Cost-Effectiveness Based Performance Evaluation for Suppliers and Operations

October 2002
Volume 9 • Number 4

Contents

Cost-Effectiveness Based Performance Evaluation for Suppliers and Operations

by Chee-Cheng Chen and Ching-Chow Yang, Chung-Yuan Christian University

This research establishes a cost-effectiveness based performance evaluation system for suppliers and operations. The purpose is to provide a methodology for “integrating supplier and manufacturer capabilities through a common goal, profitability improvement, based on lowering the cost of purchased materials.” The merits of measuring supplier quality performance using total involved quality cost (TIQC) include: 1) a common measurement language—money, and 2) very simple and visible numbers along with direct and indirect loss ratios to help management and employees understand the importance of doing things right the first time. This study investigated the interactions and mutual movements among the three groups in the supply chain, (supplier, manufacturer, and customer), and integrated the results from different stages (incoming inspection, internal customers, external customers) and identified severity levels for quality events (rejects, sorting, rework, shutdown, scrap, and customer returns). A TIQC along with a predetermined cost structure and the principle of management by objectives were developed and used in planning and establishing this evaluation system for supplier performance. Very satisfactory and exacting results were obtained in the system simulation and demonstration. The evaluation system using TIQC as proposed in this study can be very beneficial for manufacturers in selecting the best suppliers and driving operational quality improvements.

Key words: management by objective, quality cost, quality improvement, supply chain, supplier performance evaluation

INTRODUCTION

In traditional management, manufacturers select suppliers based on price with the goal of reducing product cost. The performance appraisal for the purchasing staff is focused on reducing the raw material purchase price. Madu (1998) noted that it is a mistake to award contracts to suppliers and vendors without a total cost assessment. Often, the bidder with the lowest cost may not offer the best quality (Verma and Pullman 1998). Cost should be related to value and quality of work. Suppliers are pitted against one another to get the lowest price. The greater the number of competing suppliers, the better it is for the customer company. Cheng and Podolsky (1996) specified that supplier selection based upon the lowest bid may motivate the supplier to calculate bids based upon purchase price variances. This method carries hidden costs, as it is frequently believed that the lowest bid is composed of the lowest material costs. This sentiment, however, fails to consider the cost of quality, which can include scrap and rework costs, high warranty expense, and inspection requirements. Other costs that are discounted include coping with poor delivery performance.

Selection based on the lowest bid can be deceptive, as the lowest initial cost may actually be the most costly in the long run. A successful customer-supplier relationship depends on factors other than price alone. Evans and Dean (2000) suggest that purchasing decisions should be based on the quality of the product and not just its cost. Low purchase cost often does not equal low overall cost. If an inexpensive part causes a large amount of scrap or leads to high warranty costs, that “inexpensive” part may end up having a higher overall cost.

In the past, there was little communication between a company’s departments. This style led organizations to lower the competition strength when becoming “customer-oriented.” Many companies have not been successful in facing these pressures because they have taken a narrow, functionally focused approach to operational improvement. One reason functionally focused initiatives do not work well is that the solutions often involve changes to multiple functions, not just improvements in a single function. Another reason is that functionally focused initiatives address narrow concerns and preempt a broader examination of the issues. Typically, more radical, “out-of-the-box” thinking is necessary to address broader issues effectively. Increasingly, firms are being organized by processes rather than by function. One of the biggest advantages of focusing on processes instead of functions is that processes enable the organization to focus on the customer (Copacino 1997; Stahl and Grigsby 1997). Cross-functional and cross-company teams can add product and service combinations that add value. By including customers and suppliers in the new product development team, a company can be sure it is developing products that fit its customers’ needs while taking advantage of its suppliers’ core competencies (Schorr 1998). Weele (2000) emphasized that consumers and some industrial manufacturers should strongly recommend that their suppliers organize their activities around processes, which are relevant for their customers, rather than functions.


The purchasing function directly affects a firm’s ability to compete through its impact on quality, cost, technology, and supplier responsiveness. Today, organizations are trying to reduce the number of suppliers and establish longer-term buyer-seller relationships to achieve a competitive advantage through more effective use of the supply base. Hence, supplier evaluation and selection is becoming increasingly critical in the development of effective longer-term relationships and performance. The measurement and evaluation of a supplier’s performance will therefore assume added importance in the ongoing supplier evaluation process. Methods will be required to establish and accurately reflect the total costs of doing business with individual suppliers. A total-cost approach to supplier evaluations recognizes that the purchase price is only a fraction of the cost associated with material receipt. Other costs exist that are not traditionally measured, yet are significant to long-term sourcing decisions and, ultimately, to bottom-line profitability (Krause, Pagell, and Curkovic 2001). The purchasing focus must be shifted from primarily a unit-price oriented approach to a total-cost based performance evaluation of the suppliers. Such an approach incorporates incoming quality, quality in the manufacturing process, and other related costs as measurable factors that should be included when evaluating the total costs of buying from various suppliers. In fact, the total-cost based selection and retention of appropriate suppliers becomes key to product consistency and to the organization’s ability to meet competition. Choosing the right suppliers is becoming critical to the success of most firms (Monczka and Trecha 1988).

When a supplier fails to meet quality, delivery, and reliability requirements, additional costs are incurred by the buying organization. These excess costs, direct overhead, and the consequential loss have an immediate impact on the firm’s available resources. Waste of human resources, equipment, and time, which all cost money, adversely affects the firm’s competitive position. Unsatisfactory supplier performance that results in additional costs is often not reflected in the purchase price or charged back to the supplier. These costs are hidden costs. Management of the purchasing base requires a formal, total-cost based approach for evaluating supplier performance. A total-cost based evaluation is necessary to recognize suppliers that can positively impact an organization’s profitability by providing the lowest total cost to the buying firm. By establishing supplier performance indexes related to supplier nonperformance costs, the hidden costs associated with inadequate quality, delivery, reliability, and other elements of performance can be identified.

The development of the total-cost based supplier and operation performance evaluation system described in this article is based on the authors’ work with an international electronics firm (D Company). The relevance of the system to design, purchasing, and the other functions is presented, as well as a review of other such systems. In addition to describing the system, the process used to develop such an approach is reviewed, and conclusions are drawn.

Literature Review and Research Objectives

The literature on supplier performance evaluation, cost of quality, cost measuring systems, and activity-based accounting and activity-based management applications is varied. In this section, the authors review literature that closely relates to the topic of interest, leading to the development of their research focus.

Companies commonly use one of three basic supplier measurement and evaluation techniques or systems today: a categorical system, a weighted-point system, or a cost-based system. These systems differ in their ease of use, level of decision subjectivity, required resources to use the system, and implementation costs. Monczka, Trent, and Handfield (1998) compared the advantages and disadvantages of these systems, and concluded that, by far, the most thorough and least subjective is the cost-based system, emphasizing the impact of the material’s quality cost upon the product cost, and raising the total cost of ownership concept. The use of total cost of ownership information permits one to reduce the subjectivity in the selection process by indicating and qualifying the supplementary activities caused by the suppliers. It forms an objective basis for negotiations between the buyer and suppliers and can increase the efficiency of long-term contracts between the buyer and seller (Degraeve and Roodhooft 1999). The total cost of ownership measurement has increasing importance as purchasing strives to select the lowest total cost source of supply (not the lowest price). Total cost of ownership applies not only to items sourced from external suppliers but also to internally manufactured items (Carr and Ittner 1992; Cavinato 1992; Ellram and Sifferd 1993; Degraeve, Labro, and Roodhooft 2000).

Cost of quality (COQ) concepts affect operating costs, profitability, and customer needs. Higher product quality standards have been a trend among world-class manufacturers since the 1960s. Several studies indicated that COQ made up 30 percent of all U. S. manufacturing costs (Albright and Roth 1992). COQ is a significant cost driver that firms need to control effectively to sustain their competitive advantage. U. K. (Machowski and Dale 1998) and U. S. (Shank and Govindarajan 1994) firms have used J. M. Juran’s (Juran and Gryna 1970) four-category matrix to classify COQ. This total quality management (TQM) theorist stated that control costs (prevention and appraisal) are positively related to increases in product quality. Conversely, failure costs (internal and external) are negatively related to increases in product quality. Crosby (1984) urged manufacturers to actively measure COQ. He classified COQ into two broad categories:

  1. The price of conformance, which includes the costs of ensuring that goods are produced defect free
  2. The price of nonconformance, which includes all costs incurred because of defective quality problems occurring on the first run.

The cost of conformance is a fraction (2 to 3 percent vs. 20 to 25 percent) of that generated by nonconformance costs (Rust 1995). Shank and Govindarajan (1994) noted the isomorphism between Juran’s (Juran and Gryna 1970) and Crosby’s (1984) COQ typologies. Crosby’s conformance costs included Juran’s prevention and appraisal costs. His nonconformance costs included Juran’s internal and external failure costs (Tansey, Carroll, and Lin 2001).

COQ approaches have many objectives (Wasserman and Lindland 1996). Perhaps the most important is to translate quality problems into the “language” of upper management—the language of money. Quality problems expressed as the number of defects typically have little impact on top managers, who are generally more concerned with financial performance. Quality cost information helps management evaluate the relative importance of quality problems and thus identify major opportunities for cost reduction (Evans and Lindsay 1999). Harrington (1987); Juran, Gryna, and Bingham (1988); Chen and Tang (1992); Atkinson, Hamburg, and Ittner (1994); and Bland, Maynard, and Herbert (1998) used the term “cost of poor quality” in place of quality costs or the cost of quality that speaks directly to the real issue and challenge at hand: reducing and eliminating the nonvalue-added costs and waste associated with poor quality.

Breyfogle, Cupello, and Meadows (2001) believe organizations, both public and private, that can virtually eliminate the cost of poor quality can become the leaders of the future. In most organizations, 40 percent of the total effort, both human and mechanical, is waste. If that waste can be eliminated or significantly reduced, the per-unit price that must be charged for goods and services to yield a good return on investment is greatly reduced and often ends up being a price that is globally competitive (Cupello 1999). On average, the cost of material for an enterprise comprises about 60 percent to 80 percent of the total cost. Not surprisingly, the focus has shifted to managing these costs, thus the market for enterprise resources planning and supply chain management tools is expected to continue to grow well into the next decade. This shift has also caused a drastic change in procurement practices. The role of purchasing has shifted from simply placing orders to providing strategic management of the company’s assets and profitability (Ptak 2000).

Activity-based costing (ABC) is a methodology that measures the cost and performance of activities, resources, and cost objects. Resources are assigned to activities, and activities are then assigned to cost objects based on their use. ABC recognizes the causal relationships between cost drivers and activities (Player and Keys 1999). Many companies are beginning to apply various forms of ABC to assess their “hidden” costs and benefits (Turney 1990; Ittner 1999). Christopher (1998) was convinced the advantage of using ABC is that it enables each customer’s unique characteristics in terms of ordering behavior and distribution requirements to be separately accounted for. Once the cost attached to each level of activity is identified (for instance, cost per line item picked, cost of delivery, and so on), a clearer picture of the true cost-to-serve emerged (Kaplan and Cooper 1997). The demand for more accurate and relevant management accounting information has led to the development of activity-based management (ABM). ABM is a systemwide, integrated approach that focuses management’s attention on activities with the objective of improving customer value and the resulting profit. ABM emphasizes ABC and process value analysis. ABC improves the accuracy of assigning costs by first tracing costs to activities and then to products or customers that consume these activities. Process value analysis, on the other hand, emphasizes activities analysis trying to determine why activities are performed and how well they are performed. The objective is to find ways to perform necessary activities more efficiently and to eliminate those that do not create customer value (Hansen and Mowen 2000).

One difficulty facing companies today is the inadequacy of most cost accounting systems to supply data in a suitable format that considers total cost. The main reason for these difficulties is the lack of adequate methods for determining the financial consequences of poor quality. Many quality-related costs, such as rework, scrap, warranty claims, and quality department expenditures, may be readily available from existing accounting records, especially in manufacturing firms. Accounting systems that are not designed with quality costing in mind, however, typically identify only a fraction of the quality-related expenditures (Ittner 1999). The development of better computer applications offers the prospect of being able to collect and structure cost information in a way that is more relevant to planners and decision makers. The object of this research is to specify the interaction and mutual movement of the three groups in the supply chain (supplier, manufacturer, and customer) based on the quality performance in different stages and its consequential cost. This research aims to establish a rating system for the supplier’s performance from the orientation of the lowest total involved quality cost (TIQC) using an efficient predetermined cost structure matrix and prove the suitability of this system using real case simulation and demonstration.

TOTAL COSTS OF QUALITY MEASUREMENT SYSTEM DEVELOPING

One goal of the quality management function is to educate top management about the long-range effects of total quality performance on the profits and quality reputation of the company. Management must understand that strategic planning for quality is as important as strategic planning for any other functional area. When the strategic plan addresses cost issues, quality cost considerations should be prominent. Quality costs should be considered first. Since quality costs are waste costs, their reduction is always taken from the “fat” of the organization (Pyzdek 2001). Quality cost measurement and reporting, key features in any management accounting system for both manufacturing and service industries, should provide both operational and financial information about quality, including information such as the number of defects, quality cost reports, quality cost trend reports, and quality cost performance reports (Hansen and Mowen 2000).

This research refers to a 12-step process for establishing a quality cost reporting system recommended by the Institute of Management Accountants (Evans and Lindsay 1999) and the process for developing a total cost system as defined in the book Purchasing and Supply Chain Management, by Monczka, Trent, and Handfield (1998). The following six-step process for a total cost of quality measurement system is suggested:

  • Step 1: Define the structure of total quality cost and the categories of costs
  • Step 2: Identify total cost items to evaluate
  • Step 3: Identify nonperformance events and criteria for each item or commodity
  • Step 4: Identify affected functions or activities and associated costs
  • Step 5: Record nonperformance occurrences and the related costs
  • Step 6: Establish standardized and objective measurement scales

Prior to implementation, a needs analysis should be performed to determine if a COQ program could benefit the company. The needs assessment should also include a benefit/cost analysis and an implementation plan. As with any major quality project, a sponsor should be found and management support secured (Pyzdek 2001).

Structure of Total Cost of Quality and Categories of Costs

Any cost accounting system should include three fundamental elements: cost, cost object, and cost measurement process. Management accounting systems are structured to measure and assign costs to entities called “cost objects.” A cost object is any item, such as products, customers, departments, projects, activities, and so on, for which costs are measured and assigned (Hansen and Mowen 2000). Cost objects are products, departments, or jobs for which costs are collected and summarized by unit (business unit). The reporting can be done and analyzed using items (for products), departments of shops (for departments), and projects or events (for job costing).


Woods (1994) stated that four categories of quality cost are usually considered: prevention costs, appraisal costs, internal failure costs, and external failure costs. Another COQ (or more accurately, cost of poor quality) relating to customer behavior is sometimes mentioned in TQM implementations but is seldom pursued. It is called “opportunity cost of sales lost” due to a customer’s experience with a poor quality product or because of poor satisfaction with the handling of quality delivery events. These intangible effects on quality costs are often called “hidden quality costs” (Krishnan, Agus, and Husain 2000). Some companies have found a “multiplier effect” between the measured costs and true failure costs. Bank (2000) specified one of the goals of TQM is to halve the COQ and to halve it again over time. There are three main cost areas: cost of conformance; cost of nonconformance; and cost of lost opportunities to be identified, measured, and improved. Perhaps the most difficult COQ to quantify is the cost of lost opportunities. This is the lost revenue resulting from the loss of existing customers, the loss of potential customers, and the lost business growth arising from the failure to deliver products and services at the required quality standards. Examples include cancellations due to inadequate service at the required response times, ordering of competitors’ products because the company’s products are not available, the intangible cost of a demoralized work force, and the wrong products offered for a specific customer’s application. Westinghouse Electronics Corporation reported that its “experience indicates that a multiplier effect of at least three or four is directly related to such hidden effects of quality failure. To measure it or to place a dollar value on it is difficult, if not impossible” (Campanella 1999). It is defined and called “consequential cost (or loss) of failure” (which includes engineering time, management time, shop and field downtime, delivery problems, lost orders, lost market share, customer dissatisfaction, and decreased capacity) in this research.

This research integrates these viewpoints and refers to the “cost of quality matrix” specified by Evans and Lindsay (1999) in the book The Management and Control of Quality, which is the basis of the authors formulating the total cost of quality matrix. They have added a category of costs, “consequential costs of failure,” in this new structure of quality cost measurements, as shown in Table 1.

The components and the element hierarchy in this total cost of quality matrix are defined next. These components are more convenient for further discussions and computerizing this matrix.

1. The total cost of quality matrix represents the quality cost structure of a business unit, to form a “unit of quality cost,” say “,” where the columns refer to the department and the rows to the involved costs.

denotes the number of quality costs from item A to Y, the matrix order is (5 x 5). The number of TIQC can be obtained as:

2. The rows in matrix refer to the “category of quality cost,” including prevention costs, appraisal costs, internal failure costs, external failure costs, and consequential costs of failure.

The subtotal of the prevention costs can be obtained as the sum of the values for items A, F, K, P, and U.

3. The columns in matrix refer to “department of quality cost,” including design engineering, purchasing, production supporting, and sales. The number of departments can be determined by the cost accounting system requirements. The subtotal of the quality cost caused by purchasing can be obtained as the sum of the values for items F, G, H, I, and J.


4. The corresponding element of department cost is the “item of quality cost,” including A, B, C,…,Y.

5. The components forming a quality cost item are quality cost activities. Let Ai;  i  denote the activity of item A. For examples, the constitution of A, F, G, H, I, and J can be shown as (Campanella 1999):

A: Prevention costs of product/design development

A1 Design quality progress reviews
A2 Design support activities
A3 Product design qualification test
A4 Service design—qualification

F: Prevention costs of purchasing

F1 Supplier review
F2 Supplier rating
F3 Purchase order technical data reviews

G: Appraisal costs of purchasing

G1 Receiving or incoming inspection and tests
G2 Measurement equipment
G3 Qualification of supplier product

H: Internal failure costs of purchasing

H1 Disposition costs for purchased material rejects
H2 Purchased material replacement costs
H3 Purchased material reject rework

I: External failure costs of purchasing

I1 Complaint investigation/customer or user service
I2 Extra rework for returned products
I3 Recall costs for field failures

J: Consequential costs of failure—purchasing

J1 Extra production line loss due to purchased material failures
J2 Delivery delay loss due to purchased material failures
J3 Lost sales due to purchased material failures
J4 Extra liability costs due to purchased material failures

The quality cost of A can be obtained by adding up the values for the associated activities, A1, A2, A3, A4,…, An. The activity is the most fundamental component in this quality cost measurement system. Activities are people and/or equipment doing work for other people. Thus, an activity is a basic unit of work performed within an organization useful to managers for purposes of planning, controlling, and decision-making. Activities not only act as cost objects but also play a prominent role in assigning costs to other cost objects (Hansen and Mowen 2000).

Identifying Items of Total Cost Evaluation

George and Weimerskirch (1998) noted that successful companies establish internal performance indicators that reflect the factors that produce customer satisfaction and quality improvement. Customer-focused measurement is based on actual performance vs. customer expectations. Measuring for measurement’s sake has no value. The best measures are customer focused and goal oriented. Companies should only measure what they can control. Quality cost measurement need not be accurate to the penny to be effective. The purpose of measuring such costs is to provide broad guidelines for management, decision making, and action. The very nature of COQ makes such accuracy impossible. In some instances, it will only be possible to obtain periodic rough estimates of such costs as lost customer goodwill, cost of damage to the company’s reputation, and so on (Pyzdek 2001).

Not all purchase items require total cost measurement. Most buyers find that 20 percent of purchased items contribute to 80 percent of the total cost. The best total cost candidates include items that have the highest dollar impact on the purchasing budget. Problem items contributing high nonperformance costs are another logical choice (Monczka, Trent, and Handfield 1998). In selecting activity measures that relate the amount of activity in supplying items to the outputs that are passed to beneficiaries, activity measures that fit each company will be highly dependent on the details of its internal processes. The effectiveness of a material or service stream is determined by understanding the cost and time components for the total stream of use. This includes all of the acquisition costs plus the actual usage cost, maintenance costs, training costs, environmental impact costs, and the time required to deliver the value from the purchase stream. (Riggs and Robbins 1998).

A bill of material, operations process charts, and process flow diagram should be required for a clear picture of the relations and sequences from raw material to final product in all assembly processes.

  • The American Production and Inventory Control Society defines a bill of material as “a listing of all of the subassemblies, intermediates, parts, and raw materials that go into making the parent assembly showing the quantities of each required to make an assembly.”
  • Operation process charts record in sequence only the main operation and inspections. They are useful for a preliminary investigation and give a bird’s-eye view of the process.
  • A process flow diagram graphically and sequentially shows the various steps, events, and operations that make up a process. It provides a picture, in the form of a diagram, of what actually happens when a product is made or a service is performed (Arnold and Chapman 2001).

Identifying Nonperformance Events/Criteria for Each Item or Supplier

Pooler and Pooler (1997) specified in their book, Purchasing and Supply Management, aspects that are tracked by some companies to measure suppliers’ quality performance. These aspects are reported using a survey and include (the sequence of events is followed by rank of percent from high to low): rejects, production stoppages due to poor quality, rework in dollars or hours, scrap generated in use of the material, customer complaints, and warranty costs resulting from failure.

In considering industrial practice, this research added “sorting” as a quality cost event that may occur in incoming, in process, or final products in stock and deleted “warranty cost,” which is treated as the consequential loss from customer complaints. Breyfogle, Cupello, and Meadows (2001) indicated that often within an organization’s business segments there is no established link between customer values and the process that creates the product or service. Customer complaints are valuable data that can help an organization identify the source of process errors. Six quality cost events relating to poor material and supplier quality with respect to different levels in severity are defined in this study:

  • Rejects
  • Sorting
  • Shutdown
  • Rework
  • Scrap
  • Customer complaints

Different quality cost events will generate different activities, affected departments, problem sources (to which to allocate the quality cost), and associated costs.


Identifying Affected Functions or Activities and Associated Costs

COQ is always mixed in with general business operating costs. It is likely that the cost measurement system will be redesigned to allow the routine collection of such costs when the job consists of many parts or products, rather than a single item like a building. What process stage should be identified in the event that occurred? Who should be the owner in the event of a quality cost item that relates to the cost allocation? Items scrapped near the end of their processing cost more than those scrapped early. Rework costs can also be entered into a separate account for each job, rather than being added to the existing basic labor, setup, or material accounts for the job. Where items must be sent back to an earlier step, the cost of moving, setup, and scheduling may be included in the total job costs (Woods 1994).

To apply the total cost of quality matrix, as per Table 1, one must ascertain all activities, items, and the owner of these costs. In considering the different values added in the various manufacturing processes, one can expand Table 1 based on the required cost centers (subdepartments of production) to measure the associated costs and allocate the quality costs more accurately. This can also be applied to the expansion of the quality event classification. Dividing the production cost center into performing, insertion, assembly, testing, and packing, one can form a new total cost of quality matrix, as shown in Table 2.


A corresponding total cost of quality matrix for a specific quality cost event with the affected departments and required activities can be defined easily using the standard operation procedure relating to this event. Following is an example:


The “scrap” quality cost event is caused by material failure. The owner of this quality event is purchasing. To follow the standard operation procedure for “scrap,” the affected departments include purchasing and production, supporting the required cost-item activities including G, H, J, L, M, P, and R (refer to (1), matrix ). Let denote the corresponding total cost of quality matrix for this event. This matrix is represented as:


The TIQC of this event is the sum of the values of G, H, J, L, M, P, and R.

There will be a corresponding quality cost matrix with respect to a specific quality cost event and its affected functions and activities. This corresponding matrix is unique and is always a sub-set of matrix of equation (1). The authors can summarize all of the possible quality cost events vs. all possible owners (departments) of quality cost to formulate a table of interrelations, as shown in Table 3. (There will be a bigger matrix depending on the number of cost centers defined.)


Evans and Dean (2000) were convinced that analyzing the costs of poor quality is one approach that many firms use to identify improvement opportunities. Once the activities are identified for each category, resource drivers can be used to improve the cost assignments to the individual activities. Root (cost) drivers can also be identified, especially for failure activities, and used to help managers understand what is causing the costs for these activities. This information may then be reviewed and used to select ways to reduce the quality costs.

Recording Nonperformance Occurrence and Related Costs

The cost associated with material/supplier nonperformance is established from each functional activity using the aforementioned matrix approaches. Quality costs can also be classified as observable or hidden. Observable quality costs are those that are available from an organization’s accounting records. Some cost methods can be applied to calculate or estimate the involved quality costs depending on the cost sources and characteristics after the events/activities are identified.

1. Observable costs

  • Material and product-related costs. These costs can be calculated using product costing. Costs are assigned to products using quantity and price standards for all three manufacturing costs: direct material, direct labor, and overhead.
  • Activities and handling-related costs. These are all of the examples of quality costs listed in the prior section, elements of A, B, C,…, X, and Y of (1), matrix except the “consequential costs of failure,” E, J, O, T, and Y items. All of the quality costs are observable and should be available from the accounting measurements using well-defined handling procedures or instructions. Once activities are identified and described, the next task is to determine the cost of performing each activity. This requires identifying the resources being consumed by each activity. Activities that consume resources are items such as labor, material, energy, and capital. The cost of these resources is found in the general ledger, but how much is spent on each activity is not revealed. Thus, it becomes necessary to assign the resource costs to activities using direct tracing and resource drivers. For labor resources, a work distribution matrix/sheet is often used. A work distribution matrix simply identifies the amount of labor consumed by each activity and is derived from the interview process (or a written survey) (Hansen and Mowen 2000).

    The costs associated with each nonperformance “event” can be the actual cost per event or an average cost per event. These data may be collected through interviews with selected/related managers and nonmanagement personnel to establish average resources, times, and the cost associated with various supplier nonperformance events (Monczka and Trecha 1988; Monczka, Trent, and Handfield 1998).

    Methods of data collection include individual interviews, surveys, focus groups, and time studies (Player and Keys 1999).

2. Hidden costs

Hansen and Mowen (2000) noted that hidden costs are mainly in the external failure category, defined as the “consequential costs of failure” separately in this study. These hidden quality costs can be significant and should be estimated. Although estimating hidden quality costs is not easy, two methods have been suggested: the multiplier method and market research.

  • The multiplier method assumes that the total consequential costs of failure are simply some multiple of the measured costs:

    Total consequential costs of failure = (Measured external failure costs)

    Where is the multiplier effect, the value for is based on experience. Assessing the amount of consequential costs for failure allows management to determine more accurately the level of resource spending for prevention and appraisal activities. Specifically, with an increase in failure costs, one would expect management to increase its investment in control costs.

  • Formal market research methods are used to assess the effect poor quality has on sales and market share. Customer surveys and interviews with members of a company’s sales force can provide significant insight into the magnitude of a company’s hidden costs. Market research results can be used to project the consequential cost of failures or future profit losses attributable to poor quality.

A key obstacle to carrying out a COQ determination is that there is no clear definition/agreement among practitioners as to what should be included or how much should be assigned dollar-wise (Woods 1994). This research suggests adopting the “predetermined method,” which can eliminate the hesitation of firms to apply quality cost measurements because of concerns regarding complexity, logical conflict among cases/events, more resources required, taking too much time, or incompleteness.

The predetermined method involves establishing a database for the individual matrix (mentioned in Table 3, to treat “departments” as X-axis of geometry, “quality events” as Y-axis so as to choose the right matrix for cost calculations) covering materials, products, business units as fully and completely as possible, based on various standard operation procedures. User-friendly executions of quality cost measurements can be obtained. Users can select/identify quality cost events, processes of occurrence, affected product lines, quantity, material part number (material failure), and the problem source, to get the amount of TIQC. There are other advantages in this method including: 1) easy maintenance for handling procedure changes, new product phase-in, and organization changes; 2) a continuous, consistent, and objective base of comparisons that can prevent abnormal discounting or over-counting; and 3) efficient cost reporting, to sort and plot the trend in the cost category, cost center (department), and cost event…all kinds of cost objects and for their measuring true total cost (price). A computerized system of TIQC measurement using this predetermined method has been developed for Company D that is accurate and user-friendly.


Establish Standardized and Objective Measurement Index

Management wants quality costs reported in a way that is meaningful and can be easily interpreted. One format for reporting quality costs is with index numbers or indices. Index numbers are ratios that measure quality costs relative to some base value, such as the ratio of quality costs to total sales revenue or the ratio of quality costs to units of final product. These index numbers can be used to compare quality management efforts between time periods or between departments for functions (Russell and Taylor 2000). The main use of quality cost data is to justify and support quality performance improvement. Quality cost data help identify problem areas and direct resources to these areas. To be effective, the COQ system must be integrated with other quality information systems to assure that root causes will be addressed. Statistical analysis can be used to correlate quality cost trends with other quality data to help direct attention to problem causes (Pyzdek 2001).


A company should select performance measures and indicators that best represent the factors that lead to improved customer, operational, and financial performance (Evans and Dean 2000). Christopher (1998) defined the overall objective of the supplier development team as reducing the costs and increasing the efficiency for both parties—in other words a “ win-win” outcome. Anything that can reduce the costs for purchased supplies can have a significant effect on total costs. The development of a standardized ratio or index supports direct comparisons or supplier ranking based on total cost. Monczka and Trecha (1988) initiated the index relating total cost to contract purchase price. Atkinson, Hamburg and Ittner (1994) have the same idea:

The best index rating is 1.0. A higher index means worse total cost performance.

Bhote (1991), in his book, Next Operation as Customer (NOAC), defined a measure of quality effectiveness and cost effectiveness for manufacturers: “total quality cost as a percentage of sales.” This is also a good and simpler index. The manufacturer is always a supplier to its customers. If the index could be defined and performed properly, the measurement of total (quality) cost allows a firm to select the right suppliers and reduce its material costs by providing visibility to the true cost of purchased material.

SUPPLIER AND OPERATION PERFORMANCE EVALUATION

Quality costs are powerful indicators to motivate management to go to TQM programs. By reporting grand total costs of quality, management can be convinced of the need to improve quality. Reporting quality costs as a percentage of profit, quality costs as a percentage cost of goods sold, quality costs as a percentage of product price, and so on, management can be presented with the size of a quality problem. This will also stimulate management to look for opportunities to reduce costs. The opportunity costs of lost sales will force management to think about reducing customer dissatisfaction and defection to competitors. The COQ concept will also help a company introduce a financial control system for the quality control function (Madu 1998).

W. Edwards Deming emphasized, “In the past, purchasing departments concentrated on the cost of purchase and ignored the cost of use. Some purchasing agents look at price tag but are blind to total cost” (Latzko and Saunders 1995). This research suggests a simplified measure for supplier performance that can be designed and applied to comparisons among operations, suppliers, and other cost objects. This measure must be easily converted to trends, ranking, and other advanced/quantified index and extended applications (for example, the measuring of true total costs and true unit price) using a unified computer-calculating formula. To use Deming’s definition, the percentage of the supplier’s TIQC to purchase price (PP) is the measurement of “cost of use.”


Interpret this index as follows: “Over a specified period, a buyer paid the supplier dollars (purchase price) for an item, but the total cost of doing business with the supplier is actually percent greater.” A perfect index rating is 0.0 percent. This index allows a buyer to compare one supplier’s total cost performance index against another supplier’s regardless of the actual dollar values. The accurate measurement of a specific part’s true unit price is one of extended applications of SPI. The formulas are shown here:

True total costs = PP + TIQC (6)

True unit price = (True total costs) ÷ (Total used volume) (7)

Similarly, the measure of an operation’s or an organization’s performance can be the percentage of the operation’s TIQC to budgeted amounts (BA).

The OPI can be deployed to the performance measurement for activity, cost item, event, product, and so on. Bhote (1991) emphasized that without a base for measurement it becomes nearly impossible to effect quality, cost, and cycle-time improvements and suggested that “the cost measurement should be at least an order of magnitude lower than the expected tangible benefits” as an important principle for applying management by objectives (MBO) to a performance evaluation. Applying MBO concepts can provide the priority and space for improvements.

In effect, ABM and continuous improvements can support the robust zero-defect view of quality costs. There is no optimal trade-off between control and failure costs. The latter are nonvalue-added costs and should be reduced to zero. Some control activities are nonvalue added and should be eliminated. Other control activities are value added but may be performed inefficiently, and the costs caused by the inefficiency are nonvalue added. Thus, the costs for these categories may also be reduced to lower levels. Managers of support and producing departments usually are held accountable for the performance of their units. Their ability to control costs is an important factor in their performance evaluation. This ability is usually measured by comparing actual costs with planned or budgeted costs. If actual costs exceed budgeted costs, the department may be operating inefficiently, with the difference between the two costs the measure of that inefficiency. Similarly, if actual costs are less than budgeted costs, the unit may be operating efficiently (Hansen and Mowen 2000).


EXAMPLE AND COMPARISON OF RESULTS

Table 4 provides an example of the method used to calculate the SPI.

The TIQC matrix is represented as

The TIQC of this event is $400, the sum of the values of A, F, H, J, M, P, Q, and R.

SPI = ($400 ÷ $3300) ¥ 100% = 12.1%

Another example is presented to demonstrate how the proposed index and its extended applications, formula (5), (6), and (7), can be compared to the purchase price and true unit price index. The basic manufacturer’s purchased material data (part no.: 20018F1) from five suppliers in the first quarter (Q1) and second quarter (Q2) of year 2001 are given in Table 5. Significantly exacting and effective performance rating results from SPI with the MBO principle were obtained and compared to the purchase price index.

CONCLUSIONS

The cost-effectiveness based supplier performance evaluation using the TIQC analysis presented in this research was intended to provide methodologies and approaches in an efficient, accurate, and objective manner for:

  • Total quality companies, in their ability to identify the costs actually caused by each downstream activity, department, product, cost, and organization unit.
  • The management of companies to clearly understand and try to measure all intangible quality costs (consequential cost of failures), which have greater impact on the company’s performance image in the eyes of its customers.
  • Internal departments and supplier performance promotions by identifying areas of nonperformance along with responsibility for corrective actions. This analysis also helps identify cost savings opportunities.

How does one link the quality cost measurements to ISO 9000 implementation? Standard operation procedures can be organized along with activities, processes, and departments that will be a valuable task for accurate cost-activity calculations. Further study on this topic should be considered.


ACKNOWLEDGMENT

The constructive comments and valuable remarks on content and structure of this article from the anonymous reviewers are greatly appreciated. This work is partly supported by the DELTA Electronics Foundation.

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BIOGRAPHIES

Chee-Cheng Chen is a doctoral candidate at the Department of Industrial Engineering, Chung-Yuan Christian University, Taiwan. He is currently the quality manager for DELTA Electronics, Inc. His research interests include the study of quality management, process improvement, and supply-chain management. He is a member of ASQ and the Institute of Industrial Engineers.

Chen has worked in the electronics industry for more than 15 years. He was the general manager for Taiwan and director of quality for the Asia Pacific region at two respective U. S. invested companies in Taiwan from 1993-2000; a marketing manager and quality assurance manager of an electronics manufacturer in Taiwan from 1990-1993; and head of the vender quality assurance department at Philips (Chupei), Taiwan from 1987-1990.

He received his M.B.A degree at the Graduate School of Management Science, I-Shou University, Taiwan, and his bachelor’s degree in industrial engineering from Chung-Yuan Christian University in Taiwan in 1985. He can be reached by e-mail at carl2000@ms43.hinet.net .

Ching-Chow Yang is an associate professor at the Department of Industrial Engineering, Chung-Yuan Christian University, in Taiwan. He teaches courses in project management, total quality management, quality management of service business, and policy and strategy management. He is presently on the board of assessors for the National Quality Award of the R.O.C.

Yang has consulted for more than 100 companies in Taiwan and in Mainland China on policy and strategy management, project management, and total quality management (TQM) studies. He leads several project teams in TQM and six-sigma approaches in some manufacturing and service industries. He has published books on TQM and service quality management. He has also published a number of journal articles and conference papers. Yang received his doctorate in management science from National Chiao-Tung University, Taiwan. He may be contacted by e-mail at chinchow@cycu.edu.tw .

 

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