Management can quantify the unknown external failure costs of customer dissatisfaction using the Taguchi method. For this reason, the Taguchi approximation evaluates quality-improvement projects more thoroughly since it considers the previously unquantifiable factor of customer dissatisfaction.
Cost of Quality (COQ)
Once the Taguchi method quantifies the external failure cost of customer dissatisfaction, it plays a pivotal role in integrating this with internal failure, prevention, and appraisal costs. This comprehensive integration forms the company’s quality-cost equation, also known as Cost of Quality (COQ), providing a thorough coverage of every aspect of quality-cost management. The Taguchi method empowers managers to confidently implement the necessary changes for their quality improvement efforts. This practical application is crucial, as the impact of quality improvements on a company’s bottom line can be difficult to measure.
Although accountants have made great strides in identifying and measuring the costs of making and monitoring quality improvements, they have been less successful in identifying the benefits of such improvements. This is mainly because the major benefit, increased customer satisfaction, is not easily identifiable or measurable.
While the benefits of quality improvement may not always be immediately apparent, they can manifest over the long term as increased sales revenue. In today’s competitive landscape, however, a more immediate concern may be stemming the tide of declining sales. It’s important to keep in mind the long-term benefits that quality improvement can bring. This underscores the importance of considering the opportunity cost (i.e., customer dissatisfaction or lost sales) of not making such improvements. While measuring this opportunity cost remains challenging, Japanese engineer Genichi Taguchi developed a technique for estimating it in 1984, making it crucial for you to be aware of and cautious of such costs.
Quality Costs
Cost of QualityConcerns about quality improvement can be divided into two components: design quality and conformance quality. Quality of design relates to the product’s functionality and physical characteristics that satisfy customer expectations. It is largely viewed as the responsibility of inventors, engineers, architects, and draftsmen. Once these groups have achieved design quality, the product moves into manufacturing.
Conformance quality becomes important in manufacturing, where design specifications are translated into manufacturing specifications and a final product. Conformance quality relates to how closely this final product achieves its design specifications and customer satisfaction. Managers and accountants have focused their efforts on assessing conformance quality. Hence, the costs associated with this conformance quality are what accountants call quality costs.
To better control these quality costs, managers and accountants have broken them down into four categories:
- appraisal costs,
- prevention costs,
- internal failure costs, and
- external failure costs.
Internal and external failure costs relate to when the failure is detected inside the company or by the customer. Internal failure costs include scrap materials and products, rework, reinspection costs, and work interruptions. External failure costs include product warranties, sales returns, allowances, and lost sales. The possibility of incurring internal and external failure costs prompts companies to incur appraisal and prevention costs.
Appraisal costs are also known as monitoring costs or inspection costs. Typical examples of these costs include maintaining the quality control department, evaluating methods, materials, and processes, and testing product samples. Statistical sampling techniques and quality control charts determine when, how often, and how much product needs to be inspected. Until the 1970s, these techniques and the minimization of appraisal costs were the primary quality control procedures used by accountants.
Then, it became apparent that appraisal costs reduce the number of defective products before they reach the consumer (external failure) but do not reduce the number of internal failures. Thus, the emphasis on appraisal costs focuses on discovering rather than preventing defects. This realization marked the end of the appraisal-cost era and the beginning of the prevention-cost era.
Prevention Costs
The prevention cost era began in many other developed nations before the U.S. These nations discovered that preventing defects reduces the probability of producing a defective product. This reduces internal and external failures and appraisal costs. Thus, companies began to incur expenses for equipment preventive maintenance, improving manufacturing specifications and procedures, and training personnel.
As the popularity of prevention procedures and related costs spread, the cost-control emphasis shifted to managing total quality costs (i.e., the combined internal and external failure costs, appraisal costs, and prevention costs). Control of total quality costs requires that accountants understand the relationships among internal and external failure costs and among prevention and appraisal costs. Cost management aims to achieve the lowest point in the total quality cost curve. This recognizes the tradeoff between appraisal and prevention costs and internal and external failure costs. Conceptually, as appraisal and prevention costs increase (the left side of the graph), internal and external failure costs decrease up to a point.
Once this point is reached, additional appraisal and prevention costs do not lower total quality costs (the right side of the graph). In practice, however, it is very difficult to identify this point of lowest total quality cost. The difficulty stems from a lack of proper cost identification and measurement. Identifying quality costs was difficult in the past because accounting systems spread costs across many accounts (materials, labor, overhead, and divisional accounts). As accountants became aware of these difficulties, accounting systems were redesigned. This is part of the impetus for activity-based costing. However, even if all quality costs are properly identified, a measurement problem still exists.
External Failure Costs: The Measurement Problem
The most significant measurement problem is the external failure cost. The more easily measured components include the cost of responding to customer complaints, investigating customer warranty claims, performing warranty repairs and replacements, conducting product recalls, assessing product liability, and handling returns and allowances. Many of these costs are already available in the accounting records. However, this area’s single largest measurement problem is measuring the external failure cost associated with lost sales or customer dissatisfaction.
Customer dissatisfaction is not an expense in the traditional accounting sense. Yet, it is a driving concern in today’s quality improvement environment. This opportunity cost is referred to as the cost of poor quality. Today, there is no widely accepted means of quantifying this cost. Companies try to estimate the cost of poor quality in various ways. Research on the cost of quality, conducted by KPMG Peat Marwick, indicates that companies frequently estimate that unobservable costs of poor quality commonly run three times all measurable quality costs and run as high as 20% of the cost of sales.
The Taguchi approximation allows managers to quantify these unobservable external failure costs to evaluate quality-improvement projects more rigorously. Without measuring this potentially substantial opportunity cost, the lowest point on the total quality cost curve cannot be correctly identified in practice. Furthermore, as engineers and quality control personnel push towards greater improvements in product quality, a larger capital investment in quality-improving technology is required. Accountants are disadvantaged in advising management on whether a capital expenditure on equipment used to improve product quality is cost-effective. The Taguchi method can overcome this problem by estimating the elusive external failure cost of customer dissatisfaction.
Explanation of the Taguchi Method
The Taguchi method is a variation of the traditional view of customer dissatisfaction due to poor quality. From a conventional manufacturing perspective, “quality losses” are incurred when a product unit falls outside the lower or upper limits of a predetermined manufacturing specification range.
For example, manufacturing specifications for a widget may require it to be 15 mm ± 3 mm. From a traditional manufacturing perspective, if the produced widget is less than 12 mm, it must be discarded. The company incurs an internal failure quality cost by scraping the materials used to produce the small widget. Similarly, if the widget produced exceeds 18 mm, the company incurs internal failure quality costs to rework the large widget into one that falls within the limits.
The traditional manufacturing perspective recognizes no internal failure quality cost for any widget within the 12 mm to 18 mm range. Furthermore, no external failure quality costs are expected if appraisal and prevention costs and procedures offer assurance that essentially all widgets sold are within the desired range. In terms of customer satisfaction, the customer is deemed satisfied with the product if it is within the range.
Under the Taguchi perspective, a “quality loss” is incurred whenever the widget does not reach the exact target value. Variations from this target value, still within the manufacturing specifications of 12 to 18 mm, do not cause the company to incur internal scrap or rework failure costs. Widgets that do not reach the exact target value, however, precipitate customer dissatisfaction because the product performs below its designed optimum. This causes the customer to return the product, refuse to buy another, and/or advise others not to buy the product.
Thus, the difference between the Taguchi and traditional perspectives is that the Taguchi method recognizes customer dissatisfaction even when the produced widget falls within the specified range. In quality-loss terms, as the distance between the widget’s true measurement and its target value doubles, the quality loss quadruples. This relationship can be expressed mathematically as the Taguchi loss function.
This function can be further developed to estimate the average expected cost of customer dissatisfaction from a widget that is not exactly on the target value. A computer program calculates this latter function for a given stable manufacturing process. The average cost calculated can then be multiplied by the total number of widgets produced to estimate the total external failure cost attributable to customer dissatisfaction. The resultant total is then added to other external failure costs to obtain total external failure costs.
Taguchi Loss FunctionHow the Taguchi Method Affects Total Quality Cost Management
External failure costs, however, are only one component of total quality costs. As discussed earlier, quality-cost management involves balancing internal and external failure costs with prevention and appraisal costs to achieve the lowest total quality cost. Once the external failure costs for the stable process have been quantified (assisted by the Taguchi method), the company’s current position on the total cost curve can be identified. This is accomplished by adding the other quality costs to the external failure cost estimate.
Then, changes to the process can be considered. Proposed quality improvements to the process, such as reducing the variability (or standard deviation) of the widget produced from the target value, can be used to project a revised external failure cost estimate. This estimate will be lower than the current external failure cost because it will produce more conforming products.  Regarding the Taguchi method, quality losses are reduced because the widget is closer to the target.
However, an additional prevention cost must be incurred to obtain this reduction in external failure costs. The additional prevention cost is the capital needed to purchase the quality-improvement technology. From a quality-cost management perspective, the question is whether such an expenditure would raise total quality costs. This issue can be resolved using a traditional capital budgeting technique to evaluate the trade-off between the increase in prevention costs (i.e., capital expenditure) and the reduction in external failure costs. The following illustration shows how the quality improvement proposal is evaluated.
Example of Capital Budgeting Application
Suppose the ACE Widget Company manufactures widgets with a target value of 15 mm. Manufacturing specifications accept widgets produced within the range of ±3 mm (i.e., 12 to 18 mm). The current manufacturing process produces widgets with an average value equal to the 15 mm target. Quality engineers suggest that replacing a particular machine with a more technologically advanced model would improve product quality by reducing variability in the manufacturing process (i.e., standard deviation).
The new equipment would not change the average value or the target. It would not produce any savings in operating or production costs (although these savings could easily be incorporated into the analysis). Furthermore, no changes in appraisal costs or internal failure costs are anticipated in the short run. Thus, the only affected costs are prevention costs and external failure costs. The purchase price of the new machine measures the increase in prevention costs.
The external failure cost savings are measured in two steps. First, the Taguchi method estimates the expected external failure costs at the current level of process variability (measured by the current standard deviation). Second, the method estimates external failure costs for the new machine’s variability level. The difference in these estimates is the reduction in external failure costs attributable to the new machine. To calculate the first and second steps, three pieces of information must be input into the computer program (or the mathematical formula): the standard deviation of the process (current, actual, and expected new), the total annual production to be obtained from the new machine, and the cost of customer rejection.
This last item, the cost of rejection, estimates the financial cost of one dissatisfied customer. The Taguchi method uses this to estimate the total financial cost of customer dissatisfaction. The cost of customer rejection may not be easy to estimate. However, some observers have found that 80% of measurable external failure costs come from customer returns. Thus, the cost of processing a customer’s return constitutes a good beginning estimate of the cost of customer rejection.
The present value of the annual reduction in external quality failure costs over the new machine’s useful life is then compared with the purchase cost, and a decision is made. The purchase is justified if the present value of the reduction in external failure costs exceeds the cost of the new machine. Tables can easily be developed to present calculations across a range of assumptions regarding the level of reduced variability, the cost of customer rejection, and the cost of capital used to compute present values.
