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Calculating defect costs


When trying to calculate the costs associated with the production of defective parts and / or service results, it is pivotal to determine where in the process the defect has arisen. If an error occurs during the very first process step, little more than simple material costs are lost. If it occurs on the very last process step, we have to forfeit the value of an entire flow unit (including profit). The location of the bottleneck is especially important here. This is because defective flow units that are produced before the bottleneck have to be calculated with input prices while defective flow units that are produced after the bottleneck have to be calculated with the opportunity costs of lost sales. This insight drives the location of testing points in the process, who have to be arranged in a way which maximizes the chances of identifying and catching defective flow units before bigger losses occur.

By implementing a buffer between steps who can produce defective parts, the process flow can be protected against errors. However, producing too much inventory through so-called error buffering might conceal the necessity for improvements of the error rate.

These lecture notes were taken during 2013 installment of the MOOC “An Introduction to Operations Management” taught by Prof. Dr. Christian Terwiesch of the Wharton Business School of the University of Pennsylvania at Coursera.org.
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