COST OF POOR QUALITY

How Better Quality Affects Pricing

by Johannes Freiesleben

In 50 Words Or Less
• Companies with high defect rates must reimburse customers by lowering
the price of their products.
• Better production quality increases the maximum potential price and
decreases unit production costs.
• Customers are lost when poor quality producers can't lower their price
enough because wasted material increases variable production costs.

Improving production quality to levels that guarantee high production efficiency and prevent the waste of resources is a
prime goal of financially successful companies.

Achieving highest possible quality minimizes the costs of poor quality and thereby the overall production costs.1 But in
addition to this internal effect of better quality, customer satisfaction increases when a lower percentage of faulty product
reaches the marketplace.

Companies with high internal quality can also achieve very low levels of externally discovered defects.2 Conversely, poor
quality producers have to struggle to keep their external quality at reasonable levels, even if they conduct extensive
inspection, because inspection can never completely inspect out all faulty products.

Given this relationship between internal and external quality, an interesting question is whether better quality can have a
positive effect on a company's pricing options.

Justifying a Higher Price?

The pricing implications of quality have so far been mostly discussed in the context of different degrees of design quality. In
economics literature, a common conjecture is that higher design quality leads to higher prices.3

The logic is as follows:

Higher prices are the result of higher average costs of production on the producer's side and higher average value on the
customer's side.
Higher production costs are incurred by using more or better ingredients to create a higher level of product features, thereby
necessitating a higher price.
For more valuable combinations of features, customers are willing to pay a higher price.
Higher design quality thereby unambiguously leads to higher prices.

But what kind of price effect, if any, can we expect from better production quality? In the eye of customers, can a higher
level of production quality justify a higher price?

The key is to ask what value customers will most likely assign to a product of a certain quality. The value they can derive
from using the product then determines their willingness to pay a certain price for it.

Different degrees of value can stem from differences in features, as in the case of design quality, or from different degrees
of conformance to specifications, which is the production quality dimension we are interested in.

In economic terms, customers' net utility is the value they can derive from the use of a product minus the price they have to
pay for it. Average customers should be able to derive a positive net utility from the product's use: They gain more than they
have to pay. From the company's perspective, these average customers effectively determine their pricing options.

Let us assume a positive net utility exists for average customers, and the company makes a positive margin on every
product it sells. As a result, both the company and its customers are satisfied with the market outcome. However, this
pleasing situation only lasts as long as all products sold meet the customers' needs--in other words, if the external quality is
flawless. When customers receive a defective product instead of a good one, their net utility might be negative since they
cannot derive full value from its use.

Let us for simplicity assume the product is completely unusable when it is defective. Then the customers definitely have a
negative net utility: They receive nothing for the price they paid!

Expected Product Utility

In the presence of quality problems, the probability customers receive a good and fully usable product is lower than 100%.
The expected utility from the use of a randomly chosen product is equally reduced. A customer cannot be sure whether a
purchase of a product will yield full value. In other words, his or her expected net utility is lower than the full utility the
customer would be able to derive from a surely flawless product. The customer might be lucky to pick a good product, but he
or she might also be unlucky and have a negative net utility.

The poorer the production quality, the higher the likelihood a defective product is sold, and the lower the expected net utility
the average customer can derive from a randomly chosen product. If the customer is a rational decision maker, willingness
to pay the regular price for a product is lower the poorer the quality level. On the market level, poor quality products can
therefore not receive the same high prices that high quality products would gain.

This result is not surprising and gets clearer when we look at it from a different angle. Rational customers expect, and
indeed have the right to expect, that the quality of the product they purchase is flawless.

When customers know the quality of a certain company is poor, they can infer they risk an increased probability of
purchasing a defective product from that company. Therefore, every random purchase embodies the risk of ending up with
an unusable product.

If the company still wants customers to take this risk and buy its product, it has to reimburse them for this risk taking by
paying a "risk premium." This risk premium is exactly the difference between the price customers would pay for a high
quality product and the price actually paid for a product of lesser quality. This reduction in the price is necessary since,
without it, a rational customer would not be willing to buy the potentially defective product.

With a lower price for the poor quality product, customers might be indifferent to purchasing a poor quality or high quality
product. If the price difference exactly reflects the difference in value between the two products, the expected net utility for
the customers is the same. To be a similarly attractive choice as the high quality product, the poor quality product must sell
at a lower price.

Effect of Warranties

Does this general relationship always hold true? For instance, isn't a poor quality producer's warranty a sufficient relief for
the customers from the risk of purchasing a defective product?

Aside from being very costly for the producer, warranties do not relieve customers from incurring costs. Even if reimbursed
for the repair or product replacement, customers still must spend time to deal with the warranty redemption. Additionally,
there might be enforcement costs, since some companies might try to avoid the high warranty expenditures by limiting their
liability as much as possible.

Therefore, rational customers will expect a variety of costs associated with a warranty redemption. These costs effectively
reduce net utility and thereby reduce willingness to pay the price they would pay for a hassle free, high quality product. This
is why even a full warranty promise cannot prevent a price reduction for the poor quality product.

Figure 1 (p. 49) shows the general relationship between the price and value a customer can
derive from the use of the product. The resulting price function p(v) comprises all possible
combinations of price and value reflecting the same expected net utility. Since the value of the
product depends on the quality level, we could also use quality as the denomination of the x-axis.

The important point is better production quality, which translates into higher value for the customer, justifies a higher price
for the product. A quality improvement therefore offers the chance of significant revenue increases.
Competitive Implications

Although the relationship between price and quality is reason enough for a company to improve its quality, there is even
more incentive when we look at it from a competitive perspective.

Imagine there are two producers in the market, A and B, that produce exactly the same product. The only difference
between them is A maintains a high quality level, while B is a poor quality producer. The earlier findings suggest a
separating equilibrium in the sense that both products are sold in the market for prices reflecting their difference in quality.

The interesting point is that although A has the option to sell its product for a higher price than B, it is not compelled to do so.
It might favor selling more quantity to increase its market share and outpace its competitor. As soon as A lowers its price
below its maximum chargeable price, it increases the customer's net utility and thereby offers more net utility per dollar than
B does. As a consequence, more customers prefer A's product, and its sales volume increases if B does not also reduce its
price.

This effect takes place whenever the relative price difference is greater or smaller than the relative difference in value, so
one product offers more net utility than the other.

In other words, if A increases its price relative to B after a successful quality improvement, it will be the customer's choice
whenever the percentage increase in price is smaller than the percentage increase in value.

B might want to accommodate its competitor's move by also lowering its price, thereby bringing its offered net utility again to
parity with A's, but let us for a moment assume B is not able to do so.

If B's price remains unchanged, Figure 2 depicts the most likely reaction of the customer to A's
pricing move. The maximum price A is able to charge is pa. Similarly, B's maximum price to
achieve utility parity with A is pb, which is lower and reflects the quality difference between the
two producers.

Whenever A lowers its price below pa, it offers the customer more net utility. The customer's choice should therefore be A's
product. Only when A increases its price above pa would it lose its customers to B, since B's product then offers the higher
net utility. Even by this simple depiction we see A's upward pricing options are far greater than B's (see Figure 2).

Production Costs

Now the interesting question is why we assumed B is not able to accommodate a potential price decrease of A by a
matching price decrease, so the customer is not lost to the high quality competitor. The reason is straightforward: Given the
two companies have similar production technologies, poorer quality increases the variable production costs because of
wasted input materials. Thus B has to bear higher unit costs and cannot afford a significant price decrease.

A simple example might illustrate this point. Imagine B has a defect rate of 20% and wants to sell 5,000 products, as does A,
which has a defect rate of close to zero. For selling 5,000 products B has to produce 6,250, since every fifth product is
defective and cannot be sold. Note the 20% defect rate is only the known defect rate, and an unknown percentage still slips
through B's inspection.

If the variable production costs are $20, B has total variable production costs of $125,000, but only 5,000 sellable products
to bear these costs. This increases its unit costs from $20 to $25--$5 higher than A's unit costs.

This significantly constrains B's ability to accommodate A's price moves. At the same time, it offers A the opportunity to
lower its price even below its competitor's unit costs.

Although it might be much more profitable for A to let its actual price stay close to pa, it has a
lot of leeway to impose competitive pressures on B by using the price mechanism when
needed. These superior pricing options of the high quality company can be seen in Figure 3 (p.
51), where the pricing range of both companies is depicted.
Two Competitive Advantages

A strong argument can be made to support the conjecture that better production quality justifies a higher price. Interestingly,
this finding is similar to the common conjecture regarding better design quality.

Excellence in either quality dimension seems to enable a company to achieve higher prices in the market. But whereas
better design quality does not necessarily increase the range of pricing options of a company, better production quality does
so by simultaneously increasing the maximum potential price and decreasing the unit production costs. A high quality
producer is thereby equipped with a desirable combination of two important competitive advantages.

The analysis has, of course, been simplistic. The price a company can demand for a product usually depends on a variety of
factors besides its quality level. Then, competing companies might differ substantially in their production structures and in
the products they sell.

Nonetheless, the findings have substantial value for a company that assesses whether it should strive for best possible
quality. They show unambiguously that better quality increases pricing options when other factors remain constant.

Importance of Information

The most serious inhibitor of this desirable pricing effect might be the customers' inability to correctly assess prepurchase
whether a company is a high or a poor quality producer and accordingly to evaluate the risk of buying a defective product.

Only when customers can quantify this quality risk can they determine which product offers the better net utility for its price.
Information about the quality differences between companies is thus a crucial dimension for the "right" purchase decision of
the customer.

This is especially true for new products, when only limited usage experience and knowledge about potential quality
deficiencies exist--for example, new car models or new internet banking services.

But, although these information asymmetries might temporarily make the customer's choice difficult, information about the
product's quality will diffuse as the percentage of informed customers increases over time.

Furthermore, existing reputations for high quality might enable companies to immediately reap the gains from superior
pricing options. And for the quality department, the arguments developed earlier might finally make it easier to sell the idea
of quality improvement to management.

ACKNOWLEDGMENT

The author thanks the Swiss National Science Foundation for its financial support of this research and S?ren Bisgaard and
Lee W. Hansen for the discussion of the topic.

REFERENCES

1. S?ren Bisgaard and Johannes Freiesleben, "Economics of Six Sigma Programs," Quality Engineering, Vol. 13, No. 2,
2000, pp. 325-331.

2. D.A. Garvin, "Quality on the Line," Harvard Business Review, September/October, 1983, pp. 3-12.

3. Andrew Metrick and Richard Zeckhauser, "Price Versus Quantity: Market Clearing Mechanisms When Sellers Differ in
Quality," National Bureau of Economic Research working paper, No. 5728, 1996.

JOHANNES FREIESLEBEN is an internal consultant with Ringier AG, Zurich, an international media company based in
Switzerland. He earned his doctorate in economics from the University of St. Gallen, specializing in the field of quality
economics.

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