DeeAnn Martinez is preparing to open her own CPA firm. DeeAnn is a smart businessperson and wants to maximize her profits. She has not yet decided whether to run a low-quality CPA firm (basically offering to sign the financial statements of anyone who will pay her fee), an average CPA firm, or a premium-quality CPA firm (competing head-to-head with large international accounting firms such as PricewaterhouseCoopers).

DeeAnn has analyzed the costs of quality related to operating a CPA firm and has developed the following analysis:

• Prevention costs: The best way to ensure the quality of the audit is to increase the quality of the staff hired and to increase the time that the staff spends on each audit. DeeAnn realizes that hiring higher-quality staff will cost more.

• Appraisal costs: DeeAnn plans to inspect the work of staff auditors by having audit managers review the work. The average salary rate for an audit manager (including all fringe benefits) is $50 per hour.

• Internal failure costs: Sometimes the audit team will do such a poor job that one of DeeAnn's audit partners will have to personally supervise the completion of the audit work. The average salary rate for an audit partner is $100 per hour.

• External failure costs: If investors or creditors rely on financial statements that later prove to be false, the audit firm that approved those financial statements will probably be sued. Of course, the frequency of being sued, and the cost of each lawsuit, will be higher if DeeAnn decides to provide low-quality audits.

DeeAnn has gathered the following numerical information about the costs of quality in relation to operating a CPA firm:

Required:
1. Assume that the revenue from each audit is the same no matter what the quality of the audit. Therefore, in order to maximize her profits, DeeAnn must minimize the expected cost of each audit. Which type of audit firm'low quality, average quality, or premium quality'should DeeAnn operate in order to maximize her expected profit per audit? Show your calculations.
2. Comment on whether the assumption about revenue made in part (1) seemsappropriate.

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Low Quality Average Quality Premium Quality Prevention costs: Staff hours spent on audit Staff salary rate. Appraisal costs: Manager review of audit work Internal failure costs: Frequency of bad audits. Partner time to fix bad audit 20 hours 40 hours 100 hours $20/hour $25/hour $40/hour 3 hours 8 hours 20 hours 1in 3 1 in 50 4 hours I in 10 5 hours 10 hours External failure costs: 1 in 5 S500,000 1 in 100 $1,000,000 1 in 40 $200,000 Frequency of lawsuits. Expected loss on each lawsuit