Quality Costs

A product that meets or exceeds its design specifications and is free of defects that mar its
appearance or degrade its performance is said to have high quality of conformance. Note that if
an economy car is free of defects, it can have a quality of conformance that is just as high as
defect-free luxury car. The purchasers of economy cars cannot expect their cars to be as
opulently as luxury cars, but they can and do expect to be free of defects.
Preventing, detecting and dealing with defects cause costs that are called quality costs or costs
of quality. The use of the term "quality cost" is confusing to some people. It does not refer to
costs such as using a higher grade leather to make a wallet or using 14K gold instead of gold
plating in jewelry. Instead the term quality cost refers to all of the costs that are incurred to
prevent defects or that result from defects in products.
Quality costs can be broken down into four broad groups. These four groups are also termed as
four (4) types of quality costs. Two of these groups are known as prevention costs andappraisal
costs. These are incurred in an effort to keep defective products from falling into the hands of
customers. The other two groups of costs are known as internal failure costs andexternal failure
costs. Internal and external failure costs are incurred because defects are produced despite efforts
to prevent them therefore these costs are also known as costs of poor quality.
The quality costs do not just relate to just manufacturing; rather, they relate to all the activities in
a company from initial research and development (R & D) through customer service. Total
quality cost can be quite high unless management gives this area special attention.
Control Activities
Control activities are the policies, procedures, techniques, and mechanisms that help ensure that
management's response to reduce risks identified during the risk assessment process is carried
out. In other words, control activities are actions taken to minimize risk. The need for a control
activity is established in the risk assessment process. When the assessment identifies a significant
risk to the achievement of an agency's objective, a corresponding control activity or activities is
determined and implemented.
Control activities can be preventive or detective:
Preventive activities are designed to deter the occurrence of an undesirable event. The
development of these controls involves predicting potential problems before they occur and
implementing procedures to avoid them.
Detective activities are designed to identify undesirable events that do occur and alert
management about what has happened. This enables management to take corrective action
promptly.

Internal control activities can be incorporated into the following:
Policies
Procedures
Sequences or combinations of procedures
Assignments of duties, responsibilities, and authorities
Physical arrangements or processes
Combinations of the above.
Failure Activities
Environmental internal failure cost are cost of activities performed because contaminants and
waste have been produced but not discharge into the environment. Thus, internal failure costs are
incurred to illuminate and manage contaminants or wastes once produced.
Internal failure activities have one of the two goals:
To ensure that the contaminants and waste produced are not released to the environment
To ensure that the level of the contaminants released to an amount that complies with
environmental standards

Examples of internal failure activities include operating equipment to minimize or eliminate
pollution, treating and disposing of toxic materials, maintaining pollution equipment, licensing
facilities for producing contaminants, and recycling scrap.

Environmental External failure cost are the cost of activities performed after discharging
contaminants and waste into the environment. Realized external failure cost are those incurred
and paid for by the firm. Examples of realized external failure activities are cleaning up a
polluted lake, cleaning up oil spills, cleaning up contaminated soil, using materials and energy
inefficiently, settling personal injury claims from environmentally unsound practices, settling
property damage claims, restoring land to its natural state, and losing sales from a bad
environmental reputation. Unrealized external failure cost, or societal costs, are caused by the
firm but are incurred and paid for by parties outside the firm. Examples of societal cost include
receiving medical care because of polluted air (individual welfare), losing lake for recreational
use because of contamination (degradation), losing employment because of contamination
(individual welfare), and damaging ecosystems from solid waste disposal (degradation).

Compliace Cost

A Compliance cost is expenditure of time or money in conforming with government
requirements such as legislation or regulation. For example, people or organizations registered
for value added taxhave the extra burden of having to keep detailed records of all input tax and
output tax to facilitate the completion of VAT returns. This may necessitate them having to
employ someone skilled in this field, which would be regarded a compliance cost.
Compliance costs arise from most government interventions. However, businesses, other
organizations and private individuals should not incur more compliance costs than necessary.
This requires an increased awareness of the balance between the costs of compliance and the
objectives of government policy. In practical terms, this means compliance costs will be given
due weight with other costs and benefits when new laws, regulation, and administrative
processes are being designed. The new requirement for a BCCS will help ensure that business
compliance costs are given adequate upfront consideration in developing policy.
Meeting Obligations Imposed by Regulation
There are three broad categories of regulation:
regulations that facilitate the collection of taxation or other monies by the government
(such as PAYE, ACC levies, student loan repayments);
regulations that require businesses to record information or submit information to the
government (such as statistics, company returns), or disclose information to third parties (such as
company financial reporting requirements);
regulations that impose obligations on business for the benefit of third parties (that is,
regulation regarding matters such as consumer rights, environmental sustainability, health and
safety, anti-discrimination, border control).
The first two bullet points are requirements that create administrative responsibilities, while the
third bullet arises from requirements that place protective obligations on business, and generally
requires the business to change the way it operates in some way. In many cases, a single
regulation will contain elements of both administrative responsibilities and protective
obligations.

WORKING DEFINITION
Compliance costs are the administrative and paperwork costs on business in meeting
these government requirements. They include both the administrative burdens and all other
compliance costs, such as equipment purchases, retooling, and recurrent production cost.
Compliance costs are distinct from the direct costs of any government requirement, such as the
amount of tax payable.
Compliance costs of a regulatory proposal are only those incremental costs that arise from that
proposal. They do not include costs from activities that would have been carried out anyway.
What are compliance cost?
Meeting Obligations Imposed by Regulation
A Working Definition
Some Costs Are Less Tangible
Some Are Non-Quantifiable
Compliance Cost versus Administrative and Economic Costs

Non-Compliance Cost

Because the cascading effects of ongoing noncompliance can geometrically accelerate the costs
of and number of people affected by a given case, prevention or, failing that, early recognition
and intervention are vital.
Not Compliance Cost Reduction at Any Cost
The overall costs of government action have to be set against the expected benefits. A
fundamental requirement of sound policy analysis is that the expected benefits to society as a
whole from government action will exceed the overall costs. Regulatory Impact Analysis (RIA)
is used to demonstrate that there is a net-benefit associated with any proposed regulatory
intervention.
Net Benefit = Benefits less Costs (administration/compliance/direct/economic)
It is important to note that compliance costs are but one, albeit important, element of the overall
costs which arise from any regulatory intervention. Therefore, policy-makers must give
consideration to all the effects that the policy may create, including any compliance cost. The
various effects of a policy (its cost and benefits) are also closely related, with changes in one
often affecting another. As a result, changes designed to address compliance costs need to be
considered in the light of: the effect on the benefit of the policy - for example, abolishing a tax
removes the compliance cost but also the revenue from tax. Similarly, abolishing health and
safety requirements in the work place risks accident or death;
the effect on overall administration costs - for example, allowing businesses to provide
information in flexible formats. This may reduce compliance costs at the expense of greater
administration cost; and
different types of compliance cost - for example, new initiatives may increase the initial start-up
compliance costs but can lower on-going costs. For example, using electronic means for sending
information to the regulator.
In designing policy, policy-makers need to ensure that the overall mix of costs and benefits
provides the greatest net benefit to society. Compliance cost reduction is unlikely to benefit
society if it is made the sole objective of major changes or pursued in isolation. In orderto assess
which trade-offs are worthwhile, information on the extent and nature of compliance costs is
required. Poorly considered changes could increase other costs unnecessarily and reduce the
potential benefits from any measure.
Four types of qualitycost:
Prevention Costs: Generally the most effective way to manage quality costs is to avoid having
defects in the first place. It is much less costly to prevent a problem from ever happening than it
is to find and correct the problem after it has occurred. Prevention costs support activities whose
purpose is to reduce the number of defects. Companies employ many techniques to prevent
defects for example statistical process control, quality engineering, training, and a variety of
tools from total quality management (TQM).
Prevention costs include activities relating to quality circles and statistical process
control.Quality circles consist of small groups of employees that meet on a regular basis to
discussways to improve quality. Both management and workers are included in these circles.
Statistical process control is a technique that is used to detect whether a process is in or out of
control. An out of control process results in defective units and may be caused by a miscalibrated
machine or some other factor. In statistical process control, workers use charts to monitor the
quality of units that pass through their workstations. With these charts, workers can quickly spot
processes that are out of control and that are creating defects. Problems can be immediately
corrected and further defects prevented rather than waiting for an inspector to catch the defect
later.
Some companies provide technical support to their suppliers as a way of preventing defects.
Particularly in just in time (JIT) systems, such support to suppliers is vital. In a JIT system, parts
are delivered from suppliers just in time and in just the correct quantity to fill customer orders.
There are no stockpiles of parts. If a defective part is received from a supplier, the part cannot be
used and the order for the ultimate customer cannot be filled in time. Hence every part received
from suppliers must be free from defects. Consequently, companies that use just in time
(JIT) often require that their supplier use sophisticated quality control programs such as
statistical process control and that their suppliers certify that they will deliver parts and materials
that are free of defects.
Appraisal Costs: Any defective parts and products should be caught as early as possible in the
production process. Appraisal costs, which are sometimes called inspection costs, are incurred
to identify defective products before the products are shipped to customers. Unfortunately
performing appraisal activates doesn't keep defects from happening again and most managers
realize now that maintaining an army of inspectors is a costly and ineffective approach to quality
control. Employees are increasingly being asked to be responsible for their own quality control.
This approach along with designing products to be easy to manufacture properly, allows quality
to be built into products rather than relying on inspections to get the defects out.
Internal failure Costs: Failure costs are incurred when a product fails to conform to its design
specifications. Failure costs can be either internal or external. Internal failure costs result from
identification of defects before they are shipped to customers. These costs include scrap, rejected
products, reworking of defective units, and downtime caused by quality problem. The more
effective a company's appraisal activities the greater the chance of catching defects internally and
the greater the level of internal failure costs. This is the price that is paid to avoid incurring
external failure costs, which can be devastating.
External Failure Costs: When a defective product is delivered to customer, external failure cost
is the result.External failure costs include warranty, repairs and replacements, product recalls,
liability arising from legal actions against a company, and lost sales arising from a reputation for
poor quality. Such costs can decimate profits.
In the past, some managers have taken the attitude, "Let's go ahead and ship everything to
customers, and we'll take care of any problems under the warranty." This attitude generally
results in high external failure costs, customer ill will, and declining market share and profits.
External failure costs usually give rise to another intangible cost. These intangible costs are
hidden costs that involve the company's image. They can be three or four times greater than
tangible costs. Missing a deadline or other quality problems can be intangible costs of quality.
Internal failure costs, external failure costs and intangible costs that impair the goodwill of the
company occur due to a poor quality so these costs are also known as costs of poor quality by
some persons.
Examples of four types of quality cost are given below:
Prevention Costs Internal Failure Costs
Systems development
Quality engineering
Quality training
Quality circles
statistical process control
Supervision of prevention activities
Quality data gathering, analysis, and reporting
Quality improvement projects
Technical support provided to suppliers

Net cost of scrap
Net cost of spoilage
Rework labor and overhead
Re-inspection of reworked products
Retesting of reworked products
Downtime caused by quality problems
Disposal of defective products
Analysis of the cause of defects in production
Re-entering data because of keying errors
Debugging software errors
Appraisal Costs External Failure Costs
Test and inspection of incoming materials
Test and inspection of in-process goods
Final product testing and inspection
Supplies used in testing and inspection
Supervision of testing and inspection activities
Depreciation of test equipment
Maintenance of test equipment
Plant utilities in the inspection area
Field testing and appraisal at customer site
Cost of field servicing and handling complaints
Warranty repairs and replacements
Repairs and replacements beyond the warranty
period
Product recalls
Liability arising from defective products
Returns and allowances arising from quality
problems
Lost sales arising from a reputation for poor
quality.
How to Distribute Quality Costs?
A company's total quality cost is likely to be very high unless management gives this area special
attention. Experts say that these costs should be more in 2% to 4% range. How does a company
reduces its total quality cost? The answer lies in how the quality costs are distributed.
Total quality cost is a function of quality of conformance. A high quality of conformance
means that a product is free of defects and a low quality of conformance means that a product
has defects. In this sense an economy car may have a quality of conformance same as a very
expensive car if it has no defects. Like wise an expensive car may have less quality of
conformance if it has defects that effect its use. When the quality of conformance is low, total
quality cost is high and most of this cost consists of cost of internal and external failure. A low
quality of conformance means that a high percentage of units is defective and hence the company
must incur high failure costs Ordinarily total quality cost drops rapidly as the quality of
conformance increases. The best way to prevent defects from happening is to design processes
that reduce the likelihood of defects and to continually monitor processes using statistical
process control methods.
Quality Cost Report:
A quality cost report details the prevention costs, appraisal costs, and internal failure
costand external failure cost that arise from company's current level of defective products or
services. Companies often construct a quality cost report that provides an estimate of the
financial consequences of the company's current level of defects. A simple quality cost reportis
shown in the following example:
Example of Quality Cost Report
Ventura Company
Quality Cost Report
For the Year1 & 2


Prevention Cost
Appraisal Costs
Internal Failure Costs
External Failure Costs
Total Quality Cost
Year 2 Year 1
Amount
1,000,000
1,500,000
3,000,000
2,000,000
-----------
7,500,000
======
Percent
2.00%
3.00%
6.00%
4.00%
---------
15.00%
=====
Amount
650,000
1,200,000
2,000,000
5,150,000
----------
9,000,000
======
Percent
1.30%
2.40%
4.00%
10.30%
---------
18.00%
=====
Prevention cost increased by (1,000,000 650,000) = 350,000
Appraisal cost increased by (1,500,000 1,200,000) = 300,000
Internal Failure cost (3,000,000 2,000,000) = 1,000,000
Total Increase = 1,650,000
External failure cost decreased by = 3,150,000
Net Quality Cost Benefit = 3,150,000 1,650,000
= 1,500,000
Several things should be noted from the data in the quality cost report. First, note that the
quality costs are poorly distributed in both years, with most of costs being traceable to either
internal or external failure. The external failure costs are particularly high in year 1 in
comparison to other costs. Second note that the company increased its spending on prevention
and appraisal activities in year 2. As a result, internal failure costs went up in that year (from $2
million in first year to $3 million in year 2), but external failure costs dropped sharply (from
$5.15 million in year 1 to $3 million in year 2). Because of the increase in appraisal activates in
year 2,more defects were caught inside the company before they were shipped to the customers.
This resulted in more cost for scrap, rework, and so forth, but saved huge amounts in warranty
repairs, warranty replacements, and external failure costs. Third, note that as a result of greater
emphasis on prevention and appraisal, total quality cost decreased inyear2.As continued
emphasis is placed on prevention and appraisal in future years, total quality cost should continue
to decrease. That is , future increases in prevention and appraisal costs should be more than
offset by decreases in failure costs. Moreover, appraisal costs should also decrease as more effort
is placed into prevention.