External failure costs

External failure costs are one of the four types of quality costs among prevention costs, appraisal costs and internal failure costs. Together with internal failure costs they are called failure costs (in PAF typology) . External failure costs are considered, out of other quality costs, as very significant, quite difficult of evaluate but very devastating as may reach hundreds of millions that company would need to spend. They may be related to both products are services and appear when defect exists. It is assumed these kind of failures could not be discovered before delivery to customer as they are mostly hidden costs. They have bad impact on image of the company and its reputation. External failure costs are generated :

1. as consequence of not meeting customer requirements (understood also as not meeting satisfaction and need of a customer),
2. because of lack of fulfilling specific requirements,
3. from lost opportunities.

Types of expenses related to external failure costs

Expenses coming from external failure costs might be visible in many costs appearing in the company, such as :

• returns,
• allowances,
• recalls,
• repairs and servicing,
• shipping and handling,
• replacing a defective product,
• guaranty,
• complaints,
• product liability,
• legal fees,
• costs of lawsuits,
• lost market share,
• other maintainability costs,
• environment costs,
• societal costs,
• goodwill costs.

How quality costs impact external failure costs

It is assumed that higher costs are spent on prevention costs and appraisal costs, failure costs will decrease (including external failure costs). It is coming from the fact that more products should be produced with good quality. Optimal level is reached when prevention and appraisal costs are balanced against failure costs.

Examples of External failure costs

• Legal costs incurred when a customer sues for defective products.
• Warranty claims and replacement parts for customer complaints.
• Cost of reworking and disposing of defective products.
• Cost of customer returns and refunds.
• Cost of repairing damaged products.
• Loss of sales due to customer dissatisfaction or bad publicity.
• Cost of recall campaigns.
• Cost of investigating customer complaints.
• Cost of providing technical support for a faulty product.
• Cost of hiring a third party to investigate and fix defects.

Advantages of External failure costs

• External failure costs can help to identify and analyze the sources of errors and defects. They give an opportunity to take proactive measures to prevent similar issues in the future.
• External failure costs can help to identify the weak spots in the production process. This knowledge can be used to improve the quality of the product and reduce the risk of customer dissatisfaction.
• These costs can help to detect the reasons for customer complaints and suggest strategies for eliminating them.
• By analyzing external failure costs, companies can identify the areas where investments should be made for improvement. This helps to increase customer satisfaction and improve the overall quality of the product.
• External failure costs can also help in developing effective strategies for customer service and after-sales support. This ensures that customers get the best possible experience with the product.

Limitations of External failure costs

External failure costs are costs incurred when the product or service fails to meet customer requirements. These costs can be significant, as they relate to the unplanned and additional costs associated with the failure of the product or service. However, there are several limitations to consider when assessing the impact of external failure costs. These include:

• Lack of visibility: external failure costs are often difficult to identify and measure, as they may be incurred after the product or service has been delivered, and often only become apparent when customer complaints arise.
• Poorly defined customer requirements: external failure costs can be increased if customer requirements are not well-defined and understood. This can lead to costly rework and delays in resolving customer issues.
• Poor communication: external failure costs can be exacerbated by poor communication between the customer and the supplier. This can lead to delays in resolving customer issues, as well as added costs for rework.
• Poor quality control: external failure costs can be caused by inadequate quality control processes, which can lead to more frequent customer complaints and costly rework.

Other approaches related to External failure costs

Other approaches related to External failure costs include:

• Cost of Poor Quality (COPQ): COPQ is the costs associated with providing products and services that do not meet customer requirements.
• Warranty Costs: Warranty costs are those incurred due to the repair or replacement of defective products that have already been sold to customers.
• Lost Sales: Lost sales occur when customers are not satisfied with the quality of a product or service, and thus choose not to buy.
• Customer Service Costs: Customer service costs are those associated with the effort to satisfy the customer after a product or service fails to meet their expectations.
• Regulatory Compliance Costs: Regulatory compliance costs are those related to meeting governmental regulations and standards.

In addition to external failure costs, there are other approaches related to quality costs, including Cost of Poor Quality, Warranty Costs, Lost Sales, Customer Service Costs, and Regulatory Compliance Costs.

Footnotes

External failure costs — recommended articles

Prevention cost — Stockout costs — Benefits of risk management — Cost of poor quality — Quality cost — Product recall — Product knowledge — Internal failure costs — Concentration risk

References

• Finkler S. A., Ward D. M., Baker J. J. (2007), Essentials of Cost Accounting for Health Care Organizations, Jones & Bartlett Learning
• Hansen D., Mowen M. (2005), Cost Management: Accounting and Control, Cengage Learning
• Neyestani B. (2017), Quality Costing Technique: An Appropriate Financial Indicator for Reducing Costs and Improving Quality in the Organizations in "MPRA Paper No. 77375", Department of Civil Engineering, De La Salle University, Philippines
• Razak D. S. A., Mills G., Roberts A. (2016), External Failure Cost in Construction Supply Chains in "Proceedings of the 32nd Annual ARCOM Conference" Vol 2, Association of Researchers in Construction Management, UK
• Vysochynska O. (2016), Total cost of poor quality, University College at Southeast Norway
• Warren C. S., Reeve J. M., Duchac J. (2008), Financial & Managerial Accounting, Cengage Learning

Author: Katarzyna Żurek