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This paper presents a methodology for optimal allocation of sensors in a multistation assembly process for the purpose of diagnosing in a timely manner variation sources that are responsible for product quality defects. A sensor system distributed in such a way can help manufacturers improve product quality while, at the same time, reducing process downtime. Traditional approaches in sensor optimization fall into two categories: multistation sensor allocation for the purpose of product inspection (rather than diagnosis); and allocation of sensors for the purpose of variation diagnosis but at a single measurement station. In our approach, sensing information from different measurement stations is integrated into a state-space model and the effectiveness of a distributed sensor system is quantified by a diagnosability index. This index is further studied in terms of variation transmissibility between stations as well as variation detectability at individual stations. Based on an understanding of the mechanism of variation propagation, we develop a backward-propagation strategy to determine the locations of measurement stations and the minimum number of sensors needed to achieve full diagnosability. An assembly example illustrates the methodology.