Danna Lummus, the president of Karlene Company, has recently returned from a conference on quality and productivity. At the conference, she learned that many American firms have made significant progress in improving quality and reducing quality costs. Many of these firms have been able to reduce quality costs from 20 to 30 percent of sales to 2 to 3 percent of sales. She was skeptical, however, about this statistic.

Even if the quality gurus were right, she was sure that her company's quality costs were much lower-probably less than 5 percent. On the other hand, if she was wrong, she would be passing up an opportunity to improve profits significantly and simultaneously strengthen her competitive position.

In fact, she reflected on the comment of one of the quality experts: "Quality has become a condition of entrance to the market. If the product is not good, you will quickly go out of business." The qual- ity issue was at least worth exploring. Moreover, she decided that it may be too risky not to assess her company's quality performance. She knew that her company produced most of the information needed for quality cost reporting-but there never had been a need to bother with any formal quality data gathering and analysis.

This conference, however, had convinced her 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, Linda contacted her controller and requested a preliminary estimate of the total quality costs currently being incurred. She also instructed the controller to classify quality costs into four categories: prevention, appraisal, internal failure, and external failure costs. The controller has gathered the following information from the past year, 2008:

a. Sales revenue is $30,000,000; net income is $6,000,000.

b. During the year, customers returned 90,000 units needing repair. Repair cost averages $7 per unit.

c. Ten inspectors are employed, each earning an annual salary of $45,000. These 10 inspectors are involved only with final inspection (product acceptance).

d. Total scrap is 90,000 units. All scrap is quality related. The cost of scrap is about $15 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 $3 per unit.

f. A customer canceled an order that would have increased profits by $750,000. The customer's reason for cancellation was poor product performance. The Accounting and Marketing Departments agree that the company loses at least this much each year for the same reason.

g. The company employs eight full-time employees in its Complaint Department. Each earns $37,500 a year.

h. The company gave sales allowances totaling $375,000 due to substandard prod- ucts 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 $240,000.
j. Inspection of the final product requires testing equipment. The annual cost of operating and maintaining this equipment is $360,000.

Required

1. Prepare a simple quality cost report, classifying costs by category. Comment on the quality costs/sales ratio.

2. Discuss the distribution of quality costs among the four categories. Are they properly distributed? Explain.

3. Discuss how the company can improve its overall quality and at the same time reduce total quality costs. Consider specifically the strategy advocated by the American Society for Quality Control.

4. Suppose Karlene Company decides that a five-year program will reduce quality costs to 2.5 percent of sales and that control costs will be 80 percent of total quality costs. Calculate the income increase that will occur if sales remain at $30,000,000. Also, calculate the total amount spent on control and failure costs.

5. Refer to Requirements 1 and 4. Suppose that Danna decides to create a bonus pool to allow employees to share in the benefits from quality improvements. The bonus pool is 20 percent of quality cost reductions. How much will be put in the bonus pool for the five-year period? Why establish such a pool? Suppose that Danna's quality manager suggests that the bonus be based only on reduc- tions of appraisal and failure costs. Explain why he might suggest this modifica- tion. Do you agree?

6. For Danna's company, hidden quality costs are estimated by using a multiplier of three. What are the actual external failure costs? What methods are available for estimating hidden quality costs? What effect does this estimation have on a quality-improvement strategy? Finally, should reductions of these costs be included in the bonus pool mentioned in Requirement 5? If included, what would be the effect on the bonus pool?