What are Failure Costs?

Failure costs are those incurred by a manufacturer when it produces defective goods. There are two types of failure costs, which are internal and external. Internal failure costs occur before goods are shipped to customers, while external failure costs arise subsequent to shipment. Examples of the two types of costs are noted below.

Internal Failure Costs

There are multiple types of internal failure costs, which include the following:

Process failures. A process may be defective, resulting in a reset of the appropriate machinery and the scrapping of all output during this reset process.
Scrap. The production process may generate out-of-spec goods that cannot be reworked. These items must be thrown out.
Rework. The production process may generate out-of-spec goods that can be reworked. The cost of this rework can be quite high.
Reduced resale prices. When goods have been reworked, the seller may be forced to sell them at a reduced price, possibly eliminating the standard profit on these units.

External Failure Costs

External failure costs are the expenses incurred when a product or service fails to meet quality standards after it has been delivered to the customer. These costs can damage a company’s reputation and profitability. Examples of external failure costs include the following:

Warranty claims. This includes the costs associated with repairing or replacing defective products under warranty.
Product recalls. This includes the expenses related to retrieving defective products from customers, including logistics, communications, and compensation.
Customer complaints management. This includes the handling of customer complaints, which can involve resources such as customer service teams, investigation efforts, and resolution costs.
Lost sales. This includes the revenue lost due to dissatisfied customers or a tarnished reputation.
Legal costs. This includes the costs arising from lawsuits or settlements due to product defects or failures causing harm or loss.
Compensation costs. This includes the payments made to customers for inconvenience, harm, or loss caused by defective products or services.
Brand damage. This includes the long-term financial impact of a damaged reputation, which can include reduced customer loyalty and decreased market share.
Regulatory fines and penalties. This includes the expenses incurred for failing to comply with industry regulations or standards due to defective products.
Product liability insurance premiums. This includes the increases in insurance premiums resulting from the claims and risks associated with defective products.
Field service costs. This includes the expenses related to dispatching technicians to fix problems at customer sites.

These costs highlight the importance of ensuring high-quality standards during production and delivery to avoid significant financial and reputational impacts.

External Failure Costs vs. Internal Failure Costs

External failure costs tend to be substantially higher than internal failure costs, so it makes sense for a manufacturer to expend more effort to ensure that all products leaving the factory adhere to its quality standards.