Wayne Johnson, president of Banshee Company, recently returned from a conference on quality and productivity. At the conference, he was told that many American firms have quality costs totaling 20 to 30 percent of sales. He, however, was skeptical about this statistic.

But even if the quality gurus were right, he was sure that his company’s quality costs were much lower—probably less than 5 percent. On the other hand, if he was wrong, he would be passing up an opportunity to improve profits significantly and simultaneously strengthen his competitive position. The possibility was at least worth exploring. He knew that his company produced most of the information needed for quality cost reporting—but there never was a need to bother with any formal quality data gathering and analysis.

This conference, however, had convinced him that a firm’s profitability can increase significantly by improving quality—provided the potential for improvement exists. Thus, before committing the company to a quality improvement program, Wayne requested a preliminary estimate of the total quality costs currently being incurred. He also indicated that the costs should be classified into four categories: prevention, appraisal, internal failure, and external failure. He has asked you to prepare a summary of quality costs and to compare the total costs to sales and profits. To assist you in this task, the following information has been prepared from the past year, 2010:

a. Sales revenue, $15,000,000; net income, $1,500,000.

b. During the year, customers returned 90,000 units needing repair. Repair cost averages $1 per unit.

c. Four inspectors are employed, each earning an annual salary of $60,000. These four inspectors are involved only with final inspection (product acceptance).

d. Total scrap is 150,000 units. Of this total, 60 percent is quality related. The cost of scrap is about $5 per unit.

e. Each year, approximately 450,000 units are rejected in final inspection. Of these units, 80 percent can be recovered through rework. The cost of rework is $0.75 per unit.

f. A customer cancelled an order that would have increased profits by $150,000. The customer’s reason for cancellation was poor product performance.

g. The company employs three full-time employees in its complaint department. Each earns $40,500 a year.

h. The company gave sales allowances totaling $45,000 due to substandard products being sent to the customer.

i. The company requires all new employees to take its three-hour quality training program. The estimated annual cost of the program is $30,000.

Required:

1. Prepare a simple quality cost report classifying costs by category.

2. Compute the quality-cost-to-sales ratio. Also, compare the total quality costs with total profits. Should Wayne be concerned with the level of quality costs?

3. Prepare a pie chart for the quality costs. Discuss the distribution of quality costs among the four categories. Are they properly distributed? Explain.

4. Discuss how the company can improve its overall quality and at the same time reduce total quality costs.

5. By how much will profits increase if quality costs are reduced to 2.5 percent of sales?