The Measurement of Quality Costs: An Alternative Paradigm Thomas L. Albright and Harold P. Roth Thomas L. Albright is Assistant Professor of at The University of Alabama and Harold P. Roth is Professor of Accounting at the University of Tennessee. In recent years, the focus of cost/manage- rial accounting has shifted from providing cost data for inventory valuation on financial state- ments to providing information for cost man- agement. Under the cost management ap- proach, accounting systems provide informa- tion to help managers better evaluate and manage operations. One aspect of operations that is very important in this new approach is assessing the quality of processes and prod- ucts. While many quality costs are recorded in the accounting records, others, such as the cost of customer dissatisfaction with a prod- uct, are not. These unrecorded costs are con- sidered to be hidden quality costs, and man- agers may erroneously ignore them since the magnitude of the costs is unknown. Edwards Deming! refers to these unknown and un- Inowable hidden costs as the most important figures managers need. Therefore, if manag- ers are to consider all costs and benefits in their analyses of quality investments and per- formance, they need an estimate of these hid- den or unrecorded costs. ‘The purpose of this paper is to show how the Taguchi? quality loss function can be used. to estimate unrecorded quality costs. The pa- per illustrates an alternative definition of quality costs by evaluating the economic im- pact of variation from a target specification. ‘Traditional measures of quality are dichoto- , defective versus non-defective, and they imply there are no hidden quality costs when products are non-defective. The Taguchi loss function is, therefore, a radical departure from the traditional views of product quality. ‘The first section of the paper discusses the importance of quality in the cost management area to show why accountants need to be con- cerned with quality measurement technique: ‘The second section then presents a brief his- tory of the development of quality cost con- cepts to show why quality costs are important and why accountants need to understand these concepts. The third section reviews qual- ity cost concepts. The fourth section discusses the methods that can be used to estimate the hidden quality costs, and the fifth section in- troduces the Taguchi quality loss function. Then the next section illustrates how the loss function can be used to estimate the hidden quality costs, and it identifies some produe- tion processes that may cause these costs. The paper concludes with a discussion of how man- agers can use the Taguchi quality loss func- tion to justify improvements in quality and manage costs. QUALITY AND COST MANAGEMENT Quality is an important cost-management. topic because quality management can help organizations lower costs and improve prof- its. However, before quality can be managed it first must be measured. Unfortunately, most accounting systems do not provide data for ‘The authors would like to thank Robert Ingram, Paul Krueger, Imogene Posey, Bill Samson, Mary Stone, and Bill Woodall for their coromente and suggestions on ear- lier drafts of this paper. }W. Edwards Deming, Out of the Crisis (Cambridge MA: Massachusetts Institute of Technology, Center for Ad- vanced Engineering Study, 1986), p. 121. °Genichi Taguchi, a Japanese engineer, has developed 2 model that describes quadratically increasing qual- ity costs as a product's actuel measurement deviates product's actual measurements (width, weigh, thickness, ote. fall within the upper and lower specification16 helping companies evaluate quality, although accounting data can play a vital role in qual- ity management if the system has a cost man- agement focus. The link between quality and cost management has been noted by many accounting writers. Robert Kaplan was one of the first account- ing researchers to note the importance of qual- ity measurement in cost management sys- tems. In describing the accounting system that organizations need to support world class op- erations, he notes: ‘The challenge is to devise new internal ac- counting systems that will be supportive of the firm's new manufacturing strategy. Im- proved measures of quality, inventory perfor- mance, productivity, flexibility, and innova tion will be required * Howell and Soucy also note the importance of quality when they identify higher quality as a major trend in companies that desire to be world class manufacturers. They note the reasons for increased emphasis on quality are higher quality products provided by foreign competitors and the recognition that poor quality is a significant cost driver.‘ They con- clude that one implication of this trend is that accountants need "...to identify and address many nonfinancial areas of manufacturing performance." One of these areas is quality. Other writers in the accounting area also have noted the importance of quality measure- ment in a cost-management environment. For example, a recent National Association of Ac- countants (currently the Institute of Manage- ment Accounts (IMA)) study found that com- panies managing the cost of quality have a competitive advantage (although only a few companies seem to recognize the relationship between quality and profitability).® If the cost-management system is to pro- vide relevant data for managing companies in the current environment, quality measure- ment must be considered. Although non- financial measures of quality, such as num- ber of customer complaints and number of defects, are important quality measures, fi- nancial data may be just as important. Qual- ity costs are one type of financial data that cost-management systems need to provide. Accounting Horizons /June 1992 Although quality cost concepts are not new, they have only recently appeared in the ac- counting literature. QUALITY COST DEVELOPMENT Quality cost concepts have developed in the last 40 years in three areas. The initial development occurred in the quality control area of industrial engineering, and this area has continued to be a major factor in refining quality cost concepts. The Federal government also influenced quality cost development by requiring that defense contractors and sub- contractors evaluate their quelity costs. Since the 1980s, the third area of development has been in the accounting literature where qual- ity cost concepts have been discussed. A brief summary of the impact each of these areas has had on the development of quality cost concepts follows. Quality Control ‘The concepts underlying the costs of qual- ity originated in the early 1950s in the qual- ity control literature. Dr. J. M. Juran discussed the cost of quality in Chapter 1 of the Quality Control Handbook published in 1951. An early article entitled, "The Quality Manager and Quality Costs," was written by W. J. Maser and published in the October 1957 issue of Industrial Quality Control. In 1961, Dr. A. V. Feigenbaum included a chapter entitled "Quality Costs" in his Total Quality Control. ‘These early authors defined the basics of qual- ity cost measurements and provided a tax- onomy for classifying costs into prevention, appraisal, and failure categories. , "Measuring Manufacturing Perfor- : A Now Challenge for ial Accounting Research,” The Accounting Review (October 1983), p. 689, “Robert A. Howell and Stephen R. Soucy, "The New Manufacturing Environment: Major Trends for Man- agement Accounting,” Management Accounting (Suly 1987), p. 22. ibid, p. 27. “John Hawley Atkinson, Jr, Gregory Hohner, Barry ‘Mundt, Richard B. Troxel, and William Winchell, Cur- rent Trends in Cost of Quality: Linking the Cost of Qual- ity and Continuous Improvement (Montvale, NJ: Na- tional Association of Accountants, 1991), p. 67.‘The Measurement of Quality Costs: An Alternative Paradigm 7 Since then, quality control personnel have continued to develop and refine quality cost concepts. For example, Quality Progress, a journal of the American Society for Quality Control (ASQC), has published many articles on quality costs during this period. In addi- tion, the ASQC organized various committees to study the quality cost area. The most im- portant committees were a Quality Cost Tech- nical Committee and a Quality Costs Commit- tee. The Quality Cost Technical Committee prepared three reports dealing with measur- ing and managing quality costs,” and more recently, the Quality Costs Committee pub- lished Principles of Quality Costs to provide a ‘on quality cost concepts for per- a ‘who need to develop and implement: A ity cost systems.® The committee recognized the interface between quality costs and ac- counting by including a section describing the interface in Chapter 1 and by devoting an ap- pendix to "Basic Financial Concepts.” Department of Defense Requirements In the 1960s, cost of quality concepts be- came important to many defense contractors and subcontractors when the Department of Defense (DOD) included quality requirements in its regulations. In December 1963, DOD issued MIL-Q-9858A, Quality Program Re- quirements,® which required contractors to identify the costs of prevention and correction of nonconforming supplies and to maintain and use quality cost data in managing the quality program. Although the specific data determined by the contractor, the standard requires that the data be available for review by a governmental representative. Another DOD requirement related to qual- ity cost is MIL-STD-1520C, Corrective Action and Disposition System for Nonconforming Material." This standard requires the con- tractor to determine and record the costs as- sociated with nonconformances to see if there is a need for corrective action. The cost data also are used to measure the effectiveness of any corrective actions taken. Although these DOD requirements as- sured that quality cost data were collected, they did not require that the data be furnished to the government. However, Amendment 2 of MIL-Q-9858A dated March 8, 1985, now requires the contractor, upon request, to fur- nish the quality cost data to the government. From such data, the government may deter- mine the effectiveness of the contractor's qual- ity program. Accounting The development of quality cost concepts in the accounting literature has coincided with the development of the cost management area, and most of the literature on quality costs has been published in the managerial accounting and cost management areas. For example, in 1987 the National Association of Accountants (NAA) published a study entitled Measuring, Planning, and Controlling Quality Costs" to provide accountants with an introduction to quality costs. Specifically, the purpose of the study was to "...identify major issues in the measurement, planning, and control of qual- ity costs; summarize the experiences and suc- cess of selected companies in measuring qual- ity costs, and provide specific guidance in implementing a quality cost measurement, planning, and control system.”!? In this study, the researchers examined quality cost systems in four organizations and concluded that ac- countants have limited involvement in those systems although their role was expected to expand in the future.'® ‘To follow up on the 1987 study, the NAA has recently published another study which "The publications of this committee included Quality ‘What and How, published in 1967 and revised wi |; Guide for Reducing Quality Coste, 1977, and Guide for Managing Vendor Quality Costs, 1980. “Quality Costs Committee, Principles of Quality Costs, 2nd ed., Jack Campanelia, Ed. (Milwaukee, ASQC Quality Press, 1990), p. xv. *United States Department of Defense, MIL-Q-8858A, Quality Program Requirements, 1963. \United States Department of Defense, MIL-STD- 1520C, Corrective Action and Disposition System for Nonconforming Material, 1980. "Wayne J Marge, Harold P. Bth, and Kay M, aston, Planning, and Controlling Quality Costs Oats NJ: National Association of Accountants, “bid, 5. Mid, p. 104,18 updates the role of quality cost measurement and reporting in manufacturing and service organizations. The researchers investi- gated the impact of cost of quality reporting on organization structure, company culture, traditional cost management, and quality con- trol functions.” Based upon the results of field interviews, the researchers concluded that: ...cost of quality reporting has evolved from being primarily a cost reduction tool to being a manufacturing and service philosophy that supports the pursuit of continuous improve- ment to reach sustained profitability and competitiveness.'® After quality cost concepts were intro- duced to accountants, articles dealing with quality cost have appeared regularly in Man- ‘agement Accounting and Journal of Cost Man- agement for the Manufacturing Industry. ‘These articles expand quality costs concepts, show how organizations measure quality costs, and discuss the role of accountants in quality cost measurement and reporting.'* Although accountants have contributed to the quality cost area during the last decade, recent developments suggest they will need to continue to be actively involved in the area. For example, one development is the require- ment by the European countries that sellers have quality systems which meet the ISO 9000 standards. The ISO guidelines for quality management identify quality cost reporting as a means for evaluating the adequacy and ef- fectiveness of quality systems.” Another de- velopment likely to occur is that companies will stress research and development expen- ditures to prevent quality problems. When this occurs, Pasewark suggests that Taguchi con- cepts may be emphasized.!® Developments such as these assure that accountants will need to continue to explore quality cost con- cepts. A review of the quality cost literature shows that quality costs are an important di- mension of an organization's total quality pro- gram, and they represent a significant expen- diture in many organizations. According to recent estimates, the cost of quality is 30 per- cent of total U.S. manufacturing costs.'° With Accounting Horizons /June 1992 quality cost of this magnitude, both manag- ers and accountants need to understand qual- ity cost concepts and recognize that recorded costs are only a fraction of an organization's total quality costs. Deming notes that these hidden quality costs, such as customer dissat- isfaction resulting from inferior products (those with high variation in tolerances), are significant and often misunderstood.” QUALITY COST CONCEPTS “Quality costs" are usually defined as “costs incurred because poor quality can exist or because poor quality does exist."2! In this definition, quality refers to conformance to design specifications. Thus, quality costs are incurred to ensure that quality standards are met or because quality standards are not met. ‘These costs of conformance often are classi- John Hawley Atkinson, Jr, et al., op. cit, p. 2. Bid, p.3. 10These articles include Thomas N. Tyson, “Quality and Profitability: Have Controllers Made the Connection?” ‘Management Accounting (November 1987), pp. 38-42; James B. Simpson and David L.. Muthler, "Quality Costs: Facilitating the Quality Initiative,” Journal of Cost Management for the Manufacturing Industry (Spring 1987), pp. 25-34; Wayne J. Morse and Kay M. Poston, "Accounting for Quality Costs in CIM," Jour- nal of Cost Management for the Manufacturing Indus- try (Fall 1987), pp. 5-11; James T. Godfrey and Wil- liam R. Pasewark, “Controlling Quality Costs,” Man- ‘agement Accounting (March 1988), pp. 48-51; Thomas P. Edmonds, Bor-Yi Tsay, and Wen-Wei Lin, “Analyz- ing Quality Costs," Management Accounting (Novem- ber 1989), pp. 25-29; Lawrence A. Ponemon “Account- ing for Quality Costs,” Journal of Cost Management for the Manufacturing Industry Fall 1990), pp. 44-48; ‘William R. Pasewark, "The Evolution of Quality Con- trol Costs in American Manufacturing,” Journal of Cost Management for the Manufacturing Industry (Spring 1991), pp. 46-52; and Cynthia D. Heagy, "Determin- ing Optimal Quality Costs by Considering Cost of Lost Sales," Journal of Cost Management for the Manufac- turing Industry Pall 1991), pp. 64-72. MInternational Organization for Standardization, ISO 9000, Quality Management and Quality System Ele- ‘ments — Guidelines, 1987. Pasewark, op. cit, pp. 60-51 17, Kush, "Design Manufacturing for Quality” Automa- tion (Pebruary 1988), p. 40. Deming, op. cit. pp. 121-123. 2The definitions in this section are based on Morse et al., op. cit, p. 19‘The Measurement of Quality Costs: An Alternative Paradigm 19 fied into three categories: prevention, ap- praisal, and failure. Prevention and appraisal costs are in- curred because poor quality of conformance can exist. Failure costs are incurred because poor quality of conformance does exist. Spe- Gifically, . Prevention costs are incurred to prevent nonconforming units from being produced. Appraisal costs are incurred to identify non- conforming units before they are shipped to customers. Failure costs are incurred because poor quality of conformance does exist.”? From an accounting perspective, the vari- ous types of quality costs are related. For ex- ample, Montgomery describes a leverage ef- fect among prevention, appraisal, and failure costs. He suggests that dollars invested in pre- vention and appraisal activities ultimately reduce internal and external failure costs by an amount that far exceeds the original in- vestment.” The traditional model that describes the relationship between the categories of qual- ity costs is shown in Figure 1. This model, which is based on the work of Juran, shows a concave cost function that is minimized at a level of conformance where the marginal cost of prevention plus appraisal equals the mar- ginal cost of failure. As shown by the "U* shaped total quality cost curve, this model implies that the optimal level of quality is less than 100 percent conformance (the "optimal" point being at the “valley” of the "U" shaped cost curve). Several problems may be encountered when attempting to operationalize a quality cost system based on Juran's quality cost model. One of these problems is determining the failure costs. Many failure costs such as rework, warranty repairs, and in-field repairs are available from the accounting records, but others must be estimated. These include costs such as lost customer goodwill and other op- portunity costs that occur because an organi- zation produces poor quality products. Since these costs are not recorded in the accounting data, they are often referred to as hidden qual- ity costs. Another problem with using the tradi- tional model to evaluate quality costs occurs because many of the recorded failure costs are driven by defect rates. For example, scrap and ™Dhid., p. 19. Douglas C. Montgomery, Introduction to Sttitica! ‘Quality Control, Second Edition (New York: John Wiley and Sons, 1991), p.9. FIGURE 1 Juran's Model of Optimum Quality Costs Total Quality Costs Percent Conforming ead20 rework costs depend on the number of defec- tive products. The traditional view of quality usually defines defects as products with some characteristic that when measured falls out- side specification limits. With this definition, all units that fall within the specification lim- its are good, and all units outside the specifi cation limits are defective. The problem with this view is all units within the specification limits are considered to be equal regardless of whether they fall on the target value or near the upper or lower specification limit. Many quality experts now believe that all units that fall within the specification limits are not equally desirable. They believe there are hidden costs associated with variability in products regardless of whether the products fall in or out of specifications. Examples of these hidden costs of variability include lost market share because products are not uni- form, customer dissatisfaction due to products varying from target, and packing costs in- curred solely because of variation in products. Although the value of the hidden quality costs may be significant, many organizations will encounter difficulties in trying to estimate and manage these costs. A KPMG Peat Marwick study noted: "Many companies will be unable to manage this hidden cost of qual- ity, however, because they cannot measure it effectively.” Although measuring these hid- den quality costs may be difficult, accountants need methods for estimating the magnitude of the costs even if the costs cannot be esti- mated with pinpoint accuracy. Montgomery states that striving for too much accuracy is a pitfall because it will cause managers to be- come impatient and abandon quality cost pro- grams.?> METHODS FOR ESTIMATING HIDDEN QUALITY COSTS Various methods have been proposed for estimating hidden quality costs. One method is to determine the known quality costs and then multiply that number by a constant, In describing this method, the ASQC note: The effect of intangible quality costs, often called "hidden quality costs,” is difficult, if not impossible, to place a dollar value on... Some Accounting Horizons/June 1992 companies, however, have found a "multiplier effect” between measured failure costs and “true failure costs.” Westinghouse Electric Corporation, for example, reported that its “experience indicates that a multiplier effect. t lease three or four is directly related to such hidden effects of quality failure." A second method that can be used to esti- mate hidden costs is to use market research to determine how poor quality and variability in products affect market share. This method has been described as follows: For example, a firm's sales force knows its customers and the effects of losing custom- ers because of poor quality. Also, trends in a firm's market share lost to competitors can be analyzed. Based on the findings of mar- ket research, a projection can be made of fu- ture loss of contribution margin. This amount can then be discounted to its present value. Making estimates like this is not so radical After all, future cash flows are estimated in evaluating capital budgeting decisions.?” Another method for estimating the hidden costs, known as the "Taguchi Quality Loss Function," has been presented in the engineer- ing area. The ASQC describes the usefulness of this method as follows: What about the hidden costs or long-term losses related to engineering/management time, inventory, customer dissatisfaction, and losing market share in the long run? Can we ‘quantify these kinds of losses? Perhaps, but not accurately. Indeed, we need a way to ap- proximate these hidden and long-term losses because they're the largest contributors to total quality loss. Taguchi uses the Quality Loss Function (QLF) for this purpose.* ‘TAGUCHI'S QUALITY LOSS. FUNCTION Theoretically, the quality loss function (QLF) measures the loss to society from a product that does not perform satisfactorily. 2John Hawley Atkinson, Jr, et al, op. cit. p. 66. 2Douglas C. Montgomery, op. cit, pp. 10-11. 2Quality Costs Committee, op. cit., p. 10. “Cynthia D. Heagy, “Determining Optimal Quality Costs By Considering Cost of Lost Sales," Journal of Cost Management for the Manufacturing Industry Fell 1991), p.67. ‘*Quality Costs Committee, op. cit.,p. 99.The Measurement of Quality Costs: An Alternative Paradigm 21 In the QLF model, costs increase quadratically as actual product characteristics deviate from a target value.” Thus, if a $0.50 loss occurs when a product's actual weight deviates 0.1 grams from the target weight, then a $2 loss occurs when the product's weight deviates by 0.2 grams. The quadratic function means that when the deviation from target doubles, the loss becomes quadrupled. ‘Taguchi justifies the quadratic loss func- tion on the basis of experience. He and Clausing recently noted: From our experience, quality loss ... increases at a geometric rate. It can be roughly quanti- fied as the Quality Loss Function (QLF) based on a simple quadratic formula.... This is a simple approximation, to be sure, not a law of nature. Actual field data cannot be expected to vindicate QLF precisely, and if your corporation has a more exacting way of tracking the costs of product failure, use ‘it. But the tremendous value of QLF, apart from its bow to common sense, is that it trans- lates the engineer's notion of deviation from targets into a simple cost estimate managers can use. The QLF estimates the loss that occurs from producing products that vary from a tar- get value regardless of whether they fall in- side or outside the specification limits. This differs from the traditional view of losses from poor quality which is illustrated in Figure 2, Panel A. The traditional view suggests that no failure costs or losses are incurred if ac- tual product measurements fall within the specification limit. However, total loss in the form of scrap, rework, or warranty replace- ment occurs if the product's actual dimensions are outside specification limits. This view sug- geste there are no losses, either hidden or re- corded, when products meet specifications but, both recorded and hidden losses occur when products fall outside the specification limits. As an alternative to the traditional view, the QLF shown in Figure 2, Panel B, shows a loss due to variability when a product devi- ates from a target value even if the actual value falls within the specification limits. The loss is shown by the "U" shaped curve which touches the horizontal axis at the target value. Thus, the QLF suggests that hidden quality costs exist any time a product varies from a target value. Herein lies the fundamental dif- ference in philosophy between the Taguchi quality loss function that considers variation from a target value and the conventional view of quality based on the concept of defect rate as a dichotomous measure. Derivation of Loss Function ‘Taguchi has defined the quality loss func- tion in terms of the deviation between the ac- tual value and the target value of the charac- teristic, Ify represents an actual value and T represents the target value, then the unit loss function L(y) is Ly) =my-1)” @ actual value of characteristic, target value of characteristic, and oportionality constant which is dependent upon the cost structure of the process or organization. ‘Taguchi derived this loss function from a ‘Taylor Theorem expansion about the target value.3! He notes that the use of a quadratic function is found extensively in the statisti- cal and control theory literature.*? where: Average Loss Function ‘The loss function in Equation 1 represents the loss for a single unit. To determine the loss for all units of a product line for a specific pe- riod, the losses for all products would be added together. Alternatively, an average loss could be estimated from a sample of observations. *°Taguchi's quality philosophy also can be used where the target value is an upper or lower limit rather than a central value. Those cases, which are known as the “smaller is better" and “larger is better” cases, are not ‘considered in this paper. Also, the case of an asym- metric loss function is not considered. *Genichi Taguchi and Don Clausing, "Robust Quality,” Harvard Business Review (January-February 1990), p. 68. "Refer to the Appendix for the derivation of the Taguchi Loss Function. 9G. Taguchi, E. Elsayed, and T. Hsiang, Quality Engi- neering in Production Systems (New York: MeGraw- Hill, 1989), p. 16.22 Accounting Horizons /June 1992 FIGURE 2 Conventional and Taguchi Loss Functions A) Conventional Loss Function Loss Incurred No Loss incued Loss Incuted Lower Upper Specification Specification Limit Umit 8) Toguchi Loss Function Quality Loss Curve Lower Upper specication \owe Specification Umit Umit‘The Measurement of Quality Costs: An Alternative Paradigm The total loss would then be calculated by multiplying the average loss by the total num- ber of units, The average loss per unit is as follows: So-1 Lag =k] = — (2) where n= number of units in sample, and k, y, and T are as previously defined. Because the term in the brackets is an aver- age of the squared deviations from the target value, Equation 2 also may be written as LO )qyg = (MSD) @) where:MSD = mean squared deviation from target. Approximation of Average Loss Although Equation 3 provides a method for calculating the average loss per unit, it requires measurement of the MSD. Tunner®? has shown that if the mean and standard de- viation for the distribution of the quality char- acteristic are known, the average loss is ap- proximated by the following formula: LY) guy = Klo? + (W- TP] where:T = target value, IL= process average, and (4) Estimating k ‘To use any of the preceding equations, the value of the proportionality constant, k, must 23 first be determined. The variable, k, is usi ally calculated by dividing the loss for a prod- uct which falls at the specification limit by the squared distance from the target value to the specification limit: ? 6) where:c = loss associated with a unit pro- duced at the limit, assuming the loss at target is zero, and d= distance from target value to speci- fication limit. ‘Thus, the value of k depends on the loss associated with a product at the upper or lower specification limit of the quality characteris- tic and on the size of the specification limit. ‘The following illustration shows how the value of k and the hidden quality costs may be esti- mated. Mlustration ABC Company manufactures a product with a feature that has a target value of 12 grams with specification limits equal to the target value plus or minus 0.25 grams. Products that are produced at the upper specification limit of 12.25 grams result in a loss of $20. During last month, 2,000 units were produced, and 10 of these units were weighed as a sample representing the population. The weights of these 10 units are shown in column 2 of Table 1 88Joseph Tanner, “Is an Out-of-Spec Product Really Out ‘of Spec?” Quality Progress (December 1980), pp. 57- 59. TABLE 1 Data for Sample Units Measured Measured - Target Measured - Target Unit No. Weight (y) Weight (y-T) Weights Squared (y -~T)? 1 12.10 0.10 0.0100 2 12.25 0.25 0.0625 3 12.15 0.15 0.0225 4 12.05 0.05 0.0025 5 11.92 0.08 0.0064 6 12.08 0.08 0.0064 7 1221 0.21 0.0441 8 12.09 0.09 0.0081 9 12.14 0.14 0.0196 10 12.06 0.06 0.0036 Total 0.185724 With the data in Table 1, ABC Company can use the QLF to estimate the hidden qual- ity costs. To determine the loss for a single unit, such as the first one in Table 1, using Equation 1, the value of the variables are: ‘These give a value of k, the proportional ity constant, of $320 calculated as follows: With k = $320, Equation 1 gives a loss for the unit of $3.20 calculated as follows: Ly) = $320 (12.10 - 12.00 $320 (0.10)? = $3.20 With the data in Table 1, Equation 2 can be used to determine an average loss per unit. Column 2 of Table 1 shows deviations of ac- tual from target, (y—T), values for the sample while column 3 shows these values squared. Summing the squared deviation values in col- umn 3 gives a total of 0.1857 for an average loss per unit of $5.9424, calculated as follows: LAY)ayg = $320 (0.1857/10) = $320 (0.01857) $5.9424 For the 2,000 units produced, the total loss is (2,000 x $5.9524) = $11,884.80. Accounting Horizons/June 1992 ‘These data in Table 1 also can be used to illustrate the approximation of an average loss using Equation 4. The mean of the weights in ‘Table 1 is 12.105 and the standard deviation is 0.09156, Substituting these values in Equa- tion 4 gives an approximation of the average loss per unit of $6.2096: Ly), 320 [0.091567 + (12.105 ~ 12.000?) 20 [0.00838 + 0.011025) = $6.2096 With this approximation, the estimated Joss for the 2,000 units is $12,419.20. Although this estimate varies from the $11,884.80 esti- mated using Equation 2, the two estimates are close enough to provide an indication of the magnitude of the hidden quali ‘To determine the sensi age loss to the size of the standard deviation, 6, Equation 4 was used to develop Table 2. Table 2 shows the average loss for products with an actual (average) value varying from 115 to 12.5 when the standard deviation is 0.06, 0,10, 0.15 and 0.20. The proportionality constant and the target value were kept con- stant at $320 and 12.00 grams, respectively. As expected, the data in Table 2 show that the average loss increases as the standard deviation of the distribution increases and as the difference between the average value and the target value increases. The data also il- lustrate how the quadratic function causes the losses to become much larger as the deviation from the target value becomes greater. TABLE 2 Average Losses Using Continuous Function LO avg kL? + =D with k = $820 and T= 12.00 Standard Deviation (a) Average Value 0.08, 010 5 0.20, 15 $80.80 $83.20 $87.20 $92.80 116 52.00 54.40 58.40 64.00 17 29.60 32.00 36.00 41.60 118 13.60 16.00 20.00 25.60 19 4.00 6.40 10.40 16.00 12.0 0.80 3.20 7.20 12.80 12.1 4.00 6.40 16.00 12.2 13.60 16.00 25.60 12.3 29.60 32.00 41.60 12.4 52.00 54.40 64.00 12.5 80.80 83.20 92.80The Measurement of Quality Costs: An Alternative Paradigm 25 Table 2 also shows that when the average is equal to the target value, there is still an average loss per unit of $0.80 and the loss in- creases greatly as the standard deviation in- creases. The loss occurs because of the vari- ability in the distribution around the target value. As Table 2 shows, the average loss at the average value of 12.00 grams increases from $0.80 to $12.80 as the standard devia- tion increases from 0.05 to 0.20. This repre- sents a 1500 percent ((12.8 — 0.80)/0.80) in- crease in the average loss. As the average gets farther away from the target value, the dif- ference in the average losses continues to be $12 when the standard deviation increases from 0.05 to 0.20, but the percentage increase becomes much smaller. For example, when the average is 11.5 grams, the increase in the loss is only 14.8 percent ((92.8 — 80.8)/80.8). Examples of Costs Caused by Variability Examples of costs that increase as actual measurements deviate from a target specifi- cation are found in many industries. The fol- lowing examples, which are based upon field studies conducted by the authors, illustrate the type of costs associated with variability. The three products which are representative of many manufacturing processes are: 1) Farm Implements, 2) Paperboard, and 3) Magnetic Cassette Tapes. Farm Implements ‘The manufacture of farm implements con- sists of cutting, forming, assembling, and painting various gauges of sheet metal. If the cumulative tolerances of several pieces of sheet metal vary from a target specification, a large gap may occur at the welding joint. As a result, certain activities with cost implica- tions occur. When a gap is large, a large weld joint must be produced which increases costs because larger welds require more materials and time to manufacture (including construct- ing several layers of welding material, grind- ing, and polishing) than smaller welds. Addi- tionally, while functionally sound, the larger weld is often unattractive and unappealing to the consumer. Thus, larger welds are likely to result in higher opportunity costs of dissat- isfied customers than smaller welds. Paperboard Paperboard manufacturing provides an- other example of the hidden costs caused by variability. Although not recorded by the ac- counting system, many costs are incurred when a paperboard product exceeds the tar- get value even though it stays within the up- per specification limit. For example, thick pa- perboard (those grades with a high basis weight) contains more pulp, is processed at slower machine speeds, requires more energy to dry, and is more expensive to transport per lineal foot than thin paperboard. In addition, the equipment used in subsequent processing operations may be subjected to extra mainte- nance costs and downtime to mitigate the ef- fects of highly variable paperboard input. Cassette Tapes ‘The manufacturing process for cassette tapes may also result in hidden quality costs. During the manufacturing process of cassette tapes, a pigment of magnetic material, mag- nesium oxide, is applied to the surface of a plastic film. The excess magnesium oxide is then removed to produce consistency in the thickness of the layer. In the manufacturing process two specifications are important: 1) the caliper or thickness of the film, and 2) the thickness of the magnetic material. In addi- tion to costs resulting from the waste of ma- terials when excess magnesium oxide is ap- plied and removed, other costs also occur as a result of variation from target. For example, variation in the thickness of the magnetic material affects the sound quality of the cas- sette. Engineering studies have suggested that sound quality deteriorates exponentially as a function of the distance between the tape and recording head. Poor sound quality has a cost ifit results in dissatisfied customers. Addition- ally, cost may increase because variation in the thickness of the film may cause jamming and tearing when the film is packaged in a cassette housing. If the film is too thick, the tape may not even fit into the cassette hous- ing. Therefore, controlling variation is of spe- cial concern for products such as 120-minute26 cassettes if the manufacturer wants to reduce costs and maintain satisfied customers. USES OF QLF ESTIMATES ‘The estimate of the hidden quality costs provided by the QLF can be used by manag- ers and managerial accountants to help them improve operations and reduce costs. Specifi- cally, the costs estimated by the Taguchi qual- ity loss function may be used to (1) provide an indication of the magnitude of the hidden quality costs, (2) help evaluate investment Proposals for process improvement, (3) help measure actual performance of process im- provement projects, and (4) evaluate progress towards quality goals. Indicating Magnitude of Costs ‘The Taguchi loss function provides an es- timate of the magnitude of the hidden quality costs. If these costs are ignored in a quality cost analysis, the failure costs will be under- stated, and managers are likely to conclude that the optimal quality level is less than it should be. Since the opportunity costs of poor quality including the cost of lost customer goodwill are often major quality cost items for firms, obtaining a reasonable estimate of these costs could prevent managers from ignoring or materially underestimating them in their analyses. If managers know that these hid- den quality costs are large, they may also have an incentive to try to reduce the cost. The QLF also shows managers that there are costs associated with variability in pro- cesses and products even when the products are within specification limits, and these costs become greater as process and product vari- ability increases. By having an estimate of these costs, managers may be more likely to realize that reducing variability in processes and produets is an effective way of improving both quality and profits. Evaluating Investment Proposals One method for reducing the hidden qual- ity costs is to invest in process improvement projects. However, before these projects are Accounting Horizons / June 1992 approved, they will probably be evaluated us- ing discounted cash flow techniques. One of the major benefits of these types of projects is the cash savings that result from reducing the variability of the process output. Thus, all potential cash savings need to be included in the evaluation or the proposed investment will appear to be less attractive than it really is. This may cause the project to be rejected be- cause it does not meet the minimum criteria set by the firm. Ifhidden quality costs are es- timated and included in the cost savings, the evaluation of these investment proposals would be improved. Measuring Actual Performance Another area where an estimate of the quality costs would be useful to management is in performance measurement and evalua- tion. If a manager is able to reduce the vari- ability of a process, the costs associated with the variability will be reduced. Likewise, the post-audit of a capital project which was ac- quired to reduce variability requires a mea- sure of the cost of the variability. The Taguchi quality loss function provides a method for improving the measurement of actual perfor- mance in this area. Evaluating Progress Towards Goals As organizations strive to put more em- phasis on quality goals, they need methods for measuring their progress towards these goals. ‘The Taguchi loss function provides a method for quantifying progress toward the goal of reducing customer dissatisfaction. Basically, the model posits that quality is best and costs are lowest when products are on target. It also emphasizes that customer dissatisfaction can be represented by a continuous function rather than a step function as implied by the con- formance to specification model. Jerry Roslund has summarized the difference between these two quality models: Conformance-oriented quality is totally inad- equate [for meeting quality objectives]. ‘Taguchi's target-oriented approach is the only sensible method for measuring quality. The bottom line is that customers will then re-‘The Measurement of Quality Costs: An Alternative Paradigm 27 ceive the best the company can offer, which is the best insurance for survival.* SUMMARY Although there are many aspects of qual- ity, the measurement and reporting of qual- ity costs emphasizes how costly it is to pro- duce poor quality products. While some qual- ity costs data are available from the account- ing records, other quality costs are hidden and must be estimated. These hidden quality costs include costs due to variability in processes and products as well as the traditional oppor- tunity costs of poor quality. If accountants are to provide comprehensive quality costs re- ports, they need models for estimating these unrecorded quality costs. As shown in this paper, the Taguchi quality loss function is a technique that accountants can use for esti- mating these hidden costs. ‘Jerry L. Roslund, "Evaluating Management Objectives With the Quality Loss Function” Quality Progress (Au- ‘gust 1989), p. 49. APPENDIX ‘To derive the loss function, L{y) is expanded about the target value, 7, in a Taylor series. Ly) =U? +y-T) or Ly) L¢T) + LTV! (y —T) + Li '(TV2t y -T +... LTV n! (y— TY +... If the terms with powers greater than 2 are ignored the equation reduces to the following: Lay) = L nya! y -"D? Ly) =ky-T? where: k = proportionality constant specific target value of the characteristic of interestCopyright © 2003 EBSCO Publishing