MANAGING COSTS AND QUALITY 16.19 If appraisal costs increase, a higher percentage – My Assignment Tutor

1 Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e TUTORIAL SOLUTIONS WEEK 9: CHAPTER 16 MANAGING COSTS AND QUALITY 16.19 If appraisal costs increase, a higher percentage of defects will be identified earlier in the manufacturing process, reducing failure costs. Higher appraisal costs also reduce the percentage of failures that reach the customer, thus making even greater savings in failure costs. If prevention costs increase there is an expectation that fewer defects will arise, hence failure costs will decrease. Usually the decrease in failure costs is greater than the increase in prevention costs. In cost management an increase in appraisal costs and prevention costs is often undertaken for the purpose of reducing quality costs overall. However, there is usually a lag between investing in prevention and reducing external failure costs (which are related to past period production) so total quality costs may rise initially.2 Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e Problem 16.47 Quality improvement programs and quality costs: manufacturer 1 Some of the factors that are critical for an organisation to successfully implement a TQM are as follows. (1) All levels of employee across the entire organisation must be educated about the quality management program so that both internal and external customers†expectations are understood and committed to, across the entire value chain. (2) The management must empower employees on the shop floor to take responsibility for quality improvement tasks, so that they can take action to prevent quality problems, manage their own quality inspection and correct the problems that do occur. (3) The organisation must establish a quality management system supported by documented quality procedures and practices. (4) The organisation must manage processes rather than focusing solely on functional departments. (5) The organisation, that is all employees, must commit to continuous improvement. 2 The cost of quality report indicates that LNTL has implemented the TQM program successfully. The total quality cost has declined from second quarter on, both in total cost and as a percentage of production cost. The trends in the four categories of quality costs over time as a percentage of the total cost of quality show: • external failure costs have halved • internal failure costs have decreased by 15 per cent • appraisal costs have remained steady • prevention costs have almost doubled. Clearly the prevention activities have been effective in reducing failure costs, particularly external failure. 3 Tonyâ€s reaction to the TQM program is more favourable now than at the initial stage because he has seen the benefits of TQM, both in improved production outcomes and an increased annual bonus (based on decreases in the cost of quality). Initially Tony was unenthusiastic about the TQM program because of concerns about its implications for his annual bonus He felt that quality is an abstract concept which does not lend itself to reliable measures of the cost of quality, the basis for his annual bonus. He was also concerned that his bonus is based on the cost of quality across the entire organisation and, therefore, there are many variables that influence LNTLâ€s cost of quality over which he had little or no control. However, once TQM and cost of quality reporting were implemented Tony could see the improvements in his production department as well as the increases in his annual bonus. 4 The opportunity cost is the potential benefit that is given up when one course of action is chosen over another, in this case it is the benefits forgone by not implementing the TQM program. There are many benefits associated with the TQM program such as the cost savings in all four categories of quality related costs, measured in the cost of quality report. However the COQ report does not provide a complete picture of the opportunity cost savings that would have been given up if LNTL had not proceeded with TQM. Other benefits forgone by not implementing TQM would include the contribution margin on future sales that are lost because of poor quality products getting into the market. These ‘costs†are difficult to measure, as unlike other quality costs, they are not recorded within the transaction-based accounting system. However they can be very important to the long-term viability of a business.3 Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e CASE 16.50 (45 minutes) Measuring and managing quality costs: manufacturer 1 Landers Ltd Cost of Quality Report Current Percentage monthâ€s cost of total Internal failure costs: Rework on defective wheels $12 000 4.4 Engineering costs to correct production line quality problems 22 500 8.2 Lost contribution on time to correct production line quality problems 37 500 13.6 Cost of faulty components that are scrapped 6 000 2.2 Cost of rewelding faulty joints discovered during processing 28 500 10.4 Cost of faulty bikes that are scrapped after finished goods inspection 15 000 5.4 121 500 44.2 External failure costs: Cost of replacement bikes provided under warranty 7 500 2.7 Cost of bikes returned by customers and scrapped 7 500 2.7 Cost of repairs under warranty 1 500 0.55 Sales commissions on faulty bikes returned by customers 750 0.3 Contribution margin forgone on bikes returned by customers 1 500 0.55 Contribution margin forgone on lost future bike sales 7 500 2.7 26 250 9.5 Prevention costs: Cost of quality training programs 4 500 1.6 4 500 Appraisal costs: Quality inspection in the goods receiving area 22 500 8.2 Quality inspections during processing 34 500 12.5 Laboratory testing of bikes and components 19 500 7.1 Operating an X-ray machine to detect faulty welds 22 500 8.2 Inspection of each bike put into finished goods warehouse 24 000 8.7 123 000 44.7 Total quality costs $275 250 100.0 2 The cost of quality report indicates that Landers costs of quality are very high compared to the overall manufacturing costs (more than 30 per cent of manufacturing costs). It appears that the company achieves its high quality through extensive appraisal activities. These appraisal activities result in a very high level of internal failure costs and relatively low external failure costs, as quality problems are detected before the bikes leave the factory. Prevention costs are very low. The company could reduce its cost of quality by increasing its expenditure on prevention activities. Effective prevention activities should help the4 Copyright © 2015 McGraw-Hill Education (Australia) Pty Ltd IRM t/a Langfield-Smith, Thorne, Smith, Hilton Management Accounting 7e company get to the point where bikes and components are made right the first time. In this environment it will be possible to reduce the level of appraisal activities. Internal failure costs will also go down. 3 It was impossible to identify the cost of quality from the existing accounting system. Many of the quality costs were hidden in manufacturing overhead cost accounts. Also some of the costs, such as contribution forgone on current and future sales, are not recorded in conventional accounting systems.