External Failure Cost

Article byGayatri Ailani
Reviewed byDheeraj Vaidya, CFA, FRM

What Is External Failure Cost?

An External Failure Cost is an expense incurred when customers discover defects in the product or service once it is delivered to them. It highlights the financial impact of post-delivery quality issues for businesses to address and minimize such occurrences.

External Failure Cost

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It holds significant importance for businesses as it directly impacts customer satisfaction, brand reputation, and financial stability. By identifying these costs, companies can gauge the repercussions of poor quality after delivery, prompting improvements in production processes, customer service, and overall product and service quality to mitigate losses and enhance customer loyalty and trust.

Key Takeaways

  • External failure costs in business are expenses incurred by a company due to product or service defects discovered after delivery to customers.
  • While they offer insightful metrics to guide quality enhancement efforts and customer-centric strategies, their limitations are evident in their reactive nature and the challenge of fully capturing intangible costs or balancing resources between reactive fixes and proactive preventive measures.
  • They serve as tangible indicators, quantifying the expenses incurred due to post-delivery quality issues, ranging from warranty claims and customer support expenses to potential legal fees arising from dissatisfaction.

External Failure Cost Explained

An external failure cost in business operates as a crucial metric in evaluating the aftermath of quality issues discovered after a product or service reaches the customer. When a flaw or defect becomes apparent post-delivery, various expenses come into play. These costs include handling customer complaints, providing customer support, issuing refunds or replacements, managing warranty claims, and potentially dealing with legal issues or fines due to non-compliance.

Understanding how these costs work involves a multi-faceted analysis. Initially, companies assess the direct expenses incurred in addressing the problem, which includes the resources invested in rectifying the issue, such as labor, materials, and logistics. Moreover, there’s the intangible cost associated with damage to the brand’s reputation and customer trust. Negative word-of-mouth, social media backlash, and decreased customer loyalty can severely impact a company’s long-term success.

Businesses utilize these cost breakdowns to reassess their quality control processes, production methods, and customer service protocols. They implement preventive measures to minimize the occurrence of defects, investing in quality checks, training programs, and improved material sourcing. By identifying weak points in their operations that lead to external failures, companies can strategically allocate resources towards proactive solutions, aiming to reduce these costs and fortify their standing in the market.

Moreover, tracking and analyzing these costs allows businesses to make informed decisions about product recalls, re-engineering processes, or discontinuing items prone to quality issues. This data-driven approach enables a company to prioritize quality improvements and allocate resources more effectively, ultimately striving for higher customer satisfaction and sustained profitability.

Examples

Let us look at some examples of these costs to understand the concept better:

Example #1

Suppose a bakery that introduces a new line of specialty cakes. After several customer purchases, complaints arise regarding the cakes’ inconsistent quality, primarily related to icing that melts quickly, ruining the cake’s appearance.

They incurred expenses in responding to customer complaints, offering refunds, or providing replacement cakes. Additionally, they invested in investigating the issue, possibly hiring food scientists or consultants to identify the problem, resulting in added consultancy fees.

Moreover, the negative feedback spread on social media impacts the bakery’s reputation. That led to a potential loss of future sales and the need to invest in marketing campaigns to rebuild trust and reassure customers about the improvements made.

Thus, the bakery conducts thorough quality checks, adjusts the icing recipe, and implements better storage techniques. These proactive steps aim to prevent similar issues in the future, thereby reducing such incidents.

Example #2

In April 2023, Ola Electric, an electric vehicle manufacturer, suffered a severe backlash from their customers over serious safety concerns. Numerous instances have been reported where the front fork arm of the scooter collapsed when riders brake sharply or encounter a sudden bump. The company attempted to redesign but later decided to recall its vehicles and offered an upgrade to its customers free of cost, thus improving its image in the market.

How To Reduce?

There are multiple ways to minimize these costs –

  • Quality Improvement: Conduct rigorous quality checks at every stage of production to minimize defects. Implement stringent testing protocols and invest in better materials to ensure higher product reliability.
  • Customer Feedback and Support: Establish effective customer support systems to address complaints promptly. Use customer feedback to identify issues and implement necessary improvements, ensuring customer satisfaction.
  • Training and Education: Invest in employee training to enhance skills and awareness regarding quality standards. Educate staff about the importance of quality control and customer-centric approaches.
  • Supplier Relations: Collaborate closely with suppliers to ensure the quality of raw materials and components. Set clear quality expectations and conduct regular audits to maintain standards.
  • Preventive Maintenance and Inspections: Regularly maintain equipment and machinery to prevent failures that could lead to defects. Perform comprehensive inspections to identify possible problems early.

Advantages And Disadvantages

External failure costs come with their own set of pros and cons. Let us have a look at them below:

Advantages

  • Identification of Quality Issues: It highlights flaws or defects that might not have been initially apparent. It enables companies to identify and address underlying quality issues. External failure costs of quality encompass the expenses a company incurs when customers identify defects or issues in their products or services after delivery.
  • Data for Improvement: Tracking these costs provides valuable data for process improvement. It guides decisions on where to invest resources to prevent similar issues from arising in the future.
  • Customer-Centric Approach: Understanding the costs associated with external failures helps prioritize customer satisfaction. Companies can focus on rectifying issues that directly impact customers, thus improving loyalty.

Disadvantages

  • After-the-Fact Analysis: These costs are incurred after the product reaches the customer. Addressing them involves reactive measures, which might only partially rectify the initial problem.
  • Incomplete Cost Picture: Not all costs are easily quantifiable. Intangible costs like reputational damage or long-term impact on customer trust might be challenging to measure accurately.
  • Resource Allocation Challenge: Solely focusing on such costs might lead to neglecting proactive measures to prevent future issues. Balancing resources between reactive and preventive strategies becomes crucial.

External Failure Cost vs Internal Failure Cost

The differences between external and internal failure costs are as follows –

External Failure CostsInternal Failure Costs
These costs occur after the product or service has reached the customer. These costs arise due to defects discovered by the end-user or in the field.Internal failure costs are incurred during the production process or before the product reaches the customer. These arise from detecting defects internally within the organization.
They directly impact customers, leading to complaints, warranty claims, returns, and potential loss of customer’s trust or brand reputation.These costs are associated with identifying and correcting defects within the company’s production or operational processes before the product is shipped or delivered.

Frequently Asked Questions (FAQs)

1. What do external failure costs include?

These costs include all the costs that occur due to a defective product or service. These costs usually include customer complaint adjustment costs, cost of defective products returned by the customer, warranty charges, legal expenses, cost of concessions or allowances, cost of correcting defects, liability, and penalty costs.

2. What helps with mitigating external failure costs?

Mitigating these costs involves proactive measures such as stringent quality checks throughout production, robust customer support to address complaints promptly, and leveraging customer feedback for continual improvements.

3. What external failure cost is very difficult to estimate?

The profit from lost customers is difficult to estimate because it becomes impossible for a firm to measure the customers lost, and hence, calculating the profit becomes tough.

This article has been a guide to what is External Failure Cost. We explain its examples, how to reduce it, advantages, and comparison with internal failure cost. You may also find some useful articles here –

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