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Chapter 16 Total Quality Management Teaching Notes for Cases 16-1: Precision Systems, Inc. This case illustrates that quality cost information can play an important role in alerting top management about the importance of quality improvement in a non-manufacturing department of a manufacturing firm. The case is based on the following article: Kalagnanam, S. S. and E. M. Matsumura, "Cost of Quality in an Order Entry Department," Journal of Cost Management (Fall 1995), pp. 68-74. The required questions are designed to acquaint students with some of the terminology of "cost of quality" and some aspects of conducting a cost of quality study. Quality costs, defined as those that arise because poor quality may exist or does exist, have been classified into the following four categories:    

Prevention (prevention of poor quality, or quality assurance); Appraisal (inspection and testing); Internal Failure (costs, such as rework or scrappage, for nonconforming products identified before delivery to customers); External Failure (costs, such as warranty expenses or freight charges, for nonconforming products delivered to customers).

This case focuses on prevention activities (see question 6), as well as internal failure and external failure costs for the order entry department at Precision Systems, Inc. Internal and external failures are defined with respect to the order entry department. Additional readings on quality costs: Kaplan, R. S. and A. A. Atkinson, Advanced Management Accounting, 2nd ed. (Englewood Cliffs, NJ: Prentice-Hall, Inc., 1989), chapter 10. Morse, W. J. and H. P. Roth, "Why Quality Costs are Important," Management Accounting, November 1987, pp. 42-43. Scholtes, P. R., L. S. Weiss and S. Reynard, Quality Improvement in the Office (Madison, WE Joiner Associates, Inc., 1988). Schonberger, R. S., "Total Quality Management Cuts a Broad Swath," Organizational Dynamics (Spring 1992), pp. 116-27.

Suggested Solutions to Required Questions 1.

Describe the role that assigning costs to order-entry errors played in quality improvement efforts at Precision Systems, Inc.

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This question is designed to help students recognize how cost management systems can interface with quality improvement efforts. As the case states, in spite of PSI's commitment to quality improvement, "the changes [in order entry] would not have been so vigorously pursued if cost information had not been presented. COQ information functioned as a catalyst to accelerate the improvement effort." This is because the cost figures captured the attention of top management. Other responses might include the following: 1) It made order entry aware of the dollar impact of its errors; 2) It provided a means of prioritizing quality improvement efforts.

2. Prepare a diagram illustrating the flow of activities between the order entry department and its suppliers, internal customers (those within PSI), and external customers (those external to PSI). There are many possible flows. For example, a sales representative may contact order entry to request a quote for a system for a customer. Subsequently, the customer order entry to place the order; order entry then generates and order acknowledge, which is sent to manufacturing, invoicing, and sales administration. Once the system has been shipped, an invoice is sent to the customer. Ultimately, collections will receive the invoice. Customer support will contact the customer to arrange installation, and will be available to answer questions over the phone. A request for parts from a service representative or directly from a customer would be routed to the stockroom, after which the part would be shipped and the customer would t billed. A request for service would result in an order acknowledgement being sent to the service department.

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Sales Administration

Customers (place orders)

Sales Representatives (request quotes)




OA (Orders Acknowledgement)




Customer Support

Order entry Service Representatives quotes) Technical Information and Marketing Departments


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3. Classify the failure items in Exhibit 1-1 into internal failure (identified as defective before delivery to internal or external customers) and external failure (nonconforming “products” delivered to internal or external customers) with respect to the order entry department. For each external failure item, identify which of order entry’s internal customers (i.e., other departments within PSI that use information from the order acknowledgment) will be affected. Items 1, 2, 5, 8, 19 and 12 are internal failures; the remaining are external failure items. Internal customers affected by external failure items are listed below. Item Number 3 4 6 7 9 11

Internal Customer(s) Affected Manufacturing, service, stockroom, invoicing Invoicing, accounting (profitability analysis) Manufacturing, service, stockroom, invoicing, accounting Shipping, invoicing, collections, customer support Manufacturing, service, stockroom Invoicing, collections, accounting

Other examples (not included in Exhibit 1): Error Type Incorrect serial # of system on OA Duplicate order Incorrect sales rep. Code

Internal Customer(s) Affected Service, customer support Stockroom, shipping, manufacturing, sales admin. Sales administration

4. For the order-entry process, how would you identify internal failures and external failures? Who would be involved in documenting these failures and their associated costs? Which individuals or departments should be involved in making improvements to the order entry process? An initial step would be to interview employees in order entry, as well as its suppliers and internal customers. Based on the interviews, data collection forms can be developed. For internal failures, order entry staff would keep track of the problems they encounter while preparing quotes and processing orders. For external failures, internal customers of order entry would keep track of the errors they encounter when using information from the quotes or order acknowledgements. Suppliers to order entry, internal customers of order entry, and order entry staff should be involved in making improvements to the order entry process. 5.

What costs, in addition to salary and fringe benefits, would you include in computing the cost of correcting errors? Possible responses include the following: Office equipment and office space Telephone (to clarify problems) Computer costs (making changes on the computer) Supplies (paper for printing new quotes or order acknowledgements) Lost interest and other costs associated from late payments by customers (due to invoicing mistakes resulting from order entry errors) Lost sales from new customers (due to delay in preparing quotes) Lost future sales from current dissatisfied customers (due to errors in order entry) Shipping costs on returns

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Rework costs Frustration and lower morale, possibly leading to poorer quality or high turnover Costs related to duplication in manufacturing Crisis management costs (express shipping) Lost revenues if underpricing Scrappage of returns 6.

Provide examples of incremental and breakthrough improvements that could be made in the order entry process. In particular, identify prevention activities that can be undertaken to reduce the number of errors. Describe how you would prioritize your suggestions for improvement. Students can brainstorm about possible improvements during a class discussion. Possible responses include: Incremental Improvements Empower employees Allow sales representatives to correct errors without approval. Urge order entry to improve communication with manufacturing and other departments. Provide feedback to order entry on types of errors, numbers of errors, and cost impact. Daily, by computer (suggestions for improvement) Educate sales representatives about effects of errors and about the process. Provide better training for sales representatives. Train sales representatives to develop accurate quotes and take on the order entry function. Have sales representatives take responsibility for the process. Track customer purchases to improve service to customers. Survey customers about problems; use the responses to prioritize problems. Stop the double-entry of information. Get input from order entry on development of forms. Implement checking in order entry to help prevent order acknowledgement errors. Develop a reward system that motivates error-free performance of sales reps. and order entry. Benchmark. Breakthrough Improvements Develop a computer system to decrease the number of times data are entered. Develop a spreadsheet or computer program to check for inconsistencies between P.O. and quotes. Check for duplication of orders. Check prices. Develop a computer system that allows sales representatives to prepare accurate quotes. Install a computer system linking order entry, manufacturing, invoicing, etc. Use cross-functional teams to manage "large" costs or different segments. Develop a system that allows parts customers to get their own quotes on-line.

Incremental Improvements Made by PSI 1) Key information for quotes is now obtained up-front by the sales representative; earlier, the sales representative faxed partial information to order entry and requested a quote. Order entry staff then spent a great deal of time obtaining missing information. With this change, the sales representative cannot request a quote until he/she has supplied key information to order entry staff. This could be considered a prevention activity.

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2) Customers are asked to include quotation numbers on their purchase orders. This allows PSI to match orders with quotes and avoid duplication in manufacturing. PSI prepares its manufacturing plan based on the quotes received because they have a reasonably good idea of which ones are likely to become firm orders. 3) Proper tools are provided to the order entry staff: Procedure manuals. Guidelines for sales discounting. Prior to this, the order entry staff had to call sales to seek clarifications regarding discounts. Printed configuration guides that contain information in the format that order entry requires. Prior to this, the formats did not always match. 4) Order-entry staff members are now responsible for both quotes and orders. Previously, some staff members were responsible for only quotes, and other staff members were responsible only for orders. This change had an immediate impact, as the person who prepared a quote now had responsibility for processing the subsequent order. 5) A regular feedback system is now in place. Each internal customer department provides feedback to order entry once every quarter. Benefits: Cycle time for preparing quotes was reduced by 60% and cycle time for processing orders was reduced by 50%. Also, order entry staff experienced greater pride in their work.

Breakthrough Improvement Efforts by PSI as of 1993 Many of these improvements are prevention activities. 1) PSI began working with a vendor to develop an on-line configurator that would configure their standard systems (order entry staff would avoid keying-in part numbers). 2) PSI planned to acquire a new, more integrated order entry system that can communicate with the configurator and turn a quote into an order acknowledgement when the order comes in. The system will also be able to generate an invoice, thereby avoiding re-keying the information. 3) PSI began working towards providing sales representatives with a laptop computer equipped with a built-in configurator. This will allow them to prepare quotes in the field. The anticipated benefits include a reduction in errors caused by incorrect or duplicate part numbers, and a reduction in cycle time for preparing quotes or processing orders and preparing invoices.

Prioritizing Improvement Activities Three considerations in prioritizing improvement activities are the perceived seriousness of the problems, the benefits of improvements, and the costs of the improvements. In this case study, the breakthrough improvement projects involve higher costs than the incremental improvement efforts. To identify the most serious problems, a Pareto analysis can be performed. In PSI's case, correcting order acknowledgement errors became the highest priority because of its associated cost of 7% of the salary and fringe benefits budget (see Exhibit 2).

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Update: Improvement Efforts by PSI as of 1996 The first incremental improvement, a stringent policy of sales representatives filling out quote forms correctly, was abandoned because the forms quickly became obsolete and the policy was unpopular with sales representatives. In addition, the policy slowed the quotation process. The initial vendor's quote for the desired configurator was judged unaffordable. After an 18month search, however, PSI was able to purchase a new integrated information system (including materials resource planning and accounting) that included a configurator. In the meantime, PSI developed an in-house configurator program that runs on the sales representatives' laptop computers. As a consequence, problems with missing, incorrect, or changed part numbers have been greatly reduced. Information on part numbers originates in manufacturing, and is maintained and kept current by the marketing department. A change from line-item pricing (listing each component part with its associated price) to bundling (listing the component parts but providing only a bottom-line price) reduced processing time because customers previously would call for verification if any one of the component prices on the invoice differed from what appeared on the quote. The current cycle typically runs as follows: Sales representative prepares a quote using laptop computer configurator and emails it to order entry; Order entry reviews the quote and sends a quote packet to send to the customer (Pricing on quote is reviewed by order entry supervisor); When the customer's order is received by order entry, the order is entered into PSI's system configurator; the order entry supervisor approves the order; The controller approves the order; The order acknowledgement is transmitted electronically to manufacturing; Manufacturing builds the product; The product is shipped; The invoice is generated the same day the product is shipped, with no further review. 7.

What nonfinancial quality indicators might be useful for the order entry department? How frequently should data be collected or information be reported? Can you make statements about the usefulness of cost-of-quality (COQ) information in comparison to nonfinancial indicators of quality? Nonfinancial indicators that might be useful in improving quality in the order entry department include: 1) The frequency of the different types of errors; 2) Time spent on correcting problems. Frequency of reporting is an important issue when implementing a COQ system. Options for frequency of tracking data and reporting include: 1) Keep track of the information on a daily basis but report monthly. Continue doing this until improvements are made and the information is no longer needed. The assumption is that continuous improvement projects will be undertaken to rectify the situation. 2) Collect sample data for a specified period once every quarter or six-month period, for example, and assess the changes in the magnitude of problems. The assumption is that results from the sample data will be used to make process improvements.

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COQ information is useful for the following reasons: 1) COQ quantifies the financial impact of the errors/problems, thereby providing a universally understood method of assessing the seriousness of the situation. As emphasized in question 1, COQ figures can play an important role in alerting top management to the seriousness of quality problems overall or in a particular area. 2) Quality cost systems cut across departmental boundaries, thereby providing a holistic measure of the benefits derived from improvement efforts. COQ information should be used in conjunction with nonfinancial indicators, as the latter provide the information actually required for making changes to the system.

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16-2 Kelsey Hospital The purpose of this case is to have students analyze and categorize costs of quality (COQ) in a nonprofit health care setting. The case describes the need for a quality costing system in a hospital and the development of such a system for two primary treatments (intubation and bronchodilator treatments) performed in the Respiratory Therapy Department of the hospital. A list of items pertaining to quality costs is presented and described for analysis, estimation, and categorization.

Teaching Notes In recent years, companies have realized that to be globally competitive, they must focus on the quality of their products and services. Traditionally, the costs relating to quality have been buried in other cost categories (i.e., administrative overhead). To evaluate the costs and benefits of efforts to enhance quality and also to better control costs relating to quality, the quality costs need to be segregated and properly measured. Therefore, many companies have established cost of quality systems. Cost classification is an important aspect of these systems because different categories are controlled differently, some categories are more serious in terms of future consequences than others, and investment in certain categories is believed to greatly reduce those in other categories. Determining and measuring costs of quality in a service organization are especially challenging. Manufacturing companies can inspect their products before delivery to customers and quality can be assessed visually or by the use of instruments. In contrast, service organizations cannot assess quality until after the service is rendered and measuring instruments are usually of no use because physical measurements are not applicable. Hence, it is much more difficult to determine and measure the costs of quality in a service organization than in a manufacturing firm. Manufacturing cost of quality cases have been written in settings such as electronics 1 and paper mills.2 The issues covered in these manufacturing cases are similar to those in the Kelsey Hospital case study, but how the costs are determined and measured in the service setting are more complex. With products, one can assess the quality of materials, the quality of product design, and the conformance to product specifications. In service settings, however, one is usually assessing quality associated with intangible items, making it a more nebulous exercise to measure quality costs. At least one service case exists in the context of a railroad 3 and involves the use of quality costs relating to environmental management. Kelsey Hospital also differs from most other manufacturing and service settings in that consideration needs to be given to quality perceptions of an outside customer group–third party payers. Furthermore, because health care organizations deal with human lives, quality is even more paramount than in most other types of organizations. The Kelsey Hospital case involves the analysis and categorization of quality costs in a nonprofit service setting. The case is based on an actual hospital’s experience with developing a cost of quality program, although all names in the case are fictional. The case largely involves opinionated discussion. The learning objectives for the case are as follows: 1. To help students understand different “customer” groups’ concerns and perceptions about quality; 1 Examples are: Signetics Corporation: Implementing a Quality Improvement Program (A), Stanford University, 1982; Texas Instruments: Cost of Quality (A), Harvard Business School, 1988. 2 Iron River Paper Mill, in Anthony, R. N. and V. Govindarajan, Management Control Systems, Irwin/McGraw-Hill, 1998, pp. 646-655. 3 Union Pacific Railroad: Using Cost of Quality in Environmental Management, Institute of Management Accountants (IMA), 1997.

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2. To help students understand the nature of the four cost of quality categories and its application in a health-care setting; 3. To help students understand how to measure costs of quality (COQ); 4. To help students understand how COQ measures can fit into a balanced scorecard (BSC). Students should have had prior exposure to some elementary material on costs of quality from either a cost/managerial accounting textbook4 or journal article.5 The case is appropriate for both undergraduate and graduate cost or managerial accounting courses. This case can be covered in a 50-minute class period. Kelsey Hospital has been used several times in undergraduate introductory managerial accounting classes immediately after textbook material on costs of quality has been covered. Lively discussions have ensued about customer perceptions and how to categorize the various costs. Drawing out additional quality costs from the students (particularly the undergraduate ones) can be challenging and it may be necessary to give some hints to them. Like most cases, when students are asked to turn in write-ups on this case prior to class discussion, there is a greater level of preparation than otherwise and this improves the quality of class discussion. However, because the case does not have complex technical accounting issues and contains no number crunching, it does not require a lot of advance preparation for students to meaningfully discuss the case. In fact, on one occasion, students were given 15 minutes of class time to read the case and the resulting class discussion was rather good. Students have reported that the case helps them better appreciate and understand costs of quality because they see it applied in a setting that they are familiar with rather than an obscure factory setting. While it may seem that some of the medical terminology would be unfamiliar to students, they seem to absorb it well from the case. Furthermore, class discussions tend to be centered around basic health-care issues and not medical complexities. Suggested solutions for the assignment questions are as follows: 1.

What groups and individuals are the "customers" of the respiratory therapy department? Describe the concerns and perceptions about quality that might differ across the different types of customer. Identify the problems that the different customers would want quality control to prevent, detect, or correct. Various "customer" groups include: • Patients • Contract physicians • Third­party payers such as insurance companies, HMOs, Medicare, and Medicaid • Other hospital departments that use the Respiratory Therapy Department's services (including "house" physicians) Different types of customers may have different perspectives on the quality of services they receive and may react differently to a given level of performance. Often, a patient cannot evaluate the quality of clinical treatment received. Most patients can only assess the quality of their treatment based on their contact with the hospital's staff. For instance, even if a therapist is highly skilled, if the therapist is   abrupt   or   rushed   during   therapy,   the   patient   may   evaluate   the   quality   of   treatment   as   low.

4 Examples are: Barefield, J.T., C.A. Raiborn, and M.R. Kinney, Cost Accounting: Traditions and Innovations, Southwestern, 2003, pp. 310-321; Horngren, C.T., S.M. Datar, and G. Foster, Cost Accounting: A Managerial Emphasis, Prentice-Hall, 2003, pp. 654-663. 5 Examples are: Carr, L.P., “Cost of Quality—Making It Work,” Journal of Cost Management, Spring 1995, pp. 6165; Kalagnanam, S. S. and E. M. Matsumura, “Cost of Quality in an Order-Entry Department,” Journal of Cost Management, Fall 1995, pp. 68-74.

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Perceptions may also differ for different treatments. For instance, while customer relations may be important   for   the   bronchodilator   treatment,   it   will   be   relatively   unimportant   for   the   emergency intubation treatment. As for contract physicians, hospitals must compete for their patronage by providing them quality in services they consider important. Also, the contract physicians usually are the ones who choose which hospital the patient will receive treatment.  Nowadays, third party payers typically pay standard rates for many of the procedures that would be performed in Respiratory Therapy. Hence, the rates they pay are not as affected by poor quality. However, while teaching institutions such as Kelsey Hospital generally have very good clinical reputations, they are notoriously inefficient (e.g., performing unnecessary procedures or having to repeat procedures). Consequently, third-party payers tend to try to limit or exclude services from these institutions. Thus, Kelsey would not only be facing normal competition from surrounding hospitals, but would have to deal with efficiency issues directly with third-party payers. Other hospital departments that use Respiratory Therapy's services might be concerned that lack of quality in Respiratory Therapy may affect the quality in their own department. Even if this poor quality is not contagious, it may nevertheless adversely affect customer perceptions about other departments. 2. Categorize the list of quality costs into prevention, appraisal, internal failure, and external failure. Justify your choices. Before categorizing, it might be useful to review definitions for the four categories. General definitions are as follows: Prevention costs are incurred to prevent the production of products or services that do not meet specifications. Appraisal costs are incurred to monitor and inspect production or services. These costs are intended to detect products or services that do not meet specification during the production process. Internal failure costs are incurred after defective or substandard product or service is detected but before it reaches the customer. External failure costs are incurred when the defective product or service gets to the customer. The categorization arrived at by the consultant (actually, it was a team of graduate students who were employed on a temporary basis by the hospital) was:    

Prevention Costs: Quality Planning and Procedures, Training Procedures, Forecast and Budget Generation, Customer Relations. Appraisal Costs: Quality Audits, Therapy Write­ups, Performance Audits, Appraisal Support. Internal Failure Costs: Incorrect Installations, Overtime, Rework, Retraining Current Employees, Handling Complaints, and Absenteeism/Turnover. External Failure Costs: Malpractice Lawsuits, Administrative Actions.

Some of these are subject to debate. For instance, Handling Complaints should probably be considered an external failure cost since the patients and contract physicians are external customers (only complaints from house physicians would be an internal failure cost). One could also argue that, although Administrative Actions and Retraining Current Employees resulted from failures, they should be classified as prevention costs since the purpose of these expenditures is to improve future quality. Another item, Therapy Write-ups, may be questioned as to why it is considered a quality cost. A response to this is that it is analogous to a 100 percent inspection.

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3. What additional costs of quality (COQ) might you suggest? How would you categorize each of them? Other costs of quality that may be considered: • Hiring and retention of employees (Prevention Cost) • Unneeded bronchodilator treatment (Internal Failure Cost) • Malpractice insurance (External Failure Cost) • Loss of future customers (External Failure Cost) • Research and development (Prevention Cost) • Patient follow­ups to evaluate their satisfaction (Appraisal Cost) 4.

Discuss how you would estimate (i.e., measure) the following costs for the Respiratory Therapy Department: Quality Planning and Procedures, Therapy Write-ups, and Incorrect Installation. Measurement of costs for: a) Quality Planning and Procedures--prorate (to three hours) the monthly salaries of those involved in the monthly meeting; also, assign eight hours of the Program Instructor's weekly wages. b) Therapy Write-ups--for intubations, multiply 0.167 hours by the number of intubations, and then multiply by the therapist's hourly wage; for bronchodilator treatments, multiply 0.083 hours by the number of treatments, and then multiply by the therapist's hourly wage. c) Incorrect Installation--Multiply the time spent after two attempts by the hourly wages of the personnel involved; also, add the extra supplies consumed for more than two attempts.


Which of Highlander’s COQ measures (or similar ones) might you include in a balanced scorecard for Kelsey’s Respiratory Therapy Department? What other performance measures would you suggest to include? Classify each of these measures into the four standard balanced scorecard categories (financial, customer, internal business process, learning & growth).

The following categorized balanced scorecard (BSC) measures might be suggested from the COQ measures obtained by Highlander:  Number of malpractice lawsuits (customer)  Number of incorrect installations (internal business process)  Number of re-done treatments (internal business process)  Number of complaints by physicians and patients (customer)  Absenteeism and turnover (learning & growth) Other categorized balanced scorecard measures that might be suggested are:  Number of unneeded treatments (internal business process)  Research and development expenditures (learning & growth)  Patient follow-up surveys to evaluate satisfaction (customer)  Cost per patient (financial)  Employee satisfaction ratings (learning & growth)  Training hours per employee (learning & growth)  Percentage of patients serviced in a timely manner (customer)

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References Barefield, J. T., C. A. Raiborn, and M. R. Kinney. 2003. Cost Accounting: Traditions and Innovations (Cincinnati, OH: Southwestern). Carr, L. P. 1995. Cost of Quality—Making It Work. Journal of Cost Management (Spring) 61-65.

Horngren, C. T., S. M. Datar, and G. Foster. 2003. Cost Accounting: A Managerial Emphasis. (Englewood Cliff, New Jersey: Prentice-Hall). Institute of Management Accountants (IMA). 1997. Union Pacific Railroad: Using Cost of Quality in Environmental Management. In L. P. Carr, Cases from Management Accounting Practice (New Jersey, Institute of Management Accountants) 103-111. Ittner, C. 1988. Texas Instruments: Cost of Quality (A). (Boston, MA: Harvard Business School). Kalagnanam, S. S. and E. M. Matsumura. 1995. Cost of Quality in an Order-Entry Department. Journal of Cost Management (Fall) 68-74.

Keating, S., and J. Shank. 1998. Iron River Paper Mill. In Anthony, R. N., and V. Govindarajan, Management Control Systems (New York, Irwin/McGraw-Hill), pp. 646-655. Stanford University. 1982. Signetics Corporation: Implementing a Quality Improvement Program (A). In Kaplan, R. S., and A. A. Atkinson. 1989. Advanced Management Accounting (Englewood Cliff, New Jersey: Prentice-Hall) 386-396.

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16-3: Union Pacific Railroad--Using Cost of Quality (COQ) in Environmental Management 1. How valid is the cost of future cleanup of the soil contaminated by the locomotive dripping oil and grease onto the soil? What additional information would you require before including this cost in a “return on investment” (ROI) analysis for the installation of the collection pans under the locomotive? The cost methodology for the cost of future clean up was based upon the current cost the company was experiencing in cleaning older spills. The amount of soil contaminated was determined from the EPA standards (one pint contaminates a cubic yard of soil). The costs were developed from a historical cost perspective. Engineering and research studies may be required to confirm the average amount of soil contaminated by a pint of oil/diesel fuel/lubricating oil before including these costs in the analysis. The mixture that is currently captured by the drip pans should be used in the studies to confirm the amount of soil contaminated over a given period. How fast does it leach out of the surrounding soil and drop below EPA standards? In addition, the company should perform engineering studies to verify the amount of material leaking from the locomotive. Does the drip pan really collect all of the material dripping off of the locomotive, or is there still some portion that is not captured and therefore should be excluded from the cost analysis? 2. Identify your criteria for failure costs and explain how you would classify the total cost of the waste-water facilities. Is it a failure or a prevention cost? What are the best arguments for and against using the cost of the waste-water facilities to justify the higher cost of biodegradable soaps and solvents? In the classical definition, failure costs are those costs incurred when customers' requirements are not met. In this case, the customer is the Environmental Protection Agency, which has very technical specifications. The cost of the waste water treatment plant is a failure cost if your criteria allows for inefficiency costs. This means any inefficiencies contained within your operation are classified as failure costs. If you have a process that meets the EPA's requirements at a cost of $25 per 1000 gallons treated and the industry average is $10 per 1000 gallons treated, the customer is going to buy the most economic service. If your costs are 2.5 times the industry average in this area, how long do you think your customers would buy from you? This is the reason for using the difference between the actual cost and the "world class" cost as the failure cost. You could include only the total cost of the plant, if the cost of biodegradable soaps and spill free fueling stations were equal to the current costs. The argument for labeling the cost of the waste water treatment plant as a prevention cost is that the customer (the EPA) requires a treatment facility and will levy fines if the requirement is not met. The fines are the failure cost and the expense of the waste water treatment plant is the prevention cost. The best argument for treating the waste water treatment plant as a failure cost is that there are technological alternatives that would stop the pollutants from entering the water in the first place. These more costly (to the department using the solvents and soaps) alternatives would be justified by reductions in the operating costs of the waste water treatment plan. The major argument against using the operating costs of the waste water treatment plant to justify other technologies is that the waste Blocher, Stout, Cokins, Chen: Cost Management 4e


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water plant would have to remain in case these new techniques did not work. 3. Looking at the trend in waste water standards established by the Environmental Protection Agency (EPA), would you feel comfortable closing these facilities permanently? Why or why not? The current method used to improve the water quality is to trace the pollutant back to its source and make the "responsible party" bear the cost of improving water quality. This includes the costs of additional chemicals, expansion of the facility, and/or other operating costs. These are the costs you are trying to avoid. The mechanism for tracing and billing the source companies is improving. In addition, the capital costs have already been incurred and can not be recovered. The only costs that can be eliminated are the operating costs. So, the best course would be to shut down the facilities but not destroy them. The major cost of a water treatment plant is the capital costs of installing the holding ponds, pumps and mixing chambers. These facilities will normally last 25 to 50 years and would cost additional money to tear out. They can always be reactivated on fairly short notice if the standards change. Unless they present a safety hazard, they can be left in place at no additional expense. 4. How realistic is it to hold a manager responsible for reducing the company’s operating costs to a “World Class” standard as indicated by the disposal of contaminated soil example? What additional information would you like to have before basing your salary increase on meeting such a target? It is very realistic to hold an operating unit responsible to a world class, competitive standard. Are industrial customers different from you and I? Don't we want better quality, more quantity at or below existing prices? If our organization cannot meet our competitors' costing structures how long would the organization survive? The use of outside standards should be mandated to produce lower costs as quickly as possible. The things that you might want to see before agreeing to link your salary increase to meeting a target are: • Engineering studies • The capital budget to support the improved operation • Source of comparison data • Historical trends and rate of improvement at the "World Class" organization. 5. Put yourself in the place of an external auditor working for a public accounting firm. Looking at the four situations outlined in the questions above, would you feel obligated to require any notes, disclosures, or comments before issuing an opinion? Under what circumstances would you feel obligated to require a disclosure of the situation? All of these questions deal with some aspect of FASB Statement No. 5 and materiality. The idea of contingent liability and how a person applies the terms probable, reasonably possible and remote is a subject the students should bring up in their discussion. The other area of concern should be the importance of these costs to the corporation. a. What about the current liability of all the soil contaminated by past years’ running of locomotives without drip pans?

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Under current law, as long as the contamination does not present a health hazard, is not moving and is not being increased, the EPA does not require a clean up plan on petroleum based products. The rational is that in 10 to 30 years the petroleum product will break down naturally and will no longer be a hazard. If you did establish a contingent liability for existing petroleum contaminated locations, you would have to reduce that liability over time to reflect the degradation of the petroleum product. Those sites that present an immediate threat to the welfare of the people living in the area have already been identified by the federal, state, and local EPA's and action plans have been developed. There is no contingent liability because the cost of remedial action is an operating expense and most sites will be cleaned up within a fairly short period of time. b. Assume that during the study of the waste-water treatment plants it was found that none of the plants could handle a five-year rain. The fine for each occurrence was $100,000 for each plant. Would you require a disclosure contained within the financial statements? Give reasons supporting your position. There is no contingent liability in this case. The fines (failure costs) would be classified as part of the operating expense and there would be no reason to establish a contingent liability account to cover the future expense of the fines. It is a normal operating expense. 6. Looking at the case, what failure costs can you identify: (a) at your place of business? (b) at this college or university? (c) in the teaching of this course? (d) what costs would you assign to each of the failures you identify? Part a Some typical failure costs would be those associated with rework, scrap, customer returns, and those found in classical Cost of Quality studies. From the case, you obtain cost of quality accounts due to inefficient operations. Is your accounting staff less than 0.2% of your revenue? Are the costs for an average service call greater than or less than the industry average? Is your operating ratio best in class or best in industry or best in the world? etc. The cost of rework should include not only the cost of the labor doing the work but also the administrative and transportation costs created by moving the work back to the correct station. In a service environment, it should include the cost of the labor required to rewrite the proposal or finished document, or the cost of performing the service a second time. The cost of failure for the accounting staff would be the current costs less 0.2% of revenue. The cost of failure for operating ratio would be the actual operating costs less the best operating ratio times total revenue. Part b First, define who the customer is: the student, the employer with whom the student hopes to find a job, or society as a whole. Then define the requirements of the customer you identified and look at the operation. Second, look at the operational efficiencies of the current process. Is the method of lecturing to a group of students who have different learning rates the most efficient way to teach a particular subject? Is the concept of having a department head for various departments efficient? Is the additional administrative cost justified to the ultimate customer? Does every department need a

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computer center or its "OWN" classrooms? Use caution in developing the failure costs for customer satisfaction in this specific example. The costs have to be incurred by the college or university. They can not be costs incurred by the student in the form of lost wages. Be careful to include costs that the university or college has control over. A failure cost might be requiring a specific course that does not add value for the customer. The dollars could have been spent on other courses. In the second area, the failure costs are easier to determine. For any course, is the cost per student lower for interactive computer based self- training or for having large lecture courses and discussion sections? Look at the difference in the cost per student and the lower cost becomes your standard cost and everything above it is failure cost. Each department head has a fixed cost associated with it. Your failure costs could be the difference between the (existing cost of all departments) less ((the cost of using the entire staff divided by the number of instructors found in the largest department) times (the cost of the largest department head)). In the administration area, you could take the current number of personnel less (the number of transactions performed/the number performed per person at the "best" facility) times the salary and overhead of the average person. Part c Does this class meet the requirements of the customer? Does the course require the same number of man-hours to prepare for as other courses at other facilities? Does the course start on time? Does the course end on time? The same caution mentioned above applies here. The cost of not meeting customer requirements has to be the sum of the costs incurred by the college or university. The man-hour cost of failure is simply the difference between actual and the "World Class" standard man-hours times the average rate per man-hour. The cost of not starting on time or finishing on time would be the additional expense of operating the classroom at full capacity for the additional time. Part d The costs are identified with each of the answers above. 7. As the Chief Financial Officer (CFO) of the company, when would you begin to feel uncomfortable assigning costs to these environmental failures? Discuss the ethical questions that would be involved in limited the generation of failure costs that are based upon noncompliance or continued contamination of the environment, resulting in possible violation of future regulations. During your discussion, address how you would minimize the financial liability of potential litigation associated with the production and distribution of asbestos and tobacco products. This is a question concerning the interpretation the person gives to FASB No. 5 and when the liability becomes significant in the eyes of the CFO. As more and more documentation is provided, the CFO should become more uncomfortable with not addressing the issue. Limiting failure costs, simply because you might have to include a note in your annual report, is a difficult question. If you truly have a large contingent cost, the ethical standards require you to make a reasonable guess as to the impact of these costs on your business. Had the asbestos or tobacco industries develop a failure cost for potential suits, don't you think they might have addressed the issue a little more aggressively. Wouldn't the existence of such an account sway a jury in awarding

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criminal damages? The account could demonstrate that the probabilities used might have been wrong but the company was at least looking at the problem in a proactive manner. 8. Under what conditions could you see a cost of quality (COQ) system working? What are the key enablers of such a system if attempted in your organization? Discuss the arguments you would use to start or “kill” a COQ system. The key factors are: • Support of top management • Ownership of the accounts by line departments • Establishment of goals • Work on the largest accounts first - concentrate your resources • Use as a directional instrument • Make the accounts measure incidents and not fixed costs The student should identify the enablers present out of those given above. Key factors for a COQ system are: • Provides a common basis for determining where the largest ($) problems are occurring • Costs are spread across various departments • Cost avoidance is not currently included in budget system Key factors against a COQ system include: • Not all costs go to the bottom line immediately • If we know there are failures, why not fix them and not bother with costing them out • It takes time 9. What are the major differences between a COQ system as presented in the case and an ActivityBased costing (ABC) system? What are the similarities? The major difference between a COQ and ABC system is a COQ system will provide a failure cost for specific incidents. An ABC system will provide a cost for all incidents but not any cost avoidance costs. The major similarity is that they both allocate dollars to a variety of incidents that provide management the information necessary to work on the largest costs first.

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Teaching Strategies for Articles 16-1: “GE Takes Six Sigma Beyond the Bottom Line” by G. T. Lucier and S. Seshadri, Strategic Finance (May 2001), pp. 40-46. This article reports the success of GE Medical Systems Inc.'s Six Sigma effort. It describes the training programs for employees in statistical process control and s Services and information offered by the Web site of the company to support the quality improvement efforts of more than 300,000 employees worldwide. Discussion Questions: 1. What is a Six Sigma approach? Sigma is the Greek letter used in statistics to denote standard deviation. Six Sigma means that the chance of a certain event, in this case it refers to defects, to occur is in a region beyond six standard deviations. The chance of occurrence is 3.4 per million. 2. Describe the processes that GE uses to implement its Six Sigma program. GE uses acronym DMAIC to describe its Six Sigma approach: Define – Define problems related to the business or critical factors to customer satisfaction. Measure – Establish base-level measures of defects inherent in the current process. Analyze – Explore underlying reasons for defects. Improve – Seek the optimal solution to reduce or eliminate defects, develop and test a plan of action for implementing and confirming the solution. Control – Implement ongoing measures to keep the problem from recurring. 3. What are black belts? What roles black belts play in GE’s Six Sigma program? Black belts are team leaders of small teams implementing/executing the Six Sigma methodology. They act as technical and cultural change agents for quality.

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16-2: “Accounting for Quality with Nonfinancial Measures: A Simple No-Cost Program for the Small Company” by R. C. Kettering, Management Accounting Quarterly (Spring 2001), pp. 14-19. The author of this article argues that, to improve product/service quality, even small companies can develop and use nonfinancial, low-cost data to improve performance and customer satisfaction. Discussion Questions: 1. In terms of a Cost of Quality (COQ) framework for managing and controlling quality costs, distinguish between cost of conformance and cost of non-conformance. Into what subdivisions can each of these two broad categories of quality-related costs be made? What is the definition of each of the four categories of quality cost in a typical COQ report? Cost of conformance = Prevention Costs + Appraisal Costs; Cost of Nonconformace = Failure Costs (Internal Failure Costs + External Failure Costs). As the authors of this article point out, the former costs are associated with the achievement of quality, while the latter costs are associated with nonachievement of quality of the organization’s output (service or product). Alternatively, one can view conformance costs as those costs incurred to make sure the product or service is right the first time; nonconformance costs, on the other hand, are incurred to correct a problem or quality defect. Breakdown of conformance costs: 

  

Prevention costs--quality costs incurred to prevent poor quality (i.e., defects) from being produced in the first place. Examples would include employee training and on-going education costs, and costs associated with certifying vendors (suppliers). Appraisal costs--these are cost incurred to detect quality defects. Examples include incoming inspection of raw materials and testing of final products. Internal failure costs--these are costs of product/service failure detected before delivery of the product or service to the customer. Examples include rework costs and the net (of salvage) cost of scrap produced. External failures costs--these are costs of product/service failure detected after delivery of the product or service to the customer. Examples include field service costs and the costs of processing product returns.

2. Provide an overview of the three-step approach that the author of this paper recommends as a “no-cost” approach that can be used by smaller (i.e., more resource-constrained) organizations to monitor and control quality. The authors maintain the financial control of quality, via the Cost of Quality (COQ) reporting framework outline above in (1), may be more appropriate for larger, more resource-rich organizations. Thus, the author suggests that smaller, more resource-constrained may be able to control quality costs by focusing on nonfinancial performance indicators. In this regard, the author proposes a three-step approach: (1) Specification of nonfinancial measures that should be monitored (2) Use of an electronic spreadsheet to record performance indicators (3) Periodic preparation of a performance report based on measures collected. 3. Provide at least two examples of non-financial quality indicators for each of the four categories of qualityrelated costs typically included in a COQ report. Examples are provided by the author in Table 2 in the article. Prevention: Design review (number of hours), preventive maintenance (number of hours), employee training (number of hours), etc. Appraisal: Material inspection (number of inspections), WIP inspection (number of inspections), etc. Internal failure: Scrap (number of units), spoilage (number of units), rework (number of units), etc. External failure: Warranty claims (number of claims), product recalls (number of recalls), etc.

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