May 6, 2015

Costing for Quality, Time and the Theory of Constraints

Cost Accounting and Cost Measurement for Poor Quality Related Costs

Companies that fail to achieve quality at design level to provide as per customer requirement will fail in the market place. Also if the production system is unable to produce as per the design specification, spoilage will occur, rework will occur and failure of the product at the customer's place occurs sooner than expected.  Failure at the customer's end results in customer dissatisfaction, return of the product for repairs and bad word of mouth for the brand. Rework results in extra costs of production. Spoilage is also a loss due to material loss, labor loss and overhead loss associated with the spoilage. As the costs of poor quality are understood and quality improvement methods have evolved, accounting for poor quality related costs also emerged.

Cost of quality framework

Cost of quality framework states that quality can be improved by improving design and production processes and this will reduce appraisal costs, internal failure costs and external failure costs. Also increase in appraisal cost has the potential to reduce internal and external failure costs. To see this phenomenon in practical real life situations, cost accountants are being asked to prepare poor cost of quality statements showing the amount spent on each category of the following costs.

Prevention costs

Appraisal costs

Internal failure costs

External failure costs

Then quality managers and engineers or industrial engineers can come out with plans to increase prevention costs and appraisal costs and decrease internal and external failure costs. Needless to say engineering or managerial economics requires that incremental cost incurred must be less than the benefit realized that is decrease in total failure costs.

Cost accountants have to take the cost of quality categories as cost objectives and provide cost figures for them.

Seven Step Activity Based Costing for Determining Cost of Quality

1. Identify the Cost Objects - Concerned product, total cost of quality, individual category of cost of quality

2. Identify Direct Costs - There are no direct costs related to cost of quality

3. Select the Cost Allocation Bases to Use for Allocating Indirect Costs of the Product - For quality related work design hour, inspection hour, rework hour, were taken as cost allocation bases. In the case of external failure there is cost of transporting the item back to the company. For this a transport event is taken as the cost allocation base.

4. Identify the Indirect Costs Associated with Each Cost Allocation Base - Total cost incurred in product design, process design, inspection, rework due to internal and external failure, transport of customer returns are accumulated.

5. Compute the Rate Per Unit of Each Cost Allocation Base - For each activity, total quantity of performance (cost allocation base) is determined and it is used to divide total cost incurred to get the rate per unit of each cost allocation base,

6. Compute the Indirect Allocated to the Product - Compute the quantities of each cost allocation base related to poor quality used by the product.  Multiplying quantity with the corresponding rate per unit of the collection base will give the indirect to be allocated to the product for that allocation base.

7. Compute the Total Cost of the Cost Object: In our case of cost of quality is the cost object and we add all items of cost of quality framework to get total cost of quality.

Nonfinancial Measures of Quality

Nonfinancial measures are also important and their importance is brought into limelight by the balanced score card approach, Cost and management accountants have also a role to play in recording data of nonfinancial measures and creating statements of these measures.

Nonfinancial measures of customer satisfaction as index of quality

1. Market research studies on customer preference and satisfaction with specific products and product features.
2. The number of defective units reported by customers as a percentage of products shipped.
3. The number of customer complaints in a period say a month
4. Percentage of products that experience a early or excessive failure
5. Delivery delays - Percentages - Highest number of days
6. On-time delivery rate

Horngren, Foster, Datar,  Cost Accounting: A Managerial Emphasis, 10th Edition, Prentice Hall Inc., 2010

Updated 6 May 2015
First Published 8 December 2011

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