Chapter 16

Total Quality Management

Teaching Notes for Cases
16-1: Precision Systems, Inc.
This case illustrates that quality cost information can play an important role in alerting top management
about the importance of quality improvement in a non-manufacturing department of a manufacturing
firm. The case is based on the following article:
Kalagnanam, S. S. and E. M. Matsumura, "Cost of Quality in an Order Entry Department," Journal of
Cost Management (Fall 1995), pp. 68-74.
The required questions are designed to acquaint students with some of the terminology of "cost of
quality" and some aspects of conducting a cost of quality study. Quality costs, defined as those that arise
because poor quality may exist or does exist, have been classified into the following four categories:

Prevention (prevention of poor quality, or quality assurance);

Appraisal (inspection and testing);
Internal Failure (costs, such as rework or scrappage, for nonconforming products identified
before delivery to customers);
External Failure (costs, such as warranty expenses or freight charges, for nonconforming products
delivered to customers).

This case focuses on prevention activities (see question 6), as well as internal failure and external failure
costs for the order entry department at Precision Systems, Inc. Internal and external failures are defined
with respect to the order entry department.
Additional readings on quality costs:
Kaplan, R. S. and A. A. Atkinson, Advanced Management Accounting, 2nd ed. (Englewood Cliffs,
NJ: Prentice-Hall, Inc., 1989), chapter 10.
Morse, W. J. and H. P. Roth, "Why Quality Costs are Important," Management Accounting,
November 1987, pp. 42-43.
Scholtes, P. R., L. S. Weiss and S. Reynard, Quality Improvement in the Office (Madison, WE Joiner
Associates, Inc., 1988).
Schonberger, R. S., "Total Quality Management Cuts a Broad Swath," Organizational Dynamics
(Spring 1992), pp. 116-27.

Suggested Solutions to Required Questions

1.

Describe the role that assigning costs to order-entry errors played in quality improvement
efforts at Precision Systems, Inc.

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This question is designed to help students recognize how cost management systems can interface with
quality improvement efforts. As the case states, in spite of PSI's commitment to quality improvement,
"the changes [in order entry] would not have been so vigorously pursued if cost information had not
been presented. COQ information functioned as a catalyst to accelerate the improvement effort." This
is because the cost figures captured the attention of top management.
Other responses might include the following: 1) It made order entry aware of the dollar impact of its
errors; 2) It provided a means of prioritizing quality improvement efforts.

2. Prepare a diagram illustrating the flow of activities between the order entry department and its
suppliers, internal customers (those within PSI), and external customers (those external to
PSI).
There are many possible flows. For example, a sales representative may contact order entry to request
a quote for a system for a customer. Subsequently, the customer order entry to place the order; order
entry then generates and order acknowledge, which is sent to manufacturing, invoicing, and sales
administration. Once the system has been shipped, an invoice is sent to the customer. Ultimately,
collections will receive the invoice. Customer support will contact the customer to arrange
installation, and will be available to answer questions over the phone.
A request for parts from a service representative or directly from a customer would be routed to the
stockroom, after which the part would be shipped and the customer would t billed. A request for
service would result in an order acknowledgement being sent to the service department.

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SUPPLIERS

PROCESS

OUTPUT

CUSTOMERS

Sales
Administration

Customers
(place
orders)

Sales
Representatives
(request
quotes)

Quote

Invoicing

Collections

OA (Orders
Acknowledgement)

Manufacturing

Shipping

Stockroom

Customer
Support

Order
entry
Service
Representatives
quotes)
Technical
Information
and
Marketing
Departments

Service

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3. Classify the failure items in Exhibit 1-1 into internal failure (identified as defective before
delivery to internal or external customers) and external failure (nonconforming products
delivered to internal or external customers) with respect to the order entry department. For
each external failure item, identify which of order entrys internal customers (i.e., other
departments within PSI that use information from the order acknowledgment) will be affected.
Items 1, 2, 5, 8, 19 and 12 are internal failures; the remaining are external failure items. Internal
customers affected by external failure items are listed below.
Item Number
3
4
6
7
9
11

Internal Customer(s) Affected

Manufacturing, service, stockroom, invoicing
Invoicing, accounting (profitability analysis)
Manufacturing, service, stockroom, invoicing, accounting
Shipping, invoicing, collections, customer support
Manufacturing, service, stockroom
Invoicing, collections, accounting

Other examples (not included in Exhibit 1):

Error Type
Incorrect serial # of system on OA
Duplicate order
Incorrect sales rep. Code

Internal Customer(s) Affected

Service, customer support
Stockroom, shipping, manufacturing, sales admin.
Sales administration

4. For the order-entry process, how would you identify internal failures and external failures?
Who would be involved in documenting these failures and their associated costs? Which
individuals or departments should be involved in making improvements to the order entry
process?
An initial step would be to interview employees in order entry, as well as its suppliers and internal
customers. Based on the interviews, data collection forms can be developed. For internal failures,
order entry staff would keep track of the problems they encounter while preparing quotes and
processing orders. For external failures, internal customers of order entry would keep track of the
errors they encounter when using information from the quotes or order acknowledgements.
Suppliers to order entry, internal customers of order entry, and order entry staff should be involved in
making improvements to the order entry process.
5.

What costs, in addition to salary and fringe benefits, would you include in computing the cost
of correcting errors?
Possible responses include the following:
Office equipment and office space
Telephone (to clarify problems)
Computer costs (making changes on the computer)
Supplies (paper for printing new quotes or order acknowledgements)
Lost interest and other costs associated from late payments by customers (due to invoicing
mistakes resulting from order entry errors)
Lost sales from new customers (due to delay in preparing quotes)
Lost future sales from current dissatisfied customers (due to errors in order entry)
Shipping costs on returns

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Rework costs
Frustration and lower morale, possibly leading to poorer quality or high turnover
Costs related to duplication in manufacturing
Crisis management costs (express shipping)
Lost revenues if underpricing
Scrappage of returns
6.

Provide examples of incremental and breakthrough improvements that could be made in the
order entry process. In particular, identify prevention activities that can be undertaken to
reduce the number of errors. Describe how you would prioritize your suggestions for
improvement.
Students can brainstorm about possible improvements during a class discussion. Possible responses
include:
Incremental Improvements
Empower employees
Allow sales representatives to correct errors without approval.
Urge order entry to improve communication with manufacturing and other departments.
Provide feedback to order entry on types of errors, numbers of errors, and cost impact.
Daily, by computer (suggestions for improvement)
Educate sales representatives about effects of errors and about the process.
Provide better training for sales representatives.
Train sales representatives to develop accurate quotes and take on the order entry function.
Have sales representatives take responsibility for the process.
Track customer purchases to improve service to customers.
Survey customers about problems; use the responses to prioritize problems.
Stop the double-entry of information.
Get input from order entry on development of forms.
Implement checking in order entry to help prevent order acknowledgement errors.
Develop a reward system that motivates error-free performance of sales reps. and order entry.
Benchmark.
Breakthrough Improvements
Develop a computer system to decrease the number of times data are entered.
Develop a spreadsheet or computer program to check for inconsistencies between P.O. and quotes.
Check for duplication of orders.
Check prices.
Develop a computer system that allows sales representatives to prepare accurate quotes.
Install a computer system linking order entry, manufacturing, invoicing, etc.
Use cross-functional teams to manage "large" costs or different segments.
Develop a system that allows parts customers to get their own quotes on-line.

Incremental Improvements Made by PSI

1) Key information for quotes is now obtained up-front by the sales representative; earlier, the sales
representative faxed partial information to order entry and requested a quote. Order entry staff
then spent a great deal of time obtaining missing information. With this change, the sales
representative cannot request a quote until he/she has supplied key information to order entry
staff. This could be considered a prevention activity.

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2) Customers are asked to include quotation numbers on their purchase orders. This allows PSI to
match orders with quotes and avoid duplication in manufacturing. PSI prepares its manufacturing
plan based on the quotes received because they have a reasonably good idea of which ones are
likely to become firm orders.
3) Proper tools are provided to the order entry staff:
Procedure manuals.
Guidelines for sales discounting. Prior to this, the order entry staff had to call sales to seek
clarifications regarding discounts.
Printed configuration guides that contain information in the format that order entry requires.
Prior to this, the formats did not always match.
4) Order-entry staff members are now responsible for both quotes and orders. Previously, some staff
members were responsible for only quotes, and other staff members were responsible only for
orders. This change had an immediate impact, as the person who prepared a quote now had
responsibility for processing the subsequent order.
5) A regular feedback system is now in place. Each internal customer department provides feedback
to order entry once every quarter.
Benefits: Cycle time for preparing quotes was reduced by 60% and cycle time for processing orders
was reduced by 50%. Also, order entry staff experienced greater pride in their work.

Breakthrough Improvement Efforts by PSI as of 1993

Many of these improvements are prevention activities.
1) PSI began working with a vendor to develop an on-line configurator that would configure their
standard systems (order entry staff would avoid keying-in part numbers).
2) PSI planned to acquire a new, more integrated order entry system that can communicate with the
configurator and turn a quote into an order acknowledgement when the order comes in. The
system will also be able to generate an invoice, thereby avoiding re-keying the information.
3) PSI began working towards providing sales representatives with a laptop computer equipped with
a built-in configurator. This will allow them to prepare quotes in the field.
The anticipated benefits include a reduction in errors caused by incorrect or duplicate part numbers,
and a reduction in cycle time for preparing quotes or processing orders and preparing invoices.

Prioritizing Improvement Activities

Three considerations in prioritizing improvement activities are the perceived seriousness of the
problems, the benefits of improvements, and the costs of the improvements. In this case study, the
breakthrough improvement projects involve higher costs than the incremental improvement efforts.
To identify the most serious problems, a Pareto analysis can be performed.
In PSI's case, correcting order acknowledgement errors became the highest priority because of its
associated cost of 7% of the salary and fringe benefits budget (see Exhibit 2).

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Update: Improvement Efforts by PSI as of 1996

The first incremental improvement, a stringent policy of sales representatives filling out quote forms
correctly, was abandoned because the forms quickly became obsolete and the policy was unpopular
with sales representatives. In addition, the policy slowed the quotation process.
The initial vendor's quote for the desired configurator was judged unaffordable. After an 18month
search, however, PSI was able to purchase a new integrated information system (including materials
resource planning and accounting) that included a configurator. In the meantime, PSI developed an
in-house configurator program that runs on the sales representatives' laptop computers. As a
consequence, problems with missing, incorrect, or changed part numbers have been greatly reduced.
Information on part numbers originates in manufacturing, and is maintained and kept current by the
marketing department. A change from line-item pricing (listing each component part with its
associated price) to bundling (listing the component parts but providing only a bottom-line price)
reduced processing time because customers previously would call for verification if any one of the
component prices on the invoice differed from what appeared on the quote.
The current cycle typically runs as follows:
Sales representative prepares a quote using laptop computer configurator and emails it to order
entry;
Order entry reviews the quote and sends a quote packet to send to the customer (Pricing on quote
is reviewed by order entry supervisor);
When the customer's order is received by order entry, the order is entered into PSI's system
configurator; the order entry supervisor approves the order;
The controller approves the order;
The order acknowledgement is transmitted electronically to manufacturing; Manufacturing builds
the product;
The product is shipped;
The invoice is generated the same day the product is shipped, with no further review.
7.

What nonfinancial quality indicators might be useful for the order entry department? How
frequently should data be collected or information be reported? Can you make statements
about the usefulness of cost-of-quality (COQ) information in comparison to nonfinancial
indicators of quality?
Nonfinancial indicators that might be useful in improving quality in the order entry department
include: 1) The frequency of the different types of errors; 2) Time spent on correcting problems.
Frequency of reporting is an important issue when implementing a COQ system. Options for
frequency of tracking data and reporting include:
1) Keep track of the information on a daily basis but report monthly. Continue doing this until
improvements are made and the information is no longer needed. The assumption is that
continuous improvement projects will be undertaken to rectify the situation.
2) Collect sample data for a specified period once every quarter or six-month period, for
example, and assess the changes in the magnitude of problems. The assumption is that results
from the sample data will be used to make process improvements.

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COQ information is useful for the following reasons:

1) COQ quantifies the financial impact of the errors/problems, thereby providing a universally
understood method of assessing the seriousness of the situation. As emphasized in question 1,
COQ figures can play an important role in alerting top management to the seriousness of
quality problems overall or in a particular area.
2) Quality cost systems cut across departmental boundaries, thereby providing a holistic
measure of the benefits derived from improvement efforts.
COQ information should be used in conjunction with nonfinancial indicators, as the latter provide
the information actually required for making changes to the system.

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16-2 Kelsey Hospital

The purpose of this case is to have students analyze and categorize costs of quality (COQ) in a nonprofit
health care setting. The case describes the need for a quality costing system in a hospital and the
development of such a system for two primary treatments (intubation and bronchodilator treatments)
performed in the Respiratory Therapy Department of the hospital. A list of items pertaining to quality
costs is presented and described for analysis, estimation, and categorization.

Teaching Notes
In recent years, companies have realized that to be globally competitive, they must focus on the quality of
their products and services. Traditionally, the costs relating to quality have been buried in other cost
categories (i.e., administrative overhead). To evaluate the costs and benefits of efforts to enhance quality
and also to better control costs relating to quality, the quality costs need to be segregated and properly
measured. Therefore, many companies have established cost of quality systems. Cost classification is an
important aspect of these systems because different categories are controlled differently, some categories
are more serious in terms of future consequences than others, and investment in certain categories is
believed to greatly reduce those in other categories.
Determining and measuring costs of quality in a service organization are especially challenging.
Manufacturing companies can inspect their products before delivery to customers and quality can be
assessed visually or by the use of instruments. In contrast, service organizations cannot assess quality until
after the service is rendered and measuring instruments are usually of no use because physical
measurements are not applicable. Hence, it is much more difficult to determine and measure the costs of
quality in a service organization than in a manufacturing firm.
Manufacturing cost of quality cases have been written in settings such as electronics 1 and paper mills.2 The
issues covered in these manufacturing cases are similar to those in the Kelsey Hospital case study, but how
the costs are determined and measured in the service setting are more complex. With products, one can
assess the quality of materials, the quality of product design, and the conformance to product
specifications. In service settings, however, one is usually assessing quality associated with intangible
items, making it a more nebulous exercise to measure quality costs.
At least one service case exists in the context of a railroad 3 and involves the use of quality costs relating to
environmental management. Kelsey Hospital also differs from most other manufacturing and service
settings in that consideration needs to be given to quality perceptions of an outside customer groupthird
party payers. Furthermore, because health care organizations deal with human lives, quality is even more
paramount than in most other types of organizations.
The Kelsey Hospital case involves the analysis and categorization of quality costs in a nonprofit service
setting. The case is based on an actual hospitals experience with developing a cost of quality program,
although all names in the case are fictional. The case largely involves opinionated discussion. The learning
objectives for the case are as follows:
1. To help students understand different customer groups concerns and perceptions about quality;
1 Examples are: Signetics Corporation: Implementing a Quality Improvement Program (A), Stanford University,
1982; Texas Instruments: Cost of Quality (A), Harvard Business School, 1988.
2 Iron River Paper Mill, in Anthony, R. N. and V. Govindarajan, Management Control Systems, Irwin/McGraw-Hill,
1998, pp. 646-655.
3 Union Pacific Railroad: Using Cost of Quality in Environmental Management, Institute of Management
Accountants (IMA), 1997.

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2. To help students understand the nature of the four cost of quality categories and its application in a
health-care setting;
3. To help students understand how to measure costs of quality (COQ);
4. To help students understand how COQ measures can fit into a balanced scorecard (BSC).
Students should have had prior exposure to some elementary material on costs of quality from either a
cost/managerial accounting textbook4 or journal article.5 The case is appropriate for both undergraduate
and graduate cost or managerial accounting courses. This case can be covered in a 50-minute class period.
Kelsey Hospital has been used several times in undergraduate introductory managerial accounting classes
immediately after textbook material on costs of quality has been covered. Lively discussions have ensued
about customer perceptions and how to categorize the various costs. Drawing out additional quality costs
from the students (particularly the undergraduate ones) can be challenging and it may be necessary to give
some hints to them. Like most cases, when students are asked to turn in write-ups on this case prior to
class discussion, there is a greater level of preparation than otherwise and this improves the quality of
class discussion. However, because the case does not have complex technical accounting issues and
contains no number crunching, it does not require a lot of advance preparation for students to
meaningfully discuss the case. In fact, on one occasion, students were given 15 minutes of class time to
read the case and the resulting class discussion was rather good. Students have reported that the case
helps them better appreciate and understand costs of quality because they see it applied in a setting that
they are familiar with rather than an obscure factory setting. While it may seem that some of the medical
terminology would be unfamiliar to students, they seem to absorb it well from the case. Furthermore,
class discussions tend to be centered around basic health-care issues and not medical complexities.
Suggested solutions for the assignment questions are as follows:
1.

What groups and individuals are the "customers" of the respiratory therapy department?
Describe the concerns and perceptions about quality that might differ across the different types
of customer. Identify the problems that the different customers would want quality control to
prevent, detect, or correct.
Various"customer"groupsinclude:
Patients
Contractphysicians
Thirdpartypayerssuchasinsurancecompanies,HMOs,Medicare,andMedicaid
OtherhospitaldepartmentsthatusetheRespiratoryTherapyDepartment'sservices(including
"house"physicians)
Differenttypesofcustomersmayhavedifferentperspectivesonthequalityofservicestheyreceive
andmayreactdifferentlytoagivenlevelofperformance.Often,apatientcannotevaluatethequality
ofclinicaltreatmentreceived.Mostpatientscanonlyassessthequalityoftheirtreatmentbasedon
theircontactwiththehospital'sstaff.Forinstance,evenifatherapistishighlyskilled,ifthetherapist
is abrupt or rushed during therapy, the patient may evaluate the quality of treatment as low.

4 Examples are: Barefield, J.T., C.A. Raiborn, and M.R. Kinney, Cost Accounting: Traditions and Innovations,
Southwestern, 2003, pp. 310-321; Horngren, C.T., S.M. Datar, and G. Foster, Cost Accounting: A Managerial
Emphasis, Prentice-Hall, 2003, pp. 654-663.
5 Examples are: Carr, L.P., Cost of QualityMaking It Work, Journal of Cost Management, Spring 1995, pp. 6165; Kalagnanam, S. S. and E. M. Matsumura, Cost of Quality in an Order-Entry Department, Journal of Cost
Management, Fall 1995, pp. 68-74.

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Perceptionsmayalsodifferfordifferenttreatments.Forinstance,whilecustomerrelationsmaybe
important for the bronchodilator treatment, it will be relatively unimportant for the emergency
intubationtreatment.
Asforcontractphysicians,hospitalsmustcompetefortheirpatronagebyprovidingthemqualityin
servicestheyconsiderimportant.Also,thecontractphysiciansusuallyaretheoneswhochoosewhich
hospitalthepatientwillreceivetreatment.
Nowadays, third party payers typically pay standard rates for many of the procedures that would be
performed in Respiratory Therapy. Hence, the rates they pay are not as affected by poor quality.
However, while teaching institutions such as Kelsey Hospital generally have very good clinical
reputations, they are notoriously inefficient (e.g., performing unnecessary procedures or having to
repeat procedures). Consequently, third-party payers tend to try to limit or exclude services from these
institutions. Thus, Kelsey would not only be facing normal competition from surrounding hospitals,
but would have to deal with efficiency issues directly with third-party payers.
Other hospital departments that use Respiratory Therapy's services might be concerned that lack of
quality in Respiratory Therapy may affect the quality in their own department. Even if this poor
quality is not contagious, it may nevertheless adversely affect customer perceptions about other
departments.
2. Categorize the list of quality costs into prevention, appraisal, internal failure, and external
failure. Justify your choices.
Before categorizing, it might be useful to review definitions for the four categories. General
definitions are as follows:
Prevention costs are incurred to prevent the production of products or services that do not meet
specifications. Appraisal costs are incurred to monitor and inspect production or services. These costs
are intended to detect products or services that do not meet specification during the production
process. Internal failure costs are incurred after defective or substandard product or service is
detected but before it reaches the customer. External failure costs are incurred when the defective
product or service gets to the customer.
The categorization arrived at by the consultant (actually, it was a team of graduate students who were
employed on a temporary basis by the hospital) was:

Prevention Costs: Quality Planning and Procedures, Training Procedures, Forecast and Budget
Generation, Customer Relations.
AppraisalCosts:QualityAudits,TherapyWriteups,PerformanceAudits,AppraisalSupport.
Internal Failure Costs: Incorrect Installations, Overtime, Rework, Retraining Current
Employees, Handling Complaints, and Absenteeism/Turnover.
ExternalFailureCosts:MalpracticeLawsuits,AdministrativeActions.

Some of these are subject to debate. For instance, Handling Complaints should probably be
considered an external failure cost since the patients and contract physicians are external customers
(only complaints from house physicians would be an internal failure cost). One could also argue that,
although Administrative Actions and Retraining Current Employees resulted from failures, they
should be classified as prevention costs since the purpose of these expenditures is to improve future
quality. Another item, Therapy Write-ups, may be questioned as to why it is considered a quality cost.
A response to this is that it is analogous to a 100 percent inspection.

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3. What additional costs of quality (COQ) might you suggest? How would you categorize each of
them?
Othercostsofqualitythatmaybeconsidered:
Hiringandretentionofemployees(PreventionCost)
Unneededbronchodilatortreatment(InternalFailureCost)
Malpracticeinsurance(ExternalFailureCost)
Lossoffuturecustomers(ExternalFailureCost)
Researchanddevelopment(PreventionCost)
Patientfollowupstoevaluatetheirsatisfaction(AppraisalCost)
4.

Discuss how you would estimate (i.e., measure) the following costs for the Respiratory Therapy
Department: Quality Planning and Procedures, Therapy Write-ups, and Incorrect Installation.
Measurement of costs for:
a) Quality Planning and Procedures--prorate (to three hours) the monthly salaries of those
involved in the monthly meeting; also, assign eight hours of the Program Instructor's weekly
wages.
b) Therapy Write-ups--for intubations, multiply 0.167 hours by the number of intubations, and
then multiply by the therapist's hourly wage; for bronchodilator treatments, multiply 0.083
hours by the number of treatments, and then multiply by the therapist's hourly wage.
c) Incorrect Installation--Multiply the time spent after two attempts by the hourly wages of the
personnel involved; also, add the extra supplies consumed for more than two attempts.

5.

Which of Highlanders COQ measures (or similar ones) might you include in a balanced scorecard for
Kelseys Respiratory Therapy Department? What other performance measures would you suggest to
include? Classify each of thesemeasuresintothefourstandardbalancedscorecardcategories(financial,
customer,internalbusinessprocess,learning&growth).

The following categorized balanced scorecard (BSC) measures might be suggested from the COQ
measures obtained by Highlander:
Number of malpractice lawsuits (customer)
Number of incorrect installations (internal business process)
Number of re-done treatments (internal business process)
Number of complaints by physicians and patients (customer)
Absenteeism and turnover (learning & growth)
Other categorized balanced scorecard measures that might be suggested are:
Number of unneeded treatments (internal business process)
Research and development expenditures (learning & growth)
Patient follow-up surveys to evaluate satisfaction (customer)
Cost per patient (financial)
Employee satisfaction ratings (learning & growth)
Training hours per employee (learning & growth)
Percentage of patients serviced in a timely manner (customer)

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References
Barefield, J. T., C. A. Raiborn, and M. R. Kinney. 2003. Cost Accounting: Traditions and
Innovations (Cincinnati, OH: Southwestern).
Carr, L. P. 1995. Cost of QualityMaking It Work. Journal of Cost Management (Spring) 61-65.

Horngren, C. T., S. M. Datar, and G. Foster. 2003. Cost Accounting: A Managerial Emphasis.
(Englewood Cliff, New Jersey: Prentice-Hall).
Institute of Management Accountants (IMA). 1997. Union Pacific Railroad: Using Cost of
Quality in Environmental Management. In L. P. Carr, Cases from Management Accounting
Practice (New Jersey, Institute of Management Accountants) 103-111.
Ittner, C. 1988. Texas Instruments: Cost of Quality (A). (Boston, MA: Harvard Business
School).
Kalagnanam, S. S. and E. M. Matsumura. 1995. Cost of Quality in an Order-Entry Department. Journal
of Cost Management (Fall) 68-74.

Keating, S., and J. Shank. 1998. Iron River Paper Mill. In Anthony, R. N., and V. Govindarajan,
Management Control Systems (New York, Irwin/McGraw-Hill), pp. 646-655.
Stanford University. 1982. Signetics Corporation: Implementing a Quality Improvement
Program (A). In Kaplan, R. S., and A. A. Atkinson. 1989. Advanced Management
Accounting (Englewood Cliff, New Jersey: Prentice-Hall) 386-396.

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16-3: Union Pacific Railroad--Using Cost of Quality (COQ) in Environmental

Management
1. How valid is the cost of future cleanup of the soil contaminated by the locomotive dripping oil
and grease onto the soil? What additional information would you require before including this
cost in a return on investment (ROI) analysis for the installation of the collection pans under
the locomotive?
The cost methodology for the cost of future clean up was based upon the current cost the company
was experiencing in cleaning older spills. The amount of soil contaminated was determined from the
EPA standards (one pint contaminates a cubic yard of soil). The costs were developed from a
historical cost perspective.
Engineering and research studies may be required to confirm the average amount of soil contaminated
by a pint of oil/diesel fuel/lubricating oil before including these costs in the analysis. The mixture that
is currently captured by the drip pans should be used in the studies to confirm the amount of soil
contaminated over a given period. How fast does it leach out of the surrounding soil and drop below
EPA standards?
In addition, the company should perform engineering studies to verify the amount of material leaking
from the locomotive. Does the drip pan really collect all of the material dripping off of the
locomotive, or is there still some portion that is not captured and therefore should be excluded from
the cost analysis?
2. Identify your criteria for failure costs and explain how you would classify the total cost of the
waste-water facilities. Is it a failure or a prevention cost? What are the best arguments for and
against using the cost of the waste-water facilities to justify the higher cost of biodegradable
soaps and solvents?
In the classical definition, failure costs are those costs incurred when customers' requirements are not
met. In this case, the customer is the Environmental Protection Agency, which has very technical
specifications.
The cost of the waste water treatment plant is a failure cost if your criteria allows for inefficiency
costs. This means any inefficiencies contained within your operation are classified as failure costs. If
you have a process that meets the EPA's requirements at a cost of $25 per 1000 gallons treated and the
industry average is $10 per 1000 gallons treated, the customer is going to buy the most economic
service. If your costs are 2.5 times the industry average in this area, how long do you think your
customers would buy from you? This is the reason for using the difference between the actual cost
and the "world class" cost as the failure cost. You could include only the total cost of the plant, if the
cost of biodegradable soaps and spill free fueling stations were equal to the current costs.
The argument for labeling the cost of the waste water treatment plant as a prevention cost is that the
customer (the EPA) requires a treatment facility and will levy fines if the requirement is not met. The
fines are the failure cost and the expense of the waste water treatment plant is the prevention cost.
The best argument for treating the waste water treatment plant as a failure cost is that there are
technological alternatives that would stop the pollutants from entering the water in the first place.
These more costly (to the department using the solvents and soaps) alternatives would be justified by
reductions in the operating costs of the waste water treatment plan. The major argument against using
the operating costs of the waste water treatment plant to justify other technologies is that the waste
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water plant would have to remain in case these new techniques did not work.
3. Looking at the trend in waste water standards established by the Environmental Protection
Agency (EPA), would you feel comfortable closing these facilities permanently? Why or why
not?
The current method used to improve the water quality is to trace the pollutant back to its source and
make the "responsible party" bear the cost of improving water quality. This includes the costs of
additional chemicals, expansion of the facility, and/or other operating costs. These are the costs you
are trying to avoid. The mechanism for tracing and billing the source companies is improving. In
addition, the capital costs have already been incurred and can not be recovered. The only costs that
can be eliminated are the operating costs. So, the best course would be to shut down the facilities but
not destroy them.
The major cost of a water treatment plant is the capital costs of installing the holding ponds, pumps
and mixing chambers. These facilities will normally last 25 to 50 years and would cost additional
money to tear out. They can always be reactivated on fairly short notice if the standards change.
Unless they present a safety hazard, they can be left in place at no additional expense.
4. How realistic is it to hold a manager responsible for reducing the companys operating costs to a
World Class standard as indicated by the disposal of contaminated soil example? What
additional information would you like to have before basing your salary increase on meeting
such a target?
It is very realistic to hold an operating unit responsible to a world class, competitive standard. Are
industrial customers different from you and I? Don't we want better quality, more quantity at or below
existing prices? If our organization cannot meet our competitors' costing structures how long would
the organization survive? The use of outside standards should be mandated to produce lower costs as
quickly as possible.
The things that you might want to see before agreeing to link your salary increase to meeting a target
are:
Engineering studies
The capital budget to support the improved operation
Source of comparison data
Historical trends and rate of improvement at the "World Class" organization.
5. Put yourself in the place of an external auditor working for a public accounting firm. Looking
at the four situations outlined in the questions above, would you feel obligated to require any
notes, disclosures, or comments before issuing an opinion? Under what circumstances would
you feel obligated to require a disclosure of the situation?
All of these questions deal with some aspect of FASB Statement No. 5 and materiality. The idea of
contingent liability and how a person applies the terms probable, reasonably possible and remote is a
subject the students should bring up in their discussion. The other area of concern should be the
importance of these costs to the corporation.
a. What about the current liability of all the soil contaminated by past years running of
locomotives without drip pans?

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Under current law, as long as the contamination does not present a health hazard, is not moving
and is not being increased, the EPA does not require a clean up plan on petroleum based products.
The rational is that in 10 to 30 years the petroleum product will break down naturally and will no
longer be a hazard. If you did establish a contingent liability for existing petroleum contaminated
locations, you would have to reduce that liability over time to reflect the degradation of the
petroleum product.
Those sites that present an immediate threat to the welfare of the people living in the area have
already been identified by the federal, state, and local EPA's and action plans have been developed.
There is no contingent liability because the cost of remedial action is an operating expense and
most sites will be cleaned up within a fairly short period of time.
b. Assume that during the study of the waste-water treatment plants it was found that none of
the plants could handle a five-year rain. The fine for each occurrence was $100,000 for each
plant. Would you require a disclosure contained within the financial statements? Give
reasons supporting your position.
There is no contingent liability in this case. The fines (failure costs) would be classified as part of
the operating expense and there would be no reason to establish a contingent liability account to
cover the future expense of the fines. It is a normal operating expense.
6. Looking at the case, what failure costs can you identify: (a) at your place of business? (b) at this
college or university? (c) in the teaching of this course? (d) what costs would you assign to each
of the failures you identify?
Part a
Some typical failure costs would be those associated with rework, scrap, customer returns, and those
found in classical Cost of Quality studies. From the case, you obtain cost of quality accounts due to
inefficient operations. Is your accounting staff less than 0.2% of your revenue? Are the costs for an
average service call greater than or less than the industry average? Is your operating ratio best in class
or best in industry or best in the world? etc.
The cost of rework should include not only the cost of the labor doing the work but also the
administrative and transportation costs created by moving the work back to the correct station. In a
service environment, it should include the cost of the labor required to rewrite the proposal or
finished document, or the cost of performing the service a second time.
The cost of failure for the accounting staff would be the current costs less 0.2% of revenue. The cost
of failure for operating ratio would be the actual operating costs less the best operating ratio times
total revenue.
Part b
First, define who the customer is: the student, the employer with whom the student hopes to find a
job, or society as a whole. Then define the requirements of the customer you identified and look at the
operation.
Second, look at the operational efficiencies of the current process. Is the method of lecturing to a
group of students who have different learning rates the most efficient way to teach a particular
subject? Is the concept of having a department head for various departments efficient? Is the
additional administrative cost justified to the ultimate customer? Does every department need a

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computer center or its "OWN" classrooms?

Use caution in developing the failure costs for customer satisfaction in this specific example. The
costs have to be incurred by the college or university. They can not be costs incurred by the student in
the form of lost wages. Be careful to include costs that the university or college has control over. A
failure cost might be requiring a specific course that does not add value for the customer. The dollars
could have been spent on other courses.
In the second area, the failure costs are easier to determine. For any course, is the cost per student
lower for interactive computer based self- training or for having large lecture courses and discussion
sections? Look at the difference in the cost per student and the lower cost becomes your standard cost
and everything above it is failure cost. Each department head has a fixed cost associated with it. Your
failure costs could be the difference between the (existing cost of all departments) less ((the cost of
using the entire staff divided by the number of instructors found in the largest department) times (the
cost of the largest department head)). In the administration area, you could take the current number of
personnel less (the number of transactions performed/the number performed per person at the "best"
facility) times the salary and overhead of the average person.
Part c
Does this class meet the requirements of the customer? Does the course require the same number of
man-hours to prepare for as other courses at other facilities? Does the course start on time? Does the
course end on time?
The same caution mentioned above applies here. The cost of not meeting customer requirements has
to be the sum of the costs incurred by the college or university. The man-hour cost of failure is simply
the difference between actual and the "World Class" standard man-hours times the average rate per
man-hour. The cost of not starting on time or finishing on time would be the additional expense of
operating the classroom at full capacity for the additional time.
Part d
The costs are identified with each of the answers above.
7. As the Chief Financial Officer (CFO) of the company, when would you begin to feel
uncomfortable assigning costs to these environmental failures? Discuss the ethical questions
that would be involved in limited the generation of failure costs that are based upon
noncompliance or continued contamination of the environment, resulting in possible violation of
future regulations. During your discussion, address how you would minimize the financial
liability of potential litigation associated with the production and distribution of asbestos and
tobacco products.
This is a question concerning the interpretation the person gives to FASB No. 5 and when the liability
becomes significant in the eyes of the CFO. As more and more documentation is provided, the CFO
should become more uncomfortable with not addressing the issue.
Limiting failure costs, simply because you might have to include a note in your annual report, is a
difficult question. If you truly have a large contingent cost, the ethical standards require you to make
a reasonable guess as to the impact of these costs on your business. Had the asbestos or tobacco
industries develop a failure cost for potential suits, don't you think they might have addressed the
issue a little more aggressively. Wouldn't the existence of such an account sway a jury in awarding

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criminal damages? The account could demonstrate that the probabilities used might have been wrong
but the company was at least looking at the problem in a proactive manner.
8. Under what conditions could you see a cost of quality (COQ) system working? What are the key
enablers of such a system if attempted in your organization? Discuss the arguments you would
use to start or kill a COQ system.
The key factors are:

Support of top management

Ownership of the accounts by line departments

Establishment of goals

Work on the largest accounts first - concentrate your resources

Use as a directional instrument

Make the accounts measure incidents and not fixed costs

The student should identify the enablers present out of those given above.
Key factors for a COQ system are:

Provides a common basis for determining where the largest ($) problems are occurring

Costs are spread across various departments

Cost avoidance is not currently included in budget system

Key factors against a COQ system include:

Not all costs go to the bottom line immediately

If we know there are failures, why not fix them and not bother with costing them out

It takes time
9. What are the major differences between a COQ system as presented in the case and an ActivityBased costing (ABC) system? What are the similarities?
The major difference between a COQ and ABC system is a COQ system will provide a failure cost
for specific incidents. An ABC system will provide a cost for all incidents but not any cost avoidance
costs.
The major similarity is that they both allocate dollars to a variety of incidents that provide
management the information necessary to work on the largest costs first.

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Teaching Strategies for Articles

16-1: GE Takes Six Sigma Beyond the Bottom Line by G. T. Lucier and S. Seshadri, Strategic
Finance (May 2001), pp. 40-46.
This article reports the success of GE Medical Systems Inc.'s Six Sigma effort. It describes the training programs for
employees in statistical process control and s Services and information offered by the Web site of the company to
support the quality improvement efforts of more than 300,000 employees worldwide.
Discussion Questions:
1. What is a Six Sigma approach?
Sigma is the Greek letter used in statistics to denote standard deviation. Six Sigma means that the chance of
a certain event, in this case it refers to defects, to occur is in a region beyond six standard deviations. The
chance of occurrence is 3.4 per million.
2. Describe the processes that GE uses to implement its Six Sigma program.
GE uses acronym DMAIC to describe its Six Sigma approach:
Define Define problems related to the business or critical factors to customer satisfaction.
Measure Establish base-level measures of defects inherent in the current process.
Analyze Explore underlying reasons for defects.
Improve Seek the optimal solution to reduce or eliminate defects, develop and test a plan of action for
implementing and confirming the solution.
Control Implement ongoing measures to keep the problem from recurring.
3. What are black belts? What roles black belts play in GEs Six Sigma program?
Black belts are team leaders of small teams implementing/executing the Six Sigma methodology. They act
as technical and cultural change agents for quality.

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16-2: Accounting for Quality with Nonfinancial Measures: A Simple No-Cost Program for the
Small Company by R. C. Kettering, Management Accounting Quarterly (Spring 2001), pp. 14-19.
The author of this article argues that, to improve product/service quality, even small companies can develop and use
nonfinancial, low-cost data to improve performance and customer satisfaction.
Discussion Questions:
1. In terms of a Cost of Quality (COQ) framework for managing and controlling quality costs, distinguish
between cost of conformance and cost of non-conformance. Into what subdivisions can each of these two
broad categories of quality-related costs be made? What is the definition of each of the four categories of
quality cost in a typical COQ report?
Cost of conformance = Prevention Costs + Appraisal Costs; Cost of Nonconformace = Failure Costs (Internal
Failure Costs + External Failure Costs). As the authors of this article point out, the former costs are associated
with the achievement of quality, while the latter costs are associated with nonachievement of quality of the
organizations output (service or product). Alternatively, one can view conformance costs as those costs incurred
to make sure the product or service is right the first time; nonconformance costs, on the other hand, are incurred
to correct a problem or quality defect.
Breakdown of conformance costs:

Prevention costs--quality costs incurred to prevent poor quality (i.e., defects) from being produced in the
first place. Examples would include employee training and on-going education costs, and costs associated
with certifying vendors (suppliers).
Appraisal costs--these are cost incurred to detect quality defects. Examples include incoming inspection of
raw materials and testing of final products.
Internal failure costs--these are costs of product/service failure detected before delivery of the product or
service to the customer. Examples include rework costs and the net (of salvage) cost of scrap produced.
External failures costs--these are costs of product/service failure detected after delivery of the product or
service to the customer. Examples include field service costs and the costs of processing product returns.

2. Provide an overview of the three-step approach that the author of this paper recommends as a no-cost
approach that can be used by smaller (i.e., more resource-constrained) organizations to monitor and
control quality.
The authors maintain the financial control of quality, via the Cost of Quality (COQ) reporting framework outline
above in (1), may be more appropriate for larger, more resource-rich organizations. Thus, the author suggests that
smaller, more resource-constrained may be able to control quality costs by focusing on nonfinancial performance
indicators.
In this regard, the author proposes a three-step approach:
(1) Specification of nonfinancial measures that should be monitored
(2) Use of an electronic spreadsheet to record performance indicators
(3) Periodic preparation of a performance report based on measures collected.
3. Provide at least two examples of non-financial quality indicators for each of the four categories of qualityrelated costs typically included in a COQ report.
Examples are provided by the author in Table 2 in the article.
Prevention: Design review (number of hours), preventive maintenance (number of hours), employee training
(number of hours), etc.
Appraisal: Material inspection (number of inspections), WIP inspection (number of inspections), etc.
Internal failure: Scrap (number of units), spoilage (number of units), rework (number of units), etc.
External failure: Warranty claims (number of claims), product recalls (number of recalls), etc.

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