C16.50

Measuring and managing quality costs: manufacturer LO 16.8

Landers Ltd is a major Australian bicycle manufacturer. Over the last decade, bicycle manufacturers from Taiwan and Korea have been able to price their bikes below the Landers products, but the company has retained its market share due to the poor quality of the imported bikes. Recently, however, the quality of the imported bikes has improved, and Landers has had to cut prices to maintain market share. The managing director, John Landers, is concerned about the viability of the business at these lower prices and asks the accountant, Eloise Martin, to investigate the problem.

Martins initial investigation indicates that the lower prices cannot be sustained in the longer term, as they do not cover the costs of manufacture, let alone contribute to the companys selling and administrative costs. She looks for possible cost reductions. The company has always had a reputation for high quality, but Martin feels that there are substantial costs incurred in attaining this level of quality. She knows that there are extensive quality inspection checks throughout the production process and that many employees spend part of their time reworking defective parts. She has also noticed the buckets full of scrapped parts and components spread throughout the factory. These costs are not recorded separately in the existing accounting system. Martin asks Landers to support the development of a cost of quality system.

1. Landers:What do you mean, a system that records the costs of poor quality! Our bikes are among the best in terms of quality!
2. Martin:I know that, John, and we know what it costs us to make our bikes, but weve got no idea how much of that cost is related to ensuring quality. I think the cost of quality here is very high. What if its a third of our manufacturing costs? And what if we could reduce it without compromising our quality? We could keep our prices down and still make a good profit.

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3. Landers:Okay, Eloise. Give your cost of quality system a try, though I dont see how it will help. Everybody knows that good quality costs money. Even if we do find out our cost of quality, I dont see how it will help us reduce it.
4. Martin:John, good quality doesnt seem to cost money in Taiwan and Korea. Their prices havent gone up, even though their quality has. Youll soon see that understanding quality costs can help you to reduce them and to improve quality at the same time.

Over the next six months Martin identifies the following costs of quality:

• cost of replacement bikes provided under warranty, $7 500

• cost of bikes returned by customers and scrapped, $7 500

• sales commissions on faulty bikes returned by customers, $750

• contribution margin forgone on bikes returned by customers, $1 500

• rework on defective wheels, $12 000

• quality inspection in the goods receiving area, $22 500

• quality inspections during processing, $34 500

• laboratory testing of bikes and components, $19 500

• contribution margin forgone on lost future bike sales, $7 500

• engineering costs to correct production line quality problems, $22 500

• lost contribution on machine downtime during correction of production line quality problems, $37 500

• operating an X-ray machine to detect faulty welds, $22 500

• cost of repairs under warranty, $1 500

• cost of rewelding faulty joints discovered during processing, $28 500

• cost of quality training programs, $4 500

• inspection of bikes put into finished goods warehouse, $24 000

• cost of faulty components that are scrapped, $6 000

• cost of faulty bikes that are scrapped after finished goods inspection, $15 000.

During this period, total manufacturing costs were $900 000.

Exhibit 16.11 figure

Q1.Prepare a cost of quality report similar to the report shown in Exhibit 16.11

.Q2.Use the information in this report to suggest ways in which the company could reduce its cost of quality.

Q3. When John Landers receives the cost of quality report, he is amazed and says, Eloise, youre the accountant. Why didnt you tell me before that our quality costs were this high? Explain to Landers why Martin was unable, because of the existing accounting system, to tell him much about the cost of quality.

Current month's costs Percentage of total* $2000 3000 2000 1 000 $8 000 4.55% 6.82% 4.55% 2.27% 18.18% 7000 3000 1 000 2000 $13 000 15.91% 6.82% 2.27% 4.55% 29.55% 3 Internal failure costs 4 Scrap in production Scrapped finished goods 6 Rework 7 Downtime Total internal failure costs 9 External failure costs 10 Warranty costs 11 Out-of-warranty repairs and replacement 12 Servicing customer complaints 13 Transportation losses 14 Total external failure costs 15 Appraisal costs 16 Materials inspection 17 In-process inspection 18 Finished goods inspection 19 Laboratory testing 20 Total appraisal costs 21 Prevention costs 22 Quality training 23 Quality planning 24 Quality reporting 25 Quality systems development 26 Total prevention costs 3000 2000 2000 4000 $11 000 6.82% 4.55% 4.55% 9.09% 25.00% 4000 1 000 2000 5000 $12000 9.09% 2.27% 4.55% 11.36% 27.27% 27 28 Total quality costs $44 000 100.00%