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.
Appraisal costs are expenses incurred by a company to ensure the quality of its products and services meet the high standards of the company, its customers, and regulations.
Appraisal costs can be expensive but are well worth the price if mistakes are avoided.
Any part of the manufacturing, development, and sales process can involve appraisal costs.
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
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:
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
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
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
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.
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.
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:
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