Module 3: Quality and Time

Module 3: Quality and time
Overview
Module 3 examines the relationship between cost, quality, and time, and explains how quality and time can be used as
strategic competitive tools. It introduces the cost-of-quality report as a tool to evaluate quality initiatives, and links cost-of-
quality and benchmarking to outline the relationship between quality and corporate strategy. You learn how to use the theory
of constraints in decision-making, and conclude the module by analyzing and solving a cost-of-quality business case.
Test your knowledge
Begin work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study
required.
Assignment reminder
Assignment 1 (see Module 5) is due at the end of week 5 (see Course Schedule). It is a good idea to review the assignment
now so that you are familiar with the requirements as you work through Modules 3-5.
Topic outline and learning objectives
3.1 Quality as a competitive tool and costs
of quality
Explain how quality is used as a competitive tool, and
evaluate the cost of a quality program by analyzing
categories of cost and nonfinancial measures. (Level 1)

3.2 Analyzing and improving quality Outline the three methods companies use to identify internal
quality problems. (Level 1)

3.3 Costs and benefits of quality
improvement
Analyze relevant costs and benefits of quality improvements,
explain how managers use cost of design quality
information, and evaluate quality performance. (Level 1)

3.4 Time and competitiveness Explain the impact of time on quality and competitiveness,
and analyze relevant revenues and costs of time. (Level 1)

3.5 Theory of constraints Explain how to maximize throughput contribution using the
theory of constraints. (Level 1)

3.6 Case: Quality and time initiatives Analyze a cost-of-quality scenario, and make a
recommendation. (Level 1)

Module summary
Print this module
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3.1 Quality as a competitive tool and costs of quality
Learning objective
Explain how quality is used as a competitive tool, and evaluate the cost of a quality program by analyzing categories
of cost and nonfinancial measures. (Level 1)
Required reading
Chapter 19, pages 922-926
LEVEL 1
Companies focus on quality to gain competitive advantage. As companies worldwide turn managements attention to the
concept of quality, international standards have emerged to mandate quality levels (for example, ISO 9001, 14001). The ISO
registration was originally designed for companies competing in the European marketplace, and companies are now required
to attain ISO registration to compete in domestic markets.
Quality improvements can lead to reduced costs through less waste, spoilage, and rework. This can result in higher levels of
customer satisfaction, which in turn can lead to competitive advantage. Global concern for the environment and effects of
climate change are also creating a greater need for companies to focus on quality initiatives that reduce waste. The quality of
a good or service is driven by consumer demand, and todays consumers are demanding that goods or services be produced
without further damage to the environment.
The term quality refers to many factors, including degree of fitness for use, level of customer satisfaction, and degree of
meeting design and engineering specifications. Here are the two important, and interrelated, aspects of quality:
Design quality measures how closely the product characteristics or services performed meet the needs and
wants of consumers such as a printer that offers printing, scanning, copier and fax functions to meet customer needs.

Conformance quality measures performance of a product or service according to design and production
specifications to reduce defects.
Page 923 of the text shows a diagram of the relationship between design quality and conformance quality.

Costs of quality
The following four costs of quality (COQ) are incurred to prevent or correct conditions and/or processes that result in low-
quality products:
Prevention costs are incurred to prevent production of products that do not conform to specifications (including
engineering design costs).

Appraisal costs are incurred to detect products or services that do not conform to specifications (including all
inspection of products).

Internal failure costs are incurred to detect nonconforming products before they are shipped to customers
(including rework, spoilage, and scrap costs).

External failure costs are incurred to detect a nonconforming product after it is shipped (including costs of lost
reputation, rework/warranty, and customer support).
Generally, costs for prevention should reduce the costs of the other three areas. Exhibit 19-1 on page 924 provides a list of
typical costs in each category and Exhibit 19-2 on page 925 provides a detailed analysis of activity-based costs of quality,
including an opportunity cost analysis for lost contribution margin and income (panel B).
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Quality has taken on even more importance in the past 30 years. This focus goes back to the works of Edward Deming, who
attempted to concentrate on quality in the auto industry in the U.S. in the 1950s. His work was rejected in the U.S. but
accepted in J apan, where manufacturers turned to quality in production. From the 1970s through the 1980s, the U.S. focused
on quality to catch the J apanese companies.
Balanced Scorecard: Costs of quality Financial and nonfinancial measures
The focus on quality has expanded from manufacturing to include performance measurement through the use of the
Balanced Scorecard (BSC). The BSC was introduced in the 1990s by Kaplan and Norton, who focused on a combination of
financial and non-financial performance indicators. In addition to financial measures, such as return on investment, managers
must also measure nonfinancial measures such as quality, processes, intangible assets, and training. These factors have an
impact on the financial measures of return on investment and sales and they must be performed well by the organization to
achieve positive returns. For example, a company like Purolator must perform well in the area of distribution because its key
performance indicator is on-time delivery, which is not directly included in financial measures. Nonfinancial measures can be
captured in the four perspectives of the BSC financial, customer, internal processes, and learning and growth.

To be successful in the marketplace, a product must provide customer satisfaction. Measures related to the BSC customer
perspective allow management to see how well the cost-of-quality goal is being met. When customers are unhappy because
of the poor quality of a good or service, this is reflected in such measures as market share, defect rates, and customer
complaints. Measures of customer quality and time are reflected in on-time delivery rates, customer service response times,
and customer survey responses. These measures are also typically captured in the BSC. (Module 9 expands on the discussion
of the Balanced Scorecard.)

3.2 Analyzing and improving quality
Learning objective
Outline the three methods companies use to identify internal quality problems. (Level 1)
Required reading
LEVEL 1
A number of tools have been developed to analyze quality-control problems in internal business processes. The textbook
introduces three of these tools:
Statistical quality control (SQC), or statistical process control (SPC) SQC statistically maps the random or
nonrandom variations in the operating process, often using control chart representing a particular step, operation or
procedure over time. Exhibit 19-3 on page 927 shows SQC charting using arithmetic average and standard deviations.
According to the 2-sigma rule, a point that falls out of the 2-sigma would occur in a normal distribution only 5% of
the time and should be investigated.

Pareto diagram Observations outside of set limits show how frequently each type of defect occurs, and help
management identify any major problems (Exhibit 19-4).

Cause-and-effect diagram The most frequently occurring problems in the Pareto diagram are analyzed through
a cause-and-effect diagram (also known as a fishbone diagram). Potential causes of each problem are brainstormed
to help determine the best solution. Each cause factor is represented by an additional arrow on the diagram (Exhibit
19-5).
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Updated August 16, 2010, MA2-TU02
3.3 Costs and benefits of quality improvement
Learning objective
Analyze relevant costs and benefits of quality improvements, explain how managers use cost of design quality
information, and evaluate quality performance. (Level 1)
Required reading
LEVEL 1
After analyzing internal business processes and identifying problems, managers suggest changes and adjustments to fix the
problems or improve the processes. They also analyze relevant costs and benefits for each suggested alternative. Relevant
costs and benefits are those that change between alternatives, and can take the form of increased (or decreased) costs or
additional (or reduced) revenues. The analysis differentiates relevant costs from sunk costs or costs that do not change
between alternatives. (You may wish to review these concepts from your earlier management accounting course.)

Exhibit 19-6 on page 930 is an example of a comparative analysis of the estimated effects of two proposed alternatives.
Managers make strategic choices based on the results of the analysis, and these choices require a further sensitivity analysis
to determine how volatile the variables are to external factors such as economic conditions. The following measures may
affect the levels of sales revenue and production costs.
Opportunity costs For example, when space used to achieve one option can be used for an alternative
production process, managers determine the lost contribution margin on the alternative process.

Cost of quality The COQ report determines the impact of interdependencies across the four categories of quality-
related costs; for example, redesigning the production process can increase prevention costs and result in a reduction
in internal and external failure costs.

Trends of quality costs over time For example, a company may look at the percentage of sales that each
category represents over a number of periods to see the overall impact of proposed changes, since many alternatives
will affect multiple periods.

The Firestone case on pages 932-933 provides an even stronger message about the costs of failure to make quality
improvements. In analyzing the situation, the managers failed to take into account all stakeholders. The most important
negative effect for the company was the perceived lack of concern for the safety of its customers, which should have been
the primary factor in dealing with the situation. This is a clear case where the company should have made immediate safety
quality improvements or withdrawn the product from the market.
Costs of design quality
Companies must also focus on costs of design quality. Poorly designed products affect the value chain production,
marketing and distribution, and customer service resulting in opportunity costs due to lost sales and increased waste and
spoilage. Because it is difficult to assign costs to these areas, most companies dont measure the financial costs of design
quality. However, they are reflected to some extent in nonfinancial measures of internal-business processes. Prevention,
appraisal, and internal failure costs also have nonfinancial measures, including defect rates, rework percentages, and number
of design changes.
COQ report and the Balanced Scorecard
The cost-of-quality report and the Balanced Scorecard are planning and control mechanisms management accountants use to
measure the success of a corporations strategy. Measuring changes over time and analyzing the changes using a variety of
perspectives helps managers gain a better understanding of the cost connections between the four areas of COQ reports.
The BSC learning and growth perspective employee turnover and satisfaction ratios, employee training, and research and
design ratios to proposed output also links to the COQ report, and efforts at improvement should show up in the trends in
the report.
Evaluating quality performance
Whether in a service organization or a manufacturing business, quality is critical to success. As managers assess the
companys input, processes, and output to determine its competitive position, the COQ report helps them to gauge the
companys quality initiatives. To understand COQ reports, both financial and nonfinancial aspects of quality should be
analyzed together. The following example shows how quality reporting works to isolate quality factors in a manufacturing
operation.
Example 3.3-1: Cost-of-quality report at Mastiff Appliances
Mastiff Appliances Inc. builds small household appliances such as irons, coffee makers, battery-powered screwdrivers, and
similar items. For a long time, Mastiff held a reputation for strong, durable, and reliable appliances. This reputation began to
decline, however, when increased competition forced the company to cut costs and this was handled poorly. For a moderate
period following the cost cutting, as long as the company was able to take advantage of its reputation, Mastiffs sales
remained relatively steady. This effect then all but disappeared. The loss of reputation, coupled with increased overseas
competition, caused Mastiffs sales to plummet sharply.

On J anuary 1, 20X6, Mastiff began a massive effort directed toward quality control. In the two years that followed, sales
failed to go up but remained steady at around $10 million per year. A significant amount of money was spent on testing
equipment, increasing inspection, setting up a statistical process control system, and reworking or throwing out defective
items. Upper management began to wonder if the company was spending and using resources effectively.
Costs over the last three years related to quality and quality control are listed in Exhibit 3.3-1.
Exhibit 3.3-1: Mastiff Appliances Quality and control costs
20X5 20X6 20X7
Depreciation of testing equipment $ 22,000 $ 34,000 $ 30,000
Disposal of defective products 54,000 76,000 60,000
Inspection 76,000 120,000 132,000
Net cost of scrap 86,000 124,000 100,000
Product recalls 340,000 82,000 40,000
Product testing 98,000 160,000 170,000
Quality engineering 56,000 80,000 84,000
Rework labour 140,000 200,000 180,000
Statistical process engineering 74,000 78,000
Supplies used in testing 4,000 6,000 7,000
Systems development 64,000 106,000 117,000
Warranty repairs 420,000 140,000 70,000
Warranty replacements 60,000 18,000 5,000
Total $1,420,000 $1,220,000 $1,073,000
Is Mastiff focusing its quality initiatives in the right areas? Were managers making the right quality decisions? In answering
this question, a COQ report would provide managers with useful information. A trend analysis of nonfinancial quality
information would also give management a better idea of how well the quality problem has been handled.
Preparing a COQ report
Step 1: Determine direct and indirect quality costs
Because this is an illustration rather than an actual business, the quality costs are given. In the real world, determining which
direct and indirect costs are quality costs is a significant part of the exercise. If scrap costs are viewed not simply as a cost of
manufacture but as a cost of quality, which could be reduced by changes in behaviour, then a significant change in approach
could result. Perhaps the manufacturing methods or inspection frequency could be improved in order to reduce these costs.
Step 2: Categorize quality costs
Once the direct and indirect costs of quality are defined and determined, the costs are sorted into the four categories:
prevention, appraisal, internal failure, and external failure. This provides strong evidence that spending in the prevention
stage can lead to significant cost savings at later stages. It is most useful to present these quality costs in terms of a sales
percentage so that the impact of quality cost on the profitability of the company is linked and apparent. The quality-cost
report for Mastiff Appliances follows in Exhibit 3.3-2.
Exhibit 3.3-2: Mastiff Appliances COQ report
20X5 20X6 20X7
Amount % of sales Amount % of sales Amount % of sales
Prevention costs:
Systems developed
$64,000 0.64% $106,000 1.06% $117,000 1.17%
Quality engineering 56,000 0.56% 80,000 0.80% 84,000 0.84%

Statistical process
engineering

0

0.00%

74,000

0.74%

78,000

0.78%
Total 120,000 1.20% 260,000 2.60% 279,000 2.79%

Appraisal costs:

Amortization of testing
equipment
22,000 0.22% 34,000 0.34% 30,000 0.30%
Inspection 76,000 0.76% 120,000 1.20% 132,000 1.32%
Product testing 98,000 0.98% 160,000 1.60% 170,000 1.70%
Supplies used in testing 4,000 0.04% 6,000 0.06% 7,000 0.07%
total 200,000 2.00% 320,000 3.20% 339,000 3.39%

Internal failure costs:

Disposal of defective
products
54,000 0.54% 76,000 0.76% 60,000 0.60%
Net cost of scrap 86,000 0.86% 124,000 1.24% 100,000 1.00%
Rework labour 140,000 1.40% 200,000 2.00% 180,000 1.80%
Total 280,000 2.80% 400,000 4.00% 340,000 3.40%

External failure costs:
Product recalls 340,000 3.40% 82,000 0.82% 40,000 0.40%
Warranty repairs 420,000 4.20% 140,000 1.40% 70,000 0.70%
Warranty replacements 60,000 0.60% 18,000 0.18% 5,000 0.05%
Total 820,000 8.20% 240,000 2.40% 115,000 1.15%

Total quality cost $1,4200,000 14.20% $1,220,000 12.20% $1,073,000 10.73%
Mastiffs effort at quality control (Exhibit 3.3-3) shifted the timing and amount of money the company spent on quality.
Prevention costs went from $120,000 in 20X5 to $279,000 in 20X7. Likewise, appraisal costs moved from $200,000 to
$339,000. This increased spending on prevention and appraisal more than paid off with reductions in both internal and
external failures as follows:
Total expenditures on quality decreased from $1,420,000 to $1,073,000 over three years, or from 14.2% of sales to
10.73%.
External failure costs dropped from a total of $820,000 to $115,000.
Exhibit 3.3-3: Mastiff Appliances Quality costs for the years ended 20X5, 20X6, and 20X7

Evidence from the COQ report supports managements decision to focus on quality.

Total expenditures on quality dropped by $200,000 in 20X6 and by $347,000 in 20X7. External failure costs dropped from
8.2% of sales in 20X5 to 1.15% of sales in 20X7. Given that external failures are those captured by the customer, this
percentage has a direct effect on product reputation.

That sales remained relatively stable for two years indicates that the emphasis on quality to the customer is paying off. Still,
product reputation is a valuable but fragile commodity. Given the level of competition, the question of whether Mastiff
responded in time remains to be answered.

Step 3: Analyze non-financial information
Exhibit 3.3-4: Mastiff Appliances Nonfinancial information
20X5 20X6 20X7
Raw materials
Percentage of returns over deliveries
Wire 4% 3% 1%
Component parts 15% 10% 8%
Batteries 10% 5% 5%
Percentage of suppliers ISO
compliant
12% 15% 25%
Production processes
Defect rate 5% 4% 3.5%
Line downtime 1% 0.9% 0.75%
Marketing
Percentage of high
customer satisfaction rating
45% 47% 54%
Percentage on-time deliveries 87% 89% 93%
All factors analyzed show a positive trend over the three years. Further improvements can be made in on-time deliveries. The
battery suppliers percentage of returns over deliveries is no longer improving. Management should check for ISO
compliance, and may consider a change in suppliers if necessary. The component parts category has the biggest opportunity
to improve, and looking into ISO compliant suppliers would be wise. An analysis should be done to see if alternative sources
of supplies would also affect the defect rate in the production line. Additional analysis of internal processes could also help
improve defect rate, line downtime, and the percentage of on-time deliveries.

In summary, having a strong focus on quality is an important competitive factor in todays global market. The COQ report
shows management the type of quality costs being incurred and the amount and trends of these costs. It helps management
understand the financial impact of quality on company profitability. It can show whether quality costs are predominately
external or internal, and can aid in budgeting a more appropriate distribution. The production and dissemination of this report
communicates to all individuals in the company that quality is a competitive factor that will be dealt with directly.

Work through the following computer illustration to create COQ reports for a manufacturing and retail operation and analyze
the results.
Computer illustration 3.3-1: Cost-of-quality report
Solution

Deresh Soccer Equipment Ltd. manufactures and sells soccer equipment through its own retail outlets. In the last four years
the company has been focusing on improving quality performance.
Exhibit 3.3-5: Deresh Soccer Financial information pertaining to quality for 20X4, 20X5, 20x6, and 20X7 (in
thousands).

Material provided
File MA2M3P1 containing a partially completed worksheet M3P1 and the solution worksheet M3P1S
Required
Using the information given in Exhibit 3.3-5, create a COQ report for Deresh Soccer. Analyze the trends seen in the cost of
quality report. Has Dereshs focus on quality yielded any results?
Procedure
Start Excel.
Open the file MA2M3P1. Go to TAB M3P1.
Review the spreadsheet. Note that the data table replicates the information given above. Also note that cells A28 to
K65 contain the format for a cost-of-quality report.
In Column A enter the titles for the cost types based on the information in the data table. Use a formula for this.
Complete the cost of quality report by entering formulas in cells D37 to K40; D45 to K48; D53 to K55 and D59 to K62.
Note that cells in columns E, G, I, and K should not reference the data table. These cells calculate the percentage of
total sales for the year represented by the cost-of-quality item on that row.
In rows 41, 49, 56, and 63 enter a formula to calculate the total of each type of cost for each year and the total
percentage.
In cell D65 enter an IF formula that verifies that all costs of quality from the data table have been included in the
report. Use a similar formula for cells F65, H65, and J 65.
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In cells E65, G65, I65, and K65 enter an IF formula that verifies the total percentages.
Now click the M3P1S tab to verify that you have correctly created the Cost-of-Quality Report for Deresh Soccer Equipment.
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It is evident from the trends in the cost-of-quality report that Deresh Soccer Equipment has focused its attention on
prevention costs. The increase in prevention costs has been more than offset by the savings in external failure costs. Total
quality costs have been reduced by about 2%. While appraisal costs are up, internal failure costs are down. The company
may want to focus on specific preventative items that will help keep the appraisal costs down. Some analysis of nonfinancial
performance measures might help improve the materials procurement and product testing processes.
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3.4 Time and competitiveness
Updated September 7, 2010, MA2-10-TU04
Learning objective
Explain the impact of time on quality and competitiveness, and analyze relevant revenues and costs of time. (Level 1)
Required reading
LEVEL 1
Time is a critical quality variable in many companies success. Fast-food restaurants, furniture movers, couriers, and airlines
all use detailed measures of time to determine the success of their products or services. Customer response time and on-time
performance are two commonly used measures of time as a quality variable:
Customer response time is the time interval from customer order to product or service delivery. Exhibit 19-7 on
page 934 identifies components of customer-response time. Manufacturing-lead (or cycle) time is the interval from
when an order is ready to start (or be setup) on the production line to completion (finished good). Order-delivery
time is the interval from when the order is ready for pick up from the manufacturer to delivery to the customer.

On-time performance is usually expressed as a percentage that represents the ratio of times to all deliveries
that a product or service is delivered according to schedule. For example, Air Canada would report times that planes
arrived at destinations at the scheduled times as a percentage of total flights.
Speed to market has become a key determinant in competitive success for many industries, and it is considered a critical
success factor, especially in high-tech firms. Being first to market with new products (termed first-mover advantage in
strategic management) is a key strategy for many companies because it provides a high return, and early patent protection
allows companies to earn a premium on first-to-market products.
Responding efficiently to customers needs can build a companys reputation, and failure to respond quickly can send
customers to the competition. Knowing customers needs with respect to time is important in knowing how to capitalize on
time as a competitive tool. For example, an airline passenger learns upon ticket purchase that a flight will take 4 hours and
25 minutes to the connecting destination but misses the connection because of delays if this occurs on a regular basis, the
airline earns a reputation for delays and loses customers to the competition.
Time drivers and costs of time
A time driver is any factor that affects the speed with which an activity is accomplished (for example, uncertainty about when
a client or customer will place an order, limited capacity leading to bottlenecks in production, and so on). Companies often
address these factors through plant layout, product design, and production scheduling.

An important factor in production scheduling is the average wait time needed for production, which can be computed as
follows:
For example, Baker receives 200 orders per year, average manufacturing time is 10 hours, and the machine has a capacity of
4,000 hours per year.
This can become a measure and goal used in continuous improvement initiatives, as a measure in scheduling of products,
and in discussions involving lead times with customers.
Relevant revenues and costs of time
Companies must consider that time affects both revenue and costs. Customers will often pay a higher price for faster delivery
or service, while carrying costs such as inventory, rent, spoilage, waste, and deterioration increase for slower production
times. When capacity is limited, opportunity costs become more important. Introducing a new product or service may have a
negative impact on existing products. When planning to introduce new versions of a product, management must decide
whether to continue to carry the old product. For example, a new product can a negative effect on sales of an existing
product by splitting the market or changing production parameters.

Exhibit 19-8 (page 937) shows the possible negative effects of introducing a new product to an existing line of products. The
average wait time for the current product increased substantially, which in turn affected the companys ability to fulfill
demand for the product. Such a bottleneck could be alleviated with the purchase of a new machine, which then becomes a
capital budgeting issue.

3.5 Theory of constraints
Learning objective
Explain how to maximize throughput contribution using the theory of constraints. (Level 1)
Required reading
Chapter 9, pages 437-438 (to Overview of Three Costing Policies)
LEVEL 1
The theory of constraints describes methods that can be used to maximize operating income in the face of bottlenecks or
constraints. The following three measurements are important to the theory:
Throughput contribution Sales revenue minus direct material costs. Throughput is the rate at which an
organization generates cash from the sale of products. Throughput costing defines variable direct material as the only
cost included in inventory. Throughput contribution then could be considered as the net rate at which cash is
generated from the sale of products. In your introductory management accounting course, you studied absorption
and variable costing, where the principle difference in inventory valuation is the inclusion of fixed manufacturing
overhead in absorption costing. Throughput costing is a third inventory valuation technique that considers only direct
material as relevant to inventory valuation (product cost) and considers that conversion costs (direct labour and
manufacturing overhead) are period costs, charged in the period in which they are incurred.

Investments (inventory) Sum of materials costs in direct material, work in process and finished goods
inventory, R&D costs, and the cost of equipment and buildings.

Operating costs Sum of all operating costs, other than direct materials, incurred to earn throughput contribution
(includes wages and salaries, rent, utilities, property taxes, depreciation).
The objective is to increase throughput contribution while simultaneously decreasing investment and operating costs. This
method assumes that the situation under consideration is short-term and that other current operating costs are fixed. Short-
term consideration means that the focus is on the immediate improvement of a specific constraint that is currently slowing
throughput. This also reinforces the assumption that all other costs are fixed; in the short-term, most costs are considered
fixed.
Steps in managing bottlenecks
1. Recognize that the bottleneck is related to throughput contribution as a whole. A firm can only produce the number
of products that its slowest process can produce.

2. Search and find the bottleneck resource by identifying the process where large quantities of resources are waiting for
production.

3. Keep the bottleneck operation busy and ensure the pace of operations of the non-bottleneck resources are tied to the
bottleneck machine. This affects the overall production schedule. In relevant costing, you learned that to maximize
overall contribution, when scarce resources or constraints exist, you must maximize the contribution per scarce
resource.

4. Take action such as the following to increase bottleneck efficiency and capacity:

Eliminate idle time (more efficient production scheduling and plant layout design).
Schedule processes to produce products that are in demand and that have the highest contribution margin
per bottleneck.
5. Shift production from bottleneck machine to non-bottleneck machines or consider outsourcing if the item is not
strategic.
6. Reduce setup and process time through engineering redesign.
7. Improve quality of production process and parts (poor quality leads to decreased production).
In the long-run, costs that are assumed to be fixed under the theory of constraints must be considered variable costs.
Managers analyze them using activity-based costing methods. Activity-based costing focuses on the long-run perspective and
on eliminating non-value added products and processes. This approach complements the short-term focus of the theory of
constraints.

Outsourcing can also help to alleviate bottlenecks. Managers can determine whether outsourcing is a viable option by
analyzing relevant costing, quality, and capital budgeting data. If quality can be maintained, the contribution margin
increases and potential fixed costs reduce over time, which requires analysis of capital budgeting and time-value of money. It
is important to note that only non-strategic products and processes should be considered for outsourcing. Competitive
advantages arise from a companys ability to maximize its core competencies, which should not be considered for
outsourcing.
Balanced Scorecard and time-related measures
The Balanced Scorecard can identify the cause-and-effect relationships that would show how bottlenecks are created. The
BSC also helps managers determine how to alleviate bottlenecks through root-cause analysis in management meetings. For
example, improved employee training can lead to improved efficiency, increased production, and decreased defects. The
textbook on page 942 lists BSC measures that can be implemented to assess the ability to deal with bottleneck operations.

3.6 Case: Quality and time initiatives
Learning objective
Analyze a cost-of-quality scenario, and make a recommendation. (Level 1)
LEVEL 1
Case 3.6-1: Cost of quality at Welsh Manufacturing Ltd.
J ack Hughes, president of Welsh Manufacturing Ltd. completed a meeting with J erry Brice, manager of purchasing, with the
following comment:

Somethings got to be done about the costs of the A45 product. Overhead costs have been increasing and direct material
costs have skyrocketed over the past six months. What have you got to say about it, J erry?

J ack was referring to the increase of production costs for the A45 from $4.50 per unit six months ago to the current cost of
$6.65 per unit. The margins have been squeezed so that it appears profit targets for the current year will not be met. J erry
outlined what he knew at this point and agreed to look into the matter.
1. The company uses a normal costing system with budgeted material cost of $1.50 per unit, direct labour of $2.00 per
unit and manufacturing overhead charged at 50% of direct labour costs.

2. Eight months ago, J errys department decided to use multiple suppliers, so that they would not be exclusively tied to
one major supplier. Many of these new suppliers turned out to be resellers, buying materials purchased from various
sources and reselling them to Welsh at a markup.

3. The implementation of a Balanced Scorecard a year ago, was considered a success, but some managers are reluctant
to agree with the indicators chosen and question the validity of the results. For example, in the past few months
customer satisfaction measures have been falling, and customer complaints have been increasing, even though
higher production costs have not been passed on to customers. Salespeople are blaming customers greed for the
current situation. They feel that the customers are demanding too much of the company.

4. J erry gathered the following additional information on the A45 product line for comparison:

20X7 20X8
(6 months)
Revenues (50,000 / 20,000 units) $490,000 $200,000
Direct material ($1.50 / 1.95) $75,000 $39,000
Direct labour ($1.90 / 2.25) $95,000 $45,000
Manufacturing overhead applied $47,500 $22,500
Manufacturing overhead actual $47,000 $49,000
Additional data:
Scrap costs $1,000 $3,000
Design engineering $5,000 $2,500
Customer complaints (number of complaints) 90 134
Percentage of on-time delivery 96% 91%
Warranty liability $8,500 $6,200
Product inspection $4,000 $4,000
Rework $3,000 $8,000

Required
On the basis of the information available, what are the next steps for J erry to consider?

Solution
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Deresh Soccer Equipment Ltd. manufactures and sells soccer equipment through its own retail outlets. In the last four years
the company has been focusing on improving quality performance.
Exhibit 3.6-5: Deresh Soccer Financial information pertaining to quality for 20X4, 20X5, 20x6, and 20X7 (in
thousands).

Material provided
File MA2M3P1 containing a partially completed worksheet M3P1 and the solution worksheet M3P1S
Required
Using the information given in Exhibit 3.6-5, create a COQ report for Deresh Soccer. Analyze the trends seen in the cost of
quality report. Has Dereshs focus on quality yielded any results?

Procedure
1.
Start Excel.

2. Open the file MA2M3P1. Go to TAB M3P1.

3. Review the spreadsheet. Note that the data table replicates the information given above. Also note that cells A28 to
K65 contain the format for a cost-of-quality report.

4. In Column A enter the titles for the cost types based on the information in the data table. Use a formula for this.

5. Complete the cost of quality report by entering formulas in cells D37 to K40; D45 to K48; D53 to K55 and D59 to K62.
Note that cells in columns E, G, I, and K should not reference the data table. These cells calculate the percentage of
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total sales for the year represented by the cost-of-quality item on that row.

6. In rows 41, 49, 56, and 63 enter a formula to calculate the total of each type of cost for each year and the total
percentage.

7. In cell D65 enter an IF formula that verifies that all costs of quality from the data table have been included in the
report. Use a similar formula for cells F65, H65, and J 65.

8. In cells E65, G65, I65, and K65 enter an IF formula that verifies the total percentages.

9. Now click the M3P1S tab to verify that you have correctly created the Cost-of-Quality Report for Deresh Soccer
Equipment.
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Case 3.6-1: Cost of quality at Welsh Manufacturing Ltd.
Solution
J erry should consider the reasons for the increased costs as well as the decreased customer satisfaction. Possible suggestions
would include preparing a cost of quality analysis as follows:
Cost of quality analysis
Cost of quality 20X7 % of sales 20X8 % of sales
Prevention costs
Design Engineering $5,000 1.0 $2,500 1.3

Appraisal costs
Inspections 4,000 0.8 4,000 2.0

Internal failures
Rework 3,000 0.6 8,000 4.0
Scrap 1,000 0.2 3,000 1.5

External failures
Warranty Liability 8,500 1.7 6,200 3.1
Totals 21,500 4.3 23,700 11.9
It is apparent from the cost of quality analysis that internal and external failures have increased substantially in the past 6
months. By using the percentages, you can factor out that you are looking at only 6 months worth of data for 20X8 against
the full years data for 20X7. It appears that problems related to product materials may be at issue, since the cost per unit for
material has increased, yet rework and scrap costs are up. It would also be useful to do a variance analysis (Module 2) to
further back these findings. The use of multiple suppliers, especially resellers, could have had an impact on the level of
control of materials, as there seems to be poor quality product inputs. This could directly affect the amount of rework and
scrap noticed during the period, as well as the resulting increase in overall cost to produce good units.

The overhead costs are approximately double the amount applied in 20X8, which could result from changes in manufacturing
design (although this does not appear to be the case). The pre-determined overhead rate may be incorrect and not reflect
the current operating environment. Costs related to manufacturing overhead, such as rent or property taxes, could have
increased. Inspection costs have doubled compared to the previous year, which could relate to salary increases and the
additional work being performed because of the high amount of rework required.

Another area of concern for the company is the decrease in customer satisfaction. It should be noted that, although the cost
of quality report looks at financial numbers, a Balanced Scorecard looks at both financial and nonfinancial analyses. The
additional information relating to the decline in on-time delivery (possibly due to the rework) or problems in delivery and
scheduling should be looked into. Are there problems with manufacturing lead-time? The efficiency and effectiveness of the
production line needs to be examined. Further, assuming complaints are even throughout the year, the increase in customer
complaints is almost 300% per annum 134 90 = 148% x 2 = 296% (148% increase is for the first 6 months only, assumes
268 complaints in 20X8). It appears that salespeople are not in touch with the needs of customers, as they believe customers
are over-demanding. Salespeople should conduct focus groups with both satisfied and non-satisfied customers to determine
the reasons for dissatisfaction and for the increase in customer complaints.
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Module 3 self-test
Question 1
Exercise 19-17, pages 950-951
Note that the cost of quality report on the top of page 951 does not relate to this question.
Solution
Question 2
Solution
Question 3
Solution
Question 4
Solution
Question 5
Problem 19-31, page 957
Solution
Question 6
Problem 19-32, page 957
Solution
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Self-test 3
Solution 1
19-17 Costs of quality analysis
1. Appraisal cost = Inspection cost

= $5 100,000 car seats
= $500,000

2. Internal failure cost = Rework cost
= 5% 100,000 $1
= 5,000 $1 = $5,000

3. Out of pocket external failure cost = Shipping cost + Repair cost
= 2% 100,000 ($10 + $1)
= 2,000 $11 = $22,000

4. Opportunity cost of external failure = Lost future sales
= (2% 100,000) 20% $500
= 400 car seats $500 = $200,000

5. Total cost of quality control = $500,000 + 5,000 + 22,000 + 200,000
= $727,000
Note that while this question includes opportunity costs in the total cost of quality, page
925 mentions that COQ reports typically exclude opportunity costs. These costs are
difficult to estimate and are generally not recorded in financial accounting systems.
However, they can be significant; therefore, sufficient information should be provided
to direct managements attention to the impact of quality decisions on opportunity
costs.
6. Quality control costs under the alternative inspection technique:

Appraisal cost = $1.50 100,000 = $150,000
Internal failure cost = 2.5% 100,000 $1 = $2,500
Out-of-pocket external failure cost = 4.5% 100,000 ($10 + 1)
= 4,500 $11 = $49,500
Opportunity cost of external failure = 4,500 car seats 20% $500
= 900 car seats $500 = $450,000
Total cost of quality control = $150,000 + 2,500 + 49,500 + 450,000
= $652,000

7. In addition to the lower costs under the alternative inspection plan, Safe Rider
should consider a number of other factors:
a. There could easily be serious reputation effects if the percentage of external
failures increases by 225% (from 2% to 4.5%). This rise in external failures may
lead to costs greater than $500 per failure due to lost sales.
b. Higher external failure rates may increase the probability of lawsuits.
c. Due to the nature of the product, Government intervention is a concern, with
the chances of government regulation increasing with the number of external
failures.

Self-test 3
Solution 2
19-18 Cost of quality analysis, ethical considerations

1. Cost of improving quality of plastic = $25 100,000 = $2,500,000.

2. Total cost of lawsuits = 2 $750,000 = $1,500,000.

3. While economically this may seem like a good decision, qualitative factors should be
more important than quantitative factors when it comes to protecting customers
from harm and injury. If a product can cause a customer serious harm and injury, an
ethical and moral company should take steps to prevent that harm and injury. The
companys code of ethics should guide this decision.

4. In addition to ethical considerations, the company should consider the societal cost
of this decision, effects to reputation if word of these problems leaks out at a later
date, and governmental intervention and regulation. The negative societal response
could be quite strong, given infants are involved.

Self-test 3
Solution 3
19-23 Waiting time, service industry

1. If SUs advisors expect to see 300 students each day and it takes an average of 12
minutes to advise each student, then the average time that a student will wait can be
calculated using the following formula:
( )
( )
2
=
Average number
Time taken to
advise a student
of students per day
Wait time
Maximum amount Average number
Time taken to

2
advise a student
of students per day of time available

=
( )
[ ]
2
300 12
2 10 advisors 10 hours 60 minutes 300 12

=
[ ]
43,200
2 6,000 3,600
=9minutes

2. At 400 students seen a day,
( )
( )
2
=
Average number
Time taken to
advise a student
of students per day
Wait time
Average amount
Maximum amount Time taken to
2
of time available advise a student
of students per day

=
( )
[ ]
2
400 12

=
[ ]
57,600
2 6,000 4,800
=24minutes

3. If the average time to advise a student is reduced to 10 minutes, then the average
wait time would be
=
( )
( )
2
Average number
Time taken to
advise a student
of students per day
Average amount
Maximum amount Time taken to
2
of time available advise a student
of students per day

=
( )
[ ]
2
400 10

=
[ ]
40,000
2 6,000 4,000
=10minutes

Self-test 3
Solution 4
19-25 Theory of constraints, throughput contribution, relevant costs

1. Finishing is a bottleneck operation. Therefore, producing 1,000 more units will
generate additional throughput contribution and operating income.
Increaseinthroughputcontribution($72$32)1,000 $40,000
Incrementalcostsofthejigsandtools 30,000
Netbenefitofinvestinginjigsandtools $10,000

Mayfield should invest in the modern jigs and tools because the benefit of
higher throughput contribution of $40,000 exceeds the cost of $30,000.

2. The Machining Department has excess capacity and is not a bottleneck operation.
Increasing its capacity further will not increase throughput contribution. There is,
therefore, no benefit from spending $5,000 to increase the Machining Department's
capacity by 10,000 units. Mayfield should not implement the change to do setups
faster.

3. Finishing is a bottleneck operation. Therefore, getting an outside contractor to
produce 12,000 units will increase throughput contribution.
Increaseinthroughputcontribution($72$32)12,000 $480,000
Incrementalcontractingcosts$1012,000 120,000
Netbenefitofcontracting12,000unitsoffinishing $360,000
Mayfield should contract with an outside contractor to do 12,000 units of
finishing at $10 per unit because the benefit of higher throughput contribution of
$480,000 exceeds the cost of $120,000. The fact that the cost of $10 per unit is double
Mayfield's finishing cost of $5 per unit is irrelevant as the $5 refers to fixed costs.

4. Operating costs in the Machining Department of $640,000, or $8 per unit, are fixed
costs. Mayfield will not save any of these costs by subcontracting machining of 4,000
units to Hunt Corporation. Total costs will be greater by $16,000 ($4 per unit 4,000
units) under the subcontracting alternative. Machining more filing cabinets will not
increase throughput contribution, which is constrained by the finishing capacity.
Mayfield should not accept Hunt's offer. The fact that Hunt's costs of machining per
unit are half of what it costs Mayfield in house is irrelevant.
Self-test 3
Solution 5
19-31 Waiting times, manufacturing lead times

1. Average waiting time for Z39
2
Average number Manufacturing

of orders of Z39 time for Z39
Average waiting time
Annual machine Average number Manufacturing
2
capacity of orders of Z39 time for Z39

=

+

=
[50 (80)
2
]
=
(50 6,400)
=
320,000
= 160 hours per order

2 [5,000 (50 80)] 2 (5,000 4,000) (2 1,000)

Average manufacturing Average order waiting Order manufacturing time
lead time for Z39
=
time for Z39
+ for Z39

= 160 hours + 80 hours = 240 hours per order

2. Average waiting time for Z39 and Y28
=
2 2
Average number Average number Manufacturing Manufacturing

of orders of Z39 of orders of Y28 time for Z39 time for Y28
Annual machine Average nu
2
capacity

+

mber Average number Manufacturing Manufacturing

of orders of Z39 of orders of Y28 time for Z39 time for Y28

+ +

[50 (80)
2
] + [25 (20)
2
] [(50 6,400) + (25 400)] (320,000 + 10,000)
2 [5,000 (50 80) (25 20)] 2 [5,000 4,000 500] 2 500

1,000
330,000
= 330 hours

Average manufacturing
lead time for Z39
=
Average order
waiting time
+
Order manufacturing
time for Z39

= 330 hours + 80 hours = 410 hours

Average manufacturing
lead time for Y28
=
Average order
waiting time
+
Order manufacturing
time for Y28

= 330 hours + 20 hours = 350 hours

Self-test 3
Solution 6
19-32 Waiting times, relevant revenues, and relevant costs
1. The direct approach is to look at incremental revenues and incremental costs.

Selling price per order of Y28, which has
an average manufacturing lead time of 350 hours $ 8,000
Variable cost per order 5,000
Additional contribution per order of Y28 3,000
Multiply by expected number of orders 25
Increase in expected contribution from Y28 $75,000

Expected loss in revenues and increase in costs from introducing Y28

Expected Loss in Expected Increase in Expected Loss in
Revenues from Carrying Costs from Revenues Plus
Increasing Average Increasing Average Expected Increases
Manufacturing Lead Manufacturing Lead in Carrying Costs of
Product Times for All Products Times for All Products Introducing Y28
(1) (2) (3) (4) = (2) + (3)
Z39 $25,000.00
a
$6,375.00
b
$31,375.00
Y28 2,187.50
c
2,187.50
Total $25,000.00 $8,562.50 $33,562.50

a
50 orders ($27,000 $26,500)
b
(410 hours 240 hours) $0.75 50 orders
c
(350 hours 0) $0.25 25

Increase in expected contribution from Y28 of $75,000 is greater than increase in
expected costs of $33,562.50 by $41,437.50. Therefore, SRG should introduce Y28.

Alternative calculations of incremental revenues and incremental costs of
introducing Y28:

Alternative 2:
Alternative 1: Do Not Relevant Revenues
Introduce Y28 Introduce Y28 and Relevant Costs
(1) (2) (3) = (1) (2)
Expected revenues $1,525,000.00
a
$1,350,000.00
b
$175,000.00
Expected variable costs 875,000.00
c
750,000.00
d
125,000.00
Expected inv. carrying costs 17,562.50
e
9,000.00
f
8,562.50
Expected total costs 892,562.50 759,000.00 133,562.50
Expected revenues minus
expected costs $ 632,437.50 $ 591,000.00 $ 41,437.50

a
(50 $26,500) + (25 $8,000)
b
50 $27,000
c
(50 $15,000) + (25 $5,000)
d
50 $15,000
e
(50 $0.75 410) + (25 $0.25 350)
f
50 $0.75 240

2. Selling price per order of Y28, which has an average
manufacturing lead time of more than 320 hours $ 6,000
Additional contribution per order of Y28 $ 1,000

Expected loss in revenues and increase in costs from introducing Y28:

(1) (2) (3) (4) = (2) + (3)
Z39 $25,000.00
a
$6,375.00
b
$31,375.00
Y28 2,187.50
c
2,187.50
Total $25,000.00 $8,562.50 $33,562.50

a
50 orders ($27,000 $26,500)
b
c
(350 hours 0) $0.25 25

Increase in expected contribution from Y28 of $25,000 is less than increase in
expected costs of $33,562.50 by $8,562.50. Therefore, SRG should not introduce Y28.

Self-test 3
Solution 6
19-32 Waiting times, relevant revenues, and relevant costs
1. The direct approach is to look at incremental revenues and incremental costs.

Selling price per order of Y28, which has
an average manufacturing lead time of 350 hours $ 8,000
Additional contribution per order of Y28 3,000

Expected loss in revenues and increase in costs from introducing Y28

(1) (2) (3) (4) = (2) + (3)
Z39 $25,000.00
a
$6,375.00
b
$31,375.00
Y28 2,187.50
c
2,187.50
Total $25,000.00 $8,562.50 $33,562.50

a
50 orders ($27,000 $26,500)
b
c
(350 hours 0) $0.25 25

Increase in expected contribution from Y28 of $75,000 is greater than increase in
expected costs of $33,562.50 by $41,437.50. Therefore, SRG should introduce Y28.

Alternative calculations of incremental revenues and incremental costs of
introducing Y28:

Alternative 2:
Alternative 1: Do Not Relevant Revenues
Introduce Y28 Introduce Y28 and Relevant Costs
(1) (2) (3) = (1) (2)
Expected revenues $1,525,000.00
a
$1,350,000.00
b
$175,000.00
Expected variable costs 875,000.00
c
750,000.00
d
125,000.00
Expected inv. carrying costs 17,562.50
e
9,000.00
f
8,562.50
Expected total costs 892,562.50 759,000.00 133,562.50
Expected revenues minus
expected costs $ 632,437.50 $ 591,000.00 $ 41,437.50

a
(50 $26,500) + (25 $8,000)
b
50 $27,000
c
(50 $15,000) + (25 $5,000)
d
50 $15,000
e
(50 $0.75 410) + (25 $0.25 350)
f
50 $0.75 240

2. Selling price per order of Y28, which has an average
manufacturing lead time of more than 320 hours $ 6,000
Additional contribution per order of Y28 $ 1,000

Expected loss in revenues and increase in costs from introducing Y28:

(1) (2) (3) (4) = (2) + (3)
Z39 $25,000.00
a
$6,375.00
b
$31,375.00
Y28 2,187.50
c
2,187.50
Total $25,000.00 $8,562.50 $33,562.50

a
50 orders ($27,000 $26,500)
b
c
(350 hours 0) $0.25 25

Increase in expected contribution from Y28 of $25,000 is less than increase in
expected costs of $33,562.50 by $8,562.50. Therefore, SRG should not introduce Y28.

Module 3 summary
Explain how quality is used as a competitive tool, and evaluate a cost-of-quality program
by analyzing categories of cost and nonfinancial measures
Quality is a key method for gaining a competitive advantage. Here are the two basic aspects of quality:
Quality of design Does the design meet the requirements of the consumers?
Conformance quality Does the product meet the design and production specifications?
The four categories of costs are as follows:
Prevention
Appraisal
Internal failure
External failure
Outline the three methods companies use to identify internal quality problems
Statistical quality control is used to map random and nonrandom variation in operation processes.
Pareto diagram is used to show frequency of defect by type.
Cause-and-effect diagrams are used to identify the root of problems.
Analyze relevant costs and benefits of quality improvements, explain how managers use
costs of design quality information, and evaluate quality performance
Suggested changes based on analysis are reviewed to determine cost and benefit.
Consider relevant costs that change between alternatives.
Perform a sensitivity analysis.
Consider opportunity costs.
Design quality includes costs of poorly designed products including production, marketing, distribution, and customer-service
costs.
The learning and growth perspective of the Balanced Scorecard links to cost of quality through employee turnover and
satisfaction rates.
Cost-of-quality reports are used to look at trends in quality over time.
Changes between prevention costs and external failure costs show how investing in preventing quality issues substantially
reduces external failure costs.
Nonfinancial information should indicate trends to the key Balanced Scorecard perspectives.
Explain the impact of time on quality and competitiveness, and analyze relevant
revenues and costs of time
Speed to market has become one of the key competitive advantages.
Two common measures are:
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Customer response time the time between the placing of an order and when the customer receives the product
On-time performance percentage of times that a product or service was delivered according to or ahead of
schedule
Two major time considerations are uncertainty about when an order will be placed and limited capacity.
Average wait time = [average number of orders x (manufacturing time)
2
] (2 x [annual capacity of machine (average
number of orders x manufacturing time)]).
Opportunity costs and product cannibalization need to be assessed.
Explain how to maximize throughput contribution using the theory of constraints
The three key measurements are:
Throughput contribution
Investments
Operating costs
Steps in managing bottlenecks are:
1. Recognize bottleneck relation to throughput contribution.
2. Find the bottlenecked resource.
3. Keep the bottleneck operation busy and subordinate other processes to it.
4. Increase the bottleneck efficiency and capacity.
Analyze a cost-of-quality scenario, and make a recommendation
This topic is a cost-of-quality case study. You are advised to read all case studies carefully.
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Module 3: Quality and time

19-17 Costs of quality analysis

1. Appraisal cost = Inspection cost

19-18 Cost of quality analysis, ethical considerations

19-23 Waiting time, service industry

19-25 Theory of constraints, throughput contribution, relevant costs

19-31 Waiting times, manufacturing lead times

19-32 Waiting times, relevant revenues, and relevant costs

1. The direct approach is to look at incremental revenues and incremental costs.

19-32 Waiting times, relevant revenues, and relevant costs

1. The direct approach is to look at incremental revenues and incremental costs.

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