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Internal failure costs

What Are Internal Failure Costs?

Internal failure costs represent expenses incurred by an organization to rectify defects or non-conformances discovered before a product or service is delivered to the customer. These costs are a crucial component of the broader financial category known as Cost of Quality. By identifying and addressing issues internally, businesses aim to prevent more significant expenses and reputational damage that could arise if defects reach the customer. Managing internal failure costs effectively is a key aspect of operations management and a direct indicator of a company's internal quality control effectiveness. Minimizing internal failure costs contributes directly to improved efficiency and a healthier profit margin.

History and Origin

The concept of internal failure costs, alongside other quality-related expenses, gained prominence with the development of the Cost of Quality (COQ) framework. Pioneers in quality management, such as Joseph M. Juran and Philip B. Crosby, emphasized that quality is not "free" but rather a measurable financial investment. Crosby, in particular, advocated for the "price of nonconformance," arguing that organizations choose to pay for poor quality, whether through prevention, appraisal, or failure. The American Society for Quality (ASQ) defines internal failure costs as those associated with defects found before the customer receives the product or service, highlighting their role in assessing the total cost of poor quality within an organization.4 The formalization of these cost categories provided businesses with a structured way to analyze the financial impact of quality deficiencies and prioritize continuous improvement efforts.

Key Takeaways

  • Internal failure costs are expenses incurred when product or service defects are identified and corrected before reaching the customer.
  • They are a subset of the Cost of Poor Quality and contribute to the overall Cost of Quality framework.
  • Examples include rework, scrap, and internal failure analysis.
  • Effective management of internal failure costs can lead to significant savings and improved customer satisfaction.
  • Reducing these costs typically involves investments in prevention costs and appraisal costs.

Formula and Calculation

Internal failure costs are not typically calculated using a standalone formula but rather identified as a category of expenses within the broader Cost of Quality (COQ) model. The aggregate of internal failure costs forms part of the Cost of Poor Quality (COPQ).

The relationships can be expressed as:

COPQ=Internal Failure Costs+External Failure Costs\text{COPQ} = \text{Internal Failure Costs} + \text{External Failure Costs}

And the total Cost of Quality (COQ) is calculated as:

COQ=Prevention Costs+Appraisal Costs+Internal Failure Costs+External Failure Costs\text{COQ} = \text{Prevention Costs} + \text{Appraisal Costs} + \text{Internal Failure Costs} + \text{External Failure Costs}

Where:

  • Internal Failure Costs represent expenses for defects found prior to delivery.
  • External Failure Costs represent expenses for defects found after delivery.
  • Prevention Costs are incurred to prevent defects from occurring.
  • Appraisal Costs are incurred to detect defects.

Companies track these individual cost elements through their financial accounting systems to gain a comprehensive view of their quality-related expenditures.

Interpreting Internal Failure Costs

Interpreting internal failure costs involves analyzing their magnitude and trends relative to sales revenue, production volume, or total operating expenses. A high percentage of internal failure costs suggests inefficiencies in production processes, inadequate quality control measures, or insufficient investment in prevention costs. Conversely, a declining trend indicates successful process improvements and a more robust quality management system.

Organizations use this data to pinpoint specific areas of weakness, such as high rates of rework for a particular product line or excessive waste in a manufacturing stage. Management can then prioritize corrective actions, implement new training programs, or invest in better technology to reduce these costs. The goal is not to eliminate internal failure costs entirely, as some level of defect discovery is inevitable, but to optimize the balance between prevention, appraisal, and failure costs to achieve the lowest overall Cost of Quality.

Hypothetical Example

Consider "SmoothieKing Inc.," a company that manufactures blenders. One month, SmoothieKing Inc. identifies several issues during its final inspection and testing phase before shipping blenders to retailers.

  1. Motor Malfunctions: 50 blenders fail during the motor quality test due to a faulty component from a new supplier. Each faulty motor requires disassembling the blender, replacing the motor, and reassembling it. The labor and parts for this rework cost $15 per blender.
    • Cost: 50 blenders * $15/blender = $750
  2. Cosmetic Blemishes: 20 blenders have noticeable scratches on their casings. These units cannot be sold as new and are designated as scrap. The production cost for each scrapped blender is $30.
    • Cost: 20 blenders * $30/blender = $600
  3. Instruction Manual Errors: The company discovers a significant error in 100 printed instruction manuals. The manuals must be reprinted and replaced in the packaging. The cost of reprinting and insertion is $2 per manual.
    • Cost: 100 manuals * $2/manual = $200

In this hypothetical scenario, SmoothieKing Inc.'s total internal failure costs for the month amount to $750 (motor rework) + $600 (scrapped blenders) + $200 (manual reprinting) = $1,550. This figure highlights the financial impact of defects caught internally, preventing these issues from becoming more expensive external failure costs (e.g., warranty claims, recalls).

Practical Applications

Internal failure costs are a significant metric across various industries, informing strategic decisions in production, supply chain management, and quality assurance. For manufacturers, these costs directly impact production efficiency and competitiveness. For instance, if a car manufacturer discovers a defective batch of brake pads during assembly, the costs of removing and replacing them, along with any associated production delays, are internal failure costs. These costs can be substantial; in one case, an investigation into a Boeing supplier revealed that approximately 6,000 parts, mostly non-structural, were allegedly made with incorrect metals, leading to potential rework on aircraft before delivery.3 Such incidents underscore the real-world financial implications of internal quality lapses.

In service industries, internal failure costs might manifest as re-performing a service due to an error, such as a bank reprocessing an incorrect transaction or a software company fixing bugs identified during internal testing. These expenses, while not always involving physical scrap or rework, still consume resources and reduce potential return on investment. Organizations leverage data on internal failure costs to justify investments in better equipment, employee training, or enhanced inventory management systems, all aimed at preventing defects upstream and bolstering the overall financial health of the business. The National Institute of Standards and Technology (NIST) Manufacturing Extension Partnership (MEP) works with manufacturers to implement quality management systems, which can significantly reduce such costs by improving processes and efficiency.2

Limitations and Criticisms

While tracking internal failure costs is crucial for financial management, the approach has limitations. One criticism is that not all internal failure costs are easily quantifiable or attributable to specific defects. For instance, the lost productivity due to employee demoralization from constantly fixing errors, or the administrative burden of managing rework processes, can be difficult to measure precisely. Furthermore, an overemphasis on reducing internal failure costs might inadvertently lead to under-reporting of defects or pressure on quality control teams to pass non-conforming products, shifting the problem to external failure costs at a later, more expensive stage.

Another challenge lies in establishing a comprehensive and accurate system for collecting these costs. Without robust data collection and financial accounting practices, the reported internal failure costs may not reflect the true extent of the inefficiencies. This can undermine efforts to make informed decisions about quality investments. For example, reports from the Department of Commerce Office of Inspector General (OIG) have highlighted issues with the National Institute of Standards and Technology's (NIST) oversight of its Manufacturing Extension Partnership (MEP), citing inadequate monitoring that led to inefficient use of financial resources, underscoring the importance of rigorous financial tracking in quality-related programs.1 Companies must strike a balance, ensuring that their pursuit of lower internal failure costs does not compromise overall product quality or lead to a reactive rather than proactive quality management strategy.

Internal Failure Costs vs. External Failure Costs

Internal failure costs and external failure costs are both categories within the Cost of Poor Quality, representing expenses incurred due to product or service defects. The fundamental distinction lies in when the defect is discovered.

FeatureInternal Failure CostsExternal Failure Costs
Discovery PointBefore product/service delivery to the customerAfter product/service delivery to the customer
ExamplesScrap, rework, re-inspection, internal failure analysis, waste, downtime due to defects.Warranty claims, product recalls, customer complaints, returns, lost sales, legal fees, brand damage.
Impact on CostGenerally lower, as issues are contained internally.Generally higher, often involving reputational damage and customer dissatisfaction.
GoalMinimize by improving internal processes and controls.Prevent entirely by ensuring internal quality.

The primary confusion between the two often arises because both stem from poor quality. However, understanding the timing of defect discovery is critical for strategic decision-making. Internal failures provide an opportunity for immediate correction and learning before public exposure, whereas external failures carry significantly greater financial and reputational risks, including negative impacts on customer satisfaction and long-term business viability.

FAQs

What are common examples of internal failure costs?

Common examples of internal failure costs include expenses related to scrap (defective products that must be discarded), rework (correcting defects in products or services), re-inspection or re-testing after rework, failure analysis to determine the cause of defects, and waste from inefficient processes or materials that cannot be used.

How do internal failure costs differ from prevention costs?

Internal failure costs are incurred after a defect occurs but before the customer receives the product or service. In contrast, prevention costs are incurred to prevent defects from happening in the first place. Examples of prevention costs include quality planning, employee training, and investing in robust process design. Investing more in prevention often leads to a reduction in internal failure costs over time.

Why is it important to track internal failure costs?

Tracking internal failure costs is important because it provides valuable insights into the efficiency of a company's production or service delivery processes. High internal failure costs indicate areas where quality improvements are needed, helping management identify opportunities to reduce waste, save resources, and ultimately improve the company's profit margin by avoiding more expensive external failures.

Can internal failure costs be completely eliminated?

While the goal is to minimize internal failure costs, completely eliminating them is generally unrealistic. Some level of defects or non-conformances may always occur due to process variability, human error, or unforeseen issues with materials or equipment. The objective of effective quality control is to find the optimal balance where the cost of prevention and appraisal is less than the savings achieved by reducing internal and external failure costs.