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, or 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, 20x5:
- 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?
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Chapter 14 Solutions
Cornerstones of Cost Management (Cornerstones Series)
- Danna Wise, president of Tidwell Company, recently returned from a conference on quality and productivity. At the conference, she was told that many American firms have quality costs totaling 20 to 30% of sales. The quality experts at the conference convinced her that a company could increase its profitability by improving quality. However, she was of the opinion that the quality of Tidwell Company was much less than 20%probably more in the 4 to 6% range. However, because the potential for increasing profits was so great if she was wrong, she decided to request a preliminary estimate of the total quality costs currently being incurred. She asked her controller for a summary of quality costs, with the costs classified into four categories: prevention, appraisal, internal failure, or external failure. She also wanted the costs expressed as a percentage of both sales and profits. The controller had his staff assemble the following information from the past year, 20X1: a. Sales revenue, 37,240,000; net income, 4,000,000. b. During the year, customers returned 40,000 units needing repair. Repair cost averages 9 per unit. c. Twelve inspectors are employed, each earning an annual salary of 80,000. The inspectors are involved only with final inspection (product acceptance). d. Total scrap is 200,000 units. Of this total, ninety percent is quality related. The cost of scrap is about 10 per unit. e. Each year, approximately 800,000 units are rejected in final inspection. Of these units, seventy-five percent can be recovered through rework. The cost of rework is 1.80 per I unit. f. A customer cancelled an order that would have increased profits by 600,000. The customers reason for cancellation was poor product performance. g. The company employs 10 full-time employees in its complaint department. Each earns 48,600 a year. h. The company gave sales allowances totaling 180,000 due to substandard products being sent to the customer. i. The company requires all new employees to take its 4-hour quality training program. The estimated annual cost of the program is 120,000. Required: 1. Prepare a simple quality cost report classifying costs by category. 2. Compute the quality cost-sales ratio. Also, compare the total quality costs with total profits. Should Danna 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 3% of sales?arrow_forwardABC Corporation has recently completed a project to reduce total production costs by 5%. Net income has risen as a result, but the stock price has suffered from recent public disclosures about faulty products. The vice president for manufacturing and the controller are concerned that their successful cost-cutting efforts have resulted in lower market valuation. They are beginning to understand that product quality has a cost component and they have asked you, a CMA, to explain the concept of “cost of quality'" to them. A. Define, categorize, and give examples of the "cost of quality." B. What is value chain analysis and how could this impact the company's evaluation of costs? C. What other business process improvement tools may benefit the company?arrow_forwardBased on the 2015 survey, Amanda Westerly believed that Osborn had to improve product quality. In making her case to Osborn management, how might Westerly have estimated the opportunity cost of not implementing the quality-improvement program?arrow_forward
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- Mercury, Incorporated, produces cell phones at its plant in Texas. In recent years, the company's market share has been eroded by stiff competition from overseas. Price and product quality are the two key areas in which companies compete in this market. A year ago, the company's cell phones had been ranked low in product quality in a consumer survey. Shocked by this result, Jorge Gomez, Mercury's president, initiated an intense effort to improve product quality. Gomez set up a task force to implement a formal quality improvement program. Included on this task force were representatives from the Engineering, Marketing, Customer Service, Production, and Accounting departments. The broad representation was needed because Gomez believed that this was a companywide program and that all employees should share the responsibility for its success. After the first meeting of the task force, Holly Elsoe, manager of the Marketing Department, asked John Tran, production manager, what he thought of…arrow_forwardMercury, Incorporated, produces cell phones at its plant in Texas. A year ago, a consumer survey ranked the company's cell phones low in product quality. Shocked by this result, Jorge Gomez, Mercury's president, set up a task force to implement a formal quality improvement program. Included on this task force were representatives from the Engineering, Marketing, Customer Service, Production, and Accounting departments. After working together for a year, the task force prepared the quality cost report shown below: Prevention costs: Machine maintenance Training suppliers Quality circles Total prevention cost Appraisal costs: Incoming inspection Final testing Total appraisal cost Internal failure costs: Rework Scrap Total internal failure cost External failure costs: Warranty repairs Customer returns Mercury, Incorporated Quality Cost Report (in thousands) Total external failure cost Total quality cost Total production cost Prevention costs: Machine maintenance Training suppliers Quality…arrow_forwardThe salespeople at Metlock, a notebook manufacturer, commonly pressured operations managers to keep costs down so the company could give bigger discounts to large customers. Richard, the operations supervisor, leaked the $0.65 total unit cost to salespeople, who were thrilled, since that was slightly lower than the previous year's unit cost. Budgets were not yet finalized for the upcoming year, so it was unclear what the target unit cost would be. Richard knew the current year's operating capacity was two million notebooks, and Metlock produced and sold just that many. The detailed breakdown of the $0.65 total unit cost is as follows. Direct material Direct labor Variable overhead Fixed overhead Total cost per unit (a) (b) Total fixed costs Gross margin Your answer is correct. What were Metlock's total fixed costs? If the average selling price was $2.10, how much gross margin did the company generate? $0.15 Fixed costs 0.15 Total cost per unit 0.15 Gross margin 0.20 $0.65 Save for…arrow_forward
- The salespeople at Larkspur, a notebook manufacturer, commonly pressured operations managers to keep costs down so the company could give bigger discounts to large customers. David, the operations supervisor, leaked the $0.80 total unit cost to salespeople, who were thrilled, since that was slightly lower than the previous year's unit cost. Budgets were not yet finalized for the upcoming year, so it was unclear what the target unit cost would be. David knew the current year's operating capacity was two million notebooks, and Larkspur produced and sold just that many. The detailed breakdown of the $0.80 total unit cost is as follows. Direct material Direct labor Variable overhead Fixed overhead Total cost per unit $0.05 0.20 0.15 0.40 $0.80arrow_forwardvntkjarrow_forwardLindell Manufacturing embarked on an ambitious quality program that is centered on continual improvement. This improvement is operationalized by declining quality costs from year toyear. Lindell rewards plant managers, production supervisors, and workers with bonuses ranging from $1,000 to $10,000 if their factory meets its annual quality cost goals.Len Smith, manager of Lindell’s Boise plant, felt obligated to do everything he could toprovide this increase to his employees. Accordingly, he has decided to take the following actionsduring the last quarter of the year to meet the plant’s budgeted quality cost targets:a. Decrease inspections of the process and final product by 50% and transfer inspectorstemporarily to quality training programs. Len believes this move will increase theinspectors’ awareness of the importance of quality; also, decreasing inspection willproduce significantly less downtime and less rework. By increasing the output anddecreasing the costs of internal failure,…arrow_forward
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