The “Cost of Quality” (COQ) framework provides a way to understand the financial impact of a company’s quality-related activities. It measures the resources spent on preventing poor quality versus the costs incurred from quality failures. This financial accounting helps organizations see how effectively they are managing quality, which influences both operational efficiency and customer satisfaction. COQ is divided into four categories, but this article will concentrate on the two types of failure costs: internal and external. These represent the price a company pays when its products or services do not meet required standards.
What Are Internal Failure Costs?
Internal failure costs are the expenses a company incurs due to defects identified before a product or service reaches the final customer. These costs are generated when work fails to meet established quality standards and the issues are caught during internal processes. They represent the resources consumed to address problems within the organization, impacting production efficiency. Correcting these internal failures is a direct hit to a company’s profitability, as it involves spending additional money and time on products not made correctly the first time.
Common examples of internal failure costs include:
- Scrap, which refers to defective material or products that cannot be repaired, used, or sold.
- Rework or rectification, which involves the correction of defective materials or errors to make them meet quality standards, including labor and component costs.
- Re-inspecting or re-testing products that have undergone rework, adding more labor and equipment time to the production cycle.
- Equipment downtime resulting from quality problems, such as a machine breaking down due to improper maintenance.
- Failure analysis, the process of investigating the root cause of an internal failure, which requires engineering time and resources.
What Are External Failure Costs?
External failure costs represent the expenses that arise when a defective product or service is delivered to and discovered by a customer. These costs occur because the internal quality control systems did not detect the defect before the product left the company’s control. External failures are considered more damaging than internal ones because they directly affect customers and can have far-reaching consequences. The discovery of a flaw by a consumer can trigger a cascade of expensive and publicly visible problems for the business.
The tangible costs associated with external failures are often straightforward to calculate. These include:
- Warranty claims, where failed products are replaced or services are re-performed under a guarantee.
- Repairs and servicing for products in the field.
- The logistics and processing of customer returns.
- Product recalls, which include the cost of the products, transportation, and communication with the public.
Beyond these direct financial hits, external failures generate intangible costs that can be damaging. Damage to a company’s brand reputation and the loss of customer loyalty can lead to a long-term decline in sales. Handling and responding to customer complaints requires dedicated staff and resources. In some scenarios, defects that cause harm can lead to legal liabilities and costly lawsuits, representing a potentially unlimited financial risk.
Key Differences Between Internal and External Failure Costs
The primary distinction between internal and external failure costs lies in the point of detection. Internal costs are triggered by defects found within the company’s operational processes, before the customer is involved. In contrast, external costs are incurred only after a product or service has been delivered and the defect is discovered by the end user. This timing difference is the driver of all other distinctions between the two.
This leads to a difference in cost magnitude. Internal failure costs, while undesirable, are lower and more predictable, often limited to the cost of scrap, rework, and additional labor. External failure costs can be substantially higher and are often uncapped, especially when considering potential legal liabilities and large-scale recalls. The financial impact can escalate rapidly once the product is in the public domain.
The nature of their impact also differs. Internal failures primarily affect a company’s internal efficiency, productivity, and profitability. External failures, on the other hand, directly impact customer satisfaction, brand loyalty, and public perception. While internal costs can be absorbed within operational budgets, external costs are public-facing and can cause lasting damage to a company’s market standing.
Why Differentiating Failure Costs is Important
Understanding the distinction between internal and external failure costs is important for strategic business planning. This knowledge allows a company to make informed decisions about where to invest its resources to improve quality. By analyzing the sources and magnitude of these failure costs, managers can build a business case for shifting focus from correction to prevention and appraisal activities.
The core principle is that investing money to prevent defects is almost always less expensive than dealing with the consequences of failures. This is especially true when comparing prevention costs to external failure costs. The expenses associated with designing quality into a process, training employees, and conducting audits are often a fraction of the cost of a product recall or the loss of future sales due to a damaged reputation.
By differentiating and tracking these costs, a business can identify its most significant quality problems and prioritize improvement projects. This data-driven approach helps move an organization from a reactive state of fixing problems to a proactive one where it prevents them. This strategic shift not only reduces failure costs but also enhances customer satisfaction and provides a competitive advantage.