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This study examines the time series behavior of quality costs reported by 49 manufacturing units of 21 companies. Analyses using
both pooled annual data and plant-specific quarterly data indicate that the majority of units in the sample achieved ongoing
reductions in nonconformance costs while maintaining or reducing reported prevention and appraisal costs. These findings are
consistent with recent quality-based learning and continuous improvement models which suggest that, once an effective quality
program is established, companies can reduce nonconformance costs over time with little or no subsequent increase in conform-
ance expenditures.
Since the introduction of the traditional quality cost annual quality cost data from 49 manufacturingunits of
model in the 1950s (Juran 1951, Feigenbaum 1957, 21 companies indicate that increases in conformance ex-
Masser 1957), managers have been urged to base quality- penditures generally led to failure cost reductions in the
related decisions on the hypothesized tradeoff between current or following year. However, in the years follow-
the costs of prevention and appraisal (or conformance ing the start of the quality program, many plants contin-
costs) and the costs of internal and external failure (or ued reducing nonconformance costs while maintainingor
nonconformance costs). According to the traditional even reducing existing expenditures on conformance ac-
model shown in Figure 1, a company producing subopti- tivities, supporting claims that prevention and appraisal
mally poor quality (i.e., defective) products can greatly expenditures can be cut back as the quality program
reduce nonconformance costs by adding relatively inex- progresses (Fine 1986, Harrington1987). Over the life of
pensive prevention and appraisal measures. As preven- the quality program, 29 of the 39 plants that reduced
tion and appraisalexpenditurescontinue to rise, the rate of reported nonconformance costs also reduced expendi-
improvementis assumed to diminish until additionalcon- tures on conformance activities. These findings are rein-
formance expenditures produce little decrease in non- forced by time series analyses of quarterly quality cost
conformance costs. The model resolves the hypothesized data reportedby 24 manufacturingunits belongingto seven
tradeoff by specifying a nonzero optimal level of defects of the participatingcompanies, which indicate that reduc-
at the point where the marginalcost of increased preven- tions in nonconformanceexpenditureswere, on average,
tion and appraisal activities equals the marginal benefit associated with simultaneous reductions in conformance
from nonconformance cost reductions. costs. Overall, the empirical evidence is consistent with
Many proponents of traditional quality cost theory continuous improvementand quality-basedlearningmod-
have interpreted the tradeoffs portrayed in this model to els which indicatethat, once an effective qualityprogramis
mean that nonconformance costs can only be reduced by established, ongoing nonconformance cost reductions
increasing expenditures on conformance activities. Con- can be achieved with little or no subsequent increase in
tinuous improvement advocates, however, have criti- conformance expenditures.
cized this interpretation, claiming that ongoing quality The remainder of the paper is organized as follows.
improvements can be achieved with little or no incre- Section 1 provides an overview of the quality cost con-
mental investment (e.g., Schneidermann 1986, 1988, cept and reviews the various models of quality cost be-
Harrington 1987, Cole 1992). These claims have been havior. Section 2 discusses the sample, followed by
supported by recent theoretical work on quality-based descriptive statistics in Section 3. Empirical results are
learning(Fine 1986, Marcellus and Dada 1991)which sug- presented in Section 4. A summary and implications for
gests that the traditionaltradeoffmodel may be an accurate future research conclude the paper.
static representationof quality cost economics, but that in
dynamic, multiperiodsettings, nonconformancecosts can 1. MODELS OF QUALITY COST BEHAVIOR
continue to decline over time with no corresponding in-
crease in conformancecosts. 1.1. Defining Quality Costs
This paper examines the hypothesis that conformance Quality costs have traditionally been defined as all ex-
expenditures must continue to be increased to achieve penditures associated with ensuring that products con-
ongoing reductions in nonconformance costs. Reported form to specifications or with producing products that do
Subject classifications: Cost analysis: quality-cost tradeoffs. Reliability, quality control: quality control economics.
Area of review: MANUFACTURING, OPERATIONS AND SCHEDULING (SPECIAL ISSUE ON NEW DIRECTIONS IN OPERATIONS MANAGEMENT).
o TOTAL
QUALITY
COSTS where y is the actual value for a product characteristic, T
is the target value for the characteristic, and k is a con-
stant representing the cost of the countermeasure (i.e.,
nonconformance cost) that must be employed by the
PREVENTION
company. Although the specific functional form of
APPRAISAL the quality loss function has not been validated empiri-
NON-CONFORMANCE cally (Taguchi and Clausing),2 the view that any devia-
tion from target results in losses suggests that the
100% 100%
DEFECTIVE GOOD conventional definition of failures in terms of nonconfor-
mance to specifications understates the costs of poor
Figure 1. The competing models of quality cost quality, leading to suboptimal quality improvement de-
behavior. cisions (Taguchi and Clausing 1990, DeVor, Chang and
Sutherland 1992).
It is important to note, however, that the Taguchi loss
function is not necessarily inconsistent with the four tra-
not conform.1 These cost can be classified into the fol- ditionalqualitycost categories or the notion of quality-cost
lowing categories: tradeoffs. Taguchi, for example, argues that management
Conformance Costs: The costs of achieving conform- must choose the precision level that minimizes total cost,
ance to specifications. Conformance costs are comprised not just quality loss (Taguchiand Clausing).This implies a
of two elements: tradeoffbetween investments in improving,checking, and
adjustingprocesses, i.e., prevention and appraisalcosts,
Prevention: The costs incurred to keep nonconforming and the resulting reduction in quality losses, i.e., failure
products from being produced. Examples include the costs (Taguchi and Clausing, 1990, DeVor, Chang, and
costs associated with implementing and maintaining a Sutherland,1992). See Albrightand Roth (1992)and Wong
quality system, quality-related training, new product (1992) for frameworkslinkingthe Taguchi loss function to
reviews, quality planning, and the development of pro- the four traditionalquality cost categories.
cess controls.
Appraisal: The costs incurred to ensure that materials 1.2. Competing Models of Quality Cost Behavior
and products meet conformance standards, including
The two competing models of quality cost behavior are
the costs of receiving, in-process, and final inspection,
illustrated in Figure 1.3 As noted earlier, the traditional
lab tests, quality audits, and field tests.
quality cost model specifies a nonzero optimal defect
Nonconformance Costs: The costs of failure to con- level at the point where the marginal cost of prevention
form to specifications. These include: and appraisal expenditures equals the marginalreduction
in internal and external failure costs. The continuous im- Interestingly,this result runs counterto the beliefs of some
provement model, in turn, suggests that nonconformance continuous improvement advocates who maintain that
costs can be reduced with little or no incremental invest- companies that reduce preventionexpenditureswill be un-
ment in prevention and appraisal. Although illustrations able to hold theirprevious gains (e.g., Schneiderman1988).
of these models typically plot quality costs against qual- In Marcellus and Dada's model, each investment in
ity or defect levels, Bowbrick (1992) notes that most of prevention provides a learning opportunity that de-
the quality literature either implicitly or explicitly as- creases the future costs of defectives.6 Consequently, at
sumes that the models reflect the optimal movement of least part of the investment in prevention is analogous to
costs over time. a capital investment that provides benefits over multiple
Many proponents of traditionalquality cost theory, for periods. Given the capital investment-like nature of qual-
example, have interpreted the tradeoffs portrayed in the ity improvement activities, the cost of prevention be-
traditionalmodel to mean that nonconformance costs can comes concave over time as opposed to strictly convex
only be reduced by increasing expenditures on conform- in the traditionalquality cost model. Unlike the simulta-
ance activities. Lockyer (1983), Noz, Redding and Ware neous conformance and nonconformance cost reductions
(1989), and others have extended this logic to develop
found in Fine's model, however, the resulting dynamic
multiperiod theories of quality cost behavior that are
model of quality cost behavior implies that a relatively
based on an organization's stage in the quality improve-
fixed level of prevention expenditures can produce de-
ment process. These frameworks indicate that managers
must continue to increase conformance expenditures creasing marginal reductions in failure costs over
over time to achieve continuous quality improvements multiple periods, a result similar in spirit to the continu-
and move to higher stages of the quality process. When ous improvement model shown in Figure 1 (Marcellus
these increases stop, quality improvement ceases. This and Dada, p. 1371).
interpretation of the traditional tradeoff model suggests In summary, the continuous improvement and quality-
the following hypothesis. based learning models suggest the following null hypoth-
esis regardingquality cost behavior.
Hi. Conformance expenditures must be increasing over
time to achieve ongoing reductions in nonconformance H1lnul.Ongoing reductions in nonconformance costs can
costs. be achieved over time while maintaining(e.g., Marcellus
and Dada) or even reducing (e.g., Fine) existing con-
Continuous improvement advocates, on the other formance expenditures.
hand, question the claim that managers must continue to
increase conformance costs to achieve ongoing quality
improvements. Quality experts such as Deming (1982),
Schneiderman (1986, 1988), and Harrington (1987), for
TOTAL
QUALITY
COSTSt+z
example, argue that in firms committed to continuous
incremental improvement, a relatively fixed level of TOTAL
QUALITY
COSTSt
Table II
Reported Quality Costs for 49 Manufacturing Units Belonging to 21 Companies; n = 49 for Conformance and
Nonconformance and 33 for Prevention, Appraisal, Internal Failure, and External Failure.
First Year of QualityProgram Latest Year of QualityProgram
Mean Median Standard Mean Median Standard
n (%) (%) Deviation (%) (%) Deviation
PanelA: Reportedqualitycosts as a percentof sales
Prevention 33 2.1 1.8 1.5 2.0 2.3 1.1
Appraisal 33 3.1 2.4 2.5 2.5 1.8 2.3
Internalfailure 33 4.6 3.6 3.9 3.4 2.5a 3.1
Externalfailure 33 1.5 1.4 1.1 1.0 0.7a 1.1
Total conformance 49 4.8 4.4 3.0 4.2 3.8 2.6
Total nonconformance 49 6.4 5.4 4.0 4.7b 4.1c 3.2
Total qualitycosts 49 11.2 10.4 5.6 8.9b 8.6" 4.7
PanelB: Percentagedistributionof total reportedqualitycosts amongqualitycost categories
Prevention 33 18.4 17.9 10.6 23.9b 23.8" 10.9
Appraisal 33 27.3 25.1 12.8 28.7 25.9 14.4
Internal failure 33 38.9 38.0 14.6 34.8 33.1 14.5
External failure 33 16.2 9.7 14.3 13.3 8.0 13.2
Total conformance 49 43.3 41.3 15.4 48.4C 46.9a 15.9
Total nonconformance 49 56.7 58.7 15.4 51.6c 53.la 15.9
aSignificantlydifferentthan the correspondingfigurefor the firstyear of the qualityprogramat the 10%level, two-tailedt-test (means)or
Mann-Whitneytest (medians).
bSignificantlydifferentthan the correspondingfigurefor the firstyear of the qualityprogramat the 5% level, two-tailedt-test (means)or
Mann-Whitneytest (medians).
cSignificantlydifferentthan the correspondingfigurefor the firstyear of the qualityprogramat the 1%level, two-tailedt-test (means)or
Mann-Whitneytest (medians).
Table III
Summary Statistics on Annual Changes in Reported Quality Costs as a Percent
of Sales,a Pooled Observations From 49 Manufacturing
Units Belonging to 21 Companies
Standard
n Mean Median Deviation
PanelA: Changesin reportedqualitycosts/sales
APREV 157 -0.00 0.02 0.41
AAPPR 157 -0.06c -0.05d 0.36
AINT 157 -0.20d _0 11d 0.90
AEXT 157 -0.10 -0.04 1.23
ACONF 201 -0.08 -0.06b 0.37
ANCONF 201 0.33 0.26 1.54
PanelB: Percentagechangesin reportedqualitycosts/sales
%APREV 157 4.2%c 1.9% 25.8
%AAPPR 157 3.4% -5.0%c 66.8
%AINT 157 0.4% -6.3%d 86.0
%AEXT 157 11% -11.1%C 53.6
%ACONF 201 -1.4% -2.2%c 16.6
%ANCONF 201 -4.5%c -7.9%d 31.2
aAnnualchangesin qualitycost categoriesare calculatedusing the generalformulas:
AQualityCosti,t =(Quality Costs/Sales)i,t - (Quality Costs/Sales)i,tl
the mean (median) proportion of expenditures on preven- overall conformance expenditures. This finding is incon-
tion rose from 18.4% (17.9%) to 23.9% (23.8%), leading sistent with traditionalquality cost model, which implies
to an overall increase in the percentage of reported qual- that lower nonconformance costs can only be achieved
ity costs dedicated to conformance activities. through increased conformance expenditures.
One possible explanation for the reduction in appraisal
3.2. Annual Changes in Quality Costs costs is that companies pushed inspection responsibilities
Table III presents data on standardized annual changes onto their suppliers during the period under study. Data
in conformance and nonconformance costs for the entire on receiving inspection costs in 19 of the 49 plants are
sample, as well as changes in the prevention, appraisal, available to examine this hypothesis. Over the years cov-
internal failure, and external failure categories for the ered by the study, the 19 units achieved mean (median)
subsample of manufacturing plants that utilize these annual percentage reductions in the ratio of total ap-
breakdowns. As shown in the table, both mean (-0.33) praisal costs to sales of 3.2% (4.2%), significant at the
and median (-0.26) annual changes in nonconformance 10% level. Of these improvements, reductions in receiv-
costs are negative and significant at the 1% level. In per- ing inspection costs accounted for only 7.9% on average
centage terms, these reductions represent 4.5% and 7.9% (median = 13.0%). Mean and median annual percentage
of reported quality costs, respectively, both of which are reductions in the ratio of receiving inspection costs to
statistically significant at the 5% level or better. Mean sales were 2.5% and 4.4%, respectively, neither of which
(-0.20) and median (-0.11) changes in internal failure is statistically significant at conventional levels. In con-
and median (-0.04) changes in external failure costs are trast, the mean (median) percentage change in appraisal
also significant, as are median percentage changes in costs other than receiving inspection is a statistically sig-
both of the failure categories. nificant -3.2% (-5.6%). This evidence indicates that in
The summary data in Table III indicate that the reduc- the 19 plants for which data are available, reductions
tions in nonconformance costs were not accompanied by in receiving inspection costs explain only a small fraction
significant increases in prevention and appraisal activi- of the observed decrease in appraisal expenditures.
ties. In fact, median changes in appraisal and total con- To investigate whether the results in Table III are sen-
formance costs as a percent of sales are negative and sitive to the maturity of the quality improvement pro-
statistically significant. Although the mean percentage cess, the sample is partitioned by the number of years
change in prevention expenditures is positive, mean and since the start of the quality program, with the first year
median changes in prevention levels and median percent- of the programdefined as year k. 12 Table IV summarizes
age changes in prevention are not significantly different the results from this partition for the six subsequent
from zero at conventional levels. Thus, for the sample as years with fifteen or more observations. Over these peri-
a whole, the evidence suggests that the plants achieved ods, nonconformance costs declined significantly in
annual nonconformance cost reductions while maintain- years k + 1 through k + 4, with the improvement be-
ing a relatively fixed level of prevention expenditures. coming progressively smaller each period (median
Moreover, as quality improved, the plants appear to change in reported nonconformance costs from the pre-
have reduced appraisal expenditures, leading to lower vious year = -12.0% in year k + 1, -8.9 % in year k +
Table IV
Median Annual Percentage Changes in Reported Quality Costs/Sales Partitioned
by the Year of the Quality Program;a Pooled Observations From 49
Manufacturing Units Belonging to 21 Companies
Year
k+ 1 k+ 2 k+ 3 k+ 4 k +5 k+ 6
%APREV -5.0%c 0.9% 0.0% 5.9% 5.5% 2.4%
%AAPPR -11.5%c -6.7%c 2.8% 1.9% -1.3% -6.3%
%AINT -15.4%d _14.1%e -4.5% -1.6% -4.7% 0.0%
%AEXT - 15.0%e 0.0% _19.0%d -9.7% 8.4% -22.6%
%ACONF -9.4%e -2.2% -1.0% -1.0% 2.3% -5.0%
%ANCONF -12.0%e _8 9%e _8.7%d _7.0%c -0.4% -1.7%
nb 49 (33) 38 (26) 29 (25) 23 (20) 19 (18) 18 (17)
aTheyear in the tablesrefersto the numberof years since the startof the qualityprogram,with the
firstyear of the programdefinedas Year k.
bThelargersample size relates to the numberof observationsfor total conformanceand noncon-
formancecosts. The samplesize in parenthesesrefersto the numberof observationsfor the preven-
tion, appraisal,internalfailure,and externalfailurecategories.
cSignificantlydifferentfromzero at the 10%level, Wilcoxonsigned ranktest.
dSignificantlydifferentfrom zero at the 5%level, Wilcoxonsigned ranktest.
eSignificantlydifferentfromzero at the 1%level, Wilcoxonsigned ranktest.
Table V
The Association Between Median Changes in Conformance and Nonconformance Costs; Pooled Annual
Observations From 49 Manufacturing Units Belonging to 21 Companiesa; Percentage Changes in
Nonconformance Costs/Sales Partitioned by the Magnitude of Percentage Changes in
Conformance Costs/Salesb
Sorted on %APREV Sorted on %AAPPR Sorted on %ACONF
Quintile %APREV %ANCONF %AAPPR %ANCONF %ACONF %ANCONF
1 27.5 -6.2c2 19.6 -12.0d2 19.2 -6.5e2
2 10.3 -1.8 3.3 1.1 4.5 -0.8
3 2.4 90 e2 _4.9 _9.od2 -2.2 -8.1d2
4 -6.4 _-11.1e2 -8.9 -9.8e2 -9.2 -10.6e2
5 -19.5 -14 gel,2 -22.9 -11.6e2 -18.6 -12.9e2,3
'N = 201 for %ACONF and 157 for %APREV and %AAPPR.
bThe table reports median percentage changes in nonconformance costs for quintiles formed on the basis of the magnitude of
percentage changes in conformance costs.
c= Significantly different from zero at the 10% level, Wilcoxon signed rank test.
d= Significantly different from zero at the 5% level, Wilcoxon signed rank test.
e= Significantly different from zero at the 1% level, Wilcoxon signed rank test.
1 = Significantly greater reduction than quintile 1 (10% level, Mann-Whitney test); 2 = Significantly greater reduction than quintile 2;
3 = Significantly greater reduction than quintile 3.
nonconformance costs were also associated with reduc- The tests in Table V examined the association be-
tions in conformance expenditures. Quintiles 4 and 5 re- tween contemporaneous changes in conformance and
duced prevention costs by 6.4% and 19.5%, respectively, nonconformance costs. Yet a significant lag may exist
while, at the same time, lowering nonconformance costs between increases in conformance activities and reduc-
by 11.1% and 14.9%. Patterns are similar when changes tions in nonconformance costs. As Morse (1989, p.
in appraisaland total conformance costs are used to form 131) notes, "Effort and accomplishment are probably
the portfolios. The majority of observations in quintiles 4 not matched in a single reporting period. It may take
and 5 represent plants that reduced conformance expen- months, or even years, for investments in prevention
ditures after making large investments in quality training to pay off." To investigate this possibility, Table VI
and systems development during the early years of their presents median annual changes in nonconformance
quality programs, supporting Harrington's claim that costs for quintiles formed on the basis of the magni-
many of the prevention and appraisal costs that are in- tude of percentage changes in conformance costs dur-
curred at the beginning of a q-ualityprogramto systemat- ing the previous year.
ically track down and prevent defects can be cut back as The evidence shows that although plants with the larg-
the improvement process drives the defect rate lower.13 est increases (quintile 1) and decreases (quintiles 4 and 5)
Table VI
The Association Between Median Changes in Conformance Costs and Lagged Median Changes in
Nonconformance Costs; Pooled Annual Observations From 49 Manufacturing Units Belonging to 21
Companiesa; Lagged Percentage Changes in Nonconformance Costs/Sales Partitioned by the
Magnitude of Percentage Changes in Conformance Costs/Salesb
Sorted on %APREVt Sorted on %AAPPRt Sorted on %ACONFt
Quintile %APREVt %ANCONFt+1 %AAPPRt %ANCONFt+1 %ACONFt %ANCONFt+?
1 27.5 -4.0 19.6 -3.9 19.3 -1.7
2 10.3 _10.2C3 5.9 -8.2c3 5.7 -90od1,3
3 3.0 0.0 -4.5 -1.8 -1.9 -5.9
4 -5.3 -12.8el,3 -8.9 -12.81,3 -8.4 -7.fel
5 -18.1 -7.7 -24.7 -8.7 -18.6 _8.7el,3
'N = 152 for %ACONF and 108 for %APREV and %AAPPR.
bTables report median changes in nonconformance costs in year t + 1 for quintiles formed on the basis of the magnitude of percentage
changes in conformance costs in year t.
c= Significantly different from zero at the 10% level, Wilcoxon signed rank test.
d= Significantly different from zero at the 5% level, Wilcoxon signed rank test.
e= Significantly different from zero at the 1% level, Wilcoxon signed rank test.
1 = Significantly greater reduction than quintile 1 (10% level, Mann-Whitney test); 3 = Significantly greater reduction than quintile 3.
mean annual percentage changes in prevention and ap- these periods, the units reduced nonconformance costs
praisal are both positive, though the change in preven- as a percent of sales by 17.8%on average, with a median
tion is not statistically different from zero. In conjunction reduction of 27.8%. Plant-specific regressions are
with the lower nonconformance costs observed in nearly estimated to examine the association between these im-
80% of the plants in the sample, the significant positive provements and changes in conformance expenditures.
coefficient on appraisaland statisticallyinsignificantcoeffi- To control for volume fluctuations, each category of
cient on prevention suggest that, on average, the plants' quality costs is first regressed on sales to estimate the
reductions in nonconformancecosts since the start of the category's fixed and variable components. The residuals
quality program were accompanied by reductions in ap- from this regression (denoted PREV.R, CONF.R, and
praisal costs and a relatively fixed level of prevention ex- NCONF.R) represent the difference between actual costs
penditures, not the increasing conformance expenditures during the period and expected costs given the period's
predicted by the traditionalquality cost model. sales, thereby providing a measure of the variation in
quality-relatedexpenditures that is not predictable based
5.3. Plant-Specific Time Series Analysis on knowledge of the variation in sales volumes.17
Subject to the econometric and data limitations noted Table VIII presents summary statistics from the 24
earlier, the preceding analyses support the quality-based individual plant-level regressions. A test of the null hy-
learning models' implication that nonconformance costs pothesis that the average coefficient from the individual
can be reduced over time without increasing conform- regressions is equal to zero can be constructed as follows
ance costs. But the pooling of observations from manu- (Anderson 1971):
facturing units with different production functions, Z = =1NE tJ
t /1/ (+lr (3)
product attributes, and quality cost systems may obscure
wNji kj /(kj -2)
the underlying relationships among quality cost catego-
ries. This section controls for these differences by exam- where
ining the time series behavior of reported quality costs tj = the t-statistic for plant j;
from 24 manufacturing units belonging to seven of the kj = the degrees of freedom in the regression for plant
participatingcompanies.
The 24 plants provided quality cost data for periods r = the mean correlation between plant's t-statistics;
ranging from 14 to 28 quarters each (median = 19). Over and
Table VIII
Summary Statistics From Plant-Specific Regressions Examining the Longitudinal Relationship Between
Conformance and Nonconformance Costsa, 24 Manufacturing Units From 7 Companiesb
(t-statistics in parentheses)
PanelA: Total ConformanceCosts
NCONF.Rt= a + I1 CONF.Rt+ 02 CONF.Rt1 + I0 CONF.Rt2 + 4 CONF.Rt-3+ I0 CONF.Rt4 + e
Ad'.
CONF.Rt CONF R 1 CONF.Rt2 CONFRt3 CONF R R
R
Mean 0.78 -0.45 -0.02 0.12 0.02 0.34
(1.57) (-0.46) (-0. 10) (0.09) (0.07)
Median 0.40 -0.09 -0.07 -0.00 0.03 0.26
(1.99) (-0.37) (-0.26) (-0.04) (0.15)
Z-statisticc 6.87e 2.08 -0.45 0.42 0.29
PanelB: PreventionCosts
NPREV.Rt = a + y1 PREV.Rt + -y PREV.Rt1 + 03 PREV.Rt2 + -y PREV.Rt3 + -y PREV.Rt4 + e
Ad'.
PREV.Rt PREV.Rt1 PREV.Rt2 PREV.Rt3 PREV.Rt4 R
Mean 0.71 -1.21 0.04 -0.25 -0.17 0.38
(1.30) (-0.74) (0.02) (-0.33) (-0.10)
Median 0.72 -0.46 -0.22 -0.03 -0.05 0.28
(1.46) (-0.88) (-0.33) (-0.10) (-0.12)
Z-statisticc 5.56e _3.23e 0.04 -0.41 -0.46
aVariablesrepresentthe residualsfromthe regressionof qualitycost expendituresin each categoryon sales duringthe period.Regressions
reportedin the table are run in generalizeddifferencesusing the Cochrane-Orcutt
procedureto correctfor serialcorrelation.
b14 to 28 quarterlyobservationsper plant.
cThe reportedZ-statisticsare calculatedunderthe assumptionthat the individualt-statisticsbeing aggregatedare independent.
d= Significantat the 5% level, two-tailedtest.
e= Significantat the 1%level, two-tailedtest.
costs over the periods studied. These findings are rein- The final set of tests controlled for differences in pro-
forced by plant-specific regressions (not reported in the duction functions, product attributes, and quality cost
tables) of conformance and nonconformance costs on systems by estimating plant-specific regressions. Both
the period's sales and linear time trend variables (ranging preventionand total conformanceexpenditureswere again
from 1 to n, where n represents the number of quarterly positively associated with nonconformance costs. Addi-
observations for the plant). After controllingfor sales vol- tional analysis indicatedthat the plants tended to condition
umes, the Z-statistics for the coefficients on the time trend conformance expenditures on the quality problems facing
variables are -2.07 (p = 0.05) in the conformanceregres- the unit, with conformance costs increasing when prob-
sion and -4.82 (p < 0.01) in the nonconformance lems were encountered, and decreasing when quality im-
regression, corroboratingearlierevidence that many of the proved. When conformance activities were increased, the
plants in the sample reduced conformanceexpendituresas increase typically produced lower nonconformancecosts
quality improved. As with the other two sets of tests, the roughly one month following their implementation. By
findingsfrom the plant-specificregressions run contraryto conditioning conformance expenditures on the level of
the hypothesis that conformance expendituresmust be in- quality problems being encountered, the plants reduced
creasing over time to achieve ongoing reductions in con- both conformance and nonconformancecosts as the qual-
formance costs. ity programprogressed, contradictingthe hypothesis that
conformanceexpendituresmust be increasingover time to
achieve ongoing reductionsin conformancecosts.
This study makes two contributions to the quality cost
5. SUMMARY
economics literature. First, it provides the first empirical
This paper examined the hypothesis that conformance support for the continuous improvement models of qual-
expenditures must continue to be increased over time to ity cost behavior. In doing so, the study reinforces the
achieve ongoing reductions in nonconformance costs, the need for greater use of dynamic models of quality man-
principal debate between proponents of the traditional agement rather than the static models that predominate
quality cost model and continuous improvement theories today (see also Jaikumar and Bohn 1992). Second, the
of quality cost behavior. Contrary to the prediction of study points out the need to abandon the use of an aggre-
the traditional model, three sets of empirical analyses gate "conformance cost" category that includes both
found that many of the plants in the sample achieved prevention and appraisal. Neither the traditional quality
significant reductions in reported nonconformance costs cost model nor Fine's quality-based learning model dis-
while maintaining or reducing existing conformance tinguish between prevention and appraisal costs.22 Yet
expenditures. both the descriptive statistics and the second set of em-
The first set of tests took a short-term perspective by pirical analyses show that plants typically reduced ap-
examining the association between annual changes in praisal and nonconformance costs since the start of the
conformance expenditures and changes in nonconfor- quality programwhile maintaininga relatively fixed level
mance costs in the current and following year. The evi- of prevention expenditures. This finding suggests that ef-
dence indicated that additional investments in prevention fective prevention activities can reduce both appraisal
and appraisal activities were associated with significant and nonconformance costs, and that the economics un-
reductions in nonconformance costs in the current or derlying the prevention and appraisal categories are dis-
following year. However, reductions in prevention and tinctly different. A potentially useful avenue for future
appraisal costs were also associated with lower noncon- theoretical work is understanding the interactions be-
formance costs, a finding that is inconsistent with the tween prevention and appraisal activities in a dynamic
traditional quality cost model. Moreover, the data pro- learning environment.
vided no evidence that reductions in conformance expen- Although the evidence is generally consistent with re-
ditures led to higher nonconformance costs in the cent continuous improvement and quality-based learning
following period. models, the results from this study in no way invalidate
The second set of tests took a longer view of the asso- the traditionalquality cost model. As noted earlier, data
ciation between conformance and nonconformance costs and econometric limitations make it difficult to
by examining quality cost behavior since the beginning of definitively test the competing theories of quality cost
the quality program. Nearly 80% of the plants in the behavior. Moreover, even if quality-based learning mod-
sample reduced nonconformance costs as a percent of els correctly depict quality cost behavior over time, the
sales over the lives of their quality programs. Regression traditionalmodel may still be an accuratestatic represen-
analyses indicated that these reductions were positively tation of quality cost economics. The evidence does,
associated with changes in conformance costs, implying however, suggest that in dynamic, multiperiod environ-
that the reductions in nonconformance costs were gener- ments, many companies that have committed the neces-
ally accompanied by reductions in conformance expendi- sary resources to quality improvement and embraced the
tures, not the increasing conformance expenditures continuous improvement philosophy have, for what-
predicted by the traditional quality cost model. ever reason, been able to achieve ongoing reductions
9. To ensure that the results in this paper were not coefficient on %ACONFin the subsample of periods
driven by reporting differences, the tests were re- with increased conformance costs was not statisti-
peated using data from the 31 plants that provided cally different from zero (t = -0.07). In contrast,
detailed information on the components of reported the coefficient for the subsample with reduced con-
quality costs. After eliminating reported costs for ac- formance expenditures was positive and significant
tivities other than quality planning and administra- at the 2% level (t = 2.36). To examine whether
tion, training, inspection and test, scrap, rework, and these results were simply due to fixed costs being
warranties, the results remained unchanged, suggest- spread over larger sales volumes, percentage
ing that the findings are not an artifact of differences changes in nonconformance costs (unadjusted for
in reported quality cost elements. volume) were regressed on percentage changes in
10. For the entire sample of annual quality cost expendi- both conformance expenditures and annual sales. As
tures, the Pearson correlations between percentage expected, changes in nonconformance costs were
changes in quality costs and percentage changes in highly correlated with changes in sales (t = 5.92,
sales exceed 0.40 (p < 0.01) for each of the quality p < 0.01). More importantly, the coefficient on the
cost categories. In the 24 plants that provided quar- change in conformance costs remained positive and
terly quality cost data, the mean time series correla- statistically significant (t = 1.81, p = 0.07).
tions between quarterly quality cost expenditures 14. In year t - 1, median changes in nonconformance
and quarterly sales in each plant are: costs for quintile 1 are positive and significant at the
10% level. Median nonconformance cost changes in
Prevention 0.48 year t - 1 for the other quintiles are all negative.
Appraisal 0.61 15. The White (1980) test for heteroscedasticity was con-
Conformance 0.69 ducted for each of the cross-sectional regressions re-
Internal Failure 0.48 ported in the paper. In no case did the test reject the
External Failure 0.60 null hypothesis that the error terms were homosce-
Nonconformance 0.60
dastic. Because the relationshipbetween conformance
and nonconformance costs may not be linear, rank
11. The correlations in Note 10 indicate that each of the transformregressions,which provide good approxima-
quality cost categories contains both fixed and vari- tions to unknown nonlinear relations (Iman and
able components. Consequently, sales increases will Conover 1979), were also run. The results did not
lead to fixed costs being spread over a greater num- change appreciablyfrom those reportedin the tables.
ber of units, reducing the ratio of fixed costs to sales 16. Average annual percentage changes in nonconfor-
even though actual fixed expenditures have not mance costs (unadjusted for volume) were also re-
changed. To examine whether the empirical results gressed on average percentage changes in both
are robust to variable specification, tests using both conformance expenditures and sales to ensure that
pooled annual data and plant-specific quarterly time the results were not driven by fixed costs being
series data were also performed using alternative, spread over additional units. The coefficient on con-
methods to control for volume fluctuations (see formance remained positive and significant (t =
Notes 13 and 16 and subsection 4.3). The results are 2.57, p = 0.01) when the alternative specification
similar to those using the specification in Equation 2, was employed.
suggesting that the findings reported in Tables II-VII 17. Regressingnonconformancecosts (unadjustedfor vol-
are not merely due to fixed costs being spread over ume) on conformanceexpendituresand sales produced
larger sales volumes. results similarto those using the residualsapproach.
12. Since the participating companies did not measure 18. Durbin-Watson statistics indicate that the residuals
quality costs before implementing quality programs, from the time series regressions exhibit strong first-
data on increases in conformance costs from year order serial correlation. The regressions are there-
k - 1 (the year prior to the start of the quality fore estimated in first differenced form using the
program) to year k are not available. As a result, Cochrane-Orcutt procedure.
upfront investments in the development of quality 19. As noted earlier, the reported Z-statistics are com-
systems and company-wide training in quality im- puted under the assumption that the quality cost
provement philosophies and techniques are not cap- expenditures in the 24 plants are independent. The
tured in the analyses. minimum number of independent observations
13. Regression results support the findings from the needed to obtain a particular significance level for
quintile tests. When %ANCONF was regressed on the Z-statistic can be obtained based on an approach
%ACONF, the coefficient on the conformance vari- used in Lambert and Larcker (1987). Given the mean
able emerged positive and highly significant (t = t-statistic of 1.57 for the coefficient on CONF.Rt, the
2.95, p < .01). After subdividing the sample by the minimum number of independent observations
sign of the change in conformance expenditures, the needed to obtain a Z-statistic of 2.0 is (2.0/1.57)2 =
1.62, or as few as two plants. The required number COLE,R. E. 1992. The Quality Revolution. Prod. and Opns.
of independent observations for CONF.R,-1, on the Mgmt. 1, 118-120.
other hand, is 19, implying that the finding of a sta- COOK, T. D., AND D. T. CAMPBELL. 1979. Quasi-
tistically significant lagged relationship is subject to Experimentation. Houghton-Mifflin, Boston.
quality cost expenditures being independent among CROSBY, P. B. 1979. Quality is Free. McGraw-Hill, New
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DEMING,W. E. 1982. Quality, Productivity, and Competitive
20. Using the Lambert and Larcker approach, the mini-
Position. MIT Center for Advanced Engineering,
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21. Regression models similar to those in Equations 4 New York.
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higher than expected conformance and prevention FINE, C. H. 1986. Quality Improvement and Learning in
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with nonconformance costs in the following period, GARVIN, D. 1988. Managing Quality. The Free Press, New
suggesting that the increases in conformance costs York.
GILMORE,IH. L. 1983. Consumer Product Quality Control
that accompanied quality problems generally re-
Cost Revisited. Qual. Prog., April, 28-32.
duced the problems by the following quarter. Lower HARRINGTON, H. J. 1987. Poor-Quality Cost. Marcel
conformance costs were not significantly associated Dekker, New York.
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ing that reductions in conformance expenditures did Transform in Regression. Technometrics, November,
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PREV.Rt were also regressed on NCONF.R,_1 to tivity Gains From Quality Improvement, Prod. Opns.
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ACKNOWLEDGMENT Horiz., March, 8-17.
KRISHNAMOORTHI,K. S. 1989. Predicting Quality Cost
This study has benefitted from the insightful comments
Changes Using Regression. In Quality Costs: Ideas and
of Bruce Chew, Robin Cooper, Morris Cohen, George Applications Vol. 2., J. Campanella (ed.). American
Foster, Robert Kaplan, David Larcker, Fred Lindahl, Society for Quality Control, Milwaukee, Wisconsin,
Leif Sjoblom, two anonymous referees, and the associate 315-325.
editor. I also wish to thank seminar participants at LAMBERT,R. A., AND D. F. LARCKER.1987. An Analysis of
Harvard, Purdue, and Stanford. The financial support of the Use of Accounting and Market Measures of Perfor-
KPMG Peat Marwick and the Division of Research, mance in Executive Compensation Contracts. J.
Harvard University is greatly appreciated. Account. Res. 25 (Supplement), 85-125.
LOCKYER, K. G. 1983. Production Management. Pitman,
London.
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