Cost of Quality (Nov 98)

There are several schools of thought on measuring quality costs.  At one end of the spectrum is Dr J M Juran’s belief that regular cost of quality quantification and monitoring is essential.  At the other end is the view of W. Edwards Deming that costs of non conformance and the resulting loss of customer goodwill are so high that evaluation of the cost of quality is unnecessary.  Like Deming, Phil Crosby believes that the cost of quality can be minimized by making it right the first time.

Among all the above views, however, there are some commonalities:

• Poor quality costs far more than is typically realized by management.
• Most firms spend on quality in the wrong places (fix it rather than do it right the first time).
• Spending on prevention reduces the need for inspection and can potentially eliminate internal and external failure costs.
• Significant cost savings or revenue opportunities exist in creating customer goodwill by consistently providing conforming products.
• Top management must be committed to and accept full responsibility for quality if quality strategies are to be effective.
• Conventional management accounting (standard costs, overhead variance analysis, analysis of raw material prices variance, etc) is a great obstacle for TQM implementation.

There are three possible approaches to developing and using management accounting systems in support of TQM:

• Deming: Do not do quality costing analysis.  Spend the money “upstream” in understanding customers, and designing perfect products and processes.
• Crosby: Do a cost of quality analysis as a special study.  Do not use this as a management tool on an ongoing basis.
• Juran: Prepare cost of quality reports on a periodic basis as a management control tool.

In the Indian context, my personal view is that a company adopting TQM for the first time might benefit by starting with the Juran approach, which requires a clear quantification of quality costs.  The ultimate goal should be to make quality a way of life so that quality cost measurements become unnecessary, as required in the Deming approach.

Some firms that have experimented with cost of quality analysis reporting (such as Punjab Tractors, Vikram Cement, ITC-PPD) have decided that formalized reporting is not essential three to four years up the TQM journey.  But for firms starting on TQM programs, I believe the benefits of formal cost reporting are very important.  For example, the pilot projects at Sterlite Copper have enhanced quality while saving the company multiple crores of rupees.  Examples abound.

As a firm’s quality management program develops, the approach to cost of quality reporting can take several different forms:

1. Cost of quality analysis as a regular management control tool.
2. Focus on price of non conformance, including opportunity losses.
3. Focus on non financial information to monitor TQM progress:

• Input measures
• Output measures.

In the first approach, formal cost of quality reporting continues as a regular control tool.  Ford and Texas Instruments applied this strategy throughout the 1980s to bounce back into the global mainstream.  As indicated earlier, this is an excellent prescription for India’s current woes.

In the second approach, if the price of conformance spending remains consistently high, the reporting focus can shift to non conformance costs with specific inclusion of the opportunity cost of  bad quality.  The goal becomes a steady reduction in price of non conformance toward a zero level.  In the early 1990s, Xerox and Westinghouse actively used this approach, worldwide.  Each had been a Malcolm Baldrige Award winner.

The third approach deemphasizes formal cost of quality reporting systems in favour of formal non financial reporting with a heavy emphasis on continuously improving quality in operations.  One name for this approach is Statistical Process Control. Notable examples of the success of this approach are H K Heinz Company and Corning.  Several companies in India collect SPC data.  The interpretation of data however, is a chronic weakness.  Besides, most of these companies have plunged into SPC without first addressing cost of quality reporting.  Consequently, the beneficial results of SPC are not realized.

Another approach that deemphasizes cost reporting in favour of non financial measures, in the output rather than input context, is Motorola’s well known Six Sigma program for customer reported defects.  IBM has announced a similar program for eradicating customer reported defects that it calls Market Determined Quality.  These companies believe they have the capability to work towards perfection.

Whichever approach a firm chooses, quality is an undeniably important strategic variable that management accounting cannot ignore it.  It must deal explicity with the quality issue, one way or another.

After all, cost of quality is a big opportunity: 25 percent of the total cost for companies in the steel, textile, automotive, electricals, service and other sectors.