Chapter 5: External Failure Costs: The Price of Customer Dissatisfaction

External failure costs are where poor quality gets personal.

Nonconforming products that were supposed to be rectified in the plant were shipped out to paying customers—customers who might now be unhappy enough to turn into ex-customers. While the other costs of poor quality are a cost to a business, external failure costs can cost a business its business.

In this chapter, we’ll be examining external failure costs and how best to respond to them. More than any of the other costs of poor quality, these uniquely damaging costs can act as a powerful incentive to create a profitable culture of quality. The threat is real, but so are the returns.

Two kinds of external failure costs you need to know

There’s more to external failure costs than meets the eye. While some of these costs are tangible (and relatively easy to track), others extend into the future and can be difficult to pin down. Here’s what to look out for.

The usual tangible costs—with a dangerous twist

There are two kinds of costs to consider in this category—the reasonably predictable and the dangerously unpredictable.

Examples of reasonably predictable costs include the costs of handling customer complaints and returns, managing recalls, approving claims, reworking defective products under warranty, and taking corrective and preventive action (CAPA).

The main thing to note about these costs is how easy it is to underestimate them. Few manufacturers have the tools to factor in associated costs such as transportation, resolution planning and emergency production.

The second kind of cost is easy to track but can be alarmingly unpredictable.

A case in point was Ford’s decision (way back in the ‘70s) to allow cost-benefit analysis to determine whether to ship cars (the Ford Pinto) with a known quality vulnerability—or fix the problem. Based on assumptions about compensation for deaths and injuries, Ford decided to ship.

As things turned out, Ford completely underestimated the external failure costs involved. A single lawsuit (and there were many) resulted in Ford paying $128 million in compensation—more than 90% of what it would have cost to fix the issue on every Pinto during production.^[1]

And as you can imagine, Ford’s immediate, tangible external failure costs weren’t the only ones.

The steep intangible costs that extend into the future

A significant element of external failure costs is intangible—and no less costly for being impossible to quantify precisely.

The massive reputational damage Ford suffered—with sales of the Pinto declining by 60% over six years—highlights the way poor quality strikes at the heart of customer relationships.^[1]

There are various ways to gauge the impact of quality issues on a brand’s reputation. Some of the more common ones include social media sentiment analysis and net promoter score.

However, linking sales and market share to quality issues via these metrics is an art, not a science. While they may support a manufacturer’s gut feelings about the impact of quality failures, they do not prove it.

And yet while causation cannot be proven, the fact remains that without satisfied, loyal customers, any business is soon out of business. What’s more, the very future of a business can be at stake when external failure costs drain time, talent and resources from vital activities such as innovation and process improvements.

All too often, funds that should have been used to finance capital investments, grow the business and enter new markets are diverted to address the latest quality crisis.

The 1:10:100 rule and where manufacturers should be putting their money

At this point, you’re probably wondering how other manufacturers are managing their—potentially crippling—external failure costs.

Results from Gartner’s 2022 Total Cost of Quality Survey^[4] suggest that they’re putting 52% of their total cost of quality into appraisals (27%) and internal failure costs (25%) such as rework and scrap.

This allocation may seem sensible. After all, it’s much less costly to fix issues within the factory than to address defects that reach the customer. And, as we’ve seen, the full extent of external failure costs—tangible and intangible—can be steep indeed.

However, it is not ideal.

While quality costs nothing at the beginning of the manufacturing process (because quality is simply a matter of doing what you said you’d do), the costs of dealing with defects rise exponentially as products near shipment.

This escalation is captured in the handy 1:10:100 rule developed by George Labovitz and Yu Sang Chang in 1992. Applying and extending the rule, we can see that if inspection costs $1 per unit, rectifying nonconformance will rise to $10, managing CAPA to $100, resolving complaints to $1,000, and dealing with recalls to $10,000.

According to this well-accepted model, investing in prevention is, clearly, the most effective—and cost-effective—way to ensure that nonconforming output never reaches the customer and incurs external failure costs.

But there’s more.

Relying on appraisals and rework to keep nonconforming output from being shipped is risky.

Unless quality is built in (with appropriate investments in prevention), there’s a real danger of slipping into a full-blown crisis—as one of Boeing’s most dramatic quality failures demonstrates.

After a door blew out midflight in January 2024, Boeing’s CEO, Dave Calhoun, revealed the existence of “shadow factories” specializing in rework: “In our shadow factories, we put more hours into those airplanes than we do to produce them in the first place.”^[3]

In short, Boeing had been spending more time fixing defects than manufacturing planes, and this—according to Calhoun—would have to stop.

Transforming the threat of external failure costs into opportunities

One of the saddest job descriptions on LinkedIn is the role of “customer complaints coordinator”. If a business is receiving so many complaints that it needs someone to “coordinate” them, what it really needs is a “customer complaints preventer”.

Preventing poor quality—rather than merely detecting and dealing with it more efficiently—is the way forward. (And the way to returns of at least 100X or more, according to the 1:10:100 rule.)

Just as dealing with the impact of external failure is a strategic C-level activity, investments in preventing poor quality should be a C-level priority. Indeed, according to the management consulting company, McKinsey, “all organizations should recognize that when a trigger looms, an investment in quality capabilities can often open major new opportunities for competitive advantage”.^[4]

It’s time to apply the “trigger” of external failure costs and start crucial conversations about prevention with top management. The 1:10:100 rule is on your side. Here’s to your success!

TABLE OF CONTENTS

#5 External failure costs: Paying the price of customer dissatisfaction

Tackle the steep costs no manufacturer can afford

Two kinds of external failure costs you need to know

The usual tangible costs—with a dangerous twist

The steep intangible costs that extend into the future

The 1:10:100 rule and where manufacturers should be putting their money

Transforming the threat of external failure costs into opportunities

This was interesting material!