CHAPTER 14
QUALITY AND ENVIRONMENTAL COST MANAGEMENT
As discussed in Chapter 13, improving process quality and quality of products and services is a
fundamental strategic objective that is part of any well-designed Balanced Scorecard. Improving quality
can increase profitability in at least two ways: (1) by increasing customer demand and (2) by decreasing
the costs of providing goods and services. Similarly, many CEOs have made environmental management
an important focus of their companies. The objective of quality and environmental cost management is to
find ways to minimize total quality and environmental costs.
This chapter focuses on the measurement
and management of both quality and environmental cost management.
LEARNING OBJECTIVES
After studying Chapter 14, students should be able to:
1. Define quality, describe the four types of quality costs, and discuss the approaches used for quality
cost measurement.
2. Prepare a quality cost report, and explain its use.
3. Explain why quality cost information is needed and how it is used.
4. Describe and prepare three different types of quality performance reports.
5. Discuss how environmental costs can be measured, reported, and reduced.
6. Show how environmental costs can be assigned to products and processes.
KEY TOPICS
The following major topics are covered in this chapter (related learning objectives are listed for each
topic):
1. Costs of Quality (LO 1)
2. Reporting Quality Costs (LO 2)
3. Quality Cost Information and Decision Making (LO 3)
4. Controlling Quality Costs (LO 4)
5. Defining, Measuring, and Controlling Environmental Costs (LO 5)
6. Environmental Costing (LO 6)
I. COSTS OF QUALITY
The costs of quality can be substantial. These same costs, however, can also be a source of significant
savings. Quality experts state that quality costs should be about 2 to 4 percent of sales, although, in
reality, the costs of quality generally far exceed that estimate. Improving quality to these levels can mean
a significant increase in profitability.
A. Quality Defined
A quality product or service is one that meets or exceeds customer expectations. Customer expectations
are based on attributes such as performance, reliability, durability, and fitness for use. Quality of
conformance is a measure of how a product meets its specifications. A defective product is one that does
not conform to specifications.
Traditional conformance measures have focused on target values, or upper and lower limits that describe
acceptable product variation for a given quality characteristic. The robust quality view of conformance
emphasizes exactness of conformance or a target value of zero variation.
B. Costs of Quality Defined
Quality-linked activities are those activities performed because poor quality may or does exist. Costs of
quality are the costs that exist because poor quality may or does exist. Quality costs are associated with
two subcategories of quality-related activities: control activities and failure activities.
Control activities are performed by an organization to prevent or detect poor quality. Control costs are the
costs of performing control activities. There are two broad categories of control costs: prevention costs
and appraisal costs. Prevention costs are incurred to prevent poor quality in the products or services being
produced. Appraisal costs are incurred to determine whether products and services are conforming to
their requirements or customer needs.
Failure activities are performed by an organization or its customers in response to poor quality. Failure
costs are the costs incurred by an organization because failure activities are performed. There are two
broad categories of failure costs: internal failure costs and external failure costs. Internal failure costs are
incurred because products and services do not conform to specifications or customer needs. This
nonconformance is detected prior to the product being shipped or the service being delivered to outside
parties. External failure costs are incurred because products or services fail to conform to requirements or
satisfy customer needs. This nonconformance is detected after being delivered to outside parties.
Examples of the four quality costs follow. This illustration is also presented in Exhibit 14.1 on page 718.
Prevention Costs
Appraisal (Detection) Costs
Quality engineering
Inspection of materials
Quality training
Packaging inspection
Recruiting
Product acceptance
Quality audits
Process acceptance
Design reviews
Field testing
Quality circles
Continuing supplier verification
Marketing research
Prototype inspection
Vendor certification
Internal Failure Costs
External Failure Costs
Scrap
Lost sales (performance-related)
Rework
Returns/allowances
Downtime (defect-related)
Warranties
Reinspection
Discounts due to defects
Retesting
Product liability
Design changes
Complaint adjustment
Repairs
Recalls
Ill will
Teaching hint: Exercise 14.10 is a good problem to use in class that asks students to classify quality costs.
C. Quality Cost Measurement
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 the accounting records.
There are three methods to estimate hidden quality costs:
1. The multiplier method
2. The market research method
3. The Taguchi quality loss function
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 (a value that is derived based on experience)
The market research method uses formal market research methods 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 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 loss function can be described by the following equation:
L(y) = k(y – T)2
where
k = A proportionality constant dependent upon the organization’s external failure cost
structure
y = Actual value of quality characteristic
T = Target value of quality characteristic
L = Quality loss
To apply the Taguchi loss function, k must be estimated. The value for k is computed by dividing the
estimated cost at one of the specification limits by the squared deviation of the limit from the target value:
k = c/d2
where
c = Loss at the lower or upper specification limit
d = Distance of limit from target value
Teaching hint: You may want to work an example problem such as Exercise 14.9 in class to illustrate the
Taguchi loss function.
II. REPORTING QUALITY COSTS
A quality cost reporting system is essential to an organization that is serious about improving and
controlling quality costs. The first and simplest step in creating such a system is assessing current actual
quality costs. A detailed listing of actual quality costs by category can provide two important insights.
First, it reveals the magnitude of the quality costs in each category, allowing managers to assess their
financial impact. Second, it shows the distribution of quality costs by category, allowing managers to
assess the relative importance of each category.
A. Optimal Distribution of Quality Costs: Zero-Defects with Robust Quality View
For firms operating in an intensely competitive environment, improving quality is a critical competitive
dimension. Exhibit 14.5 (p. 723) shows a quality cost function consistent with the robust quality view of
zero defects. Essentially, as firms increase their prevention and appraisal costs and reduce their failure
costs, they discover that they can then cut back on their prevention and appraisal costs. Notice that failure
costs can be reduced to zero according to this model and that control costs are finite at the zero-defect
point.
Teaching hint: You may wish to use Microsoft PowerPoint® or an overhead transparency to present the
zero-defects quality graph illustrated in Exhibit 14.5, page 723. Explain how a supplier selection program
can be used to reduce total quality costs. Initially, a supplier selection program will entail additional
prevention and appraisal costs and a reduction in failure costs. However, once the desired quality level is
achieved and the supplier relationships are on a sound footing, many of the prevention and appraisal
activities can be eliminated. The result is a movement downward on the zero-defects cost graph.
B. The Role of Activity-Based Cost Management
Activity-based management classifies activities as value-added and non-value-added and keeps only those
that add value. This principle can be applied to quality-related activities. Appraisal and failure activities
and their associated costs are non-value-added and should be eliminated (eventually).
III. QUALITY COST INFORMATION AND DECISION MAKING
Teaching hint: Exercises 14.13 and 14.14 should aid in the discussion of this section.
Reporting quality costs can improve managerial planning, control, and decision making.
ISO 9000 is a family of international quality standards developed by the International Organization for
Standardization in Geneva, Switzerland, that address quality management. These standards center on the
concept of documentation and control of nonconformance and change. Companies that obtain ISO 9000
certification have been audited by an independent test company, which certifies that the company meets
certain quality standards. The standards apply to the way in which a company ensures quality.
IV. CONTROLLING QUALITY COSTS
Control enables managers to compare actual outcomes with standard outcomes to gauge performance and
take any necessary corrective actions. Quality cost performance reports have two essential elements:
actual outcomes and standard or expected outcomes. Deviations of actual outcomes from the expected
outcomes are used to evaluate managerial performance and provide signals concerning possible problems.
Quality performance reports measure the progress realized by an organization’s quality-improvement
program. Three types of progress can be measured and reported:
1. Progress with respect to a current-period standard or goal (an interim standard report)
2. The progress trend since the inception of the quality improvement program (a multiple-period
trend report)
3. Progress with respect to the long-range standard or goal (a long-range report)
Cornerstone 14.2 (p. 735) illustrates an interim quality performance report. Cornerstone 14.3 (p. 732)
provides a detailed example of multiple-period quality trend reporting, while Exhibits 14.6, 14.7, and 14.8
(pp. 733–734) illustrate multiple-period trend graphs for quality costs. Cornerstone 14.4 (p. 735)
illustrates long-range quality performance reporting.
V. DEFINING, MEASURING, AND CONTROLLING ENVIRONMENTAL COSTS
Ecoefficiency is defined as the ability to produce competitively priced goods and services that satisfy
customer needs while simultaneously reducing negative environmental impacts, resource consumption,
and costs. This means producing more goods and services using less materials, energy, water, and land,
while, at the same time, minimizing air emissions, water discharges, waste disposal, and the dispersion of
toxic substances.
Ecoefficiency implies a positive relationship between environmental and economic performance. Exhibit
14.9 on page 738 illustrates the objectives, opportunities, and outcomes that define the relationships
envisioned by ecoefficiency.
The four broad objectives of ecoefficiency are:
1. Reduce the consumption of resources
2. Reduce the environmental impact
3. Increase product value
4. Reduce environmental liability
The opportunities associated with ecoefficiency include:
1. Process improvement and innovation
2. Revalorize by-products (e.g., finding ways to convert waste materials into useful products or
useful inputs for other companies’ products)
3. Redesign products
4. New ways of meeting customer needs
The outcomes of ecoefficiency can include:
1. Better public image
2. Better external relations
3. New market opportunities
4. Lower cost of capital
5. Reduced insurance rates
6. Cost reduction
Environmental costs are costs that are incurred because poor environmental quality exists or may exist.
Environmental costs can be classified into four categories: prevention costs, detection costs, internal
failure costs, and external failure costs.
Environmental prevention costs are the costs of activities carried out to prevent the production of
contaminants and/or waste that could cause damage to the environment. Environmental detection costs
are the costs of activities executed to determine if products, processes, and other activities within the firm
are in compliance with appropriate environmental standards. Environmental internal failure costs are
costs of activities performed because contaminants and waste have been produced but not discharged into
the environment. They are incurred to eliminate and manage contaminants or waste once produced.
Environmental external failure costs are the costs of activities performed after discharging contaminants
and waste into the environment. Realized external failure costs are those incurred and paid for by the
firm. Unrealized external failure (societal) costs are caused by the firm but are incurred and paid for by
parties outside the firm. Specific activities for each environmental cost category are listed in Exhibit
14.10 (p. 741). They are also presented on the following page.
Prevention Activities
Internal Failure Activities
Evaluating and selecting suppliers
Operating pollution control equipment
Evaluating and selecting pollution control
Treating and disposing of toxic waste
equipment
Maintaining pollution equipment
Designing processes
Licensing facilities for producing contaminants
Designing products
Recycling scrap
Carrying out environmental studies
Auditing environmental risks
Developing environmental management systems
Recycling products
Obtaining ISO 14001 certification
Detection Activities
External Failure Activities
Auditing environmental activities
Cleaning up a polluted lake
Inspecting products and processes
Cleaning up oil spills
Developing environmental performance measures
Cleaning up contaminated soil
Testing for contamination
Settling personal injury claims (environmentally
Verifying supplier environmental performance
related)
Measuring contamination levels
Restoring land to natural state
Losing sales due to poor environmental reputation
Using materials and energy inefficiently
Receiving medical care due to polluted air
Losing employment because of contamination
Losing a lake for recreational use
Damaging ecosystems from solid waste disposal
Environmental cost reporting is essential if an organization is serious about improving its environmental
performance and controlling environmental costs. Reporting environmental costs by category reveals two
important outcomes:
1. The impact of environmental costs on firm profitability
2. The relative amounts expended in each category
An example of an environmental cost report is presented in Cornerstone 14.5 on page 741.
An environmental financial report may be prepared to present the costs and benefits of ecoefficiency. This
report lists the environmental benefits of the period including additional revenues, current savings, and
cost avoidance (ongoing savings). It also presents the environmental costs of the period. An example is
shown in Exhibit 14.12 (p. 744).
VI. ENVIRONMENTAL COSTING
The environmental costs of processes that produce, market, and deliver products and the environmental
post-purchase costs caused by the use and disposal of the products are examples of environmental product
costs.
There are two approaches to assigning all environmental costs: full environmental costing and full private
costing. Full environmental costing is the assignment of all environmental costs, both private and societal,
to products. Full private costing is the assignment of only private costs to individual products.
Private costing is probably a good starting point for many firms. Private costs can be assigned using data
created inside the firm.
Activity-based costing facilitates environmental costing. Tracing the environmental costs to the products
responsible for those costs is a fundamental requirement of a sound environmental accounting system.
Each environmental activity is assigned costs, activity rates are computed, and the rates are then used to
assign environmental costs to products based on usage of the activity. Cornerstone 14.6 (p. 746) presents
an example of activity-based environmental cost assignments.
VII. INFORMATION ABOUT EXERCISES, PROBLEMS, AND CASES
Exercises and problems are described below and on the following page according to coverage of content,
learning objective(s), and level of difficulty. The time required to solve the problems is roughly
proportional to the level of difficulty.
In general, basic exercises/problems are fairly simple and straightforward. The text material is relatively
brief; only one or two concepts are covered. Basic exercises and problems should take about 15 to 20
minutes each.
Moderate exercises/problems may take longer and involve more concepts. These problems may have a
“twist” and require more thought. Moderate exercises and problems may take 20 to 40 minutes each.
Challenging problems are more comprehensive and may cover more concepts. The text material is
relatively longer and may include some ambiguity. Challenging problems may take 60 to 90 minutes
each.
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Learning
Objective
Degree of
Difficulty
CS 14.1
LO 1
Basic
CS 14.2
LO 3
Basic
CS 14.3
LO 3
Basic
CS 14.4
LO 3
Basic
CS 14.5
LO 5
Basic
CS 14.6
LO 5
Basic
14.7
LO 1
Basic
14.8
LO 1
Basic
14.9
LO 1
Basic
14.10
LO 1
Moderate
14.11
LO 1, 2
Moderate
14.12
LO 2
Basic
14.13
LO 2, 3
Moderate
14.14
LO 2, 3, 4
Moderate
14.15
LO 2, 4
Moderate
14.16
LO 4
Moderate
14.17
LO 4
Moderate
14.18
LO 5
Basic
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Learning
Objective
Degree of
Difficulty
14.19
LO 5
Basic
14.20
LO 5
Basic
14.21
LO 5
Basic
14.22
LO 5
Basic
14.23
LO 6
Basic
14.24
LO 5, 6
Basic
14.25
LO 1
Basic
14.26
LO 1
Basic
14.27
LO 1
Basic
14.28
LO 5
Basic
14.29
LO 6
Basic
14.30
LO 1, 2
Moderate
14.31
LO 2
Basic
14.32
LO 3
Moderate
14.33
LO 1
Basic
14.34
LO 2
Moderate
14.35
LO 1, 2, 4
Moderate
14.36
LO 4
Moderate
14.37
LO 2
Moderate
14.38
LO 4
Moderate
14.39
LO 4
Challenging
14.40
LO 5
Basic
14.41
LO 5, 6
Moderate
14.42
LO 5, 6
Moderate
14.43
LO 5
Moderate
14.44
LO 6
Moderate
14.45
LO 5, 6
Challenging
LIST OF ILLUSTRATIONS
Illustration
Topic
Exhibit 14.1
Examples of Quality Costs by Category
Exhibit 14.2
The Taguchi Quality Loss Function
Exhibit 14.3
Quality Loss Computation Illustrated
Exhibit 14.4
Quality Cost Categories: Relative Contribution Graphs
Exhibit 14.5
Robust Quality and the Zero-Defects Quality Graph
Exhibit 14.6
Multiple-Period Trend Graph: Total Quality Costs
Exhibit 14.7
Multiple-Period Trend Graph: Individual Quality Cost Categories
Exhibit 14.8
Multiple-Period Trend Graph: Relative Quality Costs
Exhibit 14.9
Ecoefficiency Relationships
Exhibit 14.10
Classification of Environmental Costs by Activity Type
Exhibit 14.11
Relative Distribution: Environmental Costs
Exhibit 14.12
Environmental Financial Statement