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.

Martin's 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 company's 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 we've 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 it's 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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4. Landers:Okay, Eloise. Give your cost of quality system a try, though I don't see how it will help. Everybody knows that good quality costs money. Even if we do find out our cost of quality, I don't see how it will help us reduce it.
5. Martin:John, good quality doesn't seem to cost money in Taiwan and Korea. Their prices haven't gone up, even though their quality has. You'll 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.

Required:

1. Prepare a cost of quality report similar to the report shown inExhibit 16.11.
2. Use the information in this report to suggest ways in which the company could reduce its cost of quality.
3. When John Landers receives the cost of quality report, he is amazed and says, 'Eloise, you're the accountant. Why didn't 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.