Department of Accounting Education

Mabini Street, Tagum City

Davao del Norte
Telefax: (084) 655-9591, Local 116

Big Picture
Week 8 & 9: Unit Learning Outcomes (ULO): At the end of the unit, you are expected to:
a. explain the concept and objective of responsibility accounting system.
b. describe the concept of cost of quality.

Big Picture in Focus: ULOa. explain the concept and objective of responsibility
accounting system.

Metalanguage
In this section, the most essential terms relevant to the topic and to demonstrate ULOa will be
operationally defined to establish a common frame of reference as to how the texts work in your
chosen field or career.
1. Responsibility accounting – is a specific unit of an organization assigned to a manager
who is held accountable for its operations and resources.

Please proceed immediately to the “Essential Knowledge”.

Essential Knowledge
Managers are vital in the organization’s success and survival. Manages were given certain
authority to decide for the attainment of the organization’s goal. Each manager’s performance is
judged by how well he or she manages those items under his or her control. The manager is then
held responsible for the deviations between budgeted goals and actual results.

1. Responsibility center – is a specific unit of an organization assigned to a manager who is

held accountable for its operations and resources. Each manager’s performance is judged by
how well he or she manages those items under his or her control.

2. Responsibility accounting – is central to any effective profit planning and control system. It
is a system that recognizes various decision centers throughout an organization and traces
cost, revenues, assets and liabilities where pertinent by areas of responsibility. It operates on
the premise that managers should be held responsible for their performance, the activities of
their subordinates and all activities within their responsibility center.

Through responsibility accounting, managers will complied to set managerial targets and
formulate strategies to attain the firm’s overall objectives. Control mechanism will be provided
which will serve as the basis in evaluating actual results or performance.

2.1. Advantages of Responsibility Accounting

● It facilitates delegation of decision-making.
● It helps management promotes the concept of management by objective wherein
managers agree on a common set of goals and their performance evaluated on the basis
of their attainment of goals.
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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

● It aids in establishing standards of performance which are used in evaluating the efficiency
and effectiveness of the different units in the organization.
● It permits effective use of management by exception which provides that the manager will
maximize his efficiency by concentrating on those operational factors which are deviations
from plans.

2.2. Disadvantages of Responsibility Accounting

● The negative effect of some decision made in one subunit to the other subunit or to the
organization as a whole.
● Decentralization necessitates a more elaborate reporting system, hence the costs of
gathering and reporting data increases.
● The problems of job duplication or overlapping of functions are usually encountered.

2.3. Prerequisites to the Initiation and Maintenance of an Effective Responsibility

Accounting System
1) A well-defined organization structure
This requires that the spheres of jurisdiction which are set forth in the organization chart
must be clearly established and that a manager’s financial responsibility be defined in
advance.

2) Well-defined and established standards of performance in revenues, costs and

investments.
This requires that an integrated plans for the control of operation, as well as the necessary
procedures to effectuate the plan should be established and maintained.

3) A system of accounting that identifies any revenues, expenses and assets to specific units
in the organization.

4) A system that provides for the preparation of regular performance reports.

This requires that a system of preparing the regular reports showing the planned results,
actual results and the variances should be established.

2.4. Responsibility Centers and their Evaluation

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

The types of responsibility centers are cost center, profit center, investment center and
revenue center.

I. Cost Center
This is a unit within the organization wherein the manager is responsible for minimizing
costs or expenses subject to some output constraints. Example are maintenance
department of a manufacturing company, library section of a school and accounting
department of a trading concern.

Performance of a cost center is evaluated through responsibility cost report based on

standard costs and flexible budgets. To have a fair evaluation of the cost center
performance, the variance analysis report should highlight those costs that are
controllable by the manager of the department concerned.
Types of Costs in Responsibility Cost Report
1. Controllable costs – are costs which may be directly regulated at a given level of
managerial authority.
2. Noncontrollable costs – are costs that may not be directly regulated at a given level
of managerial authority.
3. Direct costs – are costs that can be specifically identified to a certain responsibility
center. Thus, all controllable costs are direct costs, but not all direct costs are
controllable costs.
4. Indirect costs – are composed mostly of costs that are merely allocated to the
responsibility center under consideration. Therefore, are noncontrollable by the
manager of the segment to which the cost is allocated.

Sample Problem:

Shown below is a comparison between the budgeted and actual costs data for the mixing
department headed by Mr. Roland Lopez.

Budget Actual
Salaries & Wages P20,000 P20,000
Supplies 8,000 12,000
Postage & Telephone 2,500 3,700
Repairs & Maintenance 4,000 2,500
Depreciation 3,000 2,000
Light & Water 2,000 2,800

The decrease in depreciation cost is due to the disposal of equipment during the period. The
disposal was approved by the Vice President for Production when Mixing Department reported
that the equipment was not functioning efficiently. The increase in light and water cost is due to
the adjustment in power rates imposed by the DLPC.

Required: Determine the net amount of cost variance that must be considered in evaluating the
performance of the Mixing Department.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

SOLUTION:
Budget Actual Variance Remarks
Direct Costs:
Controllable Costs:
Salaries & Wages P20,000 P20,000 -
Supplies 8,000 12,000 4,000 unfavorable
Postage & Telephone 2,500 3,700 1,200 unfavorable
Repairs & Maintenance 4,000 2,500 1,500 favorable

Non-controllable Cost:
Depreciation 3,000 2,000 -

Indirect Costs:
Light & Water 2,000 2,800 -
TOTAL P3,700 unfavorable

II. Profit Center

This is a unit or segment within the organization wherein the manager is responsible for
the generation or revenues and control of cost incurred in the center. Examples are loans
and discounts department of a commercial banks, ladies wear section of a department
store and college department of a university.

Performance of a profit center is measured by using the contribution approach to cost

allocation or the determination of the profit center’s contribution to indirect costs of the
company. The operating performance of the profit center is generally considered
satisfactory if it is able to generate or even exceed the expected contribution to indirect
cost or common costs of the company.

III. Investment Center

This is a unit or segment within the organization where the manager is responsible for the
control of revenues, costs and investment made in that center. Examples include
corporate headquarters or division of a large decentralized organization such as:
● Branch offices of commercial banks
● Pharmaceutical division
● Subsidiary companies

In addition to performance reports, the performance of an investment center is also

measured with the determined of its return on investment, residual income and
economic value added.

The objective of an investment center or business unit are:

a) Motivate managers to exert a high level of effort to achieve the goals of the firm.
b) Provide the right incentive for managers to make decisions that are consistent with
the goals of top management.
c) Determine fairly the rewards earned by the managers for their effort and skill

Return on Investment (ROI)

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

ROI is a performance measure used to evaluate the efficiency of an investment or compare

the efficiency of a number of different investment.

Advantages of ROI:
1) It is easily understood and has gained wide usage.
2) It is comparable to interest rates of returns of alternative investments.

Limitations of ROI:
1) Although ROI is widely used in evaluating performance, this method is subject to
some criticisms.
2) It results to disincentive for high ROI units to invest in projects with ROI greater than
the minimum rate of return but less than unit’s current ROI.

Formula of ROI:

Net Operating Income

ROI =
Average Operating Assets

Alternative Formula for ROI:

Net Operating Income Sales
ROI = X
Sales Average Operating Assets

Operating Profit Margin X Asset Turnover (Return on

ROI =
sales)

Net operating income (sometime referred to as Earnings before interest and taxes or EBIT)
– is generally used because it is consistent with the base to which it is applied, that is,
operating assets.

Operating assets – include cash, accounts receivable, inventory, plant and equipment (net)
and all other assets held for productive use in the organization.

Residual Income

Residual income is the net operating income that an investment center is bale to earn
above some minimum return on the operating assets. Generally, larger the residual income
figure, the better is the performance rating received by the division’s manager.

Advantages of Residual Income:

1) A unit pursues an investment opportunity costs as long as the return from the
investment exceeds the minimum rate of return set by the firm.
2) The firm an adjust the required rate of return for difference in risk and types of
assets.
3) It is possible to calculate a different investment charge for different types of assets.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Limitations of Residual Income:

1) It is not as intuitive as ROI.
2) It may be difficult to obtain a minimum rate of return.

Formula of Residual Income:

Operating Income P XXX
Less: Minimum required return XXX
(Operating Assets*rate of return)
Residual Income XXX

Economic Value Added (EVA)

EVA is a business unit’s income after taxes and after deducting the cost of capital. The
cost of capital is usually obtained by calculating a weighted average of the cost of the firm’s
two sources of funds – borrowing and selling stock.

The main advantage of using EVA is that it focuses manager’s attention of creating for
shareholders by earning profit greater than the firm cost of capital.
Formula of EVA:
EVA = Net operating income after taxes - (Invested capital*WACC)

Alternative formula:
Operating Income after tax P XXX
Less: desired income XXX
[(Total assets – Current Liabilities)*WACC]

EVA XXX

Sample Problem:
Image Company’s Printing Division incurred the following costs and expenses in 2018:
Direct materials P 400,000
Direct labor 300,000
Factory overhead (37.5% is fixed) 224,000
Selling & administrative (60%fixed) 156,000
Total P 1,080,000

During the year, the division was able to print 400,000 copies. It charged an average of P4.00 per
copy. Digital’s investment in the division amounted to P2,000,000 on January 1, 2018. This
amount increase by P800,000 at the end of the year. Digital normally computes interest on
investments at 18% of average invested capital.

Required:
A. Rate of return on average investment for the year 2018.
B. Residual income (loss) for the year ended December 2018.
C. If the weighted average cost of capital (WACC) is 10% and a tax rate of 30%, what is the
division’s economic value added?

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Solution:
A. Return on average investment (ROI)
P520,000
ROI = = 21.67%
P2,400,000

Sales (400,000 cps.*P4.00) P1,600,000

Less: Variable Costs:
Direct materials 400,000
Direct labor 300,000
Factory overhead (224,000*62.5%) 140,000
Selling & administrative (156,000*40%) 62,400
Total variable costs 902,400
Contribution margin P 697,600
Fixed Costs:
Factory overhead 84,000
(224,000*37.5%)
Selling & administrative 93,600
(156,000*60%)
Total fixed costs 177,600
Operating Income P520,000

(P2,000,000+2,800,000)
Average Operating Assets =
2
= P 2,400,000

B. Residual Income
Operating Income P 520,000
Less: Minimum required return 432,000
(2,400,000*18%)
Residual Income 88,000

C. Economic Value Added

EVA = P364,000 - (P2,400,000*10%)
= 364,000 - 240,000
= P 124,000
*P520,000*(1-.30)

IV. Revenue Center

This us a unit or segment within organization where the manager us responsible for selling
budgeted quantities of various products or services at budgeted price. Examples of
manager of revenue center are:
● A sales representative selling bread to supermarket
● A sales manager distributing automobile to dealers in specific geographic areas
● A manager of the toys department in a local department store.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Managers of revenue centers use variance in sales price and sales mix to monitor or
control their operations. Managers of revenue centers are responsible for achieving
budgeted levels of contribution margin by controlling the number of unit sold, product mix
and selling prices.

Three types of variance and their formulas are useful to revenue center manager in
meeting their goals:

1) Sales Price Variance

SPV = (Actual Sales Price – Master budget Actual

X
sales price) unit sales

This variance shows how much of the difference between actual and budgeted
contribution margin is caused by the difference between actual and budgeted sales
prices.

2) Sales Volume Variance

SVV = (Actual unit sales – Master X Master budget

budget unit sales) average contribution
margin per unit*

*Master budget Master budget total contribution margin

average
=
contribution Master budget sales
margin per unit

This variance measures the difference between actual unit sales and budgeted unit
sales.

3) Sales Mix Variance

Flexible Master
budget budget
Actual
average average
SMV = - X unit
contribution contribution
sales
margin per margin per
unit ** unit

**Flexible Flexible budget total contribution

budget margin
average =
contribution Actual unit sales
margin per unit

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

This variance is a measure of the change in contribution margin caused by selling

products in proportions (mix) different from those that were budgeted.

Sample Problem:
Chips Galore sells two RISC chips to small machine tool manufacturers: R66 and R100. Pertinent
data for 2018:
BUDGETED ACTUAL
R66 R100 R66 R100
Selling price per chip P 50 P 160 P 55 P 155
Variable cost per chip 40 90 43 95
Contribution margin P 10 P 70 P 12 P 60
Fixed cost per chip 6 30 5 25
Operating income P4 P 40 P7 P 35
Sales in units 1,200 400 1,000 1,000

Required:
A. Sales price variance
B. Sales volume variance
C. Sales mix variance

Solution:
A. Sales Price Variance
SPV = (Actual Sales Price – Master budget Actual
X
sales price) unit sales
For R66:
SPV = (P55 – P50) X 1,000
= P5,000 favorable

For R100:
SPV = (P155 – P160) X 1,000
= P5,000 unfavorable

B. Sales Volume Variance

SVV = (Actual unit sales – Master X Master budget
budget unit sales) average contribution
margin per unit*

SVV = (2,000 – 1,600) X 25

= P10,000 favorable

*Master budget average (P10*1,200) + (P70*400)

=
contribution margin per unit 1,600
= P25.00

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

C. Sales Mix Variance

Flexible Master
budget budget
Actual
average average
SMV = - X unit
contribution contribution
sales
margin per margin per
unit ** unit

SMV = (P40 – P25) X 2,000

= P30,000 Favorable

**Flexible budget average (P10*1,000) + (P70*1,000)

contribution margin per =
unit 2,000
= P40

3. Transfer pricing – is the value of goods or services transferred by one segment to another
segment within the company, therefore, a transfer price is an internal price that is charged by
one responsibility center to another responsibility center for goods and services.

The transfer price of interdivisional sales will affect the selling division’s sales and the buying
division’s costs but will not have any direct effect on the company’s profit. However, the
transfer price policy of the company can have an indirect effect on company profit by
influencing decisions of the division manager.

3.1. Transfer Pricing Methods

1) Minimum transfer price – the price set by transfer pricing formula is equal to the differential
costs (generally the variable costs) of the goods being transferred, plus the contribution
margin per unit that is lost to the selling division as a result of giving up outside sales.
Transfer price = differential costs per unit + lost contribution margin per unit

2) Market based transfer price – the price at which the goods are sold in the outside market.
This is the best transfer price in the sense that it will maximize the profits of the company
as a whole provided that a competitive market exists, and divisions are independent of
each other.

3) Cost based pricing – this is based on either the variable costs or full cost of the product.
It includes the following:
a. Variable cost transfer price– is based only on variable or differential costs. But when
fixed costs increase because of a transfer of goods between segments, they are
differential costs and therefore should be included in the transfer price.
b. Full cost transfer price – includes all manufacturing costs (variable and fixed) plus
portion of marketing and administrative costs.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

c. Full absorption cost based transfer price –only the manufacturing costs (variable
and fixed) should be included in determining the transfer price.
d. Cost plus transfer – these method generally apply a normal markup to costs as a
substitute for market prices when intermediate market prices are not available.

4) Negotiated transfer price – managers are permitted to negotiate the price for internally
transferred goods and services. The negotiated price is an attempt to stimulate an arm’s
length transaction between supplying and buying segment.

3.2. Standard costs in Transfer pricing

When a firm uses the standard cost accounting system, it is advisable to use standard costs
instead of actual costs in the determination of transfer prices. This is to avoid passing on to
another division the inefficiencies or efficiencies (variances) in the manufacturing operations
of the selling divisions.

Sample problem:
The Teens Division of Mike’s RTW produces teens’ wear which it sells to the company’s Sales
Division. Cost and production data for the past year are presented below:
Production in units 5,000
Direct materials P100,000
Direct labor 75,000
Factory overhead (60% fixed) 125,000
Selling & administrative (10% variable) 150,000

Required:
A. Full costs
B. Full costs plus 20%
C. Full production costs plus 40%
D. Variable costs
E. Variable manufacturing costs plus 60%

Solution:
A. Full costs
Direct materials P100,000
Direct labor 75,000
Factory overhead (60% fixed) 125,000
Selling & administrative (10% variable) 150,000
Total costs P 450,000
Divided by: Production in units 5,000
Transfer price P90.00

B. Full costs plus 20%

Direct materials P100,000
Direct labor 75,000
Factory overhead (60% fixed) 125,000

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

Selling & administrative (10% variable) 150,000

Total costs P 450,000
Divided by: Production in units 5,000
Cost per unit 90.00
Add: Markup (90*20%) 18
Transfer price P108.00

C. Full production costs plus 40%

Direct materials P100,000
Direct labor 75,000
Factory overhead (60% fixed) 125,000
Total costs P 300,000
Divided by: Production in units 5,000
Cost per unit 60.00
Add: Markup (60*40%) 24.00
Transfer price P84.00

D. Variable costs
Direct materials P100,000
Direct labor 75,000
Factory overhead (125,000*40%) 50,000
Selling & administrative (150,000*10%) 15,000
Total variable costs P 240,000
Divided by: Production in units 5,000
Transfer price P48.00

E. Variable manufacturing costs plus 60%

Direct materials P100,000
Direct labor 75,000
Factory overhead (125,000*40%) 50,000
Total variable manufacturing costs P 225,000
Divided by: Production in units 5,000
variable manufacturing costs per unit P45.00
Add: Markup (45*60%) 27.00
Transfer price P72.00

Self-help

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

You can also refer to the sources below to help you further understand the
lesson:

Cabrera, M. E. (2017). Management Accounting: Concepts and Application. Manila:

GIC Enterprises & Co., Inc.

De Leon, E.D., & De Leon N.D. (2016). Cost accounting. Manila: IC Enterprises &
Co., Inc.

Raiborn, C. A., & Kinney, M.R. (2014). Cost accounting (2014 second edition).
Philippines Hixes Press, Inc.

Let’s Check!
I. Questions:
1. Distinguish between a cost center, a profit center, and an investment center?
________________________________________________________
________________________________________________________
________________________________________________________

2. Define the term transfer pricing and why are transfer pricing systems needed?
________________________________________________________
________________________________________________________
________________________________________________________

II. True or False

Write “TRUE” if the statement is true otherwise write “FALSE” if the statements is
incorrect.

_____ 1. Under a responsibility accounting system, fewer expenses

are charged against managers the higher one moves
upward in an organization
_____ 2. Responsibility accounting functions most effectively in
decentralized organizations.
_____ 3. Return on investment (ROI) encourages managers to
accept all investment decisions that will benefit the
company as a whole when it is used as a measure of
performance.
_____ 4. Whenever the selling division must give up outside sales
in order to sell internally, it has an opportunity cost that
should be considered in setting the transfer price.
_____ 5. If transfer prices are to be based on cost, then the costs
should be actual costs rather than standard costs.

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 Department of Accounting Education
Mabini Street, Tagum City
Davao del Norte
Telefax: (084) 655-9591, Local 116

III. Multiple choice

Encircle the letter that correspond to your answer.

1) Which of the following statements is correct concerning return on investment calculations?

a. Margin equals stockholders' equity divided by sales.
b. Return on investment equals margin divided by turnover.
c. Turnover equals return on investment divided by margin.
d. Sales equals turnover divided by margin.

2) Managerial performance can be measured in many different ways including return on

investment (ROI) and residual income. A good reason for using residual income instead of
ROI is:
a. Residual income can be computed without having to measure operating assets.
b. Managers are more likely to accept projects that are beneficial to the company.
c. ROI does not take into account both turnover and margin.
d. A minimum rate of return does not have to be specified when the residual income
approach is used.

3) Transfer prices
a. reduce employee turnover.
b. are necessary for investment centers.
c. should encourage the kinds of behavior that upper-level management wants.
d. are not used for departments with high amounts of fixed costs.

4) The following selected data pertain to the belt division of Allen Corp. for last
year:
Sales P500,000
Average operating assets P200,000
Net operating income P80,000
Turnover 2.5
Minimum required return 20%
How much is the return on investment?
a. 40% c. 16%
b. 20% d. 15%

5) Division A had the following information:

Asset base in Division A P800,000
Net income in Division A P100,000
Operating income margin for Division A 20%
Target ROI 15%
Weighted-average cost of capital 12%
What is EVA for Division A?
a. P120,000 c. P15,000
b. P96,000 d. P4,000

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 6) Company Y is highly decentralized. Division X, which is operating at capacity,
produces a component that it currently sells in a perfectly competitive market
for P13 per unit. At the current level of production, the fixed cost of producing
this component is P4 per unit and the variable cost is P7 per unit. Division Z
would like to purchase this component from Division X. What would be the
price that Division X should charge Division Z?
a. P 7 c. P 11
b. P 9 d. P 13

Let’s Analyze
PROBLEM 1:
The Motor Division of Super Truck Co. uses 5,000 carburetors per month in its
production of automotive engines. It presently buys all of the carburetors it needs from
two outside suppliers at an average cost of P100. The Carburetor Division of Super
Truck Co. manufactures the exact type of carburetor that the Motor Division requires.
The Carburetor Division is presently operating at its capacity of 15,000 units per month
and sells all of its output to a foreign car manufacturer at P106 per unit. Its cost
structure (on 15,000 units) is:
Variable production costs P70
Variable selling costs 10
All fixed costs 10

Assume that the Carburetor Division would not incur any variable selling costs on units
that are transferred internally.

1) What is the maximum of the transfer price range for a transfer between the two
divisions?

2) What is the minimum of the transfer price range for a transfer between the two
divisions?

In a Nutshell
A multiple-division company is considering the effectiveness of its transfer pricing
policies. One of the items under consideration is whether the transfer price should be
based on variable production cost, absorption production cost, or external market
price. Describe the circum- stances in which each of these transfer prices would be
most appropriate

15
 Q&A List
Do you have any question for clarification?
Questions/Issues Answers
1.
2.
3.
4.
5.

Keywords index
Responsibility accounting Cost center
Profit center Investment center
Revenue center Transfer price

Big Picture in Focus: ULOb. describe the concept of cost of quality.

Metalanguage
In this section, the most essential terms relevant to the topic and to demonstrate ULOb
will be operationally defined to establish a common frame of reference as to how the
texts work in your chosen field or career.
1. Quality –isa measure of excellence or a state of being free from defects,
deficiencies and significant discrepancies. It is brought by strict and consistent
commitment to standards that achieve uniformity of a product in order to satisfy
the customers.

Please proceed immediately to the “Essential Knowledge”.

Essential Knowledge

Managing quality is vital for small businesses in order to achieve success in its
operation. Having quality products it helps to maintain customer satisfaction and
loyalty and reduce the risk and cost of replacing faulty goods.

1. Production view of quality

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Productivity is measured by the quantity of good output generated from a specific
amount of input during a time period. Any factor that either slows down a production
process or causes redundancy it hampers productivity. Activity analysis is performed
to explain the causes of these factors.

2. Consumers view of quality

The consumer’s view of quality reflects on whether the product or service delivers as
it was intended, its rate of failure, or the probability of purchasing a defective unit. The
customer perceives quality as a product’s or service’s ability to meet and satisfy all
specified needs.

Characteristics of a Product Quality Characteristics of a Service Quality

1. Performance 1. Reliability
2. Features 2. Assurance
3. Reliability 3. Tangibles
4. Conformance 4. Empathy
5. Durability 5. Responsiveness
6. Serviceability
7. Aesthetics
8. Perceived quality

3. Benchmarking – means investigating, comparing, and evaluating a company’s

products, processes, and/or services against either those of competitors or
companies believed to be the “best in class.”

3.1. Steps in Benchmarking

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4. Total quality management (TQM)– is a “management approach of an
organization, centered on quality, based on the participation of all its members and
aiming at long-term success through customer satisfaction, and benefits to all
members of the organization and to society.”

5. Types of Quality Costs

Quality costs are the costs related with prevention, detection, and restoration of
product issues related to quality. Quality costs doesn’t mean upgrading the perceived
value of a product to a higher standard. Instead, quality involves creating and
delivering a product that meets or exceed the customer’s expectation.

Quality costs fall into four categories, which are:

Prevention costs – these are costs incurred in order to keep a quality problem
from occurring. It is the least expensive type of quality cost, and so is highly
recommended. Prevention costs can include proper employee training in
assembling products and statistical process control (for spotting processes that
are beginning to generate defective goods), as well as a robust product design
and supplier certification. A focus on prevention tends to reduce preventable
scrap costs, because the scrap never occurs.

Appraisal costs – refers to the cost needed to keep a quality problem from
occurring. This is done through a variety of inspections. The least expensive is
having production workers inspect both incoming and outgoing parts to and
from their workstations, which catches problems faster than other types of
inspection. Other appraisal costs include the destruction of goods as part of the
testing process, the depreciation of test equipment, and supervision of the
testing staff.

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Internal failure costs – an internal failure cost is incurred when a defective
product is produced. This appears in the form of scrapped or reworked goods.
The cost of reworking goods is part of this cost.

External failure costs – an external failure cost when a defective product was
produced, but now the cost is much more extensive, because it includes the
cost of product recalls, warranty claims, field service, and potentially even the
legal costs associated with customer lawsuits. It also includes a relatively
unquantifiable cost, which is the cost of losing customers.

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A firm spends larger amounts on prevention and appraisal costs, the number of
defects is lower and the costs of failure are smaller. If less is spent on prevention and
appraisal, the number of defects is greater and failure costs are larger. The external
failure costs curve begins moving toward vertical when customers encounter a certain
number of defects. The ultimate external failure cost is reached when customers will
no longer buy a given product or any other products made by a specific firm because
of perceived poor quality work.

An information feedback loop should be in effect to link the types and causes of failure
costs to future prevention costs. Alert managers and employees continuously monitor
failures to discover their causes and adjust prevention activities to close the gaps that
allowed the failures to occur. These continuous rounds of action, reaction, and action
are essential to continuous improvement initiatives.

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High quality allows a company to improve current profits, either through lower costs
or, if the market will bear, higher prices. But management is often more interested in
business objectives other than short-run profits. An example of an alternative,
competing objective is that of increasing the company’s market share. Indeed, if
increasing market share were an objective, management could combine the strategies
of increasing quality while lowering prices to attract a larger market share. Giving
greater attention to prevention and appraisal activities increases quality, with the result
that overall costs decline and productivity increases. Lower costs and greater
productivity support lower prices that, in turn, often stimulate demand. Greater market
share, higher long-run profits, and, perhaps, even greater immediate profits result.

Self-help
You can also refer to the sources below to help you further understand the
lesson:

Cabrera, M. E. (2017). Management Accounting: Concepts and Application. Manila:

GIC Enterprises & Co., Inc.

De Leon, E.D., & De Leon N.D. (2016). Cost accounting. Manila: IC Enterprises &
Co., Inc.

Raiborn, C. A., & Kinney, M.R. (2014). Cost accounting (2014 second edition).
Philippines Hixes Press, Inc.

Let’s Check!
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 I. Questions:

1. Why are high-quality products and services so important in today’s global

business environment?
________________________________________________________
________________________________________________________
________________________________________________________

2. What is meant by the term quality?

________________________________________________________
________________________________________________________
________________________________________________________

II. Multiple Choice:

Encircle the letter that correspond to your answer.

1) An all-inclusive definition of quality views it as the ability of products/services to

a. only meet internal design specifications.
b. meet the customer's stated or implied needs.
c. be produced using all value-added production activities.
d. be produced with no rework costs.

2) Which of the following is false as it relates to quality?

a. Quality is the total of all characteristics of a product or service that impacts
on its ability to meet the needs of a specific person.
b. Quality must always be viewed from the user's perspective.
c. Quality is never concerned with what the user thinks, feels, or deems
important.
d. The definition of quality has evolved through time and is more currently
comprehensive than in the past.

3) Denison Company's cost of compliance is P58,000. Appraisal cost is P21,000

and failure cost is P32,000. The company's total quality cost is
a. P53,000.
b. P79,000.
c. P90,000.
d. P111,000.

For Questions 4 – 7:

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Variance Corporation is a manufacturer of a versatile statistical calculator. The
following information is a summary of defective and returned units for the previous
year.

Total defective units 1,000

Number of units reworked 750
Number of customer units returned 150
Profit for a good unit P40
Profit for a defective unit P25
Cost to rework a defective unit P10
Cost of a returned unit P15
Total prevention cost P10,000
Total appraisal cost P5,000

4) Refer to Variance Corporation. The profit lost by selling defective units not
reworked is
a. P25,000. c. P18,750.
b. P15,000. d. P3,750.

5) Refer to Variance Corporation. The total rework cost is

a. P7,500. c. P2,500.
b. P15,000. d. P3,750.

6) Refer to Variance Corporation. The cost of processing customer returns is

a. P9,000. c. P22,500.
b. P2,500. d. P2,250.

7) Refer to Variance Corporation. The total failure cost is

a. P15,000. c. P11,250.
b. P13,500. d. P8,250.

8) Refer to Variance Corporation. The total quality cost is

a. P15,000.
b. P15,750.
c. P28,500.
d. P11,250.

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 Let’s Analyze
Alpine Sunglasses Company has gathered the following in- formation pertaining to quality
costs of production for June 2020 of heavy-duty sunglasses for skiing:
Total defective units 300
Number of units reworked 190
Number of units returned 50
Total prevention cost P12,000
Total appraisal cost P6,000
Per-unit profit for defective units P10
Per-unit profit for good units P28
Cost to rework defective units P8
Cost to handle returned units P5

Using these data, calculate the following:

a. Total cost to rework
b. Profit lost from not reworking all defective units
c. Cost of processing customer returns
d. Total failure costs
e. Total quality cost

In a Nutshell
By building quality into the process, rather than making quality inspections at the end of the
process, certain job functions (such as that of quality control inspector) can be eliminated.
Additionally, the installation of automated equipment to monitor product processing could
eliminate some line worker jobs.

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In a nation with fairly high unemployment, would employers attempting to implement valid
quality improvements that resulted in employee terminations be appreciated or
condemned? Discuss your answer from the standpoint of a variety of concerned
constituencies, including the consumers who purchase the company’s products.

Q&A List
Do you have any question for clarification?
Questions/Issues Answers
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Keywords index
Quality Benchmarking
Compliance cost Failure cost

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