Textbook Problem

Danna Wise, president of Tidwell Company, recently returned from a conference on quality and productivity. At the conference, she was told that many American firms have quality costs totaling 20 to 30% of sales. The quality experts at the conference convinced her that a company could increase its profitability by improving quality. However, she was of the opinion that the quality of Tidwell Company was much less than 20%—probably more in the 4 to 6% range. However, because the potential for increasing profits was so great if she was wrong, she decided to request a preliminary estimate of the total quality costs currently being incurred. She asked her controller for a summary of quality costs, with the costs classified into four categories: prevention, appraisal, internal failure, or external failure. She also wanted the costs expressed as a percentage of both sales and profits. The controller had his staff assemble the following information from the past year, 20X1:

1. a. Sales revenue, $37,240,000; net income, $4,000,000.
2. b. During the year, customers returned 40,000 units needing repair. Repair cost averages $9 per unit.
3. c. Twelve inspectors are employed, each earning an annual salary of $80,000. The inspectors are involved only with final inspection (product acceptance).
4. d. Total scrap is 200,000 units. Of this total, ninety percent is quality related. The cost of scrap is about $10 per unit.
5. e. Each year, approximately 800,000 units are rejected in final inspection. Of these units, seventy-five percent can be recovered through rework. The cost of rework is $1.80 per I unit.
6. f. A customer cancelled an order that would have increased profits by $600,000. The customer’s reason for cancellation was poor product performance.
7. g. The company employs 10 full-time employees in its complaint department. Each earns $48,600 a year.
8. h. The company gave sales allowances totaling $180,000 due to substandard products being sent to the customer.
9. i. The company requires all new employees to take its 4-hour quality training program. The estimated annual cost of the program is $120,000.

Required:

1. 1. Prepare a simple quality cost report classifying costs by category.
2. 2. Compute the quality cost-sales ratio. Also, compare the total quality costs with total profits. Should Danna be concerned with the level of quality costs?
3. 3. Prepare a pie chart for the quality costs. Discuss the distribution of quality costs among the four categories. Are they properly distributed? Explain.
4. 4. Discuss how the company can improve its overall quality and at the same time reduce total quality costs.
5. 5. By how much will profits increase if quality costs are reduced to 3% of sales?