Life Cycle Costing (LCC)

Product Life Cycle

Product Life Cycle Illustration

Life Cycle Costing means the accumulation of costs over a product's entire life.
Putting in a diagram form, a product life cycle should look like this:-
1. Development Phase
 Product is at research and development phase where costs are incurred but
no revenue would be generated yet.

 At research stage, it is unsure whether "product" would materialize.

 It's only when research is not successful, the life cycle will not begin.
2. Introduction Phase
 Introduction Phase Demand is extremely low as customers are unaware yet
about the existence of product/service.

 Advertisement and promotional activities are required to introduce

customers regarding the existence of product.

 Company needs to sustain initial losses due to high investment including

research and development costs and marketing expenses.

 Company may also sell at very low prices to penetrate into market.
(Be careful, penetration strategy can only be adopted by big player)
3. Growth Phase
 Demand is now showing a steady and rapid increase.

 Costs per unit for product is expected to beginning to fall due to reduction in
R&D expenditure and economies of scale (from greater production level).

 Objective at this stage is to gain and build market share.

4. Maturity Phase

 Market is now filled by the product introduced at earlier phase. Company will
expect sales to drop sooner when no actions are taken to maintain the market
share.

 Another important factor now is to reduce demand elasticity as when demand

is elastic, the only way to maintain market share is to keep reducing selling
rice.

 Differentiation is required.
5. Decline / Saturation Phase

 Market reaches saturation point, product's sales curve begins to decline.

 Normally, price wars will erupt now as companies compete to maintain full
utilization of their production capacity.

 Profit from this product is beginning to fall.

 Some companies may undertake innovation actions to boost the sales of the
product (creating another life cycle) or others may opt to exit the game.
Life Cycle Costing
Life Cycle Costing

 Life cycle costing Life cycle costing tracks and accumulates costs and
revenues attributable to each product over the entire product life cycle.
Life cycle costs would include:
 Research & Development costs — design, testing, production process and equipment

 The cost of purchasing any technical data required (e.g., purchasing the right from
another organization to use a patent)

 Training costs (including initial operator training and skills updating)

 Production costs

 Distribution costs - transportation and handling

 Marketing costs - Customer service, field maintenance, brand promotion

 Inventory costs (holding spare parts, warehousing and so on)

 Retirement and disposal costs -costs incurred for the run down/support of product
at end of product's life
Life Cycle Costing
 Life Cycle Costing is based on the concept of product life cycle.

 It argues that the full cost of a product is the sum of costs at all stages (from
development till decline) & not merely the Variable Production Cost & Fixed
Production Cost at current production situation.

 Therefore: Cost per unit = Total costs over the life cycle
Sales qty over the life cycle

 Various types of information are required to perform life cycle costing studies.

 These include the acquisition cost of the item, the useful operational life of the
item in years, the annual maintenance cost of the item, transportation (delivery)
and installation costs of the item, discount and escalation rates, the annual
operating cost of the item, taxes (e.g., tax benefits from depreciation,
investment tax credit), and the salvage value or disposal cost of the item
Characteristics of Life Cycle Costing:

a. Product life cycle costing involves tracing of costs and revenues of a product over
several calendar periods throughout its life cycle.

b. Product life cycle costing traces research and design and development costs and
total magnitude of these costs for each individual product and compared with
product revenue.

c. Each phase of the product life-cycle poses different threats and opportunities
that may require different strategic actions.

d. Product life cycle may be extended by finding new uses or users or by increasing
the consumption of the present users.
Features that make life cycle costing important:
 Non-production costs are high and usually not as visible as production costs. Using
life-cycle costing will ensure these non-production costs are considered in the
pricing process. (Indirectly to say — it increases the visibility of such non-
production costs).

 Product Research and Development usually involves long period of time.

Therefore, a significant amount is incurred even before any production begins and
before any revenues are received. In this connection, it is crucial for company to
have a accurate set of revenue and cost prediction for the entire product life
cycle in order to decide whether the company should commence the costly R&D
and design activities.

 Sometimes, costs may be incurred after the end of market life of a product, at
the declining stage. Meanwhile, the profit [contribution] per unit will also be
lower at this stage. Life-cycle costing ensures that these effects are considered
earlier & the cost per unit is more acceptable.
LCC Illustration
 Solaris specializes in the manufactures of solar panels. It is planning to introduce a new slim line
solar panel specially designed for small houses. Development of the new panel is to begin shortly
and Solaris is in the process of determining the price of the panel. It expects the new product to
have the following costs. 
 LCC Illustration Contd…..
 The Marketing Director believes that customers will be prepared to pay $500 for a
solar panel but the Financial Director believes this will not cover all of the costs
throughout the lifecycle.

 Required: Calculate the cost per unit looking at the whole life cycle and comment
on the suggested price.
Applications of Life Cycle Cost
selecting among competing bidders for a project;
long-range planning and budgeting;
controlling an ongoing project;
comparing competing projects;
deciding the replacement of aging equipment;
comparing logistics concepts.
forecasting future budget needs;
selecting the most effective procurement strategy;
formulating contractor incentives;
making strategic decisions and design trade-offs;
optimizing appropriate training needs;
choosing among options;
providing effective objectives for program control;
assessing new technology application;
carrying out source selections.
Advantages of LCC
 Disadvantages
 is time consuming;

 is costly;

 has doubtful data accuracy;

 is a trying task when attempting to obtain data for analysis.

Important points on LCC
 Many important points are associated with life cycle costing, some of which include:
 The main goal of life cycle costing is to get the maximum benefit from limited resources.
 Management plays a key role in making life cycle costing a worthwhile effort.
 Risk management is the essence of life cycle costing in general.
 The availability of good data is very important for good life cycle cost estimates.
 The life cycle cost model must include all program-related costs.
 There is a definite need for both the product manufacturer and the user to organize
effectively to control life cycle cost.
 There is a definite need to perform trade-offs among life cycle cost, design to cost, and
performance throughout the life of the program.
 Some surprises may still occur, even when the estimator is very competent.
 Life cycle costing is gaining importance as a method for performing design optimization,
making strategic decisions, conducting detailed trade-off studies, etc.
 A highly knowledgeable and experienced cost analyst may compensate for various database-
related difficulties.
How to Maximize the Returns ?

 Design costs out of products Between 70% to 90% of a product's life cycle costs
are determined by decisions made early in the life cycle, at the design stage
or development stage.

 Careful design of the product and manufacturing and other processes will
keep cost to a minimum over the life cycle.
How to Maximize the Returns ?
 Minimize the “time to market”:-

 'Time to market' is the time from the conception of the product to its
introduction to the market. Competitors watch each other very carefully
to determine what types of product their rivals are developing. If an
organization is launching a new product it is vital to get it to the market
place as soon as possible. This will give the product as long a period as
possible without a rival in the market place, and affected by delay in its
market introduction. It is not unusual for the product's overall
profitability to fail by 25% if the launch is delayed by six months. This
means that it is usually worthwhile incurring extra costs to keep the
launch on schedule or to speed up the launch
How to Maximize the Returns ?

 Minimise breakeven time (BET):-

 A short BET is very important in keeping an organization liquid. The sooner

the product is launched the quicker the research and development costs will
be repaid, providing the organization with funds to develop further products.
In life cycle costing, break even occurs when revenue from the product has
covered all the costs incurred to date, including design and development
costs.
How to Maximize the Returns ?
 Maximize the length of the life span Product life cycles are not
predetermined; they can be influenced by the actions of management and
competitors. For example some products lend themselves to a number of
different uses; this is especially true of materials, such as plastic, PVC,
nylon and other synthetic materials. The life cycle of these materials can be
extended by finding new uses for them. The life cycle of the material is
then a series of individual product curves nesting on top of each other as
shown below.
Service & life cycle Services have life cycles.
 The only differences with the life cycle of a product are that the R & D stages
will not usually exist in the same way.

 The different processes that go to form the complete service are important,
however, and consideration should be given in advance as to how to carry
them out and arrange them so as to minimize cost.

 Products that take years to produce or come to fruition are usually called
projects, and discounted cash flow calculations are invariably used to cost
them over their life cycle in advance.

 The projects need to be monitored very carefully over their life to make sure
that they remain on schedule and that cost overruns are not being incurred.
 LCC Benefits
 It helps management to assess profitability over the full life of a product, which in turn
helps management to decide whether to develop the product, or to continue making the
product.

 It can be very useful for organizations that continually develop products with a relatively
short life, where it may be possible to estimate sales volumes and prices can with
reasonable accuracy.

 The life cycle concept results in earlier actions to generate more revenue or to lower costs
than otherwise might be considered.

 Better decisions should follow from a more accurate and realistic assessment of revenues
and costs, at least within a particular life cycle stage.

 It encourages longer-term thinking and forward planning, and may provide more useful
information than traditional reports of historical costs and profits in each accounting period.
Life Cycle Costing Process:
 Life cycle costing is a three-staged process.
 The first stage is life cost planning stage which includes
 Planning LCC Analysis,
 Selecting and Developing LCC Model,
 Applying LCC Model and
 Finally recording and reviewing the LCC Results.

 The Second Stage is Life Cost Analysis Preparation Stage

 The third stage Implementation and Monitoring Life Cost Analysis.

Steps for LCC…

1. Determine time for each cost element.

2. Estimate value of each cost element.

3. Calculate Present Value of each cost element every year.

4. Calculate LCC by adding each cost element costs every year.

5. Analyze the result.

Example: New Fleet Vehicle Acquisition
Life Cycle Costs Fuel Car Electric Car
Purchase Price $17,000 $ 29,000
Fuel Usage (mpg) 24 126
Annual Fuel Costs $550
Average Maintenance $250 $200
Costs
Salvage Value $8,000 $10,000
Insurance per year $950 $800
Tax Rebate $0 $7500

Miles driven per year 25,000

Avg. Price per gallon $3
Discount rate 10 %
Inflation rate 3.5 %
Fuel Car
Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
Acquisition Costs -17000
Fuel costs $ 3,125.00 $ 3,234.38 $ 3,347.58 $ 3,464.74 $ 3,586.01
Maintenance costs $ 258.75 $ 267.81 $ 277.18 $ 286.88 $ 296.92
Insurance Costs $ 983.00 $ 1,017.41 $ 1,053.01 $ 1,089.87 $ 1,128.02
Total O & M costs $ 4,366.75 $ 4,519.59 $ 4,677.77 $ 4,841.49 $ 5,010.95
Federal Tax Rebate 0 0 0 0 0
Salvage Value $8,000

Annual Cash Flows $ (17,000.00) $ 4,366.75 $ 4,519.59 $ 4,677.77 $ 4,841.49 $ (2,989.05)

PV $ 17,000.00 $ 3,969.77 $ 3,735.20 $ 3,514.48 $ 3,306.81 $ (1,855.97)

Total LCC $ 29,670.29
Electric Car

Particulars Year 0 Year 1 Year 2 Year 3 Year 4 Year 5

Acquisition Costs $ (29,000.00)
Fuel costs $ 550.00 $ 569.25 $ 589.17 $ 609.79 $ 631.14 $ 653.23
Maintenance costs $ 200.00 $ 207.00 $ 214.25 $ 221.74 $ 229.50 $ 237.54
Insurance Costs $ 800.00 $ 828.00 $ 856.98 $ 886.97 $ 918.02 $ 950.15
Total O & M costs $ 1,604.25 $ 1,660.40 $ 1,718.51 $ 1,778.66 $ 1,840.91
Federal Tax Rebate $ 7,762.50 0 0 0 0
Salvage Value $10,000

Annual Cash Flows $ (29,000.00) $ (6,158.25) $ 1,660.40 $ 1,718.51 $ 1,778.66 $ (8,159.09)

PV $ 29,000.00 $ (5,598.41) $ 1,372.23 $ 1,291.14 $ 1,214.85 $ (5,066.15)

Total LCC $ 22,213.66
Decision….

 Fuel Car LCC= $ 29,670.29

 Electric Car LCC= $ 22,213.66

 Hence all the other factors considered equal , the company will prefer to
invest in Electric Car rather than Fuel car because of its low LCC.
VE and LCC

 VE helps in reducing the Products Life Cycle.

Example
 A company using machining equipment to manufacture a certain type of
engineering part is contemplating replacing it with a better version. Four
different pieces of machining equipment, manufactured by four different
manufacturers, are being considered for its replacement; their data are
presented in Table. Determine which of the four pieces of machining equipment
should be procured to replace the existing one in regard to their life cycle costs.
 Life Cycle Cost Analysis: Machining Equipment A
 The expected cost of failure ( Cfa) per year of machining equipment A is given by:
 Cfa =(2,000)*(0.08)= 160
 The Present Value, PVaf, of machining equipment A life cycle failure cost is expressed by

…………………………… Eqn.1

 Where,
 PVaf is present value of machining equipment A life cycle failure cost.
i is annual interest rate.
k is machining equipment’s expected useful life in years.
 By Substituting value in Eqn 1, We’ll get,


Therefore, PVaf = $ 1176.61

 Thus,
the life cycle cost of machining equipment A is given by,

LCCa= PCa+ PVaf+ Pvao

Where,
 LCCa is machining equipment A life cycle cost.
 PCa is machining equipment A procurement cost.

 On substituting the Value,

 LCCa= $ 3,00,000 + $ 1176.61 + $ 44,160.52
= $ 3,45,337.13
Now
 Similarly We will obtain,
Life Cycle Cost of Machining equipment B (LCb)= $ 322,808.62
Life Cycle Cost of Machining equipment C (LCc)= $ 339,165.37
Life Cycle Cost of Machining equipment C (LCd)= $ 409,175.09

 Thus, the life cycle costs of machining equipment A, B, C, and D are

$345,337.13, $322,808.62, $339,165.37, and $409,175.09, respectively. By
examining these values, it is concluded that machining equipment B should be
purchased because its life cycle cost is the lowest.