LIFECYCLE COSTING
INTRODUCTION
• Conventional costing attempts to work out the cost of producing an item incorporating
the costs of resources that are currently used or consumed.
• Therefore, for each unit made the classical variable costs of material, direct labor and
variable overheads are included (the total of these is the marginal cost of production),
together with a share of the fixed production costs.
• The fixed production costs can be included using a conventional overhead absorption rate
(absorption costing (AC)) or they can be accounted for using activity-based costing
(ABC).
INTRODUCTION
• However, whether conventional overhead treatment or ABC is used the overheads
incorporated are usually based on the budgeted overheads for the current period.
• Once the total absorption cost of units has been calculated, a mark-up (or gross profit
percentage) is used to determine the selling price and the profit per unit.
• One major flaw in these approaches is that, the costs incorporated are the current costs
only. They are the marginal costs plus a share of the fixed costs for the current accounting
period. There may be other important costs which are not part of these categories, but
without which the goods could not have been made.
INTRODUCTION
• Examples include the research and development costs and any close down costs incurred
at the end of the product’s life.
• Why have these costs been excluded, particularly when selling prices have to be high
enough to ensure that the product makes an overall profit for the company.
• To make a profit, total revenue must exceed total costs in the long-term. This flaw is
addressed by lifecycle costing.
LIFECYCLE COSTING
• Life-cycle costing refers to the system that tracks and accumulates every individual cost
which is incurred during the whole life cycle of a product starting from its initial planning
stage to the post sales service and abandonment stage.
• The term “product life-cycle” refers to the succession of stages a product goes through. It
is claimed that every product has a life-cycle.
PRODUCT LIFECYCLE
• 1. The development and introduction stage
• This stage includes business functions such as research and development and design. It is a
stage where significant costs are incurred in the development and research of the product.
• A high level of setup costs will be incurred in this stage (preproduction costs), including
research and development (R&D), product design, and the building of production facilities.
• At the introduction stage, the product begins to generate revenue because it is just introduced
to the market.
PRODUCT LIFECYCLE
• 2. The growth stage
• This stage encompasses critical business functions like production, marketing, and
distribution.
• Here, the product gains widespread recognition in the market. With a surge in demand, it
captures a larger market share and begins to yield profits. At this stage, cost of the initial
investment is progressively recovered.
• Achieving success hinges on consumers' awareness and trial of the product, prompting the
likelihood of incurring substantial marketing and promotional expenses during this phase.
PRODUCT LIFECYCLE
• 3. The maturity stage
• During the maturity stage, product demand stabilizes, and the growth rate decelerates.
Despite this, the product remains consistently profitable.
• Sales volume experiences a significant boost in this stage, accompanied by a decline in
unit costs as fixed costs are spread across larger volumes.
PRODUCT LIFECYCLE
• 4. The decline/saturation stage
• A point comes where large / adequate quantities of the product have been sold in the
market and the product, therefore, reaches a saturation point.
• At this stage the demand for the product starts to fall and marketing costs are cut down.
The product may start making loss at this stage.
• The organization may decide to discontinue the production and to develop a new product.
COSTS COMMITTED VS COSTS INCURRED
• A committed cost is a cost that will be incurred in the future because of decisions that
have already been made. The costs that have not yet been incurred but will be incurred in
the future on the basis of decisions that have already been taken.
• Studies show that about 80% of the life-cycle costs of a product are committed at its
development and introduction stage.
• Costs are incurred only when a resource is used.
• The actual cost of a product is built up mostly in the manufacturing stage and in the
service and abandonment stage.
COSTS COMMITTED VS COSTS INCURRED
LIFECYCLE COSTS
• The concept of Lifecycle costs is that all costs should be taken into consideration when
budgeting the cost of the product, setting the price of the product, and controlling costs
throughout the product’s lifecycle regardless of whether these costs are incurred before,
during or after the product is produced.
• Thus the lifecycle costs can be categorized into:
• 1. Pre-Production costs
• Product designing
• Research and Development costs
LIFECYCLE COSTS
• 2. Product Manufacturing Costs
• Material Costs
• Cost of Machinery
• Overheads
• 3. Operation costs
• Distribution, After sell services and warranty claims
• 4. Post Production Costs
• Environmental Clean up costs
• Dismantling costs
• Disposal and decommissioning.
LIFECYCLE COSTS AND TARGET COSTING
• From a previous session recall…….
• Target costing is a cost management tool that is aimed at reducing the life-cycle costs of
products, while ensuring quality, reliability, and other consumer requirements.
• Given the target cost is derived from a target price, and since the company is planning to
profit from the product over its lifetime, then the target cost of making the product should
be below or equal to the products lifecycle costs.
• Furter, given we have seen that most of the product lifecycle costs are committed costs
then lifetime costing when used with target costing is a powerful tool for cost control.
LIFECYCLE COSTS AND TARGET COSTING
• That is the company may design a product in a way that it results into less committed cost
or the committed costs are equal to target costs earlier in the process of product
designing.
• This enables the company to achieve its targeted profit margin over the entire product
lifecycle.
ILLUSTRATION
• A company is planning a new product. Market research information suggests that the
product should sell 10,000 units at Tsh 2100/unit. The company seeks to make a mark-up of
40% product cost. It is estimated that the lifetime costs of the product will be as follows:
• Design and development costs Tsh 5,000,000
• Manufacturing costs Tsh 1000/unit
• End of life costs Tsh 2,000,000
• The company estimates that if it were to spend an additional Tsh 1,500,000 on design,
manufacturing costs/unit could be reduced.
ILLUSTRATION
• Required:
• (a) What is the target cost of the product?
• (b) What is the original lifecycle cost per unit and is the product worth making on that
basis?
• (c) If the additional amount were spent on design, what is the maximum manufacturing
cost per unit that could be tolerated if the company is to earn its required mark-up?