Cost of Quality Formula, Meaning, Types, Indirect

Table of Contents:-

  • Cost of Quality
  • Cost of Quality Meaning
  • Cost of Poor Quality 
  • Cost of Poor Quality Formula
  • Types of Cost of Poor Quality
  • Direct Poor Quality Costs
  • Indirect Poor Quality Costs

Cost of Quality

Cost of quality or ‘Quality cost’ is the amount of money a business loses because its product or service was not done right in the first place. From fixing a warped piece on the assembly line to dealing with a malfunctioning machine or a poorly performed service, businesses lose money daily due to poor quality. This can run from 15 to 30 per cent of their total costs for most businesses. A quality cost is considered to be any cost that the company would not have incurred if the quality of the product or service were perfect. 

Cost of quality, cost of achieving good quality, and cost of poor quality are the terms used to describe the costs associated with providing a quality product or service. The term “quality costs” holds different meanings to different individuals. Some people equate “quality costs” with the costs of poor quality due to finding and correcting defective work. Others relate the term with the costs of attaining good quality. Some use the term to mean the costs of running the quality department. But mainly, the term ‘quality costs’ means the ‘cost of poor quality’.

Cost of Quality Meaning

The concept of quality costs serves as a method to quantify the total expenses related to quality efforts and deficiencies. Armand V. Feigenbaum initially outlined it in a 1956 Harvard Business Review article.

Legendary Quality Guru Armand Feigenbaum states, “Quality costs are the foundation for quality. systems economics”.

Quality costs have traditionally served as the basis for evaluating investments in quality programmes. The costs of quality are those incurred to achieve good quality and to satisfy the customer, as well as costs incurred when quality fails to meet the customer’s needs.

Total quality costs are the sum of prevention, appraisal, failure, and intangible costs. The value of quality must be based on its ability to contribute to profits. A reduction in quality cost leads to increased profit. The cost of quality influences all organisational activities like marketing, purchasing, design, manufacturing, and service. Failure costs are associated with lost sales and customer goodwill, which may be impossible to measure and must be estimated.

Cost of Poor Quality 

Cost of poor quality can be defined as those costs associated with the non-achievement of product or service quality as determined by requirements established by the organisation and its contracts with customers and society. In simple terms, it is the cost of poor products or services. Cost of Poor Quality (COPQ) or Poor Quality Costs (PQC) are defined as costs that would disappear if systems, processes, and products were perfect.

COPQ gained popularity through H. James Harrington, an IBM quality expert, in his 1987 book, “Poor Quality Costs.” When decisions are made to forego quality activities, potential costs are linked to ensuing issues, termed non-conformance costs. These expenses represent money expended due to failures. COPQ serves as a refinement of the concept of quality costs.

Costs associated with poor quality are also referred to as non-conformance or failure costs. The cost of failures is the difference between what it costs to produce a product or deliver a service and what it would cost if there were no failures. This is generally a company’s largest quality cost category, frequently accounting for 70 to 90% of total quality costs. This is where the most significant cost improvement is possible. Poor quality means more money spent on correcting mistakes and lower customer satisfaction; these factors, in turn, impact revenues. And so, the death spiral begins.

Cost of Poor Quality Formula

COPQ = [Internal failure (Rs.) + External failure (Rs.) + Appraisal and Prevention (Rs.) + Lost opportunity (Rs.)] /Monthly sales (Rs.)

Non-conformances also include hidden costs such as erosion of goodwill, loss of potential contracts, etc. The cost of non-conformances may also have far-reaching consequences, e.g., company staff may be tied up in maintenance activities and need help to develop new products.

The impact of providing too little quality is such an essential concept in the field of quality control that it has a formal name-cost of poor quality (COPQ). COPQ consists of all the costs of producing a poor-quality product or service. This expense includes the costs of:

1) Materials the company added to the product or work you put into the service before the customer rejected it.

2) Getting rid of the poor-quality product rejected by a customer (because the company cannot resell it).

3) Potential lost market share (it may lose orders to competitors that offer better quality).

4) Improving the product or service to fill the gap between what the customer wants and what the company currently offers.

5) More labour and resources were needed to fix the poor-quality product.

COPQ does not include any costs associated with detecting or preventing the lack of quality. Calculating COPQ for the organisation helps determine the potential savings it can gain by implementing quality process improvements.

The cost of non-conformance is part of the cost of quality, and it means the tangible and intangible costs incurred when the product or service does not conform to the agreed-upon quality in the project plan.

Types of Cost of Poor Quality

The impact of poor quality on the customer is not reflected in an organisation’s ledger but in the customer’s wallet. Therefore, to succeed in business today, one must also consider the “indirect cost of poor quality.” This cost can exceed the total price of the service or product. It is further divided into four areas:

  • Customer-incurred poor-quality costs
  • Customer dissatisfaction, poor-quality costs
  • Loss-of-reputation poor-quality costs
  • Lost opportunity costs

There are two poor-quality cost methodologies:

  1. Direct Poor Quality Costs
  2. Indirect Poor Quality Costs

Direct Quality Costs

The direct cost of poor quality can be derived directly from entries in the company ledger. Below are the types of direct poor-quality costs:

1) Controllable Poor-Quality Cost

Management controls this cost to ensure that only customer-accepted products and services are delivered. It includes prevention and appraisal costs.

i) Appraisal Costs

 Appraisal costs represent the direct expenses incurred in measuring quality. Here, quality is defined as adherence to customer expectations. These costs pertain to inspection, testing, and other endeavours to identify defective products or services or ensure their absence. They encompass the expenses associated with inspectors, testing equipment and materials, laboratories, quality audits, field testing, and the costs linked to assessments for the International Organization for Standardization – ISO 9000 or other quality award evaluations. Consequently, they encompass the costs of implementing quality measures, monitoring, and control. A typical example of appraisal costs is the expenditure on inspections. An organisation should establish an inspection process for its products and incoming goods from suppliers before they reach the customer. This process is also known as acceptance sampling, a technique utilised to verify adherence to quality standards.

Examples of appraisal costs include:

a) Test Equipment Costs: These are the expenses associated with maintaining equipment used to test the quality characteristics of products.

b) Operator Costs: These encompass the expenses related to the time operators spend gathering data for testing product quality, making equipment adjustments to maintain quality, and halting work to assess quality.

c) Inspection and Testing Costs: These include the expenses incurred for testing and inspecting materials, parts, and the product at various stages and the end of the process.

Appraisal costs are generally higher in a service organisation than in a manufacturing company, thus constituting a more significant proportion of total quality costs. Quality in services is primarily associated with the interaction between an employee and a customer, making the appraisal of quality more challenging. In manufacturing operations, quality appraisal can mainly occur internally; however, evaluating service quality typically necessitates customer interviews, surveys, questionnaires, and similar methods.

ii) Prevention Costs

Prevention costs are expenses associated with preventing defects and imperfections. The primary focus of prevention costs is ensuring quality and minimising or eliminating the likelihood of events adversely affecting the company’s goods, services, or daily operations. This category includes the cost of establishing a quality system, including expenses such as planning and administrative systems, collaboration with vendors, training, implementation of quality control procedures, and increased attention in the design and production phases to reduce the probability of defective artistry.

These costs are incurred to prevent the production of poor-quality output. A thorough quality system should include three essential elements: training, process engineering, and quality planning. Quality planning involves establishing a production process by design specifications and developing appropriate test procedures and equipment. It is also advisable to implement training programs for employees to ensure their proficiency in emerging technologies, such as updated computer languages and programs. Thus, prevention costs encompass the expenses related to activities in quality planning, which aims to ensure that proper precautions are taken to avoid errors in sampling plans, low-quality materials, or incorrect methods and processes in the production plant.

Consider the Johnson & Johnson (J&J) safety seals on all their products with the message, “If this safety seal is open, do not use it”. This is a preventive measure because, in the overall analysis, it is less costly to purchase the safety seals in production than to undergo a possible cyanide scare.

Prevention reflects the quality philosophy of “do it right the first time,” which is the goal of the quality management program.

Examples of prevention costs include:

a) Product Design Costs: The expenses associated with designing products with quality characteristics.

b) Training Costs: The expenditures for developing and conducting quality training programs for employees and management.

c) Quality Planning Costs: The costs involved in developing and implementing the quality management program.

d) Process Costs: The expenses to ensure the production process conforms to quality specifications.

e) Information Costs: The costs of acquiring and maintaining data related to quality (typically on computers) and the development and analysis of reports on quality performance.

2) Resulting Poor-Quality Costs

This comprises internal and external error rates and encompasses all costs incurred by the company due to errors. It is directly influenced by management decisions within the controllable poor-quality cost category.

i) Internal Failures

Internal failures are those discovered during the production process. These failures occur for various reasons, including defective materials from vendors, incorrect machine settings, faulty equipment, improper methods, incorrect processing, carelessness, and false or improper material handling procedures. The costs of internal failures include lost production time, scrap, rework investigation costs, potential equipment damage, and potential employee injury. Rework costs involve the salaries of workers and the additional resources needed to perform the rework, such as equipment and raw materials. Beyond these costs lie expenses like inspection of reworked parts, schedule disruption, inventory costs for parts and materials awaiting rework, and the paperwork necessary to track items until their reintroduction.

These costs are incurred when poor-quality products are discovered before they are delivered to the customer.

Examples of internal failure costs include:

a) Scrap Costs: The costs of poor-quality products must be discarded, including labour, material, and indirect costs.

b) Rework Costs: The costs of fixing defective products to conform to quality specifications.

c) Process Failure Costs: Determining why the production process produces poor-quality products.

d) Process Downtime Costs: The costs of shutting down the production process to fix the problem.

e) Price-Downgrading Costs: The costs of discounting poor-quality products, i.e., selling products as “seconds”.

ii) External Failures

External failures are those discovered after delivery to the customer. They encompass defective products or poor services that go undetected by the producer. The resulting costs include warranty work, complaint handling, replacements, liability litigation, customer payments or discounts used to offset the inferior quality, loss of customer goodwill, and opportunity costs related to lost sales. External failure costs are typically more significant than internal failure costs per unit.

A service’s internal failure costs are low, whereas external failure costs are high. A service organisation needs more opportunities to examine and correct a defective internal process, such as an employee-customer interaction before it occurs. At that particular point, it becomes an external failure. External failures typically result in increased service time or inconvenience for the customer.

Examples of external failures include a customer waiting too long to place a phone order from a catalogue, receiving a catalogue order with the wrong item, requiring the customer to repackage and send it back, an error in a credit card billing statement requiring the customer to make phone calls or write letters to correct it, sending a customer’s orders or statements to the wrong address, or an overnight mail package that does not arrive as expected. These costs are incurred after the customer has received a poor-quality product and are primarily related to customer service.

For example, external failure costs include:

a) Product Return Costs: The costs of handling and replacing poor-quality products returned by the customer.

b) Lost Sales Costs: The costs incurred because customers are dissatisfied with poor-quality products and do not make additional purchases.

c) Product Liability Costs: The litigation costs resulting from product liability and customer injury.

d) Customer Complaint Costs: The costs of investigating and satisfactorily responding to a customer complaint resulting from a poor-quality product.

e) Warranty Claims Costs: The costs of complying with product warranties.

A service’s internal failure costs are typically low, whereas external failure costs can be high. A service organisation has limited opportunities to examine and rectify a defective internal process, often an employee-customer interaction, before it occurs. At that point, it becomes an external failure. External failures usually result in increased service time or inconvenience for the customer. Examples of external failures include a customer waiting too long to place a phone order from a catalogue, receiving a catalogue order with incorrect items, requiring the customer to repack and return it, an error in a credit card billing statement, necessitating the customer to make phone calls or write letters to correct it, sending a customer’s orders or statements to the wrong address, or an overnight mail package that does not arrive as expected.

3) Equipment Poor-Quality Cost

This cost is distinct due to the unique reporting method required for management. The last type of direct poor-quality cost is equipment PQC. Investment in equipment used to measure, accept, or control the product or service and the price of the space that equipment occupies constitutes equipment PQC. This includes the cost of equipment used to print and report quality data.

Examples include computers, typewriters, voltmeters, micrometres, coordinate measuring machines, and automated equipment. In some cases, environmental controls installed to reduce the possibility of errors are included in equipment poor-quality costs (e.g., sound baffles, clean rooms, and air-conditioning controls). Equipment poor-quality cost does not encompass equipment used to manufacture the products, such as lathes, drill presses, assembly fixtures, electrical equipment required to adjust the product to meet specifications, or computing systems used for accounting and scheduling.

Indirect Quality Costs

The impact of poor quality on the customer isn’t reflected in an organization’s ledger but rather in the customer’s wallet. Thus, to succeed in business today, one must pay attention to “indirect poor-quality costs.” These can exceed the total price of the service or product.

Some companies ignore them, others consider them only when making changes in their appraisal activities, and others incorporate them into their poor-quality cost system. The degree to which they are implemented highly depends on how important an organization considers its customers to be. They are also divided into four areas:

1) Customer-Incurred Poor-Quality Cost: This type of loss occurs when an output fails to meet customer expectations. Typical customer-incurred poor-quality costs include loss of productivity while equipment is down, travel costs and time spent returning defective merchandise, repairs after the warranty period, and loss of productivity while the error is being defined and corrected.

2) Customer-Dissatisfaction Poor-Quality Cost: Customer dissatisfaction Poor-quality cost occurs when a customer buys a competing product, affecting future sales to people whom the customer knows.

3) Loss-of-Reputation Poor-Quality Cost: It is even more difficult to measure and predict. The costs t brings differ from customer-dissatisfaction costs in that they reflect the customer’s attitude toward the company rather than an individual product line.

4) Lost Opportunity Cost: Lost opportunity cost can be defined as the value of the next best alternative forgone. It can be defined as the revenue or the profit that a person/organisation would have been able to earn if it had exercised the alternative decision instead of the decision that has been made.

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