Chapter 14, Problem 36P

1.

To determine

Calculate the relative distribution of quality costs for each year and prepare a pie chart and find out whether the company is moving in a right direction in terms of the balance among the quality cost management.

Explanation of Solution

Total Quality Management: Total Quality Management is a method that eliminates wasteful activities and improves quality throughout the value chain by allocating quality management responsibility, rewarding low-cost, high-quality results and monitoring quality costs.

Quality costs: Quality costs are costs that are incurred to avoid, identify and eliminate defects from products. Quality costs are classified into four components namely;

1. 1. “Prevention costs”.
2. 2. “Appraisal costs”.
3. 3. “Internal failure costs”.
4. 4. “External failure costs”.

For the year 2014:

Calculate the cost-to-sales ratio for appraisal cost:

$\begin{array}{c}\begin{array}{l}\text{Cost-to-sales ratio for }\\ \text{appraisal cost}\end{array}\}\text{=}\frac{\text{Total}\text{Appraisal}\text{costs}}{\text{Total}\text{quality}\text{costs}}\text{×}\text{100}\\ \text{=}\frac{\left(\text{\$320,000}\text{+}\text{\$40,000}\right)}{\text{\$2,048,000}}\text{×}\text{100}\\ \text{=}17.6\text{\%}\end{array}$

Therefore, the cost-to-sales ratio for appraisal cost is 17.6%.

Calculate the cost-to-sales ratio for prevention cost:

$\begin{array}{c}\begin{array}{l}\text{Cost-to-sales ratio for }\\ \text{prevention cost}\end{array}\}\text{=}\frac{\text{Total}\text{Prevention}\text{costs}}{\text{Total}\text{quality}\text{costs}}\text{×}\text{100}\\ \text{=}\frac{\left(\text{\$4,000}\text{+}\text{\$2,000}\text{+}\text{\$2,000}\right)}{\text{\$2,048,000}}\text{×}\text{100}\\ \text{=}0.4\text{\%}\end{array}$

Therefore, the cost-to-sales ratio for prevention cost is 0.4%.

Calculate the cost-to-sales ratio for internal failure cost:

$\begin{array}{c}\begin{array}{l}\text{Cost-to-sales ratio for }\\ \text{internal failure cost}\end{array}\}\text{=}\frac{\text{Total}\text{Internal}\text{failure}\text{costs}}{\text{Total}\text{quality}\text{costs}}\text{×}\text{100}\\ \text{=}\frac{\left(\begin{array}{l}\text{\$280,000}\text{+}\text{\$360,000}\text{+}\\ \text{\$160,000}\text{+}\text{\$200,000}\end{array}\right)}{\text{\$2,048,000}}\text{×}\text{100}\\ \text{=}48.8\text{\%}\end{array}$

Therefore, the cost-to-sales ratio for internal failure cost is 48.8%.

Calculate the cost-to-sales ratio for external failure cost:

$\begin{array}{c}\begin{array}{l}\text{Cost-to-sales ratio for }\\ \text{external failure cost}\end{array}\}\text{=}\frac{\text{External}\text{failure}\text{costs}\text{for}}{\text{Total}\text{quality}\text{costs}}\text{×}\text{100}\\ \text{=}\frac{\left(\text{\$160,000}\text{+}\text{\$120,000}\text{+}\text{\$400,000}\right)}{\text{\$2,048,000}}\text{×}\text{100}\\ \text{=}33.2\text{\%}\end{array}$

Therefore, the cost-to-sales ratio for external failure cost is 33.2%.

Prepare pie chart for the year 2014:

Figure (1)

For the year 2015:

Calculate the cost-to-sales ratio for appraisal cost:

$\begin{array}{c}\begin{array}{l}\text{Cost-to-sales ratio for }\\ \text{appraisal cost}\end{array}\}\text{=}\frac{\text{Total}\text{Appraisal}\text{costs}}{\text{Total}\text{quality}\text{costs}}\text{×}\text{100}\\ \text{=}\frac{\left(\text{\$300,000}\text{+}\text{\$28,000}\right)}{\text{\$2,048,000}}\text{×}\text{100}\\ \text{=}17.6\text{\%}\end{array}$

Therefore, the cost-to-sales ratio for appraisal cost is 17.6%.

Calculate the cost-to-sales ratio for prevention cost:

$\begin{array}{c}\begin{array}{l}\text{Cost-to-sales ratio for }\\ \text{prevention cost}\end{array}\}\text{=}\frac{\text{Total}\text{Prevention}\text{costs}}{\text{Total}\text{quality}\text{costs}}\text{×}\text{100}\\ \text{=}\frac{\left(\text{\$40,000}\text{+}\text{\$20,000}\text{+}\text{\$100,000}\right)}{\text{\$2,048,000}}\text{×}\text{100}\\ \text{=}0.4\text{\%}\end{array}$

Therefore, the cost-to-sales ratio for prevention cost is 0.4%.

Calculate the cost-to-sales ratio for internal failure cost:

$\begin{array}{c}\begin{array}{l}\text{Cost-to-sales ratio for }\\ \text{internal failure cost}\end{array}\}\text{=}\frac{\text{Total}\text{Internal}\text{failure}\text{costs}}{\text{Total}\text{quality}\text{costs}}\text{×}\text{100}\\ \text{=}\frac{\left(\begin{array}{l}\text{\$240,000}\text{+}\text{\$320,000}\text{+}\\ \text{\$100,000}\text{+}\text{\$160,000}\end{array}\right)}{\text{\$2,048,000}}\text{×}\text{100}\\ \text{=}48.8\text{\%}\end{array}$

Therefore, the cost-to-sales ratio for internal failure cost is 48.8%.

Calculate the cost-to-sales ratio for external failure cost:

$\begin{array}{c}\begin{array}{l}\text{Cost-to-sales ratio for }\\ \text{external failure cost}\end{array}\}\text{=}\frac{\text{External}\text{failure}\text{costs}\text{for}}{\text{Total}\text{quality}\text{costs}}\text{×}\text{100}\\ \text{=}\frac{\left(\text{\$160,000}\text{+}\text{\$140,000}\text{+}\text{\$440,000}\right)}{\text{\$2,048,000}}\text{×}\text{100}\\ \text{=}33.2\text{\%}\end{array}$

Therefore, the cost-to-sales ratio for external failure cost is 33.2%.

Prepare pie chart for the year 2015:

Figure (2)

Yes. Additional effort is required for “prevention and appraisal activities”. The movement is in that direction, and total failure costs is been decreased.

2.

To determine

Prepare a one-year performance report for 2015 and find out the amount of profits increased sue the quality improvements made by Company M.

Explanation of Solution

Long-range performance report: Long-range performance report compares the “current actual” with the costs that will be allowed if the “zero-defects standard” is being met by assuming that sales level is equal to that of the existing period.

Prepare a one-year performance report for 2015:

Company  M
Performance Report
One-Year Trend
Particulars	Actual Costs  2015 (a)	Actual Costs 2014 (b)	Variance $\left(\text{b}-\text{a}\right)$
Prevention costs
Quality circles (F)	$40,000	$4,000	($36,000)	U
Design reviews(F)	$20,000	$2,000	($18,000)	U
Improvement projects(F)	$100,000	$2,000	($98,000)	U
Total prevention costs	$160,000	$8,000	($152,000)	U
Appraisal costs:
Packaging inspection(V)	$300,000	(1)$400,000	$100,000	F
Product acceptance(V)	$28,000	(2)$50,000	$22,000	F
Total appraisal costs	$328,000	$450,000	$122,000	F
Internal failure costs:
Scrap(V)	$240,000	(3)$350,000	$110,000	F
Rework(V)	$320,000	(4)$450,000	$130,000	F
Yield losses (V)	$100,000	(5)$200,000	$100,000	F
Retesting (V)	$160,000	(6)$250,000	$90,000	F
Total internal failure costs	$820,000	$1,250,000	$430,000	F
External failure costs:
Returned materials (V)	$160,000	(7)$200,000	$40,000	F
Allowances (V)	$140,000	(8)$150,000	$10,000	F
Warranty (V)	$440,000	(9)$500,000	$60,000	F
Total external failure costs	$740,000	$850,000	$110,000	F
Total quality costs	$2,048,000	$2,558,000	$510,000	F

Table (1)

For comparing the costs of 2015 with costs of 2014, the costs for 2014 should be adjusted to a sales level of $10 million. Therefore, all variable costs will vary from the 2014 levels. For instance, the adjusted product packaging inspection cost is $400,000(1).

Working notes:

(1)Calculate the actual costs of packaging inspection:

$\begin{array}{c}\text{Actual costs of Packaging}\text{inspection}\text{=}\left[\begin{array}{l}\left(\frac{\text{Packaging}\text{inspection}\text{cost}\text{for}\text{2014}}{\text{Sales}\text{revenue}\text{during}\text{2014}}\right)\\ \text{×Sales}\text{revenue}\text{during}\text{2015}\end{array}\right]\\ \text{=}\frac{\text{\$320,000}}{\text{\$8,000,000}}\text{×\$10,000,000}\\ \text{=\$400,000}\end{array}$

(2)Calculate the actual costs of product acceptance:

$\begin{array}{c}\text{Actual costs of product acceptance}\text{=}\left[\begin{array}{l}\left(\frac{\text{Product acceptance}\text{cost}\text{for}\text{2014}}{\text{Sales}\text{revenue}\text{during}\text{2014}}\right)\\ \text{×Sales}\text{revenue}\text{during}\text{2015}\end{array}\right]\\ \text{=}\frac{\text{\$40,000}}{\text{\$8,000,000}}\text{×\$10,000,000}\\ \text{=\$50,000}\end{array}$

(3)Calculate the actual costs of scrap:

$\begin{array}{c}\text{Actual costs of scrap}\text{=}\left[\begin{array}{l}\left(\frac{\text{Scrap}\text{for}\text{2014}}{\text{Sales}\text{revenue}\text{during}\text{2014}}\right)\\ \text{×Sales}\text{revenue}\text{during}\text{2015}\end{array}\right]\\ \text{=}\frac{\text{\$20,000}}{\text{\$8,000,000}}\text{×\$10,000,000}\\ \text{=\$350,000}\end{array}$

(4)Calculate the actual costs of rework:

$\begin{array}{c}\text{Actual costs of rework}\text{=}\left[\begin{array}{l}\left(\frac{\text{Rework}\text{cost}\text{for}\text{2014}}{\text{Sales}\text{revenue}\text{during}\text{2014}}\right)\\ \text{×Sales}\text{revenue}\text{during}\text{2015}\end{array}\right]\\ \text{=}\frac{\text{\$360,000}}{\text{\$8,000,000}}\text{×\$10,000,000}\\ \text{=\$450,000}\end{array}$

(5)Calculate the actual costs of yield losses:

$\begin{array}{c}\text{Actual costs of yield losses}\text{=}\left[\begin{array}{l}\left(\frac{\text{Yield losses}\text{cost}\text{for}\text{2014}}{\text{Sales}\text{revenue}\text{during}\text{2014}}\right)\\ \text{×Sales}\text{revenue}\text{during}\text{2015}\end{array}\right]\\ \text{=}\frac{\text{\$160,000}}{\text{\$8,000,000}}\text{×\$10,000,000}\\ \text{=\$200,000}\end{array}$

(6)Calculate the actual costs of retesting:

$\begin{array}{c}\text{Actual costs of retesting}\text{=}\left[\begin{array}{l}\left(\frac{\text{Retesting}\text{cost}\text{for}\text{2014}}{\text{Sales}\text{revenue}\text{during}\text{2014}}\right)\\ \text{×Sales}\text{revenue}\text{during}\text{2015}\end{array}\right]\\ \text{=}\frac{\text{\$200,000}}{\text{\$8,000,000}}\text{×\$10,000,000}\\ \text{=\$250,000}\end{array}$

(7)Calculate the actual costs of returned materials:

$\begin{array}{c}\text{Actual costs of returned materials}\text{=}\left[\begin{array}{l}\left(\frac{\text{Returned materials}\text{cost}\text{for}\text{2014}}{\text{Sales}\text{revenue}\text{during}\text{2014}}\right)\\ \text{×Sales}\text{revenue}\text{during}\text{2015}\end{array}\right]\\ \text{=}\frac{\text{\$160,000}}{\text{\$8,000,000}}\text{×\$10,000,000}\\ \text{=\$200,000}\end{array}$

(8)Calculate the actual costs of returned allowances:

$\begin{array}{c}\text{Actual costs of returned allowances}\text{=}\left[\begin{array}{l}\left(\frac{\text{Returned allowances}\text{cost}\text{for}\text{2014}}{\text{Sales}\text{revenue}\text{during}\text{2014}}\right)\\ \text{×Sales}\text{revenue}\text{during}\text{2015}\end{array}\right]\\ \text{=}\frac{\text{\$120,000}}{\text{\$8,000,000}}\text{×\$10,000,000}\\ \text{=\$150,000}\end{array}$

(9)Calculate the actual costs of returned warranty:

$\begin{array}{c}\text{Actual costs of warranty}\text{=}\left[\begin{array}{l}\left(\frac{\text{Warranty}\text{cost}\text{for}\text{2014}}{\text{Sales}\text{revenue}\text{during}\text{2014}}\right)\\ \text{×Sales}\text{revenue}\text{during}\text{2015}\end{array}\right]\\ \text{=}\frac{\text{\$400,000}}{\text{\$8,000,000}}\text{×\$10,000,000}\\ \text{=\$500,000}\end{array}$

3.

To determine

Estimate the additional improvement in profits if Company M reduces its quality costs to 2.5 percent of sales revenue.

Explanation of Solution

Calculate the additional improvements in profits:

$\begin{array}{c}\begin{array}{l}\text{Additional}\text{improvements}\\ \text{in}\text{profits}\end{array}\}\text{=}\left[\text{Total}\text{quality}\text{costs}\text{for}\text{2014}-\left(\begin{array}{l}\text{Sales}\text{revenue}\text{×}\text{Reduction}\\ \text{in}\text{percent}\text{of}\text{quality}\text{costs}\end{array}\right)\right]\\ \text{=}\text{\$2,048,000}-\left(\text{\$10,000,000×}\text{2}\text{.5\%}\right)\\ \text{=}\text{\$2,048,000}-\text{\$250,000}\\ \text{=\$1,798,000}\end{array}$

Therefore, the additional improvements in profits are $1,798,000.