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ACW3220
Management Accounting 2
Week 6: BALANCE SCORECARD
QUAITY AND TIME
 Our Learning Objectives

 To understand what quality means and how to

manage it
1. The cost of quality
 Four categories and their relationships
2. Quality and the BSC
3. Total quality management (TQM)
 Accounting impediments to TQM
4. Other approaches; quality accreditation
5. Financial and non financial quality information

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1. Managing quality
Important to managing costs and enhance customer value
Introduction - what is quality?

 What is quality?
– Often defined in terms of products/ services meeting customers’
needs and expectations. In other words,
– The total features and characteristics of a product or a service
made or performed according to specifications to satisfy
customers at the time of purchase and during use
– Two basic concepts need to be understood:
1. Quality of design
– Degree to which a product’s design specifications meet
customers’ expectations
2. Quality of conformance
– Degree to which a product meets formal design specifications
 A clear understanding of customer value is needed to provide
customers with a high-quality product

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Two aspects of quality

 1. Design quality – refers to how closely the

characteristics of a product or service meet the needs
and wants of customers
 Electric kettle- to heavy to carry- led to poor quality design.

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Two aspects of quality

2. Conformance quality – refers to the performance of a

product or service relative to its design and product
specifications

 Degree to which the product meet the

design specification e.g Electric kettle-
malfunction cannot produce hot water.

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The Best Electric Kettle

This electric kettle is a high-end, variable-temperature model that’s

ideal for brewing myriad teas, making pour-over coffee, or simply
boiling water for instant oatmeal. 

Quality features : Speed, accuracy and easy use

This product has design to meet customer expectation and

ensure design specification are meet.
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 Quality and Failure

Actual Design Customer

Performance Specifications Satisfaction

Conformance Design
Quality Quality
Failure Failure

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Why do companies focus on quality

 Seeks to reduce costs and increase customer satisfaction

 Focus on the quality of a product will generally:
– build expertise in producing it
– lower the costs of making it
– create customer satisfaction for customers using it, and
– generate higher future revenues for the company selling it

 Companies need to design products that satisfy customer

expectations and ensure that design specifications are
met
 Need to understand customer value- to provide high
quality product

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Why is quality cost management important?

 Quality costs can be substantial amount

 Source of significant cost savings ( cost management)

 Source of competitive advantage (product differentiation)

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Question 1

Quality of conformance refers to: 

 A.  the degree to which the product meets its design and product
specifications
 
B.  the extent to which the actual product is designed for its
external use
 
C.  an ideal that can never be attained
 
D.  a cost control that is achievable

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Question 2

In order to have a high-quality finished product:

A.  appraisal costs must exceed external failure costs

 
B.  the product's design specifications must meet customers'
expectations
 
C.  the product must meet the standards of its design
 
D.  the product's design specifications must meet customers'
expectations AND the product must meet the standards of its design

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 Question 3

Define two basic aspects of quality are quality of design and

conformance quality and give an example of each.
Answer: Quality of design measures how closely the
characteristics of products or services meet the needs and wants
of customers.
Example, customers of photocopying machines want copiers that
combine copying, faxing, scanning, and electronic printing. If the
photocopy machines fail to meet these customer needs, sales will
fall.
 Conformance quality refers to the performance of a product or
service according to design and product specifications.
 Example, if a photocopy machine constantly has paper jams or
breaks down, it fails to satisfy conformance quality
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2. Quality from the Balance Scorecard

Quality from the Four Perspectives of
the Balanced Scorecard
1. Financial—four categories of quality costs
2. Customer—Nonfinancial measures of customer satisfaction
3. Internal business process—Analyzing quality problems and
improvements in quality
4. Learning and growth—Quality improvements

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Financial Perspective - costs of quality (COQ)
Cost incurred to
1. Prevention costs – incurred to prevent defects
preclude the production of products that and minimize
do not conform to specifications appraisal activities

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 The costs of quality

2. Appraisal costs – incurred to detect which

of the individual units of products do not Cost incurred
conform to specifications to detect
defects

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The costs of quality

3. Internal failure costs – incurred on defective

products before they are shipped to
customers

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The costs of quality

4. External failure costs – incurred on

defective products after they are shipped to
customers

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The costs of quality
High level of prevention cost- lead
1. Prevention costs to low level of internal and external
as well as appraisal costs and vice
versa.
2. Appraisal costs

3. Internal failure costs

4. External failure costs

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Question 4

Appraisal costs in quality programs are incurred:

A. to value the fixed assets of the firm

B. to detect which production units do not conform to specifications
C. to value ending work in process
D. by external appraisers to value the costs of external failures

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Question 5

Prevention costs refer to costs incurred:

A. in preventing defects
B. because defective products or services are delivered to
customers
C. in determining customer demand
D. when defective products or services are detected before
leaving the business

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Question 6

External failure costs refer to costs incurred:

A. in preventing defects
B. in determining whether defects exist
C. because defective products or services are delivered to
customers
D. when defective products or services are detected before
leaving the business

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Cost of quality report

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Lecture example 1

Lightning Technologies Ltd (LTL) produces two

extrusion machines that are very popular with plastics
manufacturers: model ABC and model XYZ. Model
ABC has an average selling price of $60000, and
model XYZ sells for about $55000. The company is
concerned about the differing performance of the two
machines in relation to quality, and has collected the
following information:

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Lecture example (Contd..)

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Lecture example (Contd..)

Required:
1. Classify the above quality costs as prevention,
appraisal, internal failure or external failure.
2. Prepare a cost of quality report for model ABC in
dollars. In addition, add a further column showing all
quality costs as a percentage of sales revenue.
3. Prepare a similar cost of quality report for model
XYZ.
4. Comment on the two reports, noting whether the
company is ‘investing’ its quality expenditure
differently for the two machines.
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 Solution Q1
• Warranty costs: external failure
• Reliability engineering: prevention
• Rework at ITI’s manufacturing plant: internal failure
• Manufacturing inspection: appraisal
• Transportation costs to customer sites to fix
problems: external failure
• Quality training for employees: prevention

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 Model ABC Model XYZ
$ % costs of % sales* $ % cost % sales*
quality of
quality

Internal failure (rework at ITI):

80 units  35%  $1 900 $53 200 12.09 1.11

100 units  25%  $1 600 $40 000 9.22 .73

External failure:

Warranty costs:

80 units  70%  $1200 67 200

100 units  10%  $400 4 000

Transportation to customers: 29 500 15 000

Total 96 700 21.99 2.01 19 000 4.38 .39

Appraisal (inspection):

300 hours  $50 15 000 3.4 .31

500 hours  $50 25 000 5.76 .45

Prevention:

Reliability engineering

1600 hours  $150 240 000

2000 hours  $150 300 000

Quality training 35 000 50 000

Total 275 000 62.52 5.73 350 000 80.64 6.36

Total cost of quality $439 900 100.00 9,16 $434 000 100.00 7.89 MONASH
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 Solution Q3
Yes, the company is ‘investing’ its quality expenditures differently
for the two machines. LTL is spending more on prevention and
appraisal for Model XYZ – more than 80 per cent of the total
quality expenditures, compared to approximately 62 per cent for
Model ABC.

The net result appears to be lower internal and external failure costs
for Model XYZ and, lower total quality costs as a percentage of
sales (7.89 per cent for XYZ and 9.16 per cent for ABC).

This problem illustrates the essence of total quality management

(TQM) systems when compared with conventional quality control
procedures. Overall costs are lower with TQM when compared
against systems that focus on ‘after-the-fact’ detection and rework.
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 Using cost of quality information

Benefits of COQ information

 Creates opportunities
– focuses managers’ attention on the costs of poor quality by
placing a dollar figure on it
– helps managers reduce costs and improve quality
– helps managers monitor the effects of the ‘quality effort’ and
identify the optimal level of quality for the firm

 Provides visibility
– Helps prioritise quality improvement programs
– Shows that firms typically spend money on the wrong categories

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Optimal level of quality performance TQC is lowest – savings in failure
costs more than offset the increase
in prevention cost
- Defect rate down to the point
called the acceptable quality level.

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Cost of quality - unobserved costs

 Some costs of quality are frequently not accounted for

due to estimation difficulties and being unrecorded in the
company accounting records

 Opportunity costs as a result from poor quality:

1. Contribution to profit foregone from lost sales
2. Loss of goodwill
3. Lost production
4. Lower prices

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 COQ information – a word of caution

 Need to recognise expenditure lag

– Quality costs first increase, then decrease
– managers may be reluctant to incur initial expenses- why
because QC is a discretion expense- may reduce ROI

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 Question 7

Which of the following types of costs are incurred in

precluding the production of products that do not conform to
specifications?

A) prevention costs
B) appraisal costs
C) internal failure costs
D) external failure costs

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Question 8
Which of the following describes appraisal costs?

A) they are incurred to prevent the production of products that do

not conform to specifications
B) they are incurred to detect which of the individual units of
products do not conform to specifications
C) they are incurred on defective products before they are
shipped to customers
D) they are incurred on defective products after they have been
shipped to customers

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Question 9

Which of the following is considered a cost of quality?

A) external failure costs
B) opportunity costs
C) sunk costs
D) contingent liabilities

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The Customer Perspective
• Nonfinancial measures of customer satisfaction include:
1. Market research information on customer preferences for and
customer satisfaction with specific product features.
2. Market share.
3. Percentage of highly satisfied customers.
4. Number of defective units shipped to customers as a percentage
of total units shipped.
5. Number of customer complaints.
6. Percentage of products that fail soon after delivery.
7. Average delivery delays.
8. On time delivery rate.

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 The Internal-Business-Process
Perspective
• Three techniques for identifying and analyzing quality
problems:
1. Control charts.
2. Pareto diagrams.
3. Cause-and-effect diagrams.

Copyright © 2018, 2016, 2015 Pearson Education, Ltd. All Rights Reserved.
1. Control Charts
 Control charts are a graph of a series of successive
observations of a particular step, procedure, or operation
taken at regular intervals of time.

 Each observation is plotted relative to specified ranges that

represent the limits within which observations are expected
to fall.

 Only those observations that fall outside the control limits

are regarded as nonrandom and worth investigating.

Copyright © 2018, 2016, 2015 Pearson Education, Ltd. All Rights Reserved.
 Quality control charts

 Statistical quality control is a formal means of

distinguishing between random and nonrandom
variations in an operating process
 Control charts are a part of statistical quality control

UCL

LCL
Source: Horngren, C., Datar, S., Foster, G., Rajan, M., Ittner, C., Wynder, M., Maguire, W., & Tan, R. (2013). Performance Measurement & Management:
Linking Strategy to Value Creation. Frenchs Forest, NSW: Pearson Australia.

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2.Pareto Diagrams
• Pareto diagram—a chart that indicates how frequently each
type of defect occurs, ordered from the most frequent to the
least frequent.
• Observations outside control limits serve as inputs for Pareto
diagrams.

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 Pareto diagrams

 Observations
outside control
limits serve as inputs
for Pareto diagram
 Pareto diagram – a
chart that indicates
how frequently each
type of defect
occurs ordered from
the most frequent to
the least frequent

Source: Horngren, C., Datar, S., Foster, G., Rajan, M., Ittner, C., Wynder, M., Maguire, W., & Tan, R. (2013). Performance Measurement & Management:
Linking Strategy to Value Creation. Frenchs Forest, NSW: Pearson Australia.

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 Cause-and-Effect Diagrams
• Problems identified by the Pareto diagram are analyzed
using cause-and-effect diagrams.
• Identifies potential causes of defects.
• Also called fishbone diagrams because they resemble the
bone structure of a fish.
• The large “bones” coming off the backbone represent the
main categories of potential causes of failure.
• The four categories are: human factors, methods and
design factors, machine-related factors and materials and
components factors.

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Cause-and-Effect Diagram, Example
Exhibit 19.5 Cause-and-Effect Diagram for Fuzzy and Unclear Photocopies at Photon Corporation

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 Nonfinancial Measures of Internal-
Business-Process Quality
• Percentage of defective products manufactured.
• Percentage of reworked products.
• Number of different types of defects analyzed using
control charts, Pareto diagrams, and cause-and-effect
diagrams.
• Number of design and process changes made to
improve design quality or reduce the costs of quality.

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The Learning-and-Growth Perspective
for Quality
• Experience and qualifications of design engineers.
• Employee training.
• Employee turnover ratio.
• Employee empowerment.
• Employee satisfaction.

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Question 10
What is it that a statistical quality control chart does?
A) it shows a graph of a series of random events of a process
B) it plots each observation relative to specified ranges that
represent the expected distribution
C) it plots control observations over various periods of time
D) it plots only those observations outside specified limits

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Question 11
Which of the following is a chart which indicates
how frequently each type of defect occurs?

A) control chart
B) Pareto diagram
C) scatter diagram
D) fishbone diagram

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3. Total Quality Management

 Total quality management (TQM)
 “a holistic management philosophy that strives for continuous
improvement in all functions of an organization” (Kaynak 2003,
p.406).

 Total = Involvement and input of everyone in the organization (

top management and its employees)

 Quality =Focuses on meeting customer need and

requirements by achieving continuous improvement in
processes. Meeting customer requirements is central to all
activities.

 Management = The way operation, policies and procedures are

conducted ( include training and instruction to all employees)
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 Total quality management (TQM) –Philosophy

 Making it right the first time

 Zero defects should be the goal

 Aims to improve the quality

of life for producers,
consumers and investors

 Quality is a journey,
not a destination

 Staff empowerment ( product and process improvement)

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4. Six Sigma and quality

accreditation
Quality culture Accreditation

 Six Sigma is a business improvement methodology that

uses a structured approach involving rigorous data
analysis and unique team based structures
– E.g. Motorola- reduce the level of defects in the manufacturing
process.

 Improvement to existing processes / improvement for

new products or processes
– Collection and detailed
analysis of data is key

– Projects are prioritised

based on improvements
to financial performance

 Could Six Sigma could stifle creativity and innovation? MONASH

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 Quality culture Accreditation

 Organisations may achieve quality accreditation by

meeting international ISO 9000 quality standards
– Accreditation is no guarantee of TQM practice, but probably a
good indicator

– Accreditation is a process of assurance, highly process driven

and based on documentary evidence

See http://
www.iso.org/iso/home/standards/management-standards/iso_9000.
htm
for more information.

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5. Financial and Non Financial

Measures
Advantages of non-financial measures of quality

 Non-financial measures of quality are often easy to

quantify and understand
 Non-financial measures direct attention to physical
processes and to areas that need improvement
 Non-financial measures provide immediate short-run
feedback on whether quality-improvement efforts have
succeeded
 Non-financial measures are useful indicators of future
long-run performance

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Advantages COQ financial measures of quality

 COQ focuses managers’ attention on the costs of

poor quality
 COQ measures assist in problem solving by
comparing costs and benefits of different quality-
improvement programs and setting priorities for cost
reduction
 COQ provides a single, summary measure of quality
performance for evaluating tradeoffs among the costs of
prevention, appraisal, internal failure and external failure

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Question 12

An important difference between financial measures of quality and

nonfinancial measures of quality is that ________.

A. financial measures of quality tend to be useful indicators of future long-

term performance, while nonfinancial measures have more of a short-
term focus
B. nonfinancial measures of quality tend to be useful indicators of future
long-term performance, while financial measures of quality have more
of a short-term focus
C. nonfinancial measures are generally too subjective to have any long-
term value, while financial measures are too objective for taxation
purposes
D. nonfinancial measures are generally too subjective to have any short-
term value, while financial measures are too objective to have medium-
term value

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Question 13
Somo Corp is committed to its quality program. For 2018, it has budgeted $2,000,000
for prevention costs and $800,000 for appraisal costs. Internal failure has a budget of
$80 per failed item, while external failure has a total budget of $400,000. Product
Testing has proposed to management a change in the 2018 budget for a new method
of testing products. If management decides to implement the new method, $1.60 per
unit of appraisal costs will be saved, up to a level of 130,000 tests. No additional
savings are expected past the 130,000 level. The new method involves saving of
$75,000 in training costs and $55,000 in yearly testing supplies. Traditionally, 5% of all
completed items have to be reworked. External failure costs average $120 per failed
unit. The company's average external failures are 1% of units sold. The company
carries no ending inventories.
Required:
a) What is the adjusted budget for appraisal costs, assuming the new method is
implemented and 800,000 units are tested during the manufacturing process in
2017?
b) How much do internal failure costs change, assuming 600,000 units are tested
under the new method and it reduces the amount of unacceptable units in the
manufacturing process by 35%?
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 Solution
 (a) Current Budget   $ 800,000
Additions: Training $75,000  
Additions: Supplies 55,000 (130,000)
Savings: 130,000 × $1.60   (208,000)
Adjusted budget   $ 462,000

 (b)
Current budget $80 × 0.05 × 600,000 = $2,400,000
Savings rate × 0.35
Net savings (reduction in internal failure costs) $ 840,000

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