Guest Watches is a division of Guest Fashions, a large, international fashion designer. Guest Watches manufactures highly stylish watches for young adults ( age 18 to 30) who are fashion conscious. It is a profit center and its senior management€™s compensation is tied closely to the reported profits. While Guest Watches has succeeded in capturing the fashion market, product dependability is eroding these gains. A number of retailers have dropped or are threatening to drop the Guest watch line because of customer returns. Guest watches carry a one- year warranty and 12 percent are returned, compared with an industry average of 4 percent. Besides high warranty costs and lost sales due to reputation, Guest Watches has higher- than- industry- average manufacturing scrap and rework costs. Senior management, worried about these trends and the possible erosion of its market dominance, hired a consulting firm to study the problem and make recommendations for reversing the situation. After a thorough analysis of Guest Watches€™s customers, suppliers, and manufacturing facilities, the consultants recommended five possible actions ranging from the status quo to a com-plete Total Quality Management, Zero Defects program (level IV). The accompanying table outlines the various alternatives for Guest Watches. (Dollar figures are in thousands.)

The consultants emphasized that while first- year startup costs are slightly higher than in subse-quent years, management must really view the above cost estimates as annual ongoing costs. Given employee turnover and supplier changes, training, prevention, and compliance costs are not likely to decline over time. The consulting firm and the newly appointed vice president for quality programs estimated that under level IV, rework and scrap would be $ 25,000 and warranty costs zero. Level IV was needed to get the firm to zero defects. A task force was convened and after several meetings gen-erated the following estimates of rework/ scrap and warranty costs for the various levels of firm commitment:

There was considerable discussion and debate about the quantitative impact of increased quality on additional sales. While no hard and fast numbers could be derived, the consensus view was that the total net cash flows (contribution margin) from additional sales as retailers and customers learn of the reduced defect rate would be
Contribution
Margin on
Additional Sales
Status quo....... $ 0
Level ......... I 600
Level II....... 1,000
Level III ....... 1,200
Level IV ....... 1,300

Required:
a. Assuming that the data as presented are reasonably accurate, what should Guest Watches do about its deteriorating quality situation? Should it maintain the status quo or should it adopt the consultants€™ recommendation and implement level I, II, III, or IV?
b. Evaluate the analysis underlying your policy recommendation in (a). Will the senior management of the Watch Division make the same decision as the senior management of GuestFashions?

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Additiona! Training Cost Additional Prevention Compliance s 0 80 Status quo Level I Level II Level III Level IV 180 350 550 340 490 Toral Warranty Costs Total Rework/ Scrap Cost Status quo Level I Level II Level III Level IV $500 300 150 75 25 $350 280 140 80 0