Preventing Corporate Failure: Causes, Strategies, TQM and the Cost of Quality

A Nigerian manufacturer wins a large contract, borrows to expand, and then watches three things happen at once: customers return faulty goods, the naira falls and raises the cost of imported inputs, and the managing director, who decides everything himself, ignores the monthly reports. Two years later the company cannot pay its suppliers.

Nobody in the business was surprised in the last month, but many people could have been worried in the first year. Corporate failure is seldom sudden. It has causes that can be named, symptoms that can be seen and, in most cases, remedies that work if they are applied early.

This topic explains the causes and symptoms of corporate failure, the strategies that prevent it, the operational changes a performance management system needs in order to carry out performance improvement, and total quality management with the cost of quality. It builds on the earlier topics on activity based costing and information needs at each level of management, whose techniques and reports several of these strategies use. The next topic covers current developments in management accounting.

Why companies fail, and how to prevent it

Corporate failure is the discontinuation of a company’s operations because it cannot earn sufficient returns or meet its obligations. It usually follows weak governance, poor management and bad investment strategy. Companies are assessed for failure risk with quantitative measures (ratios and models such as the Z-score) and qualitative measures (management quality, information flow, creative accounting), which later topics cover.

Causes

• Economic distress. Recession, high inflation, exchange rate falls and weak demand reduce sales and profit and make it hard to pay obligations.
• Management incompetence. Weak control and poor coordination lower performance and raise the chance of failure.
• Weak corporate governance. An ineffective board, poor accountability and a lack of transparency and fairness to stakeholders.
• Poor technological innovation. A company that cannot keep up with new technology becomes less competitive.
• Bad investment decisions. Investments that return too little, especially when financed by borrowing the company cannot service because the project was badly managed.
• Poor infrastructure. Unreliable power, transport, communications and security raise cost and disrupt operations.
• Political and environmental setting. Unrest, policy changes and environmental problems can speed failure.

Symptoms

Low profitability, high gearing, low liquidity, falling sales and market share, and a rising expenditure profile. Non-financial signs include delayed capital expenditure, frozen management salaries, rising staff turnover and falling market share.

Preventive strategies

• Good business strategy, kept under review as the environment changes.
• Operational controls in place and used: budgets, cash planning, costing and credit control.
• Good corporate governance, with an independent, active board.
• Participative management, so that staff understand and own the targets.
• Managerial competence, including depth below the chief executive.
• Customer focus, because customers decide whether the company survives.
• Management information from appropriate systems and equipment, so problems are seen early.
• Good human resource management, with training and retention of skilled staff.

Performance improvement, total quality management and the cost of quality

Operational changes to the performance management system

• Clear, measurable goals. Goals should be specific, measurable, achievable, relevant and time-bound.
• Regular feedback and open communication, so that problems are raised and corrected quickly.
• Training and development, with resources for continuous learning and no vacancies left unfilled.
• Recognition and rewards for good performance, linked to what individuals control.
• Performance improvement plans for individuals or units who fall short, with a structured approach and regular monitoring.
• Continuous improvement tools: total quality management, activity based budgeting, and an effective management information system, so that the accountant can report progress.

Total quality management (TQM)

Total quality management is a management philosophy of continuous improvement in every part of the organisation, with customer satisfaction as the aim. Everyone from the board to front-line staff takes part. Its principles are:

• a customer focus
• continuous improvement
• employee participation
• process management, since activities are linked
• decisions based on fact
• good supplier relationships
• strategic management of quality objectives
• continuous training

Its tools include quality planning, flowcharts and process maps, statistical process control (control charts and sampling), Pareto analysis (the 80:20 rule, which finds the few causes that give most of the problems), scatter diagrams, cause-and-effect diagrams and customer checklists. Its benefits are better process and product quality, standardisation, error prevention and customer focus. Benchmarking supports it by showing the gap to the best.

The cost of quality

The costs of quality fall into four classes:

• Prevention costs. Costs of stopping non-conforming output before it happens: quality training, design and process engineering, supplier evaluation, testing of new materials, preventive maintenance, and the extra price of better materials.
• Appraisal costs. Costs of finding which units do not conform: inspection of goods received, product testing, inspection of work in progress and of finished output.
• Internal failure costs. Costs of faulty output found before it reaches the customer: spoilage, scrap, rework, and the idle time and machine downtime caused by defects.
• External failure costs. Costs of faulty output found after delivery: warranty repairs, replacements, liability claims, handling of complaints, extra transport, and lost sales through damaged reputation.

Prevention and appraisal are the costs of conformance; internal and external failure are the costs of non-conformance. The central message is that spending more on prevention usually lowers total quality cost, because failure, especially external failure and lost sales, is far more expensive than prevention. A cost of quality report shows each class, its items and its percentage of the total, so that managers see where the money goes.

Cost of quality calculations

1. Cost of an item. Quantity (hours or units) × rate. Lost sales cost = units lost × contribution per unit.
2. Class totals. Add the items of each class.
3. Total cost of quality and percentages. Add the four classes. Class % = class total ÷ total × 100. The percentages add to 100.
4. Effect of extra prevention. Failure cost × expected percentage fall = saving. Net benefit = saving − extra prevention cost. Benefit per ₦1 spent = saving ÷ extra cost.

Money is in ₦ million to one decimal place unless stated, and each answer is rounded once, at the end.

Worked examples

1. Prevention.
   Design engineering 100,000 × 1,200 = ₦120.0m; training 4.0; total ₦124.0m.
2. Appraisal.
   Inspection 300,000 × 700 = ₦210.0m; testing 1.5; total ₦211.5m.
3. Internal failure.
   Rework 2,000 × 50,000 = ₦100.0m.
4. External failure.
   Warranty 2,500 × 55,000 = 137.5; support 2,500 × 3,000 = 7.5; transport 2,500 × 4,000 = 10.0; lost sales 1,800 × 200,000 = 360.0; total ₦515.0m.
5. Total.
   124.0 + 211.5 + 100.0 + 515.0 = ₦950.5m.
6. Percentages. Prevention 13.0%; appraisal 22.3%; internal failure 10.5%; external failure 54.2%. Total 100.0%.
7. Comment. More than half of the cost of quality is external failure, much of it lost sales that never appear in the accounting records. Prevention is only 13%, so shifting money to prevention is the obvious remedy.

1. Failure costs.
   100.0 + 515.0 = ₦615.0m.
2. Saving.
   615.0 × 20% = ₦123.0m.
3. Net benefit.
   123.0 − 45.0 = ₦78.0m.
4. Per ₦1.
   123.0 ÷ 45.0 = ₦2.73.
5. Comment. The plan is attractive, but the 20% is an estimate. The company should test it with a smaller pilot and check that the lost-sales saving is realistic.

Expect variants: a different split of items, lost sales left out of the report, or a request to explain which class each item belongs to.

Just-in-time and the other improvement tools

Management accountants are encouraged to use continuous improvement techniques alongside TQM: just-in-time (JIT) purchasing and production, which cut stock, waste and storage cost and improve cash flow (so reducing the risk of failure through bloated stock and weak liquidity), activity-based budgeting, and an effective management information system that supplies timely data to monitor progress.

Common mistakes

• Listing causes without linking them to the company in the question.
• Confusing symptoms with causes. Low liquidity is a symptom; poor investment decisions are a cause.
• Putting items in the wrong class. Inspection of output is appraisal; rework is internal failure; warranty repair is external failure.
• Leaving out lost sales from external failure when the question gives them.
• Forgetting that prevention reduces total cost.
• Calling TQM a department. It involves everyone.

Quick revision

• Causes: economy, management, governance, technology, investment, infrastructure, politics. Symptoms: low profit, high gearing, low liquidity, falling sales and share, rising costs.
• Prevention: strategy, controls, governance, participation, competence, customers, information, people.
• Improvement: SMART goals, feedback, training, rewards, improvement plans, TQM, activity based budgeting, information systems.
• Cost of quality: prevention and appraisal (conformance); internal and external failure (non-conformance).

How the marks are earned

• State causes or strategies: one mark each with a link to the company.
• Cost of quality report: correct class, correct amount and percentage; show quantity × rate.
• Discuss: link cause, symptom and remedy, and conclude.

Practice questions

These are original questions, written in the style of the Skills examination. Work each one before you open the answer.

Recall check: multiple choice

Section B style: written questions

Model answers

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