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Chapter 17 - The Management and Control of Quality
17-1
Chapter 17
The Management and Control of Quality
Teaching Notes for Cases
Case 17-1: 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.
Chapter 17 - The Management and Control of Quality
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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.
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,
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
Chapter 17 - The Management and Control of Quality
SUPPLIERS PROCESS OUTPUT CUSTOMERS
Customers
(place
orders)
Sales
Admini-
stration
Sales
Representa-
tives
(request
Service
Representa-
tives
Technical
Information
Departments
Quote
OA (Orders
Acknow-
ledgement)
Invoicing
Collections
Manufac-
turing
Shipping
Stockroom
Customer
Service
17-4
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 entry’s 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 Internal Customer(s) Affected
3 Manufacturing, service, stockroom, invoicing
4 Invoicing, accounting (profitability analysis)
Other examples (not included in Exhibit 1):
Error Type Internal Customer(s) Affected
Incorrect serial # of system on OA Service, customer support
Duplicate order Stockroom, shipping, manufacturing, sales admin.
Incorrect sales rep. Code 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,
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)
Shipping costs on returns
Chapter 17 - The Management and Control of Quality
17-5
Rework costs
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)
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.
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.
Chapter 17 - The Management and Control of Quality
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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
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
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
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).
Chapter 17 - The Management and Control of Quality
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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
Chapter 17 - The Management and Control of Quality
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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
Chapter 17 - The Management and Control of Quality
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Case 17-2: 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 electronics1 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 railroad3 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 group–third
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 hospital’s 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 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.
Chapter 17 - The Management and Control of Quality
17-10
1. To help students understand different “customer” groups’ concerns and perceptions about quality;
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" groups include:
• Patients
Different types of customers may have different perspectives on the quality of services they receive
and may react differently to a given level of performance. Often, a patient cannot evaluate the quality
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 Quality—Making It Work,” Journal of Cost Management, Spring 1995, pp. 61-
65; Kalagnanam, S. S. and E. M. Matsumura, “Cost of Quality in an Order-Entry Department,” Journal of Cost
Management, Fall 1995, pp. 68-74.
Chapter 17 - The Management and Control of Quality
17-11
of clinical treatment received. Most patients can only assess the quality of their treatment based on
their contact with the hospital's staff. For instance, even if a therapist is highly skilled, if the therapist
is abrupt or rushed during therapy, the patient may evaluate the quality of treatment as low.
Perceptions may also differ for different treatments. For instance, while customer relations may be
important for the bronchodilator treatment, it will be relatively unimportant for the emergency
intubation treatment.
As for contract physicians, hospitals must compete for their patronage by providing them quality in
services they consider important. Also, the contract physicians usually are the ones who choose which
hospital the patient will receive treatment.
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
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
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
17-12
© 2013 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
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.
3. What additional costs of quality (COQ) might you suggest? How would you categorize each of
them?
Other costs of quality that may be considered:
• Hiring and retention of employees (Prevention Cost)
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.
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 Highlander’s COQ measures (or similar ones) might you include in a balanced scorecard for
Kelsey’s Respiratory Therapy Department? What other performance measures would you suggest to
include? Classify each of these measures into the four standard balanced scorecard categories (financial,
customer, internal business process, 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)
Other categorized balanced scorecard measures that might be suggested are:
❑ Number of unneeded treatments (internal business process)
❑ Research and development expenditures (learning & growth)
Chapter 17 - The Management and Control of Quality
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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 Quality—Making 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,
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), pp. 386-396.
Chapter 17 - The Management and Control of Quality
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Case 17-3: 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 cleanup 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
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 EPA, which has very technical specifications.
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
water plant would have to remain in case these new techniques did not work.
Chapter 17 - The Management and Control of Quality
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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
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 company’s 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.
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
a. What about the current liability of all the soil contaminated by past years’ running of
locomotives without drip pans?
