LIFE CYCLE COSTING

16
Life cycle costing is an alternative approach to cost management.
While the other methods of cost management generally look at
the ‘post-production process commencement’ cost, Life-cycle
costing evaluates what a product or service will cost over its
entire life, from the conception through growth, maturity and to
its eventual conclusion.

The life-cycle cost of a product/ service includes the cost of development and design,
introduction, production, distribution, post sales service, product take-back and abandonment;
that is, ‘from cradle to grave’.

There are two concepts regarding the “Life-Cycle Costing”.

(i) Total cost of ownership
(ii) Product life cycle costing (Also referred as Sales Life Cycle Costing).

Total Cost of Ownership

Life cycle costing is a process to determine the sum of all the costs associated with an asset,
including acquisition (net of net realizable value), installation, operation, maintenance and
refurbishment costs,

Product Life Cycle Costing

“Products, like people, are mortal.” They get introduced, grow, mature and finally disappear.
The product Life cycle concept holds that all products have a life cycle. For taking the decision
regarding introducing a product, Life cycle costing accumulates the revenues and costs
associated with the various stages of a product’s life cycle.
The most important aspect to life cycle costing is the inclusion of all upstream and downstream
costs. The life cycle cost is the sum of all recurring and one-time costs over the full life span of
the product. The life cycle cost includes:
(i) R & D costs, designing costs, tooling cost, purchase cost, and installation cost,
(ii) Operating costs, maintenance and upgrade costs,
(iii) Selling and distribution costs, post-sales service costs including warranty costs, and,
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LIFE CYCLE COSTING 16.2
(iv) Abandonment costs (environment clean-up disposal and decommissioning costs) and
residual value at the end of its useful life.

life cycle costing is a complete movie of the product/ project and not just a snapshot.

Stages of Life Cycle

A product life cycle has 4 stages.
The first stage is the introduction stage. Under this stage the sales will be low and the
customers will know about the product. The main goal of this stage is to establish a market and
create primary demand for the product. The advertising costs are high under this stage. The
company suffers loss in this phase.

The second stage is the growth phase. Under this stage there will be a rapid growth in the sales.
Profit making starts in this phase.

The third stage is the maturity stage. It is described as top sales stage. Under this stage the
company is most profitable. The main concern is to maintain the market share and extend the
product life cycle.

The last stage is the decline stage. There is over capacity. Under this stage the market becomes
saturated and the product tends to become obsolete.

Stages Introduction Growth Maturity Decline

Sales Low Rapidly Rising Top sales Declining
Customers Innovators Early adopters Majority Laggards
Costs High ratio of Ratio of cost to Low ratio of cost Rise in the ratio
cost to sales sales declines to sales to sales
Profit Loss Rising Profit High Profit Declining profit
Competitors Few Rising number Majority Declining
number

Q1. Destin Products makes digital watches. Destin is preparing a product life-cycle budget for a
new watch MX3. Development on the new watch is to start shortly. Estimates for MX3 are as
follows:
Life-cycle units manufactured and sold 4,00,000
Selling price per watch ` 40
Life-cycle costs

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LIFE CYCLE COSTING 16.3
R&D and design costs ` 10,00,000
Manufacturing
Variable cost per watch ` 15
Variable cost per batch ` 600
Watches per batch 500
Fixed costs ` 18,00,000
Marketing
Variable cost per watch ` 3.20
Fixed costs ` 10,00,000
Distribution
Variable cost per batch ` 280
Watches per batch 160
Fixed costs ` 7,20,000
Customer-service cost per watch ` 1.50

Ignore the time value of money.

Calculate the budgeted life-cycle operating income for the new watch.

Q2. Activates have been identified and the budget quantifies for the three months ended 31
March 2001 as follows:
Activities Cost Driver Unit Units of Cost ` ’000)
Cost (`
basis Driver
Product Design Design hours 8,000 2,000 (See note 1)
Purchasing Production Purchase order 4,000 200
Machine hours 12,000 1,500 (See note 2)
Packing Distribution Volume (Cu. M) 20,000 400
Weight (Kg) 1,20,000 600
Note 1: this includes all design costs for new products released this period
Note 2: this includes a depreciation provision of ` 3,00,000 of which ` 8,000 applies to 3 months
depreciation on a straight line basis for a new product (NPD). The remainder applies to other
products.
New product NPD is included in the above budget. The following additional information applies
to NPD.
(i) Estimated total output over the product life cycle : 5,000 units (4 years life cycle)
(ii) Product design requirement : 400 design hours
(iii) Output in quarter ended 31 March 2001 : 250 units
(iv) Equivalent batch size per purchase order : 50 units

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LIFE CYCLE COSTING 16.4
(v) Other product unit data
Production time : 0.75 machine hours
Volume : 0.4 cu. Meters
Weight : 3 Kg

Prepare a unit overhead cost for product NPD using an activity based approach which includes
an appropriate share of life cycle costs using the information provided above.

Q3. A company proposes to replace its old and obsolete machine. Two models of machines
available are as under:
(i) Automatic machine involving an initial capital outlay of ` 5,00,000. The annual operating
cost of this model is ` 1,50,000. Salvage value at the end of its life of 5 years is ` 20,000.
(ii) Semi-automatic machine involving an initial capital cost of ` 3,00,000. The annual
operating cost is ` 2,10,000. Salvage value at the end of its life of 5 years is ` 10,000.
The company’s cost of capital is 14%. Which alternative is to be preferred? Ignore tax.

Q4. A company’s four products, M,N,O and P are in the market. Identify the phase of life cycle
for each product with a brief reason:
There is a lot of competition. Quantity sold has been increasing at 10%, 8% and 7%
M
in the last three years.
Until last year, N had no competition. Suddenly the company finds 4 new products
N
very similar to N in the market. However, N continues to have good sales
There is intense competition. Achieving targeted sales is becoming increasingly
O
difficult. Hence, the company is introducing slightly modified features in the market
Huge inventory of P is available. P is being sold, but there are many products in the
P
market which are priced lesser than P, but have the same utility as P.

Q5. The Board of Directors XY Co. Limited are considering a new type of handy sewing machine
which their R & D has developed. The expenditure so far on research has been ` 95,000 and a
consultant’s report has been prepared at a cost of ` 22,500. The report provides the following
information:

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LIFE CYCLE COSTING 16.5
Cost of production per unit:
Material ` 45.00
Labour ` 75.00
Fixed Overheads (Based on Company’s normal allocation rates) ` 20.00
` 140.00
Anticipated Additional fixed costs:
Rent for additional space ` 1,25,000 p.a.
Other additional fixed cost ` 70,000 p.a.

New machine will be built with the available facilities with a cost ` 1,10,000 (material ` 90,000)
and Labour ` 20,000). The materials are readily available in the stores which are regularly used.
However, these are to be replenished immediately. The price of these materials have since been
increased by 50%. Scrap value of the machine at the end of the 10th year is estimated at `
20,000. The product scraps generated can be disposed of at the end of year 10 for a price of `
1,43,000.

Years 1-5 Years 6-10

Demand (Units) Probability Demand (Units) Probability
40,000 0.15 24,000 0.30
20,000 0.60 16,000 0.50
12,000 0.25 4,000 0.20

It is estimated that the commercial life of the machine will be no longer than 10 years and after
tax cost of capital is 10%. The full cost of the machine will be depreciated on straight line basis
which is allowed for computing the taxable income, over a period of 10 years. Tax rate is 30%.
tax on scrap.

1-5 (cumulative) 6-10 (cumulative) 10th year

DCF factors at 10% → 3.79 2.355 0.386
Compute the minimum price for the handy sewing machine.

Q6. Quickcomp is a successful version of a software package that is widely used. Fastercomp is
the next version, for which the development is complete and it is ready to be sold immediately
in the market as budgeted. However, for Fastercomp, user manuals, training modules and
diskettes have not yet been made, whereas, for the Quickcomp version, these are overstocked
by 5,000 units, Release of Fastercomp version will render the Quickcomp version not saleable.
The following information is provided:
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LIFE CYCLE COSTING 16.6

Quickcomp Fatercomp
Selling Price per unit ` 14,000 19,000
Variable cost per unit ` (consisting of use manuals, training) 1,000 4,000
modules and diskettes
Development Cost per unit ` (total cost of development 7,000 10,000
spread over the expected sales quantity during the products’
life-cycle)
Marketing/Administration Cost per unit ` (Fixed budgeted 3,500 4,000
annual outflow divided by the expected sales quantity for
each product for the year)
Total Cost per unit ` 11,500 18,000
Operating Income per unit (`) 2,500 1,000

From a purely financial perspective, the company wants your advice whether to delay the
release of the new version by 2 months by when the inventory of the existing version would
have sold out or to release the new version immediately, Support your advice with relevant
figures.

STUDYATHOME.ORG CA. RAJ K AGRAWAL