The cost of bad quality: Financial management’s last black hole?

9 reasons why Finance must step up to apply financial discipline - now

Over the past 20 years, we've seen how companies choose - or refuse - to invest in quality.

Quite a few get it wrong.

Not 'wrong' by our standards, the criteria of a quality management software company.

But by yours. By the criteria Finance departments - like yours -use to assess the attractiveness of investment opportunities: strategic alignment and ROI.

In this discussion, we make the case for imposing financial discipline on an area that has escaped systematic financial scrutiny for far too long: the cost of quality. We argue that Finance must take the lead in frank discussions about the economics of quality and continuous improvement.

The cost of bad quality cannot remain a corporate blackhole - uncharted territory where quality dollars disappear without a trace. Finance and Quality must cooperate and collaborate in tracking and controlling these costs.

Only then will companies be equipped to optimize the ROI of their investments in quality, maximize customer satisfaction and thrive.

1. Ignorance of the cost of bad quality is sabotaging financial discipline.
2. The costs of bad quality aren't even recognized.
3. The costs of bad quality are undocumented and poorly controlled.
4. Present-day financial management systems aren't designed to track the full costs of quality.
5. Popular ideas about the behaviour of quality costs are outdated.
6. The economics of continuous improvement are ignored.
7. The ratio of investments in good quality to investments in poor quality must be flipped.
8. Finance must take the lead in ensuring that investments in quality are channelled to areas with the highest ROI.
9. Effective financial discipline requires the right tools to track, control and optimize the cost of quality.

1. Ignorance of the cost of bad quality is sabotaging financial discipline.

Finance departments are in the dark about their cost of quality.

(This is the case even at some of the world's largest manufacturers, with revenues exceeding $5 billion.)

Stats from the Gartner 2022 Cost of Quality Survey Report highlight just how critical the situation is.

Only 13% of respondents reported to Finance about their cost of quality.

Only 9% said Finance helped generate cost of quality data.

Only 3% said Finance reviewed the cost of quality at management meetings.

What on earth is going on? And how long has it been going on for?

1993: "While 83% of companies surveyed [by the accounting firm, Grant Thornton] said that quality is a top priority, less than one-third have calculated costs associated with quality."
The Management and Control of Quality, Evans and Lindsay, 1993

2022: Only 30% of respondents know (or think they know) their total cost of quality.
Findings from the Gartner 2022 Cost of Quality Survey Report

As you can see, the needle hasn't shifted in almost 30 years. The vast majority of manufacturers still cannot put a figure to this equation:

Total Cost of Quality = Cost of Good Quality (Prevention and Appraisal) + Cost of Bad Quality (Internal quality failures that were caught on site + External quality failures that reached the customer)

What does this black hole of untracked costs imply?

Among other things, it suggests that Finance departments cannot do their job of ensuring financial discipline.

Deloitte - a leading global provider of professional services - claims that many life sciences companies are unable to answer fundamental questions about their cost of quality:

There is a common thread running through the industry: the inability to define and quantify the amount of spend needed to support quality and compliance efforts and what the output of those efforts is and should be.
Critical need to define the operational cost of quality, Deloitte, 2018

As we've already seen, the same is true of most manufacturers.

If your Finance department is anything like the 97% who do not review cost of quality data at management meetings, you too may struggle to answer fundamental questions that lie squarely within your remit:

• What is bad quality costing your business? (Not just the obvious costs of bad quality such as scrap and warranty claims, but all the costs of bad quality.)
• What would your operating profit be if your cost of bad quality was completely under control?
• What is your total spend on quality? How much should it be?

And finally, how can you generate the highest return on your quality dollars if you don't know what they are and how they are being spent?

2. The costs of bad quality aren't even recognized.

In most cases, they are simply treated as business as usual.

68% of organizations use current or past cost of quality figures to set their cost of quality targets.
Gartner 2022 Cost of Quality Survey Report.

There is no sustained motivation to reduce them-no incentive to consider if technologies exist to drive them down.

Standard costs include COPQ (Cost of Poor Quality) in its budget base. […] This makes management blind to what quality failures contribute to costs.
"Understanding the Financial Component of Quality", lecture for the American Society for Quality by Dr Gregory Watson, 2020

When this happens, bad quality is normalized. It becomes so embedded in budgetary assumptions that it disappears from view.

The result is sanctioned losses in the form of safety stocks; excess material allowances; standby machines, equipment and personnel - and so the list goes on.

3. The costs of bad quality are undocumented and poorly controlled.

Apart from a few exceptions, no one seems to be taking responsibility for tracking and tackling the costs of bad quality.

Most of the costs [of quality] were the result of poor quality and were avoidable. Finally, while the costs of quality were avoidable, there was no clear responsibility for action to reduce them nor was there any structured approach to do so.
The Management and Control of Quality, Evans and Lindsay, 1993

This remains true more than thirty years later - and the losses aren't trivial either.

On average 2.7% of a company's revenue is lost on the costs of dealing with poor quality.
Gartner 2022 Cost of Quality Survey Report

These losses aren't just avoidable; they are underestimated. Most companies only track the most obvious costs of bad quality.

In any case, no company can predict the potentially astronomical costs of external failure.

Ironically, decisions made in the name of shareholder value over the past two decades have cost [Boeing's] investors $87 billion since 2018. The long-term damage to Boeing's reputation and market position is even greater as Airbus has outsold Boeing in new aircraft orders each of the last five years.
"Why Boeing's Problems with the 737 MAX began more than 25 years ago", Bill George, Working Knowledge, Harvard Business School, 2024

It gets worse.

Internal and external failures have a tendency to snowball - which means their costs do too.

Deloitte coined the term 'organizational distraction' to describe the way companies risk falling behind their competitors when vital resources are redirected to remediation.

Gartner has shown that employees suffer a 'loss of focus' after significant quality incidents. This 'loss of focus' is itself a major cause of work-related errors.

While the average employee makes 134 errors a year, those at organizations with 'lower focus' commit 71% more errors.
Findings from Anticipating Poor Quality Performance: How to Catch Quality Errors Sooner, Gartner, 2021

In this scenario, disrupted production causes a loss of focus, which in turn leads to more mistakes and disruption - driving a never-ending cycle of failure.

4. Present-day financial management systems aren't designed to track the full costs of quality.

Many companies aren't equipped to track and control their costs of quality.

Organizations need a systematic record of all relevant quality costs and a clear quality cost overview.

Whereas in other functional departments it is 'daily business' to implement cost-driven approaches, in quality management, companies are still facing uncertainties and challenges which often hinder them from looking at costs of quality.
Quality cost reduction: Impact of quality-related costs and how to reduce them, Deloitte, 2019

The majority still lack a single, company-wide model that captures the costs of both good and bad quality.

Despite the increasing importance of accounting for quality costs, most accounting systems are poorly designed to handle the task of accounting for such costs.
The Management and Control of Quality, Evans and Lindsay, 1993

Little, it seems, has changed since 1993.

Only 46% of companies surveyed applied a standard cost-of-quality model across all business units.
Findings from the 2022 Gartner Cost of Quality Survey Report

5. Popular ideas about the behaviour of quality costs are outdated.

Although costs of quality typically account for up to 20% of total company sales - and thus provide a huge potential for cost savings - they are often not taken seriously enough when optimizing the business or looking at cost reduction.
Quality cost reduction: Impact of quality-related costs and how to reduce them sustainably, Deloitte, 2019

So why aren't quality costs 'taken seriously'?

We suspect that whether or not you attempt to track your cost of quality will depend on your mental model of how these costs behave.

What do you picture when you think of the interactions between the costs of good and bad quality?

What comes to mind when you consider how investments in good quality (prevention and appraisal) affect the losses incurred by bad quality (internal and external failure)?

There are at least three ways to visualize these costs - two of which are dangerously outdated.

Let's dive in.

(1) The 1950s model: Quality is a trade-off - you can have too much of a good thing.

Outdated 1950s cost of quality model
Source: The Management and Control of Quality, Evans and Lindsay, 1993

If this is the image that comes to mind, you evidently see quality as a trade-off between investments in good quality and the losses incurred by bad quality.

Invest too much in quality and you're cheating your shareholders (by eating into profitability). Spend too little and you're short-changing your customers (with shoddy products).

The ideal amount to invest is, therefore, the point in the graph where you get the lowest level of nonconformance for the lowest total cost.

So far, so reasonable-if you were a manufacturer in the 1950s.

The model originated in the mid-1950s when quality control occurred through inspection. Elimination of defects depended on the relative efficiency of inspectors in finding and sorting out defective products.
Taguchi loss function-famous Ford case study, Paul Allen, YouTube, 2021

Inspecting quality into products is very expensive indeed - which is probably why the cost-of-quality-assurance curve extends upwards to infinity.

It's also a short-term fix that does nothing to improve the quality of the processes that are churning out defective products.

What's more, it completely ignores the revenue effect of quality - the way good quality drives customer satisfaction and loyalty.

Crucially, and most damagingly, it perpetuates and validates the idea that 100% conformance is neither attainable (unless you're willing to spend exorbitant amounts of money) nor desirable.

This may have been true in the 1950s.

As we'll see, it's no longer true now.

(2) The more modern version: Quality always comes at a price - there's no such thing as a free lunch.

Revised cost of quality model
Source: The Management and Control of Quality, Evans and Lindsay, 1993

If this is your idea of quality, it's certainly an improvement.

Instead of positioning continuous improvement as a steep, endless drain on financial resources, it acknowledges the way new technologies have drastically lowered prevention and appraisal costs.

The result is a total cost of quality curve that dips down to a minimum at 100% conformance, thereby offering clear economic justification for pursuing continuous improvement.

But while this model is a better reflection of current realities, it doesn't go far enough.

It fails to capture the way improvements in quality catalyze further improvements - a phenomenon known as the Deming Chain Reaction Theory.

Simply stated, a chain reaction can be established if a firm first improves its quality […] This should then result in reduced rework, improved use of time and materials, and ultimately improvement in total plant productivity.
Peter O'Neill, Amrik Sohal and Chih Wei Teng, "Quality management approaches and their impact on firms' financial performance-An Australian study", International Journal of Production Economics, 2015

(3) The current 2016 model: Quality is free!

The current cost of quality model

Source: M. Plewa, G. Kaiser and E. Hartmann, "Is quality still free? Empirical evidence on quality cost in modern manufacturing",
International Journal of Quality & Reliability Management, 2016

2016 was an important year in cost-of-quality research.

It was the year Deming's Chain Reaction Theory proved to be more than just a theory.

In a landmark study, researchers in Germany uncovered a significant relationship between quality improvements and quality costs:

Given the large sample size at hand with its homogenous origin, we confidently conclude that substantial savings in CoQ [Cost of Quality] are possible when reaching higher overall quality levels. The important management implication of these findings is that higher levels of quality do not necessarily require increased spending on prevention and appraisal.
M. Plewa, G. Kaiser and E. Hartmann, "Is quality still free? Empirical evidence on quality cost in modern manufacturing", International Journal of Quality & Reliability Management, 2016

Once these manufacturers achieved a certain level of quality (90% in this case), prevention and appraisal costs declined - even as the costs of bad quality declined.

In other words, the high performers were achieving lower rates of failure for free.

They were getting something for nothing.

Just think, for a moment, about the ROI of that.

6. The economics of continuous improvement are ignored.

Companies that accept the 1950s trade-off model of quality are, naturally, tempted to do and spend as little as possible on continuous improvement.

They, therefore, never achieve the huge returns that come with higher levels of quality.

But there's another reason why just enough, isn't enough: the Taguchi Loss Function.

According to the Japanese engineer and statistician Genichi Taguchi, producing a product that is 'in spec' (i.e., within quality tolerances) isn't good enough when there's an ideal target value for a critical quality characteristic.

The key words here are 'ideal target value' and 'critical quality characteristic'.

For such products, a goal-post mentality - where your aim is merely to remain 'in spec' - doesn't cut it.

You need to hit the quality bullseye. And you need to keep improving your processes until you can.

Why? Because anything less than this never-ending quest for perfection can be very costly.

According to Taguchi, larger deviations from the target value ('T' on the graph) result in exponentially larger losses.

Taguchi function: Losses (y-axis) rise exponentially on either side of the target value (x-axis)
The Management and Control of Quality, Evans and Lindsay, 1993

The million-dollar question is "Was Taguchi right?".

According to Ford Motor Company, he definitely had a point.

In a case known as The Batavia Gearbox, Ford outsourced production of a gearbox to a foreign competitor, while also continuing to produce it at its plant in Batavia, Ohio.

To Ford's surprise, customers were far less likely to complain about the outsourced gearboxes and demand repairs. Even though the Batavia gearboxes were in spec.

Foreign competitor's gearboxes vs Batavia gearboxes
Ford Transmission Quality Study by Ford Motor Company, YouTube

The difference in external failure costs was so glaring that Ford took the outsourced transmissions apart to analyze their quality.

Foreign competitor's bullseye approach
Ford Transmission Quality Study by Ford Motor Company, YouTube

Ford's goal-post mentality
Ford Transmission Quality Study by Ford Motor Company, YouTube

While the average Batavia gearbox used 70% of the tolerance (a great result), the foreign ones were only using 27%.

Both plants were producing high-quality transmissions - if quality were measured by goal-post standards.

But only one plant was constantly aiming for the ideal bullseye. And customers could tell the difference.

'Zero defects' wasn't enough to satisfy Ford's customers. It might not be enough to satisfy yours either.

Zero defects are a highway down the tube. The sad truth is that all the parts of an apparatus may meet the specifications, yet the apparatus may be unsatisfactory or may even be a total failure. It is necessary in this world to outdo specifications, to move continually toward better and better performance of the finished product.
W. Edwards Deming, Report No.14: Drastic Changes for Western Management, Center for Quality and Productivity Improvement, University of Wisconsin-Madison,1986.

7. The ratio of investments in good quality to investments in poor quality must be flipped.

Prevention and intelligent appraisal are investments.

Refusing to invest in prevention and intelligent appraisal is also an investment - an investment in poor quality. It's a choice to 'invest' in rework, scrap, downtime, customer complaints, warranty claims, potential litigation and the snowball effects of poor quality.

Prevention offers something-for-nothing levels of ROI. Poor quality is a huge drain on resources.

[Good] quality doesn't cost. The accounting model is a snare and a delusion because it hides the cost of not doing-which is 70%. 70% of the cost is [the cost of] poor quality where you scrap the stuff or have to rework it.
Peter Drucker on Joseph Juran and Quality, Interview by the American Society for Quality, 1990s

There are two important reasons why bad quality is so costly. (And why prevention is so much better than cure.)

Bad quality's long shadow
"Understanding the Financial Component of Quality", Lecture for the American Society for Quality by Dr Gregory Watson, 2020

Even relatively low defect rates can have a disproportionate effect on the cost of goods sold.

While a defect rate of between 5% and 7% may not seem like much, it can translate to as much as 40% of your cost of goods sold.

That 5% to 7% that's bad is now following expedited activities. We're doing special things. We're buying extra parts and testing things.
"Understanding the Financial Component of Quality", lecture for the American Society for Quality by Dr Gregory Watson, 2020

This is the 1:10:100 rule developed by George Labovitz and Yu Sang Chang in 1992.

What it means in practice is that quality dollars are not equal - you get a lot more bang for your quality buck the earlier in the production process that you spend it. If inspection costs $1 per unit, rectifying nonconformance might rise to $10, managing corrective and preventive actions to $100, resolving complaints to $1000, and dealing with recalls to $10,000.

It matters whether money is poured into preventing bad quality - or dealing with the consequences of it.
Mahesh Gupta and Vickie S Campbell, "The Cost of Quality", Prevention and Inventory Management Journal, 1995

So why does prevention -the cost of quality category with the highest ROI - continue to receive such a tiny proportion of the overall quality spend?

2016: Ninety-five per cent of [the cost of quality] is expended on appraisal and failure. Reducing failure costs by eliminating the causes of failure can also lead to substantial reductions in appraisal costs.
Barrie G Dale, David Bamford, Ton van der Wiele, Managing Quality, 6th edition, Wiley, 2016

2019: The key challenge is to reduce quality correction costs on the one hand and to shift from quality correction costs to quality prevention costs on the other.
Quality cost reduction: Impact of quality-related costs and how to reduce them, Deloitte, 2019

2022: 81% of quality costs are spent dealing with poor quality (appraisal costs plus internal and external failure costs). Only 19% is spent on prevention.
Findings from the 2022 Gartner Cost of Quality Survey Report

8. Finance must take the lead in ensuring that investments in quality are channelled to areas with the highest ROI.

While Quality departments know they need investments in prevention to drive down nonconformance, they cannot provide the necessary economic justification - without input from Finance.

And while they might sense that resources are being misallocated, they cannot maximize quality dollars - without support from Finance.

The allocation of dollars across the four COQ [cost of quality] categories is just as important as the volume of dollars spent. Furthermore, allocation and volume are fundamentally intertwined.

Prevention programs have the greatest potential for real savings because they eliminate the core causes of problems instead of just treating surface symptoms.
Mahesh Gupta and Vickie S Campbell, "The Cost of Quality", Prevention and Inventory Management Journal, 1995

In 2017, Forbes - in association with the American Society for Quality - conducted a global survey of 1869 senior executives and quality professionals.

Almost half said their quality efforts had increased profitability.

Quality has a direct impact on profit growth.
Forbes Insights, 2017

1 in 5 said their quality efforts had resulted in significant growth (of at least 5%) in the most recent year.

What's more, bad quality was described as a 'productivity sink'- draining time and resources from employees.

Workforce preparedness and outdated processes are the greatest quality issues faced by organizations. The amount of time consumed with quality issues is rising.
Forbes Insights, 2017

And whose responsibility is it to replace 'outdated processes' with 21st-century tools, if not Finance?

Capability building and financial performance are inextricably linked […] The CFO must step outside the finance silo and continually scan company operations to identify opportunities to invest in value-creating capabilities.
The CFO's role in capability building, McKinsey, 2021

9. Effective financial discipline requires the right tools to track, control and optimize the cost of quality.

One of the most effective investments in prevention is a quality management system (QMS) that drives continuous improvement by making insights actionable.

A truly useful QMS would also track quality costs in real time, constantly collecting, updating and quantifying all quality-related operations.

Our experience with manufacturers ranging from Fortune 500 companies to small and medium entities indicates that an investment in a QMS leads to total-cost-of-quality reductions of at least 10%.

If we assume that the average total cost of quality is 5.1% of revenue (as the 2022 Gartner Cost of Quality Survey Report states), a manufacturer with $100 million in revenue stands to save $510,000 per annum.

Yet only 18% of the companies surveyed by Gartner had a QMS.

We believe this discrepancy has everything to do with another significant statistic.

According to the 2022 Gartner Cost of Quality Survey Report, 0% of respondents had a Finance department that focused high-level efforts on the cost of quality.

0%.

A business is not merely an organization chart, all departments striving for individual goals (sales, profit, productivity). It is a network of people, materials, methods, and equipment, all working in support of each other for a common aim.
W. Edwards Deming, from a paper delivered at a meeting of The Institute of Management Sciences, Osaka, Japan, 1989

It's time Finance stepped across organizational silos to track and control the cost of quality.

It's time Finance stepped up to ensure that corporate funds are allocated to investments in quality that offer the highest ROI.

It's high time.

If you'd like to learn more about exercising financial discipline on the black hole of quality costs, we're here to help.