Cost of Quality

Just in case you are having trouble bringing up the case, here is the only case in Chapter 11.

Case study question: Swift Airlines Swift Airlines has a daily return flight from London to Nice. The aircraft for the flight has a capacity of 120 passengers. Swift sells its tickets at a range of prices. Its business plan works on the basis of the following mix of ticket prices for each day’s flight:

Swift’s head office accounting department has calculated its costs as follows:

Cost per passenger (to cover additional fuel, insurance, baggage handling etc.) assuming full load £25 per passenger

Flight costs (to cover aircraft lease, flight and cabin crew costs, airport and landing charges etc.) £3,000 (120 @ £25) £7,500 per flight

Route costs (to cover the support needed for each destination) £2,000 (based on ½ of the daily cost of £4,000 (balance charged to return flight)) Business overhead £3,000 (allocation of head office overhead)

Total £15,500

This results in a budgeted profit of £5,500 per flight, assuming that all seats are sold at the budgeted price. The head office accountant for European routes has advised the route manager for Nice that while the Nice–London inbound leg is breaking even, losses are being made on the London–Nice outbound leg. If profits cannot be generated, the route may need to be closed, with the aircraft and crew being assigned to another route. The route manager for Nice has extracted recent sales figures, a typical flight having the following sales mix:

The route manager has calculated a loss on each outbound flight of £1,305. She believes that there is a market for 48-hour ticket purchases if a new fare of £40 was introduced, as this would be £5 less than the price charged by a competitor for the same ticket. She estimates that she could sell 15 seats per flight on this basis. This would not affect either the 7-day purchase, which is used by business travelers, or stand-by fares, which are usually oversubscribed. The additional revenue of £600 (15 @ £40) would cover almost half the loss. The route manager has prepared a report for her manager asking that the new fare be approved and allowing her three months to prove that the new tickets could be sold. Comment on the route manager’s proposal. Case studies provide the reader with the opportunity to interpret and analyze financial information produced by an accountant for use by non-accounting managers in decision-making. There is a suggested answer for the case in Part IV, although the nature of case studies is that there is rarely a single correct answer, as different approaches to the problem can highlight different aspects of the case and a range of possible approaches are possible.

Quality and waste at Planet Engineering

Planet Engineering is a manufacturing company that was acquired through a leveraged buy-out by investors whose objective is to float the company on the Stock Exchange within five years of its acquisition. As part of this goal, Planet Engineering is expected to maximize profits and cash flow and minimize any capital expenditure on new plant and equipment.

Planet’s sales growth has been relatively stagnant despite gross profit margins falling from 35% to 30% over the last three years. Margins have been impacted by considerable rework of Planet’s products due to plant and equipment that is ageing. Planet’s production manager has brought the board of directors’ attention to the fact that the inefficient equipment in the factory and the drive to reduce costs are resulting in waste and complaints from customers about product quality. However, the board does not accept these arguments and has blamed poor management practices for the falling gross profit margins.

The production manager has asked the company’s accountant to identify the specific costs that are associated with poor quality and waste. The accountant has no financial information but does have some non-financial data. She undertakes an analysis of a sample of factory employee timesheets, which identifies about 5% of employee time being spent on rework rather than on productive work. She also reviews the cost of waste removal which is primarily from the factory. Information provided by the waste removal contractor identifies an estimated cost of $40,000 per annum that could be avoided if the results of poor quality production were not sent to landfill sites.

Before submitting her figures to the production manager, the accountant speaks to Planet’s human resources manager about the issues and is advised that as a result of the ageing plant and equipment, there have been a series of notifiable injuries to workers under health and safety legislation. The cost of lost time due to injuries, legal costs, and fines from the regulatory authority have averaged $50,000 over the last three years.

While the accountant is discussing the problem over coffee with Planet’s sales manager, he tells her that several customers are lost each year due to complaints about poor quality. After a brief investigation, the sales manager reports back that lost customers over the last three years who have cited quality problems have cost Planet an average of $400,000 in lost sales each year. This does not include the inability to win new customers who are aware of Planet’s reputation for poor quality.

Planet’s accountant summarizes the estimated annual cost of quality and wastage as follows:

Plus an indeterminate lost margin from reputational damage which affects the likelihood of attracting new customers and skilled employees.

The production manager undertakes his own review into the plant and equipment needs of Planet and determines that an investment of $500,000 would bring the plant and equipment to a standard that would effectively eliminate the rework, waste, and health and safety costs caused by the older plant. Over a five-year period, the depreciation cost to the company would be $100,000 per annum. Even ignoring the ability to win new customers once Planet’s reputation improves, the figures prepared by the accountant suggest that the investment will be more than compensated by cost savings.

The production manager, in presenting this information to the board, is better able to argue that an investment in modern plant and equipment will reduce costs, improve the gross margin, and support efforts to achieve sales growth.