company returns), or disclose information to third parties (such as company financial reporting requirements); regulations that impose obligations on business for the benefit of third parties (that is, regulation regarding matters such as consumer rights, environmental sustainability, health and safety, anti-discrimination, border control). The first two bullet points are requirements that create administrative responsibilities, while the third bullet arises from requirements that place protective obligations on business, and g enerally requires the business to change the way it operates in some way. In many cases, a single regulation will contain elements of both administrative responsibilities and protective obligations.

WORKING DEFINITION Compliance costs are the administrative and paperwork costs on business in meeting these government requirements. They include both the administrative burdens and all other compliance costs, such as equipment purchases, retooling, and recurrent production cost. Compliance costs are distinct from the direct costs of any government requirement, such as the amount of tax payable. Compliance costs of a regulatory proposal are only those incremental costs that arise from that  proposal. They do not include costs from activities that would have been carried out anyway. What are compliance cost? Meeting Obligations Imposed by Regulation

A Working Definition Some Costs Are Less Tangible Some Are Non-Quantifiable Compliance Cost versus Administrative and Economic Costs Non-Compliance Cost

Because the cascading effects of ongoing noncompliance can geometrically accelerate the costs of and number of people affected by a given case, prevention or, failing that, early recognition and intervention are vital.  Not Compliance Cost Reduction at Any Cost The overall costs of government action have to be set against the expected benefits. A fundamental requirement of sound policy analysis is that the expected benefits to society as a whole from government action will exceed the overall costs. Regulatory Impact Analysis (RIA) is used to demonstrate that there is a net-benefit associated with any proposed regulatory intervention.  Net Benefit = Benefits less Costs (administration/compliance/direct/economic) It is important to note that compliance costs are but one, albeit important, element of the overall costs which arise from any regulatory intervention. Therefore, policy-makers must give consideration to all the effects that the policy may create, including any compliance cost. The various effects of a policy (its cost and benefits) are also closely related, with changes in one often affecting another. As a result, changes designed to address compliance costs need to be considered in the light of: the effect on the benefit of the policy - for example, abolishing a tax removes the compliance cost but also the revenue from tax. Similarly, abolishing health and safety requirements in the work place risks accident or death; the effect on overall administration costs - for example, allowing businesses to provide information in flexible formats. This may reduce compliance costs at th e expense of greater administration cost; and different types of compliance cost - for example, new initiatives may increase the initial start-up compliance costs but can lower on-going costs. For example, using electronic means for sending information to the regulator. In designing policy, policy-makers need to ensure that the overall mix of costs and benefits  provides the greatest net benefit to society. Compliance cost reduction is unlikely to benefit society if it is made the sole objective of major changes or pursued in isolation. In orderto assess which trade-offs are worthwhile, information on the extent and nature of compliance costs is

required. Poorly considered changes could increase other costs unnecessarily and reduce the  potential benefits from any measure.

Four types of qualitycost: Prevention Costs: Generally the most effective way to manage quality costs is to avoid having defects in the first place. It is much less costly to prevent a problem from ever happening than it is to find and correct the problem after it has occurred. Prevention costs  support activities whose  purpose is to reduce the number of defects. Companies employ many techniques to prevent defects for example statistical process control, quality engineering, training, and a v ariety of tools from total quality management (TQM).

Prevention costs include activities relating to quality circles and statistical process control.Quality circles consist of small groups of employees that meet on a regular basis to discussways to improve quality. Both management and workers are included in these circles. Statistical process control  is a technique that is used to detect whether a process is in or out of control. An out of control process results in defective units and may be caused by a miscalibrated machine or some other factor. In statistical process control, workers use charts to monitor the quality of units that pass through their workstations. With these charts, workers can quickly spot  processes that are out of control and that are creating defects. Problems can be immediately corrected and further defects prevented rather than waiting for an inspector to catch the defect later.

Some companies provide technical support to their suppliers as a way of preventing defects. Particularly in just in time (JIT) systems, such support to suppliers is vital. In a JIT system, parts are delivered from suppliers just in time and in just the correct quantity to fill customer orders. There are no stockpiles of parts. If a defective p art is received from a supplier, the part cannot be used and the order for the ultimate customer cannot be filled in time. Hence every part received from suppliers must be free from defects. Consequently, companies that use just in time (JIT) often require that their supplier use sophisticated quality control programs such as statistical process control and that their suppliers certify that they will deliver parts and materials that are free of defects. Appraisal Costs: Any defective parts and products should be caught as early as possible in the  production process. Appraisal costs , which are sometimes called inspection costs, are incurred to identify defective products before the products are shipped to customers. Unfortunately  performing appraisal activates doesn't keep defects from happening again and most managers realize now that maintaining an army of inspectors is a costly and ineffective approach to quality control. Employees are increasingly being asked to be responsible for their own quality control. This approach along with designing products to be easy to manufacture properly, allows quality to be built into products rather than relying on inspections to get the defects out. Internal failure Costs: Failure costs are incurred when a product fails to conform to its design specifications. Failure costs can be either internal or ex ternal. Internal failure costs  result from identification of defects before they are shipped to customers. These costs include scrap, rejected

 products, reworking of defective units, and downtime caused by quality problem. The more effective a company's appraisal activities the greater the chan ce of catching defects internally and the greater the level of internal failure costs. This is the price that is paid to avoid incurring external failure costs, which can be devastating. External Failure Costs: When a defective product is delivered to customer, external failure cost is the result.External failure costs  include warranty, repairs and replacements, product recalls, liability arising from legal actions against a company, and lost sales arising from a reputation for  poor quality. Such costs can decimate profits.

In the past, some managers have taken the attitude, "Let's go ahead and ship everything to customers, and we'll take care of any problems under the warranty." This attitude generally results in high external failure costs, customer ill will, and declining market share and profits. External failure costs usually give rise to another intangible cost. The se intangible costs are hidden costs that involve the company's image. They can be three or four times greater than tangible costs. Missing a deadline or other quality problems can be intangible costs of quality. Internal failure costs, external failure costs and intangible costs that impair the goodwill of the company occur due to a poor quality so these costs are also known as costs of poor quality  by some persons. Examples of four types of quality cost are given below: Prevention Costs Systems development Quality engineering Quality training Quality circles statistical process control Supervision of prevention activities Quality data gathering, analysis, and reporting Quality improvement projects Technical support provided to suppliers

Internal Failure Costs  Net cost of scrap  Net cost of spoilage Rework labor and overhead Re-inspection of reworked products Retesting of reworked products Downtime caused by quality problems Disposal of defective products Analysis of the cause of defects in production Re-entering data because of keying errors Debugging software errors Appraisal Costs External Failure Costs Test and inspection of incoming materials Cost of field servicing and handling complaints Test and inspection of in-process goods Warranty repairs and replacements Final product testing and inspection Repairs and replacements beyond the warranty Supplies used in testing and inspection  period Supervision of testing and inspection activities Product recalls Depreciation of test equipment Liability arising from defective products Maintenance of test equipment Returns and allowances arising from quality Plant utilities in the inspection area  problems Field testing and appraisal at customer site Lost sales arising from a reputation for poor quality.

How to Distribute Quality Costs?

A company's total quality cost is likely to be very high unless management gives this area special attention. Experts say that these costs should be more in 2% to 4% range. How does a company reduces its total quality cost? The answer lies in how the quality costs are distributed. Total quality cost is a function of quality of conformance . A high quality of conformance means that a product is free of defects and a low quality of conformance means that a product has defects. In this sense an economy car may have a quality of conformance same as a very expensive car if it has no defects. Like wise an expensive car may have less quality of conformance if it has defects that effect its use. When the quality of conformance is low, total quality cost is high and most of this cost consists of cost of internal and external failure. A low quality of conformance means that a high percentage of units is defective and hence the company must incur high failure costs Ordinarily total quality cost drops rapidly as the quality of conformance increases. The best way to prevent defects from happening is to design processes that reduce the likelihood of defects and to continually monitor processes using statistical  process control methods. Quality Cost Report:

A quality cost report  details the prevention costs, appraisal costs, and internal failure costand external failure cost that arise from company's current level of defective products or services. Companies often construct a quality cost report that provides an estimate of the financial consequences of the company's current level of defects. A simple quality cost report is shown in the following example: Example of Quality Cost Report Ventura Company Quality Cost Report For the Year1 & 2

Year 2 Amount Percent

Year 1 Amount Percent

Prevention Cost

1,000,000

2.00%

650,000

1.30%

Appraisal Costs

1,500,000

3.00%

1,200,000

2.40%

Internal Failure Costs

3,000,000

6.00%

2,000,000

4.00%

External Failure Costs 2,000,000 ----------7,500,000 Total Quality Cost ======

4.00% --------15.00% =====

5,150,000 ---------9,000,000 ======

10.30% --------18.00% =====

Prevention cost increased by (1,000,000 –  650,000) = 350,000 Appraisal cost increased by (1,500,000 –  1,200,000) = 300,000 Internal Failure cost (3,000,000 –  2,000,000) = 1,000,000 Total Increase = 1,650,000 External failure cost decreased by = 3,150,000 Net Quality Cost Benefit = 3,150,000  –  1,650,000 = 1,500,000

Several things should be noted from the data in the quality cost report. First, note that the quality costs are poorly distributed in both years, with most of costs being traceable to either internal or external failure. The external failure costs are particularly high in year 1 in comparison to other costs. Second note that the company increased its spending on prevention and appraisal activities in year 2. As a result, internal failure costs went up in that year (from $2 million in first year to $3 million in year 2), but external failure costs dropped sharply (from $5.15 million in year 1 to $3 million in year 2). Because of the increase in appraisal activates in year 2,more defects were caught inside the company before they were shipped to the customers. This resulted in more cost for scrap, rework, and so forth, but saved huge amounts in warranty repairs, warranty replacements, and external failure costs. Third, note that as a result of greater emphasis on prevention and appraisal, total quality cost decreased inyear2.As continued emphasis is placed on prevention and appraisal in future years, total quality cost should continue to decrease. That is , future increases in prevention and appraisal costs should be more than offset by decreases in failure costs. Moreover, appraisal costs should also decrease as more effort is placed into prevention.