©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Quality, Time, and the Theory of Constraints Chapter 19 May 2, 2005

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 1 Explain the four cost categories in a cost-of-quality program.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Two Aspects of Quality Actual Performance Design Specifications Customer Satisfaction Quality of Design Do characteristics of product meet needs of customers Conformance Quality How does product perform relative to specifications

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality Prevention costsAppraisal costs Internal failure costsExternal failure costs

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Prevention Costs l Costs incurred to insure that products to be produced conform to specifications l Examples include design engineering, process engineering, evaluation of suppliers, preventative equipment maintenance, quality training, etc.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Appraisal Costs l Costs to identify which products produced do not conform to specifications l Examples include: Inspection, product testing, manufacturing process inspection

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Internal Failure Costs l Identifying product failures prior to shipment to customers l Examples include: Spoilage, rework, scrap, repair of equipment breakdowns, costs to redo defective manufacturing processes

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster External Failure Costs l Costs to fix product problems after products are shipped to customers l Examples include: Warranty repair costs, product liability claims, customer support on problem calls, transportation costs to bring back and replace defective products

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Hierarchy of Costs l Objective is to reduce External Failure costs first, followed by Internal failure costs l May require increase in Prevention costs and Appraisal costs l Ultimately, only Prevention costs remain significant reducing the need for appraisal costs and eliminating Internal and External failure costs

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality Example Vegas Photo Corporation made 10,000 photocopying machines last year. Vegas Photo determines the costs of quality of its photocopying machines using a 7-step activity-based costing approach.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality (Steps 1 and 2) Identify cost objects. 10,000 photocopying machines Identify the direct costs of quality of the products. No direct costs of Quality; indirect only Step 1Step 2

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality (Step 3) Select the cost-allocation bases to use for allocating indirect costs of quality to the products. Prevention Appraisal Internal failure External failure Step 3 Determine the total quantities of each of these cost-allocation bases used in all of Vegas operations

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality (Step 4) Identify the indirect costs of quality associated with each cost-allocation base. Step 4

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality (Step 5) Compute the rate per unit. Step 5

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality (Step 5) Prevention costs: Design engineering (R&D)$80 per hour Process engineering (R&D)$60 per hour Appraisal costs: Inspection (Manufacturing) $40 per hour

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality (Step 5) Internal failure costs: Rework (Manufacturing)$100 per hour External failure costs: Customer support (Marketing)$ 50 per hour Transportation (Distribution)$240 per load Warranty repair (Customer Service)$110 per hour

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality (Step 6) Step 6 Compute the indirect costs of quality allocated to the product.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality (Step 6) Prevention costs: Design engineering (R&D) 20,000 hours Process engineering (R&D) 22,500 hours Appraisal costs: Inspection (Manufacturing)120,000 hours

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality (Step 6) Internal failure costs: Rework (Manufacturing)50,000 hours External failure costs: Customer support (Marketing) 6,000 hours Transportation (Distribution) 1,500 loads Warranty repair (Customer Service)60,000 hours

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality (Step 6) What is the total cost for design engineering? 20,000 hours × $80 = $1,600,000 What is the total cost for inspection? 120,000 hours × $40 = $4,800,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality (Step 6) Cost of Quality and Value Chain CategoryTotal Costs Prevention costs: Design engineering (R&D)$1,600,000 Process engineering (R&D) 1,350,000 Total$2,950,000 Appraisal costs: Inspection$4,800,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality (Step 6) Cost of Quality and Value Chain CategoryTotal Costs Internal failure costs: Rework (Manufacturing)$5,000,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality (Step 6) Cost of Quality and Value Chain CategoryTotal Costs External failure costs: Customer support (Marketing)$ 300,000 Transportation (Distribution) 360,000 Warranty repair (Customer Service) 6,600,000 Total$7,260,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Costs of Quality (Step 7) Step 7 Compute the total costs of quality of the product. Prevention costs $ 2,950,000 Appraisal costs 4,800,000 Internal failure costs 5,000,000 External failure costs 7,260,000 Total$20,010,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 2 Use three methods to identify quality problems within each of the categories.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Techniques Used to Analyze Quality Problems 1. Control charts 2. Pareto diagrams 3. Cause-and-effect diagrams

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Control Charts On the basis of experience, Vegas decides that any observation outside the arithmetic mean  ± 2  standard deviations should be investigated.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Control Charts Production Line A Days Defect Rate  + 2   +    -   - 2 

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Control Charts  + 2   +    -   - 2  Production Line B Days Defect Rate

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Pareto Diagram Copies are fuzzy and unclear Copies are too light/dark Paper gets jammed Number of Times Defect Observed

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Pareto Diagram As a first step, Vegas analyzes the causes of the most frequently occurring failure, fuzzy and unclear copies. Final Draft of a Sales Contract Final Draft of a Sales Contract

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Cause-and-effect Diagrams Methods and Design Factors Human Factors Machine-related Factors Materials and Components Factors Multiple suppliers Incorrect specification Variation in purchased components Flawed part design Incorrect manufacturing sequence Inadequate tools Incorrect speed Poor maintenance Inadequate supervision Poor training New operator

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 3 Identify the relevant costs and benefits of quality improvements.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Costs Careful analysis of Vegas cause-and-effect diagram reveals that the frame of the copier is often mishandled as it travels from the suppliers’ warehouses to Vegas’ plant. Mishandling causes the dimensions of the frame to vary from specifications, resulting in fuzzy and unclear copies.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Costs Alternative solutions: Improve the inspection of the frames immediately upon delivery. Redesign and strengthen the frames and the containers used to transport them to better withstand mishandling during transportation.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Costs What must management do to evaluate each alternative? Additional Additional Inspection CostRedesign Cost Difference $200,000$230,000 $30,000 Vegas determines the fixed and variable cost component of each activity involved.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Relevant Costs Further Redesigning Inspection Frames Relevant savings: Rework costs$480,000$ 640,000 Customer-support costs 20,000 28,000 Transportation costs 45,000 63,000 Warranty repair costs 450, ,000 Total$995,000$1,361,000

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Comparison FurtherRedesigning Inspection Frames Relevant savings$995,000 $1,361,000 Additional cost 200, ,000 Difference$795,000 $1,131,000 What should Vegas do? Redesigning the frames provides a $336,000 incremental benefit over further inspection.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Redesign or Inspect l Even if inspect costs more, it may be in the best interest of the firm to redesign l Solve problems before they arrive at the customers doorstep l Avoids hard to quantify opportunity costs such as lost customers and lost sales

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 4 Provide examples of nonfinancial quality measures of customer satisfaction and internal performance.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Nonfinancial Measures – leading indicators of future problems Nonfinancial measures of customer satisfaction: Number of customer complaints Defective units as a percentage of total units shipped to customers Percentage of products that experience early or excessive failure On-time delivery rate

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Nonfinancial Measures Nonfinancial measures of internal performance: Number of defects for each product line Process yield (ratio of good output to total output) Employee turnover (ratio of the number of employees who left the company to the total number of employees)

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Learning Objective 5 Describe the benefits of financial and nonfinancial measures of quality.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster Evaluating Quality Performance Financial measures are helpful to evaluate trade-offs among prevention costs, appraisal costs, and failure costs. Nonfinancial measures help focus attention on the precise problem areas that need improvement and also serve as indicators of future long-run performance.

©2003 Prentice Hall Business Publishing, Cost Accounting 11/e, Horngren/Datar/Foster End of Chapter 19