Quality costs can also be classified as observable or hidden. Observable quality costs are those that are available from an organization’s accounting records. Hidden quality costs are opportunity costs resulting from poor quality. (Opportunity costs are not usually recognized in accounting records.) Consider, for example, all the examples of quality costs listed in Exhibit 14-2. With the exception of lost sales, customer dissatisfaction, and lost market share, all the quality costs are observable and should be available from the accounting records. Note also that the hidden costs are all in the external failure category. These hidden quality costs can be significant and should be estimated. Although estimating hidden quality costs is not easy, three methods have been suggested: (1) the multiplier method, (2) the market research method, and (3) the Taguchi quality loss function.
The Multiplier Method
The multiplier method assumes that the total failure cost is simply some multiple of measured failure costs:
Total external failure cost= k(Measured external failure costs)
where k is the multiplier effect. The value of k is based on experience. For example, Westinghouse Electric reports a value of k between 3 and 4.6 Thus, if the measured external failure costs are $3 million, the actual external failure costs are between $9 million and $12 million. Including hidden costs in assessing the amount of external failure costs allows management to more accurately determine the level of resource spending for prevention and appraisal activities. Specifically, with an increase in failure costs, we would expect management to increase its investment in control costs.
The Market Research Method
Formal market research methods are used to assess the effect of poor quality on sales and market share. Customer surveys and interviews with members of a company’s sales force can provide significant insights into the magnitude of a company’s hidden costs. Market research results can be used to project future profit losses attributable to poor quality.
The Taguchi Quality Loss Function
The traditional zero defects definition assumes that hidden quality costs exist only for units that fall outside the upper and lower specification limits. The Taguchi loss function assumes that any variation from the target value of a quality characteristic causes hidden quality costs. Furthermore, the hidden quality costs increase quadratically as the actual value deviates from the target value. The Taguchi quality loss function, illustrated in Exhibit 14-3, can be described by the following equation:
The multiplier method assumes that the total failure cost is simply some multiple of measured failure costs:
Total external failure cost= k(Measured external failure costs)
where k is the multiplier effect. The value of k is based on experience. For example, Westinghouse Electric reports a value of k between 3 and 4.6 Thus, if the measured external failure costs are $3 million, the actual external failure costs are between $9 million and $12 million. Including hidden costs in assessing the amount of external failure costs allows management to more accurately determine the level of resource spending for prevention and appraisal activities. Specifically, with an increase in failure costs, we would expect management to increase its investment in control costs.
The Market Research Method
Formal market research methods are used to assess the effect of poor quality on sales and market share. Customer surveys and interviews with members of a company’s sales force can provide significant insights into the magnitude of a company’s hidden costs. Market research results can be used to project future profit losses attributable to poor quality.
The Taguchi Quality Loss Function
The traditional zero defects definition assumes that hidden quality costs exist only for units that fall outside the upper and lower specification limits. The Taguchi loss function assumes that any variation from the target value of a quality characteristic causes hidden quality costs. Furthermore, the hidden quality costs increase quadratically as the actual value deviates from the target value. The Taguchi quality loss function, illustrated in Exhibit 14-3, can be described by the following equation:
Exhibit 14-3 demonstrates that the quality cost is zero at the target value and increases symmetrically, at an increasing rate, as the actual value varies from the target value. Assume, for example, that a company produces watches and the quality characteristic is accuracy (as measured by how much time is gained or lost in three months). Assume k = $2 and T = 0 minutes. Exhibit 14-4 illustrates the computation of the
quality loss for four units. Notice that the cost quadruples when the deviation from target doubles (Units 2 and 3). Notice also that the average deviation squared and the average loss per unit can be computed. These averages can be used to compute the total expected hidden quality costs for a product. If, for example, the total units produced are 5,000 and the average squared deviation is 7.5, then the expected cost per unit is $15 (7.5 x $2) and the total expected loss for the 5,000 units would be $75,000 ($15 x 5,000).
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