Appraisal Costs

What are Appraisal Costs?

Appraisal costs are expenses related to quality control that a company incurs to ensure its products and services meet the standards of its customers, the company, and regulatory requirements.

Companies are willing to pay these fees for tests and inspections to prevent defective goods and services from reaching their customers. They do it by critiquing the entirety of their manufacturing, development, and sales process.

Examples of Activities that Generate Appraisal Costs

• Hiring staff for inspections
• Inspecting manufacturing equipment
• Inspecting work-in-process goods
• Inspecting finished goods
• Inspecting incoming products from suppliers
• Reviewing documents related to services
• Auditing standard operating procedures
• Purchasing screening equipment for testing
• Field testing
• Hiring secret shoppers for stores

Appraisal Costs – Example

Let’s look at the car manufacturing process. When a car is manufactured, it goes through several main stages to become a finished product:

1. Stamping

Stamping requires molding steel plates into the components of the car.

Potential appraisal costs for stamping:

• Inspecting the quality of the steel from suppliers
• Ensuring that stamping equipment is working properly
• Checking the finished stamped product for defects

2. Welding

In the welding phase, the components of the car are welded together to form the car’s body.

Potential appraisal costs for welding:

• Hiring employees to oversee the welding
• Maintaining the accuracy and performance of welding equipment
• Testing the weld strength
• Purchasing the measuring equipment to test the weld strength

3. Painting

Multiple layers of paint and gloss are added to the completed body of the car.

Potential appraisal costs for painting:

• Inspecting paint thickness
• Inspecting for visual blemishes
• Ensuring that painting equipment is producing a consistent spray

4. Assembly

During the assembly stage, all components, including interior and exterior, are assembled for a finished product.

Potential appraisal costs for assembly:

• Examining each component being added during assembly
• Resources spent on double-checking components were installed correctly
• Inspecting assembly equipment to ensure that it is operating properly

5. Final Inspection and Testing

For the final stage in the process of car manufacturing, a company will run the car through numerous tests for quality and performance to arrive at a customer-ready product. Car manufacturers will test for things including collision safety, the responsiveness of steering, proper tire alignment, the durability of tires, stitching of the seats, and much more.

Potential appraisal costs for final inspection and testing:

• Losses from vehicles used/destroyed for testing
• Hiring third parties to run various tests
• Hiring focus groups for opinions on the new product
• Purchasing equipment and measuring tools for in-house testing

Each part of the process requires perfect execution. Any mistake in manufacturing can lead to a poor product visually or functionally. The result can be negative press at the low end and putting customer’s safety at risk on the high end. A mistake made in one car can ruin the reputation of the entire company.

Rationality Behind Appraisal Costs

Appraisal costs aren’t a drop in the bucket for a company’s expenses. They can be significant and require a team of employees and third-party services to conduct tests and inspections. While costs can be high, appraisal for quality is a necessity and is well worth its price.

Catching defects early in the process of the manufacturing or development of a product or service can save a company millions or even billions in revenue. The savings come from avoiding losses in revenue that can be caused by a blow to a company’s reputation if defective products and services reach the customer.

In a business environment where digital media is accessible and used by all, maintaining standards of quality are more important than ever. A slip or mistake in quality or reliability can quickly be brought to attention and spread to the masses through reviews online and shares on social media.

When you look at the potential for losses due to damage in reputation, it is less expensive to spend whatever is necessary on appraisal costs than to avoid appraisal costs altogether and risk future problems.

Example Showing the Effects of Appraisal Costs

To show the importance of appraisal costs, we will analyze Company A and Company B. Both companies earn $1,000,000 per month in profit from the sales of electronics.

Company A maintains a strict quality control process and incurs appraisal costs of $150,000 per month, whereas Company B chooses not to check for quality because they are confident in their manufacturing process.

Over 12 months, Company A brings in an initial profit of $12,000,000. However, their appraisal costs of $150,000 per month lead to a total amount of appraisal costs of $1,800,000. The additional cost ate up 15% of their profits and left them with final profits after appraisal costs of $10,200,000.

Ouch. 15% of profits reduced from appraisal costs? It seems like a lot, right?

Well, let’s look at Company B.

Company B decided to avoid appraisal costs so they wouldn’t eat away from their profits. Company B did well for the first four months and profited $4,000,000 compared to Company A, who profited $3,400,000.

On May 1st, one of Company B’s electronic devices was found defective and overheated until the product went up in flames. The customer of the product took to the media, and soon, the problem was aired across all news outlets. The negative publicity caused the company’s profits to decline by 40% for the remainder of the year.

At the end of the year, Company B’s total profit was $8,800,000, which was 14% lower than Company A.

Because of their care for quality, Company A ended the year profiting 14% more than Company B.

Key Takeaway

Appraisal costs are not to be neglected. In the modern-day world with social media and the ever-increasing spotlight shined on companies, no business can afford to sacrifice quality and take their chances on defective products and services reaching their customers.

While appraisal costs use resources such as time and money, they are necessary, nonetheless.

Additional Resources

CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and developing your knowledge base, please explore the additional relevant CFI resources below:

• Appraisal Management Company (AMC)
• Internal Controls
• Operations Management
• Switching Costs
• See all commercial lending resources