Applying differential analysis to quality
High quality is essential to success in a competitive environment. Therefore, companies use differential analysis to make decisions about the quality of their products.
Assume Erie Waters produces bottled water. The variable cost of a case (12 one-liter bottles) is as follows:
| Water and bottles | $2.00 |
| Inspection and rework costs | 1.00 |
| All other variable costs | 3.00 |
| Total variable cost per case | $6.00 |
In addition, the company has $150,000 of fixed costs per year.
The company inspects the product at various stages. When inspectors find the water is below standard or the bottles have defects, production workers replace the water and/or the bottles. The cost of inspecting the product and replacing water and/or bottles averages $1.00 per case, and is shown as inspection and rework costs.
Management of Erie Waters is concerned about product quality. Despite the inspection just noted, management has learned that dissatisfied customers are switching to competitive products. Management is considering purchasing a high-quality water product. This product would increase water and bottle costs to $2.50 per case while decreasing inspection and rework costs to $0.40 per case. All other variable costs would remain at $3.00 per case. Erie Waters would sell this water for $8.00 per case.
If the high-quality water is purchased, Erie Waters expects to sell 100,000 cases of water this year at $8.00 per case. If Erie continues to use the current low-quality water, the company expects to sell 90,000 cases of water this year at $8.00 per case. Fixed costs are $150,000 per year whether the company buys high-quality water or low-quality water. Should Erie Waters buy the high-quality water? We compare the two alternatives below.
| Low-quality water (90,000 cases) |
High-quality water (100,000 cases) |
|
| Revenue at $8.00 per case | $ 720,000 | $ 800,000 |
|
Water and bottles at $2.00 per case for low quality and $2.50 per case for high quality |
(180,000) [90,000 cases x $2.00] |
(250,000) [100,000 cases x $2.50] |
|
Inspection and rework at $1.00 per case for low quality and $0.40 per case for high quality |
(90,000) [90,000 cases x $1.00] |
(40,000) [100,000 cases x $0.40] |
| All other variable costs at $3.00 per case |
(270,000) [90,000 cases x $3] |
(300,000) [100,000 cases x $3] |
| Fixed costs | (150,000) | (150,000) |
| Net income | $ 30,000 | $ 60,000 |
Erie Waters should purchase the high-quality water because it increases net income from $30,000 to $60,000 per year. In addition, a high-quality product improves the company’s prospects for maintaining or even increasing its market share in years to come. Many companies have learned the hard way that letting quality slip creates a bad reputation that is hard to overcome.