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Exercise 19-17: Cost of Quality Analysis

Definitions:
Prevention Costs: Costs incurred to preclude the production of products
that do not conform to quality specifications.
Appraisal Costs: Costs incurred to detect which of the individual units of
products do not conform to quality specifications.
Internal Failure Costs: Costs incurred on a defective product before it is
shipped to customers.
External Failure Costs: Costs incurred on a defective product after it is
shipped to customers.

Dream Rider produces car seats for children from newborn to 2 years old.
The company is worried because one of its competitors has recently
come under public scrutiny because of product failure. Historically,
Dream Rider's only problem with its car seats was stitching in the straps.
The problem can usually be detected and repaired during an internal
inspection. The cost of the inspection is $4, and the repair cost is $.75.
All 250,000 car seats were inspected last year and 9% were found to
have problems with the stitching in the straps during the internal
inspection. Another 3% of the 250,000 car seats had problems with the
stitching, but the internal inspection did not discover them. Defective
units that were sold and shipped to customers needed to be shipped
back to Dream Rider and repaired. Shipping costs are $7, and repair
costs are $.75. However, the out-of-pocket costs (shipping and repair)
are not the only costs of defects not discovered in the internal
inspection. For 20% of the external failures, negative word of mouth
will result in a loss of sales, lowering the following year's sales by $300
for each of the 20% of units with external failures.

Required:
1. Calculate appraisal cost.

Appraisal cost = inspection cost = $4 X 250,000 car seats = $1,000,000


1000000
2. Calculate internal failure cost.

Internal failure costs = rework costs = (9% X 250,000) X $.75 = $16,875


16875
3. Calculate out-of-pocket external failure cost,

Out-of-pocket cost = (shipping cost + repair cost) X defective units

Out-of-pocket cost = ($7 + $.75) X (3% X 250,000) = $7.75 X 7,500 = $58,125


58125
4. Determine the opportunity cost associated with the external failures

External failures = Lost future sales = (3% X 250,000) X 20% X $300

External failures = 7,500 X 20% X $300 = 1,500 X $300 = $450,000


5. What are the total cost of Quality?

Appraisal costs $1,000,000


Internal failure $16,875
External failure (out-of-pocket) $58,125
External failure (lost sales) $450,000
Total $1,525,000

6. Dream Rider is concerned with the high up-front cost of inspecting all
250,000 units. It is considering an alternative internal inspection plan that
will cost only $1.00 per car seat inspected . During the internal inspection,
the alternative technique will detect only 5% of the 250,000 car seats as
having stitching problems. The other 7% with stitching problems will be
detected after the car seats are sold and shipped. What are the total costs
of quality for the alternative technique.

Appraisal cost = $1.00 X 250,000 = $250,000

Internal failure cost = (.05 X 250,000) X $.75 (rework) = $9,375

External failure (out-of-packet) costs = 7% X 250,000 X ($7 + $.75) = $135,625

External failure (0pportuniy cost) = 20% X (.07 X 250,000) X $300 = $1,050,000

Total cost of quality control =


Appraisal costs $250,000
Internal failure $9,375
External failure (out-of-pocket) $135,625
External failure (lost sales) $1,050,000
Total $1,445,000

7. What factors other than cost should Dream Rider consider before changing
inspection techniques?

In addition to lower costs under the alternative inspection plan, Dream Rider
should consider a number of other factors.

a. There could easily be serious reputation effects if the % of external failures


increases by 133% from 3% to 7% This rise in external failures may lead to
costs greater than $500 per failure due to lost sales.

b. Higher external failure rates may increase the probability of lawsuits.

c. Government intervention is a concern, with the chances of government


regulation increasing with the number of external failures.

Exercise 19-18: Cost of Quality, Ethical Considerations

Refer to information in Exercise 19-17 in answering this question. Dream Rider has discovered a more
serious problem with the plastic core of its car seats. An accident can cause the plastic in some of the
seats to crack and break, resulting in serious injuries to the occupant. It is estimated that this problem
will affect about 175 car seats in the next year. This problem could be corrected by using a higher
quality of plastic that would increase the cost of every car seat produced by $15. If this problem is not
corrected, Dream Rider estimates that out of the 175 accidents, customers will realize that the problem
is due to a defect in the seats in only three cases. Dream Rider's legal team has estimated that each of
these three accidents would result in a lawsuit that could be settled for about $775,000. All lawsuits
settled would include a confidentiality clause, so Dream Rider's reputation would not be affected.

1. Assuming that Dream Rider expects to sell 250,000 car seats next year, what would be the
cost of increasing the quality of all 250,000 car seats?

$15 X 250,000 = $3,750,000

2. What will be the total cost of the lawsuits next year if the problem is not corrected?

3 X $775,000 = $2,325,000

3. Dream Rider has decided not to increase the quality of the plastic because the cost of
increasing the quality exceeds the benefits (saving the cost of lawsuits). What do you
think of this decision? (Note: Because of the confidentiality clause, the decision will have
no effect on Dream Rider's reputation.)

While economically this may seem like a good decision, qualitative factors should be more
important than quantitative factors when it comes to protecting customers from harm and
injury. If a product can cause a customer serious harm and injury, an ethical and moral
company should take steps to prevent that harm and injury. The company's code of ethics
should guide this decision.

4. Are there any other costs or benefits that Safe Rider should consider?

In addition to ethical considerations, the company should consider the societal cost of this decision,
reputation effects if word of these problems leaks out at a later date, and governmental intervention
and regulation.
Exercise 19-20 Quality improvement, relevant costs, relevant revenues
Given:
SpeedPrint manufactures and sells 18,000 high-technology printing presses each year.
The variable and fixed costs of rework and repair are as follows:

Variable Fixed Total


Costs Costs Costs
Rework costs per hour $79 $115 $194
Repair costs
Customer-support costs per hour 35 55 90
Transportation costs per load 350 115 465
Warranty repair costs per hour 89 150 239

Quality Problem: Current presses have a quality problem which causes viarations in the
shade of some colors.
Proposal: Change a key component in each press

Extra cost of new component $70


Component per press 1
# of presses requiring component 18,000
Time horizon (in years) 1

Advantages/Savings with component change


Fixed rework costs saved $0
Fixed repair costs saved $0
Rework hours saved 14,000
Customer support hours saved 850
Hours of warranty repairs saved 8,000
Fewer loads moved 225
Additional unit sales of presses 140
Contribution margin generated by
additional sales of presses $1,680,000

Required:
1. Should SpeedPrint change to the new component?

Cost of change: $70 X 1 X 18,000 original sales level ($1,260,000)


Advantages:
Additional CM generated through sales $1,680,000
COQ Savings
Variable rework cost savings 1,106,000
Variable customer support savings 29,750
Variable transportation savings 78,750
Variable warranty repair cost savings 712,000 $3,606,500
Net advantage of changing component $2,346,500

2. Suppose the estimate of 140 additional presses sold is uncertain. What


is the minimum number of additional presses that SpeedPrint needs to
sell to justify adopting the new press?
Net advantage of changing component $2,346,500
Additional CM generated through sales $1,680,000
Additional TCM generated without additional sales $666,500
Thus no additional sales are needed.

Note: If additional sales had been needed:


Additional TCM needed through additional sales (assumed) $1,000,000
Since:
TCM generated from 140 units of additional sales = $1,680,000
Additional CM expected per new unit sold ($1,680,000 / 140) 12,000
Additional unit sales needed to justify component change 83.33
Exercise 19-29 Statistical quality control
Given:
Keltrex Cereals produces a wide variety of breakfast products. The company's three best
selling breakfast cereals are Double Bran Bits, Honey Wheat Squares, and Sugar King Pops.
Each box of a particular type of cereal is required to meet pre-determined weight specifications,
so that no single box contains more or less cereal than another. The company measures the
mean weight per production run to determine if there are variances over or under the company's
specified upper and lower level control limits. A production run that falls outside of the specified
control limit does not meet quality standards and is investigated further by management to
determine the cause of the variance. The three Keltrex breakfast cereals had the following
weight standards and production run data for the month of March.

March results:
Double Bran Bits Lower (1) Upper (2) Double Bran Bits
Production Std. Mean Weight 2-Sigma 2-Sigma Actual Mean Weight
Run # Per Production Run Control Limit Control Limit Per Production Run
1 17.97 17.41 18.53 18.23
2 17.97 17.41 18.53 18.14
3 17.97 17.41 18.53 18.22
4 17.97 17.41 18.53 18.30
5 17.97 17.41 18.53 18.10
6 17.97 17.41 18.53 18.05
7 17.97 17.41 18.53 17.84
8 17.97 17.41 18.53 17.66
9 17.97 17.41 18.53 17.60
10 17.97 17.41 18.53 17.52
Std. Deviation 0.28
(1) 17.97 - (2)(.28) = 17.41
(2) 17.97 + (2)(.28) = 18.53

Honey Wheat Squares Lower (1) Upper (2) Honey Wheat Squares
Production Std. Mean Weight 2-Sigma 2-Sigma Actual Mean Weight
Run # Per Production Run Control Limit Control Limit Per Production Run
1 14 13.68 14.32 14.11
2 14 13.68 14.32 14.13
3 14 13.68 14.32 13.98
4 14 13.68 14.32 13.89
5 14 13.68 14.32 13.91
6 14 13.68 14.32 14.01
7 14 13.68 14.32 13.94
8 14 13.68 14.32 13.99
9 14 13.68 14.32 14.03
10 14 13.68 14.32 13.97
Std. Deviation 0.16
(1) 14.00 - (2)(.16) = 13.68
(2) 14.00 + (2)(.16) = 14.32

Sugar King Pops Lower (1) Upper (2) Sugar King Pops
Production Std. Mean Weight 2-Sigma 2-Sigma Actual Mean Weight
Run # Per Production Run Control Limit Control Limit Per Production Run
1 16.02 15.60 16.44 15.83
2 16.02 15.60 16.44 16.11
3 16.02 15.60 16.44 16.24
4 16.02 15.60 16.44 15.69
5 16.02 15.60 16.44 15.95
6 16.02 15.60 16.44 15.50
7 16.02 15.60 16.44 15.86
8 16.02 15.60 16.44 16.23
9 16.02 15.60 16.44 16.15
10 16.02 15.60 16.44 16.60
Std. Deviation 0.21
(1) 16.02 - (2)(.21) = 15.60
(2) 16.02 + (2)(.21) = 16.44
Required:
1. Using the 2-Sigma rule, what variance investigation decision would be made?
The 2-Sigma rule will trigger a decision to investigate whenever the actual mean weight of a
production run is outside of the control limits.

Upper: Mean + (2 X Std. Deviation)


Lower: Mean - (2 X Std. Deviation)

The only runs with values outside the specified control limits were associated with the
production of Sugar King Pops. Runs: 6 and 10

2. Present the Statistical Control Charts for each of the three breakfast cereals for
March. What inferences can be drawn from the charts?

See Chart 1, 2, and 3.

Chart 1: Double Bran Bits had no production run observations outside the control limits.
However, there is an apparent trend observable from the statistical control chart
which shows steady movement toward the lower control limit. This trend should
be investigated by management to learn if there is faulty equipment or an out of
control process that will eventually result in under weighted cereal boxes.

Chart 2: Honey Wheat Squares has no observations outside of either control limts. In
fact, the process appears to be in control. Variations appear to be random in
nature with no apparent trends that warrant further investigation.

Chart 3: Sugar King Pops has two observations outside the control limits. One falls below
the lower control limit and one above the upper control limit. These two production
runs are not in conformance with quality standards. Management attention is
needed to determine the cause of the significant variances.

3. What are the costs of quality in this example?

Prevention Costs: Costs incurred to preclude the production of products that do not
conform to quality specifications. Examples include costs of designing the process,
maintaining equipment, and employee training to properly operate the production line.

Appraisal Costs: Costs incurred to detect which of the individual units of products do
not conform to quality specifications. Examples include costs of inspections to check
weight of cereal boxes.

Internal Failure Costs: Costs incurred on a defective product before it is shipped to


customers. Examples include costs of refilling cereal boxes that do not meet specifications;
costs to fix causes of failure such as machine calibration, material variability, or human
error; costs of reconfiguring manufacturing processes to prevent errors in filling cereal boxes.

External Failure Costs: Costs incurred on a defective product after being shipped to
customers. Examples include costs of customer ill-will, costs of returning and replacing
incorrectly filled boxes.

How could Keltrex employ Six Sigma programs to improve quality?

Six Sigma quality is a standard of excellence that requires a strict understanding of both
customer expectations and reasons for manufacturing defects to improve current quality
performance. The statistical term six sigma translates to 3.4 defects per 1 million incidents,
or near perfection in quality variability. Key aspects of Six Sigma are to define, measure,
analyze, improve and control processes.

Keltrex Cereals could employ Six Sigma programs to reduce variability in box weights. The
company would first need to define the quality problem (i.e. variability in weight per cereal
box), measure the incidents of defect using statistical quality control tools, analyze potential
reasons for variability in the weight per cereal box (machine calibration, material variability,
human error, etc). Assuming, as an example, that the variability is due to machines the
compamy may choose to better calibrate the existing machines, purchase new machines
that are more precise, or investigate other engineering alternatives. Finally, as improvements
are made to the existing machines, the company needs to monitor the improvements to
ensure that the variability problem has been resolved.
Statistical Control Chart
Double Bran Bits
for the Month of March
18.8

18.6

18.4

18.2

18

17.8

17.6

17.4

17.2

17

16.8
1 2 3 4 5 6 7 8

Standard Mean Weight (Ounces) Lower Control Weight Upper Co


Actual Mean Weight Per Production Run
rt

ch

7 8 9 10

ght Upper Control Limit


Statistical
Control Chart for
Honey Wheat Squares for March
14.4

14.2

14

13.8

13.6

13.4

13.2
1 2 3 4 5 6 7 8

Standard Mean Weight (Ounces) Lower Control Limit Upper Control Limit Actual Mean Weigh
March

7 8 9 10

mit Actual Mean Weight Per Production Run


Statistical Control Chart
Sugar King Pops
March
16.8

16.6

16.4

16.2

16

15.8

15.6

15.4

15.2

15

14.8
1 2 3 4 5 6 7 8
Standard Mean Weight Lower Control Limit Upper Control Limit Actual Mean Weight P
rt

7 8 9 10
Actual Mean Weight Per Production Run
Investigate or not investigate
Given:
You are the manager of a manufacturing process. A significant material efficiency
variance of $10,000 has been reported for the week's operations. The magnitude
of the variance falls outside of the upper control limit of a statistical control diagram.
You are trying to decide whether to investigate this variance. You feel that if you do
not investigate and the process is out of control, the present value of the cost savings
foregone over the planning horizon is $3,800. The cost to investigate is $500. The
cost per period of being out of control is $700. If an out-of-control process is
discovered, the cost of correcting it is $300. You assess the probability that the
process is out of control at 30%.

Required:
1. Should the process be investigated? What are the expected costs of
investigating and of not investigating?
State of Nature
Actions In Control Out of Control EMV of the
Probability of the state of nature 0.70 0.30 Decision
Investigate the process (and fix if necessary) ($500) ($1,500) ($800)
Do not investigate the process $0 ($3,800) ($1,140)

Decision: Investigate

2. At what level of probability that the process is out of control would the
expected costs of each action be the same?
State of Nature
In Control Out of Control EMV of the
Probability of the state of nature X 1-X Decision
Investigate the process (and fix if necessary) ($500) ($1,500) #VALUE!
Do not investigate the process $0 ($3,800) #VALUE!

EMV of Investigate: ($500)(X) +(1-X)($1,500) =


EMV of Do Not Investigate: ($0)(X) + (1-X)($3,800) =
Point of Indifference $500(X)+$1,500-$1,500(X) = $3,800-$3,800(X)
$-1,000(X) +$1,500 = $3,800 - $3,800(X)
$2,800(X) = $2,300
X = $2,300/$2,800 = 0.8214285714
(1-X) = 0.1785714286

Proof: State of Nature


In Control Out of Control EMV of the
Probability of the state of nature 0.821428571 0.178571429 Decision
Investigate the process (and fix if necessary) ($500) ($1,500) ($679)
Do not investigate the process $0 ($3,800) ($679)

3. If the cost variance is $10,000, why is the cost savings foregone over the
planning horizon $3,800?

The $10,000 is the absolute size of the materials efficiency variance. Perhaps
the plant manager has already taken steps to prevent continued incurrence of the
variance (such as requiring suppliers to check more thoroughly the quality of their
materials). This action would reduce the magnitude of subsequent materials
efficiency variances. Alternatively, a large chunk of the variance may be a random
deviation. If so, it would be impossible to count on saving the full amount even if
the process is out of control.
Exercise 19-25 Theory of Constraints
Given:
The Mayfield Corporation manufactures filing cabinets in two operations: machining
and finishing.
Machining Finishing
Annual capacity (units) 100,000 80,000
Annual production (units) 80,000 80,000
Fixed operating costs (excluding DM) $640,000 $400,000
Fixed operating costs per unit produced $8 $5

Each cabinet sells for $72


Variable costs (all direct materials; added at the beg. of machining) $32
Demand is unlimited (Can sell all it can produce.)

Required:
1. Mayfield is considering using some modern jigs and tools in the finishing
operation that would increase annual finishing output by 1,000 units. The
annual cost of these jigs and tools is $30,000. Should Mayfield acquire
these tools?

Finishing is a bottleneck.
Modern jigs and tools would relax the bottleneck by 1,000 units.
Benefit of modern jigs and tools:
Additional contribution margin generated $40,000
Incremental fixed costs associated with tools (30,000)
Net advantage of buying modern jigs and tools $10,000

Recommendation: Buy modern jigs and tools

2. The production manager of the Machining Department has submitted a


proposal to do faster setups that would increase the annual capacity of
the Machining Department by 10,000 units and cost $5,000 per year.
Should Mayfield implement the change?

Machining already has excess capacity and is therefore not a bottleneck


operation. Increasing its capacity further will not increase throughput contribution.

Therefore, there is no benefit from spending $5,000 to increase the Machining


Department's capacity by 10,000 units.

Recommendation: Do not implement the change to do faster setups.

3. An outside contractor offers to do the finishing operation for 12,000 units


at $10 per unit, double the $5 per unit that it costs Mayfield to do the finishing
in-house. Should Mayfield accept the subcontractor's offer?

Finishing is a bottleneck operation.


Accepting the outside contractor's offer will increase output by 12,000 units.
Advantage of accepting
Additional Throughput CM from increased sales $480,000
Cost of outside finishing (120,000)
Net advantage of accepting the offer $360,000

Recommendation: Accept the offer.

4. The Hunt Corporation offers to machine 4,000 units at $4 per unit, half the $8
per unit that it costs Mayfield to do the machining in-house. Should Mayfield
accept the subcontractor's offer?

If Mayfield provides the materials to be converted, there is no variable cost savings


by accepting Hunt Corporation's offer. All other costs incurred by Mayfield are fixed.
Therefore, there is no cost savings by accepting the Hunt offer. In addition, since
the machining department is not a bottleneck, no additional throughput contribution
will be generated by accepting the offer from Hunt Corporation. Sales is limited by
the capacity of the finishing department. If the offer is accepted, costs will increase
by 4,000 X $4 = $16,000.

Recommendation: Reject the Hunt offer.

Exercise 19-26
Required:
1. Mayfield produces 2,000 defective units during the machining operation. What is
the cost to Mayfield of the defective items produced?

Machining is not a bottleneck operation.


Producing 2,000 defective units does not reduce throughput contribution; machining
can still produce and transfer 80,000 good units to finishing.
Therefore, the cost of the defective units is $32 X 2,000 = $64,000.

2. Mayfield produces 2,000 defective units at the finishing operation. What is


the cost to Mayfield of the defective items produced?

Finishing is a bottleneck operation.


Producing 2,000 defective units in the bottleneck operation will reduce throughput
contribution.
Therefore, the cost of the defective units is
Lost materials added in the machining department 2,000 X $32 = $64,000
Lost throughput contribution in finishing department 2,000 X ($72-$32)= 80,000
Total cost of the 2,000 defective units $144,000

Another approach: No Defects 2,000 Defects


Revenue from units sold $5,760,000 $5,616,000
Cost of units sold (includes spoiled units, if any) ** $2,560,000 $2,560,000
Gross profit $3,200,000 $3,056,000
Total cost of the 2,000 defective units $144,000

** Note that the direct material cost is irrelevant; whether the units are defective or good
the direct material costs will be incurred.
Alternative calculation: 2,000 X $72 = $144,000
$144,000
Exercise 19-31 Waiting times, manufacturing cycle times
Given:
The Seawall Corporation uses an injection molding machine to make a plastic product, Z39.
Seawall manufactures only after an order is received.
Average annual orders expected 50
Expected machine hours required per order 80
Annual machine capacity in machine hours 5,000
Definitions:
AMLT = Average manufacturing lead time
AOWT = Average order wait time
AOMT = Average order manufacturing time
AMLT = AOWT + AOMT

Required:
1. Calculate
a. The average amount of time that an order for Z39 will wait in line before it is
processed

AOWT = (Average Annual Orders Expected) X (AOMT) X (AOMT)


2 X (Annual Mach. Capacity - (Average Annual Orders Expected X AOMT))

AOWT = (50) X (80) X (80)


2 X (5,000 - (50 X 80))

AOWT = 320,000 / (2 X (5,000 - 4,000))

AOWT = 320,000
2,000

AOWT = 160 hours per order

b. The average manufacturing lead time per order for Z39.

AMLT = AOWT + AOMT

AMLT = 160 + 80 = 240 hours

2. Seawall is considering introducing a new product, Y28. Seawall estimates that,


on average, it will receive 25 orders of Y28 in the coming year. Each order of
Y28 will take 20 hours of machine time. The average demand for Z39 will be
unaffected by the introduction of of Y28.

Calculate
a. The average waiting time for an order received and

AOWT = (Average Annual Orders of Z39) X (AOMT) X (AOMT) + ( Average Annual Orders of Y28) X (AOMT) X (AOMT)
2 X [Annual Mach. Capacity - [(Annual orders expected Z39 X AOMT)] - [(Annual orders expected Y28) X (AOMT)]]

AOWT = (50 X 80 X 80) + (25 X 20 X 20)


2 X [(5,000 - (50 X 80) - (25 X 20))]
AOWT = 330,000
1,000

AOWT = 330 hours

b. The average manufacturing lead time per order for each product, if Seawall
introduces Y28.

Z39
AMLT = AOWT + AOMT = 330 + 80 = 410 hours

Y28
AMLT = AOWT + AOMT = 330 + 20 = 350 hours

Exercise 19-32 Waiting times, relevant revenues, and relevant costs


Given:
Seawall is still debating whether it should introduce Y28. The following table provides
information on selling prices, variable costs, and inventory carrying costs for Z39 and Y28.
Seawall will incur additional variable costs and inventory carrying costs for Y28 only if it
introduces Y28.
Z39 Y28
Annual average number of orders 50 25
Average Manfucturing Lead Time (AMLT)
Produce only Z39 (from P19-31) 240 N/A
Produce both Z39 and Y28 (from P19-31) 410 350
Average SP per order if AMLT per order is
less than 320 hours $27,000 $8,400
more than 320 hours $26,500 $8,000
Variable cost per order $15,000 $5,000
Inventory carrying cost per order per hour $0.75 $0.25

Required:
1. Should Seawall manufacture and sell Y28.

Total Revenue /Cost Approach Do Not Relevant


Produce Produce Revenues
Y28 Y28 Costs
Expected revenues
50 X $27,000 Z39 $1,350,000
50 X $26,500 Z39 $1,325,000
25 X $8,000 Y28 200,000
Total Revenues $1,350,000 $1,525,000 $175,000
Expected variable costs
50 X $15,000 Z39 $750,000 $750,000
25 X $5,000 Y28 125,000
Total VC $750,000 $875,000 $125,000
Expected carrying costs
50 X $.75 X 240 Z39 $9,000
50 X $.75 X 410 $15,375.00
25 X $.25 X 350 Y28 $2,187.50
Total Carrying Costs $9,000 $17,562.50 $8,562.50
Expected Revenues less Costs $591,000 $632,437.50 $41,437.50
Net benefit of producing Y28 $41,437.50

Recommendation: Produce and sell Y28.

2. Should Seawall manufacture and sell Y28. Given changes indicated below.

Z39 Y28
Annual average number of orders 50 25
Average SP per order if AMLT per order is
less than 320 hours $27,000 $6,400
more than 320 hours $26,500 $6,000
Variable cost per order $15,000 $5,000
Inventory carrying cost per order per hour $0.75 $0.25

Total Revenue /Cost Approach Do Not Relevant


Produce Produce Revenues
Y28 Y28 Costs
Expected revenues
50 X $27,000 Z39 $1,350,000
50 X $26,500 Z39 $1,325,000
25 X $6,000 Y28 $150,000
Total Revenues $1,350,000 $1,475,000 $125,000
Expected variable costs
50 X $15,000 Z39 $750,000 $750,000
25 X $5,000 Y28 125,000
Total VC $750,000 $875,000 $125,000
Expected carrying costs
50 X $.75 X 240 Z39 $9,000
50 X $.75 X 410 $15,375.00
25 X $.25 X 350 Y28 $2,187.50
Total Carrying Costs $9,000 $17,562.50 $8,562.50
Expected Revenues less Costs $591,000 $582,437.50 ($8,562.50)
Net benefit of producing Y28 ($8,562.50)

Recommendation: Do not produce and sell Y28.

Note: Total revenues decrease by $50,000, therefore difference between Q1


and Q2 is a decrease of $50,000.

($8,562.50)
d Y28) X (AOMT)]]
Exercise 19-17
Definitions:
Prevention Costs: Costs incurred to preclude the production of products
that do not conform to quality specifications.
Appraisal Costs: Costs incurred to detect which of the individual units of
products do not conform to quality specifications.
Internal Failure Costs: Costs incurred on a defective product before it is
shipped to customers.
External Failure Costs: Costs incurred on a defective product after it is
shipped to customers.

Required:
1. Classify the cost items into prevention, appraisal, internal failure, or external
failure categories.
2. Calculate the ratio of each COQ category to revenues in 2007 and 2008. Comment
on the trends in costs of quality between 2007 and 2008.

2007 2007 2008 2008


Annual Revenue $20,000,000 $25,000,000
Prevention Costs: Dollars Percentages Dollars Percentages
Design Engineering $210,000 1.05% $600,000 2.40%
Preventive equipment maintenance 110,000 0.55% 200,000 0.80%
Supplier evaluation 80,000 0.40% 200,000 0.80%
Total prevention costs $400,000 2.00% $1,000,000 4.00%
Appraisal Costs:
Inspection of production $220,000 1.10% $170,000 0.68%
Product-testing labor & equipment 530,000 2.65% 250,000 1.00%
Incoming material inspection 50,000 0.25% 80,000 0.32%
Total appraisal costs $800,000 4.00% $500,000 2.00%
Internal Failure Costs:
Scrap & rework $720,000 3.60% $670,000 2.68%
Breakdown maintenance 180,000 0.90% 80,000 0.32%
Total Internal failure costs $900,000 4.50% $750,000 3.00%
External Failure Costs:
Returned goods $120,000 0.60% $300,000 1.20%
Customer support 80,000 0.40% 65,000 0.26%
Warranty repair 1,000,000 5.00% 635,000 2.54%
Total external failure costs $1,200,000 6.00% $1,000,000 4.00%
Total Quality Costs: $3,300,000 16.50% $3,250,000 13.00%
16.50% 13.00%

Between 2007 and 2008, the company's COQ declined from 16.50% to 13.00% of sales.

Analysis of individual COQ categories indicates that the company began allocating more
resources to prevention activities in 2008 relative to 2007. As a result, appraisal costs,
internal failure costs, and external failure costs declined in 2008.

However, management should investigate the reasons why the cost of returned goods
increased and initiate corrrective action where appropriate.
3. Give two examples of nonfinancial quality measures that the company could monitor in its
balanced scorecard as part of a total quality-control effort.

Examples
# of defective units shipped to customers as a % of total units shipped.
Ratio of good output to total output at each production process.
Employee turnover
Customer satisfaction surveys
Exercise 19-19
Given:
Eastern Switching Co. (ESC) produces telecommunications equipment.
The following information is available for the first year (2007) of ESC's
TQM program.
2006 2007
(No TQM) (New TQM)
Total # of units produced and shipped 10,000 11,000
Units delivered before or on scheduled delivery date 8,500 9,900
Number of defective units shipped 400 330
Customer complaints other than for defective units 500 517
Average time from order placement to delivery (in days) 30 25
Number of units reworked during production 600 627
Manufacturing lead time (in days) 20 16
Direct and indirect manufacturing labor-hours 90,000 110,000

Required:
1. For each of the years 2006 and 2007 calculate: 2006 2007
a. % of defective units shipped 4.00% 3.00%
b. On-tine delivery rate 85.00% 90.00%
c. Customer complaints as a % of units shipped 5.00% 4.70%
d. % of units reworked during production 6.00% 5.70%

2. On the basis of your calculations in requirement 1, has ESC's


performance on quality and timeliness improved?

The calculations in requirement #1 indicate:


Quality has improved because
a. % of defective units shipped decreased
b. Customer complaints as a % of units shipped have decreased
c. % of units reworked during production has decreased
Timeliness has improved as on-time delivery has increased. Better quality
and less rework reduces delays in production and enables shorter lead times and
enables on-time delivery to customers.

3. Philip Larken, a member of ESC's board of directors, comments that


regardless of the effect that the TQM program has had on quality, the
output per labor-hour has declined between 2006 and 2007. Larkin
believes that lower output per labor-hour will lead to an increase in costs
and lower operating income.
a. How did Larkin conclude that output per labor-hour declined in 2007
relative to 2006?
2006 2007
Output per labor-hour 0.11 0.10

b. Why might output per labor-hour decline in 2007?

Output per labor-hour may have declined from 2006 to 2007 either because
workers were less productive or more likely because the initial implementation
of the quality program may have resulted in lost production time as employees
were trained and became more adept at solving production quality problems.

As workers implement good quality practices and defects and rework decrease
over time, it is possible that both quality and productivity (output per labor-hour)
will increase.

c. Do you think that a lower output per labor-hour will decrease operating
income in 2007? Explain.

It is not clear that the lower output per labor-hour will decrease operating income
in 2007. The higher labor costs in 2007 could pay off in many ways. Higher quality
and lower defects will likely result in lower material costs because of lower defects
and rework. Internal and external failure costs will also be lower, resulting in lower
customer returns and warranty costs.

Customer satisfaction will likely increase, resulting in higher sales, higher prices,
and higher contribution margins. The 10% increase in the number of units produced
and sold in 2007 may well have been due to quality improvements. Overall, the
benefits of higher quality in 2007 may very well exceed the higher labor costs per unit
of output.
Exercise 19-29
Given:
Jetrans Airlines operates daily round-trip flights on the London-Los Angeles route using a fleet
of three 747s; the Spirit of Atlanta, the Spirit of Boston, and the Spirit of Sacramento.

The budgeted quantity of fuel for each round-trip flight is the 12-month mean (average) round-
trip fuel consumption of 200 gallon-units, with a standard deviation of 20 gallon-units. A gallon-
unit is 1,000 gallons.

Using a statistical quality control (SQC) approach, Shirly Watson, the Jetrans operations
manager, investigates any round-trip with fuel consumption that is greater than 2 standard
deviations from the mean.

October results: Spirit of Spirit of Spirit of


Mean Lower (1) Upper (2) Atlanta Boston Sacramento
Flight Fuel Usage 2-Sigma 2-Sigma Fuel Usage Fuel Usage Fuel Usage
Number Per Flight Control Limit Control Limit Gallon-Units Gallon-Units Gallon-Units
1 200 160 240 208 206 194
2 200 160 240 187 188 208
3 200 160 240 194 192 221
4 200 160 240 202 214 208
5 200 160 240 211 184 242
6 200 160 240 215 226 234
7 200 160 240 216 198 249
8 200 160 240 218 212 227
9 200 160 240 221 202 232
10 200 160 240 232 186 244

(1) 200 - (2)(20) = 160


(2) 200 + (2)(20) = 240
Required:
1. Using the 2-Sigma rule, what variance investigation decision would be made?
The 2-Sigma rule will trigger a decision to investigate whenever the round-trip fuel usage
is outside of the control limits.

Upper: Mean + (2 X Std. Deviation) = 200 + (2 X 20) = 200 + 40 = 240


Lower: Mean - (2 X Std. Deviation) = 200 - (2 X 20) = 200 - 40 = 160

The only plane to be outside the specified control limits is the Spirit of Sacramento.
See red values above -- flights 5, 7, 10.

2. Present the Statistical Control Charts for round-trip fuel usage for each of the
three 747s in October. What inferences can be drawn from the charts?

See Chart 1, 2, and 3.

Chart 1: The Spirit of Atlanta has no observations outside either control limit.
However, there was an increase in fuel use in each of the last 9 round-trip
flights. The probability of 9 consecutive increases from an in-control process
is very low. This is a trend that should be investigated.
Chart 2: The Spirit of Boston appears to be in control regarding fuel usage.

Chart 3: The Spirit of Sacramento has 3 observations outside the upper control limit.
Moreover, the last 6 flights have been hovering close to the upper control
limit. This is unlikely for an in-control operation.

3. Some managers propose that Jetrans Airlines present its quality control chart
in monetary terms rather than in physical-quantity terms (gallon-units). What
are the advantages and disadvantages of using monetary fuel costs rather than
gallon-units in the SQC charts?

Advantage:
Focuses on a variable of overriding concern to top managers -- operating costs ($)

Disadvantages:

Split responsibilities.
Operations managers may not control the purchase of fuel, and therefore may want
to exclude from their performance measures any variation stemming from factors
outside their control.

Offsetting factors may mask important underlying trends when the quantity used
and the price paid are combined in a single observation.
For example, decreasing gallon usage may be offset by increasing fuel costs.
Both of these individual patterns are important in budgeting for an airline.

The distribution of fuel usage in gallons may be different from the distribution
of fuel prices per gallon. More reliable estimates of the mean and standard
deviation parameters might be obtained by focusing separately on the individual
usage and price distributions.

Note: The above disadvantages are most marked if actual fuel prices are used.
The use of standard fuel prices can reduce many of these disadvantages.
Spirit of Atlanta 2-Sigma SCC for Fuel Consumption Expressed in Gallon-Units

300

250
Gallon-Units

200

Column
C
Column
150 D
Column
E

100

50

0
1 2 3 4 5 6 7 8 9 10
Flight Number
Spirit of Boston 2-Sigma SCC for Fuel Consumption Expressed in Gallon Units

300

250
Gallon-Units

200

Column
C
Column
150 D
Column
E

100

50

0
1 2 3 4 5 6 7 8 9 10
Flight Number
Spirit of Sacramento 2-Sigma SCC for Fuel Consumption Expressed in Gallon-Units

300

250
Gallon-Units

200

Column
C
Column
150 D
Column
E

100

50

0
1 2 3 4 5 6 7 8 9 10
Flight Number
Exercise 19-35
Given:
Aardee Industries manufactures pharmaceutical products in two departments:
Tablet
Mixing Making
Measurement units grams tablets
Capacity per hour (grams; tablets) 150 200
Monthly capacity (2,000 hours available per department) 300,000 400,000
Monthly production of good units 200,000 390,000
Fixed operating costs $16,000 $39,000
Fixed operating costs per unit (grams; tablets) $0.08 $0.10
DM costs; all incurred in the Mixing Department $156,000
% of the DM mixture lost in the tablet-making process 2.50%
Grams of DMs needed per tablet 0.50
Selling price per tablet $1
All costs other than DM dollars are fixed

The Mixing Department makes 200,000 grams of DM mixture (enough to make


400,000 tablets) because the Tablet-Making Department has only enough capacity
to process 400,000 tablets.

Required:
1. If Aardee will supply a contractor with 10,000 grams of mixture, the contractor
will manufacture 19,500 tablets for Aardee (allowing for the normal 2.5% loss
during the tablet-making process) at $.12 per tablet. Should Aardee accept
the contractor's offer? 19,500

Tablet-making is a bottleneck -- supplying the DM mixture and paying for external


tablet processing will generate additional throughput contribution of
Selling price per tablet $1
DM costs per tablet 0.40
Outside contracting cost per tablet 0.12
Throughput contribution per tablet purchased $0.48
Benefit if Aardee accepts the outside contractor's offer $9,360

2. Another company offers to prepare 20,000 grams of mixture a month from


DM that Aardee supplies. The company will charge $.07 per gram of mixture.
Should Aardee accept the company's offer?

The mixing operation is not a bottleneck.


Buying extra mixture will not increase throughput contribution or decrease the
cost of obtaining the mixture since the mixing operations has no avoidable costs.

Recommendation: Reject the offer.

3. Aardee's engineers have devised a method that would improve quality in the
tablet-making operation. They estimate that the 10,000 tablets currently being
lost would be saved. The modifications would cost $7,000 a month.
Should Aardee implement the new method?
Tablet-making is a bottleneck operation.
The quality program will increase sales revenue by (no change in VC) $10,000
Monthly incremental cost of the quality program 7,000
Advange of the modifications $3,000

Recommendation: Implement the new methods

4. Suppose that Aardee also loses 10,000 grams of mixture in its mixing operation.
These losses can be reduced to zero if the company is willing to spend $9,000
per month in quality-improvement methods.
Should Aardee adopt the quality-improvement method?

Cost savings from quality programs (cost of previously lost mixture) $7,800
Cost of the quality program 9,000
Disadvantage of the quality-improvement ($1,200)

Recommendation: Do not Implement the new quality-improvement method.

5. What are the benefits of improving quality at the mixing operation compared with
improving quality at the tablet-making operation?

The benefit of improving quality of the mixing operation is the savings in materials costs
less the cost of the improvement program.

The benefit of improving quality of the tablet-making operation (the bottleneck operation)
is the increased sales revenue less the cost of the improvement program.

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