Chapter 4 Product Life Cycle Costing

1. Objectives
1.1 Explain the concept of life cycle costing.
1.2 Describe the phase of life cycle costing.
1.3 Describe how to maximize the return of over the product life cycle.
1.4 dentify the benefits of life cycle costing.
1.! Explain the implications of using life cycle costing especially in assisting management
with decisions.
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$ife %ycle
%osting
&eaning
'tages of
life cycle
mplications of using
life cycle
1. Development stage
(ow to maximize
return
2. ntroduction stage
3. )rowth stage
4. &aturity stage
!. Decline stage
*enefits of life cycle
(ow to assist
management decision
Design costs
&inimise time to
mar+et
&aximise the length
of life span
&inimise brea+even
time
2. The Nature of Life Cycle Costing
2.1 Life Cycle Costing
$ife cycle costing tracs and accu!ulates costs and revenues attributable to each
product over the entire product life cycle.
2.2 , product-s life cycle costs are incurred fro! its design stage through develop!ent
to !aret launch" production and sales" and finally to its eventual #ithdra#al
fro! the !aret.
2.3 , product life cycle can be divided into five phases.
.a/ Development 0 1he product has a research and development stage where costs
are incurred but no revenue is generated. (ere2 target costing may be used in
combination with life cycle costing.
.b/ ntroduction 0 1he product is introduced to the mar+et. 3otential customers
will be unaware of the product or service2 and the organization may have to
spend further on advertising to bring the product or service to the attention of
the mar+et.
4hen a product is ne# to the !aret2 and a co!petitor has not already
established a rival product in the mar+et2 a company may be able to choose
its pricing strategy for the new product.
.i/ f a !aret penetration ./ strategy is chosen2 the aim should
be to sell the product at a lo# price in order to obtain a large share of
the mar+et as 5uic+ly as possible. 1his pricing strategy is therefore
based on lo# prices and high volu!es.
.ii/ f a !aret si!!ing ./ strategy is chosen2 the aim is to
sell at a high price in order to !a$i!i%e the gross profit per unit sold.
&ales volu!es #ill be lo#2 and the product will be purchased only by
customers who are willing to pay a high price to obtain a 6uni5ue7 item.
)radually2 the selling price will be reduced2 although it will be +ept as
high as possible for as long as possible. 1his approach is often used
with high technology products.
.c/ )rowth 0 1he product gains a bigger mar+et as demand builds up. 'ales
revenues increases and the product begins to ma+e a profit.
.d/ &aturity 0 Eventually2 the growth in demand for the product will slow down
and it will enter a period of relative maturity. t will continue to profitable. 1he
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product may be modified or improved2 as a means of sustaining its demand.
.e/ Decline 0 1he mar+et will have bought enough of the product and it will
therefore reach saturation point. Demand will start to fall. Eventually it will
become a loss#ma+er and this is the time when the organization should decide
to stop selling the product or service.
2.4 1he horizontal axis measures the duration of the life cycle2 which can last from2 say 18
months to several hundred years. %hildren-s crazes or fad products have very short
lives while some products2 such as binoculars .invented in the eighteenth century/ can
last a very long time.
2.! '$a!ple 1
,*% %o specializes in the manufacture of solar panels. t is planning to introduce a
new slimline solar panel specially designed for small houses. Development of the
new panel is to begin shortly and 'olaris is in the process of determining the price of
the panel. t expects the new product to have the following costs.
9ear 1 9ear 2 9ear 3 9ear 4
:nits manufactured and sold 22;;; 1!2;;; 2;2;;; !2;;;
< < < <
=>D costs 12?;;2;;; 1;;2;;;
&ar+eting costs 1;;2;;; @!2;;; !;2;;; 1;2;;;
3roduction cost per unit !;; 4!; 4;; 4!;
%ustomer service costs per unit !; 4; 4; 4;
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Disposal of specialist e5uipment 3;;2;;;
1he &ar+eting Director believes that customers will be prepared to pay <!;; for a
solar panel but the Ainancial Director believes this will not cover all of the costs
throughout the lifecycle.
(e)uired*
%alculate the cost per unit loo+ing at the whole life cycle and comment on the
suggested price.
&olution*
$ifecycle cost
<;;;
=>D .12?;; B 1;;/ 22;;;
&ar+eting .1;; B @! B !; B 1;/ 23!
3roduction .12;;; B C2@!; B 82;;; B 222!;/ 182;;;
%ustomer service .1;; B C;; B 8;; B 2;;/ 12@;;
Disposal 3;;
1otal lifecycle costs 22223!
1otal production .D;;; units/ 42
%ost per unit !2?.4;
1he total lifecycle costs are <!2?.4; per solar panel which is higher than the price
proposed by the mar+eting director. 'olaris will either have to charge a higher price
or loo+ at ways to reduce costs.
t may be difficult to increase the price if customers are price sensitive and are not
prepared to pay more. %osts could be reduced by analysing each part of the costs
throughout the life cycle and actively see+ing cost savings. Aor example2 using
different materials2 using cheaper staff or ac5uiring more efficient technology.
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+. ,a$i!ising the (eturn over the Product Life Cycle
-./ 0esign costs out of products
3.1 *etween @;E to ?;E of a product-s life cycle costs are determined by decisions made
early in the life cycle2 at the design or development stage. 1he following figure
illustrates a typical pattern of cost co!!it!ent and cost incurrence during the three
stages of a product-s life cycle 0 the planning and design stage2 the manufacturing
stage and the service and abandonment stage.
3.2 9ou will see from the figure that approximately 8;E of a product-s costs are
co!!itted or loced in during the planning and design stage. ,t this stage product
designers determine the product-s design and the production process. n contrast2 the
maFority of costs are incurred at the !anufacturing stage2 but they have already
become loced1in at the planning and design stage and are difficult to alter.
-2/ ,ini!ise the ti!e to !aret
3.3 %ompetitors watch each other very carefully to determine what types of product their
rivals are developing. f an organization is launching a new product it is vital to get it
to the mar+et place as soon as possible. 1his will give the product as long a period as
possible without a rival in the mar+et place and should mean increased mar+et share in
the long run.
3.4 Aurthermore2 the life span may not proportionally lengthen if the product3s launch
is delayed and so sales may be per!anently lost. t is usual for the product-s overall
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profitability to fall by 2!E if the launch is delayed by six months. 1his means that it is
usually worthwhile incurring extra costs to +eep the launch on schedule or to speed up
the launch.
-C/ ,a$i!ise the length of the life span
3.! 3roduct life cycles are not predeterminedG they are set by the actions of management
and competitors. Hnce developed2 some products lend the!selves to a nu!ber of
different usesG this is especially true of materials2 such as plastic2 3I%2 nylon and
other synthetic materials. 1he life cycle of the material is then a series of individual
product curves nesting on top of each other as shown below.
3.C *y entering different national or regional !arets one after another an organisation
may be able to !a$i!ise revenue. 1his allows resources to be better applied2 and
sales in each mar+et to be maximised. Hn the other hand2 in todayJs fast moving world2
an organisation could lose out to a competitor if it failed to establish an early presence
in a particular mar+et.
-0/ ,ini!ise breaeven ti!e
3.@ , short brea+even time is very important in +eeping an organisation li5uid. 1he sooner
the product is launched the 5uic+er the research and development costs will be repaid2
providing the organisation with funds to develop further products.
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4. 4!plications of 5sing Life Cycle Costing
4.1 1raditional costing systems do not attempt to measure the profitability of a product
over its entire life.
4.2 $ife cycle costing compares the revenues and costs of the product over its entire life.
1his has many benefits.
.a/ 1he potential profitability of products can be assessed before !ajor
develop!ent of the product is carried out and costs incurred. Non1profit1
!aing products can be abandoned at an early stage before costs are
committed.
.b/ Techni)ues can be used to reduce costs over the life of the product.
.c/ Pricing strategy can be deter!ined before the product enters production.
1his may lead to better control of mar+eting and distribution costs.
.d/ .ttention can be focused on reducing the research and develop!ent phase
to get the product to mar+et as 5uic+ly as possible. 1he longer the company can
operate without competitors entering the mar+et the more revenue can be
earned and the sooner the product will reach the brea+even point.
.e/ *y !onitoring the actual perfor!ance of products against plans2 lessons
can be learnt to i!prove the perfor!ance of future products. t may also be
possible to improve the estimating techni5ues used.
4.3 ,n understanding of the product life cycle can also assist management with decisions
withK
.a/ 3ricingG
.b/ 3erformance managementG
.c/ Decision#ma+ing
4.4 Pricing. ,s a product moves from one stage in its life cycle to the next2 a change in
pricing strategy !ight be necessary to !aintain !aret share. Aor example2 prices
might be reduced as a product enters its maturity phases .and annual sales volume
stops rising/.
4.! Perfor!ance !anage!ent. ,s a product moves from one stage of its life cycle to
another2 its financial performance will change. ,anage!ent should understand that
an i!prove!ent or decline in perfor!ance could be lined to changes in the life
cycle and should therefore .to some extent at least/ be expected.
4.C 0ecision1!aing. n addition to helping management with decisions on pricing2 an
understanding of life cycle costing can also help #ith decisions about !aing ne#
invest!ents in the product .new capital expenditure/ or #ithdra#ing a product
fro! the !aret.
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'$a!ination &tyle 6uestions
6uestion 1 7 Life Cycle Costing and target costing
1raditional cost control systems focused on cost containment rather than cost reduction.
1oday2 cost management focuses on process improvement and the identification of how
processes can be more effectively and efficiently performed to result in cost reductions.
(e)uired*
Discuss how the cost management techni5ues of target costing and life cycle costing differ
from the traditional cost containment approach and how each see+s to achieve cost reduction.
.1; mar+s/
6uestion 2 7 Life Cycle Costing and .2C
$es 'aturniens ', ma+es digital watches. $es 'aturniens is preparing a product life cycle
budget for a new watch2 &L3. Development on the new watch with features such as a
calculator and a daily diary is to start shortly. $es 'aturniens expects the watch to have a
product life cycle of 3 years. Estimates about &L3 are as followsK
8ear 1 8ear 2 8ear +
:nits manufactured and sold !;2;;; 2;;2;;; 1!;2;;;
3rice per watch <4! <4; <3!
=>D and design costs ?;;2;;; 1;;2;;; #
&anufacturing
Iariable cost per watch <1C <1! <1!
Iariable cost per batch <@;; <C;; <C;;
4atches per batch 4;; !;; !;;
Aixed costs C;;2;;; C;;2;;; C;;2;;;
&ar+eting
Iariable cost per watch <3.C; <3.2; <228;
Aixed costs <4;;2;;; <3;;2;;; <3;;2;;;
Distribution
Iariable cost per watch <1 <1 <1
Iariable cost per batch <12; <12; <1;;
4atches per batch 2;; 1C; <12;
Aixed costs <24;2;;; <24;2;;; <24;2;;;
%ustomer service costs per watch <2 <1.!; <1.!;
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(e)uired*
.a/ %alculate the budgeted life cycle operating profit for the new watch.
.b/ 4hat percentage of the budgeted product life cycle costs will be incurred at the end of
the =>D and design stagesM
.c/ ,n analysis reveals that 8;E of the total product life cycle costs of the new watch will
be loc+ed in at the end of the =>D and design stages. 4hat implications would this
finding have on managing &L3-s costsM
.d/ $es 'aturniens- &ar+et =esearch Department estimates that reducing &L3-s price by
<3 each year will increase sales by 1;E each year. f sales increase by 1;E2 $es
'aturniens plans to increase manufacturing and distribution batch sizes by 1;E as well.
,ssume that all variable costs per watch2 variable costs per batch and fixed costs will
remain the same. 'hould $es 'aturniens reduce &L3-s price by <3M
6uestion + 7 Life Cycle Costing and 2udgeting
4argrin designs2 develops and sells many 3% games. )ames have a short lifecycle lasting
around three years only. 3erformance of the games is measured by reference to the profits
made in each of the expected three years of popularity. 4argrin accepts a net profit of 3!E of
turnover as reasonable. , rate of contribution .sales price less variable cost/ of @!E is also
considered acceptable.
4argrin has a large centralised development department which carries out all the design wor+
before it passes the completed game to the sales and distribution department to mar+et and
distribute the product.
4argrin has developed a brand new game called 'tealth and this has the following budgeted
performance figures.
1he selling price of 'tealth will be a constant <3; per game. ,nalysis of the costs show that at
a volume of 1;2;;; units a total cost of <13;2;;; is expected. (owever at a volume of 142;;;
units a total cost of <1!;2;;; is expected. f volumes exceed 1!2;;; units the fixed costs will
increase by !;E.
'tealth-s budgeted volumes are as followsK
8ear 1 8ear 2 8ear +
'ales volume 82;;; units 1C2;;; units 42;;; units
n addition2 mar+eting costs for 'tealth will be <C;2;;; in year one and <4;2;;; in year two.
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Design and development costs are all incurred before the game is launched and has cost
<3;;2;;; for 'tealth. 1hese costs are written off to the income statement as incurred .i.e.
before year 1 above/.
(e)uired*
.a/ Explain the principles behind lifecycle costing and briefly state why 4argrin in
particular should consider these lifecycle principles. .4 mar+s/
.b/ 3roduce the budgeted results for the game D'tealth- and briefly assess the game-s
expected performance2 ta+ing into account the whole lifecycle of the game. .? mar+s/
.c/ Explain why incremental budgeting is a common method of budgeting and outline the
main problems with such an approach. .C mar+s/
.d/ Discuss the extent to which a meaningful standard cost can be set for games produced
by 4argrin. 9ou should consider each of the cost classifications mentioned above.
.C mar+s/
.1otal 2! mar+s/
.,%%, A! 3erformance &anagement December 2;;8 N4/
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6uestion 4 7 Life Cycle Costing
, company manufactures &33 players. t is planning to introduce a new model and
development will begin very soon. t expects the new product to have a life cycle of 3 years
and the following costs have been estimated.
9ear ; 9ear 1 9ear 2 9ear3
:nits manufactured and sold 2!2;;; 1;;2;;; @!2;;;
3rice per unit <?; <8; <@;
=>D costs <8!;2;;; <?;2;;; # #
Production costs
Iariable cost per unit <3; <2! <2!
Aixed costs <!;;2;;; <!;;2;;; <!;;2;;;
Marketing costs
Iariable cost per unit <! <4 <3
Aixed costs <3;;2;;; <2;;2;;; <2;;2;;;
Distribution costs
Iariable cost per unit <1 <1 <1
Aixed costs <1?;2;;; <1?;2;;; <1?;2;;;
%ustomer service costs per unit <3 <2 <2
(e)uired*
.a/ Explain life cycle costing and state what distinguishes it from more traditional
management accounting techni5ues. .1; mar+s/
.b/ %alculate the cost per unit loo+ing at the whole lifecycle and comment on the price to be
charged. .@ mar+s/
.1otal 1@ mar+s/
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6uestion 9 7 Life Cycle Costing
4 has recently completed the development and testing of a new product which has cost
<4;;2;;;. t has also bought a machine to produce the new product costing <1!;2;;;. 1he
production machine is capable of producing 12;;; units of the product per month and is not
expected to have residual value due to its specialized nature.
1he company has decided that the unit selling prices it will charge will change with the
cumulative numbers of units sold as follows.
%umulative sales units 'elling price
< per unit in this band
; to 22;;; 1;;
22;;1 to @2;;; 8;
@2;;1 to 142!;; @;
142!;1 to !42!;; C;
!42!;1 and above 4;
*ased on these selling prices2 it is expected that sales demand will be as shown below.
&onths 'ales demand per month .units/
1 0 1; 2;;
11 0 2; !;;
21 0 3; @!;
31 0 @; 12;;;
@1 0 8; 8;;
81 0 ?; C;;
?1 0 1;; 4;;
1;1 0 11; 2;;
1hereafter "il
:nit variable costs are expected to be as follows.
< per unit
Airst 22;;; units !;
"ext 122!;; units 4;
"ext 2;2;;; units 3;
"ext 2;2;;; units 2!
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1hereafter 3;
4 operates a Oust#in#time .O1/ purchasing and production system and operates its business on
a cash basis.
, columnar cash flow statement showing the cumulative cash flow of the product after its
introduction and growth stages has already been completed and this is set out below.
ntroduction )rowth
&onths 1 0 1; 11 0 2; 21 0 3;
"umber of units produced and sold 22;;; !2;;; @2!;;
'elling price per unit <1;; <8; <@;
:nit variable cost <!; <4; <4;
:nit contribution <!; <4; <3;
1otal contribution <1;;2;;; <42!2;;;
%umulative .<4!;2;;;/ .<2!2;;;/
(e)uired*
.a/ %omplete the cash flow statement for each of the remaining two stages of the product-s
life cycle. Do not copy the introduction and growth stages in your answer. gnore the
time value of money. .! mar+s/
.b/ Explain2 using your answer to .a/ above and the data provided2 the possible reasons for
the changes in costs and selling prices during the life cycle of the product. .! mar+s/
.1otal 1; mar+s/
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